For any organisation, it is important to enjoy a sound and strong financial position. A sound financial position helps the business to meet up all the contingencies which can be anticipated or unanticipated. So, it is always preferable for the business to not distribute all the profits to the owners and rather some share of the profits should be kept aside by the businesses to meet any unforeseen liabilities that occur in the nearby future. The only way to make this possible is by making provisions and creating reserves out of the total profits that a business earns throughout the year. These can be set aside when the business prepares the final accounts at the end of that particular year. The terms provisions and reserves are very different with respect to their concept, purpose, usage, etc. Both of the terms can’t be used interchangeably.
What are Reserves?
Reserves are nothing but a certain amount of the profits and surpluses, which are kept aside to meet up the uncertainties in the future. Reserves are basically created to meet any unforeseen liabilities or losses that might occur in the future. Reserves are always created for specific purposes. Reserves can be utilized to buy any fixed asset, pay off dividends to the shareholders, for legal settlements, buy back shares, expansions, and many more. Reserve is a very important tool when it comes to regulating and safeguarding the soundness of the financial position of the firm. For any firm to enjoy the continuity or smooth flow of current business operations as well as to settle long-term liabilities, it is fundamental to create reserves. Following are some points that make the concept of reserves more understandable:
- Reserves are never created out of the actual or net profits but rather created out of the divisible profits.
- Creating a reserve in the firm does not fall under any legal obligation meaning thereby that these are created as per the choice and requirement of the firm. The firms willingly draw a certain amount of divisible profits every year so that it can be used in the time of need.
- Reserves can be put to many uses, like distributing dividends, writing off losses, facilitating working capital requirements etc., but can never be used to fulfil any liability or obligation, which is already known to the firm. It is there for unforeseen obligations.
- Whenever the amount accumulated in the form of reserves is invested in the securities outside and not internally, then it is called a ‘reserve fund’.
- Just like the capital invested in the business belongs to the proprietor, the profits also belong to them, and so is the amount kept aside from that divisible profits. So the treatment for the reserves is the same as the capital of the firm, i.e., shown in the liabilities side of the balance sheet.
According to William Pickles, “Reserves mean the amount set aside out of profits and other surpluses, which are not embarked in any way to meet any particular liability, known to exist on the date of the Balance Sheet.”
Accounting Treatment of Reserves
The amount kept aside cannot be used as a synonym to any of the expenses or losses for which it is being utilised, so it cannot get debited from the Profit & Loss account. Reserves, when created, do not cause any reduction in the net profits rather they are created out of the divisible profits meaning thereby it is only the appropriation of profit after ascertaining the net profits. Thus, the amount is debited to the Profit & Loss Appropriation account.
Importance of Reserves
The importance of reserves are as follows:
1. Helps in strengthening the financial position of the business:
Reserves are also known as ‘ploughing back of profits’ because rather than distributing all the profits and surplus to the shareholders or the board of directors, it is retained or invested back into the business. Using accumulated or undivided profits then becomes the source of internal financing for the expansion and growth of the business. Also, preserves are used for replacing old and obsolete assets and acquiring new fixed assets. The day-to-day working capital requirements can also be met using undistributed profits. So, it helps to maintain a sound and healthy financial health of the business as with the creation of reserves, firms and businesses become self-reliant and less dependent on finance sources from outside.
2. Equalisation of dividends over the years:
Disbursing dividends to the current shareholders is very important for any business or firm. For any company to maintain its goodwill in the market, it is imperative to pay timely dividends to the shareholders. Sustaining a uniform rate of dividend every year helps to attract potential shareholders to invest in the company. Slowly and gradually with time, the companies can also increase the dividend rate as the companies always have a backup of extra funds in the form of reserves. Thus, creating a reserve out of the profits and surplus helps the companies to achieve this objective of equalising the dividend over the years, as when the company experiences a shortage of funds to distribute timely dividends, then the required amount can be withdrawn from these reserves. Regular dividend payments and sound goodwill help to maintain a good relationship between the company and its shareholders.
3. Helpful in meeting the unanticipated loss or liability:
Reserves are helpful to meet the future losses and liabilities that occur all of a sudden. Every firm follows for research to find out the liabilities and losses, which they might have to face in the coming times, but firms and businesses may not always be able to predict all the liabilities or losses, which are about to happen in the near future. So, it becomes imperative for the firms to create reserves out of which future uncertainties can be fulfilled. Any particular type of abnormal loss or expense can be furnished using the reserves created for that particular purpose.
4. Furnish funds for the specific liability:
Firms do not always create general reserves with which all kinds of losses and obligations can be fulfilled, but sometimes they create reserves for specific or particular purposes as well. The best example of a specific reserve is ‘Debenture Redemption Reserve’, which is designated specifically for the payment of debentures. For instance, if the firm has issued debentures of ₹5 lakhs for 5 years, so after 5 years, the company will be in need of this specific amount for redeeming the debentures. So, consequently, the company can create a fund by depositing a fixed amount in it, drawn from the current year’s profits at the end of every year. So, finally, this accumulated fund can be utilized after 5 years for paying off the amount of debentures in lump-sum which otherwise could be difficult for the company to arrange at one time. Other examples of specific funds are Investment Fluctuation Fund, Workmen Compensation Fund, reserve for asset replacement, etc.
5. Keeping Working Capital and Long term funds intact:
Reserves keep the working capital intact and increase the availability of funds for working capital. In emergent and unforeseen situations, enterprises can utilize the amount kept aside to meet day-to-day requirements. So, it improves the operational efficiency of the firm. Creating reserves not only helps the firms to meet up working capital requirements but can also be put to use when it comes to arranging funds for long-term expenses.
Creation of Reserve
Reserves are never created out of the actual or net profits but rather created out of the divisible profits. The following illustration will explain how reserves are created.
Illustration:
There is a corporation named GFG Rollers Corp., and the main business of this corporation is to manufacture rollers and blades for industries for their production purposes. In the year 2021, GFG Rollers Corp. earned a profit of ₹2,35,000 through its business operations. The dividend payout ratio for the year 2021 has been decided at 30% to be paid to the shareholders. Also, the board of directors of the Corporation has proposed to keep aside 20% of net profits under the head of General Reserves. There already exists a fund for General Reserves with ₹10,000 in balance and a balance of ₹1,00,000 in Surplus. Find out the amount of Reserves and Surplus at the end of the year, 2021.
Solution:
i) For Dividend Reserve at the end of the year 2021,
Net Profits = ₹2,35,000
Dividend declared = 30%
Dividend Reserve = Net profits x Dividend payout ratio
Dividend Reserve =
Dividend Reserve = ₹70,500
ii) For General Reserve at the end of the year 2021,
Net Profits = ₹2,35,000
Opening General Reserve = ₹10,000
General Reserve = Opening Balance + % of net profits transferred to general reserves
General Reserve =
General Reserve = ₹10,000 + 47,000
General Reserve = ₹57,000
iii) For Surplus at the end of the year 2021,
Net Profits = ₹2,35,000
Opening Surplus = ₹1,00,000
Surplus = Opening Balance + Net profits – % of net profits transferred to general reserves – Dividend Reserve
Surplus = ₹1,00,000 + ₹2,35,000 – ₹47,000 – ₹70,500
Surplus = ₹2,17,500
For Reserves and Surplus at the end of the year 2021,
Reserves and Surplus = Dividend Reserves + General Reserves + Surplus
Reserves and Surplus = ₹70,500 + ₹57,000 + ₹2,17,500
Reserves and Surplus = ₹3,45,000
Thus, the total balance for the Reserves and Surplus at the end of the year 2021 stands at ₹3,45,000.