Reserves mean the amount set aside out of profits and other surpluses to meet future uncertainties. In other words, a reserve is meant for meeting any unknown liability or loss in the future. Reserve is created through the appropriation of profits.
According to the American Institute of Accounting, The use of the term reserve is limited to indicate that an undivided part of the assets is being held or retained for general or specific purposes.
According to William Pickles, Reserve means the amounts set aside out of profits and other surpluses, which are not earmarked in any way to meet any particular liability, known to exist on the date of the Balance sheet.
Examples of Reserves:
1. General Reserve
2. Capital Reserve.
3. Contingency Reserve.
4. Reserve for Expansion.
5. Dividend Equalisation Reserves.
6. Debenture Redemption Reserves.
7. Capital Redemption Reserves, etc.
Features of Reserves:
A) A reserve is created out of net profits or divisible profits or undistributed profits.
B) It is not created to meet any known liability or for providing Depreciation.
C) Creation of Reserve is not a legal necessity except in certain cases. Normally, it is created voluntarily for strengthening the general financial position of the business.
D) Reserves represent accumulated or undistributed profits and as such, they are treated as part of the capital fund.
Importance of Reserves:
1. Strengthening the financial position of the business: Creation of Reserves help in strengthening the financial position of the business.
When the reserves are created, the working capital base of the entity is strengthened by retaining so much of cash which would have been withdrawn by the proprietor or distributed as dividend among shareholders.
2. Fund for meeting any unforeseen liability or loss: Creation of reserve provides fund for meeting any unforeseen or abnormal loss arising in the future.
3. To provide funds for meeting a specific liability: Sometimes a reserve called debentures redemption reserve is created for the purpose of repayment of debentures after a specific period.
For example: If debentures of Rs. 10 lakhs is to be redeemed after five years, a reserve is created for this purpose by transferring a fixed amount from the divisible profits each year.
4. The equalisation of dividends over the years: Goodwill of a company depends upon maintaining a uniform rate of dividend from year to year and also to increase the rate of dividend steadily.
Reserves help the directors to achieve this objective because, in the period of the inadequacy of profits, the required amount can be utilized from reserves.
5. Complying with the legal requirement: A limited company, declaring dividend above a specific percentage, is required to transfer a minimum specified percentage of profit to reserve.
In such a case, the creation of reserves is a legal necessity and is required to be made for complying with the legal requirement.
Different 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.
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.
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.