Difference between Revenue and Capital Reserve

The Core Idea: Where the Money Comes From

The distinction between revenue reserve and capital reserve is not about what the reserve is called — it is about the nature of the profit from which it was created. A reserve is revenue or capital based on the source of the profit that fed it, not on what the business plans to do with it later.

Revenue reserves come from revenue profits — the profits a business earns from its normal, day-to-day operations. These are the profits that appear in the Profit & Loss account at the end of the year, the kind that could ordinarily be paid out as dividends to shareholders. Capital reserves, by contrast, come from capital profits — gains that arise outside the regular trading activities of the business. These are not available for dividend distribution under normal circumstances.

The Three Grounds of Difference

1. Source of Creation

Revenue reserve is created out of revenue profits. These profits arise from the normal operating activities of the business — selling goods, providing services, earning commission, and so on. Because these profits are the result of the business's core operations, they are otherwise available for dividend distribution (unless the business chooses to retain them as a reserve).

Capital reserve is created primarily out of capital profits. Capital profits do not arise from normal operating activities. Common examples include:

• Profit on sale of a fixed asset (sold above its book value)
• Profit on reissue of forfeited shares
• Premium received on issue of shares or debentures
• Profit on redemption of debentures

These profits are not available for distribution as dividends. However, the book makes an important point: revenue profits may also be used for the creation of capital reserves. This means a business can choose to transfer a portion of its revenue profit to a capital reserve, but the reverse is not true — capital profits cannot be used to create a revenue reserve.

2. Purpose

Revenue reserve is created to strengthen the financial position of the business, to meet unforeseen contingencies (like a sudden drop in sales or an unexpected expense), or for some specific purposes (like replacing machinery or paying off a loan). It is a tool of financial prudence — the business chooses to set aside profits rather than distribute them all as dividends.

Capital reserve is created for compliance with legal requirements or accounting practices. The law may require certain capital profits to be transferred to a capital reserve rather than being treated as available for distribution. For example, the Companies Act requires that the premium received on issue of shares be credited to a Securities Premium Reserve (a capital reserve) and used only for specified purposes.

3. Usage

Revenue reserve has two sub-types:

• A specific revenue reserve (like a Debenture Redemption Reserve or a Dividend Equalisation Reserve) can be utilised only for the earmarked purpose for which it was created.
• A general reserve (also called a Revenue Reserve or Contingency Reserve) can be utilised for any purpose, including distribution of dividends. This is the most flexible type of reserve.

Capital reserve can be utilised only for specific purposes as provided in the law in force. The two most common uses are:

• To write off capital losses (such as loss on sale of a fixed asset, or discount on issue of shares)
• To issue bonus shares (fully paid-up shares distributed to existing shareholders without any payment from them)

Summary Table

Accounting Treatment — The Journal Entry

When a reserve is created, the entry is: …