D10 CAPITAL STRUCTURE AND

FINANCE COSTS
 The capital of a limited liability company
• The proprietor’s capital in limited liability company consists of
SHARE CAPITAL.
• How does a company raises its capital/ equity
– It issues share who are paid for by investors for them to become share
holders
– These shares are denominated in units of 25cents, $1 etc
– These denominations or the face value of the shares are referred to as
Legal value/nominal value/par value
• Shareholders
– Owners of the company.
• Share premium or capital paid – up in excess of par value:
– Raises when the company issues shares at the amount which exceed
their par value.
– The difference between the amount at which shares are issued and
the par value of shares.
 Capital structure of limited liability company
Share capital can be categorised as authorised, issued, called up or paid up capital

Authorised share capital:

 Is the Maximum Amount of Capital Company is empowered (Authorised) to issue
 It varies from company to company , and can only be changed by agreement.

Issued share capital:

 It is the capital actually issued out of authorised capital
 Issues share capital cannot exceed the amount of authorised capital

Called –up capital:

 Is part of issued capital that shareholders have been asked to pay

Paid – up capital:
 Actual amount of called up capital that has been paid.
 Ordinary shares and preference shares

There are two types of shares which a company can issue:

1. Ordinary shares
2. Preference shares

Ordinary shares or equity shares:

 Are shares which are not given any preference in payment of dividends or
liquidation.
 Shareholders of these share referred to as ordinary shareholders or equity
share holders
 Shareholders of these shares have no right to fixed dividends but are
entitled to all profits left after payment of any preference dividends
 Ordinary shares and preference shares continued………

Preference shares:
 Shares which confer certain preference rights on their holders.
 The shareholders of preference shares have preference over ordinary
shareholder with regards to:
1. Payment of dividends
2. Repayment of capital at the time of liquidation
Preference shares can be classified into two ways:
a) Redeemable preference share:
• means shares which the company will redeem (repay) after a specified
period.
• They are treated like loan notes and recognised as long term liabilities of
the company, as they should be repaid at a later date like loans
• Dividends on these shares are treated like interest on loan and are
included as finance costs in the income statement.
b) Irredeemable preference shares:
• Are treated like ordinary shares
• They form part of the equity and their dividends are treated as
appropriation of profit
 Capital structure of limited liability company

The capital structure of a company consists of its own funds and debt funds

DEBT
OWN FUND
FUND

Ordinary Preference Loan

Capital Capital Notes

Classification of preference shares

depends on the terms of issue

Loan notes: constitute debt capital and bear a fixed rate of interest.
Characteristics of…

Characteristics
Ordinary shares Preference shares Loan notes
Money invested part of equity
Money invested is part of Money invested part of debt
or part of debt (depends
own fund (equity) fund
on terms of issue)
Shareholders have voting Shareholders do not have
rights voting rights
Can be secured or
Can be redeemable or
unsecured on company
irredeemable
assets
Shareholders have Repayable according to the
Paid after preference preference over ordinary agreed terms.
shareholders and providers shareholder in payment in
of loans in the case of liquidation If unsecured, have
liquidation of a company preference over shareholders
in case of insolvency.
Specified rate of interest.
No specific rate of dividend, Interest on loan is expense,
Specified rate of dividend
given as declared has to be paid irrespective of
availability of profit.
Shares can be issued at par or premium

If $1 per share is nominal value

If shares are
issued

At par At premium

Nominal value $1 = Issue price Nominal value $1 < Issue price

Accounting entries

excess of the issue price of shares over their par value

Share premium is not available for payment of dividends

can be used only for specific purposes such as the issue of

bonus shares

Accounting entries
1. Shares issued at par
A company issued 500,000 shares of $1 each at par for fully cash (fully payable at the time of issue)
Dr Cash account $500,000
Cr Ordinary shares $500,000
Being issue of 500,000 shares for cash at par
2. Shares issued at premium
A company issued 500,000 shares of $1 each at a premium of $0.25 for cash (fully payable at the time
of issue)
Dr Cash account $625,000
Cr Ordinary shares $500,000
Cr Share premium account $125,000
Being issue of 500,000 shares for cash at $1.25 ($1+ $0.25)
Reserves which may appear in company statement of financial
position
Other reserves appear in the
SOFP

Revaluation Retained
General reserve
reserve earnings

When assets are

When the company wants Contains
increased in value as a
to set aside some profits accumulated
result of revaluation,
separately for some reason profits from all
amount credited to this
this reserve is created past years
reserve

The accounting entry is:

Dr Retained Earnings
Cr Appropriate reserve account (e.g. General reserve account)
Being transfer of profits to reserves

Reserves are created by appropriating profits

 Reserves which may appear in company statement of financial position
continued…….

NB: Share capital and reserves belongs to ordinary shareholders who own the
equity in the company.

Reserve can be:

Statutory reserves: Non-statutory reserves:

Are reserves which a company Reserves consisting of profits

which are distributed as dividends if
is required to set up by the law the company wishes to do that.
and which are not available for
the distribution of dividends
 Bonus issue
 A bonus issue of shares is an issue of shares to existing shareholders
without receiving any cash from them.

 It is made by converting a part of reserves into share capital. In a way, it

is a bonus given to the existing shareholders.

Accounting Entries:
First the reserves to be used for the bonus issue are decided.

E.g. retained earnings,

Then the following entry is made:
general reserve, share
Dr Source reserves account
premium reserve etc
Cr Ordinary share capital
Being reserves decided for issuing bonus
Example

A company made a bonus issue of shares at 1:2 (one new bonus share was given for every two ordinary
shares held). Its existing share capital is 200,000 shares of $1 each. The reserves / profits to be
capitalised are as follows:

Share premium $60,000

General reserve $30,000
Accumulated profits $120,000

Make accounting entries for the bonus issue and show its effect on the SOFP date.

The amount of bonus issue = 1/2 x $200,000 = 100,000 shares of $1 each = $100,000

The entry is:

Dr Share premium $60,000

Dr General reserve $30,000
Dr Retained earnings $10,000
Cr Ordinary share capital $100,000
Being the bonus issue of shares record

Continued…
Continued…

Statement of Financial Position extract before the bonus issue

Extract of SOFP $’000 $’000

Shareholders equity
Share capital (200,000 share of $1 each ,fully 200
paid)
Reserves
Share premium 60
General reserves 30
Accumulated profits 120 210
410

Statement of financial position extract after the bonus issue

Share Capital will become $300,000 ($200,000 + $100,000 bonus)

Accumulated Profit will become $110,000 ($120,000 – $10,000)
 Advantages and disadvantaged of bonus issues
• Advantages:
– Increases capital without diluting current shareholders 'holdings
– It is a good way to reward shareholders as they have more shares to
sell
– Increases the liquidity for shareholders and generally for the
market. As the number of shares increases, shareholders can sell
part of them and retain others
– Capitalises reserves so as they cannot be paid as dividends
• Disadvantages:
– Does not raise any cash
– Could risk payment of future dividends if profits fall
– If the number of shares increases without change in earnings, the
earnings per share are reduced
* Earning per share = Earnings/ number o shares
 Right Issue
A rights issue of shares is an issue of new shares for cash; offered to the existing
shareholders who can sell them if they wish.
Right issue of shares is the beneficial for existing shareholders as shares are usually
issued at a discount to the current market price.

Accounting entry for rights issue is the same as for regular issue of shares
Example
Renauld Co provides the following information:

200,000 ordinary shares of $1 200,000

Share premium account 40,000
General reserve account 50,000
Accumulated profits 110,000
Shareholder’s equity 400,000

It made a rights issue of 1 share for every two shares held at $1.20 each.

Make accounting entries for the rights issue and show its effect on the SOFP..
Continued…
Continued…

Accounting entries for right issue

DrCash $120,000
Cr Ordinary shares $100,000
Cr Share premium $20,000
Being right issue made for 100,000 shares at $1.20
RENAULD COMPANY
SOFP extract after right issue
Share holder’s equity
Share capital
300,000 ordinary shares of $1 $300,000
Reserves
Share premium account $60,000
General reserve account $50,000
Accumulated profits $110,000
Shareholder’s equity $520,000
(Note: SOFP total increased by $120,000, assets total will also increase by the same amount on
account of receipt of cash against right issue)
 Advantages and disadvantages of right issues

Advantages Disadvantages
• Raises cash for the company • If large number of
• Keeps reserves for future dividends shareholders sell the rights,
• Protect the existing shareholders
the existing control pattern
from the threat of dilution of their
control, existing shareholders is diluted
percentage of control remains the • The existing shareholders
same even after the new issue of may have limited resources.
shares
• Benefit shareholders as they are
This may limit the total
issued at lower price than market amount that can be raised
price by a right issue
• Shareholders can sell their rights •
and earn profit if they do not want
to purchase new shares
 Accounting for Dividends
Accounting entries for dividends are:
Dr Retained earnings X
Dividend Cr Dividends payable X
Being dividend declared recorded
Appropriation of
Dr Dividends payable X
profits
Cr Cash X
Being dividend paid recorded

Components of the statement of changes in equity (SOCIE)

Components of SOCIE

Ordinary Share Revaluation Any other Retained

Share capital premium reserve reserve earnings
Specimen of statement of changes in equity

Share Revaluation Accumulated

Total
capital reserve profits
$000 $000 $000 $000
Balance at 01/10/20X6 X X X X
Issue of shares X X
Surplus on revaluation of
X
property
Total comprehensive
X X X
income
Ordinary dividends (X) (X)
Balance at 30/09/20X7 X X X X
 Finance Costs
• What are finance costs?
– Refers to the cost of debts and other forms of
finance raised by a company
• How is finance cost calculated?
– It is calculated on the basis of the amount
outstanding, the period it was outstanding and the
rate of interest.
• Accounting entry is:
– Dr Interest account X
– Cr cash/ bank ( if paid) X
– Cr Interest payables (unpaid) X