Start learning about the basics of reserves in accounting today, including how they affect your UK company’s balance sheet and financial statements.
Definition of Reserves Accounting
Simply put, reserves are profits a company has made that are set aside for a specific purpose in the future.
There is a huge variety of uses for reserve funds, including:
- Paying off debt
- Paying an expected legal settlement
- Paying out bonuses
- Purchasing fixed assets
Reserve accounting prevents these funds from being used for other things like buying back shares or paying dividends. The money in the reserve should be used for what it was intended for.
But technically, there are no legal restrictions on what a company can use reserve funds for. They can ultimately be used for anything.
However, many businesses go wrong in using the reserves for things that don’t benefit the business as a whole. Owners and shareholders need to remember that unexpected costs will eventually pop up, and if the funds aren’t there to cover them, it’s a big problem.
Reserves accounting ensures that should a business be faced with unexpected expenses, there is a way to pay for them. For example, if a moving company needs repairs done on a truck. This is an unexpected event that can implicate the profits of the business.
Types of Reserve Accounting
Capital reserves
The capital reserve is funds that come from capital profits, meaning non-normal trading activities. The reserve usually covers capital losses. These are when the value of capital assets, like property or investments decreases.
Here are some examples of capital reserve:
- Reserve created for redeeming capital.
- The extra amount gained from re-evaluating liabilities and assets.
- Profit earned from selling fixed assets.
- Profit gained from re-issuing forfeited shares.
Revenue reserves
A revenue reserve account comprises retained earnings from normal business operations. These funds are generally reserved for unexpected costs, which come from general reserves. The expected costs are also covered by specific revenue reserves.
Here are some examples:
- Future contingency reserve
- Dividend equalisation reserve
- Employee bonuses
- General revenue reserve
- Expansion or growth reserve
- Legal reserve
How Do Reserve Accounts Work With Journal Entries
Recording transactions for reserve accounting is quite simple, here’s how it works:
- Debit your retained earnings account with how much you’re putting into the reserve.
- Balance that debit with the same amount on the credit side of the journal.
The aim is that both the debits and credits need to balance out. This is known as double-entry accounting.
So, for example, if your business needs to repair one of the trucks for deliveries, you may need to allocate £2,000 towards the maintenance.
To do this from reserve accounts, you debit the company’s retained earnings and credit the reserve account.
Now, once the maintenance is complete and the expense has been paid for, you reverse the transaction. To do this you:
- Debit the reserve account
- Credit the retained earnings account
Both of these are the same amount, just under different columns. But they will always balance each other out.
FAQ
Why is reserve accounting so important?
Reserve accounting allows businesses to prepare for the unexpected without losing all the built-up finances. Life happens, and if businesses aren’t prepared with some sort of savings (reserve) it could be a big problem for the success of the company. You don’t want to start dipping into salaries and taking out credit, it’s a long road to recovery.
Are reserves an asset or liability
Reserves on a balance sheet are liabilities because they are funds kept aside to pay for things in the future.
What are equalisation reserves?
Equalisation reserves are for insurance companies to ensure they have enough funds available should a catastrophic incident occur. There are specific rules set out by HMRC for this type of reserve.
Final Thoughts
Understanding reserves in accounting can be complicated. There are different types of reserves and the accounts they come out of. Businesses need to monitor reserves to ensure that there are sufficient funds for future certainties and uncertainties.
Hiring an accountant can help you establish the type of reserve you need and the types of situations that might arise in your company’s field. It’s always better to be prepared.
Sources:
https://www.investopedia.com/terms/b/balance-sheet-reserves.asp
https://gocardless.com/guides/posts/reserve-accounting/
https://byjus.com/commerce/what-are-reserves-in-accounting/
https://www.investopedia.com/terms/e/equalizationreserve.asp