Share Capital, Distributable Profits and Reduction of Capital Chapter 12 Share Capital, Distributable Profits and Reduction of Capital

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.

Total shareholders’ funds Issued share capital Ordinary (or common) Preference Distributable (via dividends) but must be reduced by any unrealised loss before distributing dividends Reserves: Non-distributable Share premium Capital redemption

Issued share capital Ordinary (or common) entitled to residual income after paying expenses, interest and taxes Risk Residual profit Preference not entitled to residual income, but may be entitled to a: Fixed (or floating) rate dividend Specific prior rights Dividend Return of capital. Cumulative Non-cumulative Participating Redeemable Convertible

Preference shares types Cumulative Dividends accumulate if not paid because of lack of profits Non-Cumulative Dividends not paid are lost Convertible Can be converted to ordinary shares in future based on agreed terms Participating Can get additional dividends once ordinary dividends are distributed Redeemable Company can buy them back at an agreed price

Reasons for share issues In lieu of cash dividends Raising funds Offer for subscription Placing Rights issue Consideration on acquisitions

Accounting for share issues illustration Business Ventures Ltd issued a prospectus for 2 million ordinary shares. A further $1.20 is payable on allotment Note: Why are share issues not always fully paid on allotment? A. Company may not require all funds immediately eg. an expansion plan which may take several months, or years, to complete. Investors holding shares that are not fully paid have a liability for the uncalled capital. The issue is to the public at $3 a share, with $0.80 per share payable on application. and the final $1.00 when called. Note: If an investor sells partly paid shares the liability for the uncalled capital passes to the purchaser. The company received applications for exactly 2 million shares.

Preliminary expenses fees to underwriters and to other professionals providing expert information for the prospectus. legal fees in drawing up the constitution and registering the company developing, registering and printing the prospectus

Preliminary expenses Preliminary expenses $XXX Accounts payable $XXX Preliminary expenses should be written off in the Income Statement in the year in which they are incurred. Preliminary expenses $XXX Accounts payable $XXX Being artwork for prospectus Accounts payable $XXX Bank $XXX Being payment of creditors

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

Accounting for share issues - Allotment (or issue) The directors approve and authorise the issue of shares. The trust account funds transferred to the company’s general funds.

Accounting for share issues Close trust bank account Pay preliminary expenses from net revenue earned on the application monies Shareholders are liable to pay the second instalment of $1.20 per share. The allotment account entry anticipates receipt of this instalment.

Accounting for share issues When a call is made, the journal entry is: When the monies are received, the entry is:

Capital maintenance Rules to protect creditors to prevent company from repaying capital to shareholders (via dividends) when it owes money to creditors. businesses have unlimited liability – all of the owner’s assets may be claimed by creditors to recover amounts owing Owners liable only to the amount they have agreed to pay for the shares owned

Sources of company’s financing Preference investors Loan creditors Trade creditors Ordinary equity investors – Share capital They appoint and renumerate directors Shareholders receive part of residual income and net assets but not unrealised gains such as revaluation reserves Need to make sure outstanding debts are settled before In other words restrict dividends to realised profits

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 test of liquidity Current assets Distribution - Current liabilities test of financial position Assets – Distribution – Liabilities We assume distribution has been made. If the company cannot meet the solvency test on this assumption, the distribution must not be made. Test of liquidity 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). Part 2 of solvency test 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 non-current assets and liabilities, does it still meet the solvency test?

The solvency test Here is part of Company A’s Balance Sheet. Can it pay $200,000 of dividends to shareholders?

The solvency test

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.

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.

Reduction of issued share capital Companies Act permits share capital reduction subject to court order Capital already lost and not represented by assets Repayment of capital – unwanted liquid resources Repurchase of issued shares (Treasury shares) Redemption of shares.

Accounting for reduction due to losses Writing off accumulated losses If a company has accumulated losses instead of retained earnings as part of equity, the directors may appoint new management and cancel shares with a paid-in 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 may show that new management is positive, and if it is successful in returning the company to running surpluses, shareholders can expect to benefit.

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 journal entry would be:

Accounting for reduction due to losses The revised equity structure is:

Buyback of own shares – treasury shares In Europe and USA (and NZ), companies may buy back shares, known as treasury shares, and hold them for reissue Any other shares repurchased by the company must be cancelled immediately. shares held by the issuing company on which rights and obligations (e.g. voting rights and dividends) are suspended. The company cannot exercise voting rights, nor receive any distribution in respect of these shares 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.

A stock buyback Does not affect the company's revenue or profits. It first reduces its cash account on the asset side of the balance sheet by the amount of the buyback.

Illustration Say a company repurchases 100,000 shares for $50 each. The company would subtract $5 million from its cash balance. In the equity section, the company increases the "treasury stock" account by $5 million. Treasury stock represents money paid out to reacquire stock; it is a "contra equity" account that offsets contributed capital, so increasing treasury stock $5 million has the effect of reducing net contributed capital $5 million. The balance sheet is back in balance.

\Stock buyback Common shares : goes up when the company sells to the public. Retained earnings: accumulation of all profits and losses since the company started operations minus the dividends paid to shareholders When a company buys back its shares, it reduces the amount of shares on the market. Usually the share stock increases because shareholders have confidence in the companies growth potential.

Stock buy back Accounting Cash goes down credit to Cash Debit to treasury stock which is a contra account of Equity Therefore overall Assets decrease, equity decreases by the amount spent to buy back the shares and treasury shares increases.

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.

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.

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:

References Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 15th Edition chapter 12