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 categorised 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:

• Revenue reserves (distributable reserves)
• 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, it arises when non-current assets (like land and buildings) are revalued upwards. The gain is credited to the revaluation surplus through other comprehensive income, not to profit or loss; this is covered in the later chapter on revaluation of tangible non-current assets.

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.

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/f	xxx

Definitions

Other reserves

Companies may, at their own discretion, 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

This chapter focuses on two methods of issuing share capital that affect existing shareholders directly: a bonus issue and a rights issue.

Definitions

Bonus (scrip) issue

It involves issuing free shares to existing shareholders in proportion to their current holdings, usually by capitalising 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 entry is:

Dr. Share premium / retained earnings (the reserve being capitalised) xxx

Cr. Share capital xxx

Advantages of a bonus issue

• No cash outflow: conserves company cash while rewarding investors.
• Increases marketability: a lower share price after a bonus issue can attract more investors.
• Signals confidence: indicates strong reserves and financial health.

Disadvantages of a bonus issue

• No new funds raised: does not bring in additional capital for the company.
• Dilution of earnings per share (EPS): more shares mean lower EPS.
• Future dividend burden: more shares mean a higher total dividend payout if dividends per share remain the same.

Illustration 1: bonus issue

A company made a 3-for-4 bonus issue (i.e., 3 new shares for every 4 shares 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@$0.50)	$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:

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

2. 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. If shareholders take up their rights, their ownership percentages are maintained, and the issue is a relatively cheap way to raise capital.

Accounting treatment: a rights issue brings in cash, so the journal entry is:

Dr. Cash and bank

Cr. Share capital

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

Advantages of a rights issue

• Preserves ownership: existing shareholders maintain their proportionate control if they subscribe.
• Cost-effective: lower issuance costs compared to a public offering.
• Confidence signal: indicates management’s belief in the company’s prospects.

Disadvantages of a rights issue

• Dilution risk: if shareholders don’t subscribe, their ownership percentage decreases.
• Market perception: may signal financial distress.
• Limited reach: restricted to existing shareholders, reducing potential capital inflow.

Illustration 2: recording a rights issue in the financial statements

A company made a 2-for-5 rights issue (i.e., 2 new shares for every 5 shares already held) at $1.50 per share. 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 rights issue and make the journal entry for the rights issue
2. Present the statement of financial position (equity only) after the rights issue

Suggested solution:

1. What is the number and value of the rights issue? Do you know the answer?

2. How would the statement of financial position be after the rights 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, dividends declared or paid during the period are recorded in the general ledger and presented in the financial statements; any declared but unpaid amount is shown as a liability (dividends payable). 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 for an interim dividend is:
Dr. Retained earnings xxx
Cr. Cash and bank xxx

Final dividend:

At year-end, the directors may propose a final dividend. Shareholders then approve it at the Annual General Meeting (AGM), usually held in the subsequent year. As of year-end, it remains a proposed dividend, so it doesn’t qualify to be recorded as a liability. IAS 10 (Events After the Reporting Period) treats a dividend proposed or declared after the reporting date as a non-adjusting event: it is disclosed in the notes to the financial statements, not recognised as a liability. If a dividend is instead declared or approved before the reporting date and remains unpaid, it’s recorded as a liability (dividends payable).

Once the final dividend is approved at the AGM, it becomes a liability and is recorded:

Upon approval of the proposed dividend:
Dr. Retained earnings xxx
Cr. Dividends payable xxx

Upon payment of the dividend:
Dr. Dividends payable xxx
Cr. Cash and bank xxx

Calculation of dividends: a dividend is usually given either as an amount per share or as a percentage of nominal (par) value (e.g., 10% of $1 par value).

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 3: dividend computations

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

Do you know the answer?

Statement of changes in equity

The statement of changes in equity (SOCIE) shows how each component of equity moved during the period. It has a column for each component of equity and a row for each type of movement.