reserves

Share capital and reserves

TheLawStudent

Called up share capital

The share capital account tells the reader the aggregate amount that has been ‘called up’ (i.e. the amount of the nominal value of its shares that the company has required its shareholders to pay) on each class of issued shares, not including any premium. This called up value may, or may not, be the same as the aggregate of the nominal value of the issued shares, for example, if they are not fully paid. It is relatively rare to encounter shares which are not fully paid up.

Example:

A newly-incorporated company has issued 300,000 ordinary shares of £1, and has called up 75p per share. The value of the called up share capital in the company’s Balance Sheet will therefore be £225,000.

Reserves

Reserves can be described as the capital of the company in excess of the called up value of the issued share capital. Reserves can be split into two categories:

  • capital reserves (e.g. share premium account, revaluation reserve, capital redemption reserve), which I will discuss below; and
  • revenue reserves (e.g. retained earnings), which I will discuss in a future post.

Broadly speaking, assets representing the capital reserves cannot be distributed by way of dividend or other payment to shareholders. However, revenue reserves are distributable reserves and therefore, assets representing such reserves can be distributed to shareholders in the form of dividends.

Share premium account

The share premium account represents the difference between the nominal value of the shares and the amount that the shareholders actually paid for the shares i.e. the subscription price (if greater). N.B. The market price of the shares, once they have been issued, has no bearing at all on the company’s accounts and so, if their market price goes up or down, the share premium account will remain unaltered.

The share premium account is a capital reserve. Assets representing it therefore cannot be distributed to shareholders, except in exceptional circumstances such as a bonus issue or on a buyback of shares.

Revaluation reserve

A revaluation reserve is created when a company’s directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts. For example, the value of its real property portfolio may have increased, and so the company re-values the assets in question to their current value.

The increase in the value of the asset in the Balance Sheet causes the figure for Net Assets to rise correspondingly i.e. in simple terms, the top half of the Balance Sheet has increased. It is therefore necessary to make a corresponding change to the bottom half of the Balance Sheet. This is achieved by creating or increasing an existing revaluation reserve by the same value.

The revaluation reserve represents a notional profit to the company from the rise in value of the asset. This profit is, however, unrealised until the asset is sold, and as such it is a capital reserve and is not distributable as a dividend until the company sells the asset and realises the profit (s.830(2) CA 2006).

Any subsequent reduction in a re-valued asset’s value can be set off against the revaluation reserve.

Capital redemption reserve

A capital redemption reserve can only be created as a consequence of a transaction between the company and its shareholders under detailed provisions of the Companies Act 2006 such as, for example, a buyback of shares out of a company’s capital. Such transactions are relatively unusual and do not form part of the course of everyday business for any company.

Differences between company and sole trader/partnership accounts

TheLawStudent

There are a number of differences in the content of financial statements for companies: terminology used, tax, dividends and the content of the financial statements. I will briefly mention the differences here and then we will look at some of them in more depth in later posts.

Terminology

As we move from considering unincorporated entities (sole traders and partnerships) to companies, the accounting terminology differs to bring company accounts in line with accounting standards.

Tax in company accounts

So far, tax has not played a part in any of the accounting statements that we considered for sole traders and partnerships. This is because partnerships and businesses run by sole traders do not have separate legal personality, and therefore do not pay tax. The partners or the sole trader pay tax by reference to their own personal tax computations.

Companies however do have a separate legal personality, and as such, they must pay tax on their own account. In practice, therefore, the Profit and Loss Account of a company includes a statement of the tax the company should pay on its profits. This is corporation tax and will ultimately affect the profitability of the company.

Dividends

The owners of companies are shareholders and the shareholders’ return on their investment is the dividend that they may receive.

Like drawings that a sole trader takes from his business, a dividend is an appropriation of profits (after tax). It is not an expense of the business. In practice, dividends will usually appear in a financial statement called the ‘statement of equity’ (or ‘statement of changes in equity’) because they are transactions between the company and its shareholders. Dividends are also sometimes included in an addition to the Balance Sheet called the Statement of Changes in Equity (SoCiE). This shows profits brought forward and added to current year profits subject to any deductions for dividends. The resulting ‘Retained Earnings’ will appear on the bottom half of the Balance Sheet, showing the total profits carried forward to the next accounting period.

Capital accounts: the bottom half of the balance sheet

Company accounts follow a format which differs from those of sole traders and partnerships. The main difference relates to the bottom half of the Balance Sheet and this is due to the fact that the capital of a company consists of share capital, reserves and retained earnings.