Equity
What you must know
Equity is the residual interest in assets after deducting liabilities. Know the components: share capital (ordinary and preference), share premium, retained earnings, revaluation surplus, other reserves and non-controlling interests. Understand the accounting for share issues (at par and at a premium), treasury shares, bonus issues (capitalisation of reserves), rights issues, and the treatment of dividends (recognised as a liability only when declared and legally binding). Distinguish equity from liabilities using the substance of the contractual obligation, including puttable instruments and instruments settled in a variable number of own shares. Know the statement of changes in equity and the disclosure of reserves.
Traps candidates fall into
- Treating a bonus issue as raising cash; it merely capitalises reserves.
- Recognising a dividend as a liability before it is appropriately authorised and no longer at the entity's discretion.
- Classifying redeemable preference shares as equity when redemption is mandatory.
- Forgetting that a rights issue at a discount includes a bonus element, requiring adjustment of prior-year EPS.
- Recording treasury shares as an asset rather than a deduction from equity.
- Mixing revaluation surplus with distributable reserves.
Rule of thumb
Classify by substance: if the issuer has an unavoidable obligation to deliver cash or another financial asset, it is a liability. Dividends reduce retained earnings and become liabilities only when declared.
Worked example
A 1-for-4 bonus issue is made on 800,000 ordinary shares of 1 each. Issue 200,000 new shares: debit retained earnings 200,000, credit share capital 200,000. No cash is received, total equity is unchanged, and the number of shares rises to 1,000,000.