What Is Capital Reserve in Accounting and Its Importance

A capital reserve in accounting is a type of account that helps businesses set aside funds for future needs.

It's essentially a savings account for the company, where excess profits are stored for later use.

Capital reserve can be used to absorb losses, pay dividends, or even fund new business ventures.

In many countries, including the United States, capital reserve is a required account for publicly traded companies.

A capital reserve is essentially a pool of profits that have been set aside for a specific purpose, like buying fixed assets or paying off debts. These funds are earmarked for future use, not for immediate spending.

In practice, capital reserves can be used to cover unexpected costs, like machinery repairs, which can help businesses avoid being left out of pocket.

There are two main types of reserves: revenue reserves and capital reserves. Revenue reserves are created from profits earned over the course of normal business operations.

Revenue reserves are intended for unexpected costs, such as machinery repairs, or specific and expected costs, like a building construction project.

Capital reserves, on the other hand, are created from capital profits, or earnings from non-normal trading activities. They are usually used solely for capital losses.

In addition to revenue reserves and capital reserves, there are other types of reserves that businesses may use. A general reserve account can be a useful tool for businesses to set aside funds for unexpected costs or difficult financial periods.

Businesses can use a general reserve account to create a cash buffer for unexpected items or difficult financial periods. This can help them to pay suppliers and replenish their working capital, enabling them to run everyday operations without hiccups.

A business can also allocate their retained profits for specific future costs, such as buying new premises or machinery, repaying debts, funding legal costs or expansions, and paying employee bonuses or future dividends. This can be done by setting up appropriately labelled reserve accounts in the balance sheet.

You may want to create criteria that must be fulfilled before these funds can be used, such as having all chief business owners or investors sign it off. Additionally, treating your general reserves as a fixed expense can be a good idea, so you add to them regularly and avoid using the money to pay for non-core business items.

Here are some examples of specific reserve accounts that businesses may set up:

By setting up these specific reserve accounts, businesses can ensure that they have the funds they need for specific purposes, while also maintaining a healthy general reserve account for unexpected costs.

There are four types of Sub-Fund Groups that describe the type of reserve account.

Each Sub-Fund Group has a specific purpose, such as setting aside funds for future periods or planned capital projects.

The Sub-Fund Group Code RVGENL represents General Reserves, which are funds set aside for use in future periods.

These funds can be funded by annual operating surpluses or through a funding plan, and are considered to be "savings accounts" so no expenses can be charged directly to them.

Here are the four types of Sub-Fund Groups:

The Sub-Fund Group Code RVREPL represents Renewal & Replacement funds, which are used for the renewal of facilities and/or replacement of equipment.

These funds are also considered to be "savings accounts" and should be transferred to operating accounts for use.

The Sub-Fund Group Code RVCAPT represents Capital Reserves, which are funds set aside for planned capital projects.

These funds should be transferred to project accounts for use.

The Sub-Fund Group Code RVFCTY represents Faculty Renewal Reserves, which are funds set aside to support the faculty renewal initiative.

These funds should also be transferred to operating accounts for use.

Accounting for Reserves is a straightforward process that helps businesses set aside funds for specific purposes. Reserve accounting stops these funds from being used for other purposes, such as paying dividends or buying back shares.

To account for a reserve, you'll need to debit your retained earnings account for the amount you're allocating to the reserve, and then credit the same amount to the reserve account. For example, if your business wants to reserve funds for a future building construction project, you'd credit a Building Reserve fund for $5 million and debit retained earnings for the same amount.

When the reserve has been fulfilled, you'll need to reverse the transaction by debiting the reserve account and crediting the retained earnings account for the same amount. This means that you'll debit the Building Reserve fund and credit the retained earnings account for $5 million, as seen in Example 4.

Journal entries are the backbone of accounting for reserves. They help track and record transactions related to reserve accounting.

To create a journal entry for a reserve, you'll need to debit your retained earnings account for the amount allocated to the reserve. This debits the retained earnings account, which is essentially the business's profit that hasn't been distributed to shareholders.

You then balance this debit with an equivalent credit by crediting the same amount to the reserve account. For example, if your business allocates $25,000 for potential repairs, you'd debit the retained earnings account for $25,000 and credit the reserve account for $25,000.

When the reserve is fulfilled, you'll need to reverse the transaction by debiting the reserve account and crediting the retained earnings account for the same amount. This essentially cancels out the original transaction, reflecting the new reality.

Journal entries for reserves can be found on the balance sheet, although in some cases, they might be aggregated with the retained earnings line item.

You can account for a reserve by debiting your retained earnings account for the amount you're allocating to the reserve.

First, you'll need to identify the purpose of the reserve, such as a future construction project or machinery repairs. This will help you determine how much to allocate to the reserve.

To calculate the reserve, you can add up your cumulative profit and loss since you formed the business, minus any dividends paid. This will give you the total amount of revenue reserve available.

Once you've calculated the reserve, you can set up a designated reserve account and transfer an amount from your retained earnings to the designated account. Debit retained earnings for the segregated amount, and credit the designated reserve account for the same amount.

For example, if you want to reserve £1m for a future construction project, create and credit a 'building reserve account' for £1m and debit your retained earnings for the same amount.