ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing
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Chapter 9: Capital structure and finance costs
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Exercise 3
A summary balance sheet of Capco Company is as follows:
$000
Non‐currentassets 1,230
Currentassets 510
Totalassets 1,740
Equityandliabilities
Sharecapital:ordinarysharesof$0.25each 400
Sharepremium 170
Retainedearnings 520
Totalequity 1,090
Non‐currentliabilities 400
Currentliabilities 250
Totalequityandliabilities 1,740
The company makes a 1 for 2 bonus issue.
Required
Prepare a summary balance sheet immediately after the bonus issue.
3.4 Advantages and disadvantages of bonus issues
Advantages of a bonus issue
A company whose shares are traded on a stock market can use a bonus issue to
increase the number of shares in issue. This will bring down the share price and
might help to make the shares more marketable.
A bonus issue can be used to reduce the share premium account, or even remove
the share premium account entirely from the statement of financial position.
Disadvantages of a bonus issue
Except for the advantages listed above, a bonus issue serves no practical purpose.
No cash is raised from the issue.
If a bonus issue exceeds the size of the share premium account, retained earnings
will be reduced by the issue. This would convert profits that are distributable as
profits into long-term share capital that cannot be distributed.
3.5 Bonus issue and rights issue in the same year
In your examination you might be given a question in which a company makes both
a bonus issue and a rights issue in the same year, and you might be asked to
calculate the balance on the share capital account and the share premium account
after the shares have been issued.
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You can work out an answer by preparing a table with a column for the share
capital account and a column for the share premium account.
For a rights issue, calculate the premium per share, which is the difference
between the nominal value and the issue price of the shares. The shares might
have a nominal value of 25 cents or 50 cents, so be careful when you calculate the
premium. Share capital is increased by the nominal value of the shares issued,
and the premium is added to the share premium account.
For a bonus issue, add the nominal value of the share issued to the share capital
account and deduct the same amount from share premium.
Example
At 1 July 20X1, HF Company has 20,000,000 ordinary shares of $0.25 in issue, and a
share premium of $2,000,000.
On 1 December 20X1 the company makes a 1 for 4 bonus issue.
On 1 March 20X2 it makes a 2 for 5 rights issue at a price of $1.75 per share. All the
shares in the issue were taken up by shareholders.
The share capital and share premium account balances at 30 June 20X2 can be
calculated as follows
Sharecapital Share
premium
$ $
At1July20X1 5,000,0002,000,000
1for4bonusissue 1,250,000(1,250,000)
Afterthebonusissue 6,250,000750,000
Rightsissue(2for5:premium$1.50pershare) 2,500,00015,000,000
8,750,00015,750,000
Note: Before the rights issue there were 25 million shares in issue (= 6,250,000 ×
$1/$0.25). The number of shares issued in the rights issue is therefore 10,000,000 (=
25,000,000 × 2/5).
These shares have a nominal value of $$2,500,000 and the premium per share is
$1.50 (= $1.75 – $0.25) which is $15,000,000 in total.
Chapter 9: Capital structure and finance costs
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Preference shares
Long-term capital of a company
The nature of preference shares
Redeemable and irredeemable preference shares
Preference shares: equity or debt?
4 Preference shares
4.1 Long-term capital of a company
The long-term capital of a company consists of:
Equity capital, reported in the statement of financial position as ordinary share
capital and reserves
Preference shares
Long-term debt.
All companies have equity capital, but not all companies have long-term debt. Even
fewer companies have preference shares.
4.2 The nature of preference shares
A company might issue preference shares. There might be just one ‘class’ of
preference shares, but there might also be more than one ‘class’.
Preference shares have some similarities with ordinary shares. The main point of
similarity is that preference shareholders receive dividends each year on their
shares.
However, preference shares differ from ordinary shares because they give their
holders preferential rights, ahead of ordinary shareholders. This includes the right
to receive dividends on their shares before dividends can be paid to the ordinary
shareholders.
The dividend on preference shares is usually a fixed amount each year. This fixed
amount is a percentage of the nominal value of the shares.
Example
A company might have in issue 20 million 6% preference shares of $1 each.
The total annual dividend payable (which is called a ‘preference dividend’) is
$1,200,000. This is because the nominal value of the shares is $20 million and
dividends are 6% of the nominal value.
Preference dividends are normally paid every six months, so in this example the
company would make two preference dividend payments each year of $600,000.
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4.3 Redeemable and irredeemable preference shares
Most classes of preference shares are either redeemable or irredeemable. (There are
also convertible preference shares, but these are not included in the syllabus for the
examination.)
Redeemable preference shares will be bought back by the company at a date in
the future, and cancelled. When a company buys back and cancels shares, the
shares are ‘redeemed’. Shares might be redeemed at their nominal value (par
value) but the redemption price might be higher.
Irredeemable preference shares will not be redeemed. Like ordinary shares, they
are ‘permanent’ share capital.
In practice most preference shares issued by companies are redeemable.
Example
A company might have two classes of preference shares in issue. There might be 5%
redeemable preference shares and 7.5% irredeemable preference shares. The
redeemable preference shares might be redeemable at par at a specified date in the
future. When the redemption date arrives the company will buy back the shares and
cancel them.
For the purpose of financial reporting, each different class of preference shares
should be accounted for separately.
4.4 Preference shares: equity or debt?
Companies are required to show equity capital separately from liabilities in the
statement of financial position. Long-term debt is a non-current liability.
There is no special place in the statement of financial position for preference shares,
and preference shares must be classified either as equity or as debt. The rules for
deciding whether preference shares are equity or debt are fairly complex, but as a
general rule:
redeemable preference shares are usually treated as debt capital in financial
reporting
irredeemable preference shares are likely to be included in equity.
A consequence of treating preference shares as either equity or debt capital,
depending on circumstances, the dividends paid to preference shareholders are also
treated in one of two ways:
When preference shares are treated as debt capital and included in non-current
liabilities, dividends paid to the preference shareholders are reported as a
finance cost in the income statement, similar to interest costs on a loan. These
preference dividends reduce the reported profit.
When preference shares are treated as equity, dividends paid to the shareholders
are treated as equity dividends. Accounting for equity dividends is explained
later.
Chapter 9: Capital structure and finance costs
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Dividends
Preference dividends
Equity dividends
Accounting for equity dividends
5 Dividends
5.1 Preference dividends
A company does not have to pay dividends. If its profits are too low, the directors
might decide not to pay any dividend, or to pay just some dividends to some classes
of shareholders.
Preference shareholders are entitled to receive their dividend before the ordinary
shareholders can receive any dividend.
As stated in the previous section, preference dividends are reported differently in
the financial statements, depending on whether the preference shares are treated as
debt capital or equity capital.
When preference shares are treated as debt capital, the preference dividend each
year is reported as a finance charge and included in profit and loss for the year.
When preference shares are treated as equity, the preference dividends are
included within the equity dividend for the purpose of financial reporting.
Accounting for preference dividends
When preference dividends are treated as a finance cost, they are accounted for as
follows:
Debit: Preference dividends
Credit: Bank
Dividend payment
Debit: Finance charges (expense)
Credit: Preference dividends
Recording preference dividends as a finance charge (expense in profit and loss) for
the year
5.2 Equity dividends
Equity dividends are dividends paid to the equity shareholders. In most companies,
the ordinary shareholders are the only equity shareholders. Dividends are usually
stated at an amount per share: for example a company might make a dividend
payment of 60 cents per share.
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Equity dividends reduce the company’s distributable profits. When a company pays
an equity dividend, the balance on the retained earnings reserve is reduced.
Interim and final dividends
Many companies make two (or possibly more) dividend payments each year to the
ordinary shareholders.
There might be a payment during the financial year, based on profits for the first
six months of the year. This mid-year dividend is called an interim dividend.
There is usually a payment after the end of the financial year, based on profits
for the full year. This is called a final dividend.
The timing of equity dividend payments needs to be understood, and so it might be
useful to describe an example. Suppose that a company has a financial year that
ends on 31 December.
In July Year 1 it might declare an interim dividend of 30c per share, payable on
31 October Year 1.
In February Year 2, it might propose a final dividend of 95c per share for the
year ended 31 December Year 1. This proposed dividend is therefore announced
before the financial statements for Year 1 are approved by the company’s
directors and published.
The proposed dividend might require approval by the shareholders at an annual
general meeting of the company, held in April Year 2.
The final dividend for Year 2 might be paid on 15 May Year 2.
In July Year 2 the company might declare an interim dividend of 33c per share,
payable on 30 October Year 2.
The important points to note about this timetable for dividends are that:
During the course of a financial year, a company might make two payments of
equity dividends, the final dividend for the previous financial year and the
interim dividend for the current financial year.
When a company publishes its financial statements for a year, the directors
might have proposed a final dividend for the year, but this proposed dividend
will not yet have been approved by the shareholders.
A distinction must be made between:
equity dividends actually paid in the year
the proposed equity dividend that has not yet been paid when the financial
statements are prepared and published.
5.3 Accounting for equity dividends
Equity dividends are not included in the income statement of a company or in the
statement of comprehensive income. Instead:
Equity dividends actually paid during the year are reported as a reduction in
retained earnings in the statement of changes in equity (which is explained
Chapter 9: Capital structure and finance costs
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later). Equity dividend payments also reduce retained earnings in the statement
of financial position.
The proposed final dividend is reported as a note to the financial statements,
but is not included in the income statement, statement of changes in equity or
the statement of financial position.
The accounting entries for equity dividends are therefore as follows.
Debit: Equity dividends
Credit: Bank
Dividend payments
Debit: Retained earnings reserve
Credit: Equity dividends
Recording equity dividend payments as a deduction from retained earnings.
Accounting for equity dividends: summary
Dividends paid to equity shareholders are similar to drawings made by sole traders
or partners from their capital. Dividends are paid out of revenue reserves (the
retained earnings reserve account).
A dividend is usually declared as either:
a dividend per share in cents per share, or
a percentage of the nominal value of the shares.
In the UK, dividends are usually paid twice each year. During a financial year, the
amount of dividend charged against retained earnings is therefore:
the final dividend for the previous year and
the interim dividend for the current year.
The accounting rules for dividends can be summarised as follows.
Total dividends paid are not shown in the income statement, as part of the
income statement itself.
The proposed final dividend for the accounting year is not shown in the
statement of financial position, unless (in a very unusual circumstance) the final
dividend is proposed and approved before the end of the financial year.
Total dividends actually paid during the year (the final dividend for the
previous year and the interim dividend in the current year) are reported as
deductions from equity (deductions from retained earnings) in another financial
statement, the statement of changes in equity (see later in this chapter).
The final proposed dividend for the year, if it is proposed after the end of the
year (which is the normal practice), is disclosed in a note to the financial
statements, as a non-adjusting event after the reporting date (see later chapter).
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Example
A company has 2,000,000 ordinary shares of $0.50 each in issue. At the beginning of
Year 2, its accumulated profits were $450,000.
Its profit before taxation for Year 2 was $300,000. Taxation on these profits is
$90,000. During the year, the company:
paid a final dividend for the previous financial year (Year 1) of 7 cents per share
paid an interim dividend for the current financial year (Year 2) of 3 cents per
share
Profit for the year
$
Profitbeforetaxation 300,000
Taxation 90,000
Profitaftertaxation(creditretainedearningsreserve) 210,000
Retained earnings reserve
$ $
Balanceatthebeginningoftheyear450,000
ProfitaftertaxationforYear1210,000
660,000
Equitydividendpayments
FinaldividendforYear1(2,000,000x$0.07) 140,000
InterimdividendforYear2(2,000,000x$0.03) 60,000
200,000
Balanceattheendoftheyear(statementoffinancialposition)460,000
Chapter 9: Capital structure and finance costs
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Loan capital
Features of loans and loan notes
Accounting for loans and loan notes
6 Loan capital
6.1 Features of loans and loan notes
‘Loan capital’ is long-term borrowing. A loan is a liability, and is included in non-
current liabilities in the statement of financial position provided that repayment of
the loan will not fall due within the next 12 months.
Loan capital takes two main forms:
bank loans
loans in the form of a borrowing instrument, such as bonds or notes.
Longer-term bank loans to business entities are usually at a variable rate of interest,
so the interest rate payable on the loan rises or falls with changes in the market rates
of interest.
Bonds and notes are financial instruments issued by companies that enable them to
borrow from investors. Companies issue bonds or notes and these are purchased by
investors. In return the company promises to:
pay interest on the face value of the bonds or notes and
redeem the bonds or notes at a date in the future.
Interest is usually at a fixed annual rate of interest.
The difference between bonds and loan notes is the time to redemption when they
are issued. Loan notes are usually redeemable within up to about seven years from
the date of their issue. Bonds are usually longer-term and redeemable after ten years
or more.
6.2 Accounting for loans and loan notes
The rules on accounting for financial instruments are fairly complex, and the
complexities are outside the scope of the examination syllabus. For the purpose of
your examination, you need to be aware that:
Loan capital is a long-term liability, and is included in the statement of financial
position within non-current liabilities. However when the bank loan, loan notes
or bonds are redeemable within 12 months, they become current liabilities.
The interest on loans and loan notes is an expense in profit and loss, and
included within finance costs. The accruals basis is applied, which means that
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interest is charged against profit on a time apportionment basis, not on the basis
of when the interest payments are actually made.
Example
A company issued loan notes on 1 May. The notes have a face value of $15 million
and interest is payable at an annual rate of 8%. Interest payment dates are six-
monthly. On 31 October and 30 April each year. The interest rate of 8% is a market
rate of interest and the loan notes are redeemable a par after five years.
The financial year of the company ends on 31 December.
The loan notes should be accounted for in the year of issue as follows.
Interest to be included in interest costs/finance costs for the year is $15 million ×
8% × (8 months/12 months) = $800,000.
There is a non-current liability for $15 million (the amount of the loan).
There is accrued interest for two months (November and December) amounting
to $15 million × 8% × (2 months/12 months) = $200,000. This will be included in
current liabilities in the statement of financial position as at 31 December.
In the ledger accounts, the transactions might be recorded as follows. These show
liabilities for the loan ($15 million) and accrued interest ($200,000) at the end of the
year.
Loannotesaccount
$ $
1May Bank 15,000,000
Interestchargesaccount
$ $
31Oct Bank 600,000 31Dec Incomestatement 800,000
31Dec Accrualc/f 200,000
800,000 800,000
1Jan Accrualb/f 200,000