December 7, 2021

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Meaning of Reserves (accounting) and key Explanations

Meaning of Reserves (accounting) and key Explanations
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In a financial statement, companies usually set aside some money from profit or other sources to finance important business activities. The money set as reserves in accounting is usually decided by the Board of Directors. Doing this will help reduce borrowing and make the organization healthier.

Definition of Reserve in Accounting

It is the fund set aside from retained profit to meet certain business needs. The fund is used for growth and expansion of the entity.

Key Explanations

A fund. The fund called reserve is an internal source of finance. Instead of borrowing from outsiders or issuing new shares, company’s management may set aside funds from profit to meet certain business needs.

Set aside from profit. The fund is taken from profit or other sources. Generally, retained profit is seen as a revenue reserve. However, in order to inform shareholders and other stakeholders that part of the profit will be used for a project, such money is deducted from profit.

It may also come from other sources. A good example is foreign exchange reserves. It arises when the firm gained from foreign exchange transactions. This is as a result of favourable exchange rate during business transactions with other countries. And are called capital reserves.

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Another kind is the mandatory one that must be set aside by the company. This is called statutory reserves. It may be taken from profit as well. So, they are referred to as revenue reserves. Next is Equity reserves. This arises from the sale of shares and are mostly called share premium. It occurs when the company sells its shares higher than the nominal price. Share premium is a capital reserve.

Certain business needs. The fund set aside is to meet certain business needs. This can be used for capital projects like buying a fleet of official cars for managers, construction of new office buildings, a major renovation of the office, repayment of loans, paying bonus shares, meeting certain contingencies like foreign exchange losses, among others.

Meaning of Reserves (accounting) and key Explanations

Important of Accounting Reserves

Reserves are important in an organization. It tells the shareholders and other potential investors that the company is a strong one and that they should not be afraid of liquidation in the coming year.

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Although the fund may have been distributed to the owners as dividends, it can be used to increase the number of shares owned by investors. This is true when the board of directors decided to issue bonus shares.

Another importance of reserves is the additional fund it provides to the company for growth and development. The entity does not have to rely on borrowed money to fund its projects.

Accounting Treatment of Reserve

When the accounting reserves are set aside, the retained earning will be debited and the reserve account credited. At the end of the project, the fund will be reversed to retained profit. Then, debit the reserve account and credit retained earnings.

For example, a company wants to construct a new branch office for 54 million Naira. At the end of the year the board decides to transfer the amount from retained earnings to a building fund reserve account. Here the entry in the books of account shall be:

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Dr: Retained Earnings Account
Cr: Building fund reserve Account

At the construction of the building the double entry is:

Dr: Building Account
Cr: Bank Account

When the building is completed, the amount in the building fund reserve account will be reversed to Retained Earnings. Here,

Dr: Building Fund reserve account
Cr: Retained Earnings account.

Click or tap to learn more about double entry principles.

Conclusion

Reserves in accounting are set aside for prudence measures. However, the International Financial Reporting Standard (IFRS) conceptual framework has omitted the concept of conservatism or Prudence. Also, no IFRS shows how to deal with reserves. Therefore, it is performed as a managerial decision or a requirement by law within a country. Notwithstanding, it helps the entity to organize funds internally, instead of relying majorly on borrowed funds.

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