What is a General Reserve?
A general reserve is a reserve, which is created by appropriation of profits. It is created without any specific or particular purpose. The aim of creating a general reserve is to provide additional working capital or to strengthen the cash resources of the business, out of profits of the company, from Profit and Loss Appropriation Account. The General reserves may be utilized for meeting any unknown liability.
When can General reserves be created? Is it compulsory?
General Reserves are also referred to as “Free Reserve“. According to the Companies Act, general reserve is to be created only when there is sufficient profit in an enterprise. Hence it is clear that it is not compulsory to create general reserve. However, if the Articles of Association lay down that a specific amount is to be set aside out of profit before the distribution of dividend then the amount should be transferred to General Reserve Account. General Reserve Account will be shown on the liability side of the Balance Sheet.
Objects of Creating General Reserves
Following are the objects of creating general reserves in an entity:
1. Strengthening the liquid resources of a business.
2. Making available additional working capital for the firm.
3. Meeting any known liability, contingency or similar other commitment.
4. Equalizing the rate of dividend in the years in which profits are inadequate. However it will be used for the purpose only when separate dividend equalization reserve is not created.
5. Concealing actual profits in the years in which profits are excessive so as to use them to maintain dividend rate in those years in which profits are inadequate.
Auditor’s Duty in auditing general reserves
The question of creating a general reserve depends absolutely upon the policy of the management. The auditor has nothing to do with it. He can neither make recommendations in this connection cannot place any restrictions on this account.
Auditor during audit, should simply see that a general reserve is created in the interests of the business and shown properly in the Balance Sheet. He should keep the following points in mind while verifying the general reserve:
1. The auditor should ensure that the general reserve is created for the best interest of business.
2. He should see that company’s Articles of Association provide for the creation of general reserve. He should also see whether the provision regarding the creation of general reserve made in the Articles has been complied with.
3. He should see that the general reserve is created out of profit, which is real as shown in the Balance Sheet.
4. Where any part of general reserve is utilized for the payment of dividend, he should ensure that the amount drawn for the purpose is separately shown.
5. Where the general reserve is invested in outside securities, it is the duty of the auditor to see that such investments are shown on the asset side of the Balance Sheet.