Reserves are appropriations or allocations of profits retained within the business to strengthen its financial position, meet future uncertainties, or fulfill specific purposes. Types of Reserves are crucial for ensuring the sustainability and stability of an organization. They are reflected under the “Equity” section in a company’s balance sheet, except for provisions, which are liabilities.
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Types of Reserves
The types of reserves are mentioned below:
Revenue Reserves
Revenue reserves are created out of the company’s net profits and are used to meet general or specific business needs. These reserves represent retained earnings that the company does not distribute as dividends. Revenue reserves are further classified into two types:
a) General Reserves
- Description: These are created from profits without any specific purpose and are meant to strengthen the company’s overall financial position.
- Purpose:
- To serve as a cushion during financial uncertainties.
- To finance future expansions or capital investments.
- To maintain solvency during business downturns.
- Example: A company sets aside 10% of its annual profits as a general reserve.
b) Specific Reserves
- Description: These are created for a specific purpose or obligation, such as asset replacement or dividend equalization.
- Types:
- Dividend Equalization Reserve: Ensures consistent dividend payouts to shareholders, even in years of low profits.
- Debenture Redemption Reserve: Allocated to ensure funds are available for redeeming debentures upon maturity.
- Capital Redemption Reserve: Created when shares are redeemed to comply with legal requirements.
- Investment Fluctuation Reserve: Protects against fluctuations in the market value of investments.
Capital Reserves
Capital reserves are created out of capital profits rather than revenue profits. These Types of Reserves are not available for dividend distribution and are primarily used for specific capital purposes.
Sources of Capital Reserves:
- Profits from the sale of fixed assets.
- Premium received on the issue of shares or debentures.
- Gains from the revaluation of assets.
- Profits from the redemption of debentures or forfeiture of shares.
Uses of Capital Reserves:
- Issuing bonus shares to existing shareholders.
- Writing off capital losses or fictitious assets, such as preliminary expenses or accumulated losses.
- Funding large-scale capital expenditures.
Example:
A company sells a piece of land for $1 million, generating a profit of $200,000. This profit is transferred to the capital reserve.
Statutory Reserves
Statutory reserves are mandatory Types of Reserves that certain businesses are required to create by law or regulation. These reserves ensure the financial health and compliance of companies in specific sectors.
Examples of Statutory Reserves:
- Banking Companies: Under the Banking Regulation Act, banks must create statutory reserves to maintain liquidity and stability.
- Insurance Companies: Insurance providers are mandated to allocate reserves to meet future policyholder claims.
Purpose:
- To comply with legal requirements.
- To safeguard stakeholders and ensure financial stability.
Secret Reserves
Secret reserves are undisclosed reserves that a company maintains by underestimating assets or overestimating liabilities in its financial statements. These reserves are not visible in the published accounts.
Methods of Creating Secret Reserves:
- Understating revenue or profits.
- Overstating expenses or liabilities.
- Writing down assets more than necessary.
Advantages:
- Strengthens the company’s financial position discreetly.
- Provides a cushion during unforeseen circumstances.
Disadvantages:
- Lacks transparency, potentially misleading stakeholders.
- May not comply with accounting standards and regulations.
Example:
Writing off an asset prematurely or overestimating a doubtful debts provision.
Specific Purpose Reserves
These Types of Reserves are created to meet specific future obligations or requirements. They are a subset of revenue reserves and are earmarked for a particular purpose.
Examples:
- Contingency Reserve: Used to cover unexpected losses or emergencies.
- Sinking Fund Reserve: Created to repay long-term debt or replace assets.
- Asset Replacement Reserve: Allocated for replacing or upgrading fixed assets.
- Workmen Compensation Reserve: Maintained to meet compensation claims from employees.
Free Reserves
Free reserves are those that are not earmarked for any specific purpose and can be freely distributed as dividends or reinvested in the business.
Examples:
- General reserves (unless specifically allocated).
- Retained earnings.
Purpose:
- To maintain liquidity.
- To finance growth opportunities or pay dividends.
Contingent Reserves
Contingent reserves are created to address specific contingencies that might arise in the future. These are not liabilities but precautionary allocations.
Examples:
- Legal Reserve: Created to handle anticipated legal expenses.
- Warranty Reserve: Allocated to cover warranty claims for products sold.
Comparison of Reserves
| Types of Reserves | Source | Purpose | Usage |
|---|---|---|---|
| Revenue Reserves | Net profits | For general or specific business needs (e.g., dividends, expansions). | General and specific purposes. |
| Capital Reserves | Capital profits | For capital purposes (e.g., bonus shares, asset write-offs). | Cannot be used for dividends. |
| Statutory Reserves | Mandated by law | To comply with legal or regulatory requirements. | Sector-specific compliance. |
| Secret Reserves | Hidden profits | To strengthen financial position discreetly. | No direct disclosure in accounts. |
| Free Reserves | Unrestricted profits | For any purpose, including dividend payouts and reinvestments. | Flexible usage. |
| Specific Purpose Reserves | Net profits or allocations | To meet predefined obligations (e.g., sinking fund, contingency reserve). | Defined by specific needs. |
Conclusion
Types of Reserves play a vital role in financial management by safeguarding businesses against uncertainties, funding future growth, and ensuring compliance with regulations. The choice Types of Reserves depends on the organization’s financial strategy, industry norms, and statutory requirements. Proper management and disclosure of reserves are crucial for maintaining transparency, gaining investor confidence, and ensuring long-term sustainability.