What is the Contingency Reserve?
The contingency reserve is the retained earnings that have been set aside for future contingent losses which are not available for distribution as dividend and can be modified at any time depending upon the situation. It is usually estimated based on risk management techniques.
- The construction industry often creates a contingent reserve on a project basis as it is a volatile industry, and various risk factors like inflation, government policies, etc. can be affected. If this reserve is utilized, then it will be added to the cost of the project.
- If contingency doesn’t arise, then it can be released. This is not a free reserve and does not available for part of a distribution to the shareholders. The insurance industry commonly creates and uses contingency reserve and insurance business, also risk-based business, and depends on happening or non-happening of a particular event.
How to Calculate Contingency Reserve?
- Determine the risk involved in the project or task or business
- Determine reserve amount based on risk calculation
- Determine the percentage of risk and divide the total amount throughout the risk
- Open reserve account with a bank.
- Transfer the periodic reserve amount to the reserve account.
- Withdraw from reserve account if contingency arise
- If contingency doesn’t arise, then at the end of the risk period, transfer the amount from the reserve account to the normal account of the entity.
There are various methods to calculate like:
#1 – Deterministic Method: In this method percentage of contingency over the cost of the project to be determined and then apply percentage on the cost to know the amount of reserves.
#2 – Expert Judgment Method: In this method, the expert will determine the amount of contingency funds required with a strong basis and experience in risk management.
#3 – Probabilistic Method: In this method, range distribution is determined, and from that range amount of reserve is determined based on the level of confidence and experience of the owner.
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#4 – Expected Value Method: Under this expected value method, the amount is determined by multiplying the probability with impact.
Example of Contingency Reserve
From the following information calculate the amount to be transferred in contingency:
- Project Period 12 Months
- Risk of Contingency: 30%
- Cost of Project: $290,000
This $8,700 to be transferred in the separate bank account
The monthly amount to be transferred = $725
Why Use Contingency Reserve?
- It should be used to meet the contingency. It is planning of business so that during contingency also the business gets unaffected, and no shortage of money takes place.
- To meet the unexpected losses.
- To ensure that consistent and timely return to the investors.
- To stand in the industry in tough times also.
- To protect the business from heavy losses.
- To account for the effect of inflation and other changes.
- It protects the business entity from suffering heavy losses. It is often created in volatile and risk-based nature businesses like insurance business, share market, real estate business, etc.
- By creating this, it is an indication to shareholders that business had made sufficient provision, and any amount which is left after provision is available for distribution of dividends to shareholders. It gives a sense of security and assurance to shareholders.
- In some cases creating reserve is a necessary part of a business like in case of the insurance sector in the fire insurance policy, so there is uncertainty about whether fire occurs or not, and if yes, then whether as per policy insurance company is liable to pay or not? Hence creating reserve is necessary to meet the cost of the unexpected event if it happened in the future.
- It reduces the risk as if cost increased or unexpected losses suffered by the business entity, the entity can use the reserve and thereby reduce the risk of being bankrupt or shortage of finance.
- Better Risk Management: it helps to meet unexpected future expenses without interrupting the financial cycle.
- Cost Management and Better Budget Planning: This reserve helps in better cost management as the amount is set aside for contingencies; hence there are chances that the cost of the project cannot increase beyond the actual cost-plus contingency amount.
- Backup for Enough Resources: This reserve creates a backup for resources so that if resources fall short, it can restore from backup resources
- Blockage of Money: to met contingency arise in a future entity set aside money; hence it is blockage of money as it cannot be used anywhere.
- Increase in Cost: This is based on risk management techniques; hence entity needs to consult risk management experts to know the amount. Thus it increases the cost of the project.
- Uncertain reserve: as risk is unpredictable and it is to be re-evaluated at regular intervals hence reserve amount becomes uncertain
- This is the part of retained earnings, which is set aside to meet the future unexpected cost or losses. It is calculated on logical and risk-based techniques. It is often used in real estate and insurance industries.
- It is useful as it sets aside money for future losses; hence in the future, no shortage of money arises if the contingency occurs, but on the other hand, it blocks the use of money so that contingency reserve amount cannot be invested.
This has been a guide to What is Contingency Reserve & it’s Meaning. Here we discuss the examples of contingency reserve, importance, and how to calculate along with advantages and disadvantages. You can learn more about from the following articles –