Capital Surplus and Reserves on the Balance Sheet
To understand Capital Surplus on the balance sheet, you must first understand the concept of surplus. From an accounting standpoint, a surplus is a difference between the total par value of the stock outstanding and the shareholders' equity and proprietorship reserves. Don't panic! It's not as complicated as it sounds! You already know what par value and shareholders' equity represent. The only thing you haven't learned about is proprietorship reserves, which are set up to alert investors that a certain part of the shareholder equity cannot be paid out as cash dividends since they have another purpose.
A portion of the surplus almost always results in retained earnings, which has the effect of increasing shareholders' equity. A specific part of the surplus comes from other sources, such as increasing the value of fixed assets carried on the balance sheet, the sale of stock at a premium, or the lowering of the par value on common stock. These "other" sources are frequently called "Capital Surplus" and placed on the balance sheet.
In other words, Capital Surplus tells you how much of the company's shareholders' equity is not due to retained earnings.
Reserves and Proprietorship Reserves
"Reserves" on the balance sheet is a term sometimes used to refer to the shareholders' equity section of the balance sheet, exclusive of the basic share capital portion. Reserves represent one of those areas of balance sheet analysis that most people skip by without ever thinking much of it. Depending on the sector or industry in which a business operates, that can be a mistake. In fact, reserves deserve special attention when analyzing a company. Although we aren't going to discuss them in depth at the moment, I'll briefly describe a few examples of the reserves you might come across, so you have a general understanding of their purpose on the balance sheet.
Reserves on the balance sheet include the following items:
- Capital Reserves, which usually arise as a result of issuing stock in excess of par value.
- Retained earnings, which arise as a result of past profitable operations. In simplified terms, retained earnings are net profits that have not been distributed to shareholders as dividends.
- Fair Value Reserves, which can include adjustments for available-for-sale securities and assets, which are particularly important for businesses like a property and casualty insurance company that holds large fixed-income investments.
- Hedging Reserves, which can arise as a result of hedges a company has taken on to protect itself against volatility in certain input costs.
- Asset Revaluation Reserves, which arise when a company has to adjust the value of an asset that is carried in the asset section of its balance sheet and needs an offsetting transaction.
- Foreign Currency Translation Reserves, which 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, which are reserves that a company is required by law or regulation to establish and that cannot be paid out as dividends.
The Accounting Term "Reserves" Often Refers to Another Concept
When you hear investors, managers, 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 establishing reserves intended to keep the income statement as close to economic reality as possible (though, in actuality, less-than-ethical or even well-intentioned-but-too-optimistic management may use it to its advantage, overstating owner earnings engaging in "cookie jar" accounting).
For example, reserves in this context might come into play in the following situation: A company has a substantial amount of its current assets in accounts receivables. The company charges off a percentage of the total amount it believes won't be paid based on past experience and an examination of the current accounts receivable balances. This accounting transaction lowers current assets and is known as an allowance for doubtful and bad accounts. It is a contra-asset account offsetting accounts receivable.
If management turns out to be too pessimistic, the reserves can be reversed in the future and profitability will appear to increase.