What is the General Reserve?

General Reserve is part of the profit and loss appropriation account. General Reserve is the amount kept aside from the company’s profit during its normal operation to meet future needs. I.e., contingencies, strengthening the company’s financial position, increasing working capital, paying dividends to the shareholders, offsetting specific future losses, etc. 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.read more.

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 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’s 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 operation. The management of the company decides to keep aside 10 % of the profits earned during the financial year for meeting future liabilities and not for any specific purpose. Which reserve is the company creating, and where will it 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.read more?

In the above case, the company kept aside 10 % of the profits, i.e., $ 10,000 ($100,000 * 10%) earned from its normal operation during the financial year without any specific purpose. This general reserve will be considered as part of the profit and loss appropriation account. It will be shown under the head’s reserves and surplus on the liabilities side of the company’s balance sheet. So this is an example the company has made.

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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. read more. So they provide resources and the funds required for the expansion of business activities and meeting the company’s future obligations, thereby improving the financial position.One of the significant benefits of creating a general reserve is overcoming the losses that may occur shortly. So at the time of losses, a company can pay off its present liabilities with the help of available reserves.Reserves help maintain 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 available reserves, the company creates an account. It helps to replace useless and obsolete assets with new assets without the requirement of borrowing funds from the outside.The amount available in the general reserve account can be used to distribute dividends. If the company wants to maintain a uniform rate of dividends, then 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:

  • If the company incurs losses during a financial year and has an existing general reserve, it will offset its losses using the available general reserve. 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.read more. With the help of the general reserve, the company’s financial position will show a better picture than it is for the period under considerationAs there is no specific purpose for which the general reserve is created, there exists the chance that the management of the company will not adequately utilize the reserve. There could be a misappropriation of the funds.The company creates the general reserve available from 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.read more.

Important Points

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 available reserves for various purposes, such as settling any unknown future contingencies, strengthening the company’s financial position, increasing working capital, paying dividends to the shareholders, offsetting some specific future losses, etc.As the amount of available reserve is accumulated to meet the company’s future obligations, it helps improve the financial position by helping the company meet the uncertain financial contingencies.There is no prescribed percentage mentioned anywhere for the creation of the available reserves by the company, and it is at the company’s discretion how much reserve it wants to accumulate.The company creates them only in case it earns a profit during the period, and if there arise the losses in the business, then the reserves are not created by the company.

Conclusion

It is the free reserve that the company can utilize for any purpose it requires after fulfilling certain types of conditions. E.g., settling any unknown future contingencies, 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 the company’s future obligations, thereby improving the financial position. No prescribed percentage is mentioned anywhere for the company’s creation of the general reserves. It is at 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 general reserve accounting along with its advantages and disadvantages. You can learn more about accounting from the following articles –

  • Reserve RatioCapital Reserve MeaningLIFO ReserveForfeited Shares