Question

Explain what a “Reserve” account is designed to accomplish.

Answer 1

Solution:-

A reserve is profits that have been appropriated for a particular purpose. Reserves are sometimes set up to purchase fixed assets, pay an expected legal settlement, pay bonuses, pay off debt, pay for repairs and maintenance, and so forth. This is done to keep funds from being used for other purposes, such as paying dividends or buying back shares. It can serve as a signal to investors, that a certain amount of cash is not to be distributed to them in the form of dividends. The board of directors is authorized to create a reserve.

A reserve is something of an anachronism, because there are no legal restrictions on the use of funds that have been designated as being reserved. Thus, funds designated as a reserve can actually be used for any purpose. Reserve accounting is quite simple - just debit the retained earnings account for the amount to be segregated in a reserve account, and credit the reserve account for the same amount. When the activity has been completed that caused the reserve to be created, just reverse the entry to shift the balance back to the retained earnings account.

For example, a business wants to reserve funds for a future building construction project, and so credits a Building Reserve fund for $5 million and debits retained earnings for the same amount. The building is then constructed at a cost of $4.9 million, which is accounted for as a debit to the fixed assets account and a credit to cash. Once the building is completed, the original reserve entry is reversed, with $5 million debited to the Building Reserve fund and $5 million credited to the retained earnings account.

A reserve line item does not necessarily have to be presented separately in the balance sheet; it may be aggregated into the retained earnings line item.

The term reserve is not defined under Generally Accepted Accounting Principles, except for its application to oil and gas reserves.