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What are Reserves (in Accounting)?

A Reserve may be defined as a sum set aside out of the business profits of a business unit. It is set aside with a view to providing for unexpected or unknown future losses or for strengthening the overall financial position of the unit.

The reserves represent undistributed profit of the business so it is also classified under Retained Profits. It is an example of Appropriation of profits and appears under the Liabilities (or Application of Funds) in the Balance Sheet. Since it is created after ascertaining net profits, it effectively does not reduce the profits of the business.

Objectives
The main purpose of creating Reserves is to stabilise the financial position of the business. The main objectives are:
  • To strengthen the financial position of the business
  • To increase the amount of working capital
  • To meet future contingencies
  • To acquire a asset for the business at a later date
  • To meet any unknown liability or loss


Types
Reserves are broadly classified as Capital Reserves and Revenue Reserves.
Capital Reserves are created out of the capital profits of the business and are sometimes required to be created under some statute. For example, the Companies Act requires some reserves to be created in case of issue of shares at a premium. Other examples are when there is a gain on revaluation of assets, a revaluation reserve is required to be created. These are not available for distribution to shareholders in the normal course of business.

These are aimed at making the financial statements strong and represents financial prudence.

Revenue Reserves are created from normal business profits and are used to set aside funds in the ordinary course of business. These can be used to pay dividends even if the business runs a loss. Examples of Revenue Reserves include the Credit Balance of Profit & Loss Account (also called the Income Statement) and General Reserves.


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