Reserves are categorised into two types, and they are:
Revenue reserve is created out of a company's operating profits of a specific period. Moreover, it can be used in the following ways:
Expansion of a business
Dividends that are to be given to the shareholders
Stabilise the share percentage rate
Furthermore, revenue reserves can be classified into two sub-classes:
Special reserves are those reserves where the profits made by a company are assigned and moved to a particular reserve. This separate reserve is created for a select reason, and hence it is named as special reserves. Instances when a special reserve is created:
Board of directors may decide to make a special reserve.
Articles of Association may require it.
To obey the needs of Companies Act.
Some special reserve examples can be staff welfare reserve, debenture redemption reserve, dividend equalisation reserve, etc. Out of the three mentioned special reserves, the dividend equalisation reserve is a contingency reserve. It is used to make dividend payments to shareholders in years when there is not enough profit for dividend distribution. The other reserves are not created with a contingent motive but for definite utilisation. However, if surplus occurs in such reserves, that excessive fund can be used for paying dividends.
The amount of money kept aside by an organisation to meet future obligations, both known and unknown, is called a general reserve. It is extracted from the profit made by that company and used for future needs. In other words, the general reserve meaning of a company is the earned profits that are kept separately out of the gains to clear upcoming obligations.
General reserves are considered a part of Profit and Loss Appropriation Account and fall under free reserves. They can be used for the below-mentioned uses:
To enhance the working capital.
In settling contingencies
In order to strengthen the economical position of an organisation
To pay dividends to the shareholders that exceed the specified amount limit
To balance future debts
They also include money that is conserved for revaluation and litigation purposes
To have more insight into the topic, what is reserved, read the next kind.
The reserves that are made out of the non-operative profits earned by a company during a specific period are termed as capital reserves. These reserves are created for funding a company's long-term objectives or waive off its capital liabilities in the coming times.
Furthermore, a capital reserve account on a balance sheet helps an organisation in preparing to tackle unforeseen happenings like instability, inflation, need of expanding the business or start with a new project.
First, let's Take an Example From an Individual's Perspective:
Suppose an individual wants to purchase a land sometime in the future. So he/she starts saving money by selling off items from home that have become old, like an old car. He/she also creates a savings account to keep all the money from the sales and that person is not allowed to spend those funds anywhere other than investing in real estate.
Now, look at an Example from a Business View:
To construct a new office space, a company requires capital. But it does not want to avail a loan as they will have to bear a considerable amount as interest. Here, creation of a capital reserve comes into play. A company may think of selling other lands and old assets, and the money received is going to be transferred into the capital account. However, a company is not entitled to pay any shares from this reserve. So, they can use the total fund for constructing a new building for their office.
Some Sources from which Capital Reserves can be Earned:
Premium earned on publishing shares and debentures.
Profit gained prior to an enterprise's incorporation.
Profit earned from selling fixed assets.
Capital saving account.
The excess amount after revaluing assets and liabilities.
Credits gained after distribution of forfeited dividends.
Apart from the two main types of reserves, there is another reserve named statutory reserve. These are mainly used in insurance businesses. An insurance organisation is mandated to include assets on its balance sheet with regards to their expected future obligations.
From an economics viewpoint, surplus indicates those earnings that are retained by a company. It is regarded to be virtuous because it shows that resources are available for future purposes.
As per accounting, surplus earnings are debited, and the corresponding amount is then transferred to the reserve account. The balance sheet shows the reserve account under Reserves and Surplus.
In addition to what are reserves, you can look for more topics related to Commerce on Vedantu's official website.
1. What are the Applications of Reserve?
Some uses of Reserves are:
Write off gathered losses
Write off share issue cost
2. What is Reserve and Surplus in a Balance Sheet?
In a balance sheet, reserves are the funds earmarked by an enterprise for specific purposes, and surplus shows the profit balance after clearing all the significant liabilities.
3. What is Meant by a Free Reserve?
The funds that do not have any fixed purpose and can be debited at any point are called free reserves.
4. Is a Reserve Account an Asset or a Liability?
Reserve accounts are considered as a liability.