Reserve means a provision for a specific purpose. There are lots of unknown expenditures which can occur in current year or in future. To meet such type of expenses the business firm has to make the reserves. By maintaining the reserves, actual position of the profit and loss of any accounting year does not disturb. For example:- share premium account, provision for bad debts or capital redemption reserves. Capital redemption reserves can be used as bonus shares and converted into share capital. Reserves are also the part of capital of company other than share capital. These reserves can not be distributed among the shareholders as dividend.

Surplus is the credit balance of the profit and loss account after providing for dividends, bonus, provision for taxation and general reserves etc.  Surplus profit may also be earmarked for special purposes such as reserves for obsolescence of plant and machinery. Balance of profit is carried forward in next year as retained earning. General reserve can be used for distribution of dividend among shareholders when profit is insufficient.

Reserves and surpluses are shown in liabilities side of balance sheet.

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