Reserve in Accounting

Reserve in Accounting§

Definition§

A reserve in accounting refers to the portion of a company’s capital, excluding its share capital, that largely arises from retained profits or the issuance of share capital at more than its nominal value. Reserves are distinct from provisions, as provisions are set aside for known liabilities or asset value diminutions, whereas reserves represent undivided surpluses. Some reserves are non-distributable (e.g., share premium account, capital redemption reserve) but may be reserved for specific purposes. It’s essential to understand that reserves are part of the general net assets of a company, not specific sums of money set aside.

Detailed Explanation§

• Reserves vs. Provisions: Provisions are created for known liabilities or diminutions in asset value—a loss that has already occurred. Conversely, reserves account for accumulated profits or capital surpluses that are yet to be distributed. They can be earmarked for future contingencies or investments but aren’t tied to specific liabilities.

• Retained Earnings: This type of reserve, also known as revenue reserves, consists of a company’s profit retained for reinvestment or future distribution as dividends. Retained earnings are vital for business growth, expansion, and stability.

• Undistributable Reserves: These include reserves that legally cannot be distributed as dividends due to regulatory or corporate governance restrictions. They may include the share premium account or capital redemption reserve and can often be converted into permanent share capital through a bonus issue.

Examples of Reserves§

1. General Reserve: Amount set aside from profits for future needs, contingencies, or business expansion.
2. Share Premium Account: Arises when shares are issued at a price higher than their nominal value.
3. Capital Redemption Reserve: Created during the redemption of preference shares or buyback of a company’s own shares.
4. Dividend Equalization Reserve: Set aside to ensure the stability of dividends over the years.

Frequently Asked Questions (FAQs)§

Q1. Are reserves the same as profits?

A1. No, reserves are portions of accumulated profits retained for specific or general future use, whereas profits refer to earnings during a specific period.

Q2. Can companies use all their reserves to pay dividends?

A2. No, only certain reserves, such as retained earnings, can be distributed as dividends. Undistributable reserves, like the share premium account, cannot be used for dividend distribution.

Q3. How do reserves contribute to a company’s financial health?

A3. Reserves provide a financial cushion, aid in funding expansion and innovation, support future contingencies, and ensure stable dividend distributions.

Related Terms§

• Capital: The wealth, in the form of money or assets, owned by a company.
• Provisions: Funds set aside for known liabilities or diminution in the value of assets.
• Retained Earnings: Accumulated profit kept for reinvestment or distribution.
• Share Premium Account: The excess amount received over the nominal value of issued shares.
• Capital Redemption Reserve: Fund created for repurchasing the company’s own shares or redeeming preference shares.

Online Resources§

1. Investopedia - Accounting Reserves
2. The Balance - Understanding Reserves

Suggested Books for Further Studies§

1. “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
2. “Financial Accounting” by Robert Libby, Patricia A. Libby, and Daniel G. Short.
3. “Advanced Accounting” by Joe Ben Hoyle, Thomas Schaefer, and Timothy Doupnik.

Accounting Basics: “Reserve” Fundamentals Quiz§

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