An Introduction
Capital and reserves tend to have an integral role in maintaining and safeguarding the financial health of a business organisation. The fact that they ensure continuity of everyday business operations and aid to meet both unexpected and long-term liability, make them indispensable.
On that note, let’s take this opportunity to find out more about reserves in accounting and become familiar with its vital aspects.
What is a Reserve in Accounting?
In the literal sense, a reserve can be defined as earnings that have been kept aside for a specific purpose. One can explain reserve meaning in accounting by describing it as the portion of available earnings that business owners keep aside to meet any sort of financial contingencies.
For instance, firm owners may use their reserves to invest, purchase fixed assets, install new equipment, pay dividends to shareholders, settle legal obligations, etc. Here, the portion of reserve that is invested outside the firm is termed as a reserve fund.
Reserves are mostly created to improve the financial standing of an organisation. They are also popularly known as the ploughing back of profits. Notably, they are created to meet an unforeseen financial obligation or expansion purpose.
Funds for expansion, general reserve, dividend equalisation reserve, etc. are some of the most common examples of reserves.
Types of Reserves
Reserve in accounting is mainly of 3 types. Read along to find out more about them.
1. Revenue Reserve
Popularly known as retained earnings, this particular reserve is created with the help of the earnings generated through the primary operations of a business firm. Revenue reserve is mostly used for two purposes; for expansion of the scale of production for the business units and to pay dividends to company shareholders.
2. Capital Reserve
The said reserve is created straight from capital earnings. Unlike revenue reserves, these earnings aren’t distributed to a firm’s shareholders (as dividends) and do not tend to occur frequently. Notably, a capital reserve is created as per the Companies Act. However, firms can use this reserve to write off their capital losses.
Generally, capital reserves are created with the help of profits generated through –
Forfeiture of shares
Sale of fixed assets
Revaluation of existing assets
Earnings at hand before incorporating the firm.
Redemption of preference shares or debenture.
3. Specific Reserve
Special reserves are funds that are created by business owners to meet specific financial obligations. The dividend equalisation reserve, reserve for asset replacement, reserve for debenture redemption and reserve for capital redemption are among the most common examples of specific reserves.
Now that we have become familiar with the type of reserves in accounting let’s find out how they are created and treated in the books of account.
How are Reserves Created?
A reserve in accounting is an appropriation of earnings and usually is not charged on them. It must be noted that when a reserve is created, it does not reduce the aggregate of net profit. However, a significant share of divisible profit gets reduced.
Since reserves are created from earnings generated through a firm’s core operations, it is recorded in its Profit and Loss Account. On the other hand, in the balance sheet, reserves appear on the liability side under the header of ‘Reserves and Surplus.’
Subsequently, the reserve account is created by debiting the firm’s retained earnings and then crediting the concerned reserve account.
The journal entry below offers a clear idea of how reserves are treated in the books of accounts
Profit and Loss A/C Dr. To Reserve A/C
On that note, let’s check out the perks reserves in accounting.
Benefits of Reserves in Accounting
Reserves of a company help to improve its financial position.
They serve as sources of internal financing and facilitate the expansion of a firm’s scale of operation.
They help to pay timely dividends to shareholders. This directly helps to increase a company’s goodwill and fosters a good relationship between the company and its shareholders.
Reserves prove effective in meeting financial obligations and losses.
With the help of reserves, business owners can replenish their working capital and maintain the firm’s everyday operations smoothly.
By investing the number of reserves in new equipment and additional assets, business owners can improve their operational productivity.
Test Your Knowledge: Find out if there are any limitations of reserves accounting and list them in your own words.
Difference Between the Capital Reserve and Revenue Reserve
Check out this table to find out the basic differences –
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Reserve Accounting
Reserve accounting has a term reserve that means a source where we can save and can use when needed or it refers to those earnings that are kept aside for a specific purpose. So, reserve accounting means that some portion of the earnings are kept aside and can satisfy the financial losses or financial needs.
For example, if the owner of the firm wants to purchase more assets like machinery for more production the reserves can be used, if the owner was to invest in any other prospect of the business reserves will be helpful, reserves will be helpful to pay the dividends to the shareholders, or to settle any legal obligations like situations. And if the owner invests the reserves out of the business that is called reserve funds.
According to a common perspective, the reserves are created to become secure or to improve the financial standing of any organization. The term ploughing back of profits is also used for these reserves. Hence, the reserves are created to face any financial loss, obligation, or expansion of business.
Reserves and Their Types
There are mainly three types of reserves. Those reserves are mentioned below -
Revenue reserves
Revenues are commonly popular with the term retained earnings. The revenue reserves are created by the earnings generated through the primary business of an organization. The most common use for the revenue reserve is to expand the organization to increase the scale of production of business units or to pay dividends to the shareholders of the organization.
Capital reserve
As the name suggests the capital reserve originates straight from the capital itself. Unlike the revenue reserve, the capital reserve is not distributed among the shareholders of the organization and occurs only once throughout the life of an organization. The capital reserve is used to write off the capital losses and it is created as per the companies act. The capital reserve is created through forfeiture of shares, revaluation of existing assets, the redemption of preference shares or so-called debenture, sale of fixed assets, and from the earnings at hand before incorporating the firm.
Specific reserve
As the name suggests the specific reserves are used for the specific operations. The special reserves are created by the owners to clear their specific financial obligations. The specific reserve is moreover used for asset replacement, debenture redemption, and capital redemption. The specific reserves originated from the earnings gained by the main purpose of the organization.
FAQs on Reserves: Meaning, Types, and Benefits in Business
1. What is a reserve in the context of business accounting?
In accounting, a reserve is an amount of profit or surplus that has been set aside, or appropriated, to strengthen the company's financial position or to meet future needs. Unlike a provision, which is a charge against profit for a known liability, a reserve is an appropriation of profit. It is not meant to cover a known liability or a depreciation in asset value but to be used for specific or general purposes like business expansion, offsetting future contingencies, or improving the balance sheet.
2. What are the main types of reserves found in a company's financial statements?
Reserves in a business are primarily classified into two main categories based on the source of their creation:
- Revenue Reserves: These are created from the normal operating profits of the business. They can be used for various purposes, including dividend distribution. Examples include General Reserve and Retained Earnings.
- Capital Reserves: These are created from capital profits, which are non-operating gains. Examples include profit on the sale of fixed assets, profit on forfeiture of shares, or premiums received on the issue of shares or debentures. These are generally not available for dividend distribution.
3. How is a 'reserve' fundamentally different from a 'provision'?
The fundamental difference lies in their purpose and accounting treatment. A provision is a charge against profit created to meet a known liability or a decrease in the value of an asset, even if the exact amount is uncertain (e.g., Provision for Doubtful Debts). In contrast, a reserve is an appropriation of profit, meaning it is set aside from profits already earned to strengthen financial stability or fund future growth. A provision is mandatory to ascertain true profit, while creating a reserve is discretionary.
4. What is the primary difference between a Capital Reserve and a Revenue Reserve?
The primary difference is their source and usage. A Revenue Reserve is created from profits earned during the ordinary course of business activities and can generally be used to pay dividends. A Capital Reserve is created from capital profits (e.g., sale of a fixed asset at a profit) and is typically not available for distribution as dividends to shareholders. Its use is often restricted by law, such as for writing off capital losses or issuing bonus shares.
5. Why is it important for a business to create and maintain reserves?
Creating and maintaining reserves is crucial for several reasons:
- Financial Stability: They act as a financial cushion to absorb unexpected losses or economic downturns without affecting normal operations.
- Funding for Growth: Reserves provide an internal source of funds for expansion, modernisation, or diversification, reducing reliance on external debt.
- Legal Compliance: Certain reserves, like the Debenture Redemption Reserve (DRR), are legally mandatory.
- Dividend Equalisation: A General Reserve can be used to maintain a stable rate of dividend payments to shareholders even in years of low profit.
6. What are some common examples of specific reserves and their purpose?
A specific reserve is created for a clearly defined purpose and can only be used for that purpose. Common examples include:
- Debenture Redemption Reserve (DRR): Created out of profits to ensure funds are available for the repayment of debentures upon maturity.
- Investment Fluctuation Reserve (IFR): Set up to cover any fall in the market value of investments.
- Workmen Compensation Reserve: Created to meet any potential liability arising from accidents or injuries to employees at the workplace.
7. Can a company legally use its Capital Reserve to pay dividends to shareholders?
No, as per the Companies Act, a Capital Reserve cannot be used to distribute cash dividends to shareholders. This is because these reserves are generated from capital transactions, not regular business operations, and are intended to be a permanent part of the company's capital structure or to cover capital losses. However, a capital reserve can be used for issuing fully paid-up bonus shares to existing shareholders under specific conditions.
8. How does a 'reserve fund' differ from a simple 'reserve'?
While often used interchangeably, there is a technical difference. A reserve refers to any amount set aside from profits. A reserve fund, however, specifically refers to a reserve where the corresponding amount is invested in securities or assets outside the business. This ensures that cash is readily available when the need for the reserve arises. A reserve that is not invested outside is simply retained and used within the business itself.
9. How do reserves improve the financial stability and goodwill of a company?
Reserves significantly improve a company's financial standing and reputation. A strong reserve base indicates prudent financial management and profitability, which enhances the company's goodwill among investors, lenders, and creditors. It signals that the company can weather financial shocks, fund its own growth, and maintain stable dividend payments, making it a more secure and attractive investment. This financial strength is reflected in a healthier Balance Sheet.
