Over the next two months, we will look at a specific topic that affects both members and students looking to take ICB examinations: company reserves
We will investigate how they arise and for what purposes they can be used (or not used). This month we will be looking at the nature of revenue reserves. Next month will cover capital reserves and their uses.
What are reserves?
Company reserves are the profits that sit in the company’s accounts, ready for use later. There are two types of reserves – capital reserves and revenue (distributable) reserves. These distributable reserves are amounts that can be used for any reasonably agreed purpose (and are held in the company to be paid out later), like investing in new assets or paying out dividends to shareholders.
How does a company accumulate reserves?
The basic form of reserves arises when profits are made through trading. The first thing that must be considered is that any corporation tax due must be calculated and allowed for in the accounts before anything else can happen. Corporation Tax is a reduction of profits and reduces the profit and loss account balance. Note: this is different to the tax affairs of a non-incorporated business, where the owner (either a sole trader or a partnership) is personally responsible for their tax debt, and if paid out of the business bank account, must be treated as drawings.
Remember, in a profitable business, the profit and loss account has a credit balance. What does this mean in reality? Profits are the property of the business owner (in this case the shareholders), and the credit balance reflects this. The profits are owed back to the shareholders. In law, it does not matter if the company is a micro-entity with a single shareholder or a large national corporation with hundreds of shareholders – the processes are identical. Although, the larger the company, the more complex the format of the reserves might be.
How does this differ from a non-incorporated business?
Sole traders or partnerships only have three items in the bottom half of a balance sheet: an opening (or brought forward) capital account, a net profit or loss figure, and a drawings account which leads to a closing capital balance (the total at the bottom of the balance sheet). Owners of a business can show this as separate amounts to be carried forward each year or to show the profits, losses and drawings being offset against the opening capital and carrying forward a single closing capital balance to the next accounting year.
In a limited company, however, the difference is that the capital account (which arises from the sale of shares) is always kept separate and only changes if the amount of issued shares changes. There are no drawings in a limited company, as the shareholders can only take funds from the business from declared dividends. Remember, a director can take out funds in several different ways. But we are only considering shareholders in this article. Hence the profit/loss section of the accounts is always kept separately from the capital section and forms the capital reserves.
Let us consider some figures to work through:
In our company, we assume that we have issued ordinary shares to the value of £1,500. The share capital account would appear as follows (remember that the ordinary share capital account has a credit balance, which is a running balance situation usually shown as negative amounts.
|
Ordinary Share Capital Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Balance b/d
|
|
|
-1,500
|
|
|
|
|
|
|
The profit and loss account
The first of the revenue reserves is the actual profit and loss Accounts. You are all aware of how the balance on the profit and loss account arises: income fewer expenses, and the balance for the current year's accounts will appear in different ways depending on the software you use. For manual calculations, it is simply the end product of completing trading for the profit and loss account.
Those of us who are old enough to remember manual accounts would have had to close all the revenue accounts and journalise them across to a profit and loss account, ending up with a credit balance (in the case of a profit) or a debit balance (in the case of a loss). Fun fact – in the early years of ICB, we tested this process in our original level 2 examination! How times have moved on.
Suppose the net profit at the end of the trading year amounts to £120,000 after corporation tax has been accounted for, then the balance in the account would appear as follows:
|
Profit and Loss Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Balance b/f after Corporation Tax
|
|
|
-120,000
|
|
|
|
|
|
|
Because the balance sits in the accounts after all tax has been accounted for, the entire amount could be left in the business for future use. If this is the case, the balance will fluctuate each year depending on the level of profits or losses. The account will appear in the bottom half of the balance sheet under reserves.
The bottom half of the balance sheet would hence appear as the following:
|
Financed by:
|
£
|
|
Ordinary Share Capital
|
1,500
|
|
Reserves - Profit and Loss Account
|
120,000
|
|
|
121,500
|
These profits are often used to pay dividends, and we will look at how this operates in a later section of this article entitled ‘Under what circumstances can these reserves be used?’.
It might be that your company decides to leave all the profits sitting in this profit and loss account, and there is no problem with doing this. In a micro company with a single, or a small number of owners/directors, this could be the case. However, as companies grow, and their financial affairs become more complex, the use of additional reserves often comes into play.
Setting up other reserve accounts
The term ‘other reserves’ covers a wide list of possibilities. Generally, it is set up to hold profits that someone wishes to be allocated for whatever reason rather than to leave them in the profit and loss account to be issued as dividends. You could have a single reserve account called ‘general’ reserves.
In essence, we can refer to these reserves with any reasonable title. Pick a title that makes sense. These reserves can be used for pretty much anything (if it does not break company laws and/or accounting rules), and you can have as many differently named reserves as you wish.
If you are taking an ICB exam, you will be told the name of the reserve to use. It may be that such a reserve already exists, and you are simply adding to it so the balance will increase.
What we are doing is simply ‘transferring’ an amount from the profit and loss account to a reserve account. This transaction is paper-only and only affects the bottom half of the balance sheet. Nothing is affected in the top half of the balance sheet.
Suppose we decide that over the next few years we have a large outlay for plant and machinery to cover - we could decide to keep an amount of the profits in the business to help towards this outlay. However, simply transferring an amount of the retained profits into a reserve account does not mean you have the funds to pay for this. Profits do not always equal money in the bank.
We decide to transfer £30,000 of the retained profits into a plant and machinery reserve.
The bookkeeping entry for this transfer is a journal entry. We are going to debit the profit and loss account and credit the plant and machinery reserve account as follows:
|
Profit and Loss Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Balance after CT
|
|
|
-120,000
|
|
31 Dec 2020
|
Transfer to plant and machinery reserve
|
30,000
|
|
-90,000
|
|
Plant and Machinery Reserve Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Transfer from profit and Loss
|
|
30,000
|
-30,000
|
|
|
|
|
|
|
The bottom half of our balance sheet will now appear as:
|
Financed by:
|
£
|
|
Ordinary Share Capital
|
1,500
|
|
Reserves – Plant and Machinery Reserve
|
30,000
|
|
Reserves - Profit and Loss Account
|
90,000
|
|
|
121,500
|
The total at the bottom has not been charged, as the journal entry you make will only affect the two accounts in the same section of your chart of accounts.
In a set of ‘manual’ accounts, when you are learning about this topic or undertaking an ICB exam, you might be asked to produce the appropriation account – which is simply a list of how the profits are being appropriated.
|
Profit and Loss Appropriation Account
|
£
|
|
Profit and Loss b/f
|
120,000
|
|
Less
|
|
|
Transfer to plant and Machinery reserve
|
30,000
|
|
Profit and Loss c/d
|
90,000
|
Under what circumstances can these reserves be used
1. Payment of dividends
All the distributable reserves, after corporation tax, can be issued as dividends and paid to shareholders. Let us assume first that the entire profits are paid out. If this happens, once the dividend is declared, the balance on the profit and loss account would be transferred to a current liability account to record the amounts owed to the shareholder(s).
|
Profit and Loss Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Balance after CT
|
|
|
-120,000
|
|
31 Dec 2020
|
Transfer of declared dividend
|
120,000
|
|
0
|
|
Dividend due account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Transfer of declared dividend
|
|
120,000
|
-120,000
|
This is never a good move, however, as it leaves absolutely nothing in the business to cover either a ‘bad’ year or to re-invest in the business.
This transaction will influence the actual balance sheet totals as it also affects the top half.
In this instance, an extract of the balance would show the following:
|
Balance Sheet (extract)
|
£
|
|
Current Liabilities
|
|
|
Dividends due
|
120,000
|
|
|
|
|
Financed by:
|
|
|
Ordinary Share Capital
|
1,500
|
Both halves of the balance sheet will be reduced by £120,000.
Note: these figures above will not balance in their current format as there are additional items in the top half of the balance sheet for which we have not accounted – this is merely an extract of the affected sections.
Once the dividend is paid out, the money will credit the bank and debit the dividend account, thus leaving with a zero balance here and the bank heavily reduced.
If, however, we revert to the situation where profits are transferred to the Plant and Machinery Reserve, we will have less dividend to declare. If £30,000 is transferred to the reserve, and a dividend of £60,000 is declared, this will leave £30,000 in the Profit and Loss Account as follows:
|
Profit and Loss Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Balance after CT
|
|
|
-120,000
|
|
31 Dec 2020
|
Transfer to Plant and Machinery reserve
|
30,000
|
|
-90,000
|
|
31 Dec 2020
|
Transfer of declared dividend
|
60,000
|
|
-30,000
|
The appropriation account will contain the following:
|
Profit and Loss Appropriation Account
|
£
|
|
Profit and Loss b/f
|
120,000
|
|
Less
|
|
|
Dividend declared
|
60,000
|
|
Transfer to plant and Machinery reserve
|
30,000
|
|
Profit and Loss c/d
|
30,000
|
The balance sheet extract will appear as:
|
Balance Sheet (extract)
|
£
|
|
Current Liabilities
|
|
|
Dividends due
|
60,000
|
|
|
|
|
Financed by:
|
|
|
Ordinary Share Capital
|
1,500
|
|
Reserves – Plant and Machinery reserve
|
30,000
|
|
Reserves – Profit and Loss
|
30,000
|
|
|
61,500
|
2. ‘Using up’ the reserves
If at some stage (say six months later) a machine is purchased, then there are several transactions to consider:
The machinery is purchased, and a debit entry is made in fixed assets whilst a credit entry will appear in the bank (or the creditors). This won't affect the total of the top half of the balance sheet as the increase in fixed assets will be matched by a corresponding decrease in the bank or an increase in creditors. The total remains the same, but the content of the various sections will alter.
We do, however, have to look at the effect on the bottom half of the balance sheet.
The balance in the reserve account is no longer needed, so it must be transferred back into the profit and loss account by a journal entry:
|
Plant and Machinery Reserve Account
|
|
Date
|
Details
|
Dr
|
Cr
|
Balance
|
|
31 Dec 2020
|
Transfer from profit and loss
|
|
30,000
|
-30,000
|
|
30 June 2021
|
Transfer back to profit and loss
|
30,000
|
|
0
|
|
31 Dec 2020
|
Balance after CT
|
|
|
-120,000
|
|
31 Dec 2020
|
Transfer to Plant and Machinery reserve
|
30,000
|
|
-90,000
|
|
31 Dec 2020
|
Transfer of declared dividend
|
60,000
|
|
-30,000
|
|
30 June 2021
|
Reverse transfer of plant and machinery reserve
|
|
30,000
|
-60,000
|
The actual total of the bottom half of the balance sheet will also not have changed, although the individual balances will be different.
|
Balance Sheet (extract)
|
£
|
|
Current Liabilities
|
|
|
Dividends due
|
60,000
|
|
|
|
|
Financed by:
|
|
|
Ordinary Share Capital
|
1,500
|
|
Reserves – Profit and Loss
|
60,000
|
|
|
61,500
|
However, this increases the profit and loss balance again by the value of the purchased machine. So, how is this possible, and how can we explain it?
Remember, the profits weren't used up when the machine was purchased. The accounts that were affected were the asset and the bank – both of which appear in the top half of the balance sheet. We no longer require the reserve account. Therefore, we need to remove this. The only way to do this is to transfer it back to profit and loss. So, how do we ‘get rid' of this amount of profit?
Think back again to your profit and loss account - the topic of depreciation now comes into play.
Remember the definition of depreciation. Depreciation is the method by which the cost of an asset is utilised up across its useful life. Each year we process an amount of depreciation through the accounts, reducing the value of the asset by the annual depreciation and reducing the profit and loss balance accordingly. So, by the time the asset has been fully depreciated, the profit and loss account will have also been reduced by the same amount.
So, each year, both the top and the bottom halves of the balance sheet will be reduced.
We have taken an amount of profit, transferred it into a reserve account to retain it in the accounts and not issue it as a dividend, and used available funds to purchase an asset. We then transferred the value of the reserve amount back to the profit and loss account and reduced it via the method of depreciation over the useful life of that asset. This can be repeated over and over again, and you do not need to ‘clear’ down the reserve account each time – you can use ‘part’ of the reserve to show the purchase of an asset and leave the rest in the reserve account for a future year.
Summary
This first part of our peek into the workings of company reserves explains how the profits that arise from trading can be utilised. Either by the payment of dividends or by the retention of profits within the company to be used to fund investment.
Next month we will investigate the slightly more complex issue of capital reserves, which have specific origins and limited uses.
