What is Specific Reserve? | Types, Sources, Objectives, Advantages and Disadvantages

Specific Reserves can be defined as the set-aside profits that the company keeps to meet some specific obligations previously decided by the company. While creating this reserve, the purpose of using the reserve is previously stated. These reserves can not be used for any other purpose other than the stated purpose. The company can use the specific reserve for any other purpose only if the Article of Association (AoA) allows it and the board of directors agree to use the specific purpose for any other purpose other than the stated purpose.

Reserves can be classified as Revenue reserves and Capital reserves. Revenue reserves help the company to operate its day-to-day activities in case of contingency, and Capital reserves help in funding Capital decisions in case of contingency. Revenue reserves can be further classified as General reserves and Specific reserves. General reserves are the set-aside profits that the company keeps to fulfill various business needs like meeting contingencies, offsetting future losses, etc. Specific Reserves are the set-aside profits that the company uses to meet some specific obligations.

Types of Specific Reserve

Specific reserves can be of different types, but mainly every company resides with these three special reserves:

1. Dividend Equalisation Reserve

A debenture equalisation reserve is created to balance the amount of dividends to be paid to the shareholders. Any company has to go through ups and downs while operating a business in this dynamic environment. Earned profits can be more in one accounting period and can be less in another accounting period. Dividend equalisation funds can be created by transferring the excess profits into the funds, and this fund will be used to pay the shareholders in that accounting period in which there will be less profits.

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2. Debenture Redemption Reserve

Debenture Redemption Reserve is used to pay off the debenture holders at the end of the specified period. Debenture Redemption Reserve is created by setting aside some profit, and then the company invests the amount of this reserve into external securities. Earned interest and interest due to this investment are then in turn used to pay off the debenture holders.

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3. Investment Fluctuation Reserve

This reserve is created to offset any losses caused by the investment made outside the business in shares, debentures or any type of instrument. Investments are subject to market risks and are very vulnerable to market conditions. It tends to fluctuate over and over, causing profits and even losses for investors. To offset/counter these losses, investment fluctuation reserves came into existence. Some portion of profits is set aside to create this reserve and later on, used according to the prevailing conditions.

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Sources of Creating Specific Reserve

1. Retained Earnings: Accumulated profits generated over time by the company, which were not distributed among shareholders, can be used to create general reserves. This is the excess money that the company set aside to offset any kind of expenses and can be used to create specific reserves.

2. Surplus from Operations: Utilisation of any surplus amount left in the hands of the company, after meeting all the operational expenses, can be used to create specific reserves.

3. Appropriation of Profits: Allocating a portion of annual profits to the creation of specific reserves is one more method of it. Specifying the rate or portion of profits to be set aside for specific reserves leads to uniformity of reserves in the balance sheet.

4. Revaluation of Assets: Increasing the value of assets in the balance sheet can leave more space for specific reserves in the balance sheet.

Objectives of Creating Specific Reserves

As specific reserves are to be used for the specific purposes which are stated at the time of the creation of reserves, but if the Article of Association (AoA) allows the usage of specific reserves for other purposes, other purposes than the stated one, then the company is eligible to do so. Some of the basic objectives of creating specific reserves are as follows:

• For payment of outstanding liabilities
• For writing off any kind of bed debts arises
• For meeting any kind of contingency that arises due to fluctuations in the market
• To strengthen the financial position of the business
• To declare and distribute almost equal amounts of dividends every year
• To meet the needs of funds from external sources
• To improve the working capacity of the firm by providing additional working capital

Advantages of Specific Reserves

1. Risk Management: Specific reserves help in mitigating the potential losses that can happen due to the dynamic market conditions and business environment by providing funds to offset such losses on an immediate basis.

2. Financial Stability: By having specific reserves, a company can deal with a contingency on an immediate basis and can even use the reserve money for other purposes (if its Article of Association allows it.

3. Compliance with Regulations: Some companies set up the rules for creating specific reserves beforehand to ensure financial backup at the time of contingencies. So the creation of such reserves can help the company to avoid the difficulties which can happen with the non-creation of such reserves.

4. Confidence in Shareholders: Creation of Divided Equalisation Reserve or any other type of reserves related to shareholders can give confidence to them regarding financial stability.

Disadvantages of Specific Reserves

1. Not Transparent: It does not show the true, and fair position of the business, and it gets recorded under liabilities parts of the balance sheet even though it is a part of the profits.

2. Mismanagement of Funds: As specific reserves are created with any purposes if that particular contingency does not arise, the chances of it getting misused arise.

3. Idle Money: If there never arises any situation where the company can use the specific reserve, money will stay idle.