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 capitalThe Share CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more.
#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 offWriting OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more expenses incurred before the incorporation of the company.
Example
Suppose the par value of the sharePar Value Of The SharePar value of shares is the minimum share value determined by the company issuing such shares to the public. Companies will not sell such shares to the public for less than the decided value.read more 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.
#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 currencyFunctional CurrencyThe term functional currency represents the currency of the location in which business operates primarily, earns a significant portion of revenue, and incurs the cost to generate such profits. In short, it is the home currency of that country where the corporate headquarter is situated.read more. 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 dividendsDeclared DividendsDividend declared is that portion of profits earned that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of the company’s securities.read more 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.
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For eg:
Source: Reserve Accounting (wallstreetmojo.com)
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.
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For eg:
Source: Reserve Accounting (wallstreetmojo.com)
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 employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more.
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