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Capital and revenue reserves

Edexcel IAL Accounting · WAC12 Corporate and Management Accounting

Reserves are part of shareholders' equity, but they are not piles of cash. WAC12 asks you to classify six reserves as capital or revenue, and to explain how and when each is created and used.

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Capital or revenue?

Revenue reserves come from realised profits. They can be used to pay dividends.
Capital reserves arise from capital transactions or unrealised gains. They cannot be used for cash dividends; they are used for purposes allowed by company law, such as issuing bonus shares.

The distinction protects creditors: capital must stay in the company as a buffer against losses.

Reserve	Type	Created by	Used for
Retained earnings	Revenue	Profits for the year kept after dividends	Dividends, transfers to other reserves, bonus issues, financing growth
General reserve	Revenue	Directors transferring part of retained earnings	Shows profits are being kept for future needs (expansion, a cushion); can be transferred back and distributed
Foreign exchange reserve	Revenue (as Pearson mark schemes classify it)	Setting aside profits (or exchange gains) for exchange rate movements	Covering possible losses when foreign currency rates move against the company on overseas trade or operations
Share premium	Capital	Issuing shares for more than their nominal value	Paying up bonus shares; writing off share issue expenses
Revaluation reserve	Capital	Upward revaluation of non-current assets	Bonus issues; it is an unrealised gain, realised only when the asset is sold
Capital redemption reserve	Capital	Redeeming or buying back shares out of distributable profits: transfer from retained earnings equal to the nominal value redeemed	Keeps capital at the same level to protect creditors; can be used for bonus shares

Reserves are not cash

A company with retained earnings of £5 million may have an overdraft. Reserves record where the net assets came from; the resources themselves may be machinery, inventory or receivables. The maximum dividend is limited by the revenue reserves and, in practice, by the cash available.

Capital redemption reserve in detail

When shares are redeemed out of profits (not from a new issue), the nominal value redeemed is transferred:

Dr Retained earnings, Cr Capital redemption reserve.

The share capital falls, the capital redemption reserve rises by the same amount, so the 'capital' (share capital + capital reserves) does not fall. If redemption is partly financed by a new share issue, the transfer is the nominal value redeemed less the proceeds of the new issue.

Examiners report that this reserve is often poorly known, even though it is named in the specification.

Revaluation reserve in detail

If land bought for £800,000 is revalued to £1,100,000:

Dr Land £300,000, Cr Revaluation reserve £300,000.

The £300,000 is an unrealised gain: no cash has been received, and the value could fall again. That is why it cannot be paid out as a dividend.

Worked example

A company redeems 400,000 of its £1 preference shares at par, paying from cash, with no new issue of shares. Give the journal entries.

Dr Preference share capital £400,000, Cr Bank £400,000 (the redemption)
Dr Retained earnings £400,000, Cr Capital redemption reserve £400,000 (to maintain capital)

Answer: Two journals: the redemption itself and the transfer of £400,000 to the capital redemption reserve

Key idea: Revenue reserves (retained earnings, general, foreign exchange) come from profits and can fund dividends; capital reserves (share premium, revaluation, capital redemption) cannot be paid out in cash.

Check yourself

How is a share premium reserve created?
- By revaluing land upwards
- By transferring profits from retained earnings
- By redeeming shares
- By issuing shares at more than their nominal value
Show answer
By issuing shares at more than their nominal value. The excess of issue price over nominal value is credited to share premium.
Which reserve can be used to pay a cash dividend?
- Share premium
- General reserve
- Revaluation reserve
- Capital redemption reserve
Show answer
General reserve. The general reserve is a revenue reserve made of retained profits, so it can be distributed.
Why can the revaluation reserve not be used to pay dividends?
- It is always negative
- It belongs to the debenture holders
- It is shown as a liability
- The gain is unrealised: no cash has been received from it
Show answer
The gain is unrealised: no cash has been received from it. The asset has not been sold, so the gain has not been realised.
A company redeems 250,000 ordinary shares of £2 each at par out of distributable profits, with no new issue. What amount is transferred to the capital redemption reserve?
Show answer
£500000. Nominal value redeemed = 250,000 x £2 = £500,000.
A company redeems £600,000 of shares at nominal value, financed partly by a new issue of shares raising £350,000. What transfer is needed to the capital redemption reserve?
Show answer
£250000. 600,000 - 350,000 = £250,000.
Equity: share capital £2,000,000, share premium £400,000, revaluation reserve £300,000, general reserve £250,000, retained earnings £820,000. What is the maximum dividend allowed from reserves?
Show answer
£1070000. Revenue reserves only: 250,000 + 820,000 = £1,070,000.
Explain how a foreign exchange reserve is used by a company that trades overseas.
Show answer
Profits are set aside in the reserve to cover possible losses if exchange rates move against the company, for example when the home currency weakens and imports or overseas debts cost more.. It is a revenue reserve kept to absorb losses caused by adverse exchange rate movements; examiners wanted more than 'to buy foreign goods'.

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Last updated 8 November 2026. Spotted a mistake? Tell us.