Disposition of Profits
The statement of profit and loss carries the summary of operations to the point of showing a net profit or a loss for the period. The next step for consideration is the disposition made of these profits. This is sometimes spoken of as the appropriation of profits. Two practices are met at this point. Under the one, appropriation is made directly from Profit and Loss for all desired purposes. Any unappropriated balance goes into Surplus account, which will represent the balance of profits available for dividends but not used. Under the other, the Profit and Loss balance is transferred to Surplus out of which all appropriations are made, the residue remaining therein showing the same condition as under the first method. Where this second method is followed—and it is more prevalent than the first—a statement of surplus is needed for full information of the period’s transactions, thus providing a connecting link between the statement of profit and loss and the balance sheet. The form of this statement is given on page 426.
Reserves
From the point of view of the stockholder’s immediate interest, the appropriation of profits for dividends is his chief concern. Other and equally vital and urgent uses are found for profits in any well-managed concern with an expanding outlook towards the future. The appropriations of these profits to definite uses are very generally carried under the title of reserves with suitable descriptive phrases. Thus we may have a Sinking Fund Reserve, an Insurance Reserve, a Building Fund Reserve. Sometimes these are called “reserve funds” but the demands of an accurate nomenclature limit the use of “fund” to an asset account. The title “undivided profits” is also met. Where careful differentiation is made, “surplus” should be used to denote profits available for dividends; “reserve,” for profits set aside for a specific purpose; and “undivided profits,” for those on which no definite action has been taken.
Different Meanings of Reserve
Because of the loose way in which the term reserve is used by the layman and its different uses by the professional accountant, an examination of these uses will be made at this point. As a distinctive banking term, “reserve” is used to indicate the amount of cash and cash items on hand and on deposit which under the law may be counted as a cash reserve fund held against deposits and note issues. This use of “reserve” is limited strictly to financial institutions.
We find also various so-called reserves shown on the commercial balance sheet, both among the liabilities and the assets. As deductions from the assets are the various depreciation reserves and reserves for bad and doubtful accounts and notes receivable. These items are “offsets” to the carrying values of the assets in order to effect a true valuation of them. For reasons previously set forth, these offsets are carried in accounts separate from their corresponding assets. Thus they are in the nature of suspended credits to asset accounts and, if properly estimated, are in no sense related to profits; nor have they any of the elements of profits or proprietorship in them. It is unfortunate that there is lacking an adequate title, other than reserve, for this group of items. The terms “allowance” and “estimate” have been suggested, but so far have not found general favor. This group of reserves are called valuation reserves.
Reserve for Bad Debts
A fine distinction is sometimes drawn between the reserve for depreciation and the reserve for doubtful accounts, on the ground that at the time of the creation of the reserve in the one case, the depreciation is an accomplished fact, all that is then required being a fair estimate of it; whereas in the other case no particular account is known to be uncollectible, business experience teaching, however, that in the aggregate there will be some loss from this source. The purpose of this reserve is to bring about as on a given date an appraisal of the claims against customers in the light of past experience, and so apply the expense due to this cause to the period in which the sale transaction took place. This purpose is not always accurately accomplished but the estimate at the close of each period does effect an equalizing of the bad debts expense from year to year. This distinction makes the reserve for doubtful accounts closely approximate to a contingent reserve, as will be seen later. It seems best, however, to hold to the original classification and include the bad debts reserve with the other valuation reserves.
Under- and Over-Estimate of Reserves