statement of financial position equity, liability and ...€¦ · how will ordinary shareholders...

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Copyright © 2018, 2016, 2014 Pearson Education, Inc. All Rights Reserved

Part 4

Statement of financial position – equity,

liability and asset measurement and

disclosure

Chapter 12

Share capital, distributable profits and

reduction of capital

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The main purpose of this chapter is to explain the issue and reduction of capital and distributions to shareholders in the context of creditor protection.

Main purpose

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Objectives

After completing this chapter, you should be able to:

• describe the reasons for the issue of shares;

• describe the rights of different classes of shares;

• prepare accounting entries for issue of shares;

• explain the rules relating to distributable profits;

• explain when capital may be reduced;

• prepare accounting entries for reduction of capital;

• discuss the rights of different parties on a capital reduction.

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Chapter 12 covers

• Common themes

• Total owners’ equity

• Total shareholders’ funds

• Accounting entries on issue of shares

• Creditor protection: capital maintenance concept

• Creditor protection: necessity for capital maintenance

• Creditor protection: quantifying the amounts to meet

creditors’ claims

• Issued share capital: minimum share capital

• Distributable profits: general considerations

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Chapter 12 covers (Continued)

• Distributable profits: amounting using relevant

accounts

• Capital reduction

• Writing off lost capital and unrepresented assets

• Repayment of part of paid-in capital to shareholders

or cancellation of unpaid share capital

• Purchase of own shares

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Total shareholders’ funds

• Issued share capital

• Non-distributable reserves

• Distributable reserves.

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Issued share capital

• Ordinary

– Risk

– Residual profit

• Preference

– Fixed rate dividend

– Specific prior rights

• Dividend

• Return of capital.

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Non-distributable reserves

• Statutory

– Share premium

– Capital redemption

• Contractual

– Restrictions within memorandum.

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Distributable reserves

• Retained profits

• Treatment of unrealised profits

• Importance of EPS figure when deciding on

capital structure.

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Reasons for share issues

• Raising funds

• On acquisitions

• In lieu of dividends

• Director/Employee share option schemes.

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Methods of raising equity capital

• An offer for subscription

• A placing

• A rights issue.

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Possible rights for preference shares

• Cumulative

• Non-cumulative

• Participating

• Redeemable

• Convertible.

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Capital maintenance

• Rules to protect creditors

– Directors’ discretion on dividend policy

– Effect of non-distributable status.

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Creditor protection – why necessary?

• Unincorporated businesses

– Unlimited liability

• Limited liability companies

– Restricted rights against shareholders.

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Creditor risks

• Business risk

– Protection against fraud

– No protection against normal commercial risk.

• Risk of shareholders being paid ahead of

creditors

– Rules requiring minimum share capital

– Rules giving criteria for distributable profits.

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Distributable profits – private companies

• UK Companies Act definition

– Unrealised profits cannot be distributed

– No difference between realised revenue and

realised capital profits

– Realised losses must be taken into account.

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• Maintain permanent capital as at end of the

previous year.

• Distributable

– Retained realised profit brought forward

– Adjusted for net realised current year profit.

Distributable profits – private

companies (Continued)

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• Undistributable reserves are:

– share capital;

– statutory undistributable reserves;

– contractual undistributable reserves;

– excess of accumulated unrealised profit over;

accumulated unrealised losses.

Distributable profits – public

companies

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Implications of IAS compliance

on distributions

• Requirement for consolidated accounts of listed

companies to comply with IASs and IFRSs by

2005.

• These standards will affect both the disclosure and

measurement of items appearing in the income

statement and statement of financial position.

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Disclosure changes for preference shares

• In the UK, preference shares are always classified as

equity rather than liabilities.

• IAS requirement is to treat these as liabilities.

• Companies Act will require amendment so that

preference shares may be treated as liabilities.


on distributions (Continued)

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Disclosure changes for preference shares

• This change will affect

– The gearing ratios calculated in the balance sheet.

– The times interest cover ratio in the income

statement.

– Loan covenant conditions or performance-related

criteria expressed in terms of either of these ratios.

• The profit available for ordinary shareholders will

be unaffected.

Implications of IAS compliance on

distributions (Continued)

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on proposed dividends

• Currently there is a statutory requirement to

accrue proposed dividends and disclose them in

the income statement and current liabilities.

• Proposed law change for disclosure of the

aggregate amount of proposed dividends as a

note to the accounts.

• This would be an improvement as dividends are

payable out of distributable profits and not merely

the profit for the year.

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Measurement changes

• Affected by the decision a company makes about

the standards applied to the individual company

financial statements.

• Choice of applying international standards or

remaining with national standards.

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Measurement changes

• If international standards are applied, then there are

measurement changes that will affect the profit

available for distribution to equity shareholders.

• Examples are the effects of the proposed treatment of

leases

– Leases currently treated as operating will be treated in

the same way as finance leases.

– Even if companies decide to apply national standards

there will be subsequent impact as national standards

are brought into line with the international standards,

e.g. full provisioning for deferred taxation.

Implications of IAS compliance (Continued)

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Discussion questions

1.What is the relevance of dividend cover if

dividends are paid out of distributable profits?

2.How can non-distributable reserves become

distributable?

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Reduction of issued share capital

• Companies Act permits share capital reduction

subject to court

– Capital already lost and not represented by assets

– Repayment of capital – unwanted liquid resources

– Redemption of shares.

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Distributable profits:

effect of accumulated trading losses

• Elimination affecting only equity shareholders

– Existing losses eliminated

– No need to make good in future years

– Distribution from future profits not diverted to cover

losses.

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Distributable profits:

accounting for reduction due to losses

• Debit capital reduction account

• Credit profit and loss account

• Debit share capital

• Credit capital reduction account.

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Distributable profits: accounting for

reduction due to trading and asset

value losses

• Debit capital reduction account

• Credit profit and loss account

• Credit asset account



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reduction where losses are borne by more

stakeholders

• Typically, other stakeholders may be required to

suffer part of the reduction.

• Total amount to be written off is borne in agreed

ratios.

• A scheme may be developed to compensate the

other shareholders

– Issue of equity shares to loan creditors to

encourage their support.

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Accounting entries – Only change is that the balance

on the capital reduction account is not transferred to

ordinary share capital.


• Debit more stakeholders

– Preference shares – loan creditors and trade

creditors



reduction where losses are borne by more

stakeholders (Continued)

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Discussion

• What rights do loan creditors have if a company

approaches them to bear part of accumulated

losses?

• What calculations might they make before

agreeing to a proposed scheme?

• Why might it be unfair to apportion the total loss

pro rata across equity shareholders, preference

shareholders and loan creditors?

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Discussion (Continued)

• It is important in any capital reduction scheme for

the existing equity shareholders to retain overall

control.

• What would a court take into account when

considering whether to approve a scheme?

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Illustration of a capital reconstruction

XYZ plc has been making trading losses. The

statement of financial position of XYZ plc as at 31

December 20X3 was as follows:

£000

Ordinary share capital (£1 shares) 1,000

Less: Accumulated losses Note 1 (800)

200

10% debentures (£1) 600

Net assets at book value Note 2 800

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Information prior to decision

• The company is changing its product and markets

and expects to make £150,000 profit before interest

and tax every year from 1 January 20X4.

• The estimated break-up or liquidation value of the

assets at 31 December 20X3 was £650,000.

• The going concern value of assets at 31 December

20X3 was £700,000.

Illustration of a

capital reconstruction (Continued)

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Proposed reconstruction scheme

• Write off losses and reduce asset values to £700,000.

• Cancel all existing ordinary shares and debentures.

• Issue 1,200,000 new ordinary shares of 25p each and

400,000 12.5% debentures of £1 each as follows:

– Existing shareholders are to be issued with 800,000 ordinary

25p shares.

– Existing debenture holders are to be issued with 400,000

ordinary 25p shares and the debentures.

Illustration of a

capital reconstruction (Continued)

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Stakeholder initial decision

• The stakeholders, i.e. the ordinary shareholders

and debenture holders, have first to decide

– whether the company has a reasonable chance of

achieving the estimated profit for 20X4;

– whether allowing the company to continue provides

a better return than that available from the

liquidation of the company.

• Assuming that it does, they assess the effect of

allowing the company to continue

– without any reconstruction of capital;

– with a reconstruction of capital.

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Effect of liquidating

Effect of liquidating Debenture Ordinary

holders shareholders

£ £ £

Assets realised 650,000

Less: Prior claim (600,000) 600,000

Less: Ordinary shareholders (50,000) 50,000

— 600,000 50,000

• Effect is ordinary shareholders would lose almost all of their

capital, whereas the debenture holders would be in a much

stronger position.

• Important as influences the inducement that the debenture

holders require to accept any variation of their rights.

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Position if company continues

without reconstruction

Debenture Ordinary


£ £ £

Expected annual income:

Expected operating profit 150,000

Debenture interest (60,000) 60,000

Less: Ordinary dividend (90,000) 90,000

Annual income — 60,000 90,000

• However, no ordinary dividend paid until the debit balance of

£800,000 has been eliminated, i.e. there will be no dividend for

more than 9 years.

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Company continues with a reconstruction

Debenture Ordinary


£ £ £

Expected annual income:

Expected operating profit 150,000

Less: Debenture interest (50,000) 50,000

(12.5% on £400,000)

Less: Dividend on shares (33,000) 33,000

Less: Ordinary dividend (67,000) 67,000

Annual income — 83,000 67,000

Position if company continues

without reconstruction (Continued)

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How will debenture holders

react to the scheme?

• At first glance, debenture holders appear to be

doing reasonably well:

– The £83,000 provides a return of almost 14% on

the amount that they would have received in a

liquidation (83,000/600,000 × 100).

– This exceeds the 10% currently available.

– It is £23,000 more than the £60,000 currently

received.

• However, their exposure to risk has increased

because £33,000 is dependent upon the level of

profits.

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How will ordinary shareholders fare?

• For the ordinary shareholders, the return should be

calculated on the amount that they would have

received on liquidation

– 134% (67,000/50,000 × 100).

– In addition to receiving a return of 134%, they would

hold two-thirds of the share capital, which would give

them control of the company.

• Not good news for the debenture holders also

– If the company were to fail after a reconstruction the old

debenture holders would be materially disadvantaged

as their prior claim will have been reduced from

£600,000 to £400,000.

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Accounting for the reconstruction

Reconstruction account

£000 £000

Income statement 800 Ordinary share capital 1,000

Assets (losses written off) 100 10% debentures

(old debentures cancelled) 600

Ordinary share capital 300

(25p shares)

12.5% debentures 400

(new issue of debentures) 1,600 1,600

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The post-reconstruction statement of

financial position

£

Ordinary share capital (25p) 300,000

12.5% debentures of £1 400,000

700,000

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Buyback of own shares – treasury shares

• In Europe and the USA it is permissible to

buyback shares, known as treasury shares, and

hold them for reissue.

• Two common accounting treatments – the cost

method and the par value method.

• Most common method is the cost method.

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Buyback of own shares – treasury

shares (Continued)

On purchase

• The treasury shares are debited at gross cost to a

Treasury Stock account – this is deducted as a

one-line entry from equity, e.g. a statement of

financial position might appear as follows:

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On resale

• If on resale the sales price is higher than the cost price,

the Treasury Stock account is credited at cost price and

the excess is credited to Paid-in Capital (Treasury

Stock).

• If on resale the sales price is lower than the cost price,

the Treasury Stock account is credited with the proceeds

and the balance is debited to Paid-in Capital (Treasury

Stock).

• If the debit is greater than the credit balance on Paid-in

Capital (Treasury Stock), the difference is deducted from

retained earnings.

Buyback of own shares – treasury

shares (Continued)

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Review questions

2.Why do companies reorganise their capital

structure when they have accumulated losses?

5.Discuss why a company might make a rights

issue at a heavily discounted price and how

equity shareholders would be affected if they did

not take up the issue.

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