Concept to maintaining the various types if reserves
Meaning
of Reserves:
Reserve means an appropriation of profits or other surpluses to
strengthen the liquid resources of the business enterprise and not for meeting
any liability, contingency or any commitment of the business.
According to William Pickles, “Reserve means the amount set
aside out of profit and other surpluses, which are not earmarked in any way to
meet any particular liability known to exist on the date of Balance Sheet.”
Actually, in addition to the capital contributed by the
proprietor, the amount set aside from the profits or surpluses to reserves
belongs to the proprietor, which will help the business during difficult
financial period. It is an appropriation of profits and not charged on the profits.
This means that in the case of loss, reserves cannot be created. Reserves help
in strengthening the financial position of the business enterprise.
They are not created to meet any liabilities, contingencies or
commitments. It is important to mention here that the business cannot create
reserves in anticipation of some losses; however, in case of loss, reserves can
be utilized. When amount of reserve is invested in some outside securities it
is known as ‘Reserve Fund’. Since reserves are appropriation and not charge
against profits, they are shown in Profit and Loss Appropriation Account
instead of Profit and Loss Account.
The importance of reserves is
as under:
Reserves help in strengthening the financial position of the
enterprise, since it can be used to meet any unforeseen losses that may arise
in future.
By creating the reserves, profits are ploughed back into the
business which can be used as source of finance.
In order to enhance the reputation or image of the company,
regular dividends must be paid to the shareholders in time. It is also
necessary that the dividend should be equalized over the years. This objective
can be achieved, if the company maintains reserves because in the years of
inadequacy of profits, amount can be withdrawn from these reserves and paid to
the shareholders.
Reserve increases the working capital of the business
enterprise. So in emergent and unforeseen circumstances, business enterprise
can use the amount kept in reserves and keep working capital to the required
level.
Reserves can be created for some specific purpose which can be
used to meet that purpose only. For the redemption of debentures, company has
to pay huge amount to debenture holders. When the debentures become due for
payment, the company may face a financial difficulty, because a large amount is
generally required for redemption of debentures.
If, in a single go, such a large sum is to be paid out of the
working capital, the operational efficiency of the company may get affected
adversely. Hence, it is always a prudent policy for a company to retain some
money out of its profits for redeeming the debentures.
For this purpose ‘Debenture Redemption Reserve’ can be
maintained by the company, in which a fixed amount of profit is transferred.
This will facilitate payment of such huge sum, when repayment to debenture
holders is due.
Broadly, there are two types of
reserves:
(i) Revenue reserves and
(ii) Capital Reserves
Revenue reserves are created out of profits which have been
earned in the normal course and from the day to day activities of the business
concern.
Revenue reserves may further be
classified as:
(i) General Reserve
(ii) Specific Reserve and
(iii) Secret Reserve.
Now we shall move to discuss
these reserves in detail:
(A) General Reserve:
General reserve is that amount of profits which are set aside to
meet some future contingencies and not created for any specific purpose. These
are generally retained for strengthening the financial position of the business
concern and to provide additional working capital for the business when needed.
Since this reserve can be utilised to meet any unknown purpose, so it is also
called ‘Contingency Reserve’ or ‘Free Reserve’.
In any business enterprise,
general reserve is created for the following purposes:
(a) To strengthen the financial position of the business concern
(b) To make available additional working capital all the times
(c) To meet any liability or contingency, in case of unforeseen
circumstances
(d) To equalize the rate of dividend over the years in case of
inadequate profits
(B) Specific Reserve:
Specific reserves are created for some specific purposes. These
reserves cannot be utilised for any purpose other than the purpose for which
they were created. However, if the article of association permits then at the
discretion of board of directors, specific reserves may be used for a purpose
other than the purpose of its creation.
Some examples of specific
reserves are as under:
1. Dividend Equalization Reserve
2. Debenture Redemption Reserve
3. Investment Fluctuation Reserve
4. Workmen Compensation Fund
(i) Dividend Equalization
Reserve:
Dividend equalization reserve is created to equalize the rate of
dividend over the years. Usually, in the year of large and adequate profits, a
portion of profits is transferred in this account and in the year of inadequate
profits, the amount kept in this account can be used for paying the dividend to
the shareholders.
This reserve is created by way
of the following journal entry:
Profit and Loss Appropriation A/c Dr.
To Dividend Equalization Reserve A/c
(ii) Debenture Redemption
Reserve:
Debenture redemption reserve is created for the purpose of
redemption of debentures at the end of some specific period. In this
connection, every year a specific sum out of the divisible profits is set aside
in this reserve. The amount is to be invested in securities. The amount
accumulated with compound interest produces the required amount which has to be
paid to debenture holders.
This reserve is created by way
of the following journal entry:
Profit and Loss Appropriation A/c Dr.
To Debenture Redemption Reserve A/c
(iii) Investment Fluctuation
Reserve:
Sometimes business enterprises invest their surplus funds
outside their business in shares, debentures or other securities. Also, the
price of such investments keeps on changing, depending on certain market
conditions and/or government policies etc. To bear any loss in case of decrease
in value of such investments, business enterprises sets aside a part of profit
in Investment Fluctuation Reserve, so that any loss arising on account of
decrease in value of such investment can be met from this reserve.
This reserve is created by way
of the following journal entry:
Profit and Loss Appropriation A/c Dr.
To Investment Fluctuation Reserve A/c
(iv) Workmen Compensation Fund:
Workmen Compensation Fund is created to meet the claims of the
workers in case they get injured from an accident.
This can be created by way of
the following journal entry:
Profit and Loss Appropriation A/c Dr.
To Workmen Compensation find A/c
(C) Secret Reserve:
Secret reserve is a reserve that do not appear in the balance
sheet. It can be created in the years of higher profits and can be merged with
the profits during the lean periods.
Secret reserves can be created
as under:
(i) By undervaluing stock,
(ii) By making excessive provisions then the required,
(iii) By charging capital expenditure to revenue,
(iv) By showing contingent liabilities as actual liabilities of
the enterprise.
Secret reserve is secret in the sense that it is not known to
the outsides. It is suggested that keeping in view the requirement of the case,
secret reserve should be created within reasonable limits.
Capital reserves are the reserves created out of capital
profits.
Following are the examples of
some items which may form capital reserves:
1. Profit on Sale of Fixed Assets
2. Profit on Revaluation of Fixed Assets
3. Securities Premium received on Issue of Shares or Debentures.
4. Profit on Redemption of Debentures.
5. Profit prior to Incorporation
6. Profit on Reissue of Forfeited Shares, etc.
Capital reserves can be utilized for writing off capital losses.
However, in the case of joint stock Company, capital reserves can also be
utilized for issuing fully paid bonus shares to the members. Generally, capital
reserves are not available to shareholders for distribution of profits.
However, some capital reserves
such as profit on sale of fixed assets can be utilized for distribution as
dividend, if the following conditions are satisfied:
(i) Articles of Association permits the company to do so;
(ii) The profits on sale of fixed asset must have been
realized by the company in cash;
(iii) Such profits exist after revaluation of all assets and
liabilities and not due to revaluation of assets only.
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