Reserves – What are reserves?
Reserves – also known as retained earnings – are portions of a business’s profits which have been set aside to strengthen the business's financial position.
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Although the IFRS Standards sometimes call provisions a 'reserve', they are not the same thing - a provision is an upcoming liability without a confirmed date or cost.
Types of Reserves
There are two main kinds of reserves: revenue reserves and capital reserves. They are taken from different sources of income and are usually set aside for different purposes.
What are revenue reserves?
Revenue reserves are portions of profits earned by a company’s normal operations which are then set aside. Revenue reserves are divided into two types:
- General reserves: as suggested by the name, general reserves are not kept aside for any particular purpose, but for the general financial strengthening of the company.
- Specific reserves: unsurprisingly, specific reserves are set aside for a specific purpose and cannot be used for any other reason. Specific reserves are sometimes known as special reserves. For example, a bad debt reserve is an amount set aside in case a customer fails to pay.
What are capital reserves?
Capital reserves are created out of capital profits – profits which arise from sources other than normal trading activities. Capital reserves are usually set aside for capital losses.
Reserves in accounting
In accounting, reserves are recorded by debiting the retained earnings account then crediting the same amounting to the reserve account. When the activity which caused the reserve to be created has been completed, the entry should be reversed, shifting the balance back to the retained earnings account.
For example, a business wants to set aside reserves to fund the purchase of a new office. They credit the Office Reserve fund for £1 million and debits the retained earnings account for the same amount. Once the sale is finalised the original reserve entry should be reversed, with £1 million debited to the Office Reserve fund and £1 million credited to the retained earnings account.