This article is written by Anju Menon, pursuing Diploma in Companies Act, Corporate Governance and SEBI Regulations with LawSikho.com. She has previously worked as Senior Associate in the Foreign Division of Abdullah Kh. Al-Ayoub & Associates, Law Firm, Kuwait (December 2014-July2018).
Introduction
Most companies open reserve account(s) which enables in strengthening the future growth of the company. The reserve fund is created by allocating a portion from the profits earned each year. “As an example, we can talk about Apple. After the initial public offering (IPO), Apple kept all its profits as revenue reserve for few years. The idea is to strengthen the core of the company so that they can serve their customers and shareholders better. (Vaidya)”
Reserves may be created for a specific purpose such as repayment of debts, purchasing assets, etc. or it may be created simply as a general reserve without any specific purpose or as a contingency reserve to meet any unexpected risk or losses that may arise in the course of business.
In the case Canfin Homes Ltd.,, Bangalore vs Assessee the assessing officer made the following analysis:
“A reserve by its very nature is a fund which is created and maintained for the purpose of being drawn up in future. ……A mass of undistributed profits cannot automatically become a reserve and somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either as a general reserve or as a specific reserve.”
Classification of Reserve
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.
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It is to be noted that free reserve would be considered while calculating the net worth of a company. We can come to this conclusion from the definition of ‘net worth’ provided in the Companies Act, which is as follows:
“…the aggregate value of the paid-up share capital and all reserves created out of the profits and securities premium account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation”.
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”…”
The surplus is the balance after allocating dividend, bonus shares, and reserves. Also, as stated above, the debit balance of statement of profit and loss under the head ‘Surplus’ will be shown as a negative figure. This is the reason why surplus is not included when calculating the net worth of a company.
The definition of ‘Surplus’ as given in the guidance notes on ‘Terms used in Financial Statements’ formulated by the Accounting Standards Board is as follows:
“Credit balance in the profit and loss statement after providing for proposed appropriations, e.g., dividend or reserves”.
A further reference has been made with respect to ‘reserve’ and ‘surplus’ in the Companies Act under Clause 82 of Table F. As per this provision, the Board of Directors may at its discretion set aside a portion out of the profits as a reserve(s) before declaring any dividend. Such reserve(s) can be applied for any purpose including meeting contingencies or equalizing dividends and when such application is pending, the reserve may either be used in the business of the company or be invested elsewhere as the Board of Directors thinks fit. It also gives the Board of Directors the right to carry forward any profits without maintaining a reserve. Thus, it can be noted that maintaining a reserve is not mandatory and the profit that is carried forward amounts to surplus.
Restrictions on Usage
Companies which have an excess of Profit after appropriation for statutory reserves and dividend do have the tendency to retain it as Surplus of the company, rather than transferring it to any Reserves, which are Free Reserves for the company. (Co.) By doing so, some of the issues faced by companies are discussed below:
-Board of Directors are required to take the prior consent of the shareholders by passing a special resolution to borrow money where the total borrowing by the company exceeds an aggregate of its paid-up share capital and free reserves.
-For a company to grant loan or acquire securities in another company, for an amount that exceeds sixty percent of its paid-up capital, free reserves, and securities premium account or hundred percent of its free reserves, and securities premium account (whichever is higher), it would require the prior consent of the shareholders by passing special resolution in a general meeting.
– A company cannot issue bonus shares made by capitalizing reserves created by the revaluation of assets.
-A company cannot buy-back its shares if it exceeds ten percent of its total paid-up equity capital and free reserves or if it exceeds twenty-five percent of the aggregate paid-up equity capital unless approved by the shareholders by passing a special resolution in a general meeting.
We can conclude that having a lower reserve would require the constant approval of the shareholders with respect to granting loans, borrowings, etc by a company. These restrictions have induced many companies to retain the profits as surplus instead of transferring to reserve(s).
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.
A capital redemption reserve account can be used to pay any unissued shares of the company to be issued as fully paid bonus shares to the members of the company.
Buy-back of Shares
A company buying-back its own shares by paying out of free reserves or securities premium account must transfer an amount equivalent to the nominal value of the shares purchased to the capital redemption reserve account. The details of the same must be disclosed in the balance sheet.
Further Issue of Redeemable Preference Shares
If a company is unable to redeem any preference shares or pay dividend (if any) on such shares then it may issue further redeemable preference shares equal to the amount due and dividends, if any, with the consent of the preference shareholders (holding three-fourths in value of such preference shares) and the approval of the Tribunal. Upon issuing further redeemable preference shares, the preference shares that are unredeemed shall be considered to have been redeemed.
It is to be noted that the issue of further redeemable preference shares or the redemption of preference shares shall not be deemed to be an increase or a reduction in the share capital of a company.
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
We can find a list of expenses 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.
Conclusion
Companies must make an attempt to earmark a portion from the profits earned to reserve(s). Reserve(s) can be a tool to deal with all types of business risks and will act as a safety net in the time of crisis. Further, higher reserves provide companies with additional flexibility in making a business decision such as expansion plans, investments etc.
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