Equity

ADVANCED FINANCIAL ACCOUNTING

Equity Overview

• Equity represents the net value of a company, calculated as the difference between its assets and liabilities. It is the residual value that corresponds to the owners of the company and includes both the book value and market value of the company. Equity serves as a measure of the permanent resources of the company.

Fundamental Equation

• The relationship between assets, equity, and liabilities can be summarized as follows:

  • Total Assets = Total Equity + LiabilitiesThis equation illustrates how equity fits into the broader context of a company's financial position.

Key Transactions Influencing Equity

1. Incorporation of a Limited Company: Establishes initial equity through the issuance of shares.

2. Capital Increase: Additional equity acquired through new share issuance.

3. Profit Appropriation/Distribution: Determines the allocation of profits to equity owners.

4. Capital Reduction: Adjusts the equity value downwards, possibly due to losses or restructuring.

5. Other Share Issuances: May include non-cash contributions that still add to equity.

Example: Apple's Equity

• Book Value of Equity: As of September 28, 2024, Apple's equity was valued at approximately 56.95 billion USD.

• Market Capitalization: The market value was significantly higher at 3.46 trillion USD during the same period.

• Price-to-Book Value Ratio (P/BV): For 2019, this ratio stood at roughly 10.87x, whereas in 2024, it rose to 60.75x. This indicates that, compared to its book value, the investors were willing to pay substantially more for shares in 2024.

Capital Structure Overview

• Different legal forms of business (e.g., sole proprietorships, partnerships, corporations) influence how capital is structured. Each ownership type also affects rights, responsibilities, and profit distribution.

Ownership and Decision-Making

• Owners, or investors, participate in decision-making processes (through voting rights), share in the net worth of the company, and may receive dividends. However, they also bear the risk of losing their investment if the company fails.

• The focus of this discussion is clearly on corporations and their capital structures.

Share Capital

• Represents ownership in the company through shares which have a nominal or par value. Shares can be traded at market prices in both private and public markets.

Types of Equity Accounts

• Share Capital: The amount raised by issuing shares at par value.

• Called-up Capital and Uncalled Capital:

  • Called-up Capital requires minimum initial payment (at least 25% at subscription for standard companies, 100% for LLCs).

  • Uncalled Capital is due under a scheduled payment plan.

• Legal Reserve: Typically mandated to reach a certain percentage of net income.

• Other relevant accounts include Statutory Reserves, Undistributed Profits, and Retained Earnings.

• In some instances, these accounts may indicate negative equity due to losses and accumulated liabilities.

Incorporation of a Limited Company: Process

• Shares are issued at a predetermined par value, with investors expected to subscribe and subsequently pay.

• Journal Entries for Share Issuance:

  • Upon subscription:

  • Debit Called-up Capital Receivable (558)

  • Credit Share Capital (100)

  • Upon payment:

    • Debit Cash in Banks (572)

    • Credit Called-up Capital Receivable (558)

• Costs associated with incorporation do not count as expenses but might be capitalized under voluntary reserves.

Capital Increase Procedures

• A capital increase generally occurs when the issue price exceeds par value, leading to creation of share premium (additional paid-in capital).

• Journal Entries for Capital Increase:

  • Debit Cash in Banks (572)

  • Credit Share Capital (100) and Share Premium (110)

• Full payment must be received for the share premium; it cannot remain as uncalled.

Case Study - Company AFA's Incorporation

• Upon incorporation, AFA issued 20,000 shares at a €10 par value, with full subscription by ten investors.

• An individual investing €10,000 would obtain 1,000 shares (5% ownership).

• If AFA seeks a new investor contributing €200,000 in cash:

  • New shares issued = €200,000 / €16/share = 12,500 shares.

  • Established share capital and premium must be reflected in the balance sheet post-investment.

Additional Example - IAG Capital Increase

• In September 2020, IAG announced a capital increase amounting to 2.74 billion euros to strengthen its balance sheet, manage liquidity, and mitigate the impacts of the COVID-19 pandemic.