Types of Reserve

Reserve may be created for different purposes for which different types of the reserve are created. They are mentioned below:

Revenue Reserve

These types of the reserve are created out of reserve profit. They are available to distribute as a dividend to shareholders. There are two types of revenue reserve:

General Reserve

It is also called as a free reserve. It is created out of revenue profit to strengthen the financial position of a business. It is not created for specific purpose. It is created only when there is sufficient profit. It is shown on the debit side of profit and loss appropriation account. It reduces distributable profits. If it is not utilized in future, it can be distributed as a dividend in future.

Objectives and Advantages

The followings are the advantages/objectives of general reserve.

• To provide or expand the additional working capital.
• To meet unknown future loss or liability.
• To equalize rates of the dividend over the year.
• To strengthen the financial condition of a business.

Disadvantages

The following are the disadvantages of general reserve.

• It reduces the distributable profit to the shareholders.
• It may show a better financial condition of a business irrespective of loss.
• The proper utilization of such a reserve may always be questionable.

Specific Reserve

This type of reserve is created for specific purposes. It is created for meeting known liabilities. It is utilized for the purpose for which it was created. It is created whether there is profit or not. It is necessary to create such reserve to ascertain the true profit of the business during a particular period of time. It is shown on the debit side of the profit and loss appropriation account. It reduces the retained earnings. The following are some of the examples of the specific reserve.

• Dividend equalization fund,
• Staff welfare fund,
• Sinking fund,
• Research and development fund,
• Depreciation fund etc.

The different types of specific reserves are mentioned below;

1. Sinking Fund

   A sinking fund is created by setting aside a certain amount of profit annually. It is normally invested outside the business in securities. Interest received on investments is reinvested in the same securities.A sinking fund may be created for the following purposes;
   • For replacement of fixed assets
   • For the redemption of debentures or repayment of loan
   
   A sinking fund for the replacement of fixed asset is a provision. However, a sinking fund represents amount invested outside the business.
   Advantages
   The following are the advantage of sinking fund.
   
   • It is useful for the redemption of long-term liabilities or replacement of assets.
   • The fund is invested to earn interest that eventually increase the fund.
   • It enhances the future strength of a business.
   Disadvantages
   The following are the disadvantages of the sinking fund.
   • A large amount of divisible profit is utilized for sinking fund.
   • If the invested amount is not collected on time, the fund will not meet its purpose.

2. Dividend Equalization Fund

   It is created for the purpose of equalization of dividend to be distributed to the shareholders over years. When there is the high profit, some position is transferred to this fund. It is utilized to keep the dividend up and pay uniformly in the years when the profit is low.
   Advantages
   The following are the advantages of dividend equalization fund.
   • It helps to distribute the dividend to the shareholders uniformly over the years.
   • The market value of share does not fluctuate due to uniformity in the dividend over the years.
   Disadvantages
   The following are the disadvantages of dividend equalization fund.
   
   • Creation of such fund reduces the dividend profit to shareholders.
   • Small business concern may not be able to create such fund due to a poor financial position.

3. Research and Development Fund

   Research and development have become an integral part of modern businesses. Research and development are needed for new product development, grab new opportunities, new technology, quality improvement etc. Thus, investment is required for research and development. Hence, the fund created to carry out the research and development is called research and development fund.
   Advantages
   The following are the advantages of research and development fund.
   
   • It helps for research and development on new product or market or other aspects of business.
   • It helps to earn more profit from the invention of new product and services as well as a market.
   Disadvantages
   The following are the disadvantages of research nd development fund:
   
   • It is not possible to maintain such fund for every business.
   • It reduces the divisible profit of the shareholders.

Capital Reserve

Capital reserves are those reserve which are created for our profit. The profit which is not earned through the normal course of business is called capital profit. Such reserves cannot be utilized for the distribution of dividend to the shareholders. Capital reserve is created out of the capital profits such as;

• Profit on sale or revaluation of fixed assets
• Gain on forfeiture of shares
• Gain on redemption of debentures.

The capital reserve may be used for writing off the capital loss. It is also used for issue of bonus shares. It is shown on the liability side of balance sheet.

Secret Reserve

A secret reserve is the one which is not disclosed on the balance sheet. It is termed as "Internal reserve or Inner reserve". There are bays of creating secret reserves. The main objectives of creating secret reserve are to show the better financial condition than the actual.

A secret reserve is created by the following ways:

• By undervaluation of assets much below their cost market value, such as investment, stock in trade etc.
• By not writing up the value of assets, the price of which has permanently gone up.
• By creating an excessive reserve for bad debt and doubtful debt or discount on sundry debtors.
• By providing the excessive description of fixed assets.
• By writing down goodwill to a nominal value.
• By omitting some of the assets altogether from a balance sheet.
• By changing capital expenditure to reserve account and thus showing the value of assets to be less than their actual value.
• By overvaluing the liabilities.
• By the inclusion of fictitious liabilities.
• By showing contingent liabilities as actual liabilities.

Objectives

The following are the objectives of creating secret reserve

• Secret reserves strengthen the financial position of a concern. Secret reserve helps the concern to remain financially strong in spite of a period of adversity.
• It may best utilize for equalization of dividends, thereby maintaining the financial stability of the company.
• The profit which would have been utilized for the payment of dividend remain in the business.
• An increase the working capital of the company.
• The secret reserve is created to withhold information of the progress of the company from the competitors. If the TRUE position of the company is shown, there is a possibility of a new entrance.

Advantages

The following are the advantages of creating secret reserve

• Working capital of the firm increases by the creation of the secret reserve.
• Competitors are kept at bay from entering in the particular line of business.
• The rate of dividend is not equalization by creating a secret reserve.

Disadvantages

The following are the disadvantages of creating secret reserve

• The financial statement of the company does not portray a true and fair view of the financial position.
• The scope of frauds and mismanagement of a company increase.
• It is against the principles of transparency.