Reserves are the amount of profits, which is set aside until there is a need for money for some purpose. In terms of accounting, we refer to this as appropriation. The name of a reserve account indicates its purpose or use. Reserve account is a part of a company’s net worth. Therefore we can say reserve is an amount that appears on the liability side of the statement of financial position. Let us learn Treatment of Reserves in detail.
Treatment of Reserves
By definition, a reserve is that part of the profit that is not distributed among the partners but retained in the business.
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Need for Reserves in Business
If we credit entire profits to partner’s current accounts, the partners become entitled to withdraw it, in cash or kinds. This shows all earnings by the firm are related to partners.
This situation can seriously affect firm operations. One should understand that making a profit and having surplus cash are two fairly different things.
A situation may arise where a firm may make a decent profit and may still not have adequate cash to actually pay out to partners.
A business usually re-invests profits by way of acquiring assets. It may be current assets like stocks and receivables or any fixed assets. Where a firm allows partners to withdraw all the profits from the firm, there is no possibility of any growth in the volume of business.
Therefore, it is prudent not to distribute the entire amount of profit made in a year among the partners. The business retains some part of the profit in the business for its growth and continued successful existence in the near future.
Thus we open a Reserve Account in the books. After ascertaining the net profit for a particular year (i.e. after the preparation of Profit and Loss Account), a portion of the net profit which the partners agree to retain in the business is known as Reserves. Reserves are created as follows:
- Debited to the Profit and Loss Appropriation Account, and
- Credited to the Reserve (or General Reserve) Account.
Accounting treatment of reserves in case of admission of a partner:
In case of admission of a new partner, we need to transfer the reserves or accumulated profits and losses in the balance sheet to the old partners capital accounts.
Since all reserves showing in the balance sheet on the date of admission are earned by old partners. Therefore, we transfer them to old partners capital accounts in the old profit sharing ratio.
Understand the concept of Revaluation Account here in detail.
Following is the journal entry:
|Date||Particular||Amount (Dr.)||Amount (Cr.)|
|To Old Partner’s capital A/c||Cr.||XXX|
|(Being reserve transferred to Partner’s capital accounts in old profit sharing ratio))|
Solved Question on Treatment of Reserves
Micky, Mili, and Krish are partners in a firm sharing profits and losses in the ratio 2:2:1. a balance sheet of a firm as on 31st March 2017 is as below:
|Trade payables||6,425||Land and buildings||12,500|
|General reserve||3,250||Inventory of goods||5,875|
|Capital account:||Trade receivables||2,750|
|Ms.Micky||6,000||Cash in hand||70|
|Ms.Mili||6,000||Cash in bank||480|
The partners have agreed to take Ms.sakshi as a partner with effect from 1st April 2017 on the following terms:
- Sakshi shall bring ₹2,500 towards his capital.
- Increase the value of inventory by ₹1,250 and depreciate furniture by 10%
- Reserve for bad and doubtful debts should be provided at 10% of the trade receivable.
- Enhance the value of land and building by 20% and fix the value of the goodwill at ₹ 7,500
- Transfer the General reserve to the partner capital accounts
- The new profit sharing ratio shall be Micky 5/15, Ms.Mili 5/15, Mr. Krish 3/15 and Ms. Sakshi 2/15
The outstanding liabilities include₹500 due to Mr. Jain which has been paid by Ms. Micky. Necessary entries were not made in the books.
Prepare (i) Revaluation account,(ii) The capital accounts of the partners (iii) Balance sheet of the firm after the admission of Ms. Sakshi.
|To provision for doubtful debts||275||By inventory in trade||1,250|
|Furniture and fittings||325||By Land and Building||2,500|
|To Partner’s Capital A/c:||3,150|
Partner’s Capital Account
|To Micky||–||–||–||500||By Balance b/d||6,000||6,000||2,500||–|
|To Mili||–||–||–||500||By General Reserve||1,300||1,300||650||–|
|To Balance c/d||9,560||9,060||3,780||1,500||By cash||–||–||–||2,500|
|By outstanding liabilities||500||–||–||–|
|By Revaluation A/c||1,260||1,260||630||–|
A balance sheet of M/s. Micky, Mili, Krish, and Sakshi as on 1-4-2017
|Trade payables||6,425||Land and building||15,000|
|Capital account of partners||Investors of goods||7,125|
|Mr. Krish||3,780||Cash in hand||70|
|Ms.sakshi||1,500||23,900||Cash at Bank||2,980|
Calculation of sacrificing ratio
|Partners||New share||Old share||Sacrifice||Gain|
|Krish||3/15||1/5||No gain no loss|
Sacrifice by Ms.Mili=₹15,000×1/15 =₹1000 each