Reserves and Provisions
Meaning and Concept of Reserve
A reserve is a part of the profit set aside to meet different future contingencies and unexpected liabilities or losses. The whole amount of profit earned by the business is not distributed to the owners or shareholders. A part of such profit is retained in the business either for meeting its unexpected future liabilities and losses, or for strengthening the financial position. In other words, the amount which is set aside from profit for different future unknown and unexpected liabilities and losses is known as reserve.
Objectives of Reserve
- To meet unexpected future losses, liabilities and contingencies.
- To strengthen the financial position of the business.
- To reduce wasting or depreciating assets.
- To provide additional working capital.
- To improve the working capacity of the business.
- To meet the need for funds from internal sources.
Types of Reserves
Reserve is classified as: Capital Reserve, Revenue Reserve, and Secret Reserve.
Revenue Reserve is further classified into: General Reserve and Specific Reserve.
Specific Reserve includes: Sinking fund, Research and development fund, Dividend equalization fund, Workmen's compensation fund.
Sinking fund is further of two kinds: for replacement of assets, and for redemption of debentures.
Features of Reserve
- It is created only when there is profit in the business.
- It can be distributed as dividend to shareholders.
- It is created by debiting the profit and loss appropriation account.
- It is created to meet unexpected liability and strengthen the financial condition.
- Creation of reserve depends on the financial policy of the business and the analysis of the management.
- It is usually shown on the liability side of the balance sheet.
Capital Reserve
A reserve which is created out of capital profit is known as capital reserve. It is not created out of profit earned in the normal course of business. Capital reserve is created out of the profit earned from some specific transactions of a capital nature.
The examples of capital profit from which capital reserve is created are as follows:
- Profit on sale of fixed assets.
- Profit on sale of investment.
- Profit on revaluation of assets and liabilities.
- Premium on issue of shares and debentures.
- Profit on re-issue of forfeited shares.
- Discount on redemption of debentures.
- Profit on purchase of an existing business, etc.
Objectives and Advantages of Capital Reserve
- Capital reserve helps in making the organization financially strong.
- Capital reserve helps in writing off capital losses arising from the sale of fixed assets, shares and debentures.
- Capital reserve helps in the issue of fully paid bonus shares to the existing shareholders, etc.
Disadvantages of Capital Reserve
- Capital reserve is not available for distribution to shareholders.
- Capital reserve does not give any indication of the operating efficiency of the business.
- Capital reserve does not help in making the management responsible for selling old assets at a satisfactory price, etc.