Week 8: Capital Maintenance & Capital Reorganisation Flashcards
What is capital maintenance?
CAPITAL MAINTENANCE isan Accounting concept that focuses on preserving the productive capacity or economic value of a business over time.
Helps ensure that a company maintains sufficient resources to continue its operations and generate future income, by reinvesting profits or raising additional capital as needed
Helps prevent the erosion of a company’sassetbase due to excessive distributions to owners or inadequate reinvestment in its operations.
This means that dividends cannot be paid if there are brought forward retained losses
What are capital reserves?
These kinds of profits do not arise from normal business activities and cannot be distributed as dividends.
They can be:
Held to finance long-term projects (profit from sale of fixed assets)
Used for capital redemption
Used to offset future losses on revaluation/impairment of non-current and intangible assets
What are revenue reserves?
These kinds of distributable profits arise from normal operations and can be distributed as dividends.
They can also be set aside for special purposes:
Created to increase working capital of the company, kept for uncertain emergencies
Created to meet specific precise expenses or contingencies
What is the solvency statement?
The solvency statement must confirm, after reviewing of financial and cash flow statements, that the company is solvent and can meet all obligations in the next year.
The solvency procedure is as follows:
the directors resolve to propose a share capital reduction
the directors sign the solvency statement
the members pass the special resolution
the solvency and compliance statement, special resolution and a statement of capital is filed at companies house within 15 days of passing the speical resolution
What is a special resolution?
If the company is a PLC, they must obtain a special resolution from members and have this approved by the courts to protect creditors and other other classes of stockholders like preference shareholders.
a special resolution requires at least 75% of votes.
Can you pay dividends if you have plenty fo cash?
the basic rule is that a companys distrubtions can be made out of “ its accumalted realsied profits so far as not previously utilisd by distrubtuion or capitalisation less its accumalted. realied losses so far as not previously written off in a reduction or reorginisation of capital duly made.
On the 31/12/21, ABC plc has
300,000 £1 ordinary shares
Retained losses of £180,000.
It now expects profits of £18,000 p.a. from now onwards and wants to pay dividends, However, under company law, they would not be able to pay a dividend for 10 years
They can obtain a special resolution of the shareholders, and court approval, to reduce the par value of outstanding shares to a lower amount and use the difference to eliminated retained losses.
They need to generate £180,000.
By how much should they reduce the par value?
If you divide the losses into the share capital, you can work out how much you should reduce the par value. Here losses are 60% of the share capital.
180,000/300,000 = .60 or 60p
If par value is reduced to £1 – 60p = 40p they can generate £180,000 from the 60p to cover brought forward losses of £180,000.
300,000 x £0.60 = £180,000
This reduces share capital from 300,000 £1 shares to 300,000 40p shares
40p x 300,000 = £120,000
Required: Prepare the Journal entries for this and closing Statement of changes in Equity.
ACCUMULATED LOSSES
First transfer retained losses from RETAINED EARNINGS
Post to a CAPITAL REDUCTION ACCOUNT
SHARE CAPITAL
Reduce SHARE CAPITAL by 60% or 60p per share
Post to CAPITAL REDUCTION ACCOUNT which maintains capital balance.
What are the pros of capital reduction, eliminta eretained losses bought forward?
the pros:
can simplify a company’s share structure, making it more effecient
reduces bought forward retained losses
allows a company to pay dividends if they can show they will return to profitabiltiy
What are the cons of capital reduction to eliminate retained losses bought forward?
The cons are:
can be costly as needs specila resolutions from sharreholders, a solvency statement from directors and the courts approval.
can created a red flag for creditors/loan providors/ shareholders and affect the market price of the shares and their credit
could result in companies house to reregister if their share capital falls below 50,000
What is capital reduction by reducing par value?
a company may have lots of cash but large accumulated losses but still be unable to pay dividendsds under the companies act 2006
capital reduction allows the elimination of accumulated losses which have a negative impact on retained profits and prevent payment of dividends to shareholders
clearing these losses with a capital reduction may be appropiate if the company has been trading at a loss
ABC plc has 200,000 £1 ordinary shares but has incurred accumulated losses of £180,000. (a debit balance in retained profits)
Company reduces share capital to £20,000=10p x 200,000
Q: What are the journal entries to record this transaction?
Accumulated losses are first removed from RETAINED EARNINGS and put in a CAPITAL REDUCTION ACCOUNT.
Then SHARE CAPITAL IS REDUCED and a matching amount is put in the CAPITAL REDUCTION ACCOUNT, reducing R/E to 0 and Share Capital to £20K.
What is a sahre buy back for capital reduction?
a company may find it has too much liquidity, and wants to return capital to shareholders.
this may be becuase there was a failed merger after issuing new sahres so excess cash
the excess shares mean profit redistrubution is spread across a larger base so return on shares may be lower
shares can be repurchased and cancelled completly or held as treaury shares in shareholder equity
requires court and shareholder approval
What is the process of capital reduction by share buy back?
must get court and shareholder approval
the company purchases the required shares privatley or through an arms length transaction in an investment market.
cash is paid and retained earnings and cash are reduced for the fulll purchase price
a transfer is made from share capital redepmtion account for the par value of shares repurchased to maintain permenant capital
the company can only then use the redemption reserve to issue bonus shares
20,000 £1shares, with a nominal value of £20,000, are purchased at a premium for £2.00 each and cancelled.
Q: What are the journal entries to record this transaction?
First the purchase must be from distributable profits (RETAINED EARNINGS) and (CASH).
Then a transfer must be made for the par value of shares from (SHARE CAPITAL) to non-distributable reserves (CAPITAL REDEMPTION ACCOUNT) to maintain permanent capital of £100,000.
debit 40k to retained earnings
credit 40k to cash (CA in SOFP)
20k £1 par value shares are repurchased for 2.00 each so proceeds are 40k
share capital debit 20k
redpemtion reserve credit 20k
what are the pros of a share repurchase?
tax effecint
a way of returning excess cash to shareholders
can increase remaining shareholder % so they get higher dividends
can be used to faciulitate a sharehodler exit
