Accountancy · Ch 1 — Depreciation, Provisions and Reserves
Importance of Reserves
Importance of Reserves
Why Reserves Matter
A business does not exist only to earn profit in the current year. It must also prepare for the future — for unexpected losses, for growth, and for repaying long-term debts. Reserves are the tool that makes this possible.
When a firm earns profit, it has a choice: distribute the entire profit to the owners as drawings/dividends, or keep a part of it inside the business. The portion that is kept back is called a reserve. This is not a loss or an expense — it is an appropriation of profit. The business is voluntarily choosing to reduce the amount available for withdrawal so that it can strengthen itself.
The textbook gives three clear purposes for which reserves are created:
- Meeting a future contingency — an unexpected expense or loss that may arise later (e.g., a lawsuit, a natural disaster, a sudden fall in demand).
- Strengthening the general financial position — having more cash and liquid assets makes the business more stable and creditworthy.
- Redeeming a long-term liability — for example, setting aside money each year so that when debentures mature, the business has the funds to repay them without strain.
Reserves are created out of profits (credit balance in the Profit & Loss Account). They are not a charge against profit — they are an appropriation of profit. This means they reduce the amount of profit available for distribution to owners, but they do not reduce the profit figure itself.
Accounting Treatment
When a reserve is created, the journal entry is:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| Profit & Loss Appropriation A/c ……… Dr. | xxx | |||
| To General Reserve A/c | xxx | |||
| (Being profit transferred to General Reserve) |
The debit goes to Profit & Loss Appropriation Account (not the Profit & Loss Account). This is because the Profit & Loss Account shows the net profit or loss from operations. The appropriation — deciding how that profit is used — happens in the Appropriation Account. The credit goes to the Reserve Account, which appears on the liabilities side of the Balance Sheet under 'Reserves and Surplus'.
Key Distinction: Reserve vs. Provision
| Basis | Provision | Reserve |
|---|---|---|
| Purpose | Known liability/expense (amount uncertain) | Strengthening business / future contingencies |
| Created from | Charge against profit (debited to P&L A/c) | Appropriation of profit (debited to P&L Appropriation A/c) |
| Effect on profit | Reduces net profit | Reduces distributable profit only |
| Necessity | Required by law/prudence | Voluntary (except for some statutory reserves) |
| Can be used for dividends? | No | Yes (if not specifically earmarked) |
A common mistake in exams is to treat a reserve as an expense. It is not. A provision reduces the profit figure itself; a reserve only reduces what the owners can take home. The net profit remains the same — only the appropriation changes.