Reserves: Types and Importance in Accounting

The preserved earnings of an organisation to nourish and strengthen its position economically are categorised as reserves. It also includes all the funds needed to clear the outstanding payments and debts, purchase fixed assets, expand the company's operative scope, legal necessities, investment purposes, and other various plans.

Reserves are kept to prevent from spending surplus cash in other requirements. However, it does not entail any legal restrictions, and hence a company can use it according to their needs.

Now that you have a basic idea about what a reserve is, let's proceed on to its kinds.

How Many Kinds Of Reserves Are There?

Reserves are categorised into two types, and they are:

1. Revenue Reserves

2. 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:

1. 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.

2. 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.

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