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