Why are reserves considered on the liability side on a balance sheet?

Reserves are considered on the liability side of a balance sheet because they are sums of money that have been set aside to be paid out at a future date. As these reserves don't actually belong to the company, they are not considered assets but liabilities.

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It might be strange to think of reserves as constituting a liability. After all, reserves are supposed to be a good thing. If we have reserves of money, then we have money. Shouldn't the presence of money be a boon? Shouldn't saving money be an asset?

You'd think so, but it is, nonetheless, a liability. If we think more about it, we should understand why these reserves amount to a liability.

Perhaps if we worded it differently, it'd be more clear. It's not that the reserves are a liability right now. Rather, the reserves are held in the anticipation of future liabilities.

Any given company faces a number of unexpected and unpredictable situations. Reserves help a company deal with what might come its way. For example, a global pandemic might come along making it hard for a company to continue to function and pay its employees. If that company has reserves, it can use them to keep operating and to compensate its workers.

Another way to think about reserves is in the context of a bank. A bank is required to have a certain amount of money at all times. Again, we should think of this not as an asset but as a liability. The money is not for the banks, it's for their potential customers who inevitably come along and take out their money from them.

Imagine going to a bank to get your money and your bank telling you, "Sorry, we don't have your money right now."

That's not acceptable. A bank is responsible—"liable"—for your money, which is why they keep reserves.

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Reserves represent an obligation that the firm has, which makes reserves a liability item. Reserves can be future or potential obligations to various stakeholders or future use of funds to benefit stakeholders. The firm puts aside funds—or reserves—against future payout.

For instance, let's say the firm reserves against future impairments of assets. If and when an impairment actually occurs, the company does not need to recognize the entire amount of the impairment in its profit and loss statement. To illustrate, we can look at an example of a company operating in the retail sector with five stores. Four stores are doing well, but one store has seen sharp declines in sales. Moreover, the stores in the surrounding neighborhood have also reported revenue pressure. The company owner begins to think that the store might not be viable for much longer and prepares for this by taking a reserve against future charges or impairments that might be incurred.

Each time the store owner recognizes a reserve, it flows through the profit and loss statement and thereby reduces earnings. What this means is that when the store owner finally throws in the towel on this particular store and decides to close it, recognizing a charge-off or impairment, a lot of that impairment has already impacted the profit and loss statement and has been reserved for on the liability side of the balance sheet.

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A good illustration of why reserves are regarded as company liabilities rather than assets comes from the insurance industry. For an insurance company, reserves show up on the balance sheet as benefits owed to policy owners. In other words, this is money that belongs to the holders of insurance policies, not to the insurance company itself.

In the context of the insurance industry, such reserves comprise of money set aside for future insurance claims as well as claims that have been filed by policy holders but which have not yet been settled.

The insurance business, by its very nature, deals with uncertainties, and so it's essential for any functioning insurance company to set aside often considerable sums of money for future contingencies. As such amounts do not, strictly speaking, belong to the company, they are put down on the balance sheet as liabilities rather than assets.

Insurance companies always have to be careful not to over-reserve, that is to say put aside too many reserves. This can have a severe impact on a company's profitability, as it will have fewer resources available to deploy on investments. By the same token, under-reserving can free up more funds with which to invest. However, regulators will always keep a close eye on insurance companies' reserves to ensure that adequate reserves are set aside on the balance sheet.

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Reserves are profits set aside to be distributed among shareholders or for future contingencies such as debt repayment, dividend repayment, losses, or to improve the business's financial situation. Since the reserves cannot be used for other purposes, they are considered an obligation that the company must pay and therefore recorded under liabilities on the company's balance sheet. In accounting terms, a liability is an amount owed by a company to a supplier, shareholder, lender, goods provider, etc.

This aspect can be a bit confusing—why would profit held for a company's shareholders be considered a liability and not an asset? This is because, in accounting, the company functions as an individual rather than a group of shareholders. While other profits are set aside for the company's use, reserves are set aside for shareholder use. Therefore, reserves belong to the shareholders rather than the company as an individual entity, and the company has an obligation to pay them.

The accounting process for reserves occurs through the following process:

1. The retained earnings (accumulated net earnings after dividend distribution) account is debited $X.

2. The reserves account is credited $X.

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You might think that the reserves that banks hold would be listed as assets on their books because this is money that they have in their possession.  However, that is not the case.  Instead, reserves are listed under liabilities.  This is because that money does not actually belong to the bank.

To understand this, simply think about how the bank got the reserves mentioned in the question.   This is not money that the bank has earned by lending out money or through any other action.  Instead, this is money that depositors have placed in the bank.  The bank may have possession of the money, but it is actually owned by the depositors.  The bank must give that money to the depositors when they ask for it.  This is why the money in bank reserves is listed as a liability and not as an asset.

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