The amount that is kept out of the profits of an enterprise to meet the future ‘unknown’ or ‘unexpected’ liabilities is known as reserve. The creation of reserves helps in meeting the unforeseen expenses or losses that may occur in the near future. It should be noted that the creation of reserves is not compulsory. Its creation completely depends upon the will of an enterprise. It is an appropriation of profits that is created out of the undistributed profits of the business. It helps in strengthening the financial position of the business. Besides this, the number of reserves can also be utilized for the distribution of profits among its shareholders. Followings are the Importance of Reserves
Importance of Reserves
The given below are some purposes served by the creation of reserves.
Provide for Future Unexpected Liabilities: The number of reserves can be utilized to meet the unexpected future losses or expenses of the business.
Improved Financial Position: Reserves are basically the retention of a certain portion of undistributed profits of the business. Therefore, for the purpose of expanding the business, the reserves can be used as an internal source of finance.
Improve Goodwill: The reputation of a business depends on the uniformity in the payment of dividends. The reserves can be utilized for the distribution as dividends to its shareholders which gives them a sense of surety and security of their investment in the business. This, in turn, enhances the goodwill of the business.
Repayment of Long-term Liabilities: The specific reserve can be created for the repayment of long-term liabilities. For example, for the purpose of redeeming the debentures, a business may create a Debenture Redemption Reserve for making payment to its debenture-holders.
Meeting Legal Requirements: Sometimes the reserves may be created just to fulfill the legal requirements. For example, the creation of an Investment Fluctuation Fund is legally required by the Income Tax Law.
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