What are Reserves and Surplus?
The term “Reserves and Surplus” refers to the cumulative account that captures the retained earnings built by the company over a period of time, which forms part of the shareholder’s equity. Usually, the amount in Reserve and surplus is sub-divided into various accounts, which are then earmarked for specific purposes, such as the purchase of fixed assets, payment towards legal settlements, repayment of debt obligations, dividend payments, etc.
Explanation
During the course of a year, a business comes across lots of unknown expenses, and so they build reserves in order to be able to meet such expenses. Effectively, these reserves ensure that the company’s financial position is not disturbed by the surfacing of any unexpected expenses. On the other hand, the surplus is the retained balance of the profit and loss account after payment of dividends, tax provisioning, etc. Just like reserves, the surplus is also earmarked for various special-purpose expenses.
Types of Reserves and Surplus
Out of Reserve and Surplus, the surplus is primarily the account that maintains the amount of the retained earnings and has no sub-categorization, while the reserve is sub-divided into four major types as shown below:
- General Reserve: This type of reserve is created from the available surplus for meeting various certain or uncertain obligations in the future. It is simply carved out from the retained earnings of the company and kept aside for future use. It is also known as a revenue reserve.
- Capital Reserve: This type of reserve is created by a company to meet expenses for some specific purpose, such as providing for writing off any capital expense or funding any capital expenditure. This reserve is usually carved out of profit generated from the non-core operations of a business.
- Capital Redemption Reserve: This type of reserve is created using the undistributed profits from the general reserve for the redemption of preference shares or buyback of common equity shares.
- Dividend Reserve: This type of reserve comes into existence as a separate account as it helps the company to distribute a similar amount of dividend year after year.
Examples of Reserves and Surplus
Following are the examples are given below:
Example #1
Let us take the example of a company that generated earnings of $50,000 during the year, out of which it transferred $5,000 to the general reserve. Further, the company also booked gain by purchasing a piece of machinery for $7,000, whose market value is $10,000. Determine the amount of reserve and surplus at the end of the year if at the start of the year the General Reserve, Capital Reserve and Surplus was $20,000, $0 and $200,000, respectively.
- Given, Opening General Reserve = $20,000
- Opening Surplus = $200,000
- Opening Capital Reserve = $0
- Net profit = $50,000
- Transfer to General Reserve = $5,000
Solution:
Transfer to Capital Reserve is calculated as
- Transfer to Capital Reserve = $10,000 – $7,000
- Transfer to Capital Reserve = $3,000
General Reserve at the end of the year can be calculated as,
General Reserve = Opening General Reserve + Transfer to General Reserve
- General Reserve = $20,000 + $5,000
- General Reserve = $25,000
Capital Reserve at the end of the year can be calculated as,
Capital Reserve = Opening Capital Reserve + Transfer to Capital Reserve
- Capital Reserve = $0 + $3,000
- Capital Reserve = $3,000
Now, Surplus at the end of the year can be calculated as,
Surplus = Opening Surplus + (Net profit – Transfer to General Reserve)
- Surplus = $200,000 + ($50,000 – $5,000)
- Surplus = $245,000
Now, the Reserve and Surplus at the end of the year can be calculated as,
Reserve and Surplus = General Reserve + Capital Reserve + Surplus
- Reserve and Surplus = $25,000 + $3,000 + $245,000
- Reserve and Surplus = $273,000
Therefore, the Reserve and Surplus of the company at the end of the year stood at $273,000.
Example #2
Let us take the example of ABC Inc. to illustrate the concept of reserve and surplus. The company is engaged in the business of manufacturing shoes, and during 2019 it generated earnings of $100,000 from its core operation. The board of directors of the company decided to keep aside 10% of the net profit under General Reserve and declared 20% to be paid to the shareholders in the form of dividends. Determine the amount of reserve and surplus at the end of 2019 if at the start of the year the General Reserve and Surplus was $30,000 and $175,000.
- Given, Opening General Reserve = $30,000
- Opening Surplus = $175,000
- Net profit = $100,000
- % of net profit transferred to General Reserve = 10%
- Dividend payout = 20%
Solution:
Now, General Reserve at the end of 2019 can be calculated as,
General Reserve = Opening General Reserve + % of Net Profit Transferred to General Reserve * Net Profit
- General Reserve = $30,000 + 10% * $100,000
- General Reserve = $40,000
Now, Dividend Reserve at the end of 2019 can be calculated as,
Dividend Reserve = Dividend Payout * Net Profit
- Dividend Reserve= 20% * $100,000
- Dividend Reserve = $20,000
Now, Surplus at the end of 2019 can be calculated as,
Surplus = Opening Surplus + (Net Profit – Transfer to General Reserve – Transfer to Dividend Reserve)
- Surplus = $175,000 + ($100,000 – $10,000 – $20,000)
- Surplus = $245,000
Now, the Reserve and Surplus at the end of 2019 can be calculated as,
Reserve and Surplus = General Reserve + Dividend Reserve + Surplus
- Reserve and Surplus = $40,000 + $20,000 + $245,000
- Reserve and Surplus = $305,000
Therefore, the Reserve and Surplus of the company at the end of 2019 stood at $305,000.
Audit of Reserves and Surplus
The below mentioned general procedures need to be followed during the audit of Reserve and Surplus:
- Verification of the opening balance with the closing balance of the previous audited financial statements.
- Verification of the adjustment done to the Profit and Loss Statement of the current year.
- Verification of the reserves to ensure that sub-classification has been done according to their nature and purpose.
- Ensure that all prior period figures have been disclosed accurately.
Advantages
Some of the major advantages of Reserves and Surplus as follows:
- It acts as the first source of the fund when a company needs money for its business activities.
- It provides the cushion by absorbing the losses during those times when a company underperforms.
- It helps in sustaining the level of dividend distribution by covering the shortfall.
Disadvantages
Some of the major disadvantages of Reserves and Surplus are as follows:
- At times companies manipulate their financial statements by adjusting the business losses with their reserves.
- There are chances of misappropriation of funds gathered under General Reserves; it is not earmarked to any specific purpose.
Conclusion
So, the objective of Reserve and Surplus is to maintain a fund to strengthen the company’s financial position and also to settle any unknown future contingencies along with planned ones, such as dividends payment to shareholders.
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