What are legal reserves and why can't I distribute them?
Legal reserves are restricted equity, for example for development costs or revaluation. They reduce the room for dividends.
The short answer
Legal reserves are restricted equity, for example for development costs or revaluation. They reduce the room for dividends.
Basis: art. 2:365(2) and 2:373 DCC
Which items lead to a legal reserve?
If you capitalise development costs, a legal reserve must be maintained for the amount not yet amortised (art. 2:365(2) DCC). For certain increases in value at current value, the revaluation reserve of art. 2:390 DCC applies.
A legal reserve is a separate part of equity that by law cannot be freely distributed. For capitalised development costs, art. 2:365(2) DCC applies: a reserve is maintained against the capitalised amount not yet amortised. For a revaluation, the revaluation reserve under art. 2:390 DCC comes into play. These grounds differ, even though both appear under equity. Therefore check, per item, its own basis, the amount and the movement during the year. A general heading 'legal reserves' without a breakdown can hide important information.
How does a reserve change the distributable room?
These reserves cannot be distributed. If the reserve is forgotten, distributable equity looks larger than it is — and that is exactly where a dividend distribution goes wrong.
Take a BV (private limited company) with € 100.000 of equity. It includes a € 25.000 legal reserve for development costs and a € 15.000 statutory reserve. The balance sheet test then leaves at most € 60.000 of room before the distribution test and other restrictions. If the BV also pays € 50.000 to suppliers in the coming weeks, the actual room for dividends may be lower. Booking a reserve moves amounts within equity; it creates no extra money in the bank. That is why, for a distribution, you look at both the legal reserve and the company's liquidity.
How do you process movements in equity?
In the statement of changes in equity the reserves are shown separately, so that it remains visible which part of equity is tied up.
When a capitalised development amount is amortised or written off, the related reserve may change under the applicable rules. Record the opening balance, additions, releases and closing balance. Reconcile this statement with the balance sheet and with the notes. When there is a new valuation, examine whether a revaluation reserve is needed instead of treating the increase directly as free profit. In a group or with a participating interest, additional legal reserves may be relevant. So do not let a single default setting alone determine which profit is distributable in the annual accounts.
Example of a statement of changes
A BV starts the year with a € 18.000 reserve for capitalised development costs. It capitalises € 7.000 of new costs and amortises € 5.000 of the existing assets. Depending on the precise treatment, the reserve may then end at € 20.000. Show the opening balance, addition, reduction and closing balance, and reconcile them with the balance sheet item for development costs. A bare closing value without the underlying calculation does not make clear whether the reserve still covers the required amount. Therefore check whether a written-off project also leads to a correct adjustment of the reserve.
For a revaluation the basis is different. A building valued at current value can give rise to a revaluation reserve under art. 2:390 DCC; the value and the reserve call for their own explanation. Do not mix this movement with an ordinary appropriation of profit. For dividends you also assess the free room above all legal and statutory reserves and the distribution test of art. 2:216 DCC. If the reserve is released, an equally large bank balance does not automatically arise. The statement of equity therefore helps shareholders understand which part is tied up in the books and which part may be distributable after further testing.
Sources
Frequently asked questions
Is a legal reserve a separate bank account?
No. It is a restricted component of equity, not cash held separately.
Does the reserve disappear after amortisation?
A change in the underlying item can change the reserve; determine the release in accordance with the applicable rule.
Are statutory reserves the same?
No. Their restriction comes from the articles of association, but they too count in the balance sheet test for distributions.
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