Reserves - Meaning, Types & Benefits (2024)

Capital and reserves tend to have an integral role in maintaining and safeguarding the financial health of a business organisation. The fact that they ensure continuity of everyday business operations and aid to meet both unexpected and long-term liability, make them indispensable.

On that note, let’s take this opportunity to find out more about reserves in accounting and become familiar with its vital aspects.

What is a Reserve in Accounting?

In the literal sense, a reserve can be defined as earnings that have been kept aside for a specific purpose. One can explain reserve meaning in accounting by describing it as the portion of available earnings that business owners keep aside to meet any sort of financial contingencies.

For instance, firm owners may use their reserves to invest, purchase fixed assets, install new equipment, pay dividends to shareholders, settle legal obligations, etc. Here, the portion of reserve that is invested outside the firm is termed as a reserve fund.

Reserves are mostly created to improve the financial standing of an organisation. They are also popularly known as the ploughing back of profits. Notably, they are created to meet an unforeseen financial obligation or expansion purpose.

Funds for expansion, general reserve, dividend equalisation reserve, etc. are some of the most common examples of reserves.

Types of Reserves

Reserve in accounting is mainly of 3 types. Read along to find out more about them.

1. Revenue Reserve

Popularly known as retained earnings, this particular reserve is created with the help of the earnings generated through the primary operations of a business firm. Revenue reserve is mostly used for two purposes; for expansion of the scale of production for the business units and to pay dividends to company shareholders.

2. Capital Reserve

The said reserve is created straight from capital earnings. Unlike revenue reserves, these earnings aren’t distributed to a firm’s shareholders (as dividends) and do not tend to occur frequently. Notably, a capital reserve is created as per the Companies Act. However, firms can use this reserve to write off their capital losses.

Generally, capital reserves are created with the help of profits generated through –

• Forfeiture of shares

• Sale of fixed assets

• Revaluation of existing assets

• Earnings at hand before incorporating the firm.

• Redemption of preference shares or debenture.

3. Specific Reserve

Special reserves are funds that are created by business owners to meet specific financial obligations. The dividend equalisation reserve, reserve for asset replacement, reserve for debenture redemption and reserve for capital redemption are among the most common examples of specific reserves.

Now that we have become familiar with the type of reserves in accounting let’s find out how they are created and treated in the books of account.

How are Reserves Created?

A reserve in accounting is an appropriation of earnings and usually is not charged on them. It must be noted that when a reserve is created, it does not reduce the aggregate of net profit. However, a significant share of divisible profit gets reduced.

Since reserves are created from earnings generated through a firm’s core operations, it is recorded in its Profit and Loss Account. On the other hand, in the balance sheet, reserves appear on the liability side under the header of ‘Reserves and Surplus.’

Subsequently, the reserve account is created by debiting the firm’s retained earnings and then crediting the concerned reserve account.

The journal entry below offers a clear idea of how reserves are treated in the books of accounts

Profit and Loss A/C Dr. To Reserve A/C

On that note, let’s check out the perks reserves in accounting.

Benefits of Reserves in Accounting

1. Reserves of a company help to improve its financial position.

2. They serve as sources of internal financing and facilitate the expansion of a firm’s scale of operation.

3. They help to pay timely dividends to shareholders. This directly helps to increase a company’s goodwill and fosters a good relationship between the company and its shareholders.

4. Reserves prove effective in meeting financial obligations and losses.

5. With the help of reserves, business owners can replenish their working capital and maintain the firm’s everyday operations smoothly.

6. By investing the number of reserves in new equipment and additional assets, business owners can improve their operational productivity.

Test Your Knowledge: Find out if there are any limitations of reserves accounting and list them in your own words.

Difference Between the Capital Reserve and Revenue Reserve

Check out this table to find out the basic differences –

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Reserve Accounting

Reserve accounting has a term reserve that means a source where we can save and can use when needed or it refers to those earnings that are kept aside for a specific purpose. So, reserve accounting means that some portion of the earnings are kept aside and can satisfy the financial losses or financial needs.

For example, if the owner of the firm wants to purchase more assets like machinery for more production the reserves can be used, if the owner was to invest in any other prospect of the business reserves will be helpful, reserves will be helpful to pay the dividends to the shareholders, or to settle any legal obligations like situations. And if the owner invests the reserves out of the business that is called reserve funds.

According to a common perspective, the reserves are created to become secure or to improve the financial standing of any organization. The term ploughing back of profits is also used for these reserves. Hence, the reserves are created to face any financial loss, obligation, or expansion of business.

Reserves and Their Types

There are mainly three types of reserves. Those reserves are mentioned below -

1. Revenue reserves

Revenues are commonly popular with the term retained earnings. The revenue reserves are created by the earnings generated through the primary business of an organization. The most common use for the revenue reserve is to expand the organization to increase the scale of production of business units or to pay dividends to the shareholders of the organization.

2. Capital reserve

As the name suggests the capital reserve originates straight from the capital itself. Unlike the revenue reserve, the capital reserve is not distributed among the shareholders of the organization and occurs only once throughout the life of an organization. The capital reserve is used to write off the capital losses and it is created as per the companies act. The capital reserve is created through forfeiture of shares, revaluation of existing assets, the redemption of preference shares or so-called debenture, sale of fixed assets, and from the earnings at hand before incorporating the firm.

3. Specific reserve

As the name suggests the specific reserves are used for the specific operations. The special reserves are created by the owners to clear their specific financial obligations. The specific reserve is moreover used for asset replacement, debenture redemption, and capital redemption. The specific reserves originated from the earnings gained by the main purpose of the organization.