Equity reserve is one of the accounting terms that mean many things. It has different applications in bank capital, real estate, and business. What are equity reserves?
Equity reserves are reserve funds. This fund is set aside to cover any contingency, such as asset loss, a legal problem, and other unexpected events. This is a balance sheet component that offsets losses. This can also be an asset’s residual interest after lessening the liabilities.
Read on to learn more about equity reserves, including their accounting treatment.
What Are Equity Reserves?
If you go online and search for equity reserves, you will find limited results. The meaning can differ depending on a specific application.
Equity Reserves in Bank Capital
It is a type of capital that a bank reserves for any contingency, including legal actions and asset loss. This means that if ever a bank has an unfortunate incident, it needs a standby fund for paying its clients. Lastly, it includes a payment to its depositors.
It can also be a dividend reserve scheduled for stockholders in banking capital but has not yet been declared. Additionally, it can be a sinking fund for retiring stock or future debt capital instrument.
Equity Reserves in Businesses
In business, an equity reserve is a reserve fund. In a balance sheet, you will find it in the equity section. It does not include the share capital. Instead, it includes the computations for balances from other activities, including revaluation change and foreign translation.
However, not all equity reserves are available for businesses to tap. You need a sufficient amount in your equity against an asset. A strong minimum is necessary for the approval of the line of credit.
Equity Reserves in Real Estate
It is a term for real estate’s equity or the difference between the amount you owe in a mortgage and the property’s selling value. Often, you will see them from companies organizing the equity loan. It means borrowing your house’s equity.
To access your equity reserve in real estate, one of the first things to do is evaluate your credit rating and create a strategy for credit management. Next, compute the combined loan to value ratio. Evaluate your options and select a lender. After all these, you can determine the amount that you can file for a loan against a property’s equity.
Sources of Equity Reserves
In an owners equity, the following are some of the most common sources of equity reserves:
1. Legal Reserves
This is a legal capital requirement in some businesses. It is paid as the percentage of the share capital.
2. Remuneration Reserve
It is a kind of reserve that a business will use for paying bonuses to the management and employees.
3. Translation Reserve
It is a part of the consolidation of the entities of various reporting currencies.
4. Profit Reserve
As the name implies, it is a reserve from profits, including retained earnings. It considers operating surpluses when there is no profit.
Accounting Treatment of Accounting Reserves
In an ideal world, a business operates to make a profit. Consequently, when there is a profit, there is a reserve.
To compute the net profit, deduct the expenses from the revenues. Additionally, this net profit goes to reserves. They are transferred to the reserve after the dividend payment to the shareholders. As a result, these equity reserves will show up on the balance sheet.
Foreign Currency Translation Reserve
This foreign business accounting method is a part of the consolidation process. Additionally, its main goal is to convert foreign currencies into a single currency.
There are different methods for the computation of foreign currency translation. For instance, it can be current rate, temporal rate, or monetary-non-monetary translation methods.
According to accounting standards, the balance sheet’s items must convert into the exchange rate of the balance sheet’s date.
Meanwhile, the income statement must reflect the conversion depending on the exchange rate’s weighted average.
Upon purchasing a fixed asset, they are listed either through a cost method or revaluation model. Under the latter, the evaluation of the fixed assets is based on a reporting date. This reporting, however, can have balance differences. As a result, these revaluation reserves will be a part of equity reserves.
In terms of accounting treatment, the changes will not show up in an income statement until the disposal of the fixed assets. After this disposal, it will show in the balance sheet’s equity section.
General Reserved or Retained Earnings
As a business operates, it generates revenues. Depending on the overall strategies and performance of the business, it will have a net profit. From this profit will come the dividend payments.
Anything more than these payments will remain in the balance sheet and will show up as a reserve. In turn, this can be another component of the equity reserve of a business.
Fair Value Through Other Comprehensive Income
These are assets and liabilities that meet the requirements for fair value through comprehensive income that will affect equity reserves. The fair value changes over time, affecting a balance sheet. Before settling or selling, gain already becomes a part of the company’s equity reserve.
Different Types of Reserves
In accounting, there are two main reserves:
It is a reserve from the capital profit. So, it does not include the shareholder’s dividends. Any profit from a company’s core operations is not a part of the capital reserve. It includes the following:
- Cash from the sale of current assets,
- Premiums from shares issuance,
- Forfeiture of shares, and
- Excess revaluation from assets.
The creation of this reserve depends on company rules. Most businesses will take advantage of this for writing off capital losses.
In a balance sheet, capital appears as a part of surplus and reserve. It does not reach the owners or investors through dividends. Hence, special transactions are necessary for this kind of accounting reserve.
Do not confuse capital reserve with reserve capital. The latter is a resource that doubles as an emergency fund. The business withholds this fund unless a liquidation is necessary. Disclosure is not necessary so that it won’t show up on the balance sheet.
This is a part of the company’s earnings it sets aside for different purposes. So, it is a profit and loss entry. As a result, businesses use it for dividend payment, stabilizing the dividend rate, and expanding operations, among other things.
Revenue reserves have two more categories:
It strengthens the company’s financial position. This is a type of reserve for general purposes.
The second is a special reserve, which the company secures for a specific reason. This means that the company will not utilize it for any other reason other than what they earlier specified.
Again, what are equity reserves? Equity reserves are a type of bank capital representing funds set aside for contingencies such as assets, losses, legal action against banks, and other events. Equity reserves also provide a sinking fund to retire stock or debt capital instruments and provide a future reserve fund for dividends expected to be paid out to stockholders.
Benefits of Having Equity Reserves
Here are some of the most compelling reasons why your business needs reserves:
- Improve your company’s financial position
- Generate an internal financing source to support business expansion
- Pay shareholders’ dividends timely
- Pay for the wages of your employees
- Meet your company’s financial obligations to suppliers
- Replenish the working capital
- Invest in new assets to sustain business growth
Building Reserves for Your Business
In this section, we are not just talking about equity reserves. Instead, they are for creating cash reserves. These are profits that a business must allocate for different circumstances, such as expansion or settlement of legal disputes:
1. Start with a Realistic Value
Consider the size and performance of your business. Conduct a feasibility study to predict how much your business will be making. Consequently, you will have an idea of how much you should save up for your equity reserve. It isn’t a simple guessing game. You need a solid basis for any amount you come up with.
2. Improve Your Collections
To sustain the reserve that you are eyeing for your business, you must make profits. To do this, strengthen your collection strategy. Make sure that your customers pay on time to have the resources necessary to grow your equity reserves. Without enough collection, you might not have enough reserve.
3. Minimize Your Expenses
Check the expenses of the business and see what you can minimize. Find ways to cut costs to increase profits. Consequently, you will have more money to keep in your reserve. Discover opportunities to earn more by eliminating unnecessary expenditures.
4. Look for Funding
Evaluate different funding methods to increase your capital. Among others, applying for a bank loan is one of the most common methods. However, make sure to consider the interest rates as such will have a long-term impact on your business.
Crowdfunding, angel investors, and venture capitalists are other potential ways to raise more capital so that you can have a higher reserves allocation.
Frequently Asked Questions
Before ending this post, we’ll answer some questions you might have about equity reserves or reserves in general.
Are Equity Reserves Cash?
An equity reserve is not cash. Businesses usually exhaust all its cash reserves first before it resorts to utilizing the equity reserves available.
How Are Reserves Created?
This will depend on the specific type of reserve. For instance, it is taken directly as a portion of the business capital if it is a capital reserve. On the other hand, it is a portion of the profits that a company dedicates for a general or specific purpose in the case of a revenue reserve.
What Are Reserves on a Balance Sheet?
When equity reserves appear on a balance sheet, they are liabilities of a business. The business reserves this fund for the payment of its future obligations. These are most relevant in the insurance industry since a company needs adequate financial resources to settle its clients’ claims.
Why Do Businesses Create Reserves?
The creation of reserves is driven by the goal to have funds for unfortunate situations. As a result, it minimizes the financial impact of such incidents on the company. It makes sure that it has cash or equity when they need it the most.
Additionally, it can be for legal settlements, payment of debts, and handling repairs, among other common expenses.
Conclusion – Equity Reserves
An equity reserve asset’s residual interest after lessening all the liabilities. It has different applications, including in banking capital, real estate, and businesses. It also refers to any residual fund to cover any contingency, such as when there is a legal issue or loss of assets.
There are two main types of reserves in accounting – capital reserve and revenue reserve. The main difference is that capital reserve does not include the profits from business operations. Meanwhile, revenue reserves include profits, which the entity can use for general or specific purposes.