What is a Capital Reserve?
A capital reserve is an account on the balance sheet that can be used for contingencies or to offset capital losses. It represents the accumulated capital surplus of a company, created out of capital profit, such as the upward revaluation of its assets to reflect their current market value after appreciation or profits on the sale of assets. Sums allocated to a capital reserve are permanently invested and cannot be used to pay dividends.
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.
Breaking Down Capital Reserve
A capital reserve is an anachronism because the term “reserve” is not defined under generally accepted accounting principles (GAAP). A capital reserve is a sum earmarked for specific purposes, long-term projects, mitigating capital losses or any other long-term contingencies. It is created through transactions of a capital nature, such selling fixed assets, revaluing assets and liabilities, issuing stock in excess of par value (share premium), profits on the redemption of debentures, and the reissue of forfeited shares.
A capital reserve has nothing to do with trading or operational activities of the business, as it is created out of non-trading activities. Thus, capital reserves can never be an indicator of the operational health of a business.