Treatment of Reserve and Surplus

After reading this article you will learn about the treatment of reserve and surplus.

Treatment of Reserve:

Setting up of reserves for working capital are very necessary for sound financial administration in order:

i. To cover credit losses;

ii. To liquidate debts;

iii. To offset price fluctuations on inventories;

iv. To provide for improvement and expansion;

v. For depreciation and obsolescence;

vi. For taxes; and

vii. Against contingencies such as fire, theft and other unexpected liabilities.

Reserves ensure stability and financial strength to an enterprise.

Reserves may be classified as:

Reserve is not deducted before arriving at the profit, rather it is an appropriation of profit, i.e., reserve account represents the fund to which a part of profit has been allocated. Revenue reserves are intended to meet commitments which are expected to arise in future such as distributions as-dividends (in future), research and development, to cover possible future losses on exchange, etc.

Capital reserves are made for the purpose of permanently increasing the capital of the concern. Capital reserves are not distributed as dividends. The above discussed were specific reserves. It has been observed that many large industrial concerns replace a number of specific reserves by one bulk account and call it General Reserve.

Treatment of Surplus:

A company’s cash position experiences various degrees of shortage, balance and surplus over time periods. The function of financial manager is to maintain balance so that situations of cash surplus or of cash rationing do not arise. The attitude towards a situation of cash surplus will depend upon the nature of surplus.

Policies may be determined for appraising investment opportunities while the surplus is there; the aim is to restore the balance. The existence of surplus liquid resources, that is, cash and short-term securities will appear in the balance-sheets of the concern and it can be studied how the liquid position has been changing over years.

Surplus funds may be deployed as follows:

(i) Invest the surplus in increased dividends. But once dividends are increased by distributing short- term cash surplus, the shareholders may not be happy if they get less dividend in future when there are no surplus funds with the concern for distributing to them as increased dividends.

(ii) Invest the surplus in liquidity, i.e., hold on to the surplus as a policy decision. Such holding of surplus is good for the concern because then, it can be used to meet some non-discretionary expenditures at the time of need.

(iii) Surplus funds may also be invested in the equity (ordinary shares) of other companies.