Shareholders’ equity or simply equity represents the claim to the assets of a corporation [1]. Thus, the equity is a firm’s liability to its owners because shareholders are entitled to a portion of the company’s assets or retained earnings as well as the amount of capital subscribed. This investment is not, of course, free of risk. The capital invested can be lost entirely, e.g., if a firm enters into liquidation. A company’s assets are sold to pay off its existing debts, and as a result, there may be nothing left for the company’s shareholders resulting in the total loss of capital. In its simplest form, the firm’s equity consists of the issued share capital at nominal (or par) value, non-distributable and distributable reserves [2]. In fact, a typical balance sheet of a company would show figures relating to issued share capital, share premium, and retained earnings, as in Figure 1.
Figure 1. Shareholders’ funds for Coca-Cola Holdings (United Kingdom) Ltd. Source: Companies House
However, some larger companies, especially those traded on a stock exchange, tend to provide a more detailed structure of shareholders’ funds, as in Figure 2. This article discusses different components of shareholders’ equity and presents how those constituents are shown on the statement of financial position (or the balance sheet). The article aims to provide its readers with the confidence to read, analyse and interpret the shareholders’ funds.
Figure 2. Equity structure of Pearson plc. Source: Companies House
Share capital
The initial share capital is the number of shares in the company multiplied by the nominal value of the shares [3]. For example, the Scottish-based brewery Innis & Gunn was incorporated in 2002 with an initial share capital of £100, i.e., 100 shares with the nominal value of £1 each. The nominal value is the same for each of the shares. It may be of any value, e.g., £1000, £50,000, and in a variety of configurations. In practice, large-denomination shares are not issued for two main reasons. First of all, they tend to be unwieldy and difficult to sell. For instance, let us say a company has a share capital of £50,000 made up of two shares, each worth £25,000. If an owner wanted to sell part of the business, he would have to find a buyer willing to pay at least £25,000 for one share, i.e., 50% of stake in the company. Where, however, the shareholding consisted of shares with a smaller denomination, the price per share would be lower, and the entire shareholding could probably be sold more easily to various potential buyers [4]. In practice, the maximum nominal value for shares is £1. However, Pike et al. (2015) suggest that when ordinary shares of a public company are first issued, their nominal or par value is commonly valued at 25p per share [5]. The primary consideration again is marketability. Issued share capital appears on the balance sheet at its par value, which explains why it often seems a minor item compared with share premium or retained earnings (see Figure 2).
A second reason for issuing small-denomination shares is the idea of limited liability, which suggests that a shareholder is only liable for the amount of subscribed shares, i.e., the value of his shareholding. For example, the initial shareholder(s) of Innis & Gunn was only liable for £100 initially invested in the company. While private companies have no limit on share capital, the minimum capital required to incorporate plc is £50,000, one-quarter of which must be paid up [6].
Although a public company must have the legal form of a 'plc' (public limited company) to have its shares listed, the listing process is entirely independent of the company registration process. As a result, it is not unusual for a plc to have no publicly traded shares. In the United Kingdom, the vast majority of companies are, in fact, private limited companies (99.2%), of which 99% are private companies limited by shares [6]. Private companies can also be limited by guarantee but only account for 0.2% of the total number of private limited companies in the United Kingdom.
Share premium
Whether it is 1p, 5p, 25p, 50p, £1, etc., the nominal value of an ordinary share bears no relation to its market value. However, once a company is established, its shares trade above the basic par value. Hence, Pike et al. (2015) suggest that a company wanting to sell new shares is therefore likely to issue them not at their nominal value but at the premium, which can be defined as the difference between the issue price of an ordinary share and its par (or nominal value). When a company issues shares at a premium, it is legally obliged to create a separate ‘share premium’ account on its balance sheet. As stated in the following passage retrieved from the Companies Act 2006, section 610:
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(1) If a company issues shares at a premium, whether for cash or otherwise, a sum equal to the aggregate amount or value of the premiums on those shares must be transferred to an account called “the share premium account”.
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The relationship between share capital and share premium account is best described by Arnold and Lewis (2019) in their book Corporate Financial Management, 6th edition [7]:
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The par value has no real significance and for the most part can be ignored. However, a point of confusion can arise when one examines company accounts because issued share capital appears on the balance sheet at par value and so often seems pathetically small. This item has to be read with conjunction with the share premium account, which represents the difference between the price received by the company for the shares and par value of those shares.
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The authors have also provided the example of Green plc, whose ordinary shares were valued at 25p each. Those shares (10 million in total) were sold at a premium of 200p each resulting in the difference between the price received and the par value of 175p per share (200p - 25p = 175p). Green plc will now have a share premium account of £17.5m (175p multiplied by 10 million shares). It makes perfect sense why Pearson’s share capital is equal to 4.5% of total shareholders’ funds, while share premium accounts for 60.4% of total equity (see Figure 2).
Reserves
The funds that shareholders invest in a firm in addition to their initial subscription of capital [5] are known as reserves. When a company generates net profit, part of this fund goes to shareholders in the form of dividends unless the management decides otherwise (in theory, a firm is not obliged to pay out dividends). The remainder of the net profit is retained by the company and reinvested in wealth-generating assets (e.g., machinery, IT software, or buildings) or operational purposes. Nonetheless, shareholders would generally expect that retained earnings (US term) or reserves (UK term) are effectively used to ensure that the long-term return on such investment is possible. In other words, reserves are funds that allow companies to plan for long-term success. Investors can compare the amount of profit for the period available to owners with their average investment in the business during that same period by applying the return on ordinary shareholders’ funds (ROSF) ratio [4]. In general, businesses seek to generate as high a value as possible for this ratio:
From a corporate perspective, retained earnings are another way of financing corporate activities. Internal finance is less costly than, for example, selling new shares. Companies cannot also sustain their operation purely on debt such as a bank loan or by issuing corporate bonds. In Figure 2, we can see that Pearson plc presented other types of reserves on the balance sheet, separate from retained earnings, including, for example, the capital redemption reserves or fair value reserves. For the purposes of this article, we will briefly define each one of those terms with a further analysis provided in separate articles.
Please note the following definitions are mainly extracts from academic and professional sources, thus appropriate references have been made, which you can thoroughly check at the end of this article.
Capital redemption reserve is created when a company purchases its own shares in circumstances that result in a reduction of share capital. It is a reserve that cannot be distributed to the shareholders and ensures the maintenance of the company's capital base, and protects the creditors' buffer, giving them greater confidence to invest in the company [8].
Fair value reserve is created when a company decides to revaluate its non-current assets. A gain on revaluation is always recognised in equity, under a revaluation reserve or fair value reserve (unless the gain reverse’s revaluation losses on the same asset that were previously recognised in the income statement – in this instance, the gain is to be shown in the income statement). The revaluation gain is an unrealized gain that later becomes realised when the asset is disposed of (derecognised) [9].
Translation reserve is beyond the scope of this article. For more information, please refer to IAS 21 The Effects of Changes in Foreign Exchange Rates. The standard prescribes how an entity should [10]:
· account for foreign currency transactions;
· translate financial statements of a foreign operation into the entity’s functional currency; and
· translate the entity’s financial statements into a presentation currency, if different from the entity’s functional currency. IAS 21 permits an entity to present its financial statements in any currency (or currencies).
Treasury shares refer to a company's own issued shares that it has repurchased but not canceled. Shares can only be transferred into treasury where a company has purchased them from a shareholder out of distributable profits (section 724(1), Companies Act 2006).
The rules governing treasury shares are contained in sections 724 to 732 of the Companies Act 2006 [11]. To calculate the total shareholders' equity, treasury shares are always subtracted from the share capital (including share premium) and reserves.
Understanding shareholders’ funds
The total shareholders’ funds or shareholders’ equity (or simply equity) equals total assets less total liabilities. Thus, equity can also be described as the net asset value (NAV). For accounting and legal purposes, a limited company is a separate legal entity. It is regarded as being the legal person in its own right [6]. That is why equity is a firm’s liability to its owners (hence the formula: assets = liabilities + equity). When a company is incorporated, it is fair to say that the money raised by a business when it issued its shares is an owners’ loan to such a business.
References
[1] Harrison, W.T., Horngren, C.T., Thomas, C.W. and Tietz, W.M. (2017). Financial Accounting, Global Edition.11th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/811952/
[2] Elliott, B., Elliott, J. (2019). Financial Accounting and Reporting. 19th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/971476/
[3] Davies, T., Crawford, I. (2012). Financial Accounting. [ebook] Pearson. Available at: https://www.perlego.com/book/811465/
[4] Atrill, P., McLaney, E. (2019). Financial Accounting for Decision Makers. 9th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/955158/
[5] Pike, R., Neale, B., Linsley, P. (2015). Corporate Finance and Investment: Decisions and Strategies 8th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/810751/corporate-finance-and-investment-decisions-and-strategies-pdf
[6] MacIntyre, E. (2018). Essentials of Business Law: 6th edition. Pearson: Harlow
[7] Arnold, G. and Lewis, D. (2019). Corporate Financial Management. 6th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/871263/
[8] Oxford Reference (n.d.). Capital Redemption Reserve [online]. Available at https://www.oxfordreference.com/view/10.1093/oi/authority.20110803095547728?rskey=UU6hi7&result=5
[9] ACCA Global (n.d.). Accounting for Property, Plant and Equipment [online]. Available at https://www.accaglobal.com/an/en/student/exam-support-resources/fundamentals-exams-study-resources/f7/technical-articles/ppe.html
[10] International Financial Reporting Standards (n.d.). IAS 21 The Effects of Changes in Foreign Exchange Rates [online]. Available at https://www.ifrs.org/issued-standards/list-of-standards/ias-21-the-effects-of-changes-in-foreign-exchange-rates/#:~:text=IAS%2021%20prescribes%20how%20an,from%20the%20entity's%20functional%20currency.
[11] Thomson Reuters (n.d.) Practical Law. Treasury shares [online]. Available https://uk.practicallaw.thomsonreuters.com/1-107-7413?transitionType=Default&contextData=(sc.Default)&firstPage=true