Key Differences, Examples, and Journal Entries of Capital and Revenue Reserves
Reserves are crucial in accounting and financial management. They help companies safeguard profits for future needs and maintain stability even during uncertain times. Two major types—capital reserve and revenue reserve—are often discussed in exams and real business scenarios. Understanding the difference between these not only strengthens your conceptual clarity but also helps you answer related questions more confidently.
What is a Capital Reserve?
A capital reserve is created from non-operational or non-recurring gains. These are profits that arise outside of a company's everyday business activities, such as selling an old asset, issuing shares above their face value, or revaluation surpluses. Capital reserves are generally earmarked for significant investments, business expansion, covering capital losses, or issuing bonus shares. They are not typically available for distribution as dividends to shareholders.
For example, if a company sells a building and makes a profit from that sale, this gain is not from regular business operations. The profit is transferred into the capital reserve, which can later be used for expansion or other long-term company needs.
What is a Revenue Reserve?
A revenue reserve is created by setting aside a portion of profits earned through regular business activities such as sales and services. The purpose of this reserve is broad—it helps finance business growth, absorb future operational losses, or pay dividends. Revenue reserves reflect a company's reinvestment in itself for sustainable growth and are typically accumulated every year from ongoing profits.
For instance, if a company earns a profit and decides to set aside a percentage each year for future needs or to ensure stable dividends to shareholders, this amount becomes part of the revenue reserve.
Key Differences: Capital Reserve vs Revenue Reserve
| Aspect | Capital Reserve | Revenue Reserve |
|---|---|---|
| Source of Funds | Non-operational activities (e.g., sale of fixed assets, share premium) | Operational profits (e.g., business earnings) |
| Purpose | Expansion, issuing bonus shares, covering capital losses | Dividend payment, business growth, absorbing operational losses |
| Distribution | Not generally for dividends | Can be used to pay dividends |
| Occurrence | One-time or occasional | Regular, built up from annual profits |
| Nature | Non-recurring, linked to specific transactions | Recurring, from the core business |
| Regulatory Aspect | May face some legal/accounting restrictions | Largely at management’s discretion |
Examples for Better Understanding
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Capital Reserve Example:
An IT company sells its old office for ₹1 crore, having bought it for ₹70 lakhs. The profit of ₹30 lakhs is from the sale of a fixed asset and gets transferred to capital reserve.
-
Revenue Reserve Example:
A manufacturing company earns a profit of ₹50 lakhs. It sets aside ₹10 lakhs in a revenue reserve. This fund can be used for future investments or to support dividend payments in slower years.
Step-by-Step Approach to Classification
- First, identify the source of profit—operational (sales/services) or non-operational (asset sale, share issuance).
- If the profit arises from normal business activities like selling goods, it is revenue profit. When part of this profit is set aside, it becomes a revenue reserve.
- If the gain is from non-operational activity, such as selling a fixed asset or share premium, it is classified as capital profit and goes to the capital reserve.
Common Principles and Applications
- Capital reserves are typically used for funding big projects, absorbing capital losses, or issuing bonus shares—not for routine payouts.
- Revenue reserves help a company stay resilient—paying dividends or managing uncertain periods without external funding.
- Both reserves appear under "Reserves and Surplus" on the balance sheet, but only revenue reserves can usually be used for dividends.
Practice Problem
A company earns ₹10 lakhs in profit from sales and sets aside ₹2 lakhs as reserve. Separately, the company sells an old machine for ₹6 lakhs, recording a profit of ₹1 lakh on this transaction. Classify each reserve.
- ₹2 lakhs is a revenue reserve from operational profit.
- ₹1 lakh from the machine sale forms part of the capital reserve.
Summary Table: Key Comparison
| Criteria | Capital Reserve | Revenue Reserve |
|---|---|---|
| Example | Profit from asset sale, share premium | Retained profit from sales, general reserve |
| Usage | Long-term investment, covering losses | Dividend payment, business continuity |
| Frequency | Irregular, based on events | Annual/regular |
Mastering the distinction between capital reserve and revenue reserve is important for exam performance and understanding financial strategy. By working on practical classification and reviewing examples, you will solidify these foundational accounting concepts and perform better in comprehension as well as numerical questions.
To learn more about accounting terms, practice problems, or other commerce topics, explore the in-depth revision notes and study material on Vedantu’s platform.
FAQs on Difference Between Capital Reserve and Revenue Reserve Explained
1. What is a Capital Reserve?
Capital Reserve is a reserve created from non-operational or capital profits, such as profit on the sale of fixed assets, share premium, or revaluation of assets. Key points include:
- Not derived from regular business operations
- Used for purposes like writing off capital losses or issuing bonus shares
- Generally not available for dividend distribution to shareholders
2. What is a Revenue Reserve?
Revenue Reserve is created from a company’s operating profits. It includes funds set aside from net earnings for future needs. Important features:
- Created annually from normal business profits
- Used for dividend distribution, expansion, or contingencies
- Helps strengthen the company’s financial stability
3. What is the difference between Capital Reserve and Revenue Reserve?
The primary difference is their source and usage:
- Capital Reserve: Comes from non-operational profits (e.g., sale of assets) and is not usually distributable as dividend.
- Revenue Reserve: Arises from operational profits and is available for dividend payment or to meet future expenses.
4. Can Capital Reserve be used for dividend distribution?
Capital Reserve is generally not used for distributing dividends to shareholders. It is earmarked for specific purposes, such as funding capital projects, issuing bonus shares, or offsetting capital losses. Dividend payment from capital reserve is only allowed under certain legal provisions with strict conditions.
5. Give examples of Capital Reserve and Revenue Reserve.
Examples of Capital Reserve:
- Profit from the sale of fixed assets
- Share premium received on shares
- Profit on redemption of debentures
Examples of Revenue Reserve:
- General reserve
- Dividend equalization reserve
- Reserve for doubtful debts
6. How are Capital Reserve and Revenue Reserve shown in the balance sheet?
Both reserves appear under the 'Reserves & Surplus' section in the equity and liabilities part of the balance sheet. However:
- Capital Reserve is listed separately and not added to distributable profits.
- Revenue Reserve may be further classified if needed (e.g., general reserve, specific reserve) and may be used to pay dividends.
7. What is Reserve Capital and how is it different from Capital Reserve?
Reserve Capital refers to a portion of uncalled share capital which a company decides will only be called up at liquidation. Capital Reserve is a reserve from non-operating profits. Key differences:
- Reserve capital is not shown on the balance sheet until called
- Capital reserve is from capital profits and appears under Reserves & Surplus
8. Why do companies maintain both capital and revenue reserves?
Companies maintain both reserves to ensure financial prudence and flexibility:
- Capital reserves support long-term stability, capital projects, and compliance
- Revenue reserves help in meeting regular obligations, distributing dividends, and funding future growth
9. Are all reserves distributable as dividends?
No, only revenue reserves are usually available for dividend distribution. Capital reserves are generally non-distributable except under strict legal provisions. Reserve capital also cannot be distributed as dividends.
10. In which situations is Capital Reserve created?
Capital Reserve is created in cases such as:
- Profit from the sale of fixed assets above book value
- Issue of shares at a premium
- Profit on redemption of debentures or forfeiture of shares
These are non-operational, non-recurring gains not arising from regular business activities.
11. What are the uses of Revenue Reserve in a company?
Revenue Reserve can be used for diverse business needs such as:
- Paying dividends to shareholders
- Financing business expansion or modernisation
- Meeting future contingencies or unknown losses
- Strengthening the company’s working capital
12. What journal entries are used to record Capital and Revenue Reserves?
For Capital Reserve:
- Profit on sale of asset:
Asset A/c Dr.
To Capital Reserve A/c
For Revenue Reserve:
- Transfer from profits:
Profit & Loss Appropriation A/c Dr.
To General Reserve A/c
These entries ensure proper allocation of non-operational and operational profits respectively.
