Using and understanding financial statements are crucial for investors. These statements provide insights into a company’s operations and activities. Usually, companies report these operations through four financial statements. These include the balance sheet, income statement, cash flow statement and statement of changes in equity. Each of these plays a significant role in helping investors analyze the underlying company.
The balance sheet states a company’s assets, liabilities and equity. Companies prepare this statement at each period end. In contrast, the income statement reports on revenues, expenses and profits for a specific duration. The cash flow statement is similar, although it only includes cash transactions. Lastly, the statement of changes in equity provides the movements in equity balances in the balance sheet.
Each financial statement covers specific elements. However, some may also include overlapping areas. For example, the share capital can impact the balance sheet and the statement of changes in equity. Investors must understand where to find each item to analyze the underlying company. Some investors may also confuse the treatment for specific items in each financial statement.
One of those areas includes capital reserves. Most investors wonder how to treat capital reserve in the cash flow statement. However, the answer to that question may be more complex. Before discussing the treatment of capital reserves in the cash flow statement, it is crucial to understand it.
What is a Capital Reserve?
A capital reserve represents a line item in the balance sheet, reported under the equity section. This reserve refers to the cash on hand that companies can use to offset future capital losses. Similarly, it can cover future expenses that companies incur for a specific purpose. Capital reserves come from a company’s accumulated capital surplus, which generates from profits.
Therefore, a capital reserve is an amount created or extracted from a company’s profits. Usually, these amounts come from non-operating activities during a specific period. Companies retain capital reserves for a specific purpose, including funding long-term projects. In some cases, companies may also keep capital reserves to cover future capital expenses. Either way, these reserves are not available unless for a specific purpose.
Companies create a capital reserve account in the balance sheet, reporting it under shareholders’ equity. Unlike some other balances under that section, the funds available in this account is not distributable. For example, companies can distribute retained earnings as dividends. However, capital reserves are not available for such payments. Most companies use the capital reserve account to specify amounts kept aside for specific purposes.
Capital reserves do not come from profits from operating activities. Instead, these are non-operating incomes that may come from other sources. For example, companies can generate capital reserves by selling fixed assets or shares. These transactions may also cause losses, usually classified as capital losses. Companies can use capital reserves to offset those losses in the future. On top of that, these reserves may not always be monetary.
Overall, a capital reserve refers to funds set aside for a specific purpose in the future. Usually, companies use it to cover future expenses or capital losses. Sometimes, companies may also create these reserves to prepare for predicted future instability. Capital reserves generate from non-operating activities. Therefore, companies cannot contribute to these reserves through their operating income.
What is the Accounting Treatment of Capital Reserves?
The accounting treatment of capital reserves involves transferring funds from one account to another. As mentioned above, these reserves help companies finance long-term projects. Therefore, companies create this account. It stays on the balance sheet for a long period. Companies also specify the purpose for which they must use these funds. Unless the specific criteria for using these funds are available, companies cannot use them.
The accounting treatment for capital reserves involves reclassifying funds from one account to another. Usually, these funds may be in monetary form. Therefore, companies can transfer them to the capital reserves account. For non-monetary compensations, the accounting treatment will be similar. However, the involvement of cash and cash equivalent balances is not crucial.
As mentioned above, capital reserves do not come from operating activities. Instead, companies can only create these reserves through non-operating profits. In most cases, these include selling fixed assets or shares for a profit. Income from the former case become a part of the income statement. Any income on the latter increases the reserves reported in the balance sheet.
When creating capital reserves, companies simply debit the retained earnings account. These reserves do not generate from operations. Therefore, companies must only move amounts equal to any profits made on non-operating activities. Once companies establish the amount they can transfer, they can create capital reserves. At this point, they will also specify the purpose for using the capital reserves.
The journal entries to create capital reserves include the following.
| Date | Particulars | Dr | Cr |
| Retained earnings | XXXX | ||
| Capital reserves | XXXX |
Once companies use the associated funds for a specific purpose, they can remove the balance in this account. In both transactions, the accounting treatment does not involve cash flows. The transfer from one account to another occurs within the company’s accounts. In essence, both remain a part of equity and do not change in principle. This accounting treatment also affects how companies treat capital reserves in the cash flow statement.
How to Treat Capital Reserve in Cash Flow Statement?
Companies can treat capital reserves in the cash flow statement indirectly. However, these reserves do not have a direct impact on the statement. Although capital reserves refer to funds set aside for specific use, they do not involve cash flows. Instead, companies create these reserves by transferring amounts from one account to another. Therefore, it only represents a reclassification in the accounting books.
The only case where companies can treat capital reserves in the cash flow statement is when they sell fixed assets. In this case, companies will profit from the sale, which will become a part of the income statement. Companies must remove its impact on those profits in the cash flows from operating activities. Once they do so, they can include the sale proceeds from the transaction in cash flow from investing activities.
However, companies do not receive cash for every sale. Some companies may also get other forms of compensation for selling fixed assets. In that case, only the former treatment will apply. Nonetheless, companies can transfer the profits to the capital reserves account. Consequently, the second treatment involving sale proceeds in investing activities doesn’t apply.
The primary reason why capital reserves don’t impact the cash flow statement is that there is no cash involvement. These reserves primarily include reclassifying funds from one account to another. Even when companies set cash aside for a specific purpose, there is no cash flow. Only the money entering and exiting a business becomes a part of the cash flow statement.
Overall, treating capital reserves in the cash flow statement is not necessary. Since these transactions do not involve cash flows, they do not become a part of the statement of cash flows. Companies may treat them indirectly when selling fixed assets. However, that treatment does not relate to capital reserves directly. Later, when the company uses its resources against those capital reserves, it may impact the cash flow statement.
Conclusion
A capital reserve refers to funds set aside for a specific purpose. Usually, it involves retaining finances for future projects, expenses or uncertain circumstances. It comes from non-operating activities, such as profits from fixed assets or share sales. Capital reserves do not require cash flows when creating the account. Therefore, they do not affect the cash flow statement and don’t require treatment.
