Retained earnings, shown as the profit and loss account, are the accumulated profits a company has kept after losses and distributions. The other reserves each record something the law or an accounting standard requires to be kept apart: share premium, revaluation gains, the capital redemption reserve, fair value movements and similar items. Each reserve has its own rules on what can be credited to it, what can be taken out of it, and whether it can ever fund a dividend.
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What sits under capital and reserves on a company balance sheet?
For a company preparing Companies Act accounts, the balance sheet formats in Schedule 1 to the Large and Medium sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) list capital and reserves in a fixed order: called up share capital, share premium account, revaluation reserve, other reserves, and the profit and loss account. Other reserves are split into the capital redemption reserve, the reserve for own shares, reserves provided for by the articles of association, and other reserves including the fair value reserve. The small companies version in SI 2008/409 uses the same main headings but shows other reserves as one line.
| Reserve | What creates it | Can it fund a dividend? |
|---|---|---|
| Profit and loss account | Profits after tax less losses and distributions | Yes, to the extent the profits are realised |
| Share premium account | Shares issued for more than nominal value (s610) | No |
| Revaluation reserve | Upward revaluations of assets | No, while the gain is unrealised |
| Capital redemption reserve | Buybacks and redemptions of shares (s733) | No |
| Fair value reserve | Certain hedging and investment fair value changes | Generally no, while unrealised |
| Merger reserve | Premium not recorded under merger relief (s612) | Depends on whether it is realised |
What are retained earnings and what makes them move?
Each year the profit or loss is closed off to retained earnings. The balance then moves for a short list of reasons:
- Profit or loss for the year after tax.
- Dividends and other distributions. FRS 102 paragraph 22.17 requires equity to be reduced by distributions to owners. A dividend is never an expense in the profit and loss account.
- Corrections of material prior period errors and changes in accounting policy. Under FRS 102 paragraph 10.21 a material error is corrected by restating comparatives, or the opening balances of the earliest period presented, so it goes through opening retained earnings rather than this year’s profit.
- Transfers in from other reserves, for example when a revalued asset is sold or depreciated.
- Transfers out, for example to the capital redemption reserve when shares are bought back out of profits.
FRS 102 paragraph 3.18 allows a single statement of income and retained earnings instead of a full statement of changes in equity where the only changes in equity come from profit or loss, dividends, prior period error corrections and accounting policy changes. Paragraph 6.5 lists what it must show, starting with opening retained earnings and ending with closing retained earnings. Once a company has a revaluation or share issue in the year, it needs the full statement of changes in equity.
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What does the revaluation reserve hold?
When a company carries an asset at a revalued amount, paragraph 35 of Schedule 1 to SI 2008/410 requires the resulting profit or loss to be credited or debited to a separate revaluation reserve. Under FRS 102 paragraph 17.15E a revaluation increase on property, plant and equipment goes to other comprehensive income and is accumulated in equity, unless it reverses an earlier decrease charged to profit or loss. Paragraph 17.15F sends a later decrease first against that asset’s past gains in equity, with any excess charged to profit or loss.
The law limits how the reserve can be reduced. Paragraph 35(3) allows a transfer to the profit and loss account only if the amount was previously charged to that account or represents realised profit, or on capitalisation (using it to pay up bonus shares), and requires the reserve to be reduced when amounts are no longer needed for the valuation method. Paragraph 35(6) requires a note explaining the tax treatment of amounts in the reserve. In practice two transfers are common: on disposal, the remaining surplus for that asset moves to retained earnings; and each year, section 841(5) of the Companies Act 2006 treats the extra depreciation caused by the revaluation as a realised profit, which is why many companies make an annual transfer of that amount. The mechanics of revaluing assets are covered in revaluation of fixed assets.
Why does a company have a capital redemption reserve?
Section 733 of the Companies Act 2006 requires a capital redemption reserve whenever share capital is cancelled without being replaced. If shares are redeemed or bought back wholly out of profits, the nominal value cancelled is transferred to it. If a fresh issue funds part of the purchase, the shortfall between those proceeds and the nominal value cancelled is transferred, unless a private company also makes a payment out of capital. Section 734 adds rules for payments out of capital. Section 733(5) allows it to be used to pay up fully paid bonus shares, and otherwise section 733(6) treats it as if it were paid up share capital, so it can only be reduced through the formal capital reduction procedures. See company share buybacks for the full process.
Where do share premium and merger reserves fit?
Section 610 requires the excess of the issue price over nominal value to go to the share premium account, whether the shares are issued for cash or otherwise. It can be used to write off the expenses and commission of that issue, or to pay up bonus shares; otherwise it is treated like paid up capital. FRS 102 paragraph 22.9 requires transaction costs of an equity issue to be deducted from equity. More detail is in the share premium account.
Where a company secures at least a 90% equity holding in another company in exchange for its own shares, section 612 merger relief disapplies section 610 for the premium on those shares. FRS 102 paragraph 22.8 recognises that merger relief changes how the issued equity is measured. Any premium that is recorded is often labelled a merger reserve within other reserves. See merger relief and group reconstruction relief.
What are the fair value reserve and the other reserves?
Paragraph 40 of Schedule 1 to SI 2008/410 normally sends fair value changes on financial instruments and investment property through the profit and loss account. It requires a fair value reserve for changes on hedging instruments where hedge accounting keeps them out of profit or loss, and for certain exchange differences on a net investment in a foreign entity, and permits it for available for sale financial assets that are not derivatives. Paragraph 41 requires the reserve to be adjusted when amounts are no longer needed and the tax treatment to be disclosed.
The reserve for own shares and reserves provided for by the articles of association are separate headings in the same formats, used only where those circumstances apply.
How might the reserves move in one year?
Illustration only. A company starts the year with retained earnings of £200,000 and a revaluation reserve of £60,000 on its building. During the year it makes a profit after tax of £80,000, pays dividends of £50,000, and buys back shares with a nominal value of £10,000 wholly out of profits. Depreciation on the revalued building is £3,000 a year higher than it would have been at cost.
| Movement | Retained earnings £ | Revaluation reserve £ | Capital redemption reserve £ |
|---|---|---|---|
| Opening balance | 200,000 | 60,000 | 0 |
| Profit for the year | 80,000 | ||
| Dividends paid | (50,000) | ||
| Excess depreciation transfer | 3,000 | (3,000) | |
| Transfer on buyback | (10,000) | 10,000 | |
| Closing balance | 223,000 | 57,000 | 10,000 |
The buyback price itself also reduces retained earnings; only the nominal value transfer is shown here to isolate the reserve movement.
Which reserves can be used to pay a dividend?
Section 830 of the Companies Act 2006 allows distributions only out of accumulated realised profits, less accumulated realised losses. Section 853(4) defines realised profits by reference to generally accepted accounting principles at the time the accounts are prepared. So the profit and loss account is the starting point, but it can contain unrealised amounts that must be excluded, and some other reserves can contain realised profits. For example, under article 3 of the Companies (Reduction of Share Capital) Order 2008, a reserve arising from a solvency statement reduction by a private company, or a court approved reduction unless the court orders otherwise, is treated as a realised profit.
A public company faces a further test in section 831: after the distribution its net assets must not fall below called up share capital plus undistributable reserves, which include the share premium account, the capital redemption reserve and net unrealised profits. The full calculation is covered in distributable reserves and the practical steps in how to pay dividends legally.
What mistakes come up most often?
- Treating the balance on retained earnings as the dividend limit without removing unrealised gains, such as fair value gains on investment property recognised in profit or loss.
- Crediting a revaluation surplus straight to retained earnings, or leaving the surplus in the revaluation reserve after the asset has been sold.
- Forgetting the capital redemption reserve transfer on a buyback out of profits, so share capital appears to fall with no matching reserve.
- Posting share issue costs to the profit and loss account instead of against share premium or equity.
- Correcting a material prior year error through this year’s profit instead of restating opening retained earnings.
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Related Accountapedia entries
- The capital redemption reserve
- Accounting for a company purchase of own shares
- The statement of income and retained earnings
- Recording share issues: share capital and share premium
- Financial statements explained: P&L and balance sheet
Sources
- legislation.gov.uk: SI 2008/410, schedule 1
- legislation.gov.uk: SI 2008/409, schedule 1
- Financial Reporting Council: FRS 102 September 2024 tmKYWO6
- legislation.gov.uk: SI 2008/410, schedule 1
- legislation.gov.uk: Act 2006 c. 46, section 841
- legislation.gov.uk: Act 2006 c. 46, section 733
- legislation.gov.uk: Act 2006 c. 46, section 734
- legislation.gov.uk: Act 2006 c. 46, section 610
- legislation.gov.uk: Act 2006 c. 46, section 612
- legislation.gov.uk: SI 2008/410, schedule 1
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.