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Learning Objectives:
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Define and explain reserve.
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What are different types of
reserves?
Contents:
Profit earned by a business is
payable to its proprietor. But the proprietor does
not normally draw the whole amount of profit. He
leaves a portion of profit in the business in order
to increase working capital and to strengthen
financial position of the business. This portion is
known as reserve.
According to Yorston, Smyth and
Brown, "Reserve should include amounts set a
side out of profits and other surplus which are not
intended or necessary to meet any liability,
contingency or diminution in the value of assets
known to exist at the date of the balance sheet".
Thus the portion of profit
which is not paid to proprietor, but is kept a part
for meeting some known or unknown losses is called
reserve, e.g., reserve fund, contingency
fund etc. The amount is debited to profit and loss
appropriation account and credited to concerned
reserve account.
It is to be noted that reserves can
be created out of profit only. It cannot be created
if the business incurs a loss.
According to the method and object
of creation, reserves may be of the following types:
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Revenue Reserve
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Capital Reserve
Revenue Reserve:
Profit earned by a business through
its normal activities is determined at the year end
through profit and loss account. The portion of such
profit which is not paid to the proprietor, but kept
apart, is known as revenue reserve.
From the view point of its creation
revenue reserve may again be classified into two
types:
1. General Reserve:
Reserve which is created not for any specific
purpose, but for strengthening the financial
position of the business is known as general
reserve, e.g., reserve fund, contingency
fund etc. It is a matter for the proprietor or
management of the business to decide whether general
reserve will at all be created or if created, with
what amount. Usually there is no compulsion on this
point. But in case of joint stock company a specific
% of profit is to be transferred to general reserve
before it pays dividend to its shareholders. General
reserve is also known as free reserve.
General reserve is not created for
specific purposes. It is usually created for the
following purposes:
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To strengthen the financial
position of the business.
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To increase working capital of
the business.
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To meet future contingencies.
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To meet any unknown liability or
loss.
2. Specific Reserve:
Reserve created for any specific purpose is known as
specific reserve. For example,
dividend equalization fund, debenture sinking fund
etc. This reserve will be utilized for the very
purpose for which it has been created. It cannot be
used for other purposes. Specific reserve is also
known as special reserve.
Capital Reserve:
Profit may arise from sources other
than normal trading activities. Such profit is known
as capital profit. Any reserve created out of such
profit is called capital reserve. It
is usually not available for payment to shareholders
as dividend. It is usually utilized for meeting
capital losses. "The expression 'capital reserve'
shall not include any amount regarded as free for
distribution through the profit and loss account".
Such profit is earned in the following ways:
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Sale of fixed asset.
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Revaluation of assets and
liabilities.
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Issue of shares and debentures
at a premium.
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Profit prior to its
incorporation.
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Redemption of debenture at a
discount.
In addition to this, another type of
reserve is created, the existence of which is not
disclosed through balance sheet or the books of
account. It is called secret reserve.
Generally the type of business whose success is
dependent on public confidence (e.g. banks,
insurance companies and other financial
institutions) create such reserve in order to
strengthen financial position of their concern.
Secret reserve is usually created by undervaluing
assets and overvaluing liabilities. It may be noted
that no special entries are made in the books of
account in order to create such a reserve.
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