Question

Discuss the reasons for reserve accounts. Why is the purpose of a reserve account? Why does maintaining reserve balances in inventory (receivables or other assets) make the financial statements more accurate? How would you approach calculating a reserve to ensure reasonable accuracy?

Answer 1

Reserves are maintained in an account to create and provide for the reversals and non recovery or expenses in that regard.

As in case of Receivables and Other Assets one can have a provision has to be created for the reversal and non recovery, suppose we have 100$ as the receivables and as per the nature of the business it is normal that there are 5% of such receivables are defaulters then in such a case the company has to make a separate disclosure of the same to give a clear picture of the same in the accounts and the provision for such reserve has to made by deducting the same from the receivables.

Similarly, we the same for other assets wherein the fixed assets have provision for depreciation and amortization, in such cases to show true and fair view of the financial statements one has to make provision for the same.Losses in any cases will not exceed the amount receivable.

In order to make the estimates for the same one has to regularly have the information of the previous transactions and defaulters percentage based and based on the creditors those who regularly default on nominal amount.Thus in order to make proper estimates one can follow the following :

Ratio and Trend based on previous experience.

General losses in that area like loss in transit during transportation.

Fall in the value due to the reasons known, eg: loss by fire can be estimated through third party like insurance companies and bankers.

Hiring an expert in the field.

Looking into the trend in the industry.