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Summary Financial Reporting 2 (ACC2012W) - Equity
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Summary of important equity concepts
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EQUITYINTRODUCTION
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
In order to fund the assets of
Assets the business, the business
can either take out loans
(debt) or fund the assets
through equity or a mix of
Liabilities Equity both equity and debt.
Assets = Equity + Liabilities
When we look at the effect on the accounting equation, we can follow the following steps:
1. What happened to assets?
- What kind of asset was it?
- How much did it increase/decrease by?
2. What happened to liabilities?
- What kind of liability?
- How much did it increase/decrease by?
3. What happened to equity?
- If there is a change to assets or liabilities, then equity is affected.
- Was it a transaction with the owner? This will tell us whether it is directly in
equity or goes through profit and loss first.
- How much did it increase/decrease by?
- Therefore, what kind of equity is it?
DEBT V EQUITY
The characteristics of an instrument must be determined to assess whether the instrument
gives rise to a liability.
The obligation from a debt instrument will arise from a contractual term. The definition of
a “financial” liability is a contractual obligation (that does not have to be written).
- Examples of these obligations could be an annual payment, redemption of shares,
regular fixed payments, etc.
EXAMPLE: If there is an agreement to make annual fixed payments, or the holder can elect
to have the shares redeemed, then these characteristics point to obligations.
If the characteristics point to obligations, then the instruments are debt instruments and
not equity instruments.
, If we received financing through cash from issued shares, we should follow the following
thought process:
1. Apply the liability definition
2. Look at the accounting equation to determine whether the transaction affects equity
– is there a net asset change?
WHAT IS A LIABILITY?
Definition: a present obligation of the entity to transfer an economic resource as a result
of past events.
WHAT IS EQUITY?
Definition: the residual interest in the assets of the entity after deducting all its liabilities.
Distributable versus non-distributable reserves: when distinguishing whether
something is distributable or not, one would need to think about whether this reserve can
essentially be issued as a dividend.
- Retained earnings is a distributable reserve, because that is where dividends are
paid from. However, revaluation reserve is not distributable because it stays there
“forever” or gets released to profit and loss depending on the accounting policy
choice of the company.
There are various types of equity:
SHARE CAPITAL/STATED CAPITAL
This includes normal share capital from the issue of shares.
Very similar to share capital is treasury shares. This is an entity’s own shares that it has
repurchased from a shareholder. One cannot have an investment in themselves, so they
need to decrease share capital by classifying those shares as treasury shares.
- In a group, the subsidiary may have shares in the parent company, and these shares
are classified as treasury shares.
RETAINED EARNINGS
These are our accumulated profits and losses.
- In the event of making sustained losses, then the company is no longer a going
concern.
REVALUATION SURPLUS
This is a result of the gains and losses on the PPE assets.
RESERVES
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