Reserves and its Types

Any amount of money that has been set aside for certain purposes or reasons in a business is termed a reserve. In businesses, generally, a part of earnings is kept aside for unforeseen financial situations. This reserve may be used for renovation of the offices, purchasing new machines and new software or hiring trainers, etc. Reserves strengthen the financial position of the companies and make them more competitive. A reserve is created from the earnings of an organisation and does not reduce the aggregate profit of an organisation. It is recorded in the Profit and Loss Account of a company. Reserves appear on the liability side of the balance sheet under the heading of ‘Reserves and Surplus.’The reserves are prepared for multiple purposes. Some of these includes:

• Expansion and Diversification of the company
• Payment of the liability
• Purchasing the fixed assets
• Redemption of Debentures
• Payment of dividend
• Writing off the losses

Types of Reserves:

Reserves are mainly classified into three major categories, i.e., Revenue Reserve, Capital Reserve, and Secret Reserve:

1. Revenue Reserve:

Revenue Reserve is a part of the profit retained by the companies for multiple future purposes. Revenue Reserve is created out of the profit earned from the core business operations, hence is recorded in the Profit and Loss Account. The Revenue Reserve can be further categorised as:

A. General reserve: This is set aside from the profits of a business, and is generally used to improve the financial condition of an organisation, but may be used for other purposes as well.

B. Specific Reserve: As the name suggests, this type of reserve is maintained for a specific purpose by the company and cannot be used for any other purpose under any circumstances.

Some of the examples of specific reserves are:

• Debenture Equalisation Reserve
• Debenture Redemption Reserve
• Investment Fluctuation Reserve

2. Capital Reserve: 

Capital Reserve is a reserve that is created out of the capital surplus of the organization. These reserves do not emerge out of the profit earned from ordinary business activities and cannot be used for dividend distribution. These reserves are created for specific purposes and can be used for that reason only. Rather, Capital Reserves are used to write off the capital losses of the companies. Capital Reserve is shown on the Liability side of the Balance Sheet under the head ‘Reserve and Surplus’. Capital Reserves are created out of the following items:

• Profit on sale and revaluation of Fixed assets
• Premium on issue of shares and debentures
• Profit on forfeiture and re-issue of shares
• Profit on redemption of Debentures

For example, if a company wants to purchase a new office building and needs funds for this purpose, then it may sell off its old assets or lands owned, and the money earned will be set aside as a capital reserve and can only be used to buy a new office building, not for anything else.

3. Secret Reserve: 

As the name suggests, this type of reserve is not declared in the balance sheet of a firm and may also be known as hidden or internal reserve. Businesses create this type of reserve by declaring the profits less than the actual or hiding their actual profits. This type of reserve is generally maintained by banks, insurance providers, etc. 

Methods of creating Secret Reserve:

• Showing excess depreciation on fixed assets such as plant, machinery, furniture & fixtures, etc.
• Value assets, such as stocks and shares below their current market value 
• Overvaluation of liabilities
• Not recording appreciation in the value of assets
• Completely writing down an asset

Advantages of secret reserve:

• It helps to improve the financial position of a company. 
• It can be used to hide actual profits from competitors.
• It enhances and provides stability to an organisation. 

Disadvantages of secret reserve:

• The information about this reserve is not known to anyone except the management. 
• It may be used to cover frauds that occur in an organisation. 
• The financial position of an organisation may be misinterpreted due to secret reserves.