Principles of Accounting Week 4

Topic 4 Accounting for Liabilities and

Equities
Session outline

1. Exercises and review from week 1 and 2

2. Accounting for Equities
3. Class exercises for accounting for
equities
1. ISSUE
2. DIVIDENDS PAID
3. FORFEITURE
Liabilities and Capital

• Liabilities and share Capital represent the

funding part of the accounting equation
• Assets are acquired as the result of
– Shareholders introducing share capital
– The company being provided with credit from
external parties, eg banks or creditors
accounts payable

Assets = Liabilities + Owners Equity

Capital or owners equity review

Introducing owners equity funds

For example issue $20,000 of shares to
finance an acquisition of a new plant
Assets increases
Dr Cash/Bank 20,000
Capital increases
Cr Share Capital 20,000
 Share capital and reserves
• Introduction
• Accounting for the issue of shares
• Different classes of shares
• Forfeited shares
• Share splits and bonus issues
• Rights issues and share options
• Disclosure of share capital
• Reserves
Introduction

• Under the AASB Framework:

“Equity is the residual interest in the
assets of the entity after deducting all its
liabilities” (para. 49c)
Introduction

• The definition of equity is a function of the

definition of assets and the definition of
liabilities
• Read paragraphs 65-68 of the AASB
Framework relating to liabilities
Introduction

• Recognition of equity
• The recognition of equity is a function of
the recognition of assets and the
recognition of liabilities
• “The amount at which equity is shown in
the balance sheet is dependent on the
measurement of assets and liabilities”
Introduction

• Accordingly, there are no specific

paragraphs in the AASB Framework on
the recognition of equity
Introduction

• In the case of companies, shareholders’

funds is made up of a number of
accounts:
Share capital
Reserves (e.g. general reserve,
revaluation reserve, forfeited shares
reserve)
Retained earnings (or accumulated
losses)
Capital and Shareholders

Shareholders are the owners of the

company
They have certain rights
1.to vote at annual general meetings and
elect the members of the board
2.To share in the company profits through
receipt of dividends
3.To share in assets on the event of
liquidation of the company
Issue of Shares

Share can be issued through

•Private placement – to certain potential
investors
•Public issue – this requires the issue of a
prospectus
– A document which reports on the financial
performance
– Financial position
– Future plans
Accounting for the issue of
shares
• The share capital of a company
represents the amounts that owners have
contributed to the organisation
• Traditionally, shares had a par value (or
nominal value) and may have been issued
for a premium (where shares were issued
at a price in excess of the par value)
• Since July 1998 shares of a company
have no par value under the Corporations
Act 2001
Accounting for the issue of
shares
• Three main stages for issuing shares to
the public
– Application – when shares are applied for by
members of the public
– Allotment
– Call on shares if applicable
Accounting for the issue of
shares
• Example James Ltd invites the public to
subscribe for 10,000 shares at $1.00 per
share. The terms of the share issue are
• $0.50 is payable on application by 30th
September
• $0.20 is payable on allotment by 31
October
Accounting for the issue of shares -
Example
Private Placement of shares

• When shares are issued by private

placement , the proceeds are immediately
available to the company
• Eg issue of 1000 share of $1 each
accounting entries
– Dr Cash $10,000
– Cr Share Capital
$10,000
Dividend - delcared

• On the declaration date the board formally

declares the cash dividend and
announces it to the shareholders
• Example director declared a dividend of
$50,000
• Journals to reflect this are
– Dr retained earnings $50,000
– Cr Dividend payable $50,000
Dividend - paid

• When dividends are paid

• Journals to reflect this are
– Dr Dividend payable $50,000
– Cr bank $50,000
Different classes of shares
• Many companies issue both ordinary
shares and preference shares
• Ordinary shares confer voting rights while
dividends are not assured
• Preference shares offer the holders of
those shares a preference (over ordinary
shareholders) to dividends or return of
capital or both
Different classes of shares

• Preference shares usually do not confer

voting rights and may be of many types
such as:
Non-redeemable, participating preference
shares
Convertible, redeemable, participating
preference shares
Convertible, redeemable preference
shares
Different classes of shares

• Many preference shares take on

characteristics of debt (a liability) and
equity
• Preference shares that are redeemable on
a set date, provide for a fixed rate of
return and provide no voting rights will be
considered to be the same substance as
debt and should be recognised as
liabilities
Different classes of shares

• Where preference shares have the

characteristics of debt, they are to be
treated as a liability under AASB 132
Financial Instruments: Presentation
Different classes of shares

• “The substance of a financial instrument, rather

than its legal form, governs its classification on
the entity’s balance sheet. Substance and legal
form are commonly consistent, but not always.
Some financial instruments take the legal form of
equity but are liabilities in substance and others
may combine features associated with financial
liabilities. For example:
(a) a preference share that provides for
mandatory redemption by the issuer for a fixed or
determinable amount at a fixed or determinable
future date, or gives the holder the right to require
the issuer to redeem the instrument at or after a
particular date or determinable amount, is a
financial liability” (AASB 132, para. 18)
Forfeited shares

• Where calls are made and shareholders fail to

pay the calls, the shares may be forfeited
• In such instances, the shareholders may be
entitled to a full or partial refund of the monies
paid before the forfeiture of shares
• Where monies are refundable, the amounts
involved are transferred to the “forfeited shares
account” (and is a liability)
• Where monies are to be retained by the
company, the amounts are to be recorded in the
“forfeited shares reserve” (and is part of
shareholders’ funds or equity)
Share splits and bonus issues

• Companies may undertake a share split

which involves the subdivision of the
company’s shares into shares of smaller
value, resulting in no change to
shareholders’ funds or equity
• Companies may also issue bonus shares
where existing shareholders receive
additional shares, at no cost, in proportion
to their shareholding at the date of making
the bonus issue
Rights issues and share options
• A rights issue involves the issue of new
shares to existing shareholders for a
specified, and often attractive, issue price
• Where the rights themselves may be
transferred (i.e. are tradeable), the rights
are known as “renounceable’
• Where the rights cannot be traded or
transferred , they are known as “non-
renounceable rights”
Rights issues and share options

• A share option provides the holder the

right to acquire shares at a particular price
in future
• Once share options are issued, the actual
options may or may not be exercised in
future
• Share options will be exercised to the
extent that they are “in the money”
Rights issues and share options

• An option is deemed to be “in the money”

when the exercise price (the price to pay
to acquire a share) is less than the market
value of the share
• Options are often issued to employees as
part of salary packages
• AASB 2 Share-Based Payments
prescribes accounting for share options
• Under AASB 2, a cost is to be attributed to
the options on their issue
• Study Example 14.10 in Deegan (2010, p.
456)
 Disclosure of share capital
• AASB 101 requires a number of
disclosures to be made in relation to share
capital (see para. 79)
Accounting for an issue of shares

total share price

No of share issued $ 8.00 30,000.00
amount payable on application $ 2.00
amount payable on allotment $ 4.00
call $ 2.00
Jul-01 Cash Trust $ 60,000.00
Application $ 60,000.00
Receipt of application monies
application $ 60,000.00
Share capital $ 60,000.00

Cash at bank $ 60,000.00

Share trust $ 60,000.00

Allotment $120,000.00
Share capital $120,000.00

cash at bank $120,000.00

allotment $120,000.00

1-Dec Call $ 60,000.00

share capital $ 60,000.00

cash at bank $ 60,000.00

Call Account $ 60,000.00
being receipt of money from call
Reserves

• There are many types of reserves, such

as the (asset) revaluation reserve, general
reserve and reserves which are to be
created on applying particular accounting
standards
• The revaluation reserve is created by an
upwards revaluation of non-current assets
(in other words, the increase in equity or
gain is not recorded initially as income)
• General reserves are mostly created by
transferring amounts from retained
earnings
Debenture versus Share financing

1. Investors Ltd Shareholders equity is as follows

Share Capital $4,000,000

Retained earnings and reserves $1,000,000

Investor ltd plans to expand its operations by establishing a branch in Singapore. The new
branch will cost $2.5million. Expected profits before tax and interest when the new branch is
operational are $1.2 million. The tax rate is 30%. Investors Ltd is considering 2 financing
options;

a) Borrow $2.5million at 8% interest

b) Issue 100,000 shares at $25

Required; Which funding alternative yields the higher return on equity.? What other factors
should be considered?
answer

• Funding under issue of shares

• Net profit 1,200,000
• Less tax 400,000
Profit available for distribution 800,000
Return on 6,500,000 12.3%

Funding using debentures

Net profit before interest and tax 1,200,000
Interest 2500000@8% 200,000
Profit before tax 1,000,000
Tax 300,000
Return on shareholders fund 700,000
700,000/4,000,000 17.5%
Financial Statement Analysis

For analysis of EQUITIES there are a

number of ratios which can be used to
evaluate return on equity
Financial analysis

• Revision question
Financial analysis revsion

2012 2011 2010

Current Assets
Cash and cash equavents $ 60,000 40000 18000
Trade Receivables /debtors $ 70,000 60000 48000
Inventories $ 90,000 85000 64000
Investments $ 75,000 70000 45000
Plant and Equipment $ 500,000 410000 358000
$ 795,000 $ 665,000 $ 533,000

current Liabilities $ 75,000 $ 80,000 $ 70,000.00

debentures $ 80,000 $ 85,000 $ 50,000.00
Share Capital $ 340,000 $ 300,000 $ 300,000.00
Retained Earnings $ 300,000 $ 200,000 $ 113,000.00
$ 795,000 $ 665,000 $ 533,000

Profit and Loss

Sales $ 740,000 660000
Less Cost of Sales $ 420,000 450000
Gross profit $ 320,000 $ 210,000
Operating expenses $ 200,000 110000
$ 120,000 $ 100,000

Other information
market price of shares $ 15.00 $ 10.00 $ 4.00
All dividends paid in cash

The weighted average number of sharesWANOS was 31984 30000

Break-even review question
cvp multiple product and tax

The company has two products Deluxe and Standard

Deluxe standard
price $ 50.00 $ 35.00
variable cost $ 30.00 $ 20.00

sales per prodcut last year 10,000 20000

fixed costs $ 160,000.00

1 calculatge the weighted average contirbution margin

2 calculate the break eaven point for the company assuming the sane sales mix for this year, in units and sales dollars and the number of each prodcut sold
3 calculate the required sales in each unit to achieve an after tax target profit of $ 200,000.00 assuming fixed costs remainat the same level
the tax rate is 30%
solutions

1 weighted average contribution margin margin

contribution margin per product $ 20.00 $ 15.00

weighted average 10,000 20,000

x x
$ 20.00 $ 15.00
$ 200,000.00 $ 300,000.00

total contribution margin $ 500,000.00

divided by total units $ 500,000.00 = $ 16.67

30,000
ratio of each product sold
0.333 0.667
2 Breakenven in units fixed costs $ 160,000.00
WACM $ 16.67
3 fixed costs +targert profit
WACM

where target profit = Profit after tax $ 200,000.00

(1- tax rate) 70.000%

required profit before tax plus fixed cost $ 285,714

$ 160,000.00
445,714
divided by WACM $ 16.67

no of units required 26,743

33% 67%
no of units of each prodcut sold 8,914 17,829
Debenture review question

Issue a debenture at a premium

10 years pay interest on 31 December and 1 July

$
issue 1,000,000.00 at a premium of 105
at an interest rate of 9%

a issue of debentures on 1-Jul

b payment of interest on 1 jan
c accrual on 31 march
Prepare dr cr
$
a issue of debentures on 1/07/2004 Cash at bank 1,050,000
$
Debentures payable 1,000,000
$
premium on debentures 50,000

payment of interest on 1 $
b jan 1/01/2005 interest expense 42,500
$
equals 50% of the annual premium premium 2,500
$
cash bank 45,000
being payment of ineterst

$
c accrual on 31 march 31/03/2005 interest expense 21,250
$
premium 1,250
Accrual of interest and premium 31 $
mar 22,500