Types of Reserves:
A) Revenue Reserves:
Revenue Reserves are the reserves which are created out of revenue profits which have been earned in the ordinary course of business.
This reserve is created by setting aside a part of the profits in order to strengthen the financial position of the business.
These are the reserves which are created out of revenue profit which is usually distributable profits.
In other words, it is the profit which has been held from paying dividend out of the total distributable profit.
Examples of Revenue Reserves:
1. General Reserves.
2. Dividend equalization reserve.
3. Debenture redemption reserve.
4. Investment fluctuation reserve.
Types of Revenue Reserves:
There are two types of Revenue Reserves:
I) General Reserves: General Reserve is the reserve which is created by setting aside a part of the profits in order to strengthen the general financial position of the business and to meet any future contingency if any.
In case of sole proprietorship and partnership firm, it is that part of the profit which has not been transferred to capital accounts of the proprietor/partnership.
In the case of a company, it is that amount of profit which has not been distributed as dividend but has been retained in the business.
II) Specific Reserve: Specific reserve are those reserves which is created for a specific purpose and can be utilized only for that purpose but these reserves are also created out of profit.
Example of Dividend reserves are:
1. Dividend equalisation reserve is a reserve which is created by a company in order to maintain a steady rate of dividend.
2. Debenture redemption Reserve fund is a reserve created by a company in order to provide fund for the redemption of debentures.
3. Reserves for replacement of assets is a reserve which is created to provide fund for the replacement of a fixed asset at the end of its usable life.
B) Capital Reserves:
In addition to earning normal profits, a business firm may earn capital profits from some sources.
For example Profit on sale of fixed assets. The capital profits are transferred to the capital reserve account. Capital reserves are used to write off capital losses and for the issue of fully paid bonus shares.
Such reserves are generally not available for distribution as dividend among the shareholders of a company. Usually, the capital reserves are not available for distribution as dividends.
In the case of a limited company, the following are treated as capital profits:
I) Profit prior to incorporation.
II) A premium on issue of shares.
III) Profit on the reissue of forfeited shares.
IV) Profit of redemption of debentures.
V) Profit on sale of fixed assets.
VI) Profit on revaluation of a fixed asset.
C) Secret Reserves:
The term Secret reserve is applied to a reserve, the existence of which does not appear on the face of the balance sheet where there is a secret reserve, the financial position of the concerns is, no doubt, better than what appears in the balance sheet.
The object of secret reserves is to reduce the disclosed profit in years, where there is higher profit, so that during the years where there is lesser profit or loss.
Some ways of Secret Reserve:
I) By making an excessive provision for bad and doubtful debt.
II) By over-depreciating assets.
III) By under-valuation of stock.
IV) By making a provision for contingencies far beyond what is really required.
V) By an incorrect allocation of expenditure between capital and revenue.
As these operations reduce the book values of the assets without the fact being disclosed in the Balance sheet, they remain secret and are known only to the management.
However, the creation of secret reserve is prohibited under the companies act.
The distinction between Capital Reserve and Revenue Reserve:
1. Revenue reserves are created out of revenue profit.
Capital reserves are created out of capital profit.
2. Revenue reserve can be used for distribution of dividend.
It cannot be used for distribution of dividend.
3. Revenue reserves are created to meet future contingencies.
Capital reserves are created as a legal requirement.
4. It can be used for revenue as well as capital purposes.
It can only be used for setting off capital losses specified by law.