To understand capital surplus on the balance sheet, you must first grasp the concept of surplus. A surplus is a difference between the total par value of a company's issued shares of stock, and its shareholders' equity and proprietorship reserves.
It's not as complex as it sounds.
In the equity section of the balance sheet, you'll see terms like par value and shareholders' equity, and proprietorship reserves. Par value is the nominal value of the company's stock. Shareholders' equity is the difference between total assets and total liabilities. Proprietorship reserves is an account that is set up to alert investors that part of the shareholders' equity won't be paid out as cash dividends. That is because they intend to use it for another purpose.
A part of a firm's surplus comes from an increase in retained earnings. This increases the company's total shareholders' equity. Another part of the surplus comes from other sources. These might include increasing the value of fixed assets, the sale of stock at a premium, or the lowering of the par value on common stock. These other sources are often called capital surplus and placed on the balance sheet.
In other words, a capital surplus tells you how much of the company's shareholders' equity is not due to retained earnings.
Capital surplus is also known as contributed surplus or additional paid-in capital.
An Example of Capital Surplus
Let's say that Acme Corp's stock par value is $1 per share. They sell 10,000 shares of the stock for $10 each. The stock par value is $10,000 but the proceeds add up to $100,000. The capital surplus is $90,000.
What Are Reserves on the Balance Sheet?
Reserves on the balance sheet is a term used to refer to the shareholders' equity section of the balance sheet. (This is exclusive of the basic share capital portion.) You might be tempted to skip the reserves area without thinking much of it. Depending on the sector or industry of the business, that can be a mistake.
In fact, reserves deserve special focus when you are analyzing a company. The following briefly describes a few examples of the reserves you might come across. This will give you a sense of their purpose on the balance sheet.
Reserves on the balance sheet can include these items:
- Capital reserves. These usually arise as a result of stock in excess of par value.
- Retained earnings. These arise as a result of past profits. In simple terms, retained earnings are net profits that have not been paid to shareholders as dividends.
- Fair value reserves. These can include adjustments for available-for-sale securities and assets. Fair value reserves are key for businesses like an insurance company that holds large fixed-income investments.
- Hedging reserves. These can arise as a result of hedges a company has taken on to protect itself against volatility in certain input costs.
- Asset revaluation reserves. These arise when a company has to adjust the value of an asset that is carried in the asset section of its balance sheet.
- Foreign currency translation reserves. These arise from changes in the relative value of the currency in which the balance sheet is reported and the currency in which the balance sheet assets are held.
- Statutory reserves. These are reserves that a company must establish by law and that cannot be paid out as dividends.
Another Meaning for the Term 'Reserves'
When you hear investors, accountants, or analysts talk about reserves, they may not be talking about the reserves shown in the shareholders' equity section of the balance sheet. Rather, certain types of accounting transactions require reserves to keep the income statement as close to reality as possible.
For example, reserves might come into play in this situation: A company has a large amount of its current assets in accounts receivable. The company charges off some of the total amount it believes won't be paid. Perhaps past experience has led them to decide this. Or, perhaps they're basing their choice on an examination of the current balances.
This accounting transaction lowers current assets. It is known as an allowance or reserve for bad accounts. It is a contra asset account, and offsets accounts receivable. If management turns out to be too pessimistic, the reserves can be reversed in the future. In this case, profitability will appear to increase.