Reserves and surplus is a significant head on the liabilities side of the balance sheet forming part of the shareholders' funds.
Reserves are classified as Statutory and voluntary ; capital and revenue ; and free and specific.
Certain of the reserves are to be maintained by operation of law such as a reserve to be created under Income-Tax Act to claim deductions
Companies create voluntary reserves of their own accord to meet future exigencies such as dividend equalisation reserve, depreciation reserve, and debenture redemption fund, etc.
Capital reserves are those that emanate from a profit of a capital nature such as profit on re-issue of forfeited shares or profit in case of an acquisition and mergers so on
Revenue reserves are created out of revenue profits such as general reserve, dividend equalisation reserve, depreciation reserve, reserve for unexpired risk and statutory reserve and so on
Free reserves are those reserves upon which the company can freely draw. There is no specific purpose for these reserves. Free reserves can be used by the company to declare dividends, to issue bonus shares, to write off accumulated losses and to write off share issue expenses.
Specific reserves are those created for specific purposes. Reserve for unexpired risk is to meet the eventuality of a claim arising out of an existing policy. It can only be used for that purpose, and not for any other purpose. So is the case with dividend equalisation reserve which can be used only to maintain consistency of dividend.
Any reserve can be classified under the above heads.
For example, general reserve is a free, voluntary, revenue reserve.
Dividend equalisation reserve is a specific, voluntary, revenue reserve.
Statutory reserve (of a bank) is a free, revenue, statutory reserve.
Reserve for unexpired risk is a specific, statutory, revenue reserve.
It is generally explained that reserves are appropriations out of profits and provisions are charges against profits. I beg to differ here. Examine these situations.
Creation of reserves
Depreciation fund is a reserve, but is a charge against profit since it is created for replacement of an asset. But debenture redemption fund, though a reserve, is appropriated out of profit since it is created to redeem a liability.
Proposed dividend is a provision, but is an appropriation out of profits, and not a charge to profit and loss account as in the case of provision for doubtful debts.
Hence, both reserves and provisions can arise as a charge against profits or as an appropriation out of profit, depending upon the nature of provision or reserve.
Normally reserves originate from profits, though it is not always the case. The board of directors may resolve to set aside certain amount out of profits for future use.
Payment of dividend rules require the company to transfer specified amounts out of profits before dividends are proposed and declared. The company has no option but to transfer to general reserve. Such reserves arise at the end of the year. Normally, these reserves are of revenue nature since they arise out of revenue profits.
Certain reserves also originate during the course of the year. Profit on reissue of forfeited shares arises as and when the shares are reissued. They have to be immediately transferred to capital reserve lest the company errs in paying interim dividend out of such profits.
A capital reserve may also arise when preference shares are redeemed out of revenue reserves or balance to the credit of profit and loss account. As and when the preference shares are redeemed, capital redemption reserve should be created, without waiting for the year-end. It is a matter of judgment of the auditor to decide whether the reserve is to be charged to profit and loss account as in case of reserve for unexpired risks, statutory reserves, depreciation, stocks, etc. or to be appropriated out of profit as in case of transfers to general reserve, debenture redemption fund, etc.
AS 14 lays down the treatment of reserves upon mergers and acquisitions. In case of a merger, identity of the reserves of the transferee company is preserved. Consequently the reserves do not change their nature and value.
In case of amalgamation by purchase, only statutory reserves are preserved; other reserves are not preserved.
Certain reserves required to be created under the Income-Tax Act are to be preserved for a specific period of time.
For that matter, a reserve created to meet the statutory requirements under any law is preserved so long as it is necessary under the said law.
Upon liquidation of a company, the balances to the reserves become a part of shareholders funds. Unutilised amounts are transferred to the sundry shareholders acccount.
Balances to the credit of reserves are treated as shareholders funds for the purposes of balance sheet analyses.
These balances, together with share capital, constitute net worth of the entity.
(The author is a Hyderabad-based chartered accountant.)