Accountancy · Ch 7 — Depreciation, Provisions and Reserves
Types of Reserves
Types of Reserves
Types of Reserves
A reserve is created by retaining a portion of the business's profit. The purpose of this retention can be either general or specific.
General Reserve
When the purpose for which the reserve is created is not specified, it is called a General Reserve. It is also termed a free reserve because the management can freely utilise it for any purpose. A general reserve strengthens the financial position of the business.
Specific Reserve
A specific reserve is created for some specific purpose and can be utilised only for that purpose. Examples of specific reserves are:
- Dividend equalisation reserve: Created to stabilise or maintain the dividend rate. In a year of high profit, an amount is transferred to this reserve. In a year of low profit, this reserve amount is used to maintain the rate of dividend.
- Workmen compensation fund: Created to provide for claims of workers due to accidents, etc.
- Investment fluctuation fund: Created to make up for a decline in the value of investments due to market fluctuations.
- Debenture redemption reserve: Created to provide funds for the redemption of debentures.
Reserves are also classified as Revenue Reserves and Capital Reserves, according to the nature of the profit out of which they are created.
(a) Revenue Reserves
Revenue reserves are created from revenue profits — profits that arise out of the normal operating activities of the business. These profits are otherwise freely available for distribution as dividend.
Examples of revenue reserves:
- General reserve
- Workmen compensation fund
- Investment fluctuation fund
- Dividend equalisation reserve
- Debenture redemption reserve
Generally, the creation of a reserve is at the discretion of the management. A reserve cannot be created unless there are profits. However, in certain cases, the law has stipulated the creation of specific reserves, such as the Debenture Redemption Reserve. Revenue reserves can be used for dividend distribution.