Reserves: Meaning, Importance and Types

Let us make in-depth study of the meaning, importance and types of reserves.

Meaning of Reserves:

Reserve means an appropriation of profits or other surpluses to strengthen the liquid resources of the business enterprise and not for meeting any liability, contingency or any commitment of the business.

According to William Pickles, “Reserve means the amount set aside out of profit and other surpluses, which are not earmarked in any way to meet any particular liability known to exist on the date of Balance Sheet.”

Actually, in addition to the capital contributed by the proprietor, the amount set aside from the profits or surpluses to reserves belongs to the proprietor, which will help the business during difficult financial period. It is an appropriation of profits and not charged on the profits. This means that in the case of loss, reserves cannot be created. Reserves help in strengthening the financial position of the business enterprise.

They are not created to meet any liabilities, contingencies or commitments. It is important to mention here that the business cannot create reserves in anticipation of some losses; however, in case of loss, reserves can be utilized. When amount of reserve is invested in some outside securities it is known as ‘Reserve Fund’. Since reserves are appropriation and not charge against profits, they are shown in Profit and Loss Appropriation Account instead of Profit and Loss Account.

Importance of Reserves:

The importance of reserves is as under:

(i) Strengthening the Financial Position:

Reserves help in strengthening the financial position of the enterprise, since it can be used to meet any unforeseen losses that may arise in future.

(ii) Source of Internal Financing:

By creating the reserves, profits are ploughed back into the business which can be used as source of finance.

(iii) Enhancing the Reputation of Enterprise:

In order to enhance the reputation or image of the company, regular dividends must be paid to the shareholders in time. It is also necessary that the dividend should be equalized over the years. This objective can be achieved, if the company maintains reserves because in the years of inadequacy of profits, amount can be withdrawn from these reserves and paid to the shareholders.

(iv) Keeping Working Capital Intact:

Reserve increases the working capital of the business enterprise. So in emergent and unforeseen circumstances, business enterprise can use the amount kept in reserves and keep working capital to the required level.

(v) Facilitating Heavy Amount when Needed:

Reserves can be created for some specific purpose which can be used to meet that purpose only. For the redemption of debentures, company has to pay huge amount to debenture holders. When the debentures become due for payment, the company may face a financial difficulty, because a large amount is generally required for redemption of debentures.

If, in a single go, such a large sum is to be paid out of the working capital, the operational efficiency of the company may get affected adversely. Hence, it is always a prudent policy for a company to retain some money out of its profits for redeeming the debentures.

For this purpose ‘Debenture Redemption Reserve’ can be maintained by the company, in which a fixed amount of profit is transferred. This will facilitate payment of such huge sum, when repayment to debenture holders is due.

Types of Reserves:

Broadly, there are two types of reserves:

(i) Revenue reserves and

(ii) Capital Reserves

1. Revenue Reserves:

Revenue reserves are created out of profits which have been earned in the normal course and from the day to day activities of the business concern.

Revenue reserves may further be classified as:

(i) General Reserve

(ii) Specific Reserve and

(iii) Secret Reserve.

Now we shall move to discuss these reserves in detail:

(A) General Reserve:

General reserve is that amount of profits which are set aside to meet some future contingencies and not created for any specific purpose. These are generally retained for strengthening the financial position of the business concern and to provide additional working capital for the business when needed. Since this reserve can be utilised to meet any unknown purpose, so it is also called ‘Contingency Reserve’ or ‘Free Reserve’.

In any business enterprise, general reserve is created for the following purposes:

(a) To strengthen the financial position of the business concern

(b) To make available additional working capital all the times

(c) To meet any liability or contingency, in case of unforeseen circumstances

(d) To equalize the rate of dividend over the years in case of inadequate profits

(B) Specific Reserve:

Specific reserves are created for some specific purposes. These reserves cannot be utilised for any purpose other than the purpose for which they were created. However, if the article of association permits then at the discretion of board of directors, specific reserves may be used for a purpose other than the purpose of its creation.

Some examples of specific reserves are as under:

1. Dividend Equalization Reserve

2. Debenture Redemption Reserve

3. Investment Fluctuation Reserve

4. Workmen Compensation Fund

(i) Dividend Equalization Reserve:

Dividend equalization reserve is created to equalize the rate of dividend over the years. Usually, in the year of large and adequate profits, a portion of profits is transferred in this account and in the year of inadequate profits, the amount kept in this account can be used for paying the dividend to the shareholders.

This reserve is created by way of the following journal entry:

Profit and Loss Appropriation A/c Dr.

  To Dividend Equalization Reserve A/c

(ii) Debenture Redemption Reserve:

Debenture redemption reserve is created for the purpose of redemption of debentures at the end of some specific period. In this connection, every year a specific sum out of the divisible profits is set aside in this reserve. The amount is to be invested in securities. The amount accumulated with compound interest produces the required amount which has to be paid to debenture holders.

This reserve is created by way of the following journal entry:

Profit and Loss Appropriation A/c Dr.

  To Debenture Redemption Reserve A/c

(iii) Investment Fluctuation Reserve:

Sometimes business enterprises invest their surplus funds outside their business in shares, debentures or other securities. Also, the price of such investments keeps on changing, depending on certain market conditions and/or government policies etc. To bear any loss in case of decrease in value of such investments, business enterprises sets aside a part of profit in Investment Fluctuation Reserve, so that any loss arising on account of decrease in value of such investment can be met from this reserve.

This reserve is created by way of the following journal entry:

Profit and Loss Appropriation A/c Dr.

  To Investment Fluctuation Reserve A/c

(iv) Workmen Compensation Fund:

Workmen Compensation Fund is created to meet the claims of the workers in case they get injured from an accident.

This can be created by way of the following journal entry:

Profit and Loss Appropriation A/c Dr.

  To Workmen Compensation find A/c

(C) Secret Reserve:

Secret reserve is a reserve that do not appear in the balance sheet. It can be created in the years of higher profits and can be merged with the profits during the lean periods.

Secret reserves can be created as under:

(i) By undervaluing stock,

(ii) By making excessive provisions then the required,

(iii) By charging capital expenditure to revenue,

(iv) By showing contingent liabilities as actual liabilities of the enterprise.

Secret reserve is secret in the sense that it is not known to the outsides. It is suggested that keeping in view the requirement of the case, secret reserve should be created within reasonable limits.

2. Capital Reserves:

Capital reserves are the reserves created out of capital profits.

Following are the examples of some items which may form capital reserves:

1. Profit on Sale of Fixed Assets

2. Profit on Revaluation of Fixed Assets

3. Securities Premium received on Issue of Shares or Debentures.

4. Profit on Redemption of Debentures.

5. Profit prior to Incorporation

6. Profit on Reissue of Forfeited Shares, etc.

Capital reserves can be utilized for writing off capital losses. However, in the case of joint stock Company, capital reserves can also be utilized for issuing fully paid bonus shares to the members. Generally, capital reserves are not available to shareholders for distribution of profits.

However, some capital reserves such as profit on sale of fixed assets can be utilized for distribution as dividend, if the following conditions are satisfied:

(i) Articles of Association permits the company to do so;

(ii) The profits on sale of fixed asset must have been realized by the company in cash;

(iii) Such profits exist after revaluation of all assets and liabilities and not due to revaluation of assets only.