What are Reserve funds?
The word “Fund” in relation to any reserve can be used only where such a reserve is specifically represented by earmarked investments. In other words, the expression “Reserve Fund” is used only when there are earmarked investments for it; otherwise it is called only “General Reserve”.
Definition of Reserve fund
The expression reserve fund may be defined as a sum set aside out of divisible profits and retained in the business so as to provide for unexpected or unknown future contingencies or losses or to equalize dividends or to strengthen the financial position of a business concern.
A reserve fund cannot exist, side by side, with the debit balance on Profit and Loss Account. Thus, if there is a debit balance in the Profit and Loss Account it must be shown as a deduction from the Reserve Fund or General Reserve under the heading Reserves and Surplus on the liabilities side of the Balance Sheet.
Utilization of Reserve funds
Under section 80 of the Companies Act, whenever a company redeems its preference shares without issuing fresh shares, it has to transfer from its profits, which are available for distribution, a sum equal to the nominal value of the preference shares so redeemed, to the capital redemption reserve. The company can use the reserve funds only for the purpose of issuing fully paid-up bonus shares to its members.
In the absence of special Articles to the contrary, the directors of a company may transfer the whole or any portion of the Reserve Fund to the credit of Profit and Loss Appropriation Account for the purpose of increasing the amount of profit available for dividends.
Auditor’s Duty in Reserve Funds audit
In case of reserve fund, the auditor should adopt the following procedure to verify it:
1. The auditor should see that a reserve fund is shown separately on the liability side of the Balance Sheet.
2. He should see that fund is created for meeting the earmarked purpose.
3. He should see that the amount of reserve fund is invested in easily realizable securities.
4. He should ascertain that the amount invested in outside securities is not less than the amount of reserve fund.