Accounting Principles – Reserves

It is not intended to cover bookkeeping entries, or accounts, made or raised, as a matter of convenience for the purpose of showing some asset in memorandum form. By this is meant memorandum charges which require a credit in order to keep the books in balance.
Reserves should without exception be found upon the righthand side of the balance sheet. It is probable that more confusion exists with regard to reserves than any other nomenclature which is the subject of confusion. Unfortunately few persons understand without discussion what is meant by a reserve. It is a most common thing to be asked when a reserve is mentioned, “Do you mean a reserve or do you mean a fund?” This question is usually followed by the question, “Do you mean the account on the right-hand side of the balance sheet or the one on the left-hand side of the balance sheet?”

The trouble is probably due in a large measure to the practice established years ago by the comptroller of the currency in accordance with the national bank law of requiring national banks to report their reserve funds. It is probably true that the word “reserves” was first used to denote reserve funds, in the statements of resources and liabilities of national banks. This was perfectly proper when taken in connection with accounts of national banks and for the purpose which it was intended to serve. The origin of the banking reserve dates back to the time when it was first discovered that upon certain occasions more than the ordinary number of depositors might apply at one time for the money which they had on deposit. The liability to depositors was recorded by an account called individual deposits. The account was originally opened when an individual deposited cash. When cash was received the depositor was credited. If the bank used its cash for the purpose of making loans, the general cash was credited and “notes and discounts” was charged. If the account of this one depositor were magnified to represent that of several thousand, it will be seen that out of the cash received from depositors, there might be set aside an amount which would be sufficiently large to meet any reasonably large combined demands for withdrawals on the part of depositors. Such funds were held in reserve and accordingly received the name of reserve funds or reserves. This provision, it will be noticed, was for the purpose of providing for the liquidation of a liability just as a sinking fund would be accumulated for the purpose of redeeming outstanding bonds at maturity.

The term sinking fund has become so common that it is probable no one ever thinks of calling a sinking fund a reserve. There would not appear to be any reason why, when it is well known that this confusion of terms exists, care should not be taken in the use of terms and only such terms used as are descriptive of the subject and at the same time commonly accepted and understood without question. This it seems might be accomplished by calling a fund “a fund” and a reserve “a reserve.” The use of the word reserve should be avoided on the asset side wherever possible. The word fund should never appear on the liability side.

The purposes which reserves serve are numerous. One is to safeguard the business from detriment through the withdrawal of capital. Another is that of increasing the value of an asset without increasing the capital or proprietorship. Reserves are also used as a means of providing for future losses in a specific asset without at the time of loss affecting the capital or proprietorship. In a similar manner they are used as a means of providing for future losses of any kind without at the time of loss affecting the proprietorship or capital. Where a corporation takes over another concern and the net assets of the concern taken over exceed the par value of the stock issued for same, the excess is sometimes represented on the books of the corporation by a reserve. Such a reserve is as a rule temporary in its existence and stands on the books pending a revaluation of the assets. Another use for reserves is that of serving as a bookkeeping expedient for reducing proprietorship without altering the asset account affected. Still another use to which reserves are frequently put is that of controlling or measuring the extent of an asset such as a fund. They are also used to measure appropriations of capital or surplus.

A construction company entered into a contract with a certain municipality. A holding company to which the construction company was subsidiary guaranteed satisfactory performance on the part of the construction company. The bookkeeper of the holding company was instructed to make an entry which would record the transaction. He found some difficulty in making the entry because of the fact that he could not determine the amount for which the entry was to be made. He saw that it was necessary to record the contingent liability in favor of the municipality. He also decided that the offset to the contingent liability was a contingent asset in the nature of a claim against the construction company. Since it was necessary to make an entry and no amount was available he selected the nominal value one dollar ($1.00) and made an entry charging “Guarantee—Columbus Construction Company” and crediting “Reserve for Guarantee—Columbus Construction Company.” This it will be seen was purely a memorandum entry and did not affect proprietorship in any way. The entry was made in order that the facts should not be lost sight of. The use of the word reserve in this instance was obviously a misuse.

Two partners were engaged in a manufacturing business. They agreed between them that 50% of all profit should be reserved and not available for drawings. The capital was small, unequally invested and drew interest. The reserves did not draw interest. It was the purpose in establishing the reserves to build up the business and strengthen it; to protect it from the inroads of excessive drawings. The account on the books was called “Partners’ Reserves.” In this case there was somewhat more justification for the use of the word than in the other instance cited. The reserve was a part of proprietorship. It seems, however, to have been placed in an account other than those of the partners simply because of the fact that it was noninterest bearing.

An industrial corporation placed a mortgage on its property and sold bonds. The bonds contained a clause which stated that a reserve should be created annually out of profits. The reserve was created and at maturity equalled the amount of the bond issue. The company had from time to time been investing its surplus funds in securities. At maturity these were sold and the outstanding bonds redeemed. The account was called “Reserve for Redemption of Bonds.” The account represented a true reserve, but it was not appropriately named. Redemption of an outstanding obligation cannot be effected through an account on the same side of the books. The bonds were redeemed out of the proceeds of the securities sold. The account should have been called “Reserve for Protection of Bonds.” This is not suggested as an improvement of the accounting nomenclature now existing; rather as describing the conditions in this case. The reserve in reality served as a protection to the bond issue in that it prevented the surplus funds of the company from being withdrawn as dividends.

Another corporation was desirous of revaluing certain land which it owned in accordance with values in the surrounding neighborhood. Some of the directors favored increasing the value of the land and crediting the amount of the increase to surplus. Others opposed this proceeding on the ground that land values fluctuate and the value might decrease. They contended that if the credit were made to surplus the amount would be available for dividends; the dividends might be paid and the value subsequently decline. It was finally decided to revalue the land and credit the increase to a “Reserve for Appreciation of Land.”

Many concerns make provision for losses on accounts by charging profit and loss and crediting a reserve for such purposes. Consequently we frequently see the account, “Reserve for Bad Debts.” It is not an uncommon occurrence to find a reserve for contingent losses. The two reserves are similar. One is for a specific purpose. The other is for a general purpose.

A firm of contractors and builders decided, on account of labor troubles, etc., to incorporate. The combined capital investment of the partners was approximately $100,000. In order to escape the state tax on corporations, it was decided to incorporate for $25,000 and have the partners take notes of the corporation for the balance of their old capital. As taken over by the corporation, the plant and equipment was appraised and was found, together with the other assets, to exceed the liabilities and capital stock by about $25,000. This amount was credited to an account called “Reserve for Capital Surplus.” While the amount probably would have been available, as surplus, for dividends, it was the desire of the partners to have it reserved as surplus. This had the effect of withholding the amount from both the capital stock account and the partners’ note accounts as well as prevent its use for distribution as dividends.
A reserve for depreciation is merely an expedient for estimating the decrease in the value of an asset without affecting the asset account. It is the reverse of writing down the asset on account of depreciation. The former method is to be preferred since it permits the account to show the facts with regard to the asset without the introduction of any indefinite factor such as depreciation. If the depreciation is excluded the account will show the original cost of the asset, with subsequent additions and deductions at cost. Such a reserve is merely the setting aside of capital, in an amount which corresponds to the estimated depreciation of the asset, for the purpose of showing the estimated value of the asset.

A coal company obtained a part of its land in which mines were located through borrowed capital. The capital was obtained through the sale of bonds secured by a mortgage on the property. The mortgage provided that a reserve equal to ten cents (ioc.) a ton should be created annually out of earnings and that an amount equal to the reserve should be deposited with a sinking fund trustee for the redemption of the bonds.

A certain hospital decided to devote the income from certain sources to the erection of a building for housing its nurses. It will be noted that, given the commonly accepted meaning, the income would not accomplish such purpose. The receipts corresponding to the income would, however, provide the necessary fund. The income may have taken the form of subscriptions. The payment of the subscriptions may have followed. The reserve in this case, as in that of the coal company, had the effect of measuring the fund and restricting its use for special purposes.

The government, federal, state, and municipal, is in the habit of apportioning its revenues for various purposes by appropriation. The appropriation bill usually reads “and there is hereby appropriated out of any moneys not otherwise appropriated the sum of * * *.” This has the effect of restricting the general surplus and confining the application of the appropriation to a specific purpose. The respective appropriation reserves have the effect of measuring the various funds, or of determining the equity of each appropriation in the funds appropriated.

In a similar manner, a mercantile concern may appropriate a part of its surplus for a specific purpose. Some concerns have created reserves for pensions and sick benefits among employees out of their surplus. Where the concern is sufficiently well established and has sufficient cash available at any time to meet payments to employees, it is not considered necessary to fund the reserve. The funds are allowed to remain in the business; the company pays interest for their use; the amount due to the fund is determined by the reserve to which the interest is credited.

A well-known biscuit concern distributed its product to dealers in elaborate tins. The dealers were obliged to deposit with the company seventy-five cents (75c) for each tin. Receipts of this kind were charged to cash and credited to a reserve. The money was used in the business in the same manner as a bank uses its deposits. In the panic of 1907, the streets for blocks around the plant of this company were filled with trucks returning empty tins. The reserve had not been funded. No cash had been set aside for this purpose. This was a contributing factor in the failure of the company which followed in a short time.

Reserves are created in two ways. One is by charging profit and loss or surplus and crediting the reserve. The other is by charging an asset and crediting the reserve. As examples of the first we have: partners’ reserves, reserves for losses, reserves for depreciation, reserves for sinking funds, and appropriation reserves. As illustrating the second method there are: reserves for appreciation, reserves for capital surplus, reserves for contributions. It is claimed by some that reserves may only be created out of surplus. This may be conceded if all additions to assets are considered as accretions of capital and are first credited to capital in spite of the fact that they are subsequently to be set up as reserves.
The use of reserves can scarcely be considered without looking at each with regard to the purpose for which it was created. A reserve for safeguarding the business against withdrawal of capital will presumably stand the same as a capital account, until such time as the business has become sufficiently strong to withstand its apportionment among partners. A reserve for losses will be credited with future additions and charged with any losses. A reserve for depreciation will increase through credits until it equals the book value of the asset which it offsets. This statement must of course be qualified with the remark that consideration will be made for the residual value of the asset if there is any. A reserve for a sinking fund will increase until it equals the obligation, broadly speaking, which the sinking fund is to liquidate. Appropriation reserves are as a rule more stable on the credit side. They may in mercantile concerns fluctuate on both sides. As used by governmental bodies there is usually one credit. This of course assumes that there are no deficiency appropriations. The frequency with which the debits occur will depend upon whether the appropriation is for capital or revenue purposes. If for the latter, charges will be made against the appropriation reserve as disbursements, or charges which will subsequently result in disbursements are made. If the appropriation is for capital purposes the reserve will probably be closed by one debit closing the appropriation reserve into capital surplus. Where appropriation reserves are used by mercantile concerns both the debits and credits may fluctuate by additional appropriations and interest credits on the one hand and charges for payments on the other. Cases are known where mercantile concerns have made appropriations for capital purposes. The effect of such procedure is only to tie up the surplus and acts as a commitment to improvement or extension before dividends are declared.

Reserves for appreciation may likewise fluctuate. They are set up with a credit. If the asset declines in value they are subject to charge. Reserves for capital surplus are subject to the same remarks. Reserves for contributions are credited when the contribution is received. If received for current purposes the reserve is charged as frequently as disbursements are made. If for capital purposes, the reserve is charged only at such time as the capital asset has been acquired and becomes a part of the general fund. As long as the contribution exists as a special fund so long will there be no charge against the reserve for the purpose of transferring it to the capital surplus.

The disposition of reserves is, broadly speaking, the same in each case. They serve the purpose for which they were set up. Created out of surplus they revert to surplus if they have not been obliterated by use. A reserve for losses will be charged with the losses. If the estimate for the losses has been too great, the balance in the reserve may be closed out to surplus. If, however, the reserve were too small an additional credit would be necessary, if the practice of providing a reserve for losses were to be consistently followed. The same thing might be said of reserves for depreciation so far as the adequacy of the reserve is concerned. The disposition, when the reserve account equals the asset account, is largely a matter of choice. The reserve may be debited and the asset credited, or the asset may be credited and the reserve debited. One consists, technically, in closing out the reserve against the asset; the other closing out the asset against the reserve. A sinking fund reserve will be closed out to surplus after the sinking fund has been used to liquidate the liability shown by the bond account. Appropriation reserves will be reduced by charges when set up for revenue purposes. Any unrequired balance will revert to surplus as will any reserve for capital appropriations.

Reserves for appreciation will usually stand until the increased value has been determined beyond a doubt. When such has taken place the reserve may be closed into surplus. Reserves for capital surplus are very similar. As long as they represent tentative values they should stand. When the value of the assets which they represent is unquestionable they may apparently be closed into surplus. The question concerning this matter is, whether or not the surplus so acquired, and without doubt available for dividends, has been earned. The Consolidated Laws of 1909 (chapter 59, section 28, volume 5, folio 4004) provide that “It shall be unlawful for the directors or managers of any incorporated company in this state (New York) to make dividends excepting from the surplus profits arising from the business of such corporation.”
The law does not state whether the “dividends” shall be paid in cash or in stock; neither does it define “surplus profits.” These two points, however, are practically settled by the case of Williams vs. Western Union Telegraph Company (93 N. Y., 162).

The Western Union Telegraph Company declared a stock dividend out of surplus and a stockholder brought suit to prevent the payment of the dividend. The court held that the action of the company was not in violation of the law. After defining surplus as being the excess of assets over liabilities and capital, the decision continues: “Such surplus belongs to the corporation and is a portion of its property, and, in a general sense, may be regarded as a portion of its capital, but in a strictly legal sense it is not a portion of its capital, and is always regarded as surplus profits.”

It would thus appear that a reserve for capital surplus need only stand until such time as the value of the offsetting asset has been definitely determined when the reserve may be closed into the surplus proper.
A reserve for contributions will depend so far as its disposition is concerned upon the purpose to which the fund is devoted. If the fund is used for revenue purposes, the reserve will be closed by charges from time to time as disbursements are made. If it is used for capital purposes the reserve will be closed out to surplus or general reserve, as it is sometimes called in institutions, when the disbursements have been made for such purposes.

Reserves often are the subject of discussion on account of their location on the balance sheet. Generally speaking, there are two ways of showing them: one is as deductions from assets, the other is on the liabilities side, either as a separate group or as a part of capital. An explanation of the reason for placing them on the right hand side of the balance sheet will probably explain also why they should not be deducted from assets on the lefthand side.

Reserves are considered as restricted capital. Capital is the excess of assets over liabilities. Capital is the equity in the assets taken collectively, providing, of course, that there are liabilities. To admit that one particular asset belongs to the proprietor while some other particular asset belongs to the creditors would be unusual. Since reserves are a part of capital and capital is an equity, it seems somewhat unwarranted to deduct a portion of capital from a specific asset.

It has sometimes been stated that one purpose in avoiding the deduction of reserves from assets was to prevent an admission of depreciation of property in the case of a fire. Theoretically it was maintained that if the reserves were deducted from the assets it was an admission of the depreciation, whereas the reverse was true if the reserves were set up broad.

The standard fire insurance policy usually contains the following clause: “The insured, as often as required, shall exhibit to any person designated by this company all that remains of any property herein described and submit to examinations under oath by any person named by this company and subscribe the same; and as often as required, shall produce for examination all books of account, bills, invoices, and other vouchers, or certified copies thereof, etc.” It would thus appear that a mere formality so far as the balance sheet is concerned would not serve as a protection against a searching investigation on the part of the insurance company which it is assumed would determine the value of the property destroyed.