Financial accounting 8 - Equity

dexazuxo's version from 2018-01-13 14:40

Section 1

Question Answer
What is total equity?Consists of 3 parts
Issued share capital - stated as par value. if sold for a premium, will go into share premium account.
Non-Distributable reserves - Cannot be distributed to shareholders. share premium, revaluation reserve, capital redemption
Distributable reserves - Distributable to shareholders. e.g. retained earnings.
Entitlement of ordinary vs preference sharesOrdinary shares. Entitled to residual profits after fixed interest and fixed divs paid to preference shareholders. can give voting rights such as matters of divs, strategy etc.
Preference shares. usually fixed rate of divs as % of nominal value. paid before distribution of ordinary share divs. no voting rights.
Types of preference sharesCumulative and non-cumulative. Depends on whether or not payments are accumulated for payment @ later date due to lack of profit or not.
Participating. Participate in distribution of additional profits above their fixed dividend rates.
Redeemable. Option in which company is able to redeem the shares at a later date under agreed conditions.
Convertible. Option in which shareholder has choice to convert to ordinary shares under agreed conditions at agreed date.
Reasons for issuing sharesRaising funds, to fund acquisitions, issued shares instead of dividends, director/employee share option schemes.
Methods for issuing shares. offer for subscription: shares to public, list on stock exchange. a placing: shares placed on financial institutions. a rights issue: new shares offered to existing shareholders.

Section 2

Question Answer
Capital maintenance concept - Creditor protection.
Why is creditor protection necessary? Unincorporated businesses. No need to protect creditors are unlimited liability means personal assets can be take away.
Limited liability companies. creditors have restricted rights over shareholders. so have to make sure shareholders dont distribute assets (divs) to themselves that are needed to meet creditors claims. they can only lose amount invested, and due to legal separation, creditors need protection.
Risks faced by creditors1) Business risk company won't be successful so won't be able to repay
2) Risk that company will be successful but pay shareholders instead of creditors. the legislation in the Companies Act 2006 protects against this and is called capital maintenance.
What is capital maintenance? Requirement by legislation to protect the interest of creditors. involves distributable and non distributable reserves, minimum capital requirements (50,000), reduction of capital.
General rules of capital maintenancea - paid in capital not repayable to shareholders
b - reserves classified under non/distributable reserves
c - directors have discretion to amount recommended for divs from distributable.
d - directors have no discretion for usage of non-distributable reserves.

Section 3

Question Answer
Reduction of issued share capital
When might capital be reduced? When issued shares and premium is paid, its permanent. how there may be reasons for company to reduce their capital:
1. write off capital lost and not represented by assets. if company doing really bad with high retained losses and negative retained earnings, in which they cannot pay dividends for many years, then can reduce capital to absorb the losses. but need court order to approve reduction in capital.
2. purchase of own shares.
Writing off capital already lost due to trading losses. Issue: when company has accumulated trading losses, cannot pay dividends until it is positive. It may discourage any further equity investment in the company BUT can be absorbed by the ordinary shares.
Approach: eliminate this loss by reducing share capital and non distributable.
Stakeholders decision (shareholders and debenture)1. must decide if estimated returns has a reasonable chance of achieving? 2. if allowing company to continue has better return or liquidation? they assess with reconstruction and without.
How may debenture holders react to reconstruction scheme?first glance seems to be doing well as provides a high % of which they would have received in liquidation. However their exposure to risk has increased because a certain amount is dependant on the predicted level of returns. also if company failed after reconstruction, will be bad for debentures because claim reduced.
How may shareholders react? May put them in a better position as will receive more with reconstruction than liquidation.

Section 4

Question Answer
Purchase of own sharesAnother way for company to reduce their capital.
Types of purchases of own shares1. Redemption of redeemable preference shares: required to place with other shares or transfer from distributable to con distributable.
2. Buyback of own shares with intention to cancel: Reasons may include returning funds due to lack of investment opportunities, to protect against hostile takeover, to signal that shares are under-priced, tax efficiency purposes compared to dividend payments. Also, instead of paying dividends, can just buy back shares.
3. Buyback of own shares – treasury shares: Ordinary shares bought back, but not cancelled. Instead held for future re-issue. Can buy back shares for the purpose of issuing them again later on.
Benefits of holding treasury sharesa. Offers a flexibility to reissue if gearing is perceived as too high. Eg. If debts are piling up, can reissue the shares and debts will become more even.
b. Can reissue shares without diluting existing shareholders e.g. to provide employee share options.
Treasury shares accounting treatment - On purchaseWhen you buy your shares, you are giving cash. Therefore, credit cash, and debit something called treasury shares under equity. Treasury shares is one line item which is a negative number as it reduced the equity in bs
Treasury shares accounting treatment - On resale If on resale, the sales price is higher than the cost price, the treasury stock account is credited at cost price and the excess is credited to paid in capital (treasury stock). If on resale the sales price is lower than cost price, the treasury stock account is credited with the proceeds and balance is debited to paid-in capital (treasury stock).
After all this, check if share premium has a credit or debit balance. If credit (positive) keep it there its fine. If it has a debit balance, transfer this loss to retained earnings and it will absorb this.