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Chapter 13
Capital Structure and Finance Costs

© ACCA

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Chapter 13 Capital Structure and Finance Costs

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Capital Structure of Limited Liability Companies

Limited Liability Company

A limited liability company is where investors invest in the company by

buying shares and becoming shareholders. Shareholders require profits
on their investments in the form of dividend payments or share value
appreciation. Directors are hired to run the company on behalf of the
shareholders, and shareholders are only liable for their investments.

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Capital Structure of Limited Liability Companies

Limited Liability Company

The key features of a limited liability company are illustrated below:

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Capital Structure

All businesses need investment (finance) to start and stay in operation.

This investment is part of its capital.

A business’s capital structure refers to the composition of its finance, a

combination of equity (shares) and loans (debt) and other sources of
finance that it uses as long-term financing.

For example, a company with $20 million in equity and $80 million in
debt is said to be 20% equity financed and 80% debt financed.

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Capital Structure
Major Sources of Capital

A limited liability company can raise finance by raising shares or through

borrowings. The three primary sources of raising finance are:

• Ordinary Shares
• Preference Shares
• Borrowings/ Loan Notes

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Capital Structure
The sources of financing may be summarised and compared as follows:

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Capital Structure
Winding Up

A company winds up when it has gone out of business (stops trading).

On winding up of a company, the assets will be liquidated and paid out
in the below hierarchy as follows:

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Capital Structure
Winding Up

The settlement order by a specific group is as follows:

• Secured creditors: certain government authorities, banks and lenders

• Preferential creditors: employees (for arrears of salary, redundancy
payments, etc.).

• Unsecured creditors: may include certain tax authorities (for sales

tax), trade payables, auditors, and other service providers.

• Connected unsecured creditors (e.g. loans by directors/ employees).

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Capital Structure
Winding Up

The settlement order by a specific group is as follows:

• Preference shareholders (i.e. holders of preference shares).

• Ordinary shareholders – residue (if any)

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Sources of Capital
Ordinary Shares

Ordinary shares are the most common form of capital that a company
issues. The holders of ordinary shares are the company’s ordinary
shareholders. Ordinary shares are classified as equity (capital).

Ordinary shares represent ownership in the incorporated entity. The key

features of an ordinary shareholder are:

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Sources of Capital
Ordinary Shares

• Right to Profits
Shareholders have the right to share a company’s profit after all
obligations have been met (after paying all obligations to other
providers of capital).

This right is fulfilled by the company making an annual payment to

shareholders. This payment is called a dividend. The amount of
dividend that a shareholder receives will vary from year to year and
will depend on how much profit and available cash a company has. The
amount of the dividend also depends on the size of the shareholder's
investment.

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Sources of Capital
Ordinary Shares

• Right to Profits
Sometimes a company will reinvest funds within the business rather
than pay the shareholders a dividend. The company is not required
to pay dividends to its ordinary shareholders.

• Right to Vote
Ordinary shares give the shareholders the right to vote on the
company’s important decisions.

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Sources of Capital
Ordinary Shares

• Share of assets if the Entity Winds Up

Ordinary shareholders have the right to receive all remaining cash
after all other obligations have been met. If a company has been
forced to wind up because it has run out of money, there is usually no
cash left, and ordinary shareholders will lose their investment.

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Real-World Practice

Real-World Practice

Many companies' ordinary shares are traded on stock markets.

This results in the shares being traded having a quoted share
price which reflects the value of the share on the market.
If the shareholder is unhappy with how the company is being
run or the level of dividend that they are receiving, then they
can sell their shares.

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Sources of Capital
Accounting Entry for Ordinary Share Issue

The issuance of ordinary shares to the public raises finance for the
business. As a result, the equity balance increases as ordinary share
capital increases.

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Sources of Capital
Accounting Entry for Ordinary Share Issue

The double entry to record the issue of ordinary shares is:

Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.
The ordinary capital has
CR Ordinary Share Capital Equity increased (by the par value)
The part of the issue price
CR Share Premium Equity exceeding par value is
recorded.

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Example Accounting for Shares

1. Issue 100,000 $1 shares for $1 cash each.

Dr Cash $100,000
Cr Share capital $100,000

2. Issue 60,000 new shares with rights to existing shareholders at

$1.60 each.

Dr Cash $96,000
Cr Share capital $60,000
Cr Share premium $36,000

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Preference Shares
Preference shares are another form of capital that a company might
issue, although less common than issuing ordinary shares. The key
features of a preference shareholder are:

• Right to Profits
Preference shareholders have the right to receive a fixed dividend
each year. This is calculated as a fixed percentage of the preference
share’s par value (or face value). A company must pay preference
share dividends before it can pay an ordinary dividend.

For example, the holder of a 5% $1 preference share has the right to

receive a dividend of 5 cents a year. Preference shareholders do not
have any rights to profit beyond this fixed dividend.

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Preference Shares
• Right to Vote
Preference shares do not have any voting rights attached. Therefore,
they cannot vote on the company’s decisions and have no say in its
operations.

• Share of assets if the entity Winds Up

Preference shareholders take higher priority than ordinary
shareholders if a company is wound up. This means that the
preference shareholders will be paid the face value of their
investment before the ordinary shareholders can claim any part of
their investment if the entity ceases trading.

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Preference Shares
Redeemable Preference Shares

Redeemable preference shares will be redeemed (or repurchased) by

the company. There is an obligation to redeem, which means they are
classified as a liability.

Such shares may or may not have a specific redemption date.

Preference shares repaid in full are, in substance, more like debt as
there is an obligation to repurchase (redeem) in the future.

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Preference Shares
Redeemable Preference Shares

• When shares are redeemed, the shareholder receives the stated value
of the shares.

• Redeemable shares must be labelled redeemable on issue.

• Shares to be redeemed in the next 12 months are reclassified as
current liabilities.

• A redeemable preference share’s fixed dividend is classified as an

expense, not a distribution of equity to owners.

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Preference Shares
Irredeemable Preference Shares

Irredeemable preference shares will never be redeemed (or

repurchased) by the company unless it is wound up. Therefore, they are
a permanent form of capital categorised as equity (similar to ordinary
shares), as there is no obligation to redeem them.

Under IFRS, the substance of the capital needs to be considered before

classifying irredeemable preference shares as equity or debt.

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Preference Shares
Accounting Entry for Preference Share Issue

The issuance of preference shares to the public raises finance for the
business.

The double entry to record the issue of redeemable preference shares

is:

Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.
The redeemable preference
Redeemable share will be repurchased in the
CR Liability
Preference Share future. (Liability obligation)

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Preference Shares
Accounting Entry for Preference Share Issue

The double entry to record the issue of irredeemable preference

shares is:

Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.

The irredeemable
Irredeemable preference share (equity)
CR Equity
Preference Share has increased

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Borrowings/ Loan Notes

Instead of shares, a company can borrow from lenders or issue loan
notes to raise capital for the business. Borrowings are classified as
liabilities of a business and have the following characteristics:

• carry a fixed rate of interest payable by the company to the lender

each year

• principal amount will be redeemed at a fixed date in the future.

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Borrowings/ Loan Notes

Borrowings give the holder (the lender) the right to receive a fixed
return (interest), and they will be repaid at some point in the future.

This form of finance is similar to redeemable preference shares.

However, instead of dividends, the lender receives interest. Holders of
borrowings are creditors of the company, whilst redeemable preference
shareholders are known as shareholders or members of the company.

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Borrowings/ Loan Notes

There are characteristics associated with borrowings that do not apply to

other forms of capital:

• The lenders can take the company to court if they do not receive their
interest. (Shareholders do not have the same power).

• Borrowings can be secured on the assets of a company. (This means

that if a company does not repay the amount invested, the lender can
demand that some of the company’s assets be sold so the money can
be repaid.)

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Borrowings/ Loan Notes

Accounting Entry for Borrowings

The double entry to account for borrowings is:

Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.

Loans from lenders (liability) increased

CR Borrowings Liability

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Borrowings/ Loan Notes

Accounting Entry for Borrowings

The summary of the three sources of finance is illustrated in the diagram

below:

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Activity 1
State whether the statements below are True or False.

1. Ordinary shareholders are guaranteed to receive a dividend every

year.

2. Irredeemable preference shares carry the right to vote in the

decisions of a company, which means that they are classed as equity
in the Statement of Financial Position.

3. 10% Loan notes 20X5 means that the holder (the investor) will
receive a $10 interest payment every year for every $100 invested,
and the loan notes will be repaid in 20X5.

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Share Capital
Rights Issue of Ordinary Shares

A company raise funds (cash) by issuing shares through a rights issue.

A rights issue is when a company offers existing shareholders the
right to buy new shares at a price below their current market value.
The number of shares offered depends on a shareholder's existing
holding.

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Rights Issue

Definition

A rights issue is the issuance of new shares to existing

shareholders at a price below the current market value.

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Rights Issue of Ordinary Shares

Accounting Entries for Rights Issue

The issuance of a rights issue raises finance for the business through the
issue of shares (equity). Therefore, the double entry to account for the
rights issue is:

Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.
The ordinary capital has
CR Ordinary Share Capital Capital increased (by the par
value)
The excess of par value is
CR Share Premium Capital reflected in the share
premium account

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Example 1
A business raises funds through a rights issue.

It had existing 10,000 shares in issue at a par price of $1 with their

shareholders.

The business issues a rights issue at “2 for 5 at $3.00 a share”. This

means that for every five shares a shareholder owns, they may buy two
new shares at $3.00 a share.

Number of shares issued = 10,000 x 2/5 = 4,000 new shares.

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Example 1
The double entry to record the rights issue is:

DR Bank 4,000 x $2 $12,000

$4,000
CR Ordinary Share Capital 4,000 x par $1
$8,000
CR Share Premium 4,000 x ($3 – par $1)

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Rights Issue of Ordinary Shares

Advantages of Rights Issue

✓ A company is more likely to raise funds needed under a rights issue

rather than an issue of shares to the public. This is because existing
shareholders are already interested in the company.

✓ Cheaper to administer than an issue of shares to the public.

✓ Does not affect the balance of shareholder control if all shareholders
take up the rights issue.

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Rights Issue of Ordinary Shares

Disadvantages of Rights Issue

 More expensive to administer than taking on a bank loan.

 The market value per share (known as the share price) often initially
falls because of a rights issue, as the shares are issued at a price
below market value.

 The balance of shareholder control will change if not all shareholders

take up the rights issue.

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Activity 2

Fonds Retail Co’s management team has decided that it needs to raise
more capital to finance an expansion of the business.

It is now 20X9, and on 1 May 20X9, Fonds Retail Co decided to offer a

rights issue to its ordinary shareholders. The rights issue terms are 3 for
8 for $0.75 a share.

There are 160,000 25-cent shares in issue on 1 January 20X9.

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Activity 2

1. This rights issue will raise how much cash?

2. What is the accounting entry to record the rights issue when

the shareholders buy the shares?

3. What is the impact of the accounting entry on the financial

statements?

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Bonus Issue

Definition

A bonus issue is the issuance of new shares by a company

to its existing shareholders in proportion to their existing
shareholdings for no consideration/cash.

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Bonus Issue of Ordinary Shares

Shareholders receive additional shares for free or as a 'bonus'. Because

no cash is raised, the overall capital in the company will stay the same
because there are no new resources. Therefore, the new shares need to
be funded from existing capital.

A bonus issue is sometimes called a capitalisation issue.

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Bonus Issue of Ordinary Shares

Accounting Entries for Bonus Issue

Capital comprises share capital, share premium, preference share

capital, revaluation surplus and retained earnings. If capital does not
change and shares capital increases, the decrease comes from either
the share premium or retained earnings account.

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Bonus Issue of Ordinary Shares

The double entry to account for the bonus issue is:

Individual Account Category Explanation

DR Share Premium/ Capital The bonus issue is taken either
Retained Earnings from the share premium or
retained earning account

CR Ordinary Share Capital Capital The ordinary capital has

increased (by the par value)

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Example 2
BGF Co has 300,000 $0.5 ordinary shares in issue. The balance on the
share capital account is $150,000, and the balance on the share
premium account is $250,000.

The company decides to carry out a 1 for 5 bonus issue.

Number of shares to be issued = 300,000 ÷ 5/1 = 60,000 new shares

The accounting entry is:

DR Share Premium $30,000

$30,000
CR Ordinary Share Capital 60,000 x par $0.50

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Bonus Issue of Ordinary Shares

Advantages of Bonus Issues

✓ It increases the number of shares that a company has. This does not
affect the overall market value of a company. This means that the
market value per share falls, which could make the shares more
marketable.

✓ It increases the share capital balance in the statement of financial

position, giving the appearance that the company is well-capitalised.

✓ It is a return that can be made to shareholders without spending any

cash.

✓ It increases share capital without diluting current shareholder

holdings.
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Bonus Issue of Ordinary Shares

Disadvantages of Bonus Issues

 Bonus issues are costly to administer.

 If retained earnings are used instead of the share premium account,
the funds available to pay dividends in the future are reduced.

 It does not raise any cash.

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Activity 3

Samrul Co has in issue 450,000 ordinary shares that have a par value of
50 cents each. These shares were all issued several years ago at an
issue price of $1.40 each. Samrul Co prepares its financial statements to
31 December each year.

• On 1 June 20X7, there was a bonus issue of 2 for 9, with the

adjustment being made to the share premium account.

• On 1 September 20X7, Samrul Co offered a rights issue of 3 for 11 for

$1.50 a share. The current shareholders purchased all of the shares
under the rights issue.

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Activity 3

1. What are the balances on the share capital account and the
share premium account on 1 January 20X7?

2. How many shares will be in issue after the bonus issue?

3. What are the balances on the share capital and share premium
accounts after the bonus issue has been accounted for?

4. How many shares will be issued under the rights issue?

5. What are the balances on the share capital and share premium
accounts after the rights issue has been accounted for?

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Terminology
The share capital of a limited liability company represents the capital
invested by its shareholders through the purchase of shares. Shares
purchased by shareholders can be ordinary or preference shares. Below
are some of the terminologies used in respect of share capital:

• Par Value of Share Capital

Every share has a face value known as its par value (legal or nominal
value). For example, shares can have any par value, such as $1, 50
cents, or 10 cents. In exam questions, you will be given the par value.

For example, Tahsul Co is set up as a limited liability company. The par

value of each share is set at $0.50. To raise $400,000, Tahsul Co
would need to issue 800,000 ($400,000/$0.50) shares at their par
value.
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Terminology
• Authorised Share Capital
When a company is set up, it establishes the par value of each share
and the maximum number of shares it can issue. This maximum
number of shares is the company’s authorised share capital. This
authorised share capital amount can be changed by agreement with
the shareholders.

For example, Tahsul Co has authorised share capital of 1,000,000 $1

shares.

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Terminology
• Issued Share Capital
The issued share capital (sometimes called allotted share capital) is
the number of shares a company has issued to shareholders. The
issued share capital cannot exceed the authorised share capital.

For example, Tahsul Co has issued 400,000 $1 shares to

shareholders. This means that 600,000 $1 shares are still available to
be issued in the future.

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Terminology
• Called-Up Share Capital
A company may not necessarily sell its issued share capital at its par
value. The amount issued/called up to its shareholders may be a
percentage of the par value.

For example, Tahsul Co called up 60% of the par value of the shares
in an issue. This means the called-up share capital is $240,000
(400,000 shares × $1 each × 60%). This is the value of share
capital that will appear in the statement of financial position.

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Terminology
• Paid-Up Share Capital
When a company calls up a fraction of the par value, shareholders
may take their time to make pay. The amount of share capital paid is
the Paid-up share capital. The amount of share capital remaining
unpaid is the call-in arrears.

For example, Tahsul Co has received $220,000 of the amount due for
the called-up share capital. This means that the paid-up share capital
is $220,000, and there will be a receivable balance (call in arrears) of
$20,000 in the Statement of Financial Position.

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Terminology
The extract from Tahsul co’s statement of financial position is as follows:

$
Current Assets:
Call in Arrears 20,000

Equity:
Called-Up Share Capital 240,000

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Activity 4

Finds Retail Co had the following transactions during the year:

1. On 31 December 20X7, Fonds Retail Co had issued ordinary share

capital of 100,000 shares, each with a 25-cent par value. 80% of the
issued share capital was called up and paid for based on par value.

What is the value of Fonds Retail Co's ordinary share capital

and share premium account in the Statement of Financial
Position at 31 December 20X7?

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Activity 4

2. On 1 March 20X8, Fonds Retail Co called up the remaining 20% of

the issued 100,000 25-cent ordinary shares on that date. These were
paid at their par value.

What accounting entry would you create to record the

transaction on 1 March 20X8?

3. On 1 July 20X8, Fonds Retail Co issued a further 40,000 25-cent

ordinary shares at an issue price of $1 a share. Again, 100% of these
shares were called up and paid for.

What accounting entry would you create to record the

transaction on 1 July 20X8?

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Activity 4

4. On 1 September 20X8, Fonds Retail Co issued a further 20,000 25-

cent ordinary shares at an issue price of $1.50 a share. Again, 100%
of these shares were called up and paid for.

What accounting entry would you create to record the

transaction on 1 September 20X8?

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Cost of Capital
Cost of Capital for Businesses

The previous sections highlight the types of capital financing a business

can gather through equity (through the issue of shares) and liabilities
(borrowings).

As the business finances its start-up and operations with the capital
received, it also accounts for the associated costs.

The cost of capital for ordinary shares and preferences shares is the
dividend payments, while the cost for borrowings is the finance costs
(interest).

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Dividends

Definition

Dividends – An appropriation of distributable profits to

shareholders in proportion to their shareholdings.

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Dividends

Dividends are proposed by the management (board of directors) and

approved (declared) by the company at a general meeting. This is
usually the annual general meeting (AGM), at which financial statements
are presented to shareholders.

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Dividends

Dividends on Ordinary Shares

Ordinary shareholders are not necessarily entitled to receive a dividend

each year.

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Real-World Practice

Real-World Practice

If a company usually pays a dividend, this will build an

expectation that it will continue to do so. Conversely, not paying
a dividend in a year may adversely affect the company’s share
price, resulting in difficulties in raising new funds for
investment.
Therefore, large companies usually seek to keep dividends
consistent from one year to the next.

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Dividends
Dividends on Ordinary Shares

The dividend payments of ordinary shares can be calculated using

various methods:

• Percentage of Profit for the year

An ordinary share dividend should always be based on the profit after
all other obligations have been accounted for. The profit figure to be
used should be the net profit for the year (after all expenses of the
business, including interest and tax) and after any preference share
dividends.

For example, the profit is $30,000, of which 40% is to be paid as an

ordinary dividend. Therefore, the dividend is calculated as $30,000 ×
40% = $12,000.
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Dividends
Dividends on Ordinary Shares

• Percentage of Par Value of Issued Shares

A dividend percentage may be associated with the issued shares’ par
value. Therefore, the dividend payout is calculated as the percentage
multiplied by the par value of the issued shares.

For example, “a dividend of 8% will be paid”. If there are 200,000

$0.50 shares in issue, the dividend would be 200,000 shares × $0.50
× 8% = $8,000

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Dividends
Dividends on Ordinary Shares

• Dividend Per Share

The dividend payout can also be calculated based on the number of
shares issued multiplied by a given amount per share.

For example, the dividend amount per share has been announced to
be $0.10 per share. If there are 100,000 shares in issue (note that it
is shares in issue that are relevant), the dividend is calculated as
100,000 shares × $0.10 per share = $10,000

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Dividends
Accounting Entries for Dividends of Ordinary Shares

Dividends are only accounted for when they are paid. Therefore,
dividends proposed at a year-end that remain unpaid are not adjusted
for in the general ledgers, although they will be disclosed in the notes to
the financial statements.

When a dividend on ordinary (equity) shares is declared during year-

end, the dividend will only be paid out until the next financial period
once the financial statements have been approved and published.

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Dividends
Accounting Entries for Dividends of Ordinary Shares

The double entry to record the dividend payment is:

Individual Account Category Explanation

DR Retained Earnings Equity Retained Earnings (Profits)
reduce
Dividend payments reduce
CR Bank Asset the cash balance

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Dividends
Accounting Entries for Dividends of Ordinary Shares

The Retained Earnings account records the business’s total past profits
and losses. Dividend payments to shareholders are made using the
company’s residual profits. Hence the accounting entry is to reduce
(debit) the Retained Earnings account.

The accounting entry reduces both the bank balance and the retained
earnings balance in the statement of financial position, which will reduce
both net assets and capital.

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Example 3
Bloomer Co is a bakery business that pays regular dividends to its
ordinary shareholders. Its year-end is 31 December.

On 31 December 20X1, Bloomer Co proposed a final dividend for the

year of $100,000 to its shareholders. This is not paid until March 20X2.
In September 20X2, the company then pays an interim dividend of
$50,000; on December 31, it proposes a final dividend of $130,000
(which will not be paid until 20X3).

How much dividend should Bloomer Co’s financial statements

record for the year ended 31 December 20X2?

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Example 3
The rule is that dividends are only accounted for when they are paid.
Dividends proposed at a year-end are never accounted for, although
they will be disclosed in the notes to the financial statements.

The proposed dividend payment of $100,000 is only disclosed in the 31

December 20X1 financial statements.

In 20X2, Bloomer Co has paid $150,000 ($100,000 in March and

$50,000 in September). Therefore, $150,000 is the amount of dividend
that needs to be accounted for and recorded in the financial statements
for the year ended 31 December 20X2.

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Example 3
The double entry to record the entry on 31 December 20X2 is:

DR Retained Earnings $150,000

CR Bank $150,000

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Activity 5

Alamo has issued 150,000 ordinary shares with a $1.50 par value. In
addition, the company declared a 5% cash dividend in respect of 20X6
results on 17 February 20X7.

Calculate the total dividend payment and state how this will be
reflected in the financial statements for the year ended 31
December 20X6.

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Dividends
Dividends on Irredeemable Preference Shares

Irredeemable preference shares do not require the investment to be

repaid and are classed as part of equity. The dividends payable is
treated as an appropriation of profit in the same way as dividends on
ordinary shares.

The double entry to account for dividends on irredeemable preference

shares is:

Individual Account Category Explanation

DR Retained Earnings Equity Retained Earnings
(Profits) reduce
Dividend payments
CR Bank Asset
reduce the cash balance

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Example 4
Flowers Co is a company with a chain of shops which sell flowers and
potted plants. It has in issue 100,000 ordinary shares and 20,000 5%
irredeemable preference shares. The ordinary shares have a par value of
10 cents a share, and the preference shares have a par value of $1 a
share.

For the year ended 31 December 20X5, the management of Flowers Co

expects to make a profit after tax of $146,000. On 31 December 20X5,
Flowers Co paid an ordinary dividend of 40% of the expected profit. The
preference dividend was also paid on that date. On 1 January 20X5, the
balance on the retained earnings account was $600,000.

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Example 4
Irredeemable Preference Share dividend:

The preference dividend is 20,000 shares × par value $1 × percentage

5% = $1,000.

Ordinary Share dividend:

First, calculate the available profit. This will be the profit minus the
preference dividend calculated above. Profit after tax $146,000 –
Preference dividend $1,000 = $145,000.

Therefore, the ordinary dividend paid is $145,000 × 40% = $58,000.

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Example 4
Retained Earnings Account

Note: Assume the actual profit level after tax is the same as expected,
of $146,000.

The Retained Earnings account will be:

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Example 4
In the statement of profit or loss, the amount of profit for the year is
$146,000. None of the preference dividend, the irredeemable preference
shares or the ordinary dividend appears in or affects the statement of
profit or loss.

© ACCA 79

Finance Cost
Finance costs are the annual costs that a company incurs on funds
provided to it where there is an obligation to repay those funds in
future.

This term is extensive and includes all costs arising from what would be
considered by normal accounting principles to be financing transactions.
Examples are:

• Any costs incurred in respect of loans or borrowings

• Preference dividends on redeemable preference shares (because
the substance of such shares is that they are a debt/liability)

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Finance Cost
Dividends on Redeemable Preference Shares

Redeemable preference shares carry an obligation to repay the

investment and are classed as liabilities. Therefore, dividend payments
for redeemable preference shares are treated as finance costs, not as
an appropriation of profit (reduction in retained earnings).

© ACCA 81

Example 5
BB Co has 50,000 $1 6% redeemable preference shares in issue. The
6% represents the dividend that the company needs to pay. This
percentage is applied to the shares' par value to calculate the dividend's
annual amount.

The annual finance cost for redeemable preference shares is the annual
dividend of 50,000 shares × $1 par value × 6% = $3,000.

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Finance Cost
Interest Costs on Borrowings

Borrowings give the holder (the lender) the right to receive a fixed
return (interest), and they will be repaid at some point in the future.
The interest is the cost of borrowings capital and is treated as a finance
cost.

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Example 6
BB Co has $500,000 8% loan notes in issue. The 8% represents the
interest that the company needs to pay each year. This percentage is
applied to the loan notes’ par value ($500,000).

The annual finance cost for loan notes is the annual interest cost of
$500,000 × 8% = $40,000.

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Finance Cost
Accounting Entries for Finance Cost

It does not matter how a finance cost arises or what form it takes
(dividend or interest) – there is only one accounting treatment.

There will be a separate ledger account called 'Finance costs' in the

general ledger.

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Finance Cost
Accounting Entries for Finance Cost

The double entry to account for finance costs is:

Individual Account Category Explanation

DR Finance Costs Expense Finance Costs (Expense)
increases
Finance cost payments
CR Bank Asset reduce the cash balance

If the finance costs for the year are not paid by the end of the year, the
credit entry will be to a Payables account (Liability) instead of the Bank
account (Asset).
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Example 7
Continuation from Examples 5 and 6.

Assuming BB Co pays its loan note interest and preference dividend on

31 December 20X2, the company year-end. As a result, the finance cost
ledger account for BB Co will be as follows:

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Example 7
You will note that the balance on this account is closed off to the profit
or loss account at the year-end. This is because finance costs are an
expense of the business.

Finance costs are an expense of the business and will appear in the
statement of profit or loss. Therefore, the impact of finance costs is a
reduction in profit for the year.

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Activity 6

In the following activity, complete each statement by matching

the start of the sentence on the left-hand side to its correct
ending on the right.

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Activity 7

Komo Co has issued share capital comprising:

• $250,000 in 6% $1 preference shares redeemable in 20X8

• $600,000 in $0.50 ordinary shares.
In 20X6, Komo Co paid both the preference dividend and the final 20X5
ordinary dividend of $0.05 per share. In addition, the company also paid
an interim 20X6 ordinary dividend of $50,000. Profit for the year was
$265,000.

Calculate the dividend payments for the year ended 31

December 20X6 and explain how they should have been
accounted for.

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Statement of Changes in Equity

Equity Component in the Statement of Financial Position

A company's total capital and reserves are the difference between total
assets and total liabilities in the statement of financial position. It
represents the owners' (ordinary shareholders') equity interest.

• Reserves are funds that may be used for a specific purpose.

• Reserves do not represent cash.
• Reserves are not provisions (which must be liabilities).

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Statement of Changes in Equity

Distributable and Non-distributable

A company can only pay a dividend to its ordinary shareholders if it has

cleared all other obligations (such as preference dividends) and has
sufficient distributable reserves.

A distributable reserve has no restriction for its use. A non-distributable

reserve is one for which there is a specific use.

A share premium account is an example of a non-distributable reserve,

whilst retained earnings are a distributable reserve. The reasons behind
what is distributable and what is not are outside the scope of this
course.

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Statement of Changes in Equity

Share Premium

Share premium is not available for distribution because it is capital and

not profit. Its limited uses include:

• the issue of fully paid bonus shares

• settling preliminary expenses on company formation
• paying a premium to redeem shares or borrowings.

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Statement of Changes in Equity

Revaluation Surplus

The revaluation surplus is the cumulative unrealised gains on

revaluations of non-current assets (typically land and buildings).

• It cannot be used for dividend payments (it is non-distributable) until

the actual surplus is realised (from the sale of the asset)

• It can be used to issue bonus shares that are deemed to be paid in

full

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Statement of Changes in Equity

Retained Earnings

Retained earnings are accumulated profits and an essential component

of shareholders' equity. This is reinvested in the operations of the
business.

• Although these are after paying out dividends, later dividends may be
paid out of such retained profits (this is a distributable reserve).

• Portions of retained earnings may also be transferred to other named

reserves to be held for a specific purpose.

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Statement of Changes in Equity

Retained Earnings

• When a revalued asset is sold, the profit (or loss) on disposal

reported in the sale period is the difference between the sale
proceeds and the asset's carrying amount. The revaluation surplus is
then realised. This realisation is not reported in the statement of
comprehensive income. Instead, the revaluation surplus on the asset
is transferred to retained earnings (in the statement of changes in
equity). When a revalued asset is sold, retained earnings will
effectively include the same profit on disposal as if the asset had not
been revalued.

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Example 8
This example highlights the balances included within the equity section
of Khasma Co’s statement of financial position.

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Example 8
• Called-up ordinary share capital – This is the value of the called-
up ordinary share capital based on its par value and the proportion of
this that has been called up.

• Share premium account – When a company issues shares, it

usually does so at a price higher than the par value of the share. This
is the issue price.

The difference between the par value and the issue price is called a
premium, which is posted to the share premium account.

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Example 8
In this example, Khasma Co issued 100,000 $1 ordinary shares at an
issue price of $3.40. $1 is the par value, and $2.40 is the premium.
The accounting entry is:

DR Bank $340,000

CR Called-Up Ordinary Share Capital $100,000

CR Share Premium $240,000

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Example 8
• Preference share capital – Irredeemable preference shares are
included as equity in the Statement of Financial Position.

In this example, Khasma Co has $40,000 of $1 preference shares in

issue.

• Revaluation surplus – The revaluation surplus arises when the

company revalues tangible non-current assets. They represent the
difference between the revalued amount of the asset and its carrying
amount at the date of revaluation (minus any transfers for additional
depreciation).

• Retained earnings –The retained earnings balance reflects the value

of the accumulated profits and losses since the company started,
minus any dividends paid to shareholders.
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Example 8
• Reserves – The revaluation surplus and retained earnings balances
are often jointly called reserves and belong to ordinary shareholders.

• Total shareholders' equity – The total of all equity elements is

known as shareholders' equity.

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Statement of Changes in Equity

The purpose of the statement of changes in equity is to state the
changes in equity that have occurred in the financial year. It is a
reconciliation between the balances at the start and at the end of the
year for all equity accounts.

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Statement of Changes in Equity

The equity section of the statement of financial position includes the
following:

• share capital
• share premium
• revaluation surplus
• retained earnings.
Each of these elements will have its column in the statement of changes
in equity.

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Example 9
Below is the statement of changes in equity for GHI Co. for the year
ended 31 December 20X7.

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Example 9
The statement of changes in equity has columns for share capital (which
will include ordinary and irredeemable preference shares), share
premium, revaluation surplus, and retained earnings balances. At the
end of the statement is the total column.

© ACCA 105

Example 9
• Balance at 1 Jan 20X7:
The statement starts with the balance for each of these equity
elements at the start of the year. These figures will come directly
from last year's statement of financial position.

There is a balance of $1,000,000 for share capital, $340,000 for

share premium, $250,000 revaluation surplus, and $2,400,000
retained earnings.

The total of $4,030,000 will be the figure that appeared in the

statement of financial position last year for equity. The movements
that affected these equity balances in the year will be recorded next.

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Example 9
• Equity share issues – Only the par value of shares is included in
share capital. Any premium will be posted to the share premium
account. The equity shares issue includes ordinary and irredeemable
preference shares (because both are classed as equity).

• Revaluation Surplus – Any revaluation adjustments affect the

revaluation surplus column.

• Profit for the year – This figure will be included in the statement of
profit or loss as profit for the year (after all finance costs and tax).

• Dividends – Dividends are appropriations of profit, and it's in the

statement of changes in equity that this is captured. This will only be
for the dividends paid in the year.

© ACCA 107

Example 9
Once all the movements are recorded, each column is totalled. This total
will be the same as the figure in the statement of financial position in
the Equity section.

The overall total is $4,990,000, which is the balance of total equity at

the end of the year in the statement of financial position.

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Exam Guidance

Exam advice

FA students will need to know the presentation and the

elements of the statement of changes in equity. However,
they are not expected to prepare such a statement.

© ACCA 109

Activity 8
Holmil Co had the following equity section in its Statement of Financial
Position at 31 December 20X2:

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Activity 8
As well as the irredeemable preference shares, Holmil Co also has
$60,000 of 8% loan notes that are redeemable in 20X9.

During the year ended 31 December 20X3, Holmil Co issued 20,000 new
equity shares at an issue price of $1.80 a share. As a result, Holmil Co
also made a profit before tax and before deducting any finance costs of
$240,000 and has decided to pay an ordinary dividend equivalent to
50% of the available profit for the year.

© ACCA 111

Activity 8
1. How much will be shown as finance cost in the statement of
profit or loss for the year ended 31 December 20x3?

2. How much dividend will be paid to ordinary shareholders?

Assume that the tax charge for the year is $58,000.

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Activity 8
1. Which figures will appear in the statement of changes in
equity as movements in equity in the year?

a) Finance Cost of $4,800

b) Tax charge of $58,000

c) Profit for the year of $177,200

d) Issue of equity shares of $10,000 and increase in share premium

account $26,000

e) Dividend paid of $88,000

f) Dividend paid of $89,200

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Summary

• Capital structure comprises equity and debt.

• The cost of equity is dividends; the cost of debt is interest.
• Ordinary shares represent ownership in the incorporated entity.
• Redeemable preference shares and their dividends are accounted for as debt
and interest under IFRS.
• Reserves may be capital (non-distributable) or revenue (distributable).
• A bonus issue is a capitalisation of reserves offered to existing shareholders in
proportion to their holdings.
• A rights issue generates cash, is first offered to existing shareholders and has a
share price below market value.
• Preference shares that the issuing company may repurchase are redeemable
shares.
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Summary

• Preference shareholders are entitled to receive dividends before the ordinary

shareholders receive any dividend.
• If preference shares are cumulative, any unpaid dividend entitlement accrues to
the shareholder.
• Revaluation surplus is the cumulative unrealised gains on revaluations of non-
current assets, and it is non-distributable.
• Dividends are distributions to shareholders and included in the statement of
changes in equity.

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