Profits retained in the business and set aside for specified purposes. The Companies Act requires a distinction to be made in acconts between revenue and capital reserves . The former, at the discretion of the board of directors, can be distributed as dividens to equity shareholders, but the latter may not. Capital reserves are created when new shares are issued at a premium over par or when the book value of existing assets is revalued to bring it into line with replacement costs or when capital gains are made; in each case, the whole of the surplus is transferred to the capital reserve account. These reserves may later be transformed into issued capital.
Reveriue reserves are created by transfers of undistributed profits into special accounts;· e.g. asset replacemerit reserves or general reserves, out of which a dividend may be paid in a later year in which the company makes a loss. The bulk of company reserves are not kept in cash, but are in variably invested in the business (ploughed back} or outside. In all cases, however, the sums in reserve accounts are always matched by assets. Tax reserves and the balance on the profit and loss account at any time’ are .also classified as revenue reserves. A taxation equalization reserve may include tax allowances accruing under accelerated depreciation, i.e. where depreciation for tax purposes is faster than depreciation written into the company accounts and future tax liabilities on current revenue. The decision on how much profit to retain in the business and how much to distribute in dividends is the responsibility of the board of directors.
Reference: The Penguin Business Dictionary, 3rd edt.