A Reserve, by definition, is that part of the profit that is not distributed among the business’s owners but retained in the business.
If the entire profit made by a firm is credited to partner’s current accounts, the partners become entitled to withdraw it, in cash, from the firm’s coffers. This can seriously affect the business operations. One should understand that making a profit and having surplus cash are two fairly different things. A firm may make a decent profit and may still not have adequate cash to actually pay out to partners.
Profits usually get reinvested in the business by way of increased assets, mainly current assets like stocks and receivables. Even in a business that is run strictly on cash terms, allowing partners to withdraw all the profits from the business would mean no possibility of any growth in the volume of business being done by the firm.
It is therefore considered prudent not to distribute the entire amount of profit made in a year among the partners.A part of the profit is retained in the business for its growth and continued successful existence. This is done by means of opening a Reserve Account. After the net profit for a particular year has been ascertained (i.e. after the Profit and Loss Account has been prepared), that portion of the net profit which is agreed to be retained in the business is:
- Debited to the Profit and Loss Appropriation Account, and
- Credited to the Reserve (or General Reserve) Account.
The effect of this entry is two-fold. Firstly. the amount of net profit distributable among the partners is reduced. Thus a smaller amount of profit is credited to current accounts of partners. In turn, this means that partners are prevented from withdrawing the entire net profit in cash from the firm’s coffers. And secondly, a new account, General Reserve Account is created that has a credit balance and is shown in the Balance Sheet just next to fixed capital accounts.
It however always remains available for distribution among the partners whenever the partners decide to do so. It is important to note that creation of a reserve is simply an appropriation of profits, it does not imply an actual transfer of funds or cash from the business bank account to a new account. Once a Reserve Account has been opened, it can be increased (or reduced) in subsequent years through Profit and Loss Appropriation Account as may be agreed upon by the partners.