Components of equity

We’ve already seen that the accounting equation is the basis for preparing the statement of financial position. In that equation, equity is more than just share (equity) capital. To prepare the equity section correctly, you need to know the main components of equity and how common equity transactions (like share issues and dividends) affect them.

This chapter covers the other components of equity as well as dividends.

Learning objective

By the end of this chapter, you should be able to:

• Describe the nature of equity, including retained earnings and other components of equity.
• Identify and record the other components of equity that may appear in the statement of financial position.
• Define an issue of bonus shares and its advantages and disadvantages.
• Define a rights issue and its advantages and disadvantages.
• Calculate and record an issue of bonus shares in the statement of financial position.
• Calculate and record a rights issue in the statement of financial position.
• Calculate and record dividends in the general ledger accounts and the financial statements.
• Identify the components of the statement of changes in equity.

Components of equity

Equity can be categorized into:

1. Share capital - see previous chapter
2. Reserves

Definitions

Reserves

It is the portion of equity that represents profits or gains set aside for specific purposes or arising from particular transactions. Reserves can be broadly classified into two categories. Namely:

3. Revenue reserves (distributable Reserves)
4. Capital reserves (Non-distributable Reserves)

Capital reserves

Capital reserves are non-distributable reserves. They are created from capital profits rather than normal trading activities, so they can’t be distributed to shareholders as cash dividends.

These reserves arise from specific capital transactions and are sometimes known as statutory reserves. They include:

• Revaluation reserve (surplus)
• Share premium - see previous chapter

Definitions

Revaluation reserve

Also known as revaluation surplus, arises when non-current assets (like land and buildings) are revalued upwards. Refer to …on how revaluation arises.

Revenue reserves

Revenue reserves are created by appropriating profits from the statement of profit or loss. Because they come from trading profits, they can be used for dividend payments, bonus share issues, or reinvestment in business operations.

These reserves are generally distributable and are sometimes referred to as non-statutory reserves. They include:

• Retained earnings
• Other reserves

Retained earnings

Retained earnings are the most common revenue reserve in most companies. You’ll often see the same idea described using different names, including (but not limited to):

• Accumulated profit
• Undistributed profit
• Unappropriated profit

Definitions

Retained earnings

It represents the accumulated profits that a company has earned over time and retained in the business rather than distributed to shareholders as dividends.

A company may decide not to distribute all profits as dividends. The undistributed profit is retained from year to year. This can help the company pay dividends even in periods where it makes losses.

It’s important to remember that retained earnings are not necessarily cash. A company can have high retained earnings but little or no cash if the funds have been invested in assets.

Dividends are paid from retained earnings. This means that even in a year when a company makes a loss, it may still pay dividends out of prior-year retained earnings, as long as cash is available.

If the retained earnings balance is given as a debit, it represents an accumulated loss (not an accumulated profit).

Closing retained earnings to be reported on the statement of financial position is computed as follows:

Retained earnings b/f	xxx
Profit/loss for the year	xxx
Dividends	(xxx)
Transfer to general reserves (if any)	(xxx)
Retained earnings c/d	xxx

Definitions

Other reserves

The most common revenue reserve among companies is the retained earnings. Aside from that, companies at their own discretion may create reserves for specific or general purposes. Those for general purposes may be classified as general reserves. Specific reserves would be classed according to the specific purpose for which it was created, for example, non-current asset replacement reserve, etc. These other reserves are just transfers from retained earnings.

Methods of issuing share capital

Companies can issue share capital through the following methods:

• Initial Public Offering (IPO)
• Private placement
• Rights issue
• Bonus issue

For the purposes of this syllabus, we shall focus on rights and bonus issues.

Definitions

Bonus (Scrips) Issue

It involves issuing free shares to existing shareholders in proportion to their current holdings, usually by capitalizing reserves (e.g., retained earnings or share premium). No cash is received; instead, reserves are converted into share capital. The proportion of shareholders’ ownership remains unchanged, though the number of shares increases. This method is used when companies wish to increase their share capital without necessarily raising additional funds.

Accounting treatment

Bonus shares are created by converting reserves into share capital. The journal entries involve:

Dr. Reserve capital xxx

Cr. Share capital xxx

Advantages of Bonus Issue

1. Improves liquidity: Increases the number of shares in circulation, making trading easier.
2. Signals confidence: Indicates strong reserves and financial health.
3. Rewards shareholders: Provides additional shares without extra cost.
4. No cash outflow: Conserves company cash while rewarding investors.
5. May increase marketability: A lower share price after a bonus issue can attract more investors.

Disadvantages of Bonus Issue

6. No new funds raised: Does not bring in additional capital for the company.
7. Dilution of earnings per share (EPS): More shares mean lower EPS.
8. Administrative costs: Printing and issuing new share certificates incur costs.
9. Possible negative perception: The market may view it as a lack of profitable investment opportunities.
10. Future dividend burden: More shares mean a higher total dividend payout if dividends per share remain the same.

Illustration 1: Bonus issue calculation

A company has 100,000 shares of $1 nominal value. It makes a 1-for-2 bonus issue (1 new share for every 2 held) using share premium. Calculate the number and value of the bonus issues.

Do you know the answer?

Illustration 2: Bonus issue

A company made a 3-for-4 bonus issue (i.e., 3 new shares for every 4shares already held) from both retained earnings and share premium (in equal amounts). The statement of financial position extract (equity only) is given below.

Equity and liabilities	Amount
Share capital (100,000@0.5cent)	$50,000
Share premium	$80,000
Retained earnings	$120,000
Total equity	$250,000

You are required to:

1. Compute the number and value of the bonus issue and make the journal entry for the bonus issue
2. Present the statement of financial position (equity only) after the bonus issue

Suggested solution:

3. What is the number and value of the bonus issue? Do you know the answer?

1. How would the statement of financial position be after the bonus issue? Do you know the answer?

Definitions

Rights Issue

A company offers its existing shareholders the right to purchase additional shares in proportion to their current holdings, typically at a discounted price, before offering them to the public. Unlike a bonus issue, a rights issue raises additional funds, since the existing shareholders actually pay for the shares offered to them.

This maintains existing ownership percentages and provides a cost-effective way to raise capital while rewarding loyal shareholders.

Accounting treatment

Right issues raise inflow, hence, the journal entries involve:

Dr. Cash and bank

Cr. Share capital

Cr. Share premium (in the case of selling above the par value)

Advantages rights issue

• Preserves ownership: Existing shareholders maintain their proportionate control.
• Cost-effective: Lower issuance costs compared to public offerings.
• Quick capital raising: Faster than issuing shares to the public.
• Confidence signal: Indicates management’s belief in the company’s prospects.

Disadvantages rights issue

• Dilution risk: If shareholders do not subscribe, their ownership percentage decreases.
• Market perception: May signal financial distress.
• Limited reach: Restricted to existing shareholders, reducing potential capital inflow.

Illustration 1: Calculation of right issue

A company with 200,000 shares of $1 nominal value makes a 1-for-4 rights issue at $1.80 per share. Calculate and make all the necessary journal entries.

Do you know the answer?

Illustration 2: Recording right issue on the financial statement

A company made a 2-for-5 right issue (i.e., 2 new shares for every 5 shares already held) at par value. The statement of financial position extract (equity only) is given below.

Equity and liabilities	Amount
Share capital (100,000@$1)	$100,000
Share premium	$80,000
Retained earnings	$120,000
Total equity	$300,000

You are required to:

1. Compute the number and value of the right issue and make the journal entry for the bonus issue
2. Present the statement of financial position (equity only) after the right issue

Suggested solution:

3. What is the number and value of the bonus issue? Do you know the answer?

4. How would the statement of financial position be after the bonus issue? Do you know the answer?

Dividends

Dividends are distributions of a company’s after-tax profit to its shareholders. They can be:

• Interim dividends: Declared and paid during the year
• Final dividends: Proposed at year-end, paid after approval at the Annual General Meeting (AGM).

For accounting purposes, only dividends paid during the period are recorded in the general ledger and presented on the face of the financial statements. Let’s see how this affects the two forms of dividends.

Definitions

Interim Dividend

This is usually common in very large companies, as not all companies declare interim dividends. During the accounting period (usually mid-year), the company would declare and pay an interim dividend before year-end. These payments qualify to be recorded in the general ledger accounts for the year. It is shown as a reduction in retained earnings and cash. The dividend is deducted from retained earnings in the Statement of Changes in Equity (SOCIE) and not recorded as an expense on the statement of profit or loss.

The journal entry is given as:
Dr. Dividend xxx
Cr. Cash and bank xxx

Final Dividend: At year-end, a final dividend may be proposed by management, for approval by the board of directors at an AGM, usually held in the subsequent year. As of year-end, it remains a proposed dividend; hence, it does not qualify to be recorded as a liability. Rather, it is disclosed in the notes to the financial statements as a contingent liability. Once approved at AGM (next period), it becomes a liability and is recorded. IAS 10 (Events After the Reporting Period) states that proposed dividends after the reporting date are non-adjusting events and should only be disclosed.

The journal entry is given as:

Upon approval of declared dividends:
Dr. Retained Earnings xxx
Cr. Dividend xxx

Upon payment of the dividend:
Dr. Dividend xxx
Cr. Cash and Bank xxx

Definitions

Calculation of dividends

Dividend is usually calculated based on either the number of shares issued by dividend per share or as a percentage of nominal (par) value (e.g., 10% of$1 par value). The formula is given as:

If expressed as a dividend per share:

$$\text{Total Dividend}=\text{Number of Shares}\times \text{Dividend per share}$$

If expressed as a percentage:

$$\text{Total Dividend}=\text{Number of Shares}\times \text{Nominal Value per Share}\times \text{Dividend Rate}$$

Illustration 1: Dividend computations

JBL Ltd has 500,000 ordinary shares. Directors declare an interim dividend of $0.10 per share on 30 June 2024 and a final dividend of $0.15 per share on 31 December 2024 (year-end). Explain the accounting treatments of this transaction.

Do you know the answer?