Any amount set aside from the profits of a business is known as reserve. The amount so kept separate is retained in the business to help in meeting the future growth and expansion objectives or any other future contingencies that might arise like compensation for workmen.

Since, reserves are maintained by deducting the amount from the profits earned during the year, they are the appropriations of profit unlike the provisions which are categorised as a charge against profit. This is because provisions are made to cover any expected loss or a known liability which can be estimated whereas reserves are not meant to cover any loss rather they aim at strengthening the overall financial position.

Maintenance of reserves consequently leads to reduction of profits available for distribution among the business owners.

Importance of Reserves

Since the future is uncertain, a business firm would like to maintain some buffer profits to fall on in times of unfavorable situations. Also, maintaining a reserve ensures that not all the profits available are withdrawn by the owners, thus keeping some earnings for the future.

The reserves are of utmost importance in any business because –

  • They work as a shield to protect the business from any future contingency;
  • They strengthen the overall financial position of the business;
  • They provide a source of funds needed to redeem a long-term liability like debentures, etc.

Treatment of Reserves –

It is shown on the liabilities side of the balance sheet under the head Reserves and Surplus.

Examples of reserves are:

  • General reserve;
  • Workmen compensation fund;
  • Investment fluctuation fund;
  • Capital reserve;
  • Dividend equalisation reserve;
  • Reserve for redemption of debenture.

Types of Reserves

(I) A reserve can be maintained for either a general or a specific purpose. Thus, they are categorised into two types –

  1. General reserve : If the reserve is created for no specific purpose, it is known as the General Reserve. It is also popular as free reserve because the management is free to use it for any purpose whatsoever.
  2. Specific reserve : Unlike general reserve, specific reserve exits for a specific purpose in mind. It cannot be used for any other object than what is predetermined.

For example –

(i) Dividend equalisation reserve: To maintain stability in distribution of dividend dividend equalisation reserve is created. In the years of high volume of profit, a certain amount is transferred to this reserve and is utilised strategically in years of low profit.

(ii) Workmen compensation fund: To meet any accidental claims of workmen, this reserve is created.

(iii) Investment fluctuation fund: In case the value of investments decline due to volatility in the market, this reserve comes in handy.

(iv) Debenture redemption reserve: To meet redemption expenses in the future, a debenture redemption reserve is formulated.

(II) Reserves can further be classified on the basis of them being either of revenue or capital nature. It depends on the profit from which they are created –

(a) Revenue reserves: Reserves that are generated from the revenue profits are known as Revenue reserves. Revenue profits are the one which occur due to normal operations of the business. Examples of revenue reserves are:

  • General reserve;
  • Workmen compensation fund;
  • Investment fluctuation fund;
  • Dividend equalisation reserve;
  • Debenture redemption reserve;

(b) Capital reserves: Reserves that are not generated from the revenue profits of the business are known as capital reserves. Capital profits are the source of their creation. Such profit is not available freely for dividend distribution.

Such reserves are useful for issue of bonus shares or writing off capital losses.

Examples of capital profits, which are subsequently treated as capital reserves are:

  • Premium on issue of shares or debenture.
  • Profit on sale of fixed assets.
  • Profit on redemption of debentures.
  • Profit on revaluation of fixed asset & liabilities.
  • Profits prior to incorporation.
  • Profit on reissue of forfeited shares

Secret Reserve

As the name clearly suggests, it is a reserve which is not shown in the balance sheet and therefore is hidden from the external parties or the outside stakeholders. It can be created by resorting to any of the following ways –

  1. Charging higher depreciation than usual,
  2. Presenting contingent liabilities as actual liabilities
  3. Recording excessive provision for doubtful debts
  4. Booking capital expenditure to profit and loss account
  5. Undervaluation of inventories/stock

The secret reserve so created over the years is then combined with the profits during the lean period. This helps in showing a better picture of the business than what it actually is.

To prevent  itself from the harsh consequences of unknown expenses and losses, that might arise in future, a business organisation maintains several kinds of reserves. These reserves help the business sail through the tough times smoothly.

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