18.1 What is Equity?

Despite the simple definition initially provided, the Conceptual Framework does expand on the concept of equity by explaining that funds contributed by shareholders, retained earnings, and other reserves may require separate disclosures. The reasons given for a more detailed disclosure include the objective of providing information about legal restrictions on the distribution of equity that may be useful to investors for decision-making purposes, and the need to disclose the different legal rights that may attach to the various types of equity interests. The Conceptual Framework also notes that although, by definition, equity is affected by the measurement of assets and liabilities, the amount of equity reported would only coincidentally be equal to the current market value of a company. This is an important point, as it highlights one of the limitations of financial reporting: that financial statements by themselves cannot tell an investor what a company is worth.

The components of equity will vary from business to business and will be affected by the type of legal structure adopted by the business. This chapter will focus on the accounting used in the most common type of business organization – the corporation. Accounting and disclosure for other types of entities, such as proprietorships and partnerships, will be different. However, the same basic principles apply to those types of entities as well.

Let’s now look at the various components of equity, using the classification from the Conceptual Framework: funds contributed by shareholders, retained earnings, and reserves.

18.1.1. Funds Contributed by Shareholders

The funds contributed by shareholders are often the initial capital used to start a business. These funds are often referred to as contributed capital. In a corporate structure, contributed capital will take the form of shares, which can be classified into several different types. Shares, themselves, are legal instruments that provide certain rights to the holder and indicate a residual interest in the corporation’s assets. When a company is created, its incorporating documents will specify the maximum number of shares that can be issued. In some cases, this amount, referred to as authorized shares, may be specified as unlimited, meaning the company can issue as many shares as it wants. From an accounting perspective, the number of authorized shares is not relevant but the number of issued shares is. Issued shares are shares that have been issued to shareholders, usually in exchange for money, services, or other assets. Sometimes, a company may repurchase its own shares and keep them in treasury, in which case the number of issued shares will be greater than the number of outstanding shares (those shares held by parties outside of the company). In some jurisdictions, shares can be issued with a par value. This is the stated value of the share and will be directly indicated on the share certificate. Where par value shares exist, the actual issue price may differ from the par value. Amounts received by the corporation in excess of the par value represent another form of contributed capital. This amount will be reported separately from the par value of the shares and is often described as either contributed surplus or share premium. Note that many jurisdictions do not allow par value shares, meaning the issue price would simply be reported as the share capital amount. Shares can be stratified into different classes, based on the different rights and characteristics. We will discuss some of these different characteristics below.

Common Shares

Common shares, also referred to as ordinary shares, represent the final residual interest in a company’s assets after all other claims, including other equity interests, have been satisfied. In some companies, these are the only types of shares issued. These shares represent the greatest level of risk to an investor should the company fail, as all other claims against the company’s assets would need to be paid first. On the other hand, these shares also represent potentially the greatest rewards, as all the profits not otherwise allocated to debt and equity holders would belong to the common shareholders. All companies must have at least one class of common shares, although they are not always described this way. If a company issues more than one class of shares, and the other classes have additional rights over the common shares, then those classes are not common shares. Rather, they would be described as preferred shares.

Preferred Shares

Preferred shares, also known as preference shares, have special rights and privileges that give them priority over the common shares. These special privileges are often included to make the shares more attractive to investors. As well, the special rights can allow for complex ownership structures where certain groups or individuals want to maintain a degree of control. Because the preferred shares have special rights over the common shares, they are not considered a residual interest. In the event of a business’s liquidation, the preferred shareholders would rank ahead of the common shareholders in the priority of payment, but they would still be subordinated to the debt holders.

Preferred shares have many different features that can be combined in multiple configurations to provide many classes of shares for investors to choose from. However, to gain these special features, preferred shareholders often give up certain rights as well, most commonly, the right to vote on the company’s management. In many corporate structures, only the common shareholders have the right to vote for the board of directors, even though there may be several classes of shares. It is also important to note that the classes of shares may not always be described as common or preferred in the incorporation documents. The accountant must always be careful to closely examine the economic substance of the share features, and not just rely on the descriptions used by the company.

Let’s now look at some of the features of preferred shares.

• Fixed Dividend: Preferred shares often have a fixed dividend amount, usually expressed as a numerical amount per share or sometimes as a percentage of the par value of the share. For example, a preferred share could be entitled to a dividend of 5% of the par value, or $5 per share. These dividends would be equivalent if the share were issued at, or had a par value of, $100. Although the dividend amount is stated, this does not guarantee that the preferred shareholder will receive the dividend in any given year. Dividends must always be declared by the board of directors, and the directors have the discretion not to pay a dividend. However, when dividends are declared the holders of the preferred shares must be paid their stated dividends first before any distributions can be made to the common shareholders.
• Cumulative Dividend: If the directors do not declare a dividend in a current year, the holders of cumulative preferred shares would be entitled to payment of the dividend in a future year. For this type of share, undeclared dividends will accumulate at the stated rate for each year and must all be paid before any dividends can be paid to the common shareholders. These unpaid dividends do not represent a liability until the directors declare a dividend. Preferred shares can also specify a non-cumulative dividend, which means any undeclared dividends in a given year are simply lost and are not required to be paid in future years.
• Participating Dividend: When a preferred share is described as participating, it retains the right to receive not only the stated amount of dividends, but also additional dividends based on certain criteria. A typical participation calculation would involve first determining the fixed dividend on the preferred shares, and then allocating a similar proportion to the common shares. Then, additional dividends beyond these two amounts would be shared between the preferred and common shares on a pro-rata basis. There are other, more complex, ways in which participation can be calculated. The specific features of the preferred share would need to be examined to determine the method of calculation. The participation feature can make a preferred share more attractive to investors, as it provides the stability of the fixed dividend, plus the ability to receive further dividends if the company is successful.
• Redemption: A preferred share may be described as being redeemable. This means the company has the right to call the shares and repurchase them at a specified price during a specified time period. When the shares are redeemed, any dividends in arrears must be paid.
• Retraction: This feature is attractive to shareholders, as it allows them the right to require the company to repurchase the shares at a set price. Usually, time limits are set for the retraction period.
• Convertibility: Some preferred shares retain the right to be converted into common shares. The holder may choose to do this if the company has been successful and if common dividends exceed the amount that can be earned by the fixed, preferred dividend. The amount of common shares that can be obtained on conversion will be specified as a ratio, such as two common shares for each preferred share held.

Any or all of these features can be attached to classes of preferred shares. Many companies will report multiple share classes, each with different features. In some cases, the features included in a preferred share may suggest that its economic substance is more akin to debt rather than equity. These types of shares should be classified as liabilities, and their dividends would be classified as financing costs on the income statement. Shares with these features are discussed further in Chapter 14: Complex Financial Instruments.

18.1.2. Retained Earnings

The retained earnings account is a separate category of equity that represents the cumulative amount of profit earned by the company since its inception, less the cumulative amount of dividends declared. Sometimes, either as a management choice or as a legal requirement, certain portions of the retained earnings are set aside or appropriated. Appropriations of retained earnings are created to ensure that dividends are not paid from these balances, and these appropriations need to be reported separately. When the retained earnings account falls into a negative (debit) balance, it is usually referred to as a deficit, or retained losses. Retained earnings are sometimes subject to other types of accounting adjustments, such as accounting policy changes and error corrections, which are discussed in other chapters.

18.1.3. Reserves

The term reserves can refer to a number of different accounts. The previously noted appropriations of retained earnings are normally described as reserves. Another type of reserve is accumulated other comprehensive income (AOCI). As discussed in other chapters, comprehensive income results from recognition of income or expense items that are not included in the calculation of net income. There are only a few items that fall into this category, the most common of which are gains resulting from the application of the revaluation method for property, plant, and equipment, and intangibles; re-measurements of defined benefit plans; and gains resulting from remeasurement of available-for-sale financial instruments. These transactions create reserves that must be reported separately on the balance sheet. However, they may not always be described as accumulated other comprehensive income. For example, the term revaluation surplus is often used instead. Regardless of the name, the reserves must clearly identify the source of the surplus, and separate reserves are required for each type of item.