Semester 2 Week 5 PP (Capital accounting) Flashcards
What 4 things can we see in equity?
In this course we will see four possible things in equity:
Share capital
Share premium
Retained earnings
Revaluation reserve
What are the two most common kind of shares?
Ordinary shares and the other type of share capital is preference shares
Preference shares usually do not have an entitlement to a vote in the company, and receive a fixed dividend. They are usually held as liabilities rather than equity.
How are shares priced and how do we journal them?
Every share has a nominal or par value, for example:
Pascoe has 30,000 £1 shares – the nominal value is £1
It is illegal to issue shares at below their nominal value.
Dr Bank
Cr Share capital
Being issue of share capital
Quite often shares will sell for considerably above nominal value.
In this case the additional amount is not a gain in the P&L but is recorded as something called share premium.
Dr Bank
Cr share capital
Cr share premium
Being issue of shares at premium
Tranter has shares with a nominal value of £1.
They issue 100,000 new shares for cash at £1.50 each.
Cash will increase by £150,000
Share capital will increase by £100,000
Share premium will increase by £50,000
Dr Bank £150,000
Cr Share capital £100,000
Cr Share premium £50,000
Being issue of shares at a premium
Bryson has £200,000 worth of 50p ordinary shares.
They pay a dividend of 2p per share
How would this be recorded?
£200,000 of 50p ordinary shares means that they have 400,000 ordinary shares
400,000 shares x 2p = £8,000
This would reduce both cash and retained earnings by £8,000
Dr Retained earnings £8,000
Cr bank £8,000
Being dividend paid
Where do dividend payments come from?
Dividends can only be paid from retained earnings they can’t be paid from share capital or share premium.
There is no legal requirement for a company to ever pay a dividend.
Dividends are usually set by the directors and confirmed by shareholders at annual meetings.
A dividend declared but not paid before the year end would be a liability.
What do we call it when we create new shares for existing shareholders?
It is possible to create new shares for existing shareholders, this is called a bonus or scrip issue.
Essentially any reserve is taken and turned into shares. In a set ratio based on existing shareholdings.
The shares are issued at nominal value – there is no premium.
Lawrence Limited currently has 600,000 £1 ordinary shares is issue. The company decides to do a 1-for-2 share issue out of retained earnings.
Prepare the journal to account for this.
600,000 existing £1 shares, as a 1-for-2 issues this means for every two shares a shareholder has they will receive an additional “bonus” share.
600,000/2 = 300,000 new £1 shares
Issued from retained earnings
Dr Retained earnings £300,000
Cr Share capital £300,000
Being issue of shares in bonus issue
What are pre-emption rights?
Imagine you owned 60,000/100,000 (60%) of the shares in a company.
The company then issues a further 100,000 shares.
Your holding now goes down to 60,000/200,000 or 30%.
Would you be happy?
Almost certainly not!
For this reason there exists in law something called statutory pre-emption rights this means that when new shares are issued first refusal must go to existing shareholders in proportion to their current holding.
In this example that would mean that you would have to receive the opportunity to buy 60% of any new shares issued. Almost certainly not!
For this reason there exists in law something called statutory pre-emption rights this means that when new shares are issued first refusal must go to existing shareholders in proportion to their current holding.
In this example that would mean that you would have to receive the opportunity to buy 60% of any new shares issued.
What are rights issue?
This essentially involves raising funding from existing shareholders through allowing them to buy shares at a reduced price based on their existing shareholding.
This solves some problems:
The company receives its funding
The shareholders buy shares at a “bargain price”
No issue with pre-emption rights (only goes to existing shareholders)
How are Rights issues treated?
The journal for a rights issue is just the same as any other issue. The detail is really in the calculation.
Note: Shareholders have the option not the obligation to buy shares under a rights issue.
Dr bank
Cr share capital
Cr share premium
Being issue of shares under rights issue
Rights Issue Example:
Rosen Plc. currently has 600,000 £1 ordinary shares which are currently trading on the stock market at a value of £5.50 per share.
Rosen Plc undertakes a 1-for-3 rights issue for £2.50 per share. 80% of shareholders take up this deal.
Prepare the journal to account for this rights issue.
So a 1-for-3 rights issue with 600,000 existing shares means
600,000/3 = 200,000 potential new shares in issue
However, only 80% uptake this offer therefore
80% x 200,000 = 160,000 new shares
Total amount raised = 160,000 x £2.50 = £400,000
Nominal value of new shares = 160,000 x £1 = £160,000
Share premium per share = £2.50 - £1 = £1.50
Total share premium = 160,000 x £1.50 = £240,000
Dr bank 400,000
Cr share capital 160,000
Cr share premium 240,000
Being issue of shares under rights issue
What are the different models of capital maintenance?
Financial capital maintenance (most commonly used):
The simplest model – looking at the change in capital.
For example:
Kilburn Limited
20X5 20X6
Total equity £1,000,000 £1,300,000
The total equity has increased by £300,000
Grange Limited was founded in 20X1 with initial equity of £1,000,000.
15 years later it has total equity of £1,900,000
According to the financial capital maintenance model it has increased in value by £900,000
But has it really?
Capital maintenance:
Over the past 15 years inflation would have had an impact.
In other words £1,000,000 15 years ago is worth more (would buy you more ‘stuff’) that £1,000,000 now.
£1,900,000 now is worth less now than 15 years (would buy you less stuff).
Therefore although you’ve earned an additional £900,000 in absolute terms that doesn’t account for inflation.
Real financial capital maintenance:
The real financial capital maintenance model takes this into account by updating opening capital to current value – in other words taking into account inflation. The movement therefore shows the real increase in equity, excluding inflation.
Physical capital maintenance:
Looks at the production capacity of the entity. Essentially the company should only recognise an increase in equity if their physical capacity for production has increased.
Physical capital maintenance example:
Burgon Limited produces aircraft tyres. Their current production capacity is 20,000 tyres.
What would be the production for a decrease, stable and increased capital label.
If at the end of the year they can produce 19,000 tyres they have had a decrease in capital.
If at the end of the year they can produce 20,000 tyres capital has remained stable.
If at the end of the year they can produce 24,000 tyres capital has increased.
How do we show the movement of equity?
Statement of changes in equity. One of our primary statements – essentially a table showing what is in equity and how it has moved.
Statement of changes in equity example:
At 31 December 20X4 Hamilton Ltd. has share capital of £500,000, share premium of £300,000 and retained earnings of £1,200,000.
Over the year to 31 December 20X5 Hamilton makes a profit of £700,000. On 1 April 20X5, Hamilton issues 100,000 £1 ordinary shares for £150,000.
Prepare the statement of changes in equity for Hamilton for the year ended 31 December 20X5.
