September 22, 2021

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Meaning of Statutory Reserves and key Explanations

Meaning of Reserves (accounting) and key Explanations
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Statutory reserve is a special kind of fund set aside as reserves. It is as well called legal, mandatory or regulatory reserves. It is compulsory for banks and other financial institutions all over the world to keep this kind of fund out of their profit. In this article, the definition of this reserves is explained as well as how it applies to certain financial institutions in Nigeria.

Definition — What is Statutory Reserves?

It is defined as the fund set aside from profit to meet future obligations or unmatured liabilities and contingencies of a company. It may be in cash or treasury bills. And it is made mandatory by a regulatory agency established by the government of a country.

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Key Explanations

A part of profit. Similar to other types of reserves, it is a part of profit. A percentage is applied on the profit to get the amount for it. At times other parameters may be used to decide the amount to be deducted from profit as statutory fund.

Meet Future Obligations. The aim is to meet future obligations. Financial institutions mostly keep this type of fund. The reason is because they hold money that doesn’t belong to them. Clients keep money in the form of deposits and premium. In order to meet financial obligations of clients as they occur in the future a mandatory fund is kept by these companies.

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Other contingencies. In addition to immatured obligations, funds are kept for unforeseen events. Insurance companies set aside funds from profits to meet contingencies. These may include life insurance, fire, motor accident insurance policy among others. Most insurance policies occur without advance notice. Therefore, a contingent fund is reserved to meet them as they fall due.

Companies that keep this type of reserves. Not all firms are mandated to keep this type of funds. To qualify for this fund, the company must be regulated by a regulatory agency. In Nigeria, there are regulatory bodies for most financial institutions. Later on in this article, I will examine banks, insurance and pension’ companies legal reserves.

How to Calculate Statutory Reserves

There are generally two methods to calculate statutory reserves. These are rule-based and principle-based methods. In most underdeveloped economies, the rule-base is mostly used.

Under the rule-base method, a mathematical percentage is used to calculate the fund to be set aside from profit. The value for the percentage is determined by the regulator based on assumptions it thinks best fit all companies under it. But each firm may have their own unique risks. And businesses with higher profits may have more funds compared to others.
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In the principle-based method, regulators allow companies to decide the amount for mandatory funds. This is decided based on risk analysis, experiences of management and credibility of the entity including goodwill. This method is rarely used. Since the firm’s management will decide on the amount, it makes the approach subjective.

Statutory Reserves Rates for Certain Financial Institutions in Nigeria

Banks, Insurance companies and pension fund administrators are key businesses whose impact may affect the economy. These financial institutions are saddled with citizens’ money in trust. Therefore, regulations are important to ensure that clients’ money is not mismanaged and doctored. Also, funds must be available to meet future obligations from clients and customers. To ensure customers’ money are saved, legal reserves must be set aside by these institutions.

The Central Bank of Nigeria (CBN) regulates all money deposit banks. The required fund is 30 percent of profit after tax if the statutory reserve is less than the company’s paid up capital and 15 percent if otherwise. Furthermore, banks are mandated to keep funds for small businesses through Agriculture-Business/Small and Medium Scale Industrial Reserves (ABSMEEIS). This fund is 5 percent on profit after tax.

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National Insurance Commission (NAICOM) regulates Insurance companies in Nigeria. The percentage used is the higher of 1 percent of total premium or 10 percent of profit after tax. This will accumulate until it reaches an amount greater than minimum paid up capital or 50 percent of net premium.
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Also, National Pension Commission (PENCOM) is the regulatory body for Pension Fund Administrators (PFAs). The statutory reserve for PFAs is 12.5 percent on profit after tax.

Conclusion

Statutory reserves also called regulatory, mandatory or legal reserves are set aside from part of profit to meet unclaimed obligations from clients of a business. In developing economics, the rule-based approach is mostly used to calculate the reserve. Moreover, the fund is made compulsory by a regulatory agency. And it is common with banks, insurance companies and Pension Fund Administrators.

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