Can show a strong certified position: the retained profit sits in reserves that count.
Net Worth & Solvency Glossary · Entity Finance
Free Reserves Under the Companies Act, 2013
noun, plural · also "free reserve"; the pool a dividend may lawfully be paid from
Definition
Free reserves are the reserves a company has built from profits it actually earned and kept, and that are available for distribution as dividend.
Reserves that arise from an accounting entry rather than from earning, such as a revaluation of assets, are not free reserves.
Which reserves count, and which do not
Counts toward net worth
- General reservebuilt from retained profit
- Credit balance of profit and lossprofit earned and kept
- Securities premiumcounts in net worth; not available for dividend
Left out
- Revaluation reservean asset written up, not sold
- Depreciation write-backan earlier charge reversed
- Amalgamation reservearises on a merger, not from trading
The test is whether the reserve is available to be paid out, not whether it appears on the balance sheet.
The test
01Which reserves qualify as free reserves
One question decides it
Is the reserve available to be paid out? Not whether it appears on the balance sheet. A reserve can be large, properly created and audited, and still not be a free reserve because it was never available for distribution.
Usually qualify
Reserves built from earned and retained profits: the general reserve and the credit balance of the profit and loss account, for example.
Do not qualify
Reserves that represent gains the company has not realised, such as an asset written up to a higher value, or an amount credited to equity because of a fair value measurement.
The Companies Act, 2013 gives the formal definition.
Is the securities premium a free reserve? Two questions sit behind that search, with different answers.
Q1Does it count in net worth?
Yes. The securities premium is added to a company's net worth under section 2(57) of the Companies Act, 2013, where it is listed as its own item beside reserves created out of profits.
Q2Can it be used for a dividend?
A separate question. Section 52 of the Companies Act, 2013 lists the uses of the securities premium account: issuing fully paid bonus shares, writing off preliminary expenses, writing off the expenses, commission or discount on an issue of shares or debentures, providing for the premium on redeeming preference shares or debentures, and buying back the company's own shares under section 68. Paying a dividend is not among them.
So a balance can sit inside the net worth figure and outside the distributable pool at the same time.
The certified figure
02How free reserves lift the certified net worth of a company
Section 2(57) of the Companies Act, 2013 builds net worth by adding paid-up share capital, all reserves created out of profits, the securities premium account and the credit balance of the profit and loss account, and then deducting accumulated losses, deferred expenditure and miscellaneous expenditure not written off. It leaves out reserves created out of revaluation of assets, write-back of depreciation and amalgamation.
Adds
- Paid-up share capital
- All reserves created out of profits
- The securities premium account
- The credit balance of the profit and loss account
Deducts
- Accumulated losses
- Deferred expenditure
- Miscellaneous expenditure not written off
Leaves out
- Reserves created out of revaluation of assets
- Reserves from write-back of depreciation
- Reserves from amalgamation
Reserves built from retained profits therefore add directly to the figure a CA certifies. This is why classifying each reserve correctly matters: including one that does not qualify inflates the certified figure, and it is the error a reader with the accounts in front of them is most likely to catch. This is how the figure is built for a company net worth certificate under Section 2(57).
Can show very little: the losses come off the same figure the capital went into.
The lift is real, but it is not cash. A reserve records profit kept in the business, not money held. A company can carry sizeable free reserves and still be unable to fund a modest payment, so a reader judging capacity to pay looks past the reserve line to the assets behind it.
Detail and source
03Unrealised gains, notional credits and the audited accounts
The reserves most often misread are the ones created by an entry in the books rather than by earning.
Revaluation reserve
It arises when an asset is written up without being sold. The gain is unrealised, and the net worth definition leaves it out.
Reserve from writing back depreciation
It reverses an earlier charge. It does not record a profit, and the net worth definition leaves it out.
Amalgamation reserve
It arises on a merger, not from trading. The net worth definition leaves it out.
Fair value credits
Amounts credited to equity because an asset or liability was re-measured at fair value are, in most cases, not yet realised.
Searches also ask about the capital reserve, statutory reserves, the development rebate reserve and the investment allowance reserve. A reserve the company must keep for a purpose set by law, or one that did not come from distributable profit, is generally not free to pay out. Whether each named reserve qualifies is read from its origin and its terms, reserve by reserve, in Which Reserves Count Toward Company Net Worth Under Section 2(57).
Where the classification is read from. The source for every classification is the company's audited financial statements, as filed with the Ministry of Corporate Affairs. That is where a lender or tender committee will look. A classification that differs from the filed accounts has to be explained, not just asserted.
Written by Subham Jhunjhunwala · Reviewed by CA Sundram Gupta
Sources: Companies Act, 2013, section 2(57) (Ministry of Corporate Affairs). This entry describes Indian practice in general terms and is not advice on a particular company's accounts.
Need help with a certificate that uses free reserves? See our Net Worth Certificate for Company.