WallStreetMojo

WallStreetMojo

WallStreetMojo

MENUMENU
  • Blog
  • Free Video Tutorials
  • Courses
  • All In One Bundle
  • Login
Home » Accounting Tutorials » Shareholders Equity Tutorials » Reserve Accounting

Reserve Accounting

By Madhuri ThakurMadhuri Thakur | Reviewed By Dheeraj VaidyaDheeraj Vaidya, CFA, FRM

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. Unless specifically mentioned, these 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

Many legislations mandate it, 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. It can be utilized only for certain specific purposes. E.g., 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 –

Particulars Debit  Credit
Bank Account                   Dr $40mn
                   To Share Capital $10mn
                    To Securities Premium $30mn

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.

Popular Course in this category
Sale
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects)
4.9 (1,067 ratings)
250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
View Course

#4 – Translation Reserve

It is applicable when the entities have an operation in multiple countries. At the financial year-end, consolidated accounts need to be prepared, translating different reporting currencies into 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.

It would require a separate setup, and the estimated building cost is $10 million.

Particulars Debit  Credit
Retained Earnings               Dr $10mn
                           To Building Fund $10mn

The actual building cost turns out to be $ 9 million.

Particulars Debit  Credit
Building                 Dr $9mn
                           To Bank $9mn

After the completion of the building, we need to reverse the first entry, which was created for the building fund. It is since the purpose for which it was created has been fulfilled.

Particulars Debit  Credit
Building Fund                 Dr $10mn
                   To Retained Earnings $10mn

Advantages of Reserve Accounting

The following are the advantages of reserve accounting –

  • 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.
  • 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.
  • 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 –

  • 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.
  • Distorted Financial Position – Even when the company is going through the losses, it gets absorbed by the profits accumulated during the year. It prevents the stakeholder from getting a true position in the business.
  • 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.

difference1

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 for the business in the future.

Reserve Accounting difference

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

This article has been a guide to Reserve Accounting, and it’s meaning. Here we discuss the reserves types and its accounting along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

  • Accounting Convention – Meaning
  • Fund Accounting
  • Capital Reserve
  • Statutory Reserve
8 Shares
Share
Tweet
Share
Primary Sidebar
Footer
COMPANY
About
Reviews
Contact
Privacy
Terms of Service
RESOURCES
Blog
Free Courses
Free Tutorials
Investment Banking Tutorials
Financial Modeling Tutorials
Excel Tutorials
Accounting Tutorials
Financial Statement Analysis
COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Venture Capital Course
Excel All in One Course

Copyright © 2021. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

* Please provide your correct email id. Login details for this Free course will be emailed to you

Book Your One Instructor : One Learner Free Class
Let’s Get Started
Please select the batch
Saturday - Sunday 9 am IST to 5 pm IST
Saturday - Sunday 9 am IST to 5 pm IST

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Login

Forgot Password?

WallStreetMojo

Free Accounting Course

You will Learn Basics of Accounting in Just 1 Hour, Guaranteed!

* Please provide your correct email id. Login details for this Free course will be emailed to you

Special Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More