What is the definition of reserves?
Reserves can be defined as the portions of business profits that have been retained by the company, either for future investments or for unforeseen circumstances. They are mainly set aside to strengthen the financial position of the business.
During the normal course of the businesses, profits earned over a given timeline are mostly distributed amongst the owners in the form of dividends. However, companies might choose to retain these profits to fund machinery purchases or any other financial need of the company that might arise.
The reserves are kept and maintained to prevent them from being used for other purposes, like paying out dividends or buying back shares. Creation, and addition in the reserves of the company act as a signal to the investor that this cash is not supposed to be used for distribution.
The creation of reserves is mainly to ensure that the company has sufficient funds to meet certain expenditures that are non-operational. These expenses or obligations are mostly one-offs, and therefore, they are not incurred on a daily basis. Therefore, they require significant planning on the part of the company.
The company might choose to create this reserve in one go or create it over years. For example, they might choose to accumulate 10% of profits every year in order
Classification of Reserves
As mentioned earlier, reserves are defined as the amount that the company sets aside from its profits. Therefore, it is classified as a subcategory of the revenue or the profit account. Therefore, it is classified as income, and hence, retained earnings have a credit balance.
Reserves are mentioned as ‘Retained Earnings’ in the Balance Sheet, under the Income Section. However, this only holds true for Revenue Reserves and Capital Reserves.
If there are any claims, and there are reserves maintained for that, they are mentioned as liabilities in the company’s financial statement.
Types of Reserves
There are two main kinds of reserves that are created from the perspective of the business. They are revenue reserves and capital reserves. These reserves are different because of the source from where these reserves are created, and how they are set aside for different purposes. The explanation for both these types of reserves is given below:
- Revenue Reserves: Revenue Reserves are the profits that are earned by the company’s day to day operations, and are set aside. Revenue reserves are further subcategorized into two broad categories:
- General Reserves: General Reserves are not kept aside for any particular purpose. However, they are maintained for the general financial strengthening of the company, so that the company has enough reserves for any unprecedented cases.
- Specific Reserves: Specific Reserves can be defined as the amount of money that is set aside from the day to day operations of the company, with the aim and the intention of utilizing it for a specific purpose.
- Capital Reserves: Capital Reserves are created out of capital profits of the company. These are the profits that are created from sources other than normal trading activities. Capital reserves, are only generated from capital sources, and hence this reserve is mostly kept and maintained for capital losses.
Balance Sheet Reserves
Balance Sheet Reserves are also referred to as claims reserves. These are the accounting entries that are carried out in order to set aside money for future obligations of the company. Balance Sheet Reserves are disclosed as liabilities on the Balance Sheet.
However, it must also be noted that Balance Sheet reserves are only maintained when there is a definite chance that there would be sums required to be paid in lieu of financial obligations. Therefore, these types of reserves mostly exist in insurance companies or organizations that need to maintain sums of money to pay back their customers.
Journal Entries for Recording Reserves
During the normal course of the company, whenever a profit is made, it is transferred to retained earnings of the business. Reserves are subsequently created from the Retained Earnings account.
In case there are specific reserves, they are parked in that specific account. Otherwise, they are a credit to the general reserve account that the organization maintains.
The accounting rationale behind these journal entries mainly vests on the grounds that income or Retained Earnings has a credit balance, and therefore, in order to reduce this balance, there is a need to debit this account.
Hence, the reserve account is created, which is also similar in nature to any income account. Hence, it has a credit balance and should be treated as such in the financial statements of the company.
Example of Reserve Accounting
Chris Co. planned on constructing a new building their existing premises in order to expand their operations. They planned on allocating $15,000 for the new building construction.
They had a Retained Earnings account balance equivalent to $65,000. The new reserve was created as a special reserve, primarily for building-related operations. However, the construction was complete at a cost of $14,000.
In the example above, it can be seen Chris Co. is planning on constructing a new building for expansion related purposes. In order to do that, they are going to deduct the amount from the Retained Earnings, and then subsequently credit it to the new building reserve that they have created. The journal entry to record this particular transaction is as follows:
During the construction period of the business, all expenses are going to be deducted from the reserves only. As it was Chris Co. it can be seen that the total expenses incurred for the building construction amounted to $14,000.
Therefore, the excess amount from the reserve account is going to be debited back to cash. The actual cost incurred is going to be recorded as a Non-Current asset on the Balance Sheet of the company.
In accordance with the historical cost concept, it is important for organizations to record assets at the actual cost that was incurred to bring the assets in their given state.
Hence, after the construction was completed, the required journal entries would be as follows:
|Building (Property, Plant and Equipment)||$14,000|
If there was a shortage of the specific reserve that was created, Chris Co. would be required to transfer the additional amount from retained earnings, to this particular reserve. However, it must be noted these reserve accounts are temporary accounts, and hence, once the specific purpose is completed, the account no longer exists in the books of the company.