Reserve Accounting Meaning
Reserve Accounting represents the accumulated profits of the company which has been earned over the years, authorized by the board of directors and unless specifically mentioned, can be utilized without any legal restrictions for the purchase of fixed assets, settlement of legal obligations, payment of statutory bonuses and long-term debts.
Types of Reserves
The following are the types of reserves in accounting.
Reserves accounting can be further categorized into several components, depending upon the requirements of the organization. Broadly speaking, the most common examples of reserves are
#1 – Legal Reserve Fund
It is mandated by many legislations and it is equivalent to a certain percentage of the share capital.
#2 – Securities Premium
When the company receives the amount over the nominal value of the share, then the excess is termed as securities premium and can be utilized only for certain specific purposes, say issuance of fully bonus shares to the members, buyback of shares, writing off expenses incurred before the incorporation of the company.
Example
Suppose the par value of the share is $10 and due to excess demand in the market, share price shoots to $40. The excess $30 would be termed as securities premium and this would be accounted in the following way –
Explanation of Reserve Accounting Journal Entry – A shareholder would pay $40 to the company, but as the par value is $10, so rest would be housed in the securities premium account.
#3 – Remuneration Reserve
As the name suggests, this is saved to pay bonuses to employees or management.
#4 – Translation Reserve
This is applicable when the entities have an operation in multiple countries and at the financial year-end, consolidated accounts need to be prepared, translating different reporting currencies into the one functional currency. The exchange difference that arises is parked in this reserve.
#5 – Hedging Reserve
This reserve is generated when the company has taken certain positions to protect itself against volatility in certain input costs.
The list provided above is not exhaustive. There are multiple purposes for which the company can create reserves, which depend on the legal and social requirements.
Example of Reserve Accounting with Journal Entries
The following is an example of reserve accounting with journal entries.
The company is in the existing business of industrial chemical industries and now wants to expand its territory into agricultural products.
This would require a separate setup and the estimated building cost is $10 million.
The actual building cost turns out to be $ 9 million.
At the same time, after the completion of the building, we need to reverse the first entry which was created for the building fund as the purpose for which it was created has been fulfilled.
Advantages of Reserve Accounting
The following are the advantages of reserve accounting –
- #1 – Improves the Financial Stability of the Company – Parking of excess profits in the reserves helps us to deal with the contingencies systematically. The fund helps the company on rainy days.
- #2 – Expansion of Business – The company can consider expanding into other areas only if they have the requisite funds available with them. Loan funds can also be procured but it also comes with its own cost. So, reserves help the company to use funds without paying interest costs.
- #3 – Declaration of Dividend – The shareholder’s confidence in the company increases when they get profit in terms of dividends. The company can declared dividends only when they have sufficient balance in the reserves.
Disadvantages of Reserve Accounting
The following are the disadvantages of reserve accounting –
- #1 – Utilization of the Funds – The funds are earmarked for specific purposes and if they have not been utilized for the purpose for which they have been created, then it defeats the basic purpose of accounting.
- #2 – Distorted Financial Position – Even when the company is going through the losses, it gets absorbed by the profits accumulated during the year. This prevents the stakeholder to get a true position of the business.
- #3 – Siphoning of the Funds for Own Use – Due to a lack of proper monitoring on the usage of reserves, it has come to the notice that management has siphoned off the balance of the reserves for their purpose, resulting in loss to the shareholders.
Difference Between Reserve and Provisions
For a layman, reserve and provision would look similar but to an accountant, they are two different aspects.
Provision is mainly created to meet the liability but the amount is uncertain. Reserve are the funds set aside, not for any liability but to meet the requirements of the funds of the business in the future.
Conclusion
To meet the uncertainties and contingencies of the business, the creation of reserve is mandatory. It helps the business to survive in the situation when all the odds are against it. But there should be proper monitoring of the funds. It has been noticed in the past that top management had diverted the funds for their use.
Understanding the difference between provision and reserve is also required for concept clarity. Provisions and reserves both reduce the profits, but in a different sense. The former is a charge against the profit, but the latter is an increase in the capital employed.
Recommended Articles
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