Reserves are set aside to meet certain contingencies. It is used to pay dividends, sponsor a project or prepare for a worse case scenario of an economy. Whatever the reason, reserves improve the financial health of a business. In this article, let’s explain capital reserve.
Definition — What is Capital Reserve
1. A type of reserves derived from surpluses arising from increase in value of capital items of a firm.
2. These are reserves regarded as part of net earnings in the statement of financial position of a company which cannot be distributed to shareholders as profit but can be used to meet other contingencies of the business.
A type of reserves. There are other reserves. I have already explained revenue and statutory types. Revenue type is the one that is available to pay shareholder’s dividends. Statutory is a compulsory reserve. It is made mandatory by the regulator of the industry the company belongs to.
Derive from surplus from increase in the value of the asset. It arises from surpluses. This surplus is as a result of increase in the market or fair value of primary assets of the entity concerned. For example, the value of the Land and Building of an organization may increase. This leads to revaluation surplus. And revaluation reserves is a type of capital reserves.
Capital items. These are mostly the physical assets of an entity. But, it is not limited to that. Investments for more than one year may be tagged as capital items. For example, shares acquired from another company. Or premium earned from placement of shares to shareholders.
Types of capital reserve
There are mainly two types of this reserve. Share premium and revaluation reserves. Another one is currency translation reserve.
Share premium arises when the par or nominal price of the shares offer for subscription is lower than the market price. That is, the shares were sold at a premium. If the nominal price were 10 Naira and the shares were subscribed to by investors at 35 Naira, the company earns a premium of 25 Naira per every share sold.
Revaluation reserves. This arises from revaluation surpluses. It occurs when an entity revalues a physical assets. For example, land and building. It is revalued at a price higher than the written down (or book) value of the asset. The book value for a land and building of a company may be 25 million Naira. But a professional valuer believes that the value of the asset in question is now 47 million Naira. The company will have to revalue the land and building upward. This will result to a revaluation reserves of 22 million.
Currency translation reserve. It arises from the translation of foreign currency of a foreign branch office (functional currency) to the currency of the company’s head office (presentation currency). For example, a Nigeria company has a branch office in the United Kingdom. It will need to translates the British Pound to the Naira for the trial balance and other investments of the branch. This is necessary for the preparing of its financial reports. Surpluses from the translation are posted as currency translation reserves.
Capital reserves are surpluses arising from the increase in the value of capital items. These items include Properties, plants and equipment, investment assets and equity. The types of this reserve are revaluation, share premium and currency translation reserves.