Difference Between Retained Earnings and Reserves

Key Difference – Retained Earnings vs Reserves
 

The difference between retained earnings and reserves is often confused and these two terms are often used interchangeably. However, there is a subtle difference between these two terms. Both these items are recorded under the Equity section in the balance sheet. The key difference between retained earnings and reserves is that while retained earnings refer to the part of net income left in the company after the dividends are paid to shareholders, reserves is a part of retained earnings kept aside for a special purpose.

CONTENTS
1. Overview and Key Difference
2. What are Retained Earnings
3. What are Reserves
4. Side by Side Comparison – Retained Earnings vs Reserves
5. Summary

What are Retained Earnings

Retained Earnings are a part of a company’s net income which is left after paying out dividends to the shareholders. Retained earnings are reinvested in the business or used to pay off debts. These are also referred to as ‘retained surplus’.

Retained Earnings are calculated as,

Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

The amount of retained earnings each year will be dependent on the dividend pay-out ratio and the retention ratio. The company may have a policy to maintain these two ratios at a specific level; for instance, the company may decide to distribute 40% of profits in the form of dividends and retain the remaining 60%, although this combination may change over time.  If the company make a net loss in the current year, but still intends to pay dividends, this can be done through the available profits in retained earnings accumulated over the years. Sometimes, certain shareholders may claim that they do not wish to receive a dividend for a given year where they would like to see more profits reinvested in the business which will facilitate extensive growth during coming years.

What are Reserves

Reserves are a part of retained earnings that are apportioned for a specific purpose. Reserves are mainly utilized to cover unforeseen future losses if they occur. There are two main types of reserves named revenue reserve and capital reserve. Unlike for retained earnings, part of profits is assigned for reserves prior to dividend payments.

Revenue Reserve

Revenue reserve is created out of profits made by day to day business activities.

Capital Reserve

This type of reserve accumulates funds made through capital gains such as profit on sale of fixed assets, profit on revaluation of fixed assets and profit on redemption of debentures.

Read more: Difference Between Capital Reserves and Revenue Reserves

Reserves assist in strengthening the financial position of the company by preparing it for possible future losses. Reserves become extremely useful at times when the company has to incur a significant outflow of funds. If reserves are not available, the company have to assign funds that are used in routine business operations, which may result in liquidity issues.

E.g. Company E has received a significantly large order from a client where the current capacity cannot incorporate the order. If the order is to be completed on time, Company E has to invest in three new machines, for which the funds available in the Reserve will be utilized.

Figure 1: A portion of net income is apportioned between Retained Earnings and Reserves.

What is the difference between Retained Earnings and Reserves?

Summary – Retained Earnings vs Reserves

The difference between retained earnings and reserves is mainly attributable to the purpose the funds are used for; retained earnings are utilised in business activity whereas reserves are utilised for unforeseen future expenses. Other than that, retained earnings and reserves are largely similar to each other where both are separate accounts that accumulate a part of net income for future use.

Reference:
1.”Reserves: Meaning, Importance and Types.” Learn Accounting: Notes, Procedures, Problems and Solutions. N.p., 15 July 2015. Web. 01 Mar. 2017.
2.”Reserves & Surplus as Part of Retained Earnings | Chron.com.” N.p., n.d. Web. 1 Mar. 2017.

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