Reserve: Definition

A reserve is a component of profit that is not distributed to the business owners but retained in the business.

Reserve: Explanation

If all profit that a company makes is credited to the partners’ current accounts, the partners would be entitled to withdraw it in cash from the firm’s coffers. This can seriously affect the company’s operations.

It is important to understand that making a profit and having surplus cash are two different things. A firm may make a decent profit and may still not have adequate cash to pay partners.

Profits usually get reinvested in a business through increased assets, mainly current assets like stocks and receivables.

Even in a business that’s run strictly on cash terms, allowing partners to withdraw all the company’s profits would mean no possibility of any growth in the volume of business in the future.

It is, therefore, considered prudent not to distribute the entire amount of profit made in a year among the partners. Instead, a part of the profit is retained in the business for its growth and continued existence.

This is achieved by means of opening a Reserve Account.

After the net profit for a particular year has been ascertained (i.e., after the Profit and Loss Account has been prepared), that portion of the net profit which is agreed to be retained in the business is:

  • Debited to the Profit and Loss Appropriation Account
  • Credited to the Reserve (or General Reserve) Account

The effect of this entry is two-fold:

First, the amount of net profit distributable among the partners is reduced. Thus, a smaller amount of profit is credited to the partners’ current accounts.

In turn, this means that partners are prevented from withdrawing the entire net profit in cash from the firm’s coffers.

Second, a new account, the General Reserve Account, is created, which has a credit balance and is shown in the Balance Sheet just next to fixed capital accounts.

However, the account always remains available for distribution among the partners whenever the partners decide to do so.

It is important to note that the creation of a reserve is simply an appropriation of profits; it does not imply an actual transfer of funds from the business bank account to a new account.

Once a Reserve Account has been opened, it can be increased (or reduced) in subsequent years through Profit and Loss Appropriation Account, as the partners may agree.

Frequently Asked Questions

How is a general reserve in partners' capital account transactions recorded?

The accounting for this type of transaction will vary depending on the type of accounting an organization uses. In a single-entry Bookkeeping system, a journal entry would be made in which the general reserve, sometimes called "amounts not distributed," would be credited with a debit to either Retained Earnings or to a general clearing account.

What is the balance of general reserve in partners' capital account?

The balance of the general reserve in partners aapital account represents total amount that has been withheld from distribution to owners as part of net income. While this figure will usually be zero, it can also be non-zero if not all of the income earned through a business' operations is distributed to its owners each year.

Why would general reserve in partners' capital account be used?

General reserve in partners capital accounts are often utilized when businesses do not distribute all of their net revenue as dividends or distributions. In such cases, a reserve account may be introduced, which then collects the money that the owners would otherwise receive. The general reserve in partners capital account is then debited with an appropriate entry to account for this withholding, which will reduce the amount of dividends paid out.

What are examples of when general reserve in partners' capital account can be used?

General reserve in partners capital accounts are often used by businesses that do not distribute all of their income as dividends. In such cases, a reserve account may be utilized, allowing the business to collect money that would otherwise be distributed to owners and shareholders.

What is the purpose of general reserve in partners' capital account?

The general reserve account is used by businesses that retain part of their net profits and need a way to track the total amount of Retained Earnings made over the course of several accounting periods. This account provides owners with an accurate view of how much money has been withheld in each period, while also allowing for adjustments when they are made available in later time frames.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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