Reserves

Reserves

A business does not always distribute all its profit to the owners. A part of the profit may be set aside and retained in the business to provide for certain future needs. These needs could be growth and expansion, or they could be future contingencies such as workmen compensation. The portion of profit so retained is called a reserve.

Unlike provisions, reserves are appropriations of profit. They are created to strengthen the financial position of the business, not to cover a known liability or an expected loss. A reserve is not a charge against profit — it is an allocation of profit that has already been earned. Because the profit is retained in the business rather than distributed, the amount available for distribution among the owners (proprietors or shareholders) is reduced.

On the balance sheet, reserves are shown under the head Reserves and Surpluses on the liabilities side, after Capital.

Examples of Reserves

• General reserve
• Workmen compensation fund
• Investment fluctuation fund
• Capital reserve
• Dividend equalisation reserve
• Reserve for redemption of debentures

Accounting Treatment

When a reserve is created, the profit is transferred from the Profit & Loss Appropriation Account to the reserve account. The journal entry is: