Reserves and surplus or retained earnings usually occur out of profitable operations. This is a surplus not distributed through the firm as dividends. Conversely, these are profits that are to be retained inside the business. While a firm starts its operations this has no retained earnings. If in the first year this earns say Rs. 10,000 profit and chooses to distribute Rs. 5,000 like dividends, the reserves and surplus at the end of the year will be Rs. 5,000. Throughout its second year of operation if the firm forms a loss of Rs. 3,000 after that the retained earnings at the ending of the year will be Rs. 2,000. Retained reserves or earnings and surplus are in the nature of earned capital for the firm. We have seen previous that the dividends are restricted to retained earnings. It implies that at no point in time the original capital of the firm can be dispersed as dividend. Conversely, the capital originally contributed is to be kept intact.

This is possible to assign profits earned and accumulated like or reserves earnings to be earmarked for exact purposes. The earmarked retained are not distributed. Merely non-earmarked or free reserves are accessible for distribution as dividends.