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In finance, reserve accounting refers to how reserves are computed, utilized, and most importantly, accounted for. There are various kinds of accounts kept by a company or business, such as the cash account and expenditure account. Similarly, there is also a reserve account with its own ledger and balance sheet. The word “reserve” actually refers to any portion of the shareholders’ equity with the exception of their basic share capital. The shareholders’ equity, also called shareholders’ funds or stockholders’ equity, refers to the remaining interest on the assets of the company after all of the liabilities have been paid. This interest is often divided appropriately among all of the shareholders.
Another way of understanding reserve is as the profit realized from interests. A company’s reserve may be coursed back into the business to keep it going, especially during difficult times. In the past, reserve was interchangeably used with another accounting term, “provision.” But this usage has now been discontinued. Reserve accounting does not encompass provisions, which now refer to amounts provided for depreciation losses, known liabilities, and contingencies. Other provisions that are also not within the scope of reserve accounting are provisions for retirement benefits, severance, and reorganization.
The items that do fall under reserve accounting includes equity reserves that are created from company profits, retained earnings, and shareholders’ contributions. Usually, shareholders’ contributions come in the form of share premiums, surplus payments from shareholders exceeding the nominal values of their shares, and legal reserve funds which are required in various legislations. Meanwhile, profit-created reserves often come from remuneration and translation reserves and from legal reserve funds as well.
A simple way to distinguish between provisions and reserves is that the former must be “provided for” by the company, as the word suggests, because they are necessary expenditures that ensure the company’s survival. Meanwhile, reserves are like extras or surplus from profits and retained earnings. It doesn’t mean, however, that reserves can be spent freely. In business, it is dictated that the reserves be saved up for a rainy day.
In reserve accounting, two types of reserves are considered. These are capital reserves and revenue reserves. Capital reserves are those arising from profits but that cannot be distributed among shareholders or employees as cash bonuses or dividends. There are many kinds of capital reserves; some examples are share premiums, statutory reserves, and exchange fluctuation reserves.
Meanwhile, examples of revenue reserves are general reserves and retained profits. Unlike capital reserves, they can be distributed as cash shares or bonuses. Again, prudence dictates that just because they can be distributed, it does not mean that all revenue reserves are to be given away. Some portion is always set aside to serve other purposes.