When a company turns a profit, it may distribute some or all of the money as shareholder dividends. If it retains some of the profits, it lists them on the balance sheet as retained earnings. A general reserve fund is one way to set aside retained earnings for future spending.
A company's balance sheet is an equation: Assets = Liabilities + Shareholder's Equity. If, say, the company has $10 million in assets and $7 million in debt, the owners' equity is $3 million. That's how much the shareholders own after all the creditors get paid. Retained earnings (RE) go in the shareholder equity section of the balance sheet.
Say your company starts the year with $5 million in retained earnings. You generate $1.7 million in net income this year, issue $1 million in dividends to the shareholders and retain $700,000. Your retained earnings account is now $5.7 million.
There's no law requiring a business retain earnings, but sometimes it's a smart move. Retaining earnings gives the company added funds for whatever it might need in the coming year, such as:
- Buying new equipment.
- Spending on research and development.
- Expanding operations.
- Bonuses for executives.
- Repairs and maintenance.
- An anticipated legal settlement.
Even if the board of directors doesn't see an immediate need for extra money, one will probably develop eventually. Having a sizable pot of retained earnings gives the company a war chest without having to issue more stock or take out a loan.
Suppose the company ends the year with $2.3 million in retained earnings. The board of directors plans to spend it over the next couple of years replacing aging equipment. The board, however, is free to change its mind the following year and issue $2.3 million in dividends instead.
Setting up a general reserve account, or a specific reserve, is a more formal commitment. By putting some or all of the $2.3 million in a reserve, the board declares their interest in saving against future needs. There are several types of reserves in balance sheet accounting:
- A general reserve can be spent on whatever needs come up.
- A building reserve sets money aside for new construction.
- A contingency reserve is money held for unplanned, emergency needs.
- A capital reserve holds money for major spending projects.
None of the labels are binding, though. For example, the board can take a building reserve and use it for repairs and maintenance or to settle a lawsuit.
Recording reserves on the balance sheet is fairly simple. Suppose the company has $4.5 million in retained earnings and wishes to set aside $3 million for replacing old equipment. The accountant reduces retained earnings to $1.5 million and sets up a $3 million reserve. If the replacements only cost $2.6 million, the remaining $400,000 goes back into retained earnings.
The reserves can be a separate line on the balance sheet or it can be included with retained earnings. "Reserve" isn't an official term in U.S. business accounting, so companies have some flexibility.
Besides the general reserve in retained earnings, "reserve" turns up with a very different meaning elsewhere. For example, accounts receivable, the amount that customers owe the company, is listed as an asset. If the company worries some of the customers will default, it can set up a bad debt reserve to show this.
Suppose the company has $300,000 in accounts receivable, but it looks like $50,000 will never be paid. Putting $50,000 in a bad debt reserve gives anyone reading the statement a more realistic view of the company finances. Unlike a general reserve, the bad debt reserve isn't part of retained earnings and can't be spent on anything.