Making reserves will allow you to set aside money to utilise later to pay for any unforeseen losses or damages. By putting safeguards for unexpected circumstances in place, it improves the company's financial situation and aids in the redemption of long-term obligations like debentures.
An amount set aside from a company's operating profits is called the general reserve, which is part of the profit & loss account. Specifically, appropriation accounts for contingencies, improving the company's financial position, boosting working capital, providing dividends to shareholders, offsetting particular future losses, etc.
Did you know?
The decision to establish a general reserve in final accounts depends only on the management's policy. The auditor is unrelated to this.
What do You Understand by General Reserve?
These are the undesignated reserves that are produced from revenue profits. In other words, these general reserves are kept on hand to cover the company's potential future liabilities. Such reserves may also be used to strengthen or improve the company's financial situation as their intended uses are not indicated. These reserves are used for general reasons at the management's discretion. Some of the uses for which the general reserve in final accounts may be put to use are listed below:
- To improve the company's financial standing.
- To cover unforeseen costs or losses.
- To offer a means of business expansion.
General reserves are established with no particular goal in mind and have several potential uses for the company. It is also referred to as a "free reserve," which means that a company can only develop a general reserve in accounting when it has achieved enough profit. Creating a general reserve in the balance sheet is not a requirement for a corporation.
However, suppose a firm's articles of association contain a provision requiring a specific amount of its profits to be transferred to the general reserve account before being distributed to shareholders. In that case, the corporation must set aside a portion of those profits for the general reserve in final accounts.
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The Importance of General Reserves in Accounting.
Due to the potential advantages reserves have for a business, accountants must comprehend them. Reserves can aid a business in maintaining a sound financial position. Your business' reserves can be compared to savings accounts or safety nets that allow managers to deal with unplanned and unpredictable expenses. This can prevent unexpected costs from posing problems for your company that could have been avoided.
When a company encounters a loss, it can use its reserves to cover that loss, debts, bonuses, and other obligations. Additionally, reserves can be used to assist pay for both short-term and long-term projects. In the end, reserves may help a corporation maintain its financial stability.
Objectives of General Reserve in Financial Statements
The aims of building a general reserve are as follows:
1. To provide the company with an extra source of working capital.
2. To establish a fund to cover liabilities and unforeseen contingencies.
3. To equalise the regular dividend without a reserve account for dividend equalisation.
4. Increasing the company's liquidity.
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Auditor's Responsibility to Examine General Reserves in Accounting
While conducting an audit the Auditor must ensure that a general reserve is established in the company's best interests and is accurately displayed on the balance sheet while conducting an audit. Further, they should make the following considerations as they check the general reserve:
1. The auditor must guarantee that the general reserve is established in the company's best interests.
2. They should note that the general reserve is established under the company's articles of association. They shall also check to determine if the articles' requirement about the establishment of a public reserve in financial statements has been followed.
3. They should ensure that the balance sheet's general reserve is derived from actual profits as indicated by the balance sheet.
4. They should make sure that the sum drawn for the objective is separately indicated whenever any portion of the general reserve is used to pay dividends.
5. It is the auditor's responsibility to ensure that any investments made by the general reserve in outside securities are disclosed on the assets side of the financial statements.
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Is it Compulsory to Create a General Reserve?
The phrase "free reserve" is another name for general reserves. The Companies Act states that a general reserve should only be established when an enterprise is making enough money. Thus, it is evident that the creation of the general reserve in final accounts is not mandatorily required.
However, the money should be transferred to the General Reserve Account if the Articles of Association stipulate that a certain sum must be set aside from profits before dividends are paid out. On the liabilities side of the balance sheet, the general reserve account will be displayed.
Examples of General Reserve in Final Accounts
The company, Mobile Web ltd., operates in the mobile industry. In the fiscal year 2018–19, it generated a profit of ₹7,500,000 through regular business operations. The company's management decided to set aside 10% of the fiscal year's income to cover future liabilities rather than for any particular reason. What kind of general reserve is the company building, and where will it appear on the company's balance sheet?
In the instance above, the corporation set aside ₹750,000 (₹7500000 * 10%), or 10% of the income, from its regular operations for the entire fiscal year.
This general reserve will be included in the appropriation account for profit and loss. The liabilities side of the company's balance sheet will be displayed under the head's reserves and excess. So, this is an illustration provided by the company.
Advantages of General Reserve in Financial Statements
It serves as the primary internal source of financing. They so contribute the resources and money needed for the company to expand its operations and pay its future obligations, strengthening its financial position.
Overcoming potential losses shortly is one of the key advantages of building a general reserve on the balance sheet. Therefore, a corporation can use its available reserves to pay down its current liabilities in the event of losses. Reserves add to the working capital if there is a financial shortfall, which helps the company maintain the necessary working capital.
The corporation establishes a new account using the reserves that are currently on hand. It facilitates the replacement of useless and out-of-date assets with capital equipment without the need to borrow money from external sources.
Dividend payments may be made using the funds that are currently in the general reserve in accounting. If there are insufficient funds for the dividend distribution, but the corporation still wishes to maintain a consistent payout rate, then the money can be taken out of general reserves.
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Disadvantages of General Reserve in Final Accounts
If a corporation experiences losses during a fiscal year and has a general reserve on hand, it will use that reserve to offset those losses. The user of the accounting records won't see the complete picture. The general reserve will help the company's financial status to look better than it does for the period under review.
There is a danger that the company's management won't appropriately use the general reserve in accounting because the reserve was not established for a specific purpose. The money might have been improperly used. The corporation uses the profits realised throughout the period to construct the general reserve. The rate of the dividend is lowered as a result.
Conclusion:
The free reserve is one such internal source of finance that, when specific requirements are met, the corporation may use for any reason. The company's financial position may be improved, and working capital could be increased, dividends could be paid to shareholders, potential future losses could be offset, etc.
They give the resources and money needed for the firm to expand its operations and satisfy its future obligations, so strengthening its financial position. No specific proportion is specified anywhere for the formation of the general reserves by the company. How much reserve the corporation wishes to build up is entirely up to it.
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