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 aide 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 dividend) 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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1. What is a Reserve in Accounting?
Ans. Reserve can be defined as the share of available profits that a firm decides to keep aside to meet unforeseen financial obligations. Reserves in accounting are of 3 types – revenue reserve, capital reserve and specific reserve.
2. What is the Difference Between Capital Reserve and Revenue Reserve?
Ans. The capital reserve is a type of reserve which is created with the profits earned through capital earnings. Revenue reserve is a type of reserve which is created with the profits accrued through a firm’s primary operations.
3. Give 2 Examples of Reserves.
Ans. Examples of reverses – Capital redemption reserve and debenture redemption reserve.