Reserves correspond to the creation and retention of value within the company in order for it to be sustainable and may be created from different sources:
- Reserves created from shareholders’ contributions, the most common examples of which are:
- legal reserve fund – it is required in many legislations and it must be paid as a percentage of share capital.
- share premium – amount paid by shareholders for shares in excess of their nominal value
- Reserves created from profit, whereas part of the previous year’s profit is allocated to specially designated reserves:
- legal reserve fund from profit – it is common form of reserve that is legally required in several countries by indicating how much of the company’s net income of the previous year must be allocated to the legal reserve. Thresholds are also applied to determine the extent to which the legal reserve from profit should be established, for instance a limit being until the reserve accumulates a proportion of the share capital.
- remuneration reserve – will be used later to pay bonuses to employees or management.
- translation reserve – arises during consolidation of entities with different reporting currencies.
It is important to notice that reserves do not correspond to cash that the company holds. The reserve is an instrument to accumulate value for some purpose, but that value can be converted by the company into a different type of asset. That means that company may hold more or less in reserves than what it has in cash and bank deposits.