Here on the Kashoo blog, we've been discussing the various types of accounts you may find yourself setting up in your accounting software. Recent examples include valuation accounts to nominal accounts, expense accounts and suspense accounts. Each of these accounts allow you to take care of a specific function in your company's accounting. The next one on the list we'll look at is the reserve account...
What is a Reserve Account?
Otherwise known as a reserve fund, or simply a reserve, this type of account is a way to set aside a certain amount of funds from your company's profits so that they can be used for a specific purpose further down the line. What kind of purpose, you might ask? One typical example of a reason funds are held in reserve is to pay off future debts. Reserves can also be used to pay for fixed assets or to cover other unexpected future costs.
If planning for costs that are unexpected sounds like a bit of an oxymoron, that's because it kind of is. And there's actually no legal requirement for funds allocated to a reserve account to be used for any specific purpose. However, as a small business owner, you're likely already well aware of the fact that unexpected costs—from unplanned repairs and maintenance to the settlement of an unforeseen lawsuit—can (and will) crop up. Plus, putting funds aside in a reserve account can be a good way to make sure they aren't used for other purposes, like the payment of dividends to shareholders.
How to Do Reserve Accounting
So, how do you go about recording the transactions involved in a reserve fund in your company's accounting?
First, you're going to debit your retained earnings account for the amount that is being allocated to your reserve. To balance out that debit with an equivalent credit, you're going to then credit your reserve account for the same amount. (If this is sounding complicated, brush up on debits and credits in accounting.)
Let's say you've decided to put $10,000 in reserve for future repair and maintenance of your small business' office space. Following the steps outlined above, you would be debiting your retained earnings in the amount of $10,000, as well as crediting your reserve account for $10,000.
Once the reason for the reserve has been fulfilled—in this case, the repairs have been made and the related expense has been incurred—then you're going to reverse the steps laid out above, so that the balance is returned to your retained earnings. What does this look like? It's just the opposite of your initial steps: your reserve account is debited the cost of the repairs and your retained earnings account is credited the same amount.
Accounting entries related to a reserve account will be found on the balance sheet (although they may be included in the line item for retained earnings, rather than getting their own line item).
Saving for a Rainy Day
Think of a reserve account as a virtual savings account that's used to take care of unpredictable future costs your business may incur. These kinds of costs are part of the nature of doing business and you'll be much better off setting aside a virtual chunk of change in your company reserves to cover (or at least offset) these surprise expenditures.
Stay tuned for an upcoming post on whether or not you should set up an actual savings account for your business.
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