What are Free Reserves?

Reserve means a provision made for a specific purpose. There are lots of unknown expenditures which can occur in current year or in future. To meet such type of expenses the business organisation has to make the reserves out of the profits of the company for the specified expenses/purposes. By maintaining the reserves, actual position of the profit and loss of any accounting year does not get disturbed. For example:- share premium account, provision for bad debts or capital redemption reserves. Free Reserves are depicted on the Liabilities side of the Balance Sheet.

Free Reserves as per Section 2(43) of the Companies Act, 2013

“Free Reserves” means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend:

Provided that—

(i) any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or

(ii) any change in carrying amount of an asset or of a liability recognized in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value,

shall not be treated as free reserves.

What is Surplus? Do Free Reserves and Surplus have the same connotation ?

Surplus is the credit balance of the profit and loss account after providing for dividends, bonus, provision for taxation and general reserves etc.

Surplus and Free Reserves are not the same. The distinction between reserve and surplus has not been made expressly under the Companies Act, 2013. However, sub clause i and ii of clause 82 of the Table F of Schedule I, sample AOA, of the Companies Act, 2013  prescribes that the Board of the company may before recommending any dividend, sets aside such sums as they may deem fit as reserve or reserves and the company may also carry forward profit of the company without setting aside them as reserves. Table F is not mandatorily applicable to all the companies (Table F is applicable to private companies and also private companies can boilerplate the clauses specified in Table F) but has relevance since it forms part of the Companies Act, 2013. Further to support this proposition reference can also be made to Schedule III of the Companies Act, 2013, whereby it prescribes that ‘Surplus’ refers to balance in Statement of Profit and Loss Account after disclosing allocation and appropriations made by the company such as dividend, bonus shares and transfer to/from reserves and further debit balance of statement of profit and loss shall be shown as a negative figure under the head ‘Surplus’.

Where should the excess profit be retained – Reserve or Surplus?

Why retaining profits in reserves?

Generally, balance sheet of a company retains excess profit as surplus rather than free reserves. The effect of placing excess profits under Surplus would be that the threshold amount would be lower wherever we talk about the net worth of the company.

Net worth is defined in Section 2(57) of the Companies Act, 2013:

the aggregate value of the paid-up share capital and all reserves created out of profits of the company and securities premium account after deducting aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.

It is evident from the definition while calculating net worth of the company, reserves which have been created by the company out of the profits of the company are to be considered and hence, profit of the company forming part of ‘Surplus’ would be ignored.

The other side of the coin – Why retaining profits in Surplus?

A company which is in profit and wants to declare dividend. Now if the excess profits is retained in reserves, payment of dividend out of reserves shall lead to complying restrictions. The restrictions are:

• The rate of such dividend should not exceed the average dividend rate of the past three years; and
• The dividend amount shall not exceed a tenth of the paid-up capital and free reserves; and
• The losses incurred by the company should be first set off; and
• The reserves after such dividend, shall not fall below 15 per cent of the paid-up capital.

There are no such restrictions to declaring dividends out of Surplus retained by company in the P&L account.

Section 123 of the Companies Act, 2013 allows a company to retain the excess profits in reserves or surplus. This decision shall depend on the company’s plan of action and requirements.