Reserves and Surplus Meaning
Reserves and Surplus are all the cumulative amount of retained earnings recorded as a part of the Shareholders Equity and are earmarked by the company for specific purposes like buying of fixed assets, payment for legal settlements, debts repayments or payment of dividends etc.
Types of Reserves and Surplus on Balance Sheet
#1 – General Reserve
A general reserve is also known as a revenue reserve. The amount kept separately by an entity from its profits for the future purpose is known as revenue reserves. It is simply the retained earnings of an entity kept aside from the entity’s profits for meeting certain or uncertain obligations.
#2 – Capital Reserve
Capital Reserve refers to a part of the profit which is kept by an entity for a specific purpose like providing for financing long-term projects or writing off any capital expenses. This reserve is created from any capital profit of an entity that is the profit earned from profit other than the core operations of a business.
#3 – Capital Redemption Reserve
Capital Redemption Reserve is created out of the undistributed profits that are general reserve or the Profit and loss account on the redemption of preference shares or during buyback of own shares to reduce the share capital.
#4 – Dividend Reserve
Dividend reserve is the amount that is kept in a separate account for ensuring that a similar amount of the dividend is declared every year.
Example of Reserves and Surplus
Let’s take the example of a Corporation named Computer Web Inc. which is doing the business of computers and laptops. The earnings of the corporation from its normal course of the operation during the financial year 2017–18 were $ 500,000. It is decided by the management of the company to keep aside 8 % of the profits earned during the financial year for meeting future liabilities i.e., for General Reserve and corporation has issued shares for which they have received premium amounting to $ 25,000.
Also, the amount present in capital redemption reserve and dividend reserve amounted to $ 14,000 and $ 19,000 respectively during the same period. Now we need to calculate the total amount of reserves and surplus which is the sum of the general reserve, share premium account, capital redemption reserve and dividend reserve.
Total Amount of Reserves and Surplus = $40,000 ($500,000 * 8%) +$25,000 +$14000 + $19,000 = $98,000
- Reserves are considered to be the vital source of financing by internal means. So when the company is in the need of funds for its business activities and for meeting the company’s obligations the first and the easiest possible way to get funds is from the accumulated general reserves of the company.
- With the help of reserves, the company can maintain its working capital requirements as the reserves can be used to contribute towards working capital at the time of the insufficiency of funds in the working capital of the company.
- One of the main advantages of having reserves and surplus is to overcome the future losses of the companies as the time of losses reserves can be used to pay off the existing liabilities.
- Reserves are the main source of the amount required for dividend distribution available. It helps in maintaining the uniformity in the dividend distribution rate by providing the amount required for maintaining the uniform rate of the dividend when there is a shortage of amount available for distribution.
- If the losses are incurred by the company and the same are adjusted/set-off with the reserves of the company then this will somehow lead to the manipulation of accounts as the correct picture of the company’s profitability will not be shown to the users of the financial statements.
- The general reserves that constitute the major part of reserves and surplus are not created for any specific purpose but for the general use so there are chances that there can be misappropriation of funds accumulated in general reserves by the management of the company and there is a possibility that the funds will not be used properly for business expansion.
- The Creation of more reserves by the company may lead to a reduction in the distribution of dividend to the shareholders of the company.
Important Points about Reserves and Surplus
- The utilization of the reserves and surplus includes purposes such as dividend distribution, meeting future obligations, overcoming losses, managing working capital requirements, fulfilling funds requirement for expansion of business, etc.
- It is required for the company to maintain reserves sometimes in cash to manage the reduction in revenues and slow-paying customers. Generally, the maintenance of cash reserves depends upon the type of business of the company.
Reserve and surplus created by the company are the reserves which company can utilize for the purpose according to nature or the type of such reserve and surplus. Generally these reserves are created by the company for the purpose of settling any of unknown future contingencies they may arise, for strengthening and increasing company’s financial position in the market, paying of the dividends to all the shareholders of the company, increasing working capital in the company etc. after fulfilling all the conditions required for that reserve. Sometimes reserve and surplus are maintained in cash to manage the reduction in revenues and slow-paying customers.
This has been a guide to what is Reserves and Surplus and its meaning. Here we discuss different types of reserves and surplus on the Balance Sheet along with an example. we also discuss its advantages and disadvantages. You can learn more from the following articles –