Several times we have heard the word reserve in accounting but the exact meaning is at times not explained in various accounting classes and also most of the classes are not covering in the accounting courses. And even if it is explained in various accounting classes by learned faculties, students fail to understand the basics. They know it’s accounting effect. Do they really know what is it? Or why it is created for?
Let us understand the concept of reserves and their types:
Profit earned by any business is payable to its proprietor. But the proprietor does not withdraw the whole amount of profit. He leaves some amount of profit to maintain the liquidity and strengthen the financial position of the business. This amount is known as the reserve. Reserve is profits, appropriated for a particular purpose.
There is a long list of reserves created for in the books of accounts as explained in various accounting classes. And truly, it is so. However, primarily we can classify reserves in two categories:
- Revenue reserve
- Capital reserve
Revenue reserves can be further classified into:
- General reserve: Profit determined by the profit and loss statement at the end of the year, the proportion of such profit is not aid to the proprietor, but kept apart is known as revenue reserve. General reserve is created to maintain the liquidity of the business resources, meeting any known contingencies, liabilities, etc.
- Specific reserve: If the provision is created for any specific period it is known as a specific reserve. This reserve cannot be utilized for any other purposes. For example- Reserve for Repairs and Maintenance, Reserve for Outstanding Expenses.
On the other hand, Capital Reserve refers to the profit that arises from the sources other than the normal trading activities. Such profit is known as capital profit. A capital reserve is an account on the balance sheet which can be used for contingencies or to offset capital losses. It is built out of capital profit and not out of business profit.
Hence, we can infer that reserve is a great source for financing any long-term project of any company, and if a company which isn’t keen to go for debt, term loan etc. can use this reserve to fully finance their new projects. There are many sub-classifications we focus during our accounting classes on reserves. For more such details you can attend our free demo classes.