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What is Reserves and Surplus

Reserves and surplus or retained earnings normally arise out of profitable operations. It is a surplus not distributed by the firm as dividends. In other words, these are profits that are to be retained within the business. When a firm starts its operations it has no retained earnings. If in the first year it earns say Rs. 10,000 profit and decides to distribute Rs. 5,000 as dividends, the reserves and surplus at the end of the year will be Rs. 5,000. During its second year of operation if the firm makes a loss of Rs. 3,000 then the retained earnings at the end of the year will be Rs. 2,000. Retained earnings (or reserves and surplus) are in the nature of earned capital for the firm. We have seen earlier that the dividends are limited to retained earnings. This implies that at no point in time the original capital of the firm can be distributed as dividend. In other words, the capital originally contributed is to be maintained intact.
It is possible to allocate profits earned and accumulated as reserves or retained earnings to be earmarked for specific purposes. The earmarked reserves are not distributed. Only non-earmarked or free reserves are available for distribution as dividends.

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