1. Week 9
Equity

2. 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

3. 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)

4. 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.

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

6. SHARE CAPITAL (contd) Issue of shares
At a discount
Dr: Cash 95
Dr: Share discount *
Cr: Share Capital
* 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.

7. 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)

8. 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.

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

10. 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

11. 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

12. 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

13. 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

14. 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.

15. 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 RM1 each, but paid to 80sen each  10m RM0.80 each
(2) To refund any surplus capital
10m RM1 each, fully paid  10m RM0.70 each fully paid & refunds RM0.30 sen per share to shareholder
(3) To cancel paid-up capital not represented by assets

16. (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

17. (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

18. (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

19. 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

20. (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

21. 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

22. 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

23. 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.

24. Example 1 Reduction Bhd Statement of financial position as at 31/12/x9RM
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

25. 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.

26. 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

27. 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.

28. Example 1 (Contd.) Accounting entries:
Dr Capital reduction account 180,000
Cr Accumulated losses ,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 ,000
Being assets written down to current values.

29. 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 ,000
Settlement of overdraft.

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

31. 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.

32. 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.

33. 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.

34. 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

35. 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.

36. 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, % 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.

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

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

39. 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.

40. Effect of liquidating
Effect of liquidating Debenture Ordinary holders shareholders
RM RM RM
Assets realised ,000
Less: Prior claim (600,000) 600,000
Less: Ordinary shareholders (50,000) , — , ,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.

41. Position if company continues without reconstruction
Debenture Ordinary holders shareholders
RM RM RM
Expected annual income:
Expected operating profit ,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.

42. 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

43. 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.

44. 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.