Note on Reserves

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  • Things to remember

INTRODUCTION TO RESERVES

The term “Reserve” indicates to the fund or an amount of money that is set aside until it is needed for some particular purpose out of the business earned profit. Reserve fund is created for future purpose. Reserve fund is the part of the profit. So, if there is no profit, then reserve fund cannot be created. Reserve fund is not distributed to the shareholder/owner.



The amount of reserve will be shown on the liability side of balance sheet. When reserve is created, an entry should be passed in the book of accounts and that reduces the value of divisible profit. When the reserve fund is created, the cash and other assets of the business will not be set aside.

As reserve is a part of profit that are set aside for the future use, these amount will not be distributed among the shareholders as dividend. So, reserve is a general accounting term which means to withdraw some amont of money from profit earned by the business organization and keep it in safe pocket of the business and use these amount if the business face loss in near future.

Hence, the reserve are kept by every business organizations to be safe from loss and use the reserves to maintain proper sustainability and survivability of organization.

Characteristics of reserves

The characteristics of reserve are as follows:

  • Reserves are created to increase the working capital.
  • It is created on the liability side of balance sheet.
  • Reserves are the appropriation of profit for future contingency.
  • It strengthens the financial position of a concern.

Objectives of reserves

The main objectives of reserve are as follows:

  • To increase the business through internal resources.
  • To expand the working capital of a business.
  • To meet the future contingencies.
  • To strengthens the financial position of a concern.
  • To replace the wasting materials.

Types of Reserve

There are three types of reserve. They are:

  1. Capital Reserve
  2. Secret Reserve
  3. Revenue Reserve

Capital Reserve



Capital reserves are the reserve which are created out of capital profit but not created out of revenue profit. It includes profit on sale of fixed assets, premium on issue of shares, profit on revaluation of fixed assets, etc. The capital reserves are not distributed as dividend to the shareholders. They are distributed only if the article of association is permitted. The following are the examples of capital profit from which capital reserves are created:

  • Profit prior to incorporation
  • Premium on issue of share & debenture
  • Profit on reissue of forfeited share
  • Profit on redemption of debenture
  • Profit on sale ore revaluation of fixed assets

Secret reserve

Secret reserve is that reserve which is not disclosed on the list of balance sheet. Secret reserve is the outcome of understatement of assets and overstatement of liabilities. It is also known as internal reserve or implied reserve. It is created to increase the working capital and enhance the faith of shareholders.

Advantages of secret reserve

The advantages of secret reserve are as follows:

  • To increase working capital.
  • To strengthen the competitive position.
  • To enhance the faith of shareholders.

Disadvantages of secret reserve

The disadvantages of secret reserve are as follows:

  • It increases the chances of frauds and mismanagement.
  • It is against the principle of transparency.

Revenue reserve

All the reserves which are created out of revenue profit resulting from day to day activities or business operation are known as revenue reserve. The following types of revenue reserves are created in the business:

A) General Reserve:

General reserve is that type of revenue reserve which is not created for specific purpose.

Accounting treatment

It is created out of an appropriation of net profit and its accounting treatment will be as below:

Date

Particulars

L.F.

Debit (Rs)

Credit (Rs)

Profit and loss appropriation a/c……………………..Dr
To General reserve a/c
(Being net profit transferred to general reserve)

XXX


XXX

B) Specific Reserve:

Specific reserves are those reserves which are created for the specific purpose. Specific reserve is created for:

  • Dividend equalization fund
  • Sinking fund
  • Debenture redemption fund
  • Research and development fund

It is created by debiting the profit and loss appropriation account and creating the above specific reserve fund:

Accounting treatment

Date

Particulars

L.F.

Debit (Rs)

Credit (Rs)

Profit and loss appropriation a/c……………………..Dr
To Dividend equalization fund a/c
To Sinking fund a/c
(Being net profit transferred to………………. reserve)

XXX


XXX
XXX

i) Dividend Equalization Fund

It is created to equalize the dividend for each year by profit and loss appropriation account. When profit is in large amount, it is transferred to its fund so that it can be utilized to equalize the dividend when the profit is in low amount in the next year.

Advantage of dividend equalization fund:

The advantages of dividend equalization fund are as follows:

  • It helps to uniform the dividend over years.
  • The market price of share could not fluctuate due to the poor financial position.

Disadvantage of dividend equalization fund:

The disadvantages of dividend equalization fund are as follows:

  • Large amount of distributable profit is utilized for dividend equalization fund.
  • Small business firm cannot create such fund.

ii)Sinking fund

Sinking fund is a specific reserve set aside by annual contribution for redemption of a long term debt or the replacement wasting assets. This fund is invested outside the business in easily obtainable securities. There are two types of sinking fund:

  • Sinking fund for replacing assets
  • Sinking fund for redemption of liabilities

Advantage of sinking fund:

The advantages of sinking fund are as follows:

  • It is easier to redeem long term debts or replacement of assets.
  • It is to be invested in the firm and will increase the amount of fund.

Disadvantage of sinking fund:

The disadvantages of sinking fund are as follows:

  • The large amount of distributable profit is utilized for sinking fund.
  • If the invested amount is not collected in time, it will not fulfill its purpose.

Distinction between revenue reserve and capital reserve

Basis

Revenue reserve

Capital reserve

Creation

It is created by operating profit.

It is created by non-operating or capital profit.

Distribution as dividend

They are free distributed as dividend.

They are distributed only if the article of association is permitted.

Uses

It is used to meet future contingencies.

It is used to meet capital losses & to write off preliminary expenses.




References:

Sharma, Narendra et.al., Principles of Accounting-XI, Bundipuran Prakashan, Kathmandu

Koirala, Yadav Raj et.al., Principles of Accounting-XI, Asmita Books Publication, Kathmandu

Shrestha, Dasharaha et.al., Accountancy-XI, M.K. Prakashan, Kathmandu

Types of Reserves

1. Capital Reserve
2. Secret Reserve
3. Revenue Reserve

  • a. General Reserve
  • b. Specific Reserve
.

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