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.
As the creation of reserve is an appropriation of profit so, it does not reduce the profits of the firm. Therefore, the reserves are not debited to the Profit and Loss Account. Rather, it is debited to the Profit and Loss Appropriation Account. Also, the reserves created are shown on the Liabilities side of the Balance Sheet under the head Reserves and Surplus. Sometimes, a business may opt to invest the amount of reserve so created outside its operations. Such investment of reserve is known as Reserve Fund.
In the words of William Pickles, ‘Reserves means the amount set aside out of the profits and other surpluses, which are not earmarked in a way to meet any particular liability, known to exist on the date of Balance Sheet’. As per the American Institute of Accounting views- ‘The use of term reserves be limited to indicate that an undivided part of the asset is being held or retained for general or specific reserve’.
Examples of Reserves
The given below are some examples of reserves.
- Dividend Equalisation Fund
- Capital Reserve
- Debenture Redemption Reserve
- Workmen Compensation Fund
- Investment Fluctuation Fund, etc.
Features of Reserves
The following are the various features of reserves that can be derived from the above explanation.
- It is created to meet future uncertainties.
- Its creation is not compulsory.
- It is an appropriation of profits and not a charge against profits.
- It can be distributed as dividends.
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.
Types of Reserves
The reserves can be broadly bifurcated as revenue reserves and capital reserves. The revenue reserves can be further classified as general reserves and specific reserves.
Revenue Reserves
The reserves that are created out of those profits which are earned from carrying out the normal activities of a business are known as Revenue reserves. In other words, revenue reserves are created out of the revenue profits of the firm. These reserves are created to meet the unexpected expenses or losses of the business. It helps to strengthen the financial soundness of the business. These can be utilized for the distribution of dividends among the shareholders. In the words of Kohler, ‘Reserves are that portion, or any thereof, of the net worth or total equity of an enterprise representing retained earnings available for withdrawal by proprietors’. Some of the examples of Revenue reserves are Debenture Redemption Reserve, Investment Fluctuation Reserve, General Reserve, etc. The Revenue reserves can be further classified as General Reserve and Specific Reserve.
General Reserves: These are the reserves that are created out of revenue profits without any specific purposes. In other words, these reserves are maintained to meet the future unforeseen liabilities of the business. The purposes of utilizing such reserves are not specified and thus it can also be used to enhance or improve the financial position of the business. These reserves are used as per the discretion of the management for general purposes. The given below are some purposes for which the general reserve can be utilized.
- To strengthen the financial position of the business.
- To meet unexpected expenses or losses.
- To provide a channel for expanding the business.
Specific Reserves: These are the reserves that are created out of revenue profits for fulfilling the specific purposes of the business. These reserves cannot be utilized for the purposes other than specified purposes for which it has been created. For example, Debenture Redemption Reserve is a specific reserve that can be utilized for redeeming the debentures of the
company. Some of the examples of specific reserves are Investment Fluctuation Fund, Workmen Compensation Fund, Dividend Equalisation Fund, Sinking Fund, Development Rebate Reserve, etc.
Capital Reserves
The reserves that are created out of the capital profits of a business are known as Capital reserves. Capital profits are the profits that are not earned in normal business activities. These reserves are created out of the transactions which are capital in nature. Therefore, all the capital profits arising from the specific capital nature transactions can be termed as Capital reserves. The following are some examples of capital reserves.
- Profit on sale of fixed assets.
- Profit on re-issue of forfeited shares.
- Profit on revaluation of assets and liabilities.
- Premium received on issue of shares and debentures.
- Profit on redemption of debentures.
- Profit prior to incorporation.
These reserves are utilized by the business for writing off the capital losses and cannot be utilized for the distribution of dividends among the shareholders.
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