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Home Depreciation, Provisions and Reserves Reserves


Learning Objectives:

  1. Define and explain reserve.

  2. What are different types of reserves?


Definition and Explanation:

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.

Classification of Reserve:

According to the method and object of creation, reserves may be of the following types:

  1. Revenue Reserve

  2. 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:

  1. To strengthen the financial position of the business.

  2. To increase working capital of the business.

  3. To meet future contingencies.

  4. 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:

  1. Sale of fixed asset.

  2. Revaluation of assets and liabilities.

  3. Issue of shares and debentures at a premium.

  4. Profit prior to its incorporation.

  5. 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.


More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve



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