Business entities primarily function with the objective of earning profits. These profits accumulate to owners of the business and can be withdrawn by owners or distributed to them in the form of dividends in case of companies. Instead of distributing the entire profits, entities often also plough back part of profits into the business for use in future years. This accumulation of profits is done by creating reserves in the books of accounts of the entity.
This article looks at meaning of and differences between two types of reserves created by entities – general reserve and capital reserve.
Definitions and explanations
General reserve:
General reserve is the part of operational profits of a business that are not distributed but retained and accumulated to be used for the businesses’ future needs. General reserve is not a charge against profits but an appropriation of profits. It is also often termed as revenue reserve.
General reserve is created out of profits that are generated from the core revenue generating activities of the business which are undertaken during the normal course of business operations.
The accounting entry passed at the time of creation of the general reserve is as follows:
Profit and loss [Dr]
To General reserve [Cr]
(Being- part of profits of the current year accumulated in general reserve account)
The balance in general reserve (of current year accumulation and previous years) is carried in the liability side of the balance sheet.
As the name suggests, the accumulated balance in general reserve is not created for any specific purpose and can be utilized for several generic purposes such as:
- Meeting future liabilities
- Setting off of future losses
- Payout of dividends
- Expansion plans
- Maintaining working capital
There is generally no prescribed percentage that must be appropriated to general reserve. It is the company management that takes this decision based on several factors including the financial condition of the entity.
Capital reserve:
Capital reserve is the accumulation of profits that is created from profits generated out of certain capital transactions. Capital reserve is not created from routine operational profits but is created from capital profits such as sale of assets, sale of shares, revaluation of assets etc.
The accounting entry passed at the time of creation of the capital reserve is as follows:
Profit and loss [Dr]
To General reserve [Cr]
(Being- part of profits of the current year accumulated in general reserve account)
Capital reserves are created and earmarked for specific capital purposes such as:
- Financing long term capital expansion
- Financing capital asset purchases
- Set off of capital expenses etc.
Capital reserves cannot be used for payment of dividend to shareholders as they are earmarked for specific purposes.
Capital reserve is carried on the liabilities side of the balance sheet.
difference between general reserve and capital reserve:
The main points of difference between general reserve and capital reserve have been listed below:
1. Meaning
- General reserve is an appropriation of profits that is created without any specific purpose for meeting general future finance needs of the entity.
- Capital reserve is an accumulation of profits generated from capital transactions that can be utilized for financing capital purposes.
2. Source
- The source of creation of general reserve is the operating profits of the business generated during the normal course of its business activities.
- The source of creation of capital reserve is the profits generated from undertaking capital bases transactions such as sale of assets, sale of shares etc.
3. Purpose
- The purpose of creating general reserve is for financing any future needs of the business that may arise. These needs may be either revenue or capital in nature.
- The purpose of creating capital reserve is for financing future long-term capital requirements of the business.
4. Utilization examples
- The balance in general reserve can be utilized for a wide variety of purposes both revenue and capital. This can include distribution of dividend, setting off of future losses, meeting future payment obligations etc.
- The balance in capital reserve can only be utilized for capital purposes such as financing capital asset purchases, financing capital expansion projects, writing off capital expenses etc.
5. Time period
- General reserve is created for short- and medium-term requirements.
- Capital reserve is created for long term requirements.
6. Availability for dividend distribution
- The balance in general reserve is available for dividend distribution to shareholders. In years in which no profits are earned, companies can utilize balance in general reserve for distribution of dividend after meeting other statutory requirements.
- The balance in capital generally cannot be utilized for distribution and payment of dividend to shareholders. Certain jurisdictions however do allow use of capital reserve to distribute dividend in certain exceptional situations and on fulfilling of certain mandatory requirements.
7. Creation in case of business losses
- As general reserve is created out of normal operating profits it cannot be created in the accounting periods in which the business faces losses.
- Capital reserve on the other hand can still be created if the company has faced operational losses, provided it has made profits on capital transactions.
8. Indicator of
- The balance in general reserve is an indicator of the operational efficiency and profitability of a business. A large balance in this account indicates that the company has been profitable in the past years.
- The balance in capital reserve on the other hand does not provide any indication of the operational efficiency of the business. It can however indicate the ability of the entity to fund capital growth and expansion.
Conclusion – general reserve vs capital reserve:
While general reserve and capital reserve are created for different types of profits and have different uses, they have one common purpose – creating an internal source of financing for the business. Accumulation of reserves strengthen the financial health of the company as it creates a contingency fund for the entity in case it was to face losses or other financial issues in the future.
