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Karnataka class 12 commerce Accountancy Types of reserves

Karnataka class 12 commerce Accountancy Types of reserves

Karnataka class 12 commerce Accountancy Types of reserves 

Types of Reserves

A reserve is created by retention of profit of the business can be for either a general or a specific purpose.

1. General reserve : When the purpose for which reserve is created is not specified, it is called General Reserve . It is also termed as free reserve because the management can freely utilise it for any purpose. General reserve strengthens the financial position of the business.

2. Specific reserve : Specific reserve is the reserve, which is created for some specific purpose and can be utilised only for that purpose. Examples of specific reserves are given below :

  • Dividend equalisation reserve: This reserve is created to stabilise or maintain dividend rate. In the year of high profit, amount is transferred to Dividend Equalisation reserve. In the year of low profit, this reserve amount is used to maintain the rate of dividend.
  • Workmen compensation fund: It is created to provide for claims of the workers due to accident, etc.
  • Investment fluctuation fund: It is created to make for decline in the value of investment due to market fluctuations.
  • Debenture redemption reserve: It is created to provide funds for redemption of debentures.

Karnataka class 12 commerce Accountancy Types of reserves

Karnataka class 12 commerce Accountancy Types of reserves

Karnataka class 12 commerce Accountancy Types of reserves

Reserves are also classified as revenue and capital reserves according to the nature of the profit out of which they are created.

Karnataka class 12 commerce Accountancy Types of reserves 

Revenue reserves : Revenue reserves are created from revenue profits which arise out of the normal operating activities of the business and are otherwise freely available for distribution as dividend. Examples of revenue reserves are:

  • General reserve;
  • Workmen compensation fund;
  • Investment fluctuation fund;
  • Dividend equalisation reserve;
  • Debenture redemption reserve;

Karnataka class 12 commerce Accountancy Types of reserves 

Capital reserves: Capital reserves are created out of capital profits which do not arise from the normal operating activities. Such reserves are not available for distribution as dividend. These reserves can be used for writing off capital losses or issue of bonus shares in case of a company. Examples of capital profits, which are treated as capital reserves, whether transferred as such or not, are :

  • Premium on issue of shares or debenture.
  • Profit on sale of fixed assets.
  • Profit on redemption of debentures.
  • Profit on revaluation of fixed asset & liabilities.
  • Profits prior to incorporation.
  • Profit on reissue of forfeited shares

Karnataka class 12 commerce Accountancy Types of reserves 

Importance of Reserves

A business firm may consider it proper to set up some mechanism to protect itself from the consequences of unknown expenses and losses, it may be required to bear in future. It may also regard it as more appropriate in certain cases to reduce the amount that can be drawn by the proprietors as profit in order to conserve business resource to meet certain significant demands in future. An example of such a demand is the much needed expansion in the scale of business operations. This is presented as the justification for reserves in business activities and in accounting. The amount so set aside may be meant for the purpose of :

  • Meeting a future contingency
  • Strengthening the general financial position of the business;
  • Redeeming a long-term liability like debentures, etc.

Karnataka class 12 commerce Accountancy Types of reserves 

Secret Reserve

Secret reserve is a reserve which does not appear in the balance sheet. It may also help to reduce the disclosed profits and also the tax liability . The secret reserve can be merged with the profits during the lean periods to show improved profits. Management may resort to creation of secret reserve by charging higher depreciation than required. It is termed as ‘Secret Reserve’, as it is not known to outside stakeholders. Secret reserve can also be created by way of :

  • Undervaluation of inventories/stock
  • Charging capital expenditure to profit and loss account
  • Making excessive provision for doubtful debts
  • Showing contingent liabilities as actual liabilities Creation of secret reserves within reasonable limits is justifiable on grounds of expediency, prudence and preventing competition from other firms.

Karnataka class 12 commerce Accountancy Types of reserves

Difference between Reserve and Provision :

The points of difference between reserve and provision are explained below:

1. Basic nature : A provision is a charge against profit whereas reserve is an appropriation of profit. Hence, net profit cannot be calculated unless all provisions have been debited to profit and loss account, while a reserve is created after the calculation of net profit.

2. Purpose : Provision is made for a known liability or expense pertaining to current accounting period, the amount of which is not certain. On the other hand reserve is created for strengthening the financial position of the business. Some reserves are also mandatory under the law.

3. Presentation in balance sheet: Provision is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) on the liabilities side along with current liabilities. On the other hand, reserve is shown on the liabilities side after capital.

4. Effect on taxable profits : Provision is deducted before calculating taxable profits. Hence, it reduces taxable profits. A reserve is created from profit after tax and therefore it has no effect on taxable profit.

5. Element of compulsion : Creation of provision is necessary to ascertain true and fair profit or loss in compliance with ‘Prudence’ or ‘Conservatism’ concept. It has to be made even if there are no profits. Whereas creation of a reserve is generally at the discretion of the management. However, in certain cases law has stipulated for the creation of specific reserves such as Debenture Redemption Reserve. Reserve cannot be created unless there are profits.

6. Use for the payment of dividend : Provision cannot be used for distribution as dividends while general reserve can be used for dividend distribution.

Karnataka class 12 commerce Accountancy Types of reserves

Basis of DifferenceProvisionReserve
Basic natureCharge against profit.Appropriation of profit
PurposeIt is created for a known liability or expense pertaining to current accounting period, the amount of which is not certainIt is made for strengthening the financial position of the business. Some reserves are also mandatory under the law.
Effect on taxable profits.It reduces taxable profits.It has no effect on taxable profit.
Presentation in balance sheetProvision is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) on the liabilities side along with current liabilities.Reserve is shown on the liabilities side after capital.
Element of compulsionCreation of provision is necessary to ascertain true and fair profit or loss in compliance with ‘Prudence’ or ‘Conservatism’ concept. It has to be made even if there are no profits.Creation of a reserve is generally at the discretion of the management. Reserve cannot be created unless there are profits. However, in certain cases law has stipulated for the creation of specific reserves such as Debenture Redemption Reserve.
Use for the payment of dividendProvision cannot be used for distribution as dividends.Reserve can be used for dividend distribution.

Karnataka class 12 commerce Accountancy Types of reserves

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Karnataka class 12 commerce Accountancy Types of reserves

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