General reserve

General reserve is an accounting instrument of securing an entity against its future liabilities, the maturity of which is not certain, while the certainty, or at least very probable, is the very fact of their occurrence. Their creation is mainly related to the risk of operations, so there is a reference to the precautionary principle. Reserves are recognized in the balance sheet liabilities. Other objectives of general reserve include:

• improve of financial position and worth of the company
• prepare for payment of additional dividends to shareholders
• prepare for risk of eventual future losses from investment

Reserves come in two forms:

• as provisions for liabilities
• as passive accruals of costs

Provision for deferred income tax

The provision for deferred income tax is made up of units that are taxpayers of corporate income tax. If an entity's annual financial statements are not subject to the audit and announcement requirements, it may depart from determining deferred tax assets and deferred tax liabilities.

The provision (and assets) of deferred income tax is created in connection with temporary differences between the value of assets and liabilities shown in the accounting books and their tax value as well as the tax loss possible to be deducted in the future.

Provision for deferred income tax is created in the amount of income tax that will be payable in the future in connection with the occurrence of positive temporary differences, i.e. differences, which will increase the basis for calculating income tax in the future. Its amount is determined taking into account income tax rates applicable in the year when the tax obligation arose

Provision for retirement benefits and similar

A provision for retirement and similar benefits (e.g. retirement benefits, jubilee bonuses, bonuses, unused holidays, etc.) is created when the entity is obliged to pay them under the law, collective agreement or employment contracts and if their amount is significant. The decision on this matter is made by the head of the unit.

In units, in which a given financial year, the number of persons entitled to receive benefits is small and the amount of benefits paid is not significant (e.g. a one-month salary), the unit's manager may refrain from creating provisions due to this. Including in the costs of a given period of benefits paid out will not significantly distort the financial result for this period. The solution adopted by the entity regarding the creation of provisions for retirement benefits or withdrawal from their creation should be reflected in the accounting policy adopted by the entity.

Examples of General reserve

• Profit Reserve: Profit reserve is a part of the company’s after-tax profits that have been set aside to meet future liabilities or to make capital investments. This reserve is created by the company's board of directors out of profits earned in a particular fiscal year.
• Statutory Reserve: Statutory reserve is a reserve created by a company as per the legal requirements of a particular country. It is created by the company out of its profits and the amount of the reserve is set out in the relevant law.
• Capital Reserve: Capital reserve is a reserve created out of the profits of the company that are not meant to be distributed as dividends. This reserve can be used for various purposes such as for the purchase of fixed assets, redemption of preference shares or for the expansion of business.
• Contingency Reserve: Contingency reserve is a reserve set aside by a company to meet any unforeseen liabilities that may arise in the future. This reserve is created by the company out of its profits and is usually not disclosed in the financial statements.

Limitations of General reserve

General reserve is an important instrument of financial management, however, it has some limitations. These are:

• General reserve cannot be used to pay off the current liabilities of an organization since it is meant to be used for future liabilities.
• It is difficult to predict the exact amount that needs to be transferred to the general reserve since the amount and timing of future liabilities is uncertain.
• The creation of a general reserve can lead to a decrease in the capital of the entity, which can affect its financial performance.
• It can also lead to a decrease in the profits of the entity, since profits need to be transferred to the reserve in order to create it.
• The creation of a general reserve can also decrease the liquidity of the entity, since funds are being taken out of circulation.
• The creation of a general reserve can also lead to a decrease in the return on equity, since funds are not available for investment.

Other approaches related to General reserve

General reserve is an accounting instrument of securing an entity against its future liabilities, the maturity of which is not certain, while the certainty, or at least very probable, is the very fact of their occurrence. Other approaches related to General reserve include:

• Revenue Reserves: Revenue reserves are funds set aside from profits or other revenues to cover future expenses.
• Deferred Tax Reserve: A deferred tax reserve is an accounting item that records the potential future tax liability of a company.
• Contingency Reserve: A contingency reserve is an amount of money that is set aside to cover potential losses from unforeseeable events or risks.
• Capital Reserve: A capital reserve is an amount of money set aside from a company's profits to fund future capital expenditures.

In summary, General reserve is an accounting instrument of securing an entity against its future liabilities, while other approaches related to General reserve include revenue reserves, deferred tax reserve, contingency reserve, and capital reserve.

General reserve — recommended articles

Issued share capital — Contributed Surplus — Unearned Premium — Non capital loss — Shareholder loan — Charter capital — Accumulated Earnings Tax — Fictitious asset — Non-operating expense

References

• Penman, S. H., & Zhang, X. J. (2002). Accounting conservatism, the quality of earnings, and stock returns. The accounting review, 77(2), 237-264.
• Calvo, G. A., Izquierdo, A., & Mejia, L. F. (2004).On the empirics of sudden stops: the relevance of balance-sheet effects (No. w10520). National Bureau of Economic Research.
• Stella, M. P. (2009).The Federal Reserve System balance sheet-What happened and why it matters (No. 9-120). International Monetary Fund.
• Allen, M., Setser, B., Keller, C., & Roubini, N. (2002).A balance sheet approach to financial crisis (No. 2002-2210). International Monetary Fund.

Footnotes

Author: Magdalena Lewicka