Explain and contrast Reserve which is a charge against profits, and a Reserve which is an appropriation of profits. Give an example of a reserve of each class and state how they should appear in the accounts of a limited company. Also indicate an auditor’s duty in relation thereto. A reserve is made as a charge against profits, i.e. by debiting the Profit and Loss Account, where it is required to provide against a loss, actual actual or contingent, which, if definitely determined, would itself be charged to Profit and Loss Account; for example, Reserve for Bad ! Debts and Doubtful Debts. In this case, when the actual Bad Debts would be known, they would be written off to Profit and Loss Account.
Hence the Reserve made as a provision for doubtful debts is a charge. A reserve is made as an appropriation of profits i.e. by debting the Profit and Loss Appropriation Account, when it is intended to provide for the redemption of a known liability or strengthening the financial position of the business. A General Reserve, for example, is created for strengthening the financial position of the business. It is matter of financial policy and obviously represents appropriation of profit so as to retain an equivalent amount of cash in the business. Profits are merely set aside to withhold cash from distribution. It follows from the above that a reserve made as a charge against profits differs from a reserve made as an appropriation of profits in the following respects: (1) The former is obligatory, whereas the latter is usually discretionary and is a matter of financial policy. (2) The former is to be made even when the business incurs a loss. But a reserve can be created only out of profits.
Treatment in Balance Sheet In the Balance Sheet of a Limited Company, a specific reserve (provisions as it is called) is to be shown on the assets side of the Balance Sheet by way of deduction from the asset concerned. But a reserve which is an appropriation of profits must be shown on the liabilities side of the Balance Sheet. Auditor’s Duty In case of the reserve provided against an anticipated loss, the auditor’s duty is to see that provision made by the management is adequate and reasonable. He must consult the company’s Articles and Directors’ Minutes and recommendations on the points, and if he cannot persuade his client to increase them he should report the fact to the members. In the case of a reserve made as an appropriation of profit the auditor is not concerned with adequacy or otherwise of the amount of profit set aside to reserve.
It is a matter of the company’s financial policy and therefore rests entirely with management. The auditor, however, must see that the amounts have been properly taken, and do show a bona fide surplus. He must also see that the reserve is clearly and properly stated in the Profit and Loss Appropriation Account and Balance Sheet. If any reserve is represented by specifically earmarked investments, the auditor should verify such investments and report any irregularity to the members.