The Definitive Guide To Reserve Accounting & How it Keeps Your Business Financially Secure
Every successful business should invest in reserve accounting. This is because emergencies can strike without warning – you could need to cover unexpected repairs, legal fees or settlements.
Subsequently, your cash flow will be hit when faced with these risks.
Reserve accounting can ensure the stability and security of your business’s finances if you have to deal with unexpected costs.
What Are Reserves In Accounting?
Reserves, also referred to as retained earnings, are portions of a business’s profits that have been appropriated or set aside to improve the company’s financial balance, providing an additional layer of financial security.
Reserves have a plethora of uses. They are generally used to purchase fixed assets, repay debts, fund expansions, make bonuses, and make dividend payments. Furthermore, they also pay an expected legal settlement and cover potential unplanned costs.
Keeping money in reserve accounting ensures it is not used for activities like dividend payments or share repurchases but remains available for other essential expenses.
Reserve accounting is, therefore, paramount for when your business is faced with any unexpected costs so that you will have many readily prepared if this transpires.
To document reserves in accounting, an entry must be made to the retained earnings account, which is then credited in the same total amount to the reserve account. After creating the reserve is finished, it should be reversed. This will return the funds to the retained earnings account and restore its balance.
Reserve accounts are listed as liabilities on the balance sheet under ‘Reserves and Surplus’. However, if a company experiences losses, no reserves are allocated or recorded in the books.
Types Of Reserves
The two main kinds of reserves include revenue reserves and capital reserves. They are often allocated from multiple sources of income and utilized for diverse purposes.
A business can reap monetary benefits from its regular activities, some of which are retained for future use – these are known as revenue reserves.
There are two types of revenue reserves:
- General reserves are not kept aside for any specific person but rather for the general financial improvement of the company.
- Specific reserves: unlike the former, these reserves are kept aside for specific purposes and cannot be used for any other purpose. Specific reserves are also known as special reserves.
Capital reserves are built from capital gains– profits generated from sources apart from regular trading activities.
These reserves are usually put aside in case of capital losses.
Capital reserves are created with the help of profits created through:
- Sequestration of shares
- Sale of fixed assets
- Revaluation of existing assets
- Earnings on hand before adding the firm
- Retrieval of preference shares or debenture
The Importance Of Reserve Accounting
Since reserves allow money to be set aside in case of unexpected costs, the business’s financial position will significantly improve.
They act as internal financing. Internal financing options greatly benefit businesses by allowing them to expand their operations. This, in turn, facilitates a larger scope of activities and helps the business grow.
By paying out dividends on time, companies enhance their goodwill and build a positive relationship with their shareholders. This not only helps the shareholders but also ensures the business’s long-term growth. Furthermore, having reserves on hand is a great way to ensure you have the financial means to cover unforeseen expenses and losses.
Establishing a reserve enables business owners to replenish their working capital, which helps them run everyday operations without facing any hiccups.
Lastly, investing resources in new tools and extra assets can greatly boost business productivity. It will ultimately help owners to maximize their operational efficiency.
How to Set Up a Reserve Account for Your Business
Plan How Much You Want To Set Aside
Carefully consider your financial situation and decide on an average amount to spend monthly. Then find a way to save enough money to sustain yourself for the period you believe is needed.
You should have at least 3 months worth of savings in your reserve at any given time. However, you should still save up to 6 months worth, just in case. Better safe than sorry!
Every month, it is important to look at your non-negotiable expenses. This would include recurring costs such as rent, employee salaries, and vendor agreements.
To maximize your savings, try identifying negotiable expenses you can cut in case of a business closure. These costs may include marketing, materials and inventory – if managed properly, you could save even more.
Consider You Cash Reserve As A Fixed Expense
Considering your cash reserve as a fixed expense should be part of your overall financial strategy. Any money left over after taking care of bills should be treated as something that is to be expected, like any other expense, and budgeted accordingly. Generally, fixed expenses for small businesses include rent, insurance, and car payments for fleet vehicles.
To ensure you have sufficient funds for your cash reserve, it’s wise to open a separate account or create a dedicated label within your accounting system. With this setup, you can effortlessly move more money into the reserve before analysing monthly costs or calculating profits.
Develop A Policy For When You Can Use Your Reserve
Developing a guide for when you need to take out money from your cash reserve is imperative. This guide is designed to protect against overspending – you wouldn’t want to dip into your cash reserve unnecessarily, thus reducing the amount you have saved.
Without a plan in place for when to use it, this could lead to a rapid depletion of your reserve.
Creating certain criteria which must be fulfilled to approve the use of allocated funds is beneficial. This could include both business owners having to sign off on it or even board/investor consent. It’s a great way to safeguard your finances until they are truly needed.
Reserves in accounting are paramount when your business is hit with unexpected costs. Furthermore, it helps improve cash flow and ensures stability and safeguarding of your finances in the case of this emergency.
Do not underestimate reserve accounting. It is clear that every successful business needs one!
How do you account for reserves in accounting?
Retained earnings should be debited, while the same amount should be credited to a reserve account. This is necessary to set aside funds in the reserve account.
After the reserve creation project is complete, the entry must be reversed, and the balance transferred to retained earnings. This is necessary to ensure that there are no discrepancies in the entries.
Are reserves the same as retained earnings?
Retained earnings and reserves have similar characteristics but are not identical.
The major discrepancies between them are that reserves constitute a portion of retained earnings but not vice versa.
Are reserves in accounting a part of profit?
Yes, they are. Profits can be allocated to create general reserves for various company needs and contingencies. These reserves are not limited to a special purpose and can be used for any reasonable means that arise in the future – including unforeseen expenses or expansions.