Updated July 14, 2023
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 subdivided 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 a year, a business comes across lots of unknown expenses, so they build reserves 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: Companies create this type of reserve from their available surplus to fulfill certain or uncertain future obligations. It is formed by setting aside a portion of the company’s retained earnings and is known as a revenue reserve.
- Capital Reserve: A company creates this type of reserve to cover expenses for specific purposes, such as writing off capital expenses or funding capital expenditures. This reserve is typically formed using profits generated from the non-core operations of the business.
- Capital Redemption Reserve: Companies create this type of reserve by utilizing undistributed profits from the general reserve. The purpose is to redeem preference shares or buy back common equity shares.
- Dividend Reserve: This type of reserve exists as a separate account as it helps the company 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 gains 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 were $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 = $20,000 + $5,000
- General Reserve = $25,000
Capital Reserve at the end of the year can be calculated as,
- Capital Reserve = $0 + $3,000
- Capital Reserve = $3,000
Now, the Surplus at the end of the year can be calculated as,
- 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 manufacturing shoes, and in 2019 it generated earnings of $100,000 from its core operation. The company’s board of directors decided to keep aside 10% of the net profit under the General Reserve and declared 20% to be paid to the shareholders as dividends. Determine the amount of reserve and surplus at the end of 2019 if the General Reserve and Surplus were $30,000 and $175,000 at the start of the year.
- 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, the 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:
- Verify the opening and closing balances of the previous audited financial statements.
- Verify the adjustment to the current year’s Profit and Loss Statement.
- 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 are as follows:
- It is the first fund source when a company needs money for business activities.
- It provides a cushion by absorbing the losses 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.
- Misappropriation of funds collected under General Reserves is possible since they are not earmarked for any specific purpose.
Conclusion
So, the objective of Reserve and Surplus is to maintain a fund to strengthen the company’s financial position and settle any unknown future contingencies along with planned ones, such as dividends paid to shareholders.
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