What is the General Reserve?
General Reserve is the amount kept aside from the profit earned by the company during its normal course of the operation to meet future needs. I.e., like contingencies, strengthening the company’s financial position, increasing working capital, paying dividends to the shareholders, offsetting specific future losses, etc. General Reserve is considered to be part of the profit and loss appropriation accountAppropriation AccountAn appropriation account shows how the firm's net profit is divided, i.e., how much goes to pay income taxes, how much goes to shareholders as a dividend, and how much goes to retained earnings. The partnership firm, the Limited Liability Company (LLC), and the government are primarily prepare it..
Generally, it is used to meet future uncertainties like future losses of the business, future litigations, etc. and there is no prescribed percentage for the creation of reserves. It is on the company’s discretion how much reserve it wants to accumulate. In case of losses, reserves are not created by the company. They are shown in the head ‘reserves and surplus’ on the liabilities side of the balance sheet.
Example of General Reserve
Company Mobile Web ltd. is doing the business of mobiles. During the financial year 2018 – 19, it earned a profit of $100,000 from its normal course of the operation. It is decided by the management of the company to keep aside 10 % of the profits earned during the financial year for meeting future liabilities and not for any specific purpose. Which reserve the company is creating and where it will be shown in the balance sheet of the companyBalance Sheet Of The CompanyA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.?
In the above case, the company kept aside 10 % of the profits, i.e., $ 10,000 ($100,000 * 10%) earned from its normal course of the operation during the financial year without any specific purpose. So this is an example the company has made. This general reserve will be considered as part of the profit and loss appropriation account of the company. It will be shown under the head ‘reserves and surplus’ on the liabilities side of the balance sheet of the company.
Advantages of General Reserve Accounting
Some of the advantages are as follows:
- It is the primary source of financing through internal meansSource Of Financing Through Internal MeansInternal Sources of Finance are the income sources that a Company generates from within itself to cover its operating expenses or accumulate cash for investment & growth. These include Sales-generated revenue, Retained Profits, & Controlling/Reduction of working capital. . So they provide resources and the funds required for the expansion of business activities and meeting with the future obligations of the company, thereby improving the financial position.
- One of the significant benefits of creating a general reserve is to overcome the losses which may occur shortly. So at the time of losses, a company can pay off its present liabilities with the help of general reserves.
- Reserves help in maintaining the required working capital in the company as it contributes towards the working capital in case there is any shortage of funds in the working capital.
- With the help of general reserves, an account is created by the company. It helps to replace uselessly and obsolete assets with the new assets without the requirement of borrowing funds from the outside.
- The amount available in the general reserve account can be used for the distribution of dividends. If the company wants to maintain a uniform rate of dividends, then in case if there is a lack of funds for the distribution of dividends, the amount can be withdrawn from the general reserves.
Disadvantages of General Reserve
Some of the disadvantages are as follows:
- In case the company incurs losses during a financial year, and it has an existing general reserve, the company will set off its losses using the general reserve available. It will not show the exact picture to the user of the financial statementsUser Of The Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers. as with the help of the general reserve, the company’s financial position will show a better picture than it is for the period under consideration.
- As there is no specific purpose for which the general reserve is created, so there exist the chances that the reserve will not be adequately utilized by the management of the company. There could be a misappropriation of the funds.
- The company creates the general reserve available, out of the profits earned during the period. It results in a reduction in the rate of the dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity..
The different vital points are as follows:
- It is the reserve created by the company without any specific purpose using the profit generated during the period and is kept aside by the company for meeting future liabilities.
- The company can utilize the general reserves for various purposes, such as settling any of the unknown future contingencies, for strengthening the company’s financial position, increasing working capital, paying dividends to the shareholders, offsetting some of the specific future losses, etc.
- As the amount of general reserve is accumulated to meet the future obligations of the company, so it helps in improving the financial position by helping the company to meet the uncertain financial contingencies.
- There is no prescribed percentage mentioned anywhere for the creation of the general reserves by the company, and it is on the company’s discretion that how much reserve it wants to accumulate.
- The company creates them only in case it earns the profit during the period, and in case if there arise the losses in the business, then the reserves are not created by the company.
It is the free reserves that the company can utilize for any purpose it requires after fulfilling certain types of conditions. E.g., settling any of the unknown future contingencies, for strengthening the company’s financial position, increasing working capital, paying dividends to the shareholders, offsetting some of the specific future losses, etc. They provide resources and the funds required for the expansion of business activities and meeting with the future obligations of the company, thereby improving the financial position. There is no prescribed percentage mentioned anywhere for the creation of the general reserves by the company. It is on the company’s discretion on how much reserve it wants to accumulate.
This article has been a guide to what is a general reserve and its meaning. Here we discuss the example of the general reserve accounting along with advantages and disadvantages. You can learn more about accounting from the following articles –