Capital structure and finance costs

Unlike sole proprietorships and partnerships, limited liability companies typically raise finance through a combination of share capital (equity) and borrowings (debt). Understanding how companies structure their financing - and how they account for finance costs - is essential for accurate financial reporting. This chapter covers the components of capital structure, share transactions, dividends, and interest expenses.

Learning objective

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

• describe the capital structure of a limited liability company, including ordinary (equity) shares, preference shares (redeemable and irredeemable), and borrowings
• record movements in the share capital and share premium accounts, including bonus and rights issues
• calculate and record dividends on ordinary and preference shares
• calculate and record interest expenses in the general ledger accounts and the financial statements

Capital structure

A company’s capital structure shows how it finances its operations using different sources of funds. In most cases, companies finance their operations using one or both of the following:

1. Equity
2. Debt (borrowings)

Equity capital

Equity capital arises when a company raises funds by selling shares to investors. When investors buy shares, they become part-owners of the business. As owners, they may:

• receive a share of profits through dividends
• have voting rights (depending on the class of shares)

Equity capital commonly comes from issuing these classes of shares:

• Ordinary (equity) shares
• Preference shares

Definitions

Ordinary (equity) shares

It represents the most common form of equity finance and basic ownership interest in a company. This is calculated as:

$$\text{Ordinary share capital}=\text{Par value of share}\times \text{No. of share issued}$$

Par value (face value)

Also known as nominal value. It represents the initial (arbitrary) price of a share set by the company, usually, during its incorporation.

Market value (price)

This is the prevailing market price at which a share is sold. This may differ (i.e., higher or lower) than the par value of the share price initially established. For companies listed on the stock exchange market, the trading price of a share is the market price.

Share premium

This arises when shares are issued above their nominal value. The excess of the issue price over the nominal value, multiplied by the number of shares issued, is the share premium. This is calculated as:

$$\text{Share premium}=(\text{Issue price per share}-\text{Par (nominal) value per share})\times \text{No. of shares issued}$$

Journal entry

Upon issuance of ordinary shares, the share capital account is credited with nominal value only; the excess is reported in the share premium account.

Dr. Bank xxx

Cr. Share capital xxx

Cr. Share premium (where applicable) xxx

Example: Ordinary share issue

Samituga Ltd issues 200,000 ordinary shares with a $1 nominal value at $2.50 per share. Pass the relevant journal entries for this transaction.

Definitions

Preference shares

Preference shares have preferential rights over ordinary shares.

Differences between ordinary and preference shareholders.

	Preference shareholders	Ordinary shareholder
Voting rights	Usually, no voting rights	Can vote at general meetings
Priority in dividend payments	Dividends paid before ordinary shareholders; if cumulative, unpaid dividends accumulate as arrears and must be paid before any ordinary dividend.	Dividend paid after preference shareholders is usually not guaranteed
Return on investment	Limited to fixed dividend rate only	Unlimited potential share in all residual profits
Priority in liquidation	Paid after creditors but before ordinary shareholders	Last to be paid and usually receives residual assets only
Capital growth	No participation in capital appreciation (fixed return)	Benefit from increases in share value and company growth

Preference shares can be categorised into:

• Redeemable versus irredeemable preference shares
• Cumulative versus non-cumulative preference shares

Definitions

Redeemable preference shares

Under this type of preference share, companies have an obligation to repay at a future date. It is treated as a liability (non-current, unless redemption falls within 12 months, in which case it’s current) in the statement of financial position. Dividends are also treated as finance costs in the statement of profit or loss.

Irredeemable preference shares

Under this type, companies have no obligation to repay at a future date; hence, it is permanent capital. Thus, it is treated as equity in the statement of financial position. The dividends are treated as distributions of profit (not expenses) in the statement of changes in equity.

Cumulative preference shares

Under this type, unpaid dividends accumulate (arrears). Say a company makes a loss in a particular year, the dividend entitled to them is accumulated and would be paid in subsequent year (s), even before ordinary shareholders. It is more attractive to investors.

Non-cumulative preference shares

Under this type of share, if the dividend is not paid, the right is lost. The shareholder cannot claim arrears in subsequent years.

Note: Each of these classes is non-exclusive. Hence, one could be a cumulative redeemable preference shareholder or a non-cumulative redeemable preference shareholder, and so on.

Bonus and rights issues

Companies can also change their share capital without a cash issue to outside investors, through a bonus issue or a rights issue.

Definitions

Bonus issue (capitalisation issue)

A bonus issue is the issue of new shares to existing shareholders, free of charge, in proportion to their current holding, funded by transferring reserves (such as share premium) into share capital. Advantages: no cash leaves the company, and the lower resulting share price can improve marketability. Disadvantages: no new funds are raised, and usable reserves are reduced.

Rights issue

A rights issue offers new shares to existing shareholders in proportion to their current holding, in exchange for cash, usually at a discount to the market price. Advantages: raises new cash more cheaply than a public share offer. Disadvantages: can dilute earnings per share, and shareholders who don’t take up their rights lose proportional ownership.

Example: Bonus issue

Samituga Ltd has 200,000 $1 ordinary shares and a share premium account of $150,000. The company makes a 1-for-4 bonus issue, funded from share premium. Record the journal entry.

Example: Rights issue

Samituga Ltd makes a 1-for-5 rights issue of its 200,000 $1 ordinary shares, at $1.80 per share. All shareholders take up their rights. Record the journal entry.

The overall statement of changes in equity, which brings together share capital, share premium, and dividend movements over the year, is covered in the next chapter, Components of equity.

Dividends

A dividend is a distribution of profit to shareholders. Ordinary dividends and dividends on irredeemable preference shares (classified as equity) are distributions of profit shown in the statement of changes in equity - they are not expenses. Dividends on redeemable preference shares, however, are a finance cost, because the shares themselves are classified as a liability.

Example: Dividends

Samituga Ltd has $100,000 of 6% irredeemable preference shares and 200,000 ordinary shares. The directors declare the full preference dividend and an ordinary dividend of 5c per share. Record the journal entries.

Debt capital

Definitions

Debt capital

It represents funds raised through borrowings that create a legal obligation to repay the principal amount plus interest, regardless of profitability. Unlike equity capital, where investors become owners, debt capital creates a borrower-lender relationship where the lender has no ownership rights but holds a legal claim to repayment. Examples of debt capital include bank loans, debentures, and bonds. They usually have principal and interest components.

Principal

The principal is the amount borrowed. It must be repaid on an agreed future date.

Because debt capital must be repaid, it is presented as a liability in the statement of financial position (not as equity). It is classified as:

• Current liability: Debt payable within 12 months
• Non-current liability: Debt payable after 12 months

Generally, the following journal entries are passed.

1. Upon receipt of the debt capital (i.e., principal amount):
Dr. Cash and bank xxx
Cr. Debt capital xxx

2. Upon repayment of the debt capital (i.e., principal amount):
Dr. Debt capital xxx
Cr. Cash and bank xxx

Interest

In addition to repaying the principal, the company must make periodic interest payments (monthly, quarterly, or annually, depending on the loan terms). The interest rate may be fixed or variable. Interest is payable regardless of whether the company makes a profit.

$$\text{Interest expense}=\text{Interest rate}\times \text{Principal amount}\times \text{Time period}$$

For example, a company borrows $100,000 at 12% annual interest:

• Annual interest expense = 12% × $100,000 = $12,000
• Monthly interest expense = $12,000 ÷ 12 = $1,000

Generally, the following journal entries are passed.

1. At period-end (accrual of interest):
   Dr. Interest expense xxx
   Cr. Interest payable xxx

2. Upon actual payment of interest:
   Dr. Interest payable xxx
   Cr. Cash and bank xxx

Alternative (if the interest is paid immediately):
Dr. Interest expense xxx
Cr. Cash and bank xxx

Financial statement presentation

Interest expense (whether paid or unpaid) is reported in the financing category of the statement of profit or loss. Under IFRS 18, this category sits after the ‘operating profit’ and ‘profit before financing and income taxes’ subtotals, and before the final profit before income taxes. The same treatment applies to dividends on redeemable preference shares, since those shares are classified as a liability. Any unpaid interest is reported as interest payable (a current liability) in the statement of financial position.

Example: Debt capital

A company receives a bank loan of $200,000 on 1 January 2024, repayable in 5 years at 5% annual interest. Explain how the company should treat the transaction in its accounts as at 31 December 2024, assuming the interest is unpaid.

Example: Financial statement presentation

JKL Ltd has a $300,000 bank loan at 6% annual interest. The loan was taken on 1 April 2024. The company’s year-end is 31 December 2024. Interest is paid annually on 31 March. Explain the accounting treatments, including the financial statement presentation, for the transaction.