Meaning and Provisions of Law:
A capital reserve is an anachronism because the term ‘reserve’ is not defined under generally accepted accounting principles (GAAP). It is created through transactions of a capital nature, such as selling fixed assets, the upward revaluation of assets to reflect their current market value, profits on the redemption of debentures, and the reissue of forfeited shares.
Companies Act, 2013
As per sub-section (1) of Section 63 of the Companies Act, 2013:
A Company may issue Bonus Shares out of- its free reserves; Securities Premium Account; Capital Redemption Reserve Account. Further, it has been provided that Issue of Bonus Shares shall not be made out of Capitalising Reserves created out of revaluation of Reserves. Free Reserves means such reserves of the Company which is available for distribution as Dividend.
Capital reserve has nowhere been specifically defined in the Companies Act, 2013 or anywhere in Accounting Standards but taking the cue of references made of Capital Reserve at various instances in Accounting Standard 12, 14 and elsewhere we can construe that Capital Reserve is generated out of Capital Gains of the Company which may include profit out of sale of undertakings, profit out of revaluation of Capital Assets etc.
Thus, we may conclude that in order to issue Bonus Shares out of Capital Reserve we need to first check nature and purpose of creation of such Capital Reserve. If the profit of the Company which would have been available for distribution as Dividend (Example: sale of Fixed Assets or Sale of Undertaking) had been transferred to Capital Reserve during some year, then that balance of Capital Reserve may be used for issue of Bonus Shares. If it is created by revaluating fixed assets then it is not available for issued of bonus shares. A sums allocated to a capital reserve are permanently invested and cannot be used to pay dividends to shareholders. They are earmarked for specific purposes, such as long-term projects, mitigating capital losses, or any other long-term contingencies. So, it’s clear that capital reserve accounting is a great source for financing any long term project of the company. A company that isn’t very keen to do the funding from external sources (like debt, term loan, etc.) can use this reserve to fully finance their new project. Capital Reserve is the reserve which is created out of the profits of the Company generated from its non-operating activities during a period of time and is retained for the purpose of financing the long term project of the Company or write off its capital expense in future.
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