Capital Reserve

Capital Reserve Undistributable Reserves Reserve Fund Company Equity Dividend Policy
A capital reserve is an accounting term that refers to a reserve fund that is set aside for long-term projects or other significant ventures. It is part of a company's equity that is not appropriate for distribution as dividends to shareholders.
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Overview

What is a Capital Reserve?

A capital reserve is an entry on a company’s balance sheet that represents profits earmarked for specific, non-operational purposes. Unlike revenue reserves, which are often distributed as dividends to shareholders, capital reserves are set aside for long-term investments, acquisitions, expansion, or to tackle contingencies. Therefore, these reserves play a crucial role in strengthening a company’s financial stability and facilitating its long-term strategy.

Examples

  1. Asset Revaluation Reserve: The uplift in value from an asset revaluation goes to a capital reserve.
  2. Share Premium Account: Excess money received from shareholders over and above the par value of the shares is recorded in the capital reserve.
  3. Capital Redemption Reserve: Formed when a company buys its own shares out of profits or fresh capital.

Frequently Asked Questions

What is the difference between a Capital Reserve and a Revenue Reserve?

  • Capital Reserve: Set aside for long-term investments, not for dividend distribution.
  • Revenue Reserve: Generated from a company’s operational profits, usually distributed as dividends.

Can Capital Reserves be used for dividend distribution?

No, funds held in capital reserves are generally not distributed as dividends. They are specifically set aside for long-term projects, debt repayment, or other significant investments.

What are some common sources of Capital Reserves?

Sources can include profits from the sale of fixed assets, capital profits, excess money received from issuance of shares, or premiums on debenture redemption.

Why are Capital Reserves important?

Capital reserves provide financial stability, support expansions, and act as a buffer against unforeseen contingencies, thereby safeguarding a company’s future viability.

How is a Capital Reserve reported on the balance sheet?

Capital reserves appear under shareholders’ equity on the liabilities side of the balance sheet. It is distinctly categorized separately from revenue reserves.

Undistributable Reserves

Reserves that cannot be legally distributed as dividends to the shareholders including both capital reserves and some statutory reserves that must be maintained as part of terms and conditions.

Share Premium Account

Funds collected in excess of the nominal value of the shares and used as part of the capital reserve.

Asset Revaluation Reserve

Increase in the carrying amount of an asset due to revaluation, recorded in a separate reserve account under equity in the balance sheet.

References and Online Resources

  1. Investopedia: Capital Reserve
  2. Accounting Coach: Undistributable Reserves
  3. Corporate Finance Institute: Understanding Reserves

Suggested Books for Further Studies

  1. Financial Accounting Theory and Analysis: Text and Cases by Richard G. Schroeder
  2. Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield
  3. Accounting Principles by Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso
  4. Corporate Finance For Dummies by Michael Taillard

Accounting Basics: “Capital Reserve” Fundamentals Quiz

### Can capital reserves be used for daily operational expenses? - [ ] Yes, they are meant for daily operations. - [ ] Only during emergencies. - [x] No, they are set aside for long-term investments. - [ ] Yes, but only if there are no revenue reserves. > **Explanation:** Capital reserves are designated for long-term purposes like investments or for handling contingencies and are not used for daily operational expenses. ### What type of reserve is created when a company issues shares at a premium? - [ ] Revenue Reserve - [ ] General Reserve - [x] Share Premium Account - [ ] Revaluation Reserve > **Explanation:** The additional money received from issuing shares at a price higher than their par value is credited to the Share Premium Account, which is a type of capital reserve. ### How does an asset revaluation affect the capital reserve? - [ ] Decreases the capital reserve - [x] Increases the capital reserve - [ ] No impact on the capital reserve - [ ] Only affects revenue reserves > **Explanation:** When assets are revalued upwards, the difference is added to the asset revaluation reserve, which is a part of the capital reserve. ### Can shareholders receive dividends from the capital reserve? - [ ] Yes, always. - [ ] Yes, if the company's bylaws allow it. - [x] No, capital reserves are not meant for dividend distribution. - [ ] Yes, if voted upon by shareholders. > **Explanation:** Capital reserves are designated specifically for long-term investments or contingencies and are not distributed as dividends. ### What is likely not a source of capital reserves? - [ ] Sale of a fixed asset above book value - [ ] Premium from the issue of shares - [ ] Capital profits - [x] Daily operating profits > **Explanation:** Daily operating profits are typically allocated to revenue reserves rather than capital reserves. ### What aspect of a company is directly strengthened by capital reserves? - [ ] Short-term liquidity - [x] Long-term financial stability - [ ] Shareholder immediate returns - [ ] Routine operational flexibility > **Explanation:** Capital reserves enhance a company's long-term financial stability by providing funds for substantial investments or unforeseen contingencies. ### What happens to the capital reserve when a company buys back its shares? - [ ] It increases - [x] It decreases - [ ] It remains the same - [ ] It only affects revenue reserves > **Explanation:** The repurchase of shares typically leads to a decrease in the capital reserve as funds are used to buy back shares from the market. ### In accounting, where are capital reserves typically disclosed? - [x] Under shareholders' equity - [ ] In the cash flow statement - [ ] Under current liabilities - [ ] In the income statement > **Explanation:** Capital reserves are disclosed under shareholders' equity on the balance sheet, separating them from revenue reserves. ### Which of the following transactions is least likely to create a capital reserve? - [ ] Issuance of debentures at a premium - [ ] Gain from the sale of a fixed asset - [ ] Revaluation of an asset - [x] Sale of inventory > **Explanation:** Sale of inventory is a routine business activity, affecting revenue reserves rather than creating a capital reserve. ### Why might a company prefer to have a substantial capital reserve? - [ ] To increase short-term profits - [ ] To distribute more dividends to shareholders - [x] To support long-term growth and financial health - [ ] To manage daily business expenses > **Explanation:** A substantial capital reserve helps a company support long-term growth, undertake significant future projects, and maintain financial health.

Thank you for delving into the intricate world of capital reserves. Armed with this knowledge and the practice quiz, you’re well on your way to mastering essential accounting concepts.

Tuesday, August 6, 2024
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