Another common term which finds a place in the balance sheet of a firm is reserves. The amount of reserves is a very important component in the financial statements. This is because, any amount which is kept aside in reserves, brings down the amount of profits of the firms. Thus, the study of reserves and how they are created, are pertinent to the understanding of accounting terms. Let us get to know what is a reserve.
What is a Reserve?
When a company earns a given amount of profit at the end of a financial year, a certain portion of it is usually retained in the business to meet future contingencies, growth prospects and more. This amount of money which is kept aside is termed as Reserves.
Reserves help in safeguarding the financial position of a company and can be used for various purposes such as expansion, stable dividend repayments, legal requirements, meeting contingencies, improving the financial situation, investments and more. It is also sometimes referred to as retained earnings. It is shown on the liability side of a balance sheet under the head “Reserves and Surplus” along with capital. If a company incurs losses then it is not created.
Browse more Topics under Depreciation Provision And Reserves
- Depreciation and Causes of Depreciation
- Methods of Calculating Depreciation Amount
- Straight Line Method and Written Down: A Comparative Analysis
- Methods of Recording Depreciation
- Disposal of Asset and any Addition or Extension to the Existing Asset
- Need for Depreciation and Factors Affecting Amount of Depreciation
- Declining Charge Method
- Other Methods
Revenue reserves are created out of profits earned from operations of a company. It is reflected in profit and loss appropriation account. It can be used for the following purposes:
- Dividend to shareholders
- Expansion of business
- Stabilizing the dividend rate
Revenue reserves are divided into two types & each is kept aside for appropriation for profits. General reserves are created out of profits & kept aside for general purpose and financial strengthening of the company, it doesn’t have any special purpose to fulfill and can be used for any useful reason in future. Such reasons include meeting contingencies and expansions that cannot be foreseen.
Specific reserves, on the other hand, are created keeping a specific reason in mind and can only be used for its designated purpose. Examples of such reserves include Dividend Equalization Reserve, Debenture Redemption Reserves, Contingency Reserves, Capital Redemption Reserves and more.
A capital reserve is created upon revaluation of an asset, such that it reflects the current market value. The capital reserve is created out of capital profits & are usually not distributed as dividends to shareholders. As a rule, they cannot be created out of profits earned from core operations of a company.
How are Reserves Created?
When an appropriation for an amount for reserves, record an entry to create the reserve account by debiting retained earnings and crediting the general or specific reserve account.
Profit & Loss A/c – Dr.
To reserve A/c
Solved Question for You
Question: A business wants to reserve funds for a future building construction project. It credits a Building Reserve fund for INR 5 million and debits retained earnings for the same amount. The building is then constructed at a cost of INR 4.9 million, which is accounted for as a debit to the fixed assets account and a credit to cash. What happens when the building is completed?
Answer: The original entry is reversed, where INR 5 million will be debited to the building reserve account and credited to the retained earnings account.