An amount which is kept aside from our current income to meet the unexpected happening in the future is the reserve. Future is uncertain, in the business there are a lot of happenings which may happen unexpectedly. For this, arrangement of funds in a well planned manner is necessary. Some amount of total earned fund in a year is needed to set aside as a reserve.
Reserves are the amounts set aside out of profits. It is an appropriation of profits or accumulated profits to strengthen the financial position of the business. It is not a charge against profits. Reserves are not meant to cover any liability or depreciation in the value of assets.
Types of Reserves
Reserves is that part of profits that is kept aside to meet an unknown liability or for future emergency. It is created by debiting the P&L Appropriation A/c. It can be created only when there is profit in the business. It is usually shown on the liability side of the balance sheet. Reserves can be categorized into:
- General Reserve
- Capital Reserve
- Secret Reserve
- Revenue Reserve
- Specific Reserve
- Reserve Fund
- Sinking Fund
1. General Reserve
The general reserve is not tied down to any specific purpose. It can be utilized to meet any future contingency or unknown liability. It is not legally mandatory to create a general reserve. It is created only when there is sufficient profit. It is shown on the debit side of P&L Appropriation A/c.
This reserve is created by setting aside revenue profits. The object is to strengthen the general financial position of the business. It is not for a specific purpose. It is a free reserve. It acts as a safety cushion against all unforeseen contingencies in the future. It is immediately available for distribution as dividend profit.
2. Capital Reserve
A capital reserve is generally created out of profits which are of capital nature only, such as capital gains, premium on issue of shares and debentures, profits prior to incorporation, profits on revaluation of assets and liabilities, etc. It should not be distributed as dividend among the shareholders. It is used to strengthen the financial position of business, to write off capital losses or losses of abnormal nature.
Examples of capital reserves includes: security premium, capital redemption reserves, capital reserves arising on merger and acquisition of a business, statutory reserves, asset revaluation reserve and exchange fluctuation reserves.
Capital reserves are created out of capital profits. Capital profits are not regular trading profits. They are profits on rare transactions. Capital reserves are generally not available for distribution as dividend. They are set aside to strengthen the financial position of the business or to meet capital losses.
3. Secret Reserve
Sometimes, a firm creates a reserve which is not shown in the balance sheet. It is known as secret reserve or hidden reserve or internal reserve. The existence of this reserve is not disclosed in the financial statements. It strengthens the financial position of the business, promotes confidence and stability. It is not created by joint stock companies except banking, insurance and financing companies.
4. Revenue Reserves
Revenue Reserves are appropriation from revenue profits which can be distributed by way of cash dividends although some may be set aside for other purposes.
5. Specific Reserve
The Specific Reserve is created for a specific purpose. It is utilized for only that purpose for which it has been created and not for purpose other than that. Whether a firm earns profit or suffers losses, it is obligatory for it to create specific reserve. It is shown on the debit side of P&L A/c. Examples of such reserves are - dividend equalization reserves, investment fluctuation reserves, plant replacement reserves.
Specific reserve is created by setting aside revenue profits. But it is for a specific purpose. This is not immediately available for distribution.
6. Reserve Fund
When a part of the profit is set aside and used in the business, it is a reserve. But when a part of profits and other surplus is set aside and invested outside the business then it is known as reserve fund. In this case, the retained amount is invested in safe securities which are readily and easily realizable. Investments are not being carried for definite period. The purpose is to strengthen the financial position of the business house. The use of the term ‘fund’ indicates investment of reserve outside the business.
Reserve fund Investments are not made for definite period. It is created always out of divisible profits. Interest received on investments representing reserve fund may not be re-invested.
7. Sinking Fund
A sinking fund is established for the future redemption of the long-term debts or liabilities or for replacement of assets or to renew a lease. A sinking fund is a fund built up by annual contributions. The contributions are invested outside the business in readily realizable securities. Interest received on investments is reinvested in the same securities.
General Rules in Creation of Reserves
- It is created by debiting the profit and loss appropriation account.
- It is created to meet an unknown liability, or to strengthen the financial position of the company or for equalization of dividends, etc.
- A reserve is created only when there is profit in the business.
- It can be distributed among shareholders as dividend.
- The reserve is created without taking into consideration the actual amount required except in the case of redemption of debentures when a definite sum is set aside.
- Creation of reserve depends upon the financial policy of the business and discretion of its management.