Definition of General Reserve
General reserve refers to the amount of profit that are kept aside by the company in the form of reserves or we can say these are the earnings of the company that the company wishes to save for meeting future uncertainties where the future uncertainties includes meeting of contingencies, payment of dividends, increasing the working capital, offsetting future losses, strengthening the liquid resources etc.
Explanation
General Reserves are the profits retained by the company for meeting the future needs of the business. These Reserves do not have any specific use but can be used for any purpose. The companies are not bound to create such Reserves and are totally company’s discretion to accumulate the total amount of reserves which they want to accumulate. Also there is no prescribed percentage for creating the reserves. If in case there are losses in the company then the general reserve is not created by them. The amount of reserve is reported on the equity and liabilities side of the balance sheet under the head reserves and surplus.
Example of General Reserve
During the financial year 2019-20, company X earned profits of $500,000 from its business. It is decided in the company that out of the total earnings, 5% amount will be transferred in the reserve which can be used for any purpose and another 4% will be transferred to the specific reserve which will be used only for the specific purpose as decided by the management of the company. Calculate the amount of money transferred to the reserve during the period.
Solution:
General reserve is the reserve created out of the profits of the company which can be used for any purpose i.e., the purpose of its use is not defined.
In the above case out of the total profits of $500,000, company decided to transfer 5% of the profits of the company which can be used for any purpose. So, the amount to be transferred in general reserve will be:
- = Total Profits * % of transfer
- = $500,000 * 5%
- = $25,000
Rest 4% is transferred to the reserve which will be used only for the specific purpose, so it will not form part of the the reserve and will be show separately as the part of specific reserve.
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When Will General Reserves Be Created?
It is not mandatory for the company to create the reserve and transfer the amount in it. General reserve in a particular period can be created only in case the company earns profits during the period. However, in case the Articles of Association of the company states that the company has to transfer specific amount of its profit to general reserve account before distributing the dividend then it has to transfer such amount in the General Reserve Account.
General Reserve in Balance Sheet
The general reserve created by the company will be reflected under the “Reserve and Surplus” head of the liabilities section in the company’s balance sheet as the reserve account.
General Reserve vs Retained Profit
Difference between General Reserve and Retained Profit are provided and discussed as below-
- The general reserves are the part of profits that are transferred to reserves for not using it for any specific purpose but which can be used to meet future uncertainties or unexpected liability whereas retained profits refers to the earnings of the company that is left after the payment of dividends to the shareholders of the company.
- The creation of the reserves helps in the accumulation of funds to meet future contingencies whereas the amount of retained earnings are reinvested back in the business to meet day to day business needs and ultimately generate profits.
- General reserves are created by transferring some percentage (not prescribed) of current year’s profit before paying the dividend whereas the remaining profits of the current year is added to retained earnings each year.
Benefits
Benefits are provided and discussed as below-
- Creates additional working Capital: With the general reserve, organization gets the help of additional working capital when needed to expand its business segments or activities which helps them in grabbing new opportunities.
- Helps distribution of Dividend: It is much important for company to keep their stakeholder’s investment into the company intact. The one thing which is very important in this regard is to distribute dividend uniformly and is challenge to the company as well. The accumulated the Reserve helps the company in case of difficulties in distributing the dividend by the way of equalizing the dividend rate.
- Protection from future contingencies: General reserve helps the company in meeting the future obligations or losses and acts as a shield in protecting the company from future contingencies.
Disadvantages
Disadvantages are provided and discussed as below-
- True financial position cannot be judged: The Company may use the General Reserve fund at the time of loss or fund unavailability. In this way company’s financial position apparently looks healthy as a factor of payment efficiency.
- Decreases the dividend: As the general reserve is created out of the profit available to the equity shares holder before distribution of dividend. So on setting aside the general reserve the profit available for distribution to the equity share holder’s gets reduced resulting in decreasing the dividend to the equity share holder.
- Proper utilization of fund: As the fund is not created for any specific purpose but for general purpose and so it is always questionable that the appropriation of fund may not be done properly. The chances in relation to misappropriation of fund are very high.
Conclusion
Thus, general reserve can be the amount can be spent by the company on whatever type of needs come up. It is created out of the profits earned during the period by the company from its normal course of the business and it is different from specific reserve which could be used only for the specific purpose as decided by company’s management.
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