Corporate Accounting: Reserves, Impairments, and Financial Reporting

This report delves into the critical aspects of corporate accounting, specifically focusing on reserves and impairments. Part A defines reserves, classifies them into revenue and capital reserves (including general, specific, and secret reserves), and outlines the accounting procedures for reserve accounts. It also covers the importance of reserves in strengthening a company's financial position, funding investments, enhancing its image, increasing working capital, and facilitating financial requirements. Part B assesses Gali Ltd's cash-generating unit (CGU) for impairment, calculating the impairment loss and providing corresponding journal entries. The report highlights the significance of these components in financial accounting, their disclosure in financial statements, and their influence on the financial position of business entities, offering a comprehensive understanding of these key accounting concepts.

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Corporate accounting
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Introduction and study objectives
Reserves and impairments are key components of financial accounting. Both items are
disclosure in the financial statements and significantly influence the financial position of
business entities. Companies tend to retain part of their earnings at the end of a fiscal
year. The retained earnings are referred to as reserves (Fischer, 2015, p. 547).
Likewise, the International Accounting Standards Board (IASB) states that assets and
cash-generating unit (CGU) should be tested for impairment every year or when there
are indications for impairment. Assets should be reported at their fair value (recoverable
amount) and not their carrying amount. An impairment loss is realised when the
recoverable amount is lower than the carrying amount. Moreover, impairment gain is
realised when the recoverable amount is higher than the carrying amount (Amiraslani &
Iatridis, 2013, p. 76).
This study is divided into two parts: Part A and Part B. Part A address reserves as a
component of accounting. The scope of the study covers the definition of reserves,
types of reserves, and the accounting procedures for reserve accounts. Part B evaluates
Gali Ltd’s cash-generating unit (CGU) for impairment. The evaluation entails calculation
for impairments loss and journal entries in respective accounts.
Part A: Reserves in Accounting
Definition and meaning of reserves in accounting
Companies often set aside part of their annual earnings while paying out dividends to
the shareholders. The amount set aside is used to serve several objectives such as
improve the company’s financial position, meet legal requirements, business expansion,

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fulfilling short term financial obligations, and ensuring a stable repayment if dividends.
The retained portion of the income at the end of a financial year is known as reserves
(Sharma, 2019).
According to the IASB reserves are defined as, “the amount set aside out of profit and
other surpluses, which are not earmarked in any way to meet any particular liability
known to exist on the date of Balance Sheet.” Reserves are added on top of the
shareholder's contribution and are used to meet financial obligations during difficult
periods. It is important to note that reserves are not charged on profit but is instead a
portion of profit during a given year. Therefore, reserves are not recorded in the balance
sheet in case a company incurs a loss (Kennon, 2019).
Moreover, reserves are not set aside to meet particular commitments, liabilities, or
contingencies. Likewise, entities are prohibited from creating reserves after anticipating
the possibility of a loss. However, reserves can be used to meet financial obligations
when a company suffers a loss at the end of a financial year. Lastly, reserves are shown
in the balance sheet and the profit and loss appropriation accounts and not in the profit
and loss account (Thomason, 2017).
Types of reserves
In accounting, reserves are classified into two broad classes of revenue reserves and
capital reserves.

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I. Revenue reserves
Revenue reserves are realised from the profit realised by a company at the end of a
trading year. Revenue reserve is further classified into the general reserve, specific
reserve, and secret reserve (Davoren, 2018).
i) General reserve
General reserve is created from the profits realised from a financial year. General
reserves are not meant to meet the specific financial purpose. General reserves are
retained to provide extra working capital for a company to strengthen its financial
position. General reserve is referred to as free reserves and contingency reserve
because they are used to meet the unspecific financial purpose
(accountingexplanation.com, 2019). However, they are used to achieve these purposes:
a) Strengthening the financial position of a company.
b) Create additional working capital for the company that can be used anytime by
the management.
c) Meeting contingencies or liabilities arising from unforeseen circumstances.
d) Stabilising the dividend rate offered to the shareholders over the years because
of inadequate profits.
ii) Specific reserve
Unlike general reserves, specific reserves are set aside to meet a particular purpose for
a business. These retained earnings can only be used for the intended purpose and not
any other purpose. However, specific reserves can be used to meet unintended purpose

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at the discretion of the management. Specific reserves can further be classified into five
classes (Bhimani, et al., 2015, p. 102).
a) Dividend stabilizing reserve
Dividend stabilizing reserve is set aside to maintain the rate of dividends paid to
shareholders in case of small profit in the future. When adequate and significant net
income is realised, a potion is transferred into the dividend reserves account. The
created amount is then used to pay dividends when a small profit is realised (Bayoumi,
2012, p. 23).
For journal entries, the amount is debited in the profit and loss appropriation account
and credited to the dividend stabilizing reserve account.
b) Debenture redemption reserve
Debenture redemption reserve assists companies in creating debentures which are then
redeemed at the end of a particular period. Every year a specific amount is retained
from the profit and deposited in the debenture redemption reserve account. The amount
is later invested in market securities (Edmonds, et al., 2015, p. 65).
For journal entries, the amount is debited in the profit and loss appropriation account
and credited to the debenture redemption reserve account.
c) Investment fluctuation reserve
Businesses sometimes engage in external investments in securities, debentures, and
shares. Government policies and market conditions make the price of such investments
to fluctuate. A decrease in the price of such investment would lead to a loss. Therefore,

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part of the profit is set aside as investment fluctuation reserve to meet the loss arising
from the fluctuating value of investments (Kolitz, 2016, p. 82).
For journal entries, the amount is debited in the Accounting for reserve accounts
and credited to the investment fluctuation reserve account.
d) Workmen compensation fund
Companies also set aside part of their earnings to meet workers’ claims in case they get
injured at the workplace or when on duty. The retain earnings meant to meet employees
claims are deposited in the workmen compensation fund account (Deegan, 2013, p. 71).
For journal entries, the amount is debited in the profit and loss appropriation account
and credited to the workmen compensation reserve account.
iii) Secret reserve
The secret reserve is not presented in the balance sheet. Part of profit earned during the
best performance years is retained and reported in the financial statement when the
company performs least. Businesses use different techniques to create secret reserves
(Bayoumi, 2012, p. 33). Some of the techniques are.
a) Undervaluing the stock,
b) Creating extra provisions than required,
c) Changing amounts for capital expenditures to revenue,
d) Reporting contingent liabilities as entities’ actual liabilities.
II. Capital Reserves

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Capital reserves are apportioned from the capital profits. Companies use capital
reserves to write off their capital losses. Although capital reserves cannot be distributed
to the shareholders as shares, some conditions permit the distribution. First, when
articles of association allow the distribution. Second, the profits are realised in cash from
selling fixed assets. Third, the gain arises from the revaluation of all company assets
and liabilities.
Accounting for reserve accounts
The first procedure for accounting for the reserves is to make journal entries. Cash
should be placed from the cash account into a cash reserve account. Typically, a debit
entry is made into the reserve account while a credit entry of the same amount is made
into the cash account. The reconciliation process is essential to ensure that accurate
information is posted in the general ledgers (Langenderfer & Porter, 2014, p. 89).
All assets are reported in the balance sheet statement. The reserve account is a current
asset. The reserve account appears after the operating cash account under the existing
assets category in the balance sheet. Reserves are created from the retained earnings.
An increase in the reserves account is recorded by debiting the profit and loss
appropriation account and crediting affected general or specific reserve accounts.
Moreover, a decrease in reserves account is recorded by crediting the profit and loss
appropriation account and debiting involved general or specific reserve accounts
(Taschner & Charifzadeh, 2016, p. 171).
Moreover, reduction of reserves can arise from transferring funds from one reserve
account to another. The transaction is recorded by debiting the original account and

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crediting the new account. Likewise, a reserve account can be reduced by paying
dividends to shareholders using shares and cash withdrawn from such a statement. The
journal entry is made by debiting the concerned reserve account and crediting the
dividend or bonus accounts (Drury, 2013, p. 66).
Lastly, IASB’s conceptual framework for financial reporting states that reports should
show a faithful representation of the business entity. Therefore, companies should make
disclosures to their stakeholders about the creation and use of reserves. In particular,
stakeholders should be informed why the management has decided to retain part of the
profit as reserves instead of payout higher dividends. The disclosure only informs
stakeholders how reserves will be created, the amount to be put aside per annum and
recording and reconciliation of respecting accounts (Hendersen, et al., 2014, p. 213).
Importance of reserves to business entities
As mentioned before, reserve accounts are created to meet either general or specific
needs of a company. First, reserves accounts are meant to strengthen the financial
position of a company. Reserves can be used to fulfill unexpected financial losses in the
future. Second, companies need funds to finance their internal and external investment
activities. Besides relying on loans, the management can set aside part of the annual
profit to fund investments. Therefore, reserves are used as an internal source of
investment funds. Third, reserves are used to enhance a company’s image and
reputation. One method of improving a corporate image is by ensuring a regular
payment of dividends to the investors (accountingexplanation.com, 2019). The amount
of dividends paid to investors should be equalized over time. Therefore, reserves are

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used to maintain equalised payment of dividends during the years when profits are
inadequate. Amount from the reserves accounts can be used to supplement benefits
and pay dividends (Davoren, 2018).
Fourth, reserves are used to increase the working capital of an enterprise. During the
periods when a business has performed poorly or during emergencies, companies can
use their reserve accounts to maintain their functions at the recommendable level. Fifth,
reserves are used to facilitate substantial financial requirements, especially when they
are created to meet a specific purpose. For instance, debentures redemption reserve
account are used to pay the debenture holders when a company cannot achieve such
payments. Failure to set reserves aside would force a company to use its working
capital to make debenture payments. Using working capital would adversely affect a
company’s operational efficiency (Davoren, 2018).
Part B: Calculations and Journal entries
Gali Ltd holds a CGU in China. There is adequate evidence showing that the CGU is
impaired. The calculation below seeks to determine the amount of reported impairment
loss based on the information provided by the company. Moreover, the entries have
been made in respective accounts that have been affected by the impairment of the
CGU.

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Solution:
Account Carrying Amount
plant 563700
Patent 130000
Building 82000
Inventory 35000
Goodwill 29000
Total Carrying Amount 839700
The impairment loss is calculated by deducting the recoverable amount from the
carrying amount. Likewise, the recoverable amount is the higher value between the fair
value less disposal amount and the value in use.
Gali Ltd’s value in use is $ 752,700, while the fair value fewer disposal costs is $
542,626. Therefore, the recoverable amount is $752,700 (value in use).
Carrying Amount 839700
Recoverable Amount 752,700
Impairment Loss 87,000
An impairment loss is distributed, as shown below.
Distribution of Impairment Loss
Account Carrying
Amount
Loss Distribution
plant 563700 58,404
Patent 130000 13,469
Building 82000 8,496
Inventory 35000 3,625
Goodwill 29000 3,006
Total Carrying Amount 839700 87,000

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The journal entries for impairment loss occurring at 30 June 2015
Journal Entries
1 Impairment Loss A/c Dr. 87000
To Assets A/c Cr. 87000
2 Profit & Loss A/c Dr. 87000
To Impairment Loss A/c C r. 87000
3. Impairment Loss Dr. 87000
To Plant Cr. 58,404
To Patent Cr. 13,469
To Building Cr. 8,496
To Inventory Cr. 3,625
To Goodwill Cr. 3,006

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References List
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