RESERVES AND RESERVE " reserve fund " may be defined as " The amount by which the assets of a concern exceed the sum of its paid-up capital and liabilities." A " reserve," on the other hand, is " A provision for a known or expected liability or loss." If the reserve is for a liability the exact amount of which is riot known, it should be stated on the liabilities side of the balance sheet, and would usually be included among the creditors ; if, on the other hand, it is for (say) doubtful debts or depreciation of machinery, it is more properly deducted from the particular asset in question.
Adopting these two definitions, it will be seen that every liability must be provided for before the amount of the reserve fund is obtained. To this extent the balance sheets of most insurance companies are irregular, as they do not usually make a specific reserve for the liability in respect of unexpired risks, the contention being that this is covered by their large " reserve funds." This, it will be seen, is not strictly accurate, but the practice is so usual that it would be difficult to alter, and it is so well known that no one can be said to be deceived by it.
Much discussion has turned upon the point whether or not, in order to be real, a " reserve fund " must be invested outside the business, and a great deal of misapprehension prevails upon the point.
To take a concrete case, assume a balance sheet as follows : Capital . £100,000 Sundry assets , . R105,000 Creditors , . . 5,000 Cash . 7,000 Profit . 7,000 £112,000 R112,000 anya?me min.
and that it is proposed to transfer
Such a contention arises from a lack of appreciation of the real facts. of the case. A reserve fund does not cease to exist when the asset representing it is changed into stock or machinery, &c., but it ceases to exist pro tanto when the asset ceases to c.x ist. Assume the £2000 is
invested in Consols, and, the day after, it is found that a debtor for £2000 fails absolutely. The debt is written off against the reserve fund. The Consols remain, but the reserve fund has gone. The fallacy of the argument is at once apparent. As a matter of book-keeping the reserve must remain till written off against an asset or a loss in trading. As a matter of fact, it does remain till an asset has fallen in value to that extent.
Attention is sometimes called to the fact that a company with a reserve fund fails, and the question asked is, Where is the reserve fund ? Take the example already given. It is decided to open a new depart ment. As a matter of finance it would be folly to issue new capital the Consols are sold, and the proceeds used for the extension. Surely the: assets are still worth the 1107,000. It is only their nature which been changed. The reserve fund is also still there as a matter of book keeping.
Again, suppose a creditor to whom the company have usually owed IN000 calls the amount in, the Consols are sold, and he is paid off: The balance sheet then becomes— Capital . £100,000 Sundry assets . . £105,000 Creditors . . . 3,000 Reserve fund . . '2,000 1-.!105,000 .;105,000 The reserve fund remains, but the Consols have gone.
Then it may be said, Where would a bank be if it did not invest its reserve fund in realisable securities ? Obviously it must do so. That, however, is from the very nature of its business. It is not because it is the reserve fund that it must be so invested in securities. In its earliest years its capital is largely so invested.
-There is no analogy between the cafe of a bank and that of a mer cantile concern. The latter know to a day or so when they will want cash, and they have time, even in cases of financial difficulty, to look round and make the necessary arrangements. A bank has not any such know ledge. Every person to whom they owe money may demand it at practically a moment's notice. Confidence is its very life. The least whisper of financial unsoundness and the whole fabric falls to the ground. The dis honour of a bill would be serious to a mercantile house, but failure by a bank to pay any one, and that, too, at the moment, would be fatal to it.