What are Reserves?
How Many Kinds Of Reserves Are There?
Reserves are categorised into two types, and they are:
Revenue Reserves
Capital Reserves
What Is Meant By Revenue Reserve?
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
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.
General Reserves
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.
What Are Capital Reserves?
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.
What Is Surplus?
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.
FAQs on Reserves: Types and Importance in Accounting
1. What are reserves in accounting, and why are they created?
In accounting, a reserve is an amount set aside out of profits and other surpluses. It is an appropriation of profit, not a charge against it. Reserves are created to strengthen the financial position of the business, fund future growth and expansion, meet unforeseen contingencies or liabilities, and for legal compliance. They act as a financial cushion, enhancing the company's ability to absorb unexpected losses. For more details on foundational concepts, you can refer to the Introduction to Accounting Class 11 Notes.
2. What are the main types of reserves found in company accounts?
Reserves in accounting are broadly classified into two main categories:
Revenue Reserves: These are created from the normal operating profits of the business. They can be further divided into General Reserves (no specific purpose) and Specific Reserves (earmarked for a particular purpose).
Capital Reserves: These are created from capital profits, which are non-operating gains like profit on the sale of fixed assets or profit on the reissue of forfeited shares. These are generally not available for distribution as dividends.
You can explore these types of reserves in accounting with examples to gain a deeper understanding.
3. What is the fundamental difference between a Provision and a Reserve?
The fundamental difference lies in their nature and purpose. A Provision is a charge against profit, created to meet a known liability or a probable loss where the exact amount is uncertain (e.g., Provision for Doubtful Debts). In contrast, a Reserve is an appropriation of profit, set aside voluntarily to strengthen the company's financial standing and is not meant to cover a known liability. Provisions are mandatory to ascertain true profit, while reserves are created after profit has been calculated. For a detailed comparison, see the Difference Between Provision and Reserve.
4. Why is a reserve considered a liability on the Balance Sheet?
A reserve is considered a liability due to the Business Entity Concept in accounting. This principle states that the business is an entity separate from its owners (shareholders). Since reserves are undistributed profits, they represent money that the business owes back to its owners. Therefore, it is shown on the 'Equity and Liabilities' side of the Balance Sheet as an internal liability, reflecting the owners' claim on the company's assets. The Theory Base of Accounting covers these fundamental concepts.
5. What is the key distinction between a Capital Reserve and a Revenue Reserve?
The key distinction lies in their source and usage:
Source: A Revenue Reserve is created from profits earned during the ordinary course of business. A Capital Reserve is created from capital profits, which are gains of a non-recurring nature.
Usage: Revenue reserves (like General Reserve) are generally available for dividend distribution. Capital reserves are typically not available for paying dividends and are used for purposes like writing off capital losses or issuing bonus shares. You can learn more about the Difference Between Capital Reserve and Revenue Reserve for further clarity.
6. How do reserves contribute to the financial stability and growth of a business?
Reserves play a crucial role in ensuring a company's long-term financial health. They provide a vital financial cushion to absorb unexpected losses or economic shocks without jeopardising operations. Furthermore, reserves can be used to finance future growth and expansion projects, such as launching a new product line or modernising machinery, without needing to raise external debt or dilute ownership by issuing new shares. This internal financing supports sustainable growth and strategic flexibility.
7. Can a company use its Capital Reserve to pay dividends to shareholders?
Generally, no. A Capital Reserve is not created from operating profits and, as per the Companies Act, cannot be used for distributing cash dividends. Its primary purpose is to absorb capital losses or to be utilised for specific purposes like issuing fully paid bonus shares or writing off fictitious assets. This restriction ensures that the company's capital base is not eroded by distributing non-operating gains as dividends. To understand its usage better, you can review the rules governing a Capital Reserve.
8. What are some common examples of Specific Reserves?
A Specific Reserve is a type of revenue reserve created for a particular, well-defined purpose. Some common examples include:
Debenture Redemption Reserve (DRR): Created to provide funds for the redemption of debentures.
Dividend Equalisation Reserve: Set up to maintain a stable rate of dividend payments to shareholders, especially in years of low profit.
Investment Fluctuation Reserve: Created to cushion the business against a decline in the market value of its investments.
