What is Reserve Accounting?
To run a successful business, you must prepare for the unexpected. There might not be a way to arrange for every possible scenario. But there is a way to ensure that you don’t suffer too heavily from planned or unplanned future costs: reserve accounts.
Reserve accounts allow businesses to earmark a portion of their profits to cover costs that may arise further down the line. Once that cost is fulfilled, the retained earnings account is credited, and the accounts are balanced. Reserve accounts are a vital component of any company’s financial planning strategy and help prevent setbacks or failure.
Here’s What We’ll Cover:
Understanding Reserve Accounting
Reserves, otherwise known as retained earnings, are any profits that have been set aside for future use.
A business can use them for any number of things, as there are no legal restrictions on using funds designated as reserves. However, they’re most commonly used to purchase fixed assets, pay off debts, pay for legal settlements, fund expansion, distribute bonuses, pay for maintenance, cover unexpected costs, or anything other business costs that come up.
When a company marks profits as reserves, it indicates to investors that this amount will not be included in dividends. It is up to the board of directors to authorize the creation of any reserve funds.
Types of Reserve Accounts
There are two main types of reserves:
- Revenue Reserves
Revenue reserves are a certain amount of profits created from normal business operations. They can be further divided into two categories, general and specific reserves.
- General Reserves are not set aside for a specific purpose. Instead, they’re used to strengthen a company’s financial standing or cover unforeseen costs in the future.
- Specific Reserves, also known as special reserves, are set aside for a particular purpose and cannot be used for anything else. For example, a company may set aside an amount to cover losses from a buyer who goes out of business.
- Capital Reserves
Capital profits create capital reserves. These funds result from activities that fall outside normal operations. They're primarily used to cover capital losses. For example, gains on sales of fixed assets or profits earned before an enterprise’s embodiment may go into capital reserve accounts.
How Does Reserve Accounting Work?
First, you must debit your retained earnings account for the amount you will be allocated to the reserve account. Then, balance the accounts by crediting the same amount to the reserve account.
After an action takes place that fulfils the need for the reserve, you must reverse the debits and credits. Debit the reserve account and credit the same amount to the retained earnings account.
Record all reserve account entries as liabilities on the balance sheet. You’ll usually find them listed under “Reserves and surplus.” If there are no profits, then there will be no recorded reserves.
Example of Accounting for Reserves
For example, let’s say a company wants to set aside money to purchase a new factory. They credit $10 million to the Factory Reserve fund and debit $10 million to the retained earnings account. After the factory is purchased, the company reverses the entries. A credit of $10 million goes to the retained earnings account, and a debit amount of $10 million goes to the Factory reserve fund.
The following examples show how specific reserve funds can help plan for different scenarios:
- Legal Reserve Fund
This type of specific fund exists to cover legal fees that may arise from settlements or other legal issues.
- Remuneration Reserve
A remuneration reserve stores profits for internal use. The funds are later distributed as incentives or bonuses to a company’s employees and management.
- Translation Reserve
This type of reserve helps companies operate in multiple countries. For example, let's say a company makes profits from currency conversion. In that case, they place the funds in a translation reserve.
- Hedging Reserve
Hedging reserves exist to protect a company from volatility in input costs.
Utilizing reserve accounts is an essential financial strategy for running a successful business. Reserve accounts function as savings accounts that help cover unexpected costs. It's one of the best ways a company can avoid circumstances that threaten its profitability and survival.
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