What is the legal reserve?

The legal reserve is part of a company’s equity that cannot be distributed to shareholders or used to offset any losses, for example. It is legally mandated that companies with an Ltd. or a public limited company legal form must maintain the legal reserve. This requirement is included in the law to provide protection to creditors, as it prevents monetary distributions based on results that have not actually been achieved.

Legal reserve as part of equity

Equity includes, in part, the legal reserve bound by laws and regulations, as set forth in the Civil Code. The provisions apply to legal entities such as an Ltd. or a public limited company falling under the content of the legal code. These companies must maintain legal reserves.

Equity

Equity refers to the value of a company’s assets minus its liabilities. This includes assets such as cash, liquid assets, and inventory. Equity shows the financial position of the company but is not an indication of the company’s worth. In a company, it is the partners or shareholders who finance the company with equity. In the event of a company liquidation, equity represents the financial value for the shareholders. Equity, along with liabilities, is shown on the balance sheet under ’liabilities’ and represents the available capital. The legal reserve is part of this and is visible on the balance sheet.

Different types of legal reserves

There are various types of legal reserves, such as those for the issuance of shares. If a company incurs costs for issuing shares, this can be recorded on the balance sheet, and depreciation is possible. In this case, there must be a legal reserve.

Another type of legal reserve is the reserve for participation. For example, an Ltd. must maintain a reserve in the event of an increase in the value of participation in other companies compared to the previous balance sheet date.

There is also a revaluation reserve, which relates to the increase in the value of tangible and intangible fixed assets as well as the increasing value of inventories, excluding agricultural inventories. For example, the value of a company’s property may increase, leading to value enhancement. This increase must then be visible on the balance sheet as a legal reserve.

Another example of types of legal reserves is the reserve for translation differences. This applies when foreign currencies are part of the business operations, causing the value of assets and liabilities to fluctuate on the balance sheet.

Legal reserve and theoretical results

Companies are not allowed to use legal reserves, for example, to distribute dividends or buy back their own shares. The theoretical results regarding the legal reserve on the balance sheet are not the actual results because they have not yet been realized. The value of fixed assets appears on the balance sheet, such as equipment or the company’s property.

If the value of a company’s property increases, this theoretically leads to higher profit. However, actual profit is only realized when the property is sold. Therefore, a portion of the property’s value must be retained as a legal reserve on the balance sheet. Of course, it is permissible to use actual high profits to provide a payout to shareholders. However, this cannot be done to the extent that it depletes the legal reserve. For example, a creditor does not have the ability to collect a claim from the equity that exists only in theory within the company.