Answers to self-test questions
3.8 Capital and reserves
Now we can move on to the bottom part of the balance sheet. The part that shows where the money has come from to invest in the non-current assets and working capital.
So that you can refer to it easily, the relevant part of the balance sheet from the beginning of the chapter is repeated below.
Extract from Example plc’s balance sheet as at 31 December Year 7
£’000
Share capital 2,200
Reserves – retained profits 350
Other reserves 230
Shareholders’ equity 2,780
Non-current liabilities 286
Capital employed 3,066
3.8.1 Share capital
We have already discussed at the beginning of Chapter 2 that the shareholders are the owners of the business – they each have a share in its fortunes.
The most common types of share are preference shares and ordinary shares. Preference shares are so called because they have preference over the payment of dividends and the repayment of capital. Each year the preference shareholders will receive their dividend payment first, and the whole of any profits left will usually belong to the ordinary shareholders. This may be a large or small (or non-existent!) amount of money, depending on how well the company has performed during the year.
However, preference shares will receive only a fixed rate of dividend. For example, if a company has issued 5,000 8%
preference shares of £1 each the preference shareholders would receive their dividend of £400 first. The potential dividends for ordinary shareholders after payment of the preference dividend are, in theory, unlimited.
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In most cases, even the preference shareholders’ dividends are not guaranteed. Dividend payments depend on the company making profits. Furthermore, remember that the company will not necessarily pay out as dividend all of the remaining profit available for the ordinary shareholders. Some of the profit will be kept as reserves to fund future growth.
Another difference between the two types of share is that in the event of the company winding up, the preference shareholders’
capital would be repaid before the ordinary shareholders receive any repayment.
It is the ordinary shareholders that are the true owners of the business. They have voting rights which give them control over the business, for example, through their ability to vote for the appointment of individual directors or for the removal of directors from office. Preference shareholders do not usually have any voting rights.
3.8.2 Retained profit reserve
We saw in Chapter 2 that retained profit is an important source of finance for a company. Retained profit is one of the most common reserves that you will see in company balance sheets. The retained profits reserve balance is merely a statement of how much profit has been retained over the years to fund the company’s growth.
Do not make the very common mistake of thinking that the retained profit reserve balance represents hoards of cash which the company has access to. Reserves are not cash. They are merely a source of finance that has been used to buy, say, more non-current assets or inventory to expand the company’s operations. The retained profit reserve figure shows where the money originally came from. It is a sort of historical listing or balance that usually grows larger each year as more profits are retained in the business.
If you want to know whether the company has any cash then look at the other side of the balance sheet, under current assets!
The retained profit reserve might be referred to as the retained earnings reserve. Confusingly, some companies might label the retained profit reserve balance on their balance sheet as ‘profit and loss account’!
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There will usually be other reserves on a balance sheet in addition to the retained profit reserve. We will look now at the two reserves you are most likely to come across: the revaluation reserve and the share premium.
3.8.3 Revaluation reserve
In Section 3.4.5 we saw how companies can revalue their non- current assets on a regular basis. For example, if a property has increased in value the new, higher value can be shown within non-current assets on the balance sheet.
However, this will mean that the total of the top part of the balance sheet has increased. It will now be ‘out of balance’ with the total of the lower part. The sum of the values of the non-current assets and the working capital will be higher than the sum of the finance sources shown on the lower part of the balance sheet.
Exercise
Consider that the increased value of the non-current asset is rather like a profit that the business has made but which the directors cannot afford to distribute to the shareholders as dividends. The value of the property could just as easily fall in the future and the gain has not actually been realised yet in cash.
How do you think this gain should be recorded in the lower part of the balance sheet in order to make the balance sheet balance again?
Solution
The gain is shown in the lower part of the balance sheet as a reserve.
This specially created reserve is called a ‘revaluation reserve’.
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For example, if the valuer or surveyor certifies that the property has increased in value by £100,000 the balance sheet value of the property within non-current assets will be increased by £100,000 and a revaluation reserve of £100,000 will be shown in the lower part of the balance sheet.
Therefore the valuation gain is effectively treated in just the same way as a retained profit. It is shown as a reserve in the balance sheet.
The difference is that the revaluation reserve cannot be used for dividends in the future whereas a retained profit reserve can be used for dividends if the directors so desire.
The revaluation reserve is a capital reserve, which contrasts it with the retained profit reserve which is a revenue reserve. Revenue reserves are created out of profits and can be distributed to shareholders as dividends. Capital reserves cannot be distributed as dividends.
3.8.4 Share premium
The nominal value of a share is the face value that is shown on the share certificate. For example, a £1 ordinary share has a nominal value of £1 that will be printed on the share certificate. Ordinary shares with nominal values of 50 pence and 25 pence are also common.
The nominal or face value of a share might also be referred to as its par value.
The nominal value remains constant whereas the market value or price of the share will fluctuate depending on the company’s performance and on factors such as investors’ opinions of the company’s future prospects.
When a company’s £1 shares are already trading in the market the directors might decide to issue or sell some more shares. Even though these shares will still have a nominal value of £1 each the company should be able to sell them at the current market price.
The share premium is the excess which the company receives for the sale of the shares, above the nominal value of the shares sold.
For example, if 1,000 shares with a nominal value of £1 each are sold by the company at the market value of, say, £3,000 the amount of share premium received is £2,000.
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This transaction will be reflected in the balance sheet as follows:
Top part of the balance sheet Increase cash by £3,000.
Lower part of the balance sheet
Increase share capital by £1,000 (the nominal value of the shares issued/sold)
Increase share premium by £2,000 (the share premium reserve) The share premium is thus another special reserve which is shown in the lower part of the balance sheet. It is a capital reserve which means that the directors cannot use it to pay dividends to the shareholders.
3.8.5 Shareholders’ equity
The shareholders’ equity is the total of the share capital and reserves. It might also be referred to as the shareholders’ funds. The total of the shareholders’ funds represents their total investment in the company. The reserves belong to the shareholders just as much as their original capital does.
For example in the case of retained profits the shareholders have effectively agreed that the company should reinvest the profits on their behalf. The profits still belong to the shareholders, but the profits are now tied up in the company’s assets.