What is Capital Reserve?
The capital reserve is the reserve which is created out of the profits of the company generated from its non-operating activities during a period of time and is retained for the purpose of financing the long term project of the company or write off its capital expenses in future.
A capital reserve is an account on the balance sheet to prepare the company for any unforeseen events like inflation, instability, need to expand the business, or to get into a new and urgent project.
As an example, we can talk about profit on the sale of fixed assets, profit on a sale of shares, etc.
- 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 losses or any other long-term contingencies.
- It has nothing to do with trading or operational activities 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.
- Another thing that is important is nature. It is not always received in the monetary value but it is always existent in the book of accounts of the business.
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 dividend to the shareholders out of their reserve, they can use the entire amount for building a new office building for the company.
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 value, 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 asset. 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, 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.
Since it is under the complete control of a business, it can be used to write off capital losses.
Capital reserve accounting is also created sometimes for legal purposes and to maintain a sound accounting practice within the company.
Conclusion
So, it’s clear that capital reserve accounting is a great source for financing any long term project of the company. A company that isn’t very keen to do the funding from external sources (like debt, term loan, etc.) can use this reserve to fully finance their new project.
Capital Reserve Video
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