Slide 12.1
Chapter 12
Share Capital, Distributable Profits
and Reduction of Capital
Slide 12.2
Objectives
After completing this chapter, you should be able to:
• describe the reasons for the issue of shares;
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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.
Slide 12.3
Total shareholders’ funds
• Issued share capital
• Non-distributable reserves
• Distributable reserves.
Slide 12.4
Nature of company shares and share
transactions
Issues involving contributions from and
distributions to company shareholders
Equity is defined as
‘... The residual interest in the assets of the
entity after deducting all its liabilities
Or, equity = assets – liabilities
Does this mean that equity is the result of
the activity of assets and liabilities?
Slide 12.5
Issued share capital
Ordinary
 Risk
 Residual profit
Preference
 Fixed rate dividend
 Specific prior rights
 Dividend
 Return of capital.
Slide 12.6
Non-distributable reserves
Statutory
 Share premium
 Capital redemption
Contractual
 Restrictions within memorandum.
Slide 12.7
Distributable reserves
Retained profits
Treatment of unrealised profits
Importance of EPS figure when deciding on
capital structure.
Slide 12.8
Reasons for share issues
Raising funds
On acquisitions
In lieu of dividends
Director/Employee share option schemes.
Slide 12.9
Methods of raising equity capital
An offer for subscription
A placing
A rights issue.
Slide 12.10
Possible rights for preference shares
Cumulative
Non-cumulative
Participating
Redeemable
Convertible.
Slide 12.11
Accounting for share issues
 Accounting procedure
 Business Ventures Ltd issued a prospectus for 2
million ordinary shares.
 The issue is to the public at $3.00 a share, with
$0.80 per share payable on application.
 A further $1.20 is payable on allotment, and the
final $1.00 when called.
 We shall assume the company received
applications for exactly 2 million shares
Slide 12.12
Accounting for share issues
The general process is:
Initial application
Allotment (or issue)
Calls
Slide 12.13
Accounting for share issues
 Initial application
 investors are not entitled to any shares until the
directors make a formal allotment
 all share application monies must be held in a
trust account
the journal entry is:
Slide 12.14
Accounting for share issues
 Allotment
 The directors approve and authorise the allotment of
shares
 trust account funds transferred to the company’s general
funds.
Slide 12.15
Accounting for share issues
 trust bank account can now be closed
 Net revenue earned on the application monies is
used to defray preliminary expenses
 Applicants are now shareholders, and are liable to
pay the second instalment of $1.20 per share. The
allotment account entry anticipates receipt of this
instalment. Journal entry is:
Slide 12.16
Accounting for share issues
 Why are share issues not always fully paid allotment?
 Company may not require all funds immediately eg.
an expansion plan which may unfold over an
extended period of time
 Investors holding shares that are not fully paid have a
liability for the uncalled capital
 Calls
 If an investor sells partly paid shares the liability for
the uncalled capital passes to the purchaser
 Instalments subsequent to allotment are termed calls
Slide 12.17
Accounting for share issues
 When a call is made, the journal entry is:
 When the monies are received, the entry is:
Slide 12.18
Capital maintenance
Rules to protect creditors
 Directors’ discretion on dividend policy
 Effect of non-distributable status.
Slide 12.19
Creditor protection – why necessary?
Unincorporated businesses
 Unlimited liability
Limited liability companies
 Restricted rights against shareholders.
Slide 12.20
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.
Slide 12.21
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.
Slide 12.22
Distributable profits – private
companies (Continued)
Maintain permanent capital as at end of the
previous year
Distributable
 Retained realised profit brought forward
 Adjusted for net realised current year profit.
Slide 12.23
Distributable profits – public
companies
Undistributable reserves are
 Share capital
 Statutory undistributable reserves
 Contractual undistributable reserves
 Excess of accumulated unrealised profit over
accumulated unrealised losses.
Slide 12.24
The solvency test
 In New Zealand, before making any distribution to
shareholders, section 52 of the Companies Act 1993
requires the directors to test the solvency of the
company
 The solvency test is conducted on the assumption
that the distribution has been made. If the company
cannot meet the solvency test on this assumption,
the distribution must not be made.
 There are two parts to the solvency test:
a test of liquidity, and
 a test of financial position.
Slide 12.25
The solvency test
 Liquidity test
 Can the company pay its debts as they fall due in its
normal business operations? The directors must ensure
that the necessary cash flow is available, as the
company’s creditors always take precedence over
shareholders.
 It is not enough that a company has a lot of assets. It
must be able to fund in cash any liability as it falls due in
the normal course of business.
 The liquidity test looks at the assets that can be turned to
cash in the normal course of business – current assets,
eg. accounts receivable, inventory, and call deposits –
and the robustness of its revenue stream(s).
Slide 12.26
The solvency test
 Here is part of Company A’s Balance Sheet. Can it pay
$200,000 of dividends to shareholders?
Slide 12.27
The solvency test
 The directors have proposed a distribution of
$200,000. Can it pass the liquidity test?
 Immediately after the distribution was made, the
company would have liquid assets of $173,000
($373,000 – $200,000 = $173,000) to meet
liabilities of $140,000.
 It passes the liquidity test.
Slide 12.28
The solvency test
 Financial position test
 Part 2 of the solvency test looks at?
 The overall financial structure of the company.
 It is a valuation exercise to establish that the
company’s assets exceed its liabilities as at the
date of the distribution.
 If Company A has the following additional noncurrent assets and liabilities, does it still meet the
solvency test?
Slide 12.29
The solvency test
Slide 12.30
The solvency test
 Immediately after the distribution, the company would
have assets of $1,133,000 to meet liabilities of
$1,160,000. It fails the financial position (Balance
Sheet) test, and accordingly the distribution of
$200,000 may not be made.
 Would the situation change if Company A also had
some internally generated intangible assets, say
$300,000 of brand names and $100,000 of
mastheads – making total assets $1,733,000?
 No – it is unlikely that these would have value in a
forced sale.
Slide 12.31
The solvency test
 The solvency test is not a casual exercise.
 Directors cannot rely solely on the last set of audited
financial statements. They must also consider
financial activities and contingencies arising after the
date of the financial statements.
 If a company makes a distribution and is later found
not to have met the solvency test, the shareholders
can be required to pay back the distribution (section
56, Companies Act 1993).
 Additionally, by signing the solvency certificate,
directors can be held personally liable for the
company’s debts and suffer fines and other penalties.
Slide 12.32
Implications of IAS compliance
on distributions
Requirement for consolidated accounts of
listed companies to comply with IASs and
IFRSs
These standards will affect both the
disclosure and measurement of items
appearing in the income statement and
statement of financial position.
Slide 12.33
Implications of IAS compliance
on distributions (Continued)
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.
Slide 12.34
Implications of IAS compliance
on distributions (Continued)
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.
Slide 12.35
Implications of IAS compliance
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.
Slide 12.36
Implications of IAS compliance
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.
Slide 12.37
Implications of IAS compliance (Continued)
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.
Slide 12.38
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?
Slide 12.39
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.
Slide 12.40
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.
Slide 12.41
Distributable profits:
accounting for reduction due to losses
Debit capital reduction account
Credit profit and loss account
Debit share capital
Credit capital reduction account.
Slide 12.42
Accounting for reduction due to losses
 Writing off accumulated losses
 If a company has accumulated losses instead of retained
earnings as a component of equity, the directors may
appoint new management and cancel shares with a paidin value sufficient to write the accumulated losses off.
 Is this harsh treatment for the shareholders who lose part
of their investment?
 If the company continues running losses, eventually the
shareholders would lose all their investment. Writing off
accumulated losses can be a signal that new
management is positive, and if it is successful in returning
the company to running surpluses, shareholders can
expect to benefit.
Slide 12.43
Accounting for reduction due to losses
 A company has the following equity structure:
 The paid-in capital comprises 1,500,000 ordinary shares.
The new board and executive management, after a careful
assessment of the company’s prospects, have proceeded
with a cancellation of 825,000 ordinary shares with a paid-in
value of $2 each. The proceeds are to be used to write off
accumulated losses. The following journal would be made:
Slide 12.44
Accounting for reduction due to losses
 The revised equity structure is:
Slide 12.45
Distributable profits: accounting for
reduction due to trading and asset value
losses.
Distributable profits: accounting for
reduction where losses are borne by more
stakeholders
We will skip this in class as there is not
enough time available to cover this part of
the topic.
Slide 12.46
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?
Slide 12.47
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?
Slide 12.48
Buyback of own shares – treasury shares
In Europe and 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.
Slide 12.49
Buyback of own shares – treasury shares
 Treasury stock
 These are shares held by the issuing company on which
rights and obligations (e.g. voting rights and dividends)
are suspended.
 A company acquiring its own shares may retain up to 10%
of repurchased shares as treasury stock provided the
rights and obligations attaching to these shares are
suspended.
 The company cannot exercise voting rights, nor receive
any distribution in respect of these shares.
 Any other shares repurchased by the company must be
cancelled immediately.
Slide 12.50
Buyback of own shares – treasury shares
On purchase
 The treasury shares are debited at gross cost to a
Treasury Stock account – this is deducted as a oneline entry from equity, e.g. a statement of financial
position might appear as follows:
 When the treasury stock was repurchased, paid-in
capital was not reduced: it remained at ₤1.00 per
share
Slide 12.51
Buyback of own shares – treasury shares
 If the company repurchases 500 shares at $2.50 each, and
holds these as treasury stock, the journal entry is:
 And the equity structure could look like this:
 When the treasury stock was repurchased, paid-in capital was
not reduced: it remained at $2.00 per share
Slide 12.52
Buyback of own shares – treasury shares
 Treasury stock is recorded as a negative
component of equity.
 It is not an asset. Why?
 These shares cannot produce service potential or
future economic benefits so they do not meet the
definition of assets.
Slide 12.53
Buyback of own shares – treasury shares
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.
Slide 12.54
Buyback of own shares – treasury shares
 If 500 shares of treasury stock are re-issued at
$4.00 per share, the journal entry would be:
 The company paid $2.50 on the market and resold
at $4.00. The difference of $1.50 per share is the
$750 net increase in paid-in capital.
Slide 12.55
Redemption of shares
Companies may issue a separate class of
share called redeemable shares.
Normally, these are a type of preference
share, and redemption may be at the option
of either the company or the shareholder.
If the shares are redeemable at the option of the
company, all holders must be treated equally. In
addition, the company must be able to satisfy the
solvency test before redemption is undertaken.
Slide 12.56
Redemption of shares (Continued)
If the shares are redeemable at the option of the
holder, then the company redeems only those shares
where an option is exercised. However, if any shares
are not redeemed by the shareholders, they become
part of the company’s liabilities.
 On redemption, the shares are deemed to be
cancelled and so the journal entry is of the form:
Slide 12.57
Review questions
2. Why do companies reorganise their
capital structure when they have
accumulated losses?