Reserves can be classified based on the source of earnings. A revenue reserve is created out of profits generated from the trading activities of a company and a capital reserve is created out of the profits which are capital in nature such as revaluation of assets, write-back of depreciation and amalgamation etc. When a company incurs capital losses, the fund from the capital reserve is used to write-off the same.
A ‘free reserve’ is defined under the Companies Act, 2013 (“Companies Act”) as any reserve available for distribution of dividends as per the last audited balance sheet. The definition excludes any amount earned from unrealized gains, notional gains or revaluation of assets from being treated as a free reserve. Similarly, any change in carrying the amount of an asset or liability in equity will not be a part of a free reserve.
What is Reserve Capital
The Companies Act mandates a Capital Redemption Reserve (CRR) for companies repurchasing or redeeming their own shares. This safeguards the company’s financial stability in two key scenarios:
- Buy-Backs: When a company buys back its own shares, the paid-up capital shrinks. To counteract this, a portion of reserves is allocated to the CRR, ensuring a buffer against future capital depletion.
- Preference Capital Redemption: Redeeming preference shares can also weaken the capital base. The Capital Redemption Reserve requirement mitigates this by capturing a portion of distributable profits, providing security for lenders who may have concerns about the company’s financial health after the redemption.
Meaning of Surplus
Unlike free reserve, the surplus from the profits earned by a company is not included while calculating the net worth of the company. The surplus has not been specifically defined under the Companies Act. However, for the purposes of preparing balance sheet the following accounting explanation has been provided under Schedule III of the Companies Act:
“Surplus i.e., balance in Statement of Profit and Loss disclosing allocations and appropriations such as dividend, bonus shares and transfer to/ from reserves, etc:…” Further, “Debit balance of statement of profit and loss shall be shown as a negative figure under the head “Surplus”…”
What is a Capital Redemption Reserve Account and why is it maintained?
Capital redemption reserve account is a type of reserve maintained by a company limited by shares and as the name suggests this reserve deals with shares which are redeemable. The shares which are purported to be redeemed are paid out of the profits of a company. For this purpose, out of the profits, an amount equivalent to the nominal value of the share supposed to be redeemed is transferred to a reserve. This reserve is called a capital redemption reserve account.
A company may issue preference shares which can be redeemed within a period of twenty years from the date of issue. However, it is subject to the following conditions as prescribed in the Companies Act:
- The Articles of Association of the company must permit the same;
- The redemption must be out of the profits of the company which would otherwise be distributed as dividends or out of the earnings of a fresh issue of shares (made for the purposes of such redemption);
- Only fully paid-up shares can be redeemed;
- The company has to maintain a capital redemption reserve account (the provisions relating to the reduction of the share capital of a company will apply as if the Capital Redemption Reserve Account is paid-up share capital of the company);
- In case the premium is payable at the time of redemption for certain class of companies (as prescribed) which complies with the accounting standards under Section 133 of the Companies Act, it must be paid out of the profits of the company before the shares are redeemed:
- If the premium is payable for preference shares issued on or before the commencement of the Companies Act, before such shares are redeemed, the premium must be paid out of profits of the company or out of the securities premium account maintained by the company.
Why Do Lenders Benefit?
Maintaining a healthy Capital Redemption Reserve benefits lenders in several ways:
- Increased Confidence: A strong CRR demonstrates the company’s commitment to maintaining its financial strength, bolstering lender confidence and potentially improving borrowing terms.
- Enhanced Security: The CRR acts as a safety net, protecting lenders from potential losses if the company’s capital base is eroded due to future redemptions or buy-backs.
- Transparency and Stability: The CRR requirement promotes transparency in the company’s financial practices, further stabilizing the relationship with lenders.
Impact of Mergers and Acquisitions on Reserves
The Accounting Standards 14 has laid the treatment of reserve(s) in case of Mergers and Acquisitions. In a merger, the identity of the reserve(s) is preserved and is shown in the financial statements of the transferee company. They retain their nature and value. Thus, for instance, the capital redemption reserve account of the transferor company becomes the capital redemption reserve account of the transferee company. However, in case of an acquisition (amalgamation by purchase), the identity of reserves is not preserved except for the statutory reserves.
Further, with respect to the reserves created by the transferor company for the purposes of the Income Tax Act, 1961, the identity of such reserves should be preserved for a specified period.
Tax Benefit for Special Reserve
which are allowed as a deduction when computing the income from a business and profession under Section 36 of the Income Tax Act, 1961.
When a special reserve is created and maintained by certain specified entities including a financial corporation, a banking company, a housing finance company, and a portion from the profits earned from an eligible business is transferred to this reserve, the aforementioned entities are entitled to claim a deduction. This deduction has been capped at a maximum of twenty percent of the profits earned and should not be more than twice the amount of paid-up share capital and general reserves of the entity specified.
The eligible business includes providing long-term finance for the development of industry, agriculture, infrastructure, and housing.
Redemption of Preference Capital
Redemption of preference capital refers to the process by which a company buys back its outstanding preference shares from shareholders. This can be done for various reasons, such as simplifying the capital structure, improving financial flexibility, or managing earnings per share.
There are three main modes of preference capital redemption, each with its own advantages and disadvantages:
Redemption at Par
- This is the most common mode, where the company repurchases the shares at their original issue price.
- It’s straightforward and easy to understand for shareholders.
- However, it may not be attractive to shareholders if the market price of the shares has risen significantly since they were issued.
Redemption at a Premium
- In this mode, the company repurchases the shares at a price above their original issue price.
- This can be more attractive to shareholders, especially if the market price of the shares has fallen.
- However, it can be more expensive for the company, as it needs to find additional funds to pay the premium.
FAQs
Why is the creation of a CRR required?
When a company buys back or redeems its shares, it reduces its total capital. The CRR compensates for this reduction by allocating a portion of distributable profits to a separate reserve. This ensures the company doesn’t dip into its core capital, maintaining financial stability.
How is the CRR different from other reserves?
Unlike regular reserves, the CRR has specific limitations: Purpose: It can only be used for issuing fully paid bonus shares to members, not for general distributions like dividends. Statutory basis: It’s mandated by law, unlike some freely-created reserves. Accessibility: Once allocated, the funds become inaccessible for dividends, demonstrating a commitment to capital maintenance.