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Classification of Reserves

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Classification of Reserves

Explain, with illustrations, the various types of reserves.

Reserves are mainly of two types : Capital reserve and revenue reserve.

(1) Capital Reserve. According to the Companies Act, 1956, a capital reserve represents amounts which are not free for distribution among the shareholders, such as surplus upon a revaluation of fixed assets and profit earned by issue of shares at a premium, etc.

(2) Revenue Reserve. A revenue reserve is created out of current profits earned by a business concern in the ordinary course of its business activities. According to the Companies Act, a revenue reserve is any reserve other than a capital reserve. Hence a revenue reserve represents amounts which are free for distribution. A revenue reserve may again be of the following three kinds:

(a) General Reserve. A general reserve represents an amount set aside out of the profits of a business to meet any unknown contingency or to strengthen the working capital of the business. Since it is an appropriation of profit, it can be created only when there is profit.

(b) Special Reserve. A special reserve represents an amount set aside out of the profits of a business to meet some special types of known or expected possible loss or liability, e.g. Debenture Redemption Reserves, Dividend Equalisation Fund, etc.

(c) Specific Reserve. A specific reserve is a charge against revenue of a business for the purpose of meeting a known loss (e.g. depreciation) or an expected contingency (e.g. doubtful debts). Such a reserve is created whether there is profit or not. General Reserve and Specific Reserve 6. Distinguish between General Reserve and Specific Reserve and discuss the duties of an auditor in relation thereto. Distinction Between General and Specific Reserves A general reserve represents an amount set aside out of the current profits of a business to meet any unknown contingency or strengthen the financial position of the business. It is a matter of financial policy and obviously represents appropriation of profit so as to retain an equivalent amount of cash in the business. Profits are merely set aside to withhold cash from distribution.

On the other hand, a specific reserve is a charge against revenue for the purpose of providing against a known loss (e.g. depreciation) or an expected specific contingency (e.g. doubtful debts). Such a reserve is created whether there is profit or not. From the above definitions the following differences may be noted between General. Reserves and Specific Reserve:

1. A general reserve is not created to provide for any definite purpose, while a specific reserve is created for a definite purpose.

2. A general reserve is created to meet any unknown contingency or strengthen the financial position of the business. But a specific reserve is created to meet any known or expected specific contingency or liability.

3. A general reserve is created out of current profits. Hence it cannot be created if there is no profit. But a specific reserve is a charge against revenue to provide for any future liability. It must be created whether there is profit or not.

4. General reserve is a part of divisible profits and hence it may be distributed, if necessary, the only exception being the Debenture Redemption Reserve. But a specific reserve is not a part of divisible profits.

5. General Reserve is shown on the liabilities side of the Balance Sheet whereas specific reserve is shown on the Assets side of the Balance Sheet by way of deduction from the asset concerned.

6. The creation of specific reserve is obligatory but the creation of general reserve is optional.

7. The amount to be set aside as general reserve depends on the amount of profits ascertained. But the amount to be set aside as specific reserve depends on the anticipated possible loss.

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