● Reserves
● Debt–equity hybrids
● INTRODUCTION
The capital and reserves represent the owners’ stake in the business. The share capital repre- sents the shares in issue at the year end, and the reserves can come from a variety of sources.
The main ones are:
● the accumulated retained profits, less any losses, since the business started – this reserve is called the profit and loss accountand is the only distributable reserve (there is a docu- ment called the profit and loss account showing this year’s profit, and a reserve called the profit and loss account showing the accumulated profits since the business started;
● the extra premium that has been paid, over the nominal value, for the shares that have been issued – this is called the share premium account;
● the revaluation of the businesses’ assets – this is called the revaluation reserve.
It is possible to find other reserves on the balance sheet, and these will be discussed later in this chapter.
● SHARE CAPITAL AND SHARE ISSUES
In this section we will consider:
● the difference between the authorised and the issued share capital;
● the different types of shares found in company accounts;
● share issues;
● capital reconstructions through bonus issues, share splits and consolidations and reduc- tions in share capital;
● share buy-backs;
● information that is disclosed in the accounts.
●
Authorised and issued share capital
There will be two share capital numbers in the notes to the accounts: the authorised share cap- italand the issued share capital. The authorised share capital is simply the amount that the company can issue, not what it has issued. If the directors of the company wish to issue more shares than have been authorised they will have to seek shareholder approval, normally this just requires the passing of a resolution by a majority of the shareholders. The procedure for increasing the authorised share capital is contained in the Articles of Association.
The issued share capital shown on the balance sheet is the total number of shares currently in issue at their original value (this is called the nominalor the par value). All UK shares must have a par value, which is determined when the company is started. Legally shares cannot be issued at a discount to this value (s 100, Companies Act). (This is not always true overseas, for example in the USA it is possible to have shares with no par value and to be able to issue shares at any price.) The nominal value and the authorised share capital is included in the company’s Memorandum of Association.
The notes to the accounts usually describe the issued shares as allotted(the company has decided who is going to hold the shares), called up(they have asked for the money) and fully paid. (Not all shares are fully paid, many of the privatisations required shareholders to pay in instalments. Had the companies gone into liquidation the shareholders would have had to pay the outstanding amounts on their shares!)
●
Different types of share
Different kinds of shares can be found in company accounts:
● ordinary shares
● deferred shares
● preference shares.
Companies may also issue warrants to allow people to subscribe for shares at some future date.
FRS 4 (Capital Instruments) categorises shares as equity sharesand non-equity shares. Non- equity shares are shares that have any of the following characteristics:
● fixed dividend:the dividend is fixed and, therefore, its payment does not depend on the financial performance of the company, or on the dividends paid to other shareholders;
● limited rights in a liquidation:there are limited rights to share any ‘winding-up sur- plus’ if the company is liquidated;
● redeemable.
If a share has none of these characteristics, it would be regarded as an equity share. Most ordinary shares would be regarded as equity shares and most preference shares would be regarded as non-equity shares.
Ordinary shares
These are the commonest form of shares, and comprise most of a company’s share capital.
(They are referred to as common stock in America and shown as common stock in transla- tions of overseas accounts.) Ordinary shareholders are usually entitled to all of the profits after tax, minority interests and preference dividends – although usually not all of the avail- able profits are distributed as dividends.
However, it is possible (but unusual) to have different types of ordinary share; with differ- ences in:
● voting rights
● entitlement to dividend
● entitlements and ranking in the event of liquidation.
The commonest variation is in voting rights; where some shares may have restricted voting rights or no voting rights at all (these are often called A shares). Whilst this practice used to be fairly common in recent years, most companies have now enfranchised the non-voting shares.
Another variation on the ordinary share is the redeemable ordinary share. Companies may issue these (Companies Act, s 159) if they have unredeemable ordinary shares and are allowed to do so in their Articles.
Deferred shares
These are often the founders’ shares and are now rarely seen in company accounts. They either:
● do not receive a dividend until some future date, usually several years after issue; or
● they only receive a dividend after ordinary shareholders’ dividends have reached a pre- determined level.
Preference shares
Preference shares have a fixed dividend that must be paid beforeother dividends can be paid.
(They are referred to as preferred stock in America and shown as preferred stock in transla- tions of overseas accounts.) There are various types of preference shares; they can include one or more of the features outlined below:
● cumulative preference shares:if the company does not pay a preference dividend on a cumulative preference share, it is only postponing the payment, which accumulates.
The preference dividend is known as ‘in arrears’ (which must be noted in the accounts) and no other dividend can be paid until all the preference dividend arrears have been paid;
● redeemable preference shares:these have to be redeemed (repaid) at a fixed date. This makes them fundamentally the same as debt, but with the dividend being paid out of after-tax profits. They are common in two situations: management buy-outs and bank res- cues (the bank undertakes a debt–equity conversion, turning loans into redeemable pref- erence shares);
● participating preference shares: shareholders may receive two dividends: the fixed dividend, and a variable dividend (usually a proportion of the ordinary dividend);
● convertible preference shares:these are becoming increasingly common. Preference shareholders have the right to convert into ordinary shares at a predetermined rate, at some future date.
Warrants
A warrant is a type of option that gives the holder the right to buy a specified number of shares in the company at a predetermined price on or before an expiry date. They are often attached to bonds to make the issue more attractive (these are called covered warrants), although they can be traded separately. Warrants can also be issued and traded in their own right (naked warrants).
Trading in warrants, like any form of option trading, is high risk with a potential high 5 Share capital and share issues
return. If a warrant gives an option to buy a share for £1.75 and the share is trading at £2.00, the warrant would be worth at least 25p. If the share price moves up by 30p (17 per cent), the warrant price would also move by 30p (120 per cent). However, if the share price falls by 30p the warrant would be worthless.
Accounting for warrants
Warrants used to be disclosed in the notes to the accounts rather than the balance sheet itself. However, FRS 4 (Capital Instruments) now requires warrants to be disclosed as part of shareholders’ funds.
If a company has issued warrants, the notes to the accounts have to disclose the exercise price and the expiry date. When the warrants are issued, the proceeds are included in the reconciliation of movements in shareholders’ funds. If the warrant is subsequently exercised, the proceeds will include both the value that was previously recognised and any additional consideration. If the warrant lapses and is unexercised, a gain to the existing shareholders is reported in the statement of total recognised gains and losses.
ADRs
You will find reference in some accounts to American Depository Receipts (ADRs). These are not another type of share. It is a mechanism used in the USA to simplify the procedures for holding shares in foreign companies. The shares are bought, on behalf of the American investor, and deposited in a bank outside of the USA. An American bank then issues ADR cer- tificates to the American shareholder. The custodian bank then processes the payment of dividends, rights issues etc. ADRs may be traded on American stock exchanges (they are then called sponsored ADRs) if the company is registered with the Securities Exchange Commis- sion and complies with their requirements.
●
Share issues
The company’s ability to issue further shares is determined by two things:
(1) the authorised share capital;
(2) the Stock Exchange rules. The continuing obligations for listed companies limit the amount of shares that can be placed with new investors, requiring any issues of shares, convertibles or warrants to have been approved by the shareholders in a general meet- ing, or by the Stock Exchange. Placings are restricted unless the market conditions or the company’s circumstances can justify them. This essentially forces listed companies to have major new issues in the form of a rights issue(new shares are offered to existing shareholders in proportion to their existing shareholdings).
Whilst most major share issues are in the form of a rights issue, shares can also be placed directly in the market, issued to employees or issued instead of a cash dividend.
Rights issues
In a rights issue, the company offers its existing shareholders the opportunity to buy new shares at a discounted price.
For example, a shareholder could be invited to buy one share at £1.00, for every five shares he already owns. If the current market price is £1.60, the shareholder is being offered the shares at a discount to encourage him to buy the shares. This does not mean that he will necessarily make more money. It is possible to calculate a theoretical ex-rights price. If the shareholder exercises his right to buy, the shares the value of his shareholding will be:
5 existing shares at the current market price of £1.60 £8.00
1 new share issued for cash £1.00
Total for 6 shares £9.00
Theoretical ex-rights value of each share (9.00 ÷ 6) £1.50
This should be the price that the shares will be trading in the market following the rights issue.
The price will fall from £1.60 to £1.50, reflecting the fact that the new shares were issued below the market price.
Shareholders have three options in a rights issue:
(1) they can exercise their right to buy the share;
(2) they can sell their rights to buy the share (in practice this option is only available to large shareholders, the smaller shareholders’ profit will be wiped out by dealing fees). The value of the rights will depend on the difference between the issue price and the current share price;
(3) they can do nothing. In practice, when the shareholder does nothing, the company will usually sell the shares on the shareholder’s behalf and send the proceeds to the shareholder.
Most share issues are ‘underwritten’. This is a form of insurance, provided by banks and institutions, where the underwriters agree to buy the shares if no one else wants to buy them.
This ensures that the company will receive some cash from the rights issue. The underwriters were forced to buy the shares in the BP privatisation in 1987. The stock-market crash put the offer price above the market price, so that most of the shares were left with the underwriters.
Other ways of issuing shares
As long as the company has its shareholders’ or the Exchange’s permission, there are other ways that a company can issue shares. These issues are normally at a lower discount than a rights issue, and so have the advantage of generating more cash for the company. The other options available to the company are:
● a placing: the company creates new shares and its financial adviser places them with a range of investors. Companies often use this in overseas markets, placing shares overseas without offering them to investors in London;
● a vendor placing:these are usually used when the company is making an acquisition.
The company is acquired through a share exchange, but the acquired company’s share- holders may not want the acquirer’s shares. Therefore, the acquirer arranges, in advance, for the shares to be sold to other investors, usually institutions;
● a bought deal:in a bought deal, the company invites bids from investment banks and other securities houses for the shares. The shares are then sold to the highest bidder, who subsequently sells them to investors;
● a placing and an open offer: the company’s existing shareholders lose in the three methods outlined above. The company offers shares at a discount to the market price to new shareholders, thus transferring value from existing shareholders to new shareholders.
5 Share capital and share issues EXAMPLE
A placing and an open offer, also called a clawback, eliminates this objection. The com- pany sells the shares to its financial adviser, and has, therefore, guaranteed a cash inflow.
The financial adviser then offers the shares to the existing shareholders, in proportion to their existing holdings. The existing shareholders then have the opportunity to buy the shares, but they have no rights to sell for cash.
Employee share schemes
Many companies offer employees and directors the opportunity to buy shares in the company at a discounted price. The Companies Act, s 153 allows companies to make loans to employ- ees (but not directors) to buy shares. These loans should be disclosed in the company’s bal- ance sheet. However, these tend to be rare, as other schemes offer more tax advantages.
The government has given tax concessions to three types of employee share scheme, which will not be subject to income tax, although profits are subject to capital gains tax:
(1) save-as-you-earn (SAYE) schemes:this is a savings-related scheme where an employee enters into a savings contract to save a maximum of £250 per month for a minimum period of five years. The company grants an option for the employee to buy shares at a maximum discount of 20 per cent of the share’s market price on the date when the option is granted. At the end of the savings period, the employee has the option to con- vert his option into shares or to take the cash;
(2) profit-sharing schemes:under the current legislation companies are allowed to allocate
£3000 a year (or 10 per cent of salary to a maximum of £8000) for each employee to be used to buy shares for employees. These shares are bought by employee share-ownership trusts, and are held in trust for at least two years. As long as the shares are held for five years they are not subject to income tax, but profit made on the sale of shares is subject to capital gains tax in the usual way. If the shares are sold within five years, they are sub- ject to income tax on a sliding scale, determined by the time they have been held;
(3) company share-option plans:these plans grant employees the option to buy shares in the company at the current market price. The options are limited to a maximum market value (at the time when the option is granted) of £30 000 per employee. If the plan is approved by the Inland Revenue it will not be subject to income tax. Some share-option plans are used as performance incentives for senior managers and directors and are con- ditional on certain performance criteria being met.
Accounting for employee share ownership plan trusts (ESOP trusts)
The accounting for ESOPs is covered by UITF 13 (Accounting for ESOP Trusts). It states that where a company has effective control of an ESOP trust, the company should recognise the shares as an asset and charge any associated costs to operating profit on an accruals basis. For this reason, companies should:
● recognise the shares as assets until they are passed to the employees. These should be appropriately shown as fixed or current assets. Any permanent diminution in the value of shares shown as fixed assets should be recognised immediately;
● any difference between the book value and the option value (or the conditional gift value) should be charged as an operating cost over the employees’ service period when they are granted;
● the company should record its liabilities for any borrowings of the ESOP trust that it has guaranteed;
● finance and administration costs should be charged on an accruals basis.
The benefits arising under some schemes, usually for directors and senior management, are determined by the achievement of performance criteria. UITF 17 (Employee Share Schemes) is concerned with performance related schemes and is obligatory for accounting periods on or after 22 June 1997. It covers the accounting treatment of share schemes other than SAYE schemes, and any other scheme which is offered to all or substantially all employees. Con- sequently, it is concerned with share schemes for directors and senior employees, where shares are often given as part of a bonus payment.
The cost of the scheme should be based on the fair value of the shares when the award is made, and will represent the difference between the fair value and the consideration that has been paid, unless the shares are held in an ESOP trust accounted for in accordance with UITF 13. Then the cost will be the difference between the book value of the shares and the con- sideration paid. This cost should then be recognised over the period to which the employee’s performance relates. If the scheme is long term, and the award is dependent upon perform- ance, it should be assumed that the performance criteria will be met.
Scrip dividends
A scrip dividend is paid in shares, rather than cash, and so involves a share issue. The share- holder usually has the option to take the dividend in either cash or shares. Scrip dividends have two advantages to the company: there is no cash outflow, and they are not subject to ACT. (This is advance corporation tax, which is paid to the Inland Revenue shortly after the dividend payments. It may then be reclaimed later by the company. This tax is discussed in detail in Chapter 14.)
Smaller investors will often take the scrip dividend, as it allows them to increase their holding without incurring dealing fees. If the company wants to make the scrip alternative attractive to institutional investors, it will be enhanced(the value of the shares will be con- siderably greater than the cash). This was particularly important when pension funds were able to reclaim the ACT.
Accounting for scrip dividends
When the company declares a scrip dividend alternative, it usually does not know how many shareholders will elect to take the scrip alternative. Consequently, FRS 4 (Capital Instruments) requires that the dividend should be accounted for as if all shareholders will take the cash dividend. When shares are issued as a scrip dividend the value of the shares will be deemed to be equal to the cash-dividend alternative.
●
Capital reconstructions
Bonus issues
There are other forms of share issues that do not involve any cash coming into the business.
Companies can have scrip, bonus, or capitalisation issues (they all mean the same thing!). In these issues the company converts some of the reserves into share capital. Distributable reserves (the profit and loss account) and the undistributable revaluation reserves, capital redemption reserve, and the share premium account can be used to create bonus shares, as long as it is allowed by the company’s Articles. Companies will usually capitalise undistrib- utable reserves rather than distributable ones.
5 Share capital and share issues