A capital reserve is an account in the equity section of the balance sheet that can be used for contingencies or to offset capital losses. It is derived from the accumulated capital surplus of a company, created out of capital profit.
The term capital reserve is sometimes used for the capital buffers that banks have to establish to meet regulatory requirements and can be confused with reserve requirements, which are the cash reserves the Federal Reserve requires banks to maintain.
Few examples of capital reserves are: Cash received by selling current assets. Premium earned on the issue of share and debentures. Excess on revaluation of assets and liabilities.
Understanding Capital Reserve
A capital reserve is an anachronism because the term “reserve” is not defined under generally accepted accounting principles (GAAP). It is created through transactions of a capital nature, such as selling fixed assets, the upward revaluation of assets to reflect their current market value, issuing stock in excess of par value (share premium), profits on the redemption of debentures, and the reissue of forfeited shares.
Sums allocated to a capital reserve are permanently invested and cannot be used to pay dividends to shareholders. They are earmarked or specific purposes, such as long-term projects, mitigating capital losses, or any other long-term contingencies.
A capital reserve has nothing to do with trading or operational activities of the business, as it is created out of non-operating activities. Thus, capital reserves are not an indicator of the operational health of a business.