If you’re running a business, you’ll be all too aware of the need for rainy day funds. Unexpected expenses can crop up at any time, from critical repairs to legal settlements. And when you’re faced with these kinds of costs, your cash flow can suffer as a result. Reserve accounting can help you ensure that your business’s finances don’t need to take a hit if you ever need to deal with unplanned costs. Want to know more? Find out everything you need to know about reserve accounting, kicking off with our reserve accounting definition.
Reserve accounting definition
Reserves are profits that have been appropriated, or set aside, to be used for a specific purpose further down the line. There is a wide range of potential uses for reserves, including the purchase of fixed assets, paying off debts, paying an expected legal settlement, paying bonuses, covering unexpected future costs, and so on. Reserve accounting stops these funds from being used for other purposes, such as paying dividends or buying back shares.
In some senses, reserve accounting is an anachronism. In reality, there aren’t any legal restrictions governing the usage of funds that have been marked as reserves. Theoretically, these funds can be used for any purpose. However, business owners will be aware that unexpected costs can crop up at any time. Reserve accounting can help ensure that if your business is faced with an unplanned expense (for example, machinery repairs), you won’t be left out of pocket.
Types of reverse accounting
There are two main types of reserves: revenue reserves and capital reserves. Essentially, capital reserves are created from capital profits (i.e., earnings from non-normal trading activities), while revenue reserves are created from profits earned over the course of normal business operations. Capital reserves are usually used solely for capital losses, while revenue reserves are intended for unexpected costs (general reserves) or specific and expected costs (specific reserves).
How do reserve account journal entries work?
Want to know how reserve accounting entries work in practice? Well, recording the transactions that are involved in reserve accounting is relatively straightforward.
Firstly, you’ll need to debit your retained earnings account for the amount you’re allocating to the reserve. Then, you’ll balance that debit with an equivalent credit by crediting the same amount to the reserve account. For example, if your business hasn’t updated its machinery in a while, you may want to allocate $25,000 for potential repairs. To do this, you should simply debit the retained earnings account for $25,000 and credit the reserve account for $25,000, thereby making your accounts balance out.
Then, when the reserve has been fulfilled (i.e., when the repairs have been made, and the expense has been incurred), you’ll need to reverse the transaction. Essentially, this means that you’ll debit the reserve account and credit the retained earnings account for the same amount. That, in a nutshell, is how reserve accounting entries work. You can find all reserve account journal entries on the balance sheet, although in some cases, they’ll be aggregated with the retained earnings line item.
The importance of reserve accounting
Ultimately, reserve accounting ensures that unpredictable costs don’t end up tanking your business. In a sense, it’s a virtual savings account that you can dip into when you’re facing a surprise expenditure.
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