What is General Reserve? | Advantages, Disadvantages and Sources

What is General Reserve?

General reserve is referred to as the reserve that is created by keeping aside the profits that the company earned in the normal course of the business of any accounting period for fulfilling various business needs, like enhancing the working capital, payment of dividends to the shareholders, meeting various kinds of other contingency, etc.

General reserves are free reserves. It means that the companies are not legally obligated to form it, and can form a general reserve when there are sufficient profits earned by the business in an accounting period. However, if the Articles of Association (AoA) of the company state that the particular amount is to be transferred into the general reserve account before sharing the profits among shareholders, then the company must comply with the necessary rules. General reserves are formed without any specific purpose and can be used to offset any contingency. General reserves are shown in Reserves and Surplus head under the Liabilities side.

Advantages of General Reserve

1. Multi-purpose Reserves: General reserves are not rigid as specific/special reserves. So it can be used to overcome any type of contingency which may arrive at the workplace. Paying dividends to shareholders, working capital requirements, etc., can be settled using these reserves.

2. Additional Source: It helps as an additional source of working capital for the company, in case any situation of its usage does not arise. This improves the financial position of the company and strengthens and accelerates the overall growth of the company. It can be used to buy some assets if necessary, and/or pay off any liabilities if necessary.

3. Contingency: General reserves helps the company to offset the losses which occur due to various contingency which tends to occur in the dynamic world. Every company is affected by various kinds of business risks arising from micro, macro, external and internal environments, which can affect any division of the company.

4. No Need of Borrowing from External Sources: Company does not need to take any loan or ask some external lenders for finance in such circumstances. The procedure of obtaining financial help from external sources can be very hectic and costly, so it’s better to have internal help.

5. Emergency Fund: General reserve can act as an emergency fund that a company can use to offset unwanted losses and can also be used as finance in emergency situations.

Disadvantages of General Reserve

1. No Transparency: It does not show the true and fair position of the business, and it gets recorded under the liabilities parts of the balance sheet even though it is a part of the profits.

2. Less Dividend to Shareholders: The creation of general reserves leads to less dividend income to the shareholders, and the amount of reserves get deducted before distributing the profits to shareholders.

3. Mismanagement of Funds: As the general reserve is created without any purpose, the chances of them getting misused are higher than the specific reserves.

4. Idle money: If there never arises any situation where the company can use the general reserve in an accounting period, money will stay idle. Decisions like less dividends to shareholders, appropriation of profits, revaluation of assets, etc., can be questioned if the general reserve is not utilised in an accounting period.

Sources of Creating General Reserve

General reserves refer to the funds set aside by the company to strengthen its financial position and offset anticipated losses. Some most common ways of creating general reserves include:

1. Retained Earnings: Accumulated profits generated over time by the company, which were not distributed among shareholders, can be used to create general reserves. This is the excess money that the company set aside to offset any kind of expenses and can be used to create general reserves.

2. Surplus from Operations: Utilisation of any surplus amount left in the hands of the company, after meeting all the operational expenses, can be used to create the general reserve.

3. Appropriation of Profits: Allocating a portion of annual profits to the creation of general reserves is one more method of it. Specifying the rate or portion of profits to be set aside for general reserves leads to uniformity of general reserves in the Balance Sheet.

4. Revaluation of Assets: Increasing the value of assets in the balance sheet can leave more space for general reserve in the balance sheet.