What is statutory reserve?
A statutory reserve is a reserve of money set aside according to an institution's laws and regulations. It is often required to meet obligations with unknown risks of losses. It is seen on the face of the balance sheet in the form of easily convertible assets to cash. Organisations are required to hold these funds in reserve for a specific period as directed by law. The amount to be kept aside in a statutory reserve may vary according to the laws applicable, but it is a certain percentage of total liabilities. The goal is to ensure that the reserve can cover any obligations due in the near future.
One of the most important aims of any organisation is to be solvent and financially stable. Organisations can achieve this by maintaining enough liquid assets in a statutory reserve.Highlights
Frequently Asked Questions (FAQ)
What are the ways to compute balance in statutory reserves?
The amount to be kept in a statutory reserve is usually calculated using either of the two approaches—
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In the rule-based system, an organisation focuses on the number of funds required to be kept as a statutory reserve. This is decided on the basis of standardised formulations and conventions. This approach's computation of statutory reserve amount depends on several aspects set out in the fixated formula. This method may not essentially capture the underlying risks completely. The approach is inflexible and does not allow any charge on the business. The computed amount is set aside as per the applicable laws which mandate an organisation to maintain it.
As per the principle-based system, flexibility is provided to the organisation. The principle-based approach is different because the focus is not on the amount to be maintained as a reserve but on the risk that an organisation is adept at bearing. The approach considers the organisations’ understanding of business, years of experience and capacity to predict and limit the impact of future risks.
The principal aim of maintaining a statutory reserve is the base of this method of computing reserves. It helps the firms maintain liquidity for providing safety to customer’s investments. This method is also beneficial for companies as it promotes their solvency.
Share an example of statutory reserve?
Insurance companies are required to hold a certain amount of funds in reserves to protect policyholders. The applicable laws may bind the insurance companies to hold a certain percentage of their liquid assets as statutory reserves. Such a reserve will allow the insurers to honour obligations punctually. The insurance companies in financial statements shall also report the statutory reserves as per the regulations of the regulatory laws.
What are the benefits of a statutory reserve?
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The main benefits accrued to an organisation that maintains a statutory reserve are:
What are the disadvantages of a statutory reserve?
Just like any other thing, maintaining statutory reserves also brings a few limitations to the organisation-
What happens on failure to maintain statutory reserves?
If an organisation fails to maintain a statutory reserve-
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In which kind of business is statutory reserve generally maintained?
In most countries, insurance companies are mandated to maintain statutory reserves. Central banks command even banks to maintain a certain percentage of fund balances as statutory reserves. This is done to avoid the insolvency of the banks and insurance companies. People who deposit small and big savings in the bank are also protected from losses in future. In addition, insurance policyholders are ensured a certain amount of claim by the insurance company even in case of loss to the firm.
Any other kind of business, often a financial institution or other that involves many risks, is generally mandated by governing laws to maintain a statutory reserve.