Reserves and Surplus : Types, Examples, Advantages & Disadvantages

What are Reserves and Surplus?

Reserves and Surplus are defined as appropriated amounts that are maintained for a specific purpose, and they are utilized according to their specific nature or the type of such reserve and surplus. These reserves and surplus are maintained by the company to tackle any future uncertainty or contingency. Some of the common reasons for which companies maintain reserves and surplus are, for strengthening the company’s financial standing in the market, for paying off the dividends to all the shareholders, fulfilling working capital requirements, etc. Sometimes the business domain requires maintaining reserves, even sometimes in cash in order to manage the reduction in revenues and slow-paying debtors. Sometimes the statutory requirements may be the reason a company is required to maintain reserves like Debentures redemption reserves, etc.

Types of Reserves and Surplus

1. Capital Reserve: The reserve of capital is like a reserve turn out of capital gains. This primarily includes those gains that are not part of the company’s core business activity. It is maintained to ensure that the business is prepared for unexpected times such as increasing inflation, sudden payments, and fund requirements.

2. General Reserve: A general reserve is also referred to as a revenue reserve. This includes the amount that is kept separately by an entity out of its profits for future requirements. The general reserve is like the retained earnings maintained by an entity and is kept aside for meeting certain or uncertain obligations.

3. Capital Redemption Reserve: Capital Redemption Reserve is made out of the undistributed profits or the Profit and loss account on the redemption of preference shares or buyback of own shares to reduce the share capital of the company. It’s a statutory obligation to maintain CRR. The CRR can be highly useful for companies in times when the company is in need of funds.

4. Security Premium Reserve: This is the amount that is charged over and above the face value of a share. It is transferred to the SPR account. Companies Act, 2013 has mentioned that the security premium reserve can be used only for certain prescribed purposes.

Example of Reserves and Surplus

The following points are required to be considered by the management of XYZ Ltd.

1. The Dividend reserves are to be created at ₹1,00,000.

2. Capital Redemption Reserve is to be maintained at ₹2,00,000.

3. The company earned a profit of ₹55,00,000, and it is decided to maintain 10% of the profit as a general reserve.

Calculate the Reserves and Surplus for XYZ Ltd.

Particulars	Amount (₹)
Dividend Reserve	1,00,000
Capital Redemption Reserve	2,00,000
General reserve (₹55,00,000×10%)	5,50,000
Total Reserves and Surplus	8,50,000

Advantages of Reserves and Surplus

1. Internal Financing: Reserves are considered the most essential and useful source when it comes to internal financing in any business. In cases where the business is in requirement of funds for some commercial operations or to fulfill its financial obligations, the primary and the very approach source of funds is the general reserve generated by the company.

2. Working Capital Requirements: A generated general reserve can help a business to easily survive on its own when it is in some requirement of working capital. When the business runs short of funds It helps to assist in boosting the business’s working capital.

3. Liabilities: Having reserves as well as surplus has another advantage. With the help of the reserves and surplus, the business can easily manage to pay off its present liabilities in the future by maintaining sufficient reserves for the future.

4. Dividend Distribution: Reserves are used to make the payment of dividends and this is one of the most important uses of reserves. Moreover, creating reserves helps save the similarity of the dividend distribution rate by providing the required amount to maintain the uniformity of the dividend distribution rate when there is a case of shortfall of the funds available for distribution.

Disadvantages of Reserves and Surplus

1. Manipulation of Accounts: Losses are adjusted against the reserves because a business is facing losses. In such a case, the accounts will be highly manipulated and will not display the real picture of the profitability of the business. And, proper reporting will not be passed on to the readers of the financial statements.

2. Misuse of Funds: As there is widespread usage of funds all around the business, the collected reserve may be misappropriated and might be misused by the management.

3. Extra Reserves: When a business maintains reserves, somewhere or the other they are cutting down the dividends paid out to the investors. As reserves will be maintained out of the profit, this might create a rift between management and investors.

Difference Between Reserves and Surplus

Basis	Reserves	Surplus
Meaning	The reserve may be made in cash so that the company can manage revenue reduction or slow-paying debtors	A surplus is a form of excess, and it is not the same as a reserve.
Source	Reserves are the retained balance of a company’s profit and loss account after applying dividends and tax provisioning	Surplus is the remaining balance after these items are paid to shareholders.
Purpose	Reserves are the funds earmarked for a specific purpose, which the company intends to use in the future.	The surplus is where the profits of the company reside and set aside after applying all the adjustments.

Frequently Asked Questions (FAQs)

1. What are reserve and surplus?

Answer:

Reserves and surplus are the appropriated amount which is maintained for specific purpose, and they are utilized according to their specific nature or the type of such reserve and surplus. These reserves and surplus are maintained by the company to tackle any future uncertainty or contingency.

2. What is a General reserve?

Answer:

A general reserve is also referred as a revenue reserve. This includes the amount which is kept separately by an entity out of its profits for future requirement. General reserve is like the retained earnings maintained by an entity, and is kept aside for meeting certain or uncertain obligations.

3. What is a security premium reserve?

Answer:

Security Premium Reserve: This is the amount which is charged over and above the face value of share, it is transferred to the SPR account, companies act 2013 has mentioned that the security premium reserve can be used only to certain prescribed purposes.

4. How many types of reserves are there?

Answer:

Revenue reserve, Capital reserve, and Specific reserve

5. Give one disadvantage of reserve and surplus.

Answer:

As there are widespread usage of the funds all around the business, the collected reserve may be misappropriated and might be misused by the management.