Reserve in Accounting: Meaning, Objectives, Types
Meaning of Reserve
Reserve is an amount set aside
out of the profit to strengthen the financial position of the business to meet
future contingencies and losses. In other words, the amount of profit that is
kept safe for the smooth operation of an organization and to pay different
kinds of liabilities is called reserve. It is also called undistributed profit
or retained earnings. Sometimes, it can be distributed to the shareholders as
dividends. So we can say that part of the profit, which is undistributed for the
purpose of business use in the future.
Objectives or Importance of Reserve
Reserve helps the business in
strengthening the financial position of a business. It also helps to meet
uncertain and unexpected losses without and reduction in owner’s capital. The
reserves may be created for achieving any of the following objectives.
To strengthen the financial position of a firm.
To increase the working capital of a firm.
To meet future contingencies of a firm.
To meet any unknown liabilities or losses of a firm.
To replace wasting assets of a firm.
To distribute dividend uniformly.
Features or Characteristics of Reserve
The main features of reserves are
Reserves are created for meeting unknown liabilities or losses.
Reserves are created out of profits.
Reserves are recorded on the liabilities side of the balance sheet.
Reserves amounts are invested outside the business in purchase of securities from ‘reserve fund’.
Types of Reserve
A reserve which is created out of capital profit, capital profit is made from capital items. It is usually not available for payment to shareholders as dividends. It is utilized for meeting the capital losses of the firm.
Capital profit is earned in the following ways.
- Sales of fixed assets
- Revaluation of assets and liabilities
- Issue of shares and debentures at a premium
- Forfeiture of shares
- Redemption of debenture at discount
- Profit on sale of investment etc.
Advantages of Capital Reserve
of capital Reserve are as follows:
- It helps to strengthen the financial position of an enterprise.
- It helps to supply additional requirements of working capital.
- It can meet unknown and unforeseen crises.
- I help in the issue of fully paid bonus shares to the existing shareholders.
Disadvantages of Capital Reserve
disadvantages of the capital reserve are as follows:
- Shareholders cannot get a fair dividend for its distribution.
- Difficulty to determine such reserve fund.
- No reflection of the real profit on business organization.
- All business organizations cannot make this provision necessarily.
A reserve which is created out of the revenue profit. Revenue profit earned from its normal activities of a business at the ended year. The portion of such profit which is not paid to the owner but kept apart is known as ‘revenue reserve’.
Revenue profit is earned in the following ways:
- Profit on sales of goods or services
- Commission received
- Discount received
- Rent received
- Interest received etc.
Types of Revenue Reserve
a. General Reserve
b. Specific Reserve
A reserve which is created for strengthening the financial position of the business is known as a general reserve. Examples are reserve fund, contingency fund, reserves, etc.
Objectives or Advantages of General Reserve
The following are the objectives or advantages of
- To strengthen the financial position of the business
- To meet unknown and unexpected liabilities and future losses.
- To provide financial sources for further expansion of business.
- To distribute an equal rate of dividend to shareholders in case of a joint stock company.
A reserve is created for any
special purpose is known as specific reserve. This reserve is utilized for
special purposes. Such reserve cannot be utilized for any purpose other than
specified. For example: a company is generally creates debentures sinking fund
for the purpose of repayment of debentures. Such fund will be utilized only for
the purpose of repaying debenture.
Difference between Capital Reserve and Revenue reserve
It is created out of profit earned not the normal course of business.
It is created out of profit earned in the normal course of business.
Capital employed in business is increased permanently.
It increases capital employed temporarily.
It is usually not available for payment of dividends.
It is available for payment of dividends.
Only liabilities can be paid or capital losses can be met out of
It is available for meeting any type of liabilities or losses.
Difference between General Reserve and Specific Reserve
It is not
created for a special purpose but only for strengthening financially a business.
It is created
always for a specific purpose and it is utilized for that purpose only.
In case of
need, dividends can be paid out of it.
A dividend can
not be paid out of it. But on fulfillment of the objective for which a fund
has been created, the fund will no longer be required, then dividends may be paid out of it.
Types of the specific reserve are
i. Sinking fund
ii. Dividend equalization fund
iii. Research and development fund
A sinking fund is a
fund which is created for the purpose of repayment of liabilities and replacing
fixed assets. Every year a fixed amount is either charged against the profit or loss
account or appropriated out of the profit and loss appropriation account. The
same amount is withdrawn from the business in each year and invested on
investments. The interest received on these investments is re-invested again to
each compound interest every year, when the debentures are due for redemption,
the investment are sold and debentures are redeemed. Any profit on the sale of
investment is credited in the sinking fund account whereas loss is debited to the
There are two types of the sinking
fund. They are:
Sinking fund for redeeming liabilities:
It is created for the purpose of
repayment of liabilities or redemption of debenture from its creation is known
as a sinking fund for redeeming liabilities.
Sinking fund for replacing fixed assets:
It is created for the purpose of replacing old assets by creating fund for the company at the end of the life of fixed assets is called sinking for replacing fixed assets.
Advantages or Objectives of Sinking Fund
The following advantages or
objectives of the sinking fund are as follows:
- It provides adequate fund for the redemption of a debenture or other loans.
- It provides adequate fund for replacement of old fixed assets at the end of its useful life for new assets.
- It helps to invest in outside securities which will increase sum of reserve.
- It helps to maintain strong financial efficiency in future of the business.
Disadvantages of sinking fund
- It is impossible to collect sufficient fund for replacing old assets for new immediately
- It reduces the divisible profit to be distributed to the shareholders.
Dividend Equalization Fund
It is a specified fund which is
created out of profit in order to maintain equal dividend over years. The Declaration of a fixed rate of divided over years is a good sign for the long-term
stability and financial soundness of the company. Therefore, a systematic company
declared a fixed rate of dividend when the profit are high to equalize the
dividend in the future. When the profit are low, the fund originated by such transfer
is called a dividend equalization fund which insured that the fixed rate of
dividend declared during a period of prosperity can be utilized even during
a period of crisis.
Advantages of Dividend Equalization Fund
The following advantages are:
- Helps to declare to distribute equal rate of dividend to shareholders even there is loss in the business.
- Due to the uniformity of dividend over years, the market value of shares does not fluctuate abnormally.
- Helps to maintain the stability of the business.
Disadvantages of Dividend Equalization Fund
- It reduces the amount of dividend.
- Small-scale organizations can not able to create a such fund.
- Due to the equal distribution of dividend, it can not help to measure the working efficiency of the management over years.
Research and Development Fund
It is essential for creating new products or for developing new designs for any product. It is also created
out of profit to meet heavy expenditures of research and development work for new products in launching at the market. In the perfect competition market of a business era, all businessmen are required to spend for the research and development
work for a new product. These are maintained by the research and development fund.
Advantages of the Research and Development Fund
- It helps to manage required amount for research and development of new product.
- It helps to compete and lead highly competitive marketing environment.
Disadvantages of the Research and Development Fund
- It is not suitable for small-scale business organization
- Reserve and development works can be maintained if a huge amount of profit is earned.
- It reduces the divisible profits of the shareholders.
Reserve is created to strengthen the time financial position of the firm without disclosing the reserve to the public;
it is not shown in the balance sheet. Such reserves are usually maintained by
bank insurance company and other financial institutions. It is created by
showing the figure of net profit less than the actual. It may be done by any of the
- By providing excessive depreciation
- By undervaluing of current assets
- By overvaluing the liabilities
- By charging capital expenditure to revenue.
- By showing contingent liabilities as real liabilities
- By making excessive provisions for losses
- By ignoring accrued income or treating income as liability
- By including a fictitious liabilities
- By under valuation of closing stock etc.
Advantages of Secret Reserve
- It helps to strengthen the financial position of business
- It provides additional working capital
- It helps to meet the exceptional losses
- It helps to eliminate competition
Disadvantages of Secret Reserve
- True financial position of business cannot be disclosed
- Profit shown by the financial statement is not accurate.
- No record is maintained and as such not disclosed in the balance sheet
When the amount of reserve is
invested outside the business in government securities, it is called a reserve
fund. Thus, the amount of reserve which is not invested outside the business is only
called reserve. However, in actual practice, no distinction is usually drawn
between two reserve and reserve funds.
Advantages of Reserve Fund
The following advantages of reserve
fund are given:
- Regular income earned from securities.
- The amount of reserve is quite safe because investment have been made in government securities.
- There may be profit on the sale of investments if the market price of securities rises. There may also be losses if the market price falls.
Difference between Reserve and Reserve fund
It is a
charge against profit for an anticipated or contingent liability.
It is the retention of profits for strengthening the financial position of a business.
They are not
required to be invested outside the business. Thus they increase the working
It must be
invested outside the business in quickly disposable securities.
treated as expenses. They are charged to the profit and loss account.
Reserve fund in
merely keep aside divisible profits. Thus it is charged against the profit and
loss appropriation account.
Difference between Reserve Fund and Sinking Fund
It is created
for general purpose
It is created
for the specific purpose of repaying a liability
It may or may
not be invested outside of securities
invested in outside securities
It is created
only if there are profit otherwise it is not created
It is always
created by charging annual instalment of money every year