Revenue Reserve

What is Revenue Reserve?

The revenue reserve is the reserve created out of the company's profits generated from its operating activities during a period and retained to expand its business or meet contingencies in the future. A Revenue reserve account acts as an internal source of funding or finance and helps grow the company quickly.

On the surface, it would seem that there's no relationship between the operating efficiency of a business and the retention ratio. But in actuality, a company would be able to retain more when the "net profits" are noteworthy. And if we look at the ratio between "net profit" and "total capital employed," we will get a clear idea of the company's operational efficiency.

• Revenue reserves are funds set aside by a company from its profits for future use, such as investments, expansion, or emergencies, showcasing prudent financial planning and foresight.
• Revenue reserves are crucial in providing financial security and flexibility to the company, enabling it to navigate economic downturns and capitalize on new opportunities, enhancing its resilience and adaptability.
• Revenue reserves are typically disclosed in a company's financial statements. 
• They can be utilized for various purposes, depending on the company's specific needs, illustrating these reserves' versatility and strategic utility.

Revenue Reserve Explained

A revenue reserve is created from the net profit generated from the company's core operations. Companies create revenue reserves to expand the business quickly. It is one of the best resources for internal finance.

When a company earns a lot in a year and makes huge profits, a portion of the profits is set aside and reinvested in the business. This portion is called revenue reserve or, in the common term, "retained earnings."

The rest of the profit is distributed to the shareholders as dividends. Sometimes, the whole profits are distributed as a dividend to the shareholders.

A company can distribute a cash dividend or dividend in kinds. Revenue reserves can be distributed as a dividend in the form of an issue of bonus shares.

Revenue reserve accounting helps a company become stronger from the inside out to serve its shareholders for years to come.

Video Explanation

Types

These reserves serve as a financial cushion, allowing a business to weather economic downturns or invest in future opportunities. There are two primary types of revenue reserve accounts:

• General Revenue Reserves: These are also known as retained earnings or undistributed profits. General revenue reserves are accumulated over time from a company's annual profits. They provide a source of funds for various purposes, such as expanding the business, paying off debts, or distributing dividends to shareholders.
• Specific Revenue Reserves: Specific reserves are set aside for particular purposes or contingencies. These may include reserves for future capital projects, legal settlements, or taxation liabilities. By earmarking funds for specific needs, a company ensures that it has the necessary resources when these situations arise.

Examples

Now that we understand the basics and types of revenue reserve accounting, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

XYZ Inc. has been consistently profitable over the years. At the end of each fiscal year, the company retains a portion of its profits in the form of general revenue reserves, also known as retained earnings. These retained earnings are not distributed as dividends but are kept within the company for various financial purposes.

For instance, during a particularly challenging year, XYZ Inc. experienced a significant decrease in sales due to an economic downturn. Thanks to their accumulated general revenue reserves, they were able to cover operating expenses, maintain employee salaries, and avoid taking on debt to survive the tough times.

Example #2

After the initial public offering (IPO), Apple Inc. kept all its profits as revenue reserve for a few years. Even though the company was doing considerably well, it could have paid off existing debts or declared dividends. They instead, decided to set aside an amount for the first few years to be reinvested into the business.

The idea was to strengthen the company's core to serve its customers and shareholders better. Look at Apple now. It is a thriving business and one of the most valuable brands in the world.

How to create?

In this section, we will take an example to see how we can create revenue reserves from the business's profits.

We need to understand here that the revenue reserve accounting of a company isn't just on the books of the company. It's real money and is made out of real profits.

Particulars	2016 (in $)	2015 (in $)
Gross Sales & Revenue
-       New Line of Bag Sales	198,000	Nil
-       Other Bag Sales	450,000	360,000
-       Sales of Accessories	142,000	120,000
	790,000	480,000
(-) Total Sales Returns	(30,000)	(15,000)
Net Sales Revenue	760,000	465,000
(-) Total Cost of Sales	(518,000)	(249,000)
-       Cost of sales for a new line of bags	(254,000)	Nil
-       Cost of sales for other bags	(190,000)	(182,000)
-       Cost of sales for accessories	(74,000)	(67,000)
Gross Profit	242,000	216,000
(-) Operating Expenses	157,000	133,000
-       Selling, general & administrative expenses	(123,000)	(93,000)
-       Insurance expenses	(12,000)	(11,000)
-       Other expenses	(22,000)	(29,000)
Operating Profit (EBIT)	85,000	83,000
(-) Interest & Expense	(23,000)	(18,000)
Profit from operations before income taxes (PBT)	62,000	65,000
(-) Income tax	(15,000)	(17,000)
Net Profit (PAT)	47,000	48,000

This example shows how the "net profit" is calculated in the income statement.

• It is created by using the company's net profit, which is real money and is available in books and cash.

• So, we can see that the net profits for two consecutive years, 2015 and 2016, are $48,000 and $47,000, respectively.
• If we assume that 50% of the net profits will be transferred to revenue reserve or retained earnings, the amount would be $24,000 and $23,500 + 24,000 = 47,500 for 2015 and 2016, respectively.

These amounts will take place on the company's balance sheet as "retained earnings" in the shareholders' equity statement.

Here's a snapshot.

Stockholders' Equity	2016 (in US $)	2015(in US $)
Preferred Stock	55,000	55,000
Common Stock	500,000	500,000
Total Retained Earnings	23,500 + 24000 = 47,500	24,000
Total Stockholders' Equity	602,500	579,000

These retained earnings can be used as "undistributed profits" to reinvest in the business. Or these can be distributed as dividends to shareholders or can be issued as bonus shares.

Advantages

Let us understand the advantages of revenue reserve account through the points below.

• Firstly, it can be used as a great source of internal finance to meet the small-term requirements of the business.
• Secondly, it can be distributed if required by shareholders.
• Thirdly, it can be received in real monetary value and can exist in the books of accounts.
• Fourthly, it can also be used to replace old assets (which are the immediate needs of the business) or to pay off an urgent liability. Since revenue reserve is not kept for the long term, it always serves the purpose in the short or mid-term contingencies.

Revenue Reserve Vs Capital Reserve

Both types of reserves are essential components of a company's financial toolkit, serving different roles in ensuring financial stability and strategic growth. Let us understand the differences through the comparison below.

Revenue Reserves

• Revenue reserves, also known as earned surplus or retained earnings, are funds accumulated from a company's annual profits.
• These reserves represent the portion of profits that a company chooses to retain rather than distribute as dividends.
• Revenue reserves are a testament to a company's historical financial performance and are typically used for various purposes, such as reinvesting in the business, covering operational expenses, or servicing debt.
• They offer financial flexibility and stability.

Capital Reserves

• Capital reserves, on the other hand, are created from sources other than regular profits.
• They typically arise from extraordinary events, such as the sale of assets, investments, or revaluation of assets.
• Capital reserves are earmarked for specific purposes, like acquiring new assets, retiring debt, or handling legal contingencies.
• Unlike revenue reserves, capital reserves do not originate from operational profits and serve a distinct function in a company's financial structure.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to what is Revenue Reserve. Here we explain its types, examples, how to create, advantages, and compare it with capital reserve. You may also have a look at the following recommended accounting articles –

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