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Reserves− Reserves are created for strengthening the financial positions and future growth. It is created out of profit earned by business.
The broad classification of reserve is diagrammatically presented below.
1. Revenue Reserve− It is created out of revenue profit, i.e., revenue earned from normal activities of the business. It can be used for either general purpose or specific purpose. It is of two types:
a. General Reserve− When the reserve is created without any specified purpose, then the reserve is called general reserve. It is a free reserve and so can be used for any purpose. It can also be used for future growth and expansion. For example, reserve funds, retained earnings, contingencies reserves, etc.
b. Specific Reserve− When reserve is created for some specific purpose, then the reserve is called specific reserve.
Examples of specific reserve are given below.
i. Debenture Redemption Reserve
ii. Investment Fluctuation Reserve
iii. Dividend Equalisation Reserve
iv. Workmen Compensation Fund
2. Capital Reserve− It is created out of capital profit, i.e., gain from other than normal activities of business operations, such as sale of fixed asset, etc. It is created to meet the capital loss. It cannot be distributed as dividend. The example of capital reserves are given below.
i. Premium on issue of shares
ii. Premium on issue of debentures
iii. Profit on redemption of debentures
iv. Profit on sale of fixed assets
v. Profit on reissue of forfeited shares
vi. Profit prior to incorporation
3. Secret Reserves− Reserves that are created by overstating liabilities or understating assets are known as secret reserves. They are not shown in the Balance Sheet. These reduce tax liabilities, as the liabilities are overstated. It is created by management to avoid competition by reducing profit. Creation of secret reserve is not allowed by Companies Act, 1956, which requires full disclosure of all materials facts and accounting policies, while preparing final statements.