Final accounts - Part two: Equity Capital

Part two of this topic focuses on clarification of the accounting treatment of capital contributed towards the start of the business. Capital is the initial cash or non-cash contribution made by either the owner or owners of the business.  This can be in form of cash or any economic resource that can be assigned a monetary value. That is, items such as furniture, motor vehicles, land or properties, plants and equipment if not cash or it can be both. If the source of capital is from the owners of the business, it is referred to as owners’ equity.

Lesson One; Raising of Owners’ Equity

Once the idea of undertaking a particular income generating activity by the entrepreneur, capital contribution is always the starting point for any business, whether small or large. Capital originating from the owners of the business is known as owners’ equity. Since the aim of the promoters of the organization is to increase their wealth in the long run, (owners’ wealth), any profits generated are apportioned in diverse perspectives of the organization. Therefore, the following discussion on capital contribution will be anchored on the various aspects of capital contribution which assumes diverse terms used in the statement of financial position or in accountancy in general.

 

The entrepreneur/learner need to know that one can raise capital either in lump sum especially in the case of sole proprietor. That is at once by the owner. But for large organization such as private or public limited companies, capital contribution is through issuance of ordinary shares. Capital raised through this manner is called ordinary share capital and it is also referred to as owners’ equity. This is the reason why ordinary shares is defined as a unit of capital. For instance, if a company wants to raise one million US dollars as capital, the management has many options of raising that amount. For instance,

 

Option one-If the Issuing price is $1

The management may wish to raise the aforementioned amount by issuing 1,000,000 ordinary shares at $1 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1*1,000,000).   

 

Option two- If the Issuing price is $10

 The management may also decide to raise the aforementioned amount of $1,000,000 by issuing 100,000 units of ordinary shares at $10 which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $10*100,000).

 

Option three- If the Issuing price is $1,000

Further, the management may prefer to raise the same amount by issuing 1,000 ordinary shares at $1,000 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1,000*1,000).  

NB: The units are equal for their monetary value is either $1 or $10 or $1,000 each as mentioned in options one to three in that order. Therefore, if the company sell those shares to the public or privately, the one million US dollar target will be arrived at if we sum up all cash received from the public regardless of how much units of shares each individual buy.

As an entrepreneur/learner, note this;

-the number of units of shares are said to be equal for they are all issued at the same price

-the issuing price is referred to as the nominal price, issuing price or par price or par value. It is also known as the  face value. The issuance price sometimes can be more than the nominal/par value hence referred to as premium as or lower than nominal hence discounted price.

-The amount of capital raised through issue of ordinary shares using the nominal price is referred to as authorized share capital. Remember the capital clause in the memorandum of association we discussed in level two of this accounting tutorial series that the promoters of the business has to state to the registrar of companies or the authority in charge of registration of businesses the mode of raising capital (capital structure).

 

As an entrepreneur/learner, it is fair to understand that capital contribution is a property of the owner(s) which has been extended to the business. In other words, when owners of a business contribute capital to start the business, in a way, they lend to the business. This is why capital is referred to as special liability or owners’ claim for just like in the case of the other external debts, the owners who are internal lenders of the business in question have a right to be repaid the amount of capital they contributed to the business. The only difference between the external debts such as bank loan and capital contribution is that for capital contribution, it is only claimed back (repaid) by the business owner(s) if and only if (iff) the business has been closed down or terminated. Whereas the external lenders are repaid their debt plus interest within a specific period of time such as within a year, two years or so and not necessarily when the business is terminated.

 

In conclusion;

We should understand that businesses are financed through two sources which are debt affiliated in nature, namely; internal debt which is in form of capital contribution by the owners of the business and external debt, which is from third parties such as individuals and financial institutions such as banks who are not owners of the business hence we call them third parties. As an entrepreneur/learner, you should consider the distinction between the two sources of finance due to threefold reasons as explained below;

 

i)     Capital contribution represents an internal lending by the owners’ of the business to the business itself.

Customarily, small and medium business owners contribute own finances or non-financial resources to fund the activities of the organization. This is in another way lending the business for if the business fails in the future, we will witness them rushing to claim their original capital or whatever the amount they can realize, either more or less than the original capital contribution. Therefore, the entrepreneur need to put a lot of weight on the lender to borrower relationship created between the two parties once the capital has been contributed hence treat the business as a separate entity as far as that capital is concerned. But unfortunately, the common mentality of entrepreneurs/learners is that the capital given to the business also belong to the owners, hence no clear cutting line between owner’s assets and the business assets/resources. This attitude is not proper. This is why small business holders carelessly withdraw either cash or inventory for domestic consumption when need arises even without recording the same in books of accounts. Even in other cases the owner of the business will make use of his her personal property such as car or pick up to run the business and no records to show the proportion of costs consumed by the business such as depreciation, fuel or insurance expense associated to that personal property. This is where the rains start beating any entrepreneur who does not take both sources of finance with equal weight.

 

ii) External debt is financing of the business from third parties.

Although we have interrogated the matter of external debt in lesson 9.2.7 towards the tail end of this part, this nature of debt is characterized by terms and conditions and debt covenants which bind the concerned parties. The terms binding the parties concerned are stringent such that breaching of any of them by either party translates to payment of damages. This makes the management to be disciplined in handling finances from external sources unlike the case of internal sources.

 

i)      Debt/Equity Capital structure mentality

The orthodox argument in Corporate Finance is that capital structure of business is basically on external debt and owners’ contribution structural nature. This implies that equity is not a debt. But this is not true for as we have discussed in (i) above, equity is also a debt to the business. Therefore, in a nutshell, all businesses are debt financed and the parties involved in both cases should set stringent debt terms and covenants for the sake of instilling management discipline. This approach will assure management and owners of business continuity and the common problems of agency conflicts and premature termination of small business before witnessing their fifth anniversary will be a thing of the past.

 

In conclusion, Debt/Equity (D/E) capital structure for SMEs can be been revised as follows;

D/d Ratio

Where;

D” is the proportion of external debt used to finance the business activities

d” is the proportion of internal debt used to finance the business activities

This revised debt/equity model implies that both external debt and internal debt should be awarded equal debt covenant, terms and condition weight. My suggestion is that, as the management access external debt, they should attach the same covenants of external debt to internal debts (equity).

 

Lesson Two; Net Profit

As we stated earlier, the concern of business owners is to generate profits and increase their capital wealth. The entrepreneur/learner need to know that the profits generated by the business is on the basis of the capital contributed by the owner(s). Therefore, any profits made is part of owners’ equity or owners’ claim as stated earlier.

 

Net profit is also referred to as reserve or net profit of the year for it is the gain gotten from the yearly activities of the organization. Again this amount is owners’ claim or equity. Hence it is a liability to the business for it is supposed to be paid to the owners in form of profit distribution or dividends.

 

Points to be learned by the entrepreneur;

One, net profit is not an income to the business per se’. The common practice in accounting is that, the net profit is posted on the credit side of the profit and loss account. Hence most people think the reason of recording it on that side is because it represents income. Ok, it is an income but to the owners but not the business. What we see is actually a demonstration of how this income is treated. If the management does not distribute it to the owners at that moment, it remains a liability. If it is paid to the owners, it becomes an expense to the business and an income to the owners of the business.

Two, the dividend policy adopted by the management determines the rate of dividend payout. The dividend policy may be favorable or unfavorable to the owners.

Three, on the same breath of dividend policy, the retention ratio is determined by the dividend policy applicable such that if the dividend policy is 10% of the nominal value of the ordinary shares, then the retention ratio will be (1-0.1)/100.

 

Lesson Three; Retained Profit

Retained profits is the whole or part of net profit of the year that is ploughed back to the business by the management. The decision on the proportion of net profit to be ploughed back (retained) and to be distributed to the owners of the business (dividend) is at the discretion of the management. This makes this nature of investment more risky for chances of owners failing to get any returns is high especially when no much profits are made. Therefore, the part of the net profit of the year which is ploughed back for furthering the business is referred to as retained earnings and it is usually a certain percentage (%) of the whole profit amount made  in that financial period. It is also commonly referred to as retained earnings and it is owners’ equity or claim.

 

Lesson Four; General Reserve

General reserve is net profit that is set aside for general purposes. This is an extension of net profit of the year that is retained for general purposes hence it emanates from retained earnings. For instance, if the net profit of the year was $120,000 and $50,000  is set aside for general purposes, then this represents general reserve component.

 

Lesson Five; Capital Redemption Reserve Fund (CRRF)

Capital Redemption Reserve Fund (CRRF) is net profit that is set aside for redeeming or purchasing back shares already issued to the public especially preference shares. This is an extension of net profit of the year that is retained for paying back capital initially gotten from the public if such a provision was there at the time of raising such capital. This aspect will be discussed in a more advanced edition.

 

Lesson Six; Share Premium

Share premium is gain gotten when capital is raised through issue of ordinary shares at a price more than the nominal price. If the nominal price is $10 and shares are issued at $12, then the $2 (ie 12-10) is share premium and it is also owners’ equity. It is a gain associated with the capital contribution by the promoters of the organization.

 

In conclusion, all the aspects of capital highlighted in lesson one to six in this part is generally called owners’ equity or claim and the sum of all those aspects of equity explain the total assets of the business.

 

Lesson Seven; Revaluation Reserve Fund

This is a reserve that rises due to revaluation of non-current assets. It is a common practice especially when an asset is being disposed or a business is being disposed on piecemeal basis. Or in the case of partnership dissolution.