Reserve accounting
/What is a Reserve in Accounting?
A reserve represents a portion of a company’s retained earnings that is set aside for a specific future purpose, such as expansion, contingencies, or debt repayment. While it is still part of shareholders' equity, it is not available for dividend distribution once appropriated. Reserves can be created voluntarily by management or as required by law or accounting standards. They enhance financial stability by ensuring that funds are available to meet anticipated needs or absorb unexpected losses.
A reserve is something of an anachronism, because there are no legal restrictions on the use of funds that have been designated as being reserved. Thus, funds designated as a reserve can actually be used for any purpose.
Why is a Reserve Used in Accounting?
Reserves may be set up for many reasons, including the following:
To purchase fixed assets. Reserves are most commonly used to block out funds for really major fixed assets, such as the construction of a new factory.
To pay an expected legal settlement. This reserve is usually set aside when it is more likely than not that an adverse decision will be made in a lawsuit.
To pay bonuses. This reserve is usually recorded fairly late in the fiscal year, after it becomes more likely than not that significant bonuses will be paid.
To pay off debt. This reserve is needed when a business is unlikely to be able to roll over a major debt, and must instead pay for it from current cash reserves.
To pay for repairs and maintenance. This reserve is only used for very large repair and maintenance projects that are well beyond the normal expenditures in the category.
Who Creates a Reserve?
An accounting reserve is created by a company’s management, often in consultation with its accounting and finance team, based on reasonable estimates of future obligations or losses. These reserves are then reviewed and approved by the board of directors, especially if they involve significant financial implications.
Accounting for a Reserve
Reserve accounting is quite simple - just debit the retained earnings account for the amount to be segregated in a reserve account, and credit the reserve account for the same amount. When the activity has been completed that caused the reserve to be created, just reverse the entry to shift the balance back to the retained earnings account.
The term reserve is not defined under Generally Accepted Accounting Principles, except for its application to oil and gas reserves.
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Example of the Accounting for a Reserve
For example, a business wants to reserve funds for a future building construction project, and so credits a Building Reserve fund for $5 million and debits retained earnings for the same amount. The building is then constructed at a cost of $4.9 million, which is accounted for as a debit to the fixed assets account and a credit to cash. Once the building is completed, the original reserve entry is reversed, with $5 million debited to the Building Reserve fund and $5 million credited to the retained earnings account.
Presentation of a Reserve in the Financial Statements
A reserve line item does not necessarily have to be presented separately in the balance sheet; it may be aggregated into the retained earnings line item.