In this lesson, you’re expected to learn about:
– shareholders’ equity and retained profit
– statement of changes in equity
– statement of comprehensive income
– important accounting terminology and jargon
Shareholders’ Equity & Retained Profit
Now that we’ve covered the three main statements that we’d already seen before, we can now look at the two new statements.
Before we do, we need to revisit a basic concept:
– The balance sheet lists all the assets of the company and all the claims over those assets.
– The claims are made up of the claims of creditors and the claims of shareholders.
– So we can say: Assets = liabilities + shareholders’ equity.
Shareholders’ equity is made up of what the shareholders put into the company (i.e. share capital + share premium) plus the cumulative profits the company has made that have not been paid out to shareholders as dividends (i.e. retained profit).
The change in retained profit from one year to the next year-end is shown by the P&L.
With a listed company’s accounts, there are two crucial differences:
1. There may be additional components making up shareholders’ equity:
– Share related: the first five all relate to the company’s shares. Some transactions a company makes effectively increase or decrease the value and/or number of shares in issue.
– Profit related: these four components all relate to transactions where the shareholders have actually become richer or poorer through the company making a gain or loss of some sort. While such transactions can be recorded under retained profit, some companies prefer to have separate components for particular types of transactions.
2. Any transaction that affects one of the components under shareholders’ equity is categorized as one of the following:
– a transaction that affects real profits or losses of the company in the relevant year.
– a transaction that represents some other gain or loss the company has made in the relevant year but which is not considered to represent real profits or loss of the company.
– a transaction that is actually a transaction with owners, i.e. with some or all of the existing shareholders or with new shareholders. So these kinds of transactions are more about shareholders’ actual investment in the company and/or how the value attributable to the shareholders is divided among the shareholders.
Having categorized transactions as above, we treat them as follows:
· Any transaction in category 1 will increase or decrease the retained profit and will be included in the P&L.
· Any transaction in category 2 will either affect the retained profit or one of the other profit components. Instead of including this in the P&L, it is classified as being ‘other comprehensive income’.
· A transaction in category 3 doesn’t relate to gains or losses the company has made that affect the shareholders’ wealth and so will go under shareholders’ equity but will not be included in the P&L.
Let’s look at some examples to understand these different categories.
When you buy a building, you include it on your balance sheet at what you paid for it. After a few years, however, it may be worth considerably more than you paid for it because land and buildings tend to appreciate rather than depreciate. So companies are allowed to revalue buildings to their ‘fair’ value.
Examples of transactions of category 3 are – the issue of shares to investors in return for cash, the payment of dividends to shareholders.
Looking at the row headings down the left-hand side, you’ll see the following:
· Line 1: the balance of each of the equity components at the end of year 4.
· Lines 3-25: the descriptions of the transactions that have resulted in the changes to each equity item during the year. You can see that these are separated into the three categories already mentioned: profit for the period, other comprehensive income, and transactions with owners.
· Line 27: the balance of each of the equity components at the end of year 5.
Line 5: the profit for the year on the P&L is included in this column there are also other entries in this column relating to transactions falling into category 2 (other comprehensive income) and category 3 (transactions with owners).
This entry does notionally increase shareholders’ wealth, so must show as an increase in shareholders’ equity on the balance sheet. It doesn’t warrant inclusion in the P&L since it’s not reflective of the real underlying business of the company – so it’s categorized as other comprehensive income.
– Line 1: profit for the year
– Various items of gains and losses under the heading other comprehensive income.
– Line 19: total comprehensive income for the year.
One thing to note is that the P&L and the statement of comprehensive income are sometimes combined into one statement either because:
– The company chooses to do it that way.
– There is no ‘other comprehensive income’ to report.
As you may have already realized, there are a lot of different terms for the same thing in the accounting world. This can lead to some confusion as some terms mean different things to different people.
So you’ll come across lots of jargon describing which categories a transaction fits into:
· ‘goes through P&L’ or ‘is recognized in the P&L’ or ‘is charged to the P&L’ refer to a transaction that affects retained profit on the balance sheet and is included in the P&L.
· ‘goes to/through other comprehensive income’ or ‘is taken to other comprehensive income’ refer to a transaction that affects retained profit but rather than being included in the P&L, is included in other comprehensive income (OCI).
· ‘goes directly to reserves’ or ‘goes directly to equity’ refer to a transaction that affects shareholders’ equity but does not affect either the P&L or OCI.
The value at which an asset or liability is included in the balance sheet. It’s also known as book value or carrying amount.
Essentially a piece of paper conferring rights and obligations on parties. Shares, loans, and trade receivables are all examples of instruments.
The items under shareholders’ equity that we referred to as components are known as reserves by many people.
Accounting Standards, which we will cover briefly, simply refer to them as components of equity.