What it means
When a company issues shares, it receives money from investors, forming its permanent share capital. Company law usually prohibits businesses from simply paying back this money to shareholders out of everyday profits, because that would shrink the safety cushion protecting lenders and suppliers if the business hits hard times.
However, companies sometimes want to buy back their own shares to return surplus cash to owners. If they use existing profits to fund this buyback instead of issuing new shares, the total value of their permanent share capital would technically drop.
To prevent this, accounting rules require the company to transfer an amount equal to the nominal value of the cancelled shares into a Capital Redemption Reserve. This reserve sits in the equity section of the balance sheet.
The reserve is strictly off limits for paying dividends to shareholders. By locking up profits in this way, the company maintains the same level of permanent legal capital that existed before the buyback, reassuring creditors that their financial safety buffer is fully intact.
The one common use for the reserve is to pay up bonus shares, meaning new shares issued free of charge to existing shareholders. Doing so does not change total equity; it simply moves the amount from the reserve into share capital.
The rules described here reflect company law in the UK and similar jurisdictions, and other countries use different mechanisms to protect creditors. Imagine a homeowners association that requires a mandatory maintenance fund.
If homeowners decide to return some pooled funds to members, they must move an equivalent amount into a permanent reserve that cannot be spent on parties, ensuring the building always has a safety buffer for repairs.
In practice
Real-world examples
Example 1
TechStart Ltd uses $50,000 of accumulated profits to buy back and cancel 10,000 of its own shares, each with a nominal value of $1. It must transfer $10,000 into a Capital Redemption Reserve. The remaining $40,000 of the price paid comes straight out of retained earnings as a premium.
Example 2
Metro Retail plc decides to cancel 50,000 redeemable preference shares with a nominal value of 10 cents each, funded from retained earnings. The finance team creates a Capital Redemption Reserve of $5,000. The auditors check that enough distributable profit existed on the date of the redemption.
Example 3
GreenEnergy Coop uses surplus cash reserves of $100,000 to buy back 25,000 ordinary shares at a nominal value of $1 each, retiring them permanently. A Capital Redemption Reserve of $25,000 is established. Two years later the co-operative uses part of that reserve to issue free bonus shares to its members.
Think of it
Imagine a homeowners association that requires a mandatory maintenance fund. If homeowners decide to return some pooled funds to members, they must move an equivalent amount into a permanent reserve that cannot be spent on parties, ensuring the building always has a safety buffer for repairs.
Formula
Calculation
Amount transferred to Capital Redemption Reserve = Nominal value of shares redeemed or bought back out of profits
Premium paid = Price paid - Nominal value (charged to distributable profits)
Worked example. Acme Ltd buys back and cancels 5,000 ordinary shares with a nominal value of $2 each, using retained earnings.
- Transfer to the reserve = 5,000 x $2 = $10,000
Now suppose Acme pays $5 per share, so the total cost is 5,000 x $5 = $25,000.
- Premium paid = ($5 - $2) x 5,000 = $15,000
- Entry 1: debit share capital $10,000; debit retained earnings $15,000; credit cash $25,000
- Entry 2: debit retained earnings $10,000; credit Capital Redemption Reserve $10,000
- Retained earnings fall by $15,000 + $10,000 = $25,000, the full price paid, so distributable reserves shrink by exactly the cash that left the company
- Share capital falls by $10,000 and the reserve rises by $10,000, so the permanent capital base (share capital plus reserve) is unchangedCase study
Seen in the real world
This is a fictional, illustrative scenario. Brighton Logistics Ltd decided to streamline its ownership structure by buying back 20,000 of its ordinary shares from a retiring founder. Each share had a nominal value of $1. The total cost of the buyback was $45,000, which the company paid using accumulated profits stored in its retained earnings account.
Because the company used profits rather than issuing new shares to fund the buyback, company law required the finance team to protect the permanent capital base. The team processed two key accounting entries. First, they cancelled the shares by reducing share capital by $20,000 and retained earnings by the $25,000 premium, with $45,000 of cash paid out. Second, they transferred a further $20,000 from retained earnings into a Capital Redemption Reserve, representing the nominal value of the cancelled shares.
As a result, share capital plus the reserve remained unchanged, satisfying legal requirements and protecting creditors. In total, retained earnings fell by $45,000, the full price of the shares, so the buyback used up distributable reserves by exactly the cash paid. The finance director explained to the board that the $20,000 reserve was not a cost but a lock on profits that could no longer be paid out as dividends. The board noted the figure when planning that year's dividend.
Watch out
Common mistakes
- Treating the Capital Redemption Reserve as cash that can be spent on everyday business operations.
- Using the reserve to pay dividends to ordinary shareholders in future profitable years.
- Calculating the transfer based on the market price paid for the shares rather than their nominal value.
Questions
People also ask
Can a Capital Redemption Reserve be used to issue bonus shares?
Yes. A company can use this reserve to issue fully paid bonus shares, sometimes called stock dividends, to existing shareholders.
Is the Capital Redemption Reserve considered a cash asset?
No. It is purely an accounting entry in the equity section of the balance sheet, not a separate bank account holding cash.
Why do regulators require this reserve?
It protects creditors by ensuring that money used to buy back shares from profits cannot be accidentally paid out again as dividends.