What are Reserves?

Reserves are a line item of shareholders’ equity (owner's equity) line items in the statement of financial position (balance sheet) and also within the line items of the statement of changes in equity, the concept of the reserve is the amount of net profit that has been allotted to meet a particular purpose or for unspecified purposes, and reserves are created under specific laws in each country such as Companies Law in Egypt

There are several types of reserves such as statutory reserve (legal reserve), statutory reserve and bond sinking fund

Also, there are general reserves proposed by the Board of Directors, which are approved by the General Meeting

The Importance of Reserves

Strengthening the company's financial position so that it can cope with urgent events specific to the company or the economic situation, in general, to implement a specific company policy, meaning that the company wants to set aside a certain amount to expand what the company wants.

Reserves are a strong guarantee for creditors of all their types when the company has a good reserve, which enables the company to maturity payment to creditors when the company falters, for example, and this strengthens the company's ability and position with the creditors. 

Also, reserves increase the actual value of shares above their par value, because a good reserve strengths the share value and thus its market value increases, also, it works to achieve a balance of the cum dividends from one year to another, meaning that in the case that this year there are no good profits that can be dividend compared to the prior year, some reserves can be used and the dividend from them.

Types of Reserves

Statutory Reserve/ Legal Reserve: is a reserve that is stipulated in the Companies Law, and 5% of the year earnings are deducted every year for a purpose until the statutory reserve reaches 50% of the issued capital and can be used to counter the losses of the company or increase the capital but is not used in the dividend and the statutory reserve is considered as a reserve requirement.

Statutory Reserve: a reserve that the Articles of Association of the joint-stock company is stipulated for its creation, which is to be at a specified rate, and used for a specific purpose, and is considered as a reserve requirement in terms of its creation and purpose for which it was created and can be dividend through it.

Other Reserves or General reserves: they are created upon a proposal by the Board of Directors and approved by the General Meeting, these reserves are considered optional reserves that are created according to the company's desire and may not be disposed of except with the approval of the General Meeting.

Bond Sinking Fund: when issuing bonds, it is usually stipulated in the issuance contract that a reserve should be created by setting aside an annual amount of profits that at the end of the contract period has a value equal to the loan amount. The idea is for bondholders to ensure that the company has funds to call bonds when their maturities are due. This is from creditors, but from the company’s point of view, the creation of the bond sinking fund is also desirable for the call of bonds not to affect the working capital of the company if the funds obtained by the company from the bondholders have invested in the current assets. But if the company has invested in purchasing new fixed assets, then it is better to provide the funds necessary to call of bonds from the annual profits.

There was the term asset valuation reserve or capital reserve created by companies by setting aside the profits of selling fixed assets in a separate account and it was reviewed periodically to ensure that it was sufficient to meet the cost of replacing new assets and it was deleted.

Accounting treatment of reserves 

A reserve creation journal entry

Reserves and Purchase of Fixed Assets

There is always a question about whether a fixed asset can be purchased through reserves

First, there are reserves such as the statutory reserve and this reserve is legally stipulated in the joint-stock companies law and it is not permissible to dispose of it for any other purposes except under certain conditions and after the approval of the General Meeting

There are other special reserves the company creates for a specific purpose, such as purchasing a fixed asset or expanding and acquiring assets

It is assumed that this reserve is in the shareholders' equity side

Accounting Equation is, Assets = Liabilities + Owner's equity

Consequently, the opposite of this reserve is an asset as cash on hand and cash at bank or deposits linked to a purpose or a current asset that can be converted into cash

This is in the case of another reserve in the sense of any reserve other than statutory reserve 

The reserve is not a payment instrument in the sense that there can be no journal entry

A reserve is an instrument for setting aside profits to be paid for a specific purpose, and therefore the statutory reserve must be converted into liquidity and this is through certain procedures

What is important is that it is the normal journal entry when purchasing assets

This reserve, which is allocated for a variety of purposes, is then decreased by the value of the asset purchase and closed in the retained earnings account 

The reserve will set aside the company from fully paying the dividends to the partners or shareholders, and therefore the department will have sufficient sources of cash to purchase the assets in the next periods, the whole idea is that it is not possible to payment from the reserve directly, but the reserve is transferred to retained earnings.

Secret Reserves

There is a term called a secret reserve, which creates as a result of the department’s use of techniques that lead to a show of stockholders' equity in the balance sheet less than its actual value, and this is by several techniques such as

Overstating in determining the amount of the provisions and recording liabilities greater than their actual value, this of course does not show in neither the balance sheet line items nor the statement of stockholders' equity line items.

Reviewing Reserves 

Reviewing accounting journal entries related to reserves and ensuring that they meet the requirements outlined in the Companies Law, Articles of Association, and the decisions of General Meeting and the board of directors.

Reviewing the existing reserves balances at the balance sheet date and compare them with the previous period balances.