Accounting for Shareholders’ Equity

Shareholders’ equity represents the owners’ residual claim on an entity’s assets after
deducting its liabilities. This includes all funds that were directly invested in an entity by
its owners, earnings that have been reinvested over time, and unrealized gains and
losses that are not yet recognized in the entity’s income statement.

Components of Shareholders’ Equity

There are six components of shareholders’ equity. These are:

 Capital contributed by owners (or common stock, or issued capital): This is the
amount of capital that was contributed to the entity by its owners. For each class of
common shares issued, the entity must disclose the number of shares authorized,
issued, and outstanding.
 Preferred shares: These shares have rights in relation to the receipt of dividends or
assets upon liquidation of the entity, that takes precedence over the rights of common
shareholders.
 Treasury shares: Otherwise referred to as treasury stock, these refer to shares in an
entity which have been repurchased by the entity. The repurchase of shares reduces
shareholders’ equity by the amount of the acquisition cost and also reduces the number
of shares outstanding.
 Retained earnings: This refers to the aggregate amount of earnings that are recognized
in an entity’s income statements and have not been paid out as dividends.
 Accumulated other comprehensive income (or other reserves): This includes other
comprehensive income which has not been recognized as part of net income and
reflected in retained earnings.
 Non-controlling interest (or minority interest): This represents minority shareholders’
interests in subsidiaries that have been consolidated by the parent company but are not
wholly owned by it.

Statement of Changes in Equity

A statement of changes in shareholders’ equity presents a summary of the changes in
shareholders’ equity accounts over the reporting period. It reconciles the opening
balances of equity accounts with their closing balances.

There are two types of changes in shareholders’ equity:

 changes that originate from transactions with shareholders such as issue of new
shares, payment of dividends, etc. and
  changes that result from changes in total comprehensive income, such as net
income for the period, revaluation of fixed assets, changes in fair value of certain
investments, etc.

Components of changes in shareholders’ equity

Typically, a statement of shareholders’ equity summaries changes in the following equity

components:

 Common stock, which represents the legal capital of the company and it equals
the product of shares issued and the stated value of each share.
 Additional paid-up capital (also called share premium), which is the excess of
paid-up capital over the legal capital. Additional paid-up capital = (issue price –
stated price) × total number of shares issued.
 Treasury stock, which represents the value of shares repurchased by the
company. It is a contra-account to the paid-up capital.
 Capital reserve(s).
 Retained earnings: accumulated earnings since the start of the company net of
dividends paid or any restatement adjustments.
 Gains and losses on cash flow hedge: unrealized portion of change in fair value.
 Gains and losses on available for sale securities: i.e. the unrealized portion of
change in fair value.
 Revaluation surplus: represents the effect of revaluation of fixed assets.

Following are the most common changes in shareholders’ equity:

 Issue of new share capital: it increases the common stock and additional paid-up
capital component.
 Net income (loss) for the period: it increases (decreases) retained earnings.
 Payment of cash dividends: it decreases retained earnings.
 Purchase of treasury stock: it increases treasury stock component and eventually
decreases total net shareholders’ equity.
 Sale of treasury stock: it decreases treasury stock component and affects retained
earnings and additional paid-up capital and ultimately increases total
shareholders’ equity.
 Issue of bonus shares: affects common stock, additional paid-up capital and
retained earnings.
 Revaluation of fixed assets: increases revaluation surplus.
 Reversal of revaluation of fixed assets: may decrease revaluation surplus.
 Effect of foreign-exchange translation: increase/decrease in foreign-exchange
reserve.
  Effect of changes in value of available-for-sale securities: increase/decrease in
available-for-sale securities reserve.
 Restatement of financial statements, for e.g. due to change in accounting
principle: changes in retained earnings.

Question 1

Which of the following is  least likely  a component of shareholders’ equity?

A. Treasury shares

B. Taxes payable

C. Retained earnings

Solution

The correct answer is B.

Taxes payable is a liability and not a component of shareholders’ equity.

Options A and C give answers which are both components of shareholders’ equity.

Question 2

Preferred shares are classified on the balance sheet as:

A. Debt.

B. Equity.

C. Debt or equity.

Solution

The correct answer is C.

Preferred shares could be classified as debt or equity depending on the agreed-upon
terms. If the shares are perpetual, they’d be classified as equity. If the shares are
redeemable at a specified date or a predetermined event, they’d be reported as a liability.

Format: Example

Alumina, Inc. is a company engaged in extraction of Aluminum. The company’s CFO has
asked you to prepare a statement of changes in equity for the company for the year
ended 30 June 2014.

Following information is available:

 The composition of the company’s shareholders’ equity as at 1 July 2013 was as

follows:

Shillings in million

Common stock, 20 M authorized shares, 5 M issued and outstanding 50

Additional paid-in capital 120

Capital reserves 30
Retained earnings 90
Revaluation surplus 15
305

 On 30 August 2014, the company declared and issued 10% bonus shares. Price per
share at the date was Shs 40.
 On 1 September 2014, the company issued 1 million new shares for total
consideration of Shs 45 million. The stated price of a common share is Shs 10.
 Profit for the financial year ended 30 June 2014 amounted to Shs 50 million and the
company paid dividends totaling Shs 16 million.
 The company is required under law to set a side 10% of net income for the period
and credit it to capital reserve.
 500,000 shares were bought back on 30 December 2014 at Shs 40 per share.
 The company reversed upward revaluation of an asset by Shs 5 million. The
revaluation surplus already includes Shs 7 million of such initial upward revaluation.

Solution
Statement of shareholders’ equity is normally prepared in vertical format, i.e. the equity
components appear as column headings and changes during the year appear as row
headings.

Following is the statement of shareholders equity for Alumina, Inc. for financial year
ended 30 June 2014. Each change is explained in the notes below:

Alumina, Inc.
Statement of Shareholders Equity
for the year ended 30 June 2014
Note Common Additional Capital Treasury Retaine Revaluatio Total
stock paid-in reserve stock d n
capital earnings surplus
Shs in million
Balance as 50 120 30 - 90 15 305
at 1-Jul-13
Issue of A 5 15 - - (20) - -
bonus
shares
Issue of B 10 35 - - - - 45
new shares
Net C - - - - 50 - 50
income
Transfer to D - - 5 - (5) - -
capital
reserve
Dividends E - - - - (16) - -16
Share F - - - (2) - - (2)
buyback
Reversal of G - - - - - (5) (5)
revaluation
Balance as 65 170 35 (2) 99 10 377
at 30-Jun-
14

Notes:

A. Issue of bonus share results in increase in the common stock and additional paid-
in capital and decrease the retained earnings. Following journal entry is behind
this adjustment:

Retained earnings (5,000,000 × Shs 20 million

 0.1 × Shs 40)
Common stock (5,000,000 × 0.1 Shs 5
× Shs 10) million
Additional paid-in Shs 15
capital (20 - 5) million

B. When new shares are issued, credit to common stock equals the product of
number of shares issued and the stated price of the share. The excess of cash
received over the credit to common stock account goes to additional paid-in
capital. Following is the relevant journal entry:

Cash (1,000,000 × Shs 45) Shs 45 million

Common stock (1,000,000 × Shs Shs 10
10) million
Additional paid-in Shs 35
capital (45 - 10) million

C. Net income increases retained earnings.

D. Since 10% of profit of the year is transferred to the capital reserve according to
the relevant laws, following journal entry is behind the adjustment:

Retained earnings (Shs 50 × 0.1) Shs 5 million

Shs 5
Capital reserve
million

E. Cash dividends decrease the retained earnings.

F. Shares repurchased are accounted for by debiting the treasury stock account,
which is a contra-account to the shareholders’ equity. Following is the journal
entry behind the adjustment:

Treasury stock (500,000 × 40) Shs 2 million

Shs 2
Cash
million

G. This adjustment is only required under IFRS. If a fixed asset is revalued upwards, it
increased the asset book value and also increases revaluation surplus, which is a
shareholders’ equity component. When the same asset is subsequently revalued
down, the downward revaluation is written off to the extent of any upward
revaluation originally credit to revaluation surplus in relation to that asset. In this
particular case, the asset was revaluated up in earlier year such that a credit of
Shs 7 million was made to revaluation surplus. Now, a downgrade revaluation by
Shs 5 million can be written off completely against revaluation surplus and hence
this decrease in revaluation surplus.