Capital Reserve Is Not Permanent Item And Does Equal To Free Reserve

Reserves refer to the accumulated savings of members of a corporation that are segregated based on their objectives. These objectives can range from future growth to regulatory compliance, with each reserve type having a specific purpose. In general, readers of financial statements need to know the nature of each reserve and whether it is available for distribution as dividends or bonuses or is restricted for specific use. Capital reserves are a type of reserve that cannot be distributed as dividends until they are transferred to the common pool of free reserves that comply with the Companies Act, 2013.

Key Characteristics of Capital Reserves

Capital reserves are distinct from revenue reserves as they remain static in the balance sheet under the "Reserves and Surplus" head. Once created, they cannot be used until certain conditions are met, and regulatory approval is obtained. The Companies Act, 2013 does not specify how capital reserves should be used after their creation.

Accounting Framework for Capital Reserves in Certain Transactions 

Merger and Acquisition

In business combinations between unrelated parties, the capital reserve represents the excess of the fair value of assets acquired over the consideration. In contrast, in business combinations between related parties, it represents the excess of the share capital of the acquired entity over the consideration. The acquirer's management determines the fair value of each asset and liability acquired, followed by recognition at these values. This accounting treatment is in accordance with Ind AS 103 Business Combination.

Investment in Associates and Joint Ventures

In case of investments in associates and joint ventures, any excess of the entity's share of the net fair value of the investee's identifiable assets and liabilities over the cost of the investment is recognized directly in equity as capital reserve in the period of acquisition. This is in accordance with Ind AS 28.

Capital Profit on Reissue of Forfeited Shares

Capital profits on reissued forfeited shares are profits of a capital nature and should be credited to the capital reserve.

Government Grants

Government grants received to acquire non-depreciable assets such as freehold land that do not require any obligation fulfillment should be credited to the "capital reserve" in the balance sheet. This accounting treatment also applies if grants are in the nature of promoters' contributions.

Key Difference between Indian Framework and IFRS

There is relative flexibility in recognizing capital reserves and their subsequent transfer under IFRS as compared to the Indian framework, mainly applicable to listed entities and companies whose net worth exceeds INR 250 crore.

Guidance for Transferring Capital Reserves to Retained Earnings or Free Reserve

The transfer of capital reserves requires two conditions. Firstly, the underlying amount must be realized, and secondly, the amount must be available for distribution as dividends or issuing bonus shares under the Companies Act, 2013, or other applicable laws. These amounts may be transferred proportionally as assets resulting in capital reserves are depreciated, impaired, or amortized, or they can be transferred at the end of the sale of an asset. Furthermore, reserves created according to the requirements of the Companies Act, 2013, or other applicable laws, cannot be transferred to other reserves except under the legal requirements. Corporations must provide detailed disclosures about the amount of capital reserve, transaction background, year of origination, etc.

In conclusion, the guidelines will help companies adhere to the principle of transferring capital reserves to retained earnings at the right time. Entities with capital reserves in their balance sheets should evaluate whether to retain them or transfer them to retained earnings prior to finalizing their annual financial statements.

Author: Nalin Shah, Associate Partner and Divesh Jain, Qualified Associate, N.A. Shah Associates