What is the Capital Reserve?
The capital reserve is the reserve created out of the company’s profits generated from its non-operating activities during a period and is retained to finance the company’s long-term project or write off its capital expenses in the future.
A capital reserve is an account on the balance sheet to prepare the company for unforeseen events like inflation, instability, or the need to expand the business or get into a new and urgent project.
- It works in quite a different way. When a company sells off its assets and makes a profit, a company can transfer the amount to capital reserve.
- Since a company sells many assets and shares and can’t always make profits, it is used to mitigate any capital lossesCapital LossesCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets. or any other long-term contingencies.
- It has nothing to do with the trading oroperational activitiesOperational ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production. of the business. It is created out of non-trading activities and thus it can never be an indicator of the operational efficiency of the business.
- · It has nothing to do with the trading or
Table of contents
- Capital reserve refers to a type of reserve that a company set-asides from its profits, which cannot be distributed as dividends to shareholders. Instead, it is kept to fund the company’s long-term project or write off the capital expenses later.
- It is an account on the balance sheet to prepare the company for unpredictable events such as instability, inflation, or the requirement to extend the business or enter a new and urgent project.
- It is an excellent finance source for a company’s long-term project. Moreover, a company not interested in funding from external sources, such as debt, term loans, etc., may only partially utilize the reserve to fund the new project.
Capital Reserve Examples
Instead of taking a business perspective, let’s first consider an individual perspective.
Let’s say that you would like to buy land in the future. So, you begin to set aside some money, sell off old stuff at your home, sell off the old car you have, and set aside some money from your income. And you create one saving account to save all of the money you gathered for the new land. You’re not entitled to do anything with that money other than buying the land for yourself in the future.
Now, let’s extend a similar example to businesses.
If a company decides to build a new office building, they need capital. And they don’t want to loan a huge amount from outside as the cost of capital, in that case, would be huge. So, they plan to build a new building by creating a capital reserve. They decide to sell off the lands and old assets of the company. And then the money received from these transactions is transferred to the capital reserve. Since the company is not entitled to pay any dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. to the shareholders out of their reserve, they can use the entire amount for building a new office building for the company.
Capital Reserve Video Explanation
Exceptions to Capital Reserve
- Sometimes, it is not created for any particular long-term project. Rather when a company feels that they need to be prepared for any economic instability, inflation, recession, or cut-throat competition, they can set aside money from the profits they make on selling off assets or from purchasing a small company and can create a reserve.
- Capital reserve accounting can also be used for mitigating any capital losses. Since the profits on the sale of assets are not always received in the monetary valueMonetary ValueMonetary value refers to the value of a product or service measured in terms of money. , they are caught in the books of the accounts. It is similar to the losses on the sale of assets. So, using these reserves, the company can set off capital losses.
For example, let’s say that MNC Company has made a profit of $20,000 on the sale of an old fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.. But, it also has expected that they would incur a loss of $18,000 for the sale of old machinery because it has almost become obsolete.
For example, let’s say that an MNC Company has made a profit of $20,000 on selling an old So, MNC Company quickly decides to create a reserve of $18,000 out of the profit of $20,000 they have made from the selling of an old fixed asset and can be prepared to write off the loss of $18,000.
So, MNC Company quickly decides to create a reserve of $18,000 out of the profit of $20,000 they have made from selling an old fixed asset and can be prepared to write off the loss of $18,000.
But, it also has expected that they would incur a loss of $18,000 for the sale of old machinery because it has almost become obsolete.
So, it’s clear that capital reserve accountingReserve AccountingReserve accounting is the accumulation of the profits set aside over the years by the company for specific purposes like paying statutory bonus, purchasing fixed assets, meeting long-term debt, settling legal obligations, etc. is a great source for financing any company’s long-term project. A company that isn’t very keen one funding from external sourcesFunding From External SourcesAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring. (like debt, term loans, etc.) can use this reserve to finance its new project fully
Capital Reserve Video
Frequently Asked Questions (FAQs)
Yes, it can issue bonus shares, and a company may utilize the capital reserve account to grant bonus shares to its shareholders. Therefore by using these reserves to pay for the bonus shares, the company can maintain its current level of equity and does not dilute the ownership of existing shareholders.
The taxation of these reserves depends on the specific tax laws and regulations of the country where the company operates. In general, these reserves are not considered taxable income for the company as they are created from profits already taxed.
The Equity portion of the company’s balance sheet shows a capital reserve. It demonstrates how the money could cover future costs or offset capital losses. It is obtained from and produced by the company’s profit and accumulated capital surplus.
This has been a guide to What is Capital Reserve in Accounting? Here we discuss its Capital Reserve meaning, examples, and its exceptions. You may also go through the following recommended articles on accounting –
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