Reserve Accounting Meaning
Reserve accounting represents the company’s accumulated profits, which have been earned over the years, authorized by the board of directors. Unless specifically mentioned, these can be utilized without any legal restrictions for purchasing fixed assets, settlement of legal obligations, payment of statutory bonuses, and long-term debts.
To meet the uncertainties and contingencies of the business, the creation of reserves is mandatory. It helps the business to survive in a situation when all the odds are against it. But there should be proper monitoring of the funds. It has been noticed that top management had diverted the funds for their use.
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Reserve Accounting Explained
Reserve accounting signifies figures that indicate resources preserved to be utilized for specific purposes. These are gains that can help accomplish various tasks and requirements, including the purchase of assets and the improvement of financial situations.
Also known as retained earnings, these funds constitute extra finance to serve general purposes to boost business processes. In accounting, these extra funds retained after covering all expenditures and liabilities are a debit for the retained earnings account and credited to the reserve account.
The following are the types of reserves in accounting.
Reserve accounting can be further categorized into several components, depending on the organization’s requirements. The most common examples of reserves are
#1 – Legal Reserve Fund
Many legislations mandate it, 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..
#2 – Securities Premium
When the company receives the amount over the nominal value of the share, then the excess is termed as securities premiumSecurities PremiumShare premium is the difference between the issue price and the par value of the stock and is also known as securities premium. The shares are said to be issued at a premium when the issue price of the share is greater than its face value or par value. This premium is then credited to the share premium account of the company..
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. expenses incurred before the incorporation of the company.
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. is $10, and due to excess demand in the market, the share price shoots to $40. The excess $30 becomes a securities premium, which the companies account for in the following way –
|Bank Account Dr
|To Share Capital
|To Securities Premium
Explanation of Reserve Accounting Journal Entry – A shareholder would pay $40 to the company, but as the par value is $10, the 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 must 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.. The exchange difference that arises is parked in this reserve.
#5 – Hedging Reserve
Companies generate this reserve after taking certain positions to protect themselves 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.
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.
|Retained Earnings Dr
|To Building Fund
The actual building cost turns out to be $ 9 million.
After the completion of the building, we need to reverse the first entry created for the building fund. It is since the fulfillment of the assigned purpose using the funds.
|Building Fund Dr
|To Retained Earnings
The following are the advantages of reserve accounting –
- Improves the Financial Stability of the Company – Parking excess profits in the reserves help us 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. Loan funds can also be procured, but it comes with their 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. only when they have sufficient balance in the reserves.
The following are the disadvantages of reserve accounting –
- Utilization of the Funds – The funds are for specific purposes, and if businesses do not utilize them for what they create them, it defeats the basic purpose of accountingAccountingAccounting is the process of processing and recording financial information on behalf of a business, and it serves as the foundation for all subsequent financial statements..
- Distorted Financial Position – Even when the company goes through losses, the profits accumulated during the year absorb them. 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 of 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 a loss to the shareholders.
Reserve Accounting Vs Provisions Accounting
For a layman, reserve, and provision would look similar, but they are two different aspects to an accountant. Understanding the difference between provision and reserve is important for concept clarity. Provisions and reserves both reduce profits, but in a different senses. 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.".
Provisions meet the liability, but the amount is uncertain. Finally, reserves are the funds set aside, not to cover liabilities but to meet the fund requirements of the business in the future.
This article has been a guide to what is Reserve Accounting. Here we explain its types, examples, advantages, disadvantages, and vs provisions accounting. You can learn more about accounting from the following articles –