Only reserves out of profits make the cut; revaluation-created ones do not
One test decides which reserves count, and it is a test of origin, not of size.
Section 2(57) of the Companies Act, 2013 states the rule. It adds paid-up capital, all reserves created out of profits, the securities premium account and the credit balance of the profit and loss account. It then shuts out three origins by name: reserves created out of revaluation of assets, write-back of depreciation and amalgamation.
If a company could revalue its land, book the uplift to a reserve and count that reserve as net worth, it would be raising its own standing with a number it wrote in its own accounts. No cash moved and no profit was earned. The exclusion stops a valuation opinion from turning itself into evidence of financial position.
A verifier compares the certified total with the equity block in the filed accounts, finds a difference and asks which line explains it. An unexplained exact match is the worse outcome, because it usually means the revaluation surplus went in untouched.
How the Companies Act defines a free reserve
Company law uses a second, related idea: the free reserve. In one sentence, free reserves are the reserves available for dividend as per the latest audited balance sheet, and the glossary entry sets out the full definition.
The definition also excludes certain balances from the status of a free reserve.
The two definitions arrive at almost the same place by different wording.
Note that the net worth definition in section 2(57) does not use the phrase "free reserves" at all. It says "reserves created out of profits" and then lists its own three exclusions. The two definitions arrive at almost the same place by different wording. That is why a practitioner works from whichever one the recipient's format cites, and says so on the statement.
Securities premium: counted, with restrictions on its use
What the company may do with it is a separate question. Company law restricts how the premium may be used.
A verifier tests the balance against the allotment record, not the profit history. Each addition should trace to a return of allotment filed with the Registrar, showing how many shares were issued and at what price. Where premium appears with no matching filing behind it, the reserve is the symptom and the missing filing is the problem. The account itself, the premium received above face value, has its own glossary entry.
Revaluation reserve and why it is excluded
A revaluation reserve appears when a company restates an asset, usually land or a building, from historical cost to a current valuation. The credit has nowhere else to go, so it lands in equity.
The substance is the same.
Company law treats the balance cautiously wherever it sits, and the net worth definition keeps it out entirely.
One instinct runs through these rules: an unrealised uplift should not become capital, dividend or proof of standing.
It stays on the balance sheet at its full amount, available to anyone who wants the asset-rich view. A good statement reports the statutory figure and then discloses what it left out, with the amount beside it, so the reader can add it back and see exactly what was done. The surplus a revaluation creates is defined in its own entry.
Capital redemption, debenture redemption and other statutory reserves
A third group of reserves exists because a statute requires it, not because the board chose to set money aside:
- Capital redemption reserveWhen preference shares are redeemed or shares are bought back out of profits.
- Debenture redemption reserveWhere the company is required to keep one for its debentures.
- Statutory reservesThat regulated businesses, such as banks, must build out of each year's profit.
Two questions get run together here:
- Where did the money come from?The only question that bears on net worth.
- What may the company now do with it?A restriction on use, settled separately.
Only the first bears on net worth. A balance funded out of profit the company earned stays inside the figure, even where the law tightly restricts its use. A restriction on use does not reverse the profit that created it. So these reserves generally count.
So, is a capital reserve included in net worth under the Companies Act? The same origin test answers it. "Capital reserve" is a label that different events can produce, so it has to be traced before it is treated:
- A capital reserve that arose on an amalgamationExcludedExcluded by name in section 2(57).
- A capital reserve that arose from a revaluationExcludedExcluded as a revaluation reserve, whatever it is called.
- A capital reserve built from realised profitsGenerally countsSuch as a profit on selling a fixed asset that was transferred to it: a reserve created out of profits.
Say on the working which of these it was, so the reader can follow the decision.
The same reasoning works in reverse when a reserve is released. When the debentures are redeemed, or a buy-back is complete, the balance moves to another line inside the same equity block. The total does not change, and neither does net worth.
Unrealised gains sitting in other comprehensive income
Companies reporting under Ind AS put a whole category of movements into other comprehensive income (OCI) instead of profit. Typical examples:
- Fair value gains on equity investments designated at fair value through OCI.
- Remeasurements of defined benefit obligations, such as gratuity.
- Revaluation surplus on property.
- Exchange differences on translating a foreign operation.
None of these passed through the profit line on the way in. Some will later be moved to profit or loss; others never will. That split says a lot about how a reader will treat the balance, and little about the computation.
For net worth, the question is the same as everywhere else: was the balance created out of profits? Unrealised gains recognised in equity were not, and they should be expected to stay out. A company on the older Accounting Standards has less of this to consider. A company on Ind AS should expect its reserves note to be read line by line.
A reserve-by-reserve ready reckoner for your balance sheet
List each balance in your reserves note and sort it by origin, not by size.
| Counts toward net worthCreated out of profits, or the premium |
|
|---|---|
| Left outNever added, so never deducted |
|
| Trace before you decideA label, not an origin |
|
| Deducted, not left outSubtracted from the total |
|
A ready reckoner sorts the lines; it does not produce the total. The full computation in sequence takes these lines through to a figure, and what happens when the total falls below zero is covered separately. Once the figure is settled, the recipient will usually want it as an attested statement of the position.
Before the figure goes on a certificate
Not sure which of your reserves count? Talk to a CA about your reserves note before the figure goes on a certificate.
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