Reserve in Accounting: Meaning, Objectives, Types

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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 as follows:

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

Types of reserves is presented diagrammatically as follows:

Capital 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

The advantages 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

The 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.

Revenue Reserve

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

General 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 general reserve:

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.

Specific Reserve:

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

Capital Reserve	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.	It is available for meeting any type of liabilities or losses.

Difference between General Reserve and Specific Reserve

General Reserve	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

Sinking 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 same account.

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.

Secret Reserve

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 following ways:

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

Reserve Fund

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

Reserve	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 capital.	It must be invested outside the business in quickly disposable securities.
Reserve is 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

Reserve fund	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	It is 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

Neupane Nirmal

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