Reserve Accounting

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.

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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

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 –

ParticularsDebit 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.

ParticularsDebit Credit
Retained Earnings               Dr$10mn 
                           To Building Fund $10mn

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

ParticularsDebit 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.

ParticularsDebit Credit
Building Fund                 Dr$10mn 
                   To Retained Earnings $10mn

Advantages of Reserve Accounting

The following are the advantages of reserve accounting –

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.

Diff-Provision-Reserve

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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.

Reserve-Accounting-provision

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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.

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 –

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