Week 9 Equity

EQUITY Is the residual claim against the assets of a business, after all creditors are paid Assets – Liabilities = Equity Source of financing of a business from the owners (shareholders) by way of the issue of shares, and internally generated (eg retained profits). Comprises of 2 components – Share Capital and Reserves

Statement of Financial Position as at … (date) RM’000 EQUITY Share Capital 100,000 Reserves 45,000 Total Equity 145,000 LIABILITIES (non-current and current) 95,000 230,000 ASSETS (non-current and current)

Measurement of Equity (Share Capital) Equity instruments are initially measured at fair value less any issue costs. Any issue cost is written off against an existing Share Premium or Retained Profits (if no Share Premium or Share Premium is insufficient) Subsequently, equity instruments are not remeasured. Any change in the fair value of the shares is not recognised by the entity.

Share Capital Shares may be issued at nominal (par), at a premium or at a discount. At par: Dr: Cash 100 Cr: Share Capital 100 At a premium Dr: Cash 110 Cr: Share Premium 10

SHARE CAPITAL (contd) Issue of shares At a discount Dr: Cash 95 Dr: Share discount 5 * Cr: Share Capital 10 * The discount on issue of shares is a loss and usually written off against (i) an existing Share Premium and/or (ii) Retained Profits (if no Share Premium or Share Premium is insufficient). Note: When the Companies Act 2013 is enacted, the issue of shares at a premium and at a discount will no longer be applicable.

Reserves Are profits/ gains/ surpluses retained by the entity Are part of Equity, but kept separate from capital (ie separately presented) Two categories: Distributable (can be distributed to shareholders as cash dividends and stock dividends) Non-distributable (cannot be used for cash dividends. Some eg share premium can be distributed as stock dividends ie bonus shares)

Distributable reserves (Or Revenue reserves) Examples: Retained profits General reserves Asset replacement reserves Sinking fund reserves Any other reserves appropriated out of realised profits General reserves = Funds set aside from the retained earnings. General reserves can be divided into either specific, general or legal. Specific reserves can include a reassignment of dividends to shareholders; general reserves are saved to offset potential future losses; legal reserves can include money set aside for litigation or revaluation. Asset replacement reserves = Funds set aside for the replacement of wasting assets. Sinking fund reserves = The purpose of a sinking fund is to build up a fund to pay for major repairs and major plant and equipment replacements, such as lifts, air conditioning, roofs. These expenses are less frequent and the sinking fund will specify exactly what the funds will be used for.

Undistributable reserves (Capital reserves) Examples: Share premium Capital Redemption Reserves Revaluation reserve

Capital maintenance Rules to protect creditors Directors have discretion on dividend policy (paid out from distributable reserves) Non-distributable reserves need to be maintained to protect creditors

Creditor protection – why necessary? Unincorporated businesses (sole proprietorship, partnership) Owners free to introduce/withdraw capital Unlimited liability – owners are personally liable for liabilities incurred, creditors can have recourse to personal assets of owners Limited liability companies Restricted rights against shareholders Shareholders not personally liable Creditors restricted to making claims against assets Assets need to be maintained

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 & reduction of capital

Reduction of issued share capital 3 reasons why this may be done: Capital already lost and not represented by assets Repayment of capital – unwanted liquid resources Redemption of shares

Distributable profits: effect of accumulated trading losses Without a capital reduction, the profits must be used to reduce the accumulated losses. This means that the company would be unable to pay a dividend for future years if it continued at that level of profitability and ignoring tax. It would not be attractive for shareholders to put additional capital into the company because they would not be able to obtain any dividend for some years. Reduction affecting only equity shareholders Existing losses eliminated No need to make good in future years Distribution from future profits not diverted to cover losses.

Reduction of capital – Companies Act 1965 S.64 of CA65 permits a company to reduce its capital provided that: Scheme must be confirmed by court Articles of association provides for reduction of capital A special resolution was passed by the company S.64 of CA65 - a company can reduce its capital in the following 3 situations: (1) To reduce/write-off the uncalled capital on its shares E.g. 10m shares @ RM1 each, but paid to 80sen each  10m shares @ RM0.80 each (2) To refund any surplus capital 10m shares @ RM1 each, fully paid  10m shares @ RM0.70 each fully paid & refunds RM0.30 sen per share to shareholder (3) To cancel paid-up capital not represented by assets

(1) Reduction or write-off of uncalled capital Due to excess capital or shares are only partly called up No accounting transaction  no funds leave or enter the company Pool of potential funds available to company (uncalled capital) is now non-existent Memorandum entry made to recognise the change in the par value of the shares

(2) Refund of surplus capital Existence of excess cash balances & low return on capital Detrimental as it may not be able to meet shareholders’ expectations of higher return, DPS or EPS  share price may fall Reduce par value of shares & refund the surplus capital to shareholders  there is an outflow of funds Accounting entries: Dr Ordinary share capital Cr Bank Creditors have a right to object to the proposed capital reduction Court will confirm the capital reduction only afeer the creditors’ claims are satisfied, settled or secured & their consent obtained

(3) Capital reduction due to losses (capital not represented by available assets) When company has incurred heavy losses and has been unable to pay dividends to shareholders for a number of years 2 courses of action: Liquidate – disposal of assets, settlement of liabilities, distribution of remaining assets to shareholders Undergo reconstruction Undertaken only when company has evidence that it can make profits in the near future & be able to pay dividends to shareholders

Statement of Financial Position as at 31/12/2014: (3) Capital reduction due to losses (capital not represented by available assets) CR Sdn. Bhd. Statement of Financial Position as at 31/12/2014: RM Non-current tangible assets 200,000 Intangibles 20,000 Current assets 30,000 250,000 Ordinary shares of RM1 each 600,000 Accumulated losses (400,000) Current liabilities 50,000

(3) Capital reduction due to losses (capital not represented by available assets) Accumulated losses have eroded the capital Recoverable amount of assets may be less than the carrying value Negative working capital  cash flow problem What can the company do? Take positive steps to earn profits with potential dividend payments Adjust carrying amount of assets Write off accumulated losses Reduce paid up capital Secure additional funds to trade & expand Issue additional shares to raise funds

Devising a capital reconstruction scheme To ensure that the capital that is ‘lost’ is written off against claims of various parties affected by the adverse financial situation faced by the company Normally ordinary shareholders will be the ones to absorb the largest amount of losses Preference shareholders, debenture holders & creditors may be also willing to absorb losses

Devising a capital reconstruction scheme Factors to be considered to determining the amount of capital that is lost and how this loss should be allocated: Determine the total amount to be written off Eliminate acc. losses Revalue assets, write-up/down to fair values Rights of various creditors must be considered. May accept reduction on claims, or convert claims to shares Ordinary shareholders take the major loss as they are the risk bearers. Preference dividends in arrears. Shareholders may waive this

Devising a capital reconstruction scheme Factors to be considered to determining the amount of capital that is lost and how this loss should be allocated: 5. Determine the amount of loss the preference shareholders could bear. May be willing to accept reduction in paid up capital, especially if they do not have preferential right to repayment of capital over ordinary shareholders. Amount to be written off cannot be as large as that for ordinary shareholders Amount of dividend to be received in the future would be less after the reduction 6. Scheme should be equitable to all affected parties.

Example 1 Reduction Bhd Statement of financial position as at 31/12/x9 RM Land and building 100,000 Motor vehicles 50,000 Plant Inventories Trade receivables 40,000 290,000 Ordinary shares of RM1 each 300,000 Accumulated loss (180,000) 120,000 Trade payables 80,000 Bank overdraft 90,000

Example 1 (Contd.) The following values are applicable to the assets of the company: As a going concern (Value in use) If liquidate (Selling price) Land and building 100,000 Motor vehicles 40,000 20,000 Plant 30,000 Inventories 50,000 5,000 Trade receivables The directors decided to draw up a scheme of reconstruction.

Example 1 (Contd.) Determine the loss: Assets at revalued amounts: RM Land and building 100,000 Motor vehicles 40,000 Plant 30,000 Inventories 50,000 Trade receivables 260,000 Less: Current liabilities (170,000) Net assets 90,000 Paid up capital 300,000 Loss of capital 210,000

Example 1 (Contd.) As there is only 1 class of shares, all of the loss may be borne by the ordinary shareholders Proposed scheme: Ordinary shares were reduced to RM0.30 per share fully paid up Existing ordinary shareholders have agreed to take up 2 fully paid up ordinary shares for every 1 held (rights issue) Part of the cash raised by this issue is to be used to settle the bank overdraft A special resolution was passed, and the approval of the court was obtained for the scheme.

Example 1 (Contd.) Accounting entries: Dr Capital reduction account 180,000 Cr Accumulated losses 180,000 Accumulated losses written off. Dr Ordinary shares 210,000 Cr Capital reduction account 210,000 Reduction of share capital (from RM1 to RM30 sen per share) Dr Capital reduction 30,000 Cr Motor vehicles 10,000 Cr Plant 20,000 Being assets written down to current values.

Example 1 (Contd.) Accounting entries: Dr Bank 180,000 Cr Ordinary shares 180,000 Being cash received for 600,000 ordinary shares of 30 sen each, fully paid. Dr Bank overdraft 90,000 Cr Bank 90,000 Settlement of overdraft.

Capital reduction account: Example 1 (Contd.) Capital reduction account: RM Profit and loss balance 180,000 Ordinary shares 210,000 Motor vehicles 10,000 Plant 20,000 210,000

Example 1 (Contd.) Reduction Bhd Statement of financial position as at 31/12/x9 (After the reconstruction) RM Land and building 100,000 Motor vehicles 40,000 Plant 30,000 Inventories 50,000 Trade receivables Bank 90,000 350,000 900,000 ordinary shares of 30 sen each 270,000 Trade payables 80,000 The statement of financial position after the capital reduction shows that the share capital fairly reflects the underlying asset values.

Accounting for 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.

Accounting for reduction where losses are borne by more stakeholders (Continued) Accounting entries – Only change is that the balance on the capital reduction account is not transferred to ordinary share capital. Dr Share capital Dr More stakeholders Preference shares – loan creditors and trade creditors Cr Capital reduction account.

Example 2 XYZ plc has been making trading losses. The statement of financial position of XYZ plc as at 31 December 2014 was as follows: RM’000 Ordinary share capital (RM1 shares) 1,000 Less: Accumulated losses (800) 200 10% debentures (RM1) 600 Net assets at book value 800

Example 2 (Continued) Information prior to decision: The company is changing its product and markets and expects to make RM150,000 profit before interest and tax every year from 1 January 2015. The estimated break-up or liquidation value of the assets at 31 December 2014 was RM650,000. The going concern value of assets at 31 December 2014 was RM700,000.

Example 2 (Continued) Proposed reconstruction scheme Write off losses and reduce asset values to RM700,000. Cancel all existing ordinary shares and debentures. Issue 1,200,000 new ordinary shares of RM0.25 each and 400,000 12.5% debentures of RM1 each as follows: Existing shareholders are to be issued with 800,000 ordinary RM0.25 shares. Existing debenture holders are to be issued with 400,000 ordinary RM0.25 shares and the debentures.

Accounting for the reconstruction Capital reconstruction account RM’000 RM’000 Accumulated losses 800 Ordinary share capital 1,000 Assets (losses written off) 100 10% debentures (old debentures cancelled) 600 Ordinary share capital 300 (RM0.25 shares) 12.5% debentures 400 (new issue of debentures) 1,600 1,600

The post-reconstruction statement of financial position RM Ordinary share capital (RM0.25) 300,000 12.5% debentures of RM1 400,000 700,000 Net assets 700,000

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 2014; 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.

Effect of liquidating Effect of liquidating Debenture Ordinary holders shareholders RM RM RM 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.

Position if company continues without reconstruction Debenture Ordinary holders shareholders RM RM RM 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 RM800,000 has been eliminated; i.e. there will be no dividend for more than 9 years.

Position if company continues without reconstruction (Continued) Company continues with a reconstruction Debenture Ordinary holders shareholders RM RM RM Expected annual income: Expected operating profit 150,000 Less: Debenture interest (50,000) 50,000 (12.5% on RM400,000) Less: Dividend on shares (33,000) 33,000 Less: Ordinary dividend (67,000) 67,000 Annual income — 83,000 67,000

How will debenture holders react to the scheme? At first glance, debenture holders appear to be doing reasonably well: The RM83,000 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 RM23,000 more than the RM60,000 currently received. However, their exposure to risk has increased because RM33,000 is dependent upon the level of profits.

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 2/3 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 RM600,000 to RM400,000.