Not-for-profit entities
Reporting not-for-profit entities
A not-for-profit entity is one that does not carry on its activities for the purposes of profit or gain to particular persons and does not distribute its profits or assets to particular persons.
The main types of not-for-profit entity are:
- clubs and societies
- charities
- public sector organisations (including central government, local government and National Health Service bodies).
The objectives of a not-for-profit entity
- The main objective of public sector organisations is to provide services to the general public. Their long-term aim is normally to break even, rather than to generate a surplus.
- Most public sector organisations aim to provide value for money, which is usually analysed into the three Es – economy, efficiency and effectiveness.
- Other not-for-profit entities include charities, clubs and societies whose objective is to carry out the activities for which they were created.
Assessing performance in a not-for-profit entity
- It can be difficult to monitor and evaluate the success of a not-for-profit organisation as the focus is not on a resultant profit as with a traditional business entity.
- The success of the organisation should be measured against the key indicators that reflect the visions and values of the organisation. The strategic plan will identify the goals and the strategies that the organisation needs to adopt to achieve these goals.
- The focus should be the measures of output, outcomes and their impact on what the charity is trying to achieve.
Accounting in a not-for-profit entity
The financial statements of a public sector entity or a charity are set out differently from those of a profit making entity, because their purpose is different. A public sector organisation is not reporting a profit; it is reporting on its income and how it has spent that income in achieving its aims.
The financial statements include a statement of financial position or balance sheet, but the statement of profit or loss and other comprehensive income is usually replaced with a statement of financial activities or an income and expenditure account showing incoming resources and resources expended.
Example of not-for-profit accounts
An example of a statement of financial activities for a charity is shown below.
The Toytown Charity, Statement of Financial Activities for the year ended 31 March 20X7
| Incoming resources | $ | |
| Resources from generated funds | ||
| Grants | 10,541,000 | |
| Legacies | 5,165,232 | |
| Donations | 1,598,700 | |
| Activities for generating funds | ||
| Charity shop sales | 10,052,693 | |
| Investment income | 3,948,511 | |
| Total incoming resources | ––––––––– | |
| 31,306,136 |
Specialised entities and specialised transactions
Resources expended
Cost of generating funds
| Fund raising | (1,129,843) | |
| Publicity | (819,828) | |
| Charity shop operating costs | (6,168,923) | |
| Charitable activities | ||
| Supporting local communities | (18,263,712) | |
| Elderly care at home | (4,389,122) | |
| Pride in Toytown campaign | (462,159) | |
| Total resources expended | –––––––––– | |
| (31,233,587) | ||
| Net incoming resources for the year | –––––––––– | |
| 72,549 | ||
| Funds brought forward at 1 March 20X6 | 21,102 | |
| –––––––––– | ||
| Funds carried forward at 31 March 20X7 | 93,651 | |
| –––––––––– |
The statement of financial position or balance sheet of a not-for-profit entity only differs from that of a profit making entity in the reserves section, where there will usually be an analysis of the different types of reserve, as shown below:
| Toytown Charity, Balance sheet as at 31 March 20X7 | ||
| Non-current assets | $ | |
| Tangible assets | 80,500 | |
| Investments | 12,468 | |
| ––––––– | ||
| 92,968 | ||
| Current assets | ||
| Inventory | 2,168 | |
| Receivables | 10,513 | |
| Cash | 3,958 | |
| ––––––– | ||
| 16,639 | ||
| Total assets | ––––––– | |
| 109,607 | ||
| Reserves | ––––––– | |
| Restricted fund | 20,200 | |
| Unrestricted funds | 73,451 | |
| ––––––– | ||
| 93,651 |
| Non-current liabilities | ||
| Pension liability | 9,705 | |
| Current liabilities | ||
| Payables | 6,251 | |
| Total funds | ––––––– | |
| 109,607 | ||
| ––––––– |
The reserves are separated into restricted and unrestricted funds.
- Unrestricted funds are funds available for general purposes.
- Restricted funds are those that have been set aside for a specific purpose or in a situation where an individual has made a donation to the charity for a specific purpose, perhaps to replace some equipment, so these funds must be kept separate.
2 Small and medium sized entities
The SMEs Standard
Definition
A small or medium entity may be defined or characterised as follows:
- they are usually owner-managed by a relatively small number of individuals such as a family group, rather than having an extensive ownership base
- they are usually smaller entities in financial terms such as revenues generated and assets and liabilities under the control of the entity
- they usually have a relatively small number of employees
- they usually undertake less complex or difficult transactions which are normally the focus of a financial reporting standard.
One of the underlying requirements for financial reporting is that the cost and burden of producing financial reporting information for shareholders and other stakeholders should not outweigh the benefits of making that information available.
IFRS for small and medium-sized entities (the SMEs Standard) has been issued for use by entities that have no public accountability. This means that debt or equity instruments are not publicly traded. The SMEs Standard reduces the burden of producing information that is not likely to be of interest to the stakeholders of a small or medium company.
Specialised entities and specialised transactions
The problem of differential reporting
- It can be difficult to define a small or medium entity.
- If a company ceases to qualify as a small or medium entity then there will be a cost and time burden in order to comply with full IFRS and IAS Standards.
- There may be comparability problems if one company applies full IFRS and IAS Standards whilst another applies the SMEs Standard.
What is the effect of introducing the SMEs Standard?
The SMEs Standard will be updated approximately every three years. In contrast, companies that use full IFRS and IAS Standards have to incur the time cost of ensuring compliance with regular updates.
Accounting under full IFRS and IAS Standards necessitates compliance with approximately 3,000 disclosure points. In contrast, the SMEs Standard comprises approximately 300 disclosure points all contained within the one document. This significantly reduces the time spent and costs incurred in producing financial statements.
Key omissions from the SMEs Standard
The subject matter of several reporting standards has been omitted from the SMEs Standard, as follows:
- Earnings per share (IAS 33)
- Interim reporting (IAS 34)
- Segmental reporting (IFRS 8)
- Assets held for sale (IFRS 5).
Omission of subject matter from the SMEs Standard is usually because the cost of preparing and reporting information exceeds the expected benefits which users would expect to derive from that information.
Accounting choices disallowed under the SMEs Standard
There are a number of accounting policy choices allowed under full IFRS and IAS Standards that are not available to companies that apply the SMEs Standard. Under the SMEs Standard:
- Goodwill is always recognised as the difference between the cost of the business combination and the fair value of the net assets acquired. In other words, the fair value method for measuring the non-controlling interest is not available.
- Intangible assets must be accounted for at cost less accumulated amortisation and impairment. The revaluation model is not permitted for intangible assets.
- After initial recognition, investment property is remeasured to fair value at the year end with gains or losses recorded in profit or loss. The cost model can only be used if fair value cannot be measured reliably or without undue cost or effort.
Key simplifications in the SMEs Standard
The subject matter of other reporting standards has been simplified for inclusion within the SMEs Standard. Key simplifications to be aware of are as follows:
- Borrowing costs are always expensed to profit or loss.
- Whilst associates and jointly controlled entities can be accounted for using the equity method in the consolidated financial statements, they can also be held at cost (if there is no published price quotation) or fair value. Therefore, simpler alternatives to the equity method are available.
- Depreciation and amortisation estimates are not reviewed annually. Changes to these estimates are only required if there is an indication that the pattern of an asset’s use has changed.
- Expenditure on research and development is always expensed to profit or loss.
- If an entity is unable to make a reliable estimate of the useful life of an intangible asset, then the useful life is assumed to be ten years.
- Goodwill is amortised over its useful life. If the useful life cannot be reliably established then management should use a best estimate that does not exceed ten years.
- On the disposal of an overseas subsidiary, cumulative exchange differences that have been recognised in other comprehensive income are not recycled to profit or loss.
- When measuring defined benefit obligations, the entity is permitted to:
– ‘ignore estimated future salary increases
– ignore future service of current employees
– ignore possible in-service mortality of current employees between the reporting date and the date employees are expected to begin receiving post-employment benefits’ (SMEs Standard, para 28.19).
- There are numerous simplifications with regards to financial instruments. These include:
– Measuring most debt instruments at amortised cost.
– Recognising most investments in shares at fair value with changes in fair value recognised in profit or loss. If fair value cannot be measured reliably then the shares are held at cost less impairment.
Advantages and disadvantages of the SMEs Standard
Advantages
- There will be time and cost savings due to simplifications and omissions, particularly with regards to disclosure.
- The SMEs Standard is worded in an accessible way.
- All standards are located within one document so it is therefore easier and quicker to find the information required.
Disadvantages
- There are issues of comparability when comparing one company that uses full IFRS and IAS Standards and another which uses the SMEs Standard.
- The SMEs Standard is arguably still too complex for many small companies. In particular, the requirements with regards to leases and deferred tax could be simplified.
3 Entity reconstruction schemes
The purpose of an entity reconstruction
If an entity is in financial difficulty it may have no recourse but to accept liquidation as the final outcome. However it may be in a position to survive, and indeed flourish, by taking up some future contract or opportunities. The only hindrance to this may be that any future operations may need a prior cash injection. This cash injection cannot be raised because the present structure and status of the entity may not be attractive to current and outside investors.
A typical corporate profile of an entity in this situation could be as follows:
- Accumulated trading losses
- Arrears of unpaid debenture and loan interest
- No payment of equity dividends for several years
- Market value of equity shares below their nominal value
- Lack of investor and market confidence in the entity.
To get a cash injection the entity will need to undergo a reorganisation or reconstruction.
A reconstruction of the entity’s capital may help to alleviate these problems and may involve one or more of the following procedures:
- Write off the accumulated losses.
- Write off arrears of repayment of loan finance.
- Write down the nominal value of the equity capital.
How is this achieved?
To do this the entity must ask all or some of its existing stakeholders to surrender existing rights and amounts owing in exchange for new rights under a new or reformed entity.
Why would stakeholders be willing to do this?
The main reason is that a reconstruction may result in an outcome preferable to any other alternative as follows:
- Providers of loan finance and other creditors may be left with little or no prospect of repayment.
- Providers of equity finance may be left with little or no prospect of a return (dividends and capital growth) on their investment.
- Corporate liquidation may provide some return to providers of loan finance, but is unlikely to provide any return to equity holders, depending upon the financial position of the entity.
How could this be agreed between the various stakeholders?
It may be helpful to review the situation faced by each group of stakeholders as follows:
- Equity shareholders are the last group to be allocated funds in a corporate liquidation, and therefore have a high chance of receiving no return at all. It would therefore seem appropriate that they should bear most of the losses from the present situation, in exchange for potential future benefits if the entity is profitable following reconstruction.
- Trade creditors and payables may have some prospect of recovery of at least part of the amounts due to them as they rank ahead of equity holders for repayment upon corporate liquidation. Some trade creditors may also protect themselves from the risk of non-recovery by including the right to retain legal title or ownership of goods delivered to customers until they are paid for. In the event of non-recovery of amounts due to them, they will have the right to take repossession of their inventory.
- Debenture holders often have a better chance of recovery of capital under liquidation than other stakeholders because such loans are often secured against entity assets. However, even in this situation, the full amount outstanding of such loans may not be recovered. In this case, any amount not recovered from the assets used as security (or collateral) would then normally be regarded as an unsecured creditor in the same way as trade payables.
It may therefore be in the best interests of all stakeholders to agree to a scheme of reconstruction. In effect, they give up existing rights and amounts owing (which are unlikely to be recovered) for the opportunity to share in the future profitability which may arise from the extra cash which can be generated as a consequence of their actions. This can only be achieved if all stakeholders are willing to compromise by waiving some or all of their existing rights, and if they can be convinced that there is an improved prospect of future returns as a result of a reconstruction scheme.
Capital reduction schemes
Under a capital reduction scheme, an entity may:
- write off unpaid equity capital – this situation may arise, for example, if there are partly-paid shares in issue. The entity is effectively reducing the nominal value of its equity share capital by the amount not yet called up and paid by the equity holders.
- write off any equity capital which is lost or not represented by available assets – in this situation, the entity has a deficit on retained earnings due to accumulated losses, preventing the payment of an equity dividend and depressing the share price.
- write off any paid up equity capital which is in excess of requirements – in this situation, the entity uses surplus cash to repay its equity holders.
This scheme does not really affect creditors as the equity holders have reduced their capital stake in the entity, either by reducing the nominal value of the shares in issue, or by reducing the total number of shares in issue, or a combination of both.
This scheme is normally regulated by formalised procedures detailed in law, such as the Companies Act 2006 s641 in the United Kingdom. In examination questions, it is unlikely that there will be questions set which require a specific and detailed knowledge of law from any particular jurisdiction.
Illustration – Struggler
Struggler has the following statement of financial position at 30 June 20X8:
| $000 | |
| Assets | 500 |
| ––––– | |
| 500 | |
| ––––– | |
| Equity and liabilities: | $000 |
| Issued equity shares ($1 each) | 600 |
| Share premium | 100 |
| Retained earnings/(deficit) | (300) |
| Liabilities | 100 |
| ––––– | |
| 500 | |
| ––––– |
Struggler has the following problems:
- Accumulated losses which prevent payment of a dividend should the entity become profitable at some future date.
- Issued equity capital of $600,000 which is only backed by assets to the extent of $500,000.
- Difficulty in attracting new sources of equity and loan finance.
Required:
Apply a capital reduction scheme and restate the statement of financial position at 30 June 20X8.
Solution
Using the reduction of capital scheme, the deficit on retained earnings could be cleared by reducing both the share premium and issued equity capital accounts. Any balance on share premium account should be utilised first to minimise the reduction of equity capital as follows:
| $000 | $000 | |
| Dr Share premium | 100 | |
| Dr Equity share capital | 200 | |
| Cr Retained earnings | 300 | |
| The resulting statement of financial position would be: | ||
| $000 | ||
| Assets | 500 | |
| ––––– | ||
| 500 | ||
| ––––– | ||
| Equity and liabilities: | $000 | |
| Issued equity shares | 400 | |
| Share premium | nil | |
| Retained earnings/(deficit) | nil | |
| Liabilities | 100 | |
| ––––– | ||
| 500 | ||
| ––––– |
The equity holders have effectively recognised the financial reality of their situation by reducing the nominal value of the issued share capital. If the entity begins to make profits following the reconstruction, there is no longer a deficit on retained earnings to clear before a dividend can be paid. Potential equity and/or loan finance providers may also be encouraged by this situation.
The reduction in equity capital could be reflected by either a reduction in the nominal value per share (from $1 down to approximately (400/600) $0.67, or by converting and reducing shareholdings on a pro-rata basis. For example, if a person previously owned thirty shares with a nominal value of $1 each, following conversion and reduction, they would now own only twenty shares with a nominal value of $1 each. In either situation, the total equity share capital would be $400,000.
Reconstruction schemes
Reconstruction schemes extend the principles of the capital reduction schemes by including the various creditors within the scheme. In addition to reducing equity share capital, reconstruction schemes may also include:
- writing off debenture loan interest arrears
- replacement of debenture loans with new loans having different interest and capital repayment terms
- write off amounts owing to unsecured or trade payables.
In practical terms, this can only be achieved if all stakeholders agree to forego some of their current legal and commercial rights. For those in the weakest position, usually the equity holders, they would be expected to sacrifice more than others.
In the United Kingdom, these schemes are governed by the Companies Act 2006 s895. As with the capital reduction scheme considered earlier, it is unlikely that an examination question will be set which requires a detailed knowledge of specific law from any one jurisdiction.
Illustration – Machin
Consider the statement of financial position of Machin at 30 June 20X9:
| Non-current assets: | $000 | |
| Intangible – brand | 50,000 | |
| Tangible | 220,000 | |
| ––––––– | ||
| Current assets: | 270,000 | |
| 20,000 | ||
| Inventory | ||
| Receivables | 30,000 | |
| ––––––– | ||
| 320,000 | ||
| ––––––– |
| Equity and liabilities: | $000 |
| Equity share capital ($1) | 100,000 |
| Share premium | 75,000 |
| Retained earnings | (100,000) |
| ––––––– | |
| 75,000 | |
| Non-current liabilities: Debenture loan | 125,000 |
| Current liabilities: | |
| Bank overdraft | 20,000 |
| Trade payables | 100,000 |
| ––––––– | |
| 320,000 | |
| ––––––– |
The following reconstruction scheme is to be applied:
- The equity shares of $1 nominal value currently in issue will be written off and will be replaced on a one-for-one basis by new equity shares with a nominal value of $0.25.
- The debenture loan will be replaced by the issue of new equity shares – four new equity shares with a nominal value of $0.25 each for every $1 of debenture loan converted.
- Existing equity holders will be offered the opportunity to subscribe for three new equity shares with a nominal value of $0.25 each for every one equity share currently held. The shares are to be issued at nominal value. It is expected that all current equity holders will take up this opportunity.
- The share premium account is to be eliminated.
- The brand is considered to be impaired and must be written off.
- Retained earnings deficit is to be eliminated.
Required:
Prepare the statement of financial position of Machin immediately after the scheme has been put into effect. Show any workings required to arrive at the solution.
Solution
Begin by opening a reconstruction account:
All adjustments to the statement of financial position as a result of the reconstruction scheme must be accounted for within this account. Any balance remaining on this account will be used to either write down assets or create a capital reserve.
New equity shares (100,000 × $0.25) (Note 1)
New equity shares (125,000 × 4 × $0.25) (Note 2)
Brand impaired
(Note 5)
Retained earnings
(Note 6)
| Reconstruction account | |||
| $000 | Equity shares ($1) | $000 | |
| 25,000 | (Note 1) | 100,000 | |
| Debenture loan | |||
| 125,000 | (Note 2) | 125,000 | |
| Share premium | |||
| 50,000 | |||
| (Note 4) | 75,000 | ||
| 100,000 | |||
| ––––––– | ––––––– | ||
| 300,000 | 300,000 | ||
| ––––––– | ––––––– | ||
The note references refer to the details of the reconstruction scheme.
The debenture holders may be prepared to sacrifice their rights as a creditor if they believe that Machin will trade profitably following the reconstruction scheme. They will forego the rights of a creditor in exchange for the rights of an equity holder – i.e. future dividends plus growth in the capital value of their equity shares.
The resulting statement of financial position for Machin will be:
| Non-current assets: | $000 | |
| Intangible – brand | nil | |
| Tangible | 220,000 | |
| Current assets: | 20,000 | |
| Inventory | ||
| Receivables | 30,000 | |
| Bank ((20,000) + 75,000) (Note 3) | 55,000 | |
| ––––––– | ||
| 325,000 | ||
| ––––––– | ||
| Share capital (W1) | 225,000 | |
| Share premium | nil | |
| Retained earnings | nil | |
| ––––––– | ||
| 225,000 | ||
| Non-current liabilities: Debenture loan | nil | |
| Current liabilities: | ||
| Bank overdraft (eliminated by cash receipt from share issue) | nil | |
| Trade payables | 100,000 | |
| ––––––– | ||
| 325,000 | ||
| ––––––– |
(W1) Confirmation of equity share capital following reorganisation:
Note 1
Note 2
Note 3
| Issue of one new equity share for one | No | |
| 100,000 | ||
| old equity share | ||
| Convert debenture loan into new equity | 500,000 | |
| shares: | ||
| 125,000 × 4 | ||
| Issue of new equity shares for cash | 300,000 | |
| ––––––– |
900,000
–––––––
Share capital is therefore $225,000 (900,000 × $0.25).
Illustration – Bentham
Bentham has been making losses for several years, principally due to severe competition, which has put downward pressure on revenues whilst costs have increased.
The statement of financial position for Bentham at 30 June 20X1 is as follows:
| $000 | ||
| Non-current assets | 7,200 | |
| Current assets | 10,550 | |
| ––––––– | ||
| 17,750 | ||
| ––––––– | ||
| Equity and liabilities | $000 | |
| Equity share capital ($1 shares) | 20,000 | |
| Retained earnings (deficit) | (17,250) | |
| ––––––– | ||
| Non-current liabilities: | 2,750 | |
| 11% debentures 20X3 (secured) | 7,000 | |
| 8% debentures 20X4 (secured) | 5,000 | |
| Current liabilities | 3,000 | |
| ––––––– |
17,750
–––––––
The entity has changed its marketing strategy and, as a result, it is expected that annual profit before interest and tax will be $3,000,000 for the next five years. Bentham incurs tax at 25% on profit before tax.
The directors are proposing to reconstruct Bentham and have produced the following proposal for discussion:
- The existing $1 equity shares are to be cancelled and replaced by equity shares of $0.25.
- The 8% debentures are to be replaced by 8,000,000 equity shares of $0.25 each, regarded as fully paid up, plus $3,000,000 6% debentures 20X9.
- Existing shareholders will have their $1 equity shares replaced by 11,000,000 $0.25 equity shares, regarded as fully paid up.
- The 11% debentures are to be redeemed in exchange for:
– $6,000,000 6% debentures 20X9, and
– 4,000,000 equity shares of $0.25, regarded as fully paid up.
In the event of a liquidation, it is estimated that the net realisable value of the assets would be $6,200,000 for the non-current assets and $10,000,000 for the current assets.
Required:
- Prepare a statement of financial position for Bentham at 1 July 20X1, immediately after the reconstruction scheme has been implemented.
- Prepare computations to show the effect of the proposed reconstruction scheme on each of the equity shareholders, 11% debenture holders and 8% debenture holders.
- Comment on the potential outcome of the scheme from the perspective of a shareholder who currently owns 10% of the equity share capital on whether to agree to the reconstruction scheme as proposed.
Solution
Bentham – the revised statement of financial position at 1 July 20X1 following reconstruction would be:
| $000 | |
| Non-current assets | 7,200 |
| Current assets | 10,550 |
| –––––– |
17,750
––––––
| Equity and liabilities: | $000 | |
| Equity share capital (23 million shares × $0.25) (W1) | 5,750 | |
| Retained earnings | nil | |
| –––––– | ||
| Non-current liabilities: | 5,750 | |
| 6% debentures 20X9 (W1) | 9,000 | |
| Current liabilities | 3,000 | |
| –––––– | ||
| 17,750 | ||
| –––––– |
(W1) The reconstruction account would be as follows:
Reconstruction account
| $000 | $000 | |||||||
| New 6% debentures | 6,000 | 11% Debentures | 7,000 | |||||
| redeemed | ||||||||
| New equity shares: 4m × | 1,000 | 8% Debenture | 5,000 | |||||
| $0.25 | redeemed | |||||||
| New equity shares: 11m × | 2,750 | Equity cancelled | 20,000 | |||||
| $0.25 | ||||||||
| New equity shares: 8m × | 2,000 | |||||||
| $0.25 | ||||||||
| New 6% debentures | 3,000 | |||||||
Deficit on retained earnings 17,250
––––– –––––
32,000 32,000
––––– –––––
If Bentham was to be put into liquidation, rather than undergo the reconstruction, the following could be the consequence:
| $000 | |
| Net realisable value of non-current assets | 6,200 |
| Net realisable value of current assets | 10,000 |
| –––––– | |
| 16,200 | |
| Repayment of 11% secured debenture loan | (7,000) |
| Repayment of 8% secured debenture loan | (5,000) |
| –––––– | |
| Available for unsecured creditors | 4,200 |
| Unsecured creditors | (3,000) |
| –––––– | |
| Available for equity holders | 1,200 |
| –––––– |
It can be seen that, whilst secured creditors will be paid off, and there should then be sufficient assets available for payment of unsecured creditors, equity shareholders would not fully recover the nominal value of their shareholding. The equity holders would receive only (1,200/20,000) $0.06 for each $1 equity share held. Note that this does not include any legal and professional fees that may be payable to implement such a scheme.
If the scheme is implemented, the debenture holders would forego part of their prior claim for repayment in exchange for equity shares. If they are to agree to this, they must be satisfied regarding the reliability of the profit forecast for future trading, so that they can receive future dividends and enjoy capital growth on the value of their shares. Additionally, they will have a significant equity holding of 12 million out of 23 million equity shares. This is just enough to give them a majority of the equity capital; they could then use their voting power to appoint or remove directors as they see appropriate.
If the reconstruction scheme is implemented, the revised capital structure results in significantly more equity shares in issue, with reduced long term liabilities in the form of secured debenture loans. It can be seen that the current debenture loan holders have deferred the repayment date of their loans from 20X3 and 20X4 respectively to 20X9, and accepted a reduced rate of interest on their loans. In addition, they have received some equity shares which will give them the opportunity to share in the future prosperity of Bentham if it becomes profitable following the reconstruction.
From the perspective of someone who holds 10% of the equity before the reconstruction takes place, the following comments can be made:
- The gearing ratio has reduced as follows:
| Before: | $000 | After: | $000 |
| Gearing ratio | 12,000 | 9,000 | |
| ––––––– = 81.3% | ––––––– = 61.0% | ||
| 14,750 | 14,750 |
The reduction in gearing will be regarded as a decrease in financial risk for the equity holders.
- If the forecast regarding expected profit before interest and tax is reliable, then the following will result:
| $000 | |
| Profit before interest and tax | 3,000 |
| Less: debenture interest (9,000 × 6%) | 540 |
| ––––– | |
| Profit before tax | 2,460 |
| Tax (× 25%) | (615) |
| ––––– | |
| Profit after tax available to equity holders | 1,845 |
Potentially, there are retained profits available for payment of an equity dividend. Whilst it may not be advisable to distribute all profit after tax in the form of a dividend, it is a positive step to have retained earnings within the entity. Additionally, interest cover of (3,000/540) 5.5 may be regarded as reasonable in the circumstances.
- One further factor is the change in proportionate voting power if the reconstruction scheme is implemented. Previously, someone who owned 10% of the equity share capital would have 10% × 11 million = 1.1 million equity shares in the restructured entity out of 23 million equity shares – i.e. 4.7% of the equity shares. This is a significant dilution of voting power, but it may be a reasonable thing to give up in exchange for the future prospect of the continuation of Bentham, together with the potential receipt of a dividend if the forecast is realistic.
Test your understanding 1 – Wire
Wire has suffered from poor trading conditions over the last three years.
Its statement of financial position at 30 June 20X1 is as follows:
| Non-current assets: | $ | $ | |
| Land and buildings | 193,246 | ||
| Plant and equipment | 60,754 | ||
| Investment in Cord | 27,000 | ||
| ––––––– | |||
| Current assets: | 281,000 | ||
| Inventory | 120,247 | ||
| Receivables | 70,692 | ||
| ––––––– | 190,939 | ||
| ––––––– | |||
| 471,939 | |||
| ––––––– | |||
| Equity and liabilities: | $ | ||
| Equity shares ($1) | 200,000 | ||
| Retained earnings (deficit) | (39,821) | ||
| ––––––– | |||
| Non-current liabilities: | 160,179 | ||
| 8% debenture 20X4 | 80,000 | ||
| 5% debenture 20X5 | 70,000 | ||
| Current liabilities: | ––––––– | 150,000 | |
| Trade payables | 112,247 | ||
| Interest payable | 12,800 | ||
| Overdraft | 36,713 | ||
| ––––––– | 161,760 | ||
| ––––––– | |||
| 471,939 | |||
| ––––––– |
It has been difficult to generate revenues and profits in the current year and inventory levels are very high. Interest has not been paid to the debenture holders for two years. Although the debentures are secured against the land and buildings, the debenture holders have demanded either a scheme of reconstruction or the liquidation of Wire.
During a meeting of directors and representatives of the shareholders and debenture holders, it was decided to implement a scheme of reconstruction.
The following scheme has been agreed in principle:
- Each $1 equity share is to be redesignated as an equity share of $0.25.
- The existing 5% debenture is to be exchanged for a new issue of $35,000 9.5% loan stock, repayable in 20X9, plus 140,000 equity shares of $0.25 each. In addition, they will subscribe for $9,000 debenture stock, repayable 20X9, at par value. The rate of interest on this new debenture is 9.5%.
- The equity shareholders are to accept a reduction in the nominal value of their shares from $1 to $0.25 per share, and subscribe for a new issue on the basis of one-for-one at a price of $0.30 per share.
- The 8% debenture holders, who have received no interest for two years, are to receive 20,000 equity shares of $0.25 each in lieu of the interest payable. It is agreed that the value of the interest liability is equivalent to the fair value of the shares to be issued. In addition, they have agreed to defer repayment of their loan until 20X9, subject to an increased rate of interest of 9.5%.
- The deficit on retained earnings is to be written off.
- The investment in Cord has been subject to much speculation as Cord has just obtained the legal rights to a new production process. As a result, the value of the investment has increased to $60,000. This investment is to be sold as part of the reconstruction scheme.
- The bank overdraft is to be repaid.
- 10% of the receivables are regarded as non-recoverable and are to be written off.
- The remaining assets were independently valued, and should now be recognised at the following amounts:
| $ | |
| Land | 80,000 |
| Buildings | 80,000 |
| Equipment | 30,000 |
| Inventory | 50,000 |
If the reconstruction goes ahead, the following is expected to happen:
- It is expected that, due to the refinancing, operating profits will be earned at the rate of $50,000 after depreciation, but before interest and tax.
- Wire will be subject to tax on its profit before tax at 25%.
Required:
- Prepare the statement of financial position of Wire immediately after the reconstruction.
- Advise the equity holders and debenture holders whether or not they should support the reconstruction scheme.
External reconstructions
External reconstruction schemes normally involve the assets and liabilities of the current entity being transferred to a new entity on an agreed basis. Typically, this will require information regarding the following:
- details of purchase consideration to acquire the business as a whole, or specified assets and liabilities – this may give rise to goodwill for the purchaser.
- details of what will happen to assets and liabilities currently belonging to the entity which are to be sold, transferred, written off or realised as appropriate – this will lead to a profit or loss on realisation for the vendor.
- how repayment or settlement of capital of the selling entity is to be arranged.
Illustration – Smith
Smith has agreed to acquire the net assets, excluding the bank balance, and the debenture liability which is to be paid off in cash, of Thompson. The purchase consideration comprises the following:
| $000 | ||
| 50,000 | $1 equity shares at a fair value of $1.04 | 52,000 |
| $30,000 debenture loan issued at par value | 30,000 | |
| Cash | 18,000 | |
| ––––––– | ||
| 100,000 | ||
| ––––––– | ||
When determining the consideration to be paid, the directors of Smith valued the land and buildings of Thompson at $40,000, inventory at $15,000 and receivables at carrying value, subject to a 3% write off for bad debts.
After the sale, Thompson is liquidated.
The statement of financial position of Thompson immediately before the acquisition is as follows:
| Non-current assets: | $ | |
| Land and buildings | 24,000 | |
| Plant and machinery | 22,000 | |
| ––––––– | ||
| Current assets: | 46,000 | |
| Inventory | 19,000 | |
| Receivables | 20,000 | |
| Bank | 5,000 | |
| ––––––– |
90,000
| Equity and liabilities: | $ | |
| Equity shares ($1) | 30,000 | |
| Share premium | 10,000 | |
| Retained earnings | 16,000 | |
| ––––––– | ||
| Non-current liabilities: | 56,000 | |
| 20,000 | ||
| 6% debentures | ||
| Current liabilities: | ||
| Trade payables | 14,000 | |
| ––––––– | ||
| 90,000 | ||
| ––––––– |
Required:
- Prepare the closing entries for Thompson
- Prepare the opening statement of financial position for Smith.
Solution
| Closing accounting for Thompson | |||
| (W1) Realisation account | $ | $ | |
| Carrying values: | |||
| Land and buildings | 24,000 | ||
| Plant and equipment | 22,000 | ||
| Inventory | 19,000 | ||
| Receivables | 20,000 | ||
| Creditors | 14,000 | ||
| Purchase consideration | 100,000 | ||
| Profit on realisation (bal fig) (W3) | 29,000 | ||
| ––––––– | ––––––– | ||
| 114,000 | 114,000 | ||
| ––––––– | ––––––– | ||
| (W2) Bank and cash | $ | $ | |||
| Balance b/fwd | 5,000 | ||||
| Cash received for sale of business | 18,000 | ||||
| Debenture stock paid off | 20,000 | ||||
| Cash to shareholders as part of | 3,000 | ||||
| winding up (W3) | ––––––– | ––––––– | |||
| 23,000 | 23,000 | ||||
| ––––––– | ––––––– | ||||
| (W3) Capital settlement on winding up | $ | $ | |||
| Equity shares received at FV | 52,000 | ||||
| Debenture received | 30,000 | ||||
| Cash return to equity holders (W2) | 3,000 | ||||
| Share capital | 30,000 | ||||
| Share premium | 10,000 | ||||
| Retained earnings | 16,000 | ||||
| Profit on realisation (W1) | 29,000 | ||||
| ––––––– | ––––––– | ||||
| 85,000 | 85,000 | ||||
| ––––––– | ––––––– | ||||
| (W4) Receivable Account – Smith | $ | $ | |||
| Purchase consideration due | |||||
| Equity shares | 100,000 | ||||
| Shares at FV | 52,000 | ||||
| Debenture loan | 30,000 | ||||
| Cash | 18,000 | ||||
| ––––––– | ––––––– | ||||
| 100,000 | 100,000 | ||||
| ––––––– | ––––––– |
| Smith – Statement of Financial Position | ||
| Assets | $ | |
| Goodwill* | 17,600 | |
| Land and buildings | 40,000 | |
| Plant and equipment | 22,000 | |
| ––––––– | ||
| Current assets: | 79,600 | |
| Inventory | 15,000 | |
| Receivables | 19,400 | |
| ––––––– | ||
| 114,000 | ||
| Equity and liabilities | ––––––– | |
| $ | ||
| Equity share capital ($1)** | 50,000 | |
| Share premium** | 2,000 | |
| Non-current liabilities: Debenture loan | 30,000 | |
| Current liabilities: | ||
| Trade payables | 14,000 | |
| Bank overdraft | 18,000 | |
| ––––––– |
114,000
Notes:
- Goodwill is the difference between the consideration paid and the net assets acquired:
| $ | $ | ||
| Consideration | 100,000 | ||
| Land and buildings | 40,000 | ||
| Plant and equipment | 22,000 | ||
| Inventory | 15,000 | ||
| Receivables ($20,000 × 97%) | 19,400 | ||
| Trade payables | (14,000) | ||
| ––––––– | (82,400) | ||
| Goodwill | ––––––– | ||
| 17,600 | |||
| ––––––– |
** The fair value of equity shares issued is $52,000 (50,000 × $1.04).
Of this the nominal value will be $50,000 (50,000 × $1) giving rise to a share premium of $2,000 (50,000 × ($1.04 – $1)).
Test your understanding 1 – Wire
Wire – statement of financial position at 30 June 20X1
(after reconstruction)
| Non-current assets: | $ | |
| Land and buildings at valuation | 160,000 | |
| Equipment | 30,000 | |
| Financial asset – investment in Cord | nil | |
| ––––––– | ||
| Current assets: | 190,000 | |
| Inventory | 50,000 | |
| Receivables (70,692 × 90%) | 63,623 | |
| Bank (W2) | 92,287 | |
| ––––––– | ||
| 395,910 | ||
| ––––––– | ||
| Equity and liabilities: | $ | |
| Equity shares ($0.25 each) (W3) | 140,000 | |
| Share premium (W3) | 17,800 | |
| Retained earnings | nil | |
| Capital reserve (W1) | 1,863 | |
| ––––––– | ||
| Non-current liabilities: | 159,663 | |
| 9.5% debentures (W4) | 124,000 | |
| Current liabilities: | ||
| Trade payables | 112,247 | |
| ––––––– | ||
| 395,910 | ||
| ––––––– |
| Wire – workings: | ||||||
| (W1) Reconstruction account | $ | $ | ||||
| Carrying values: | ||||||
| Land and buildings | 193,246 | |||||
| Equipment | 60,754 | |||||
| Investment in Cord | 27,000 | |||||
| Inventory | 120,247 | |||||
| Receivables written off (70,962 × 10%) | 7,069 | |||||
| Deficit on retained earnings written off | 39,821 | |||||
| Revised valuations: | ||||||
| Land and buildings | 160,000 | |||||
| Equipment | 30,000 | |||||
| Investment in Cord | 60,000 | |||||
| Inventory | 50,000 | |||||
| Share capital reduced (200,000 @ $0.75) | 150,000 | |||||
| Capital reserve (bal fig) | 1,863 | |||||
| ––––––– ––––––– | ||||||
| 450,000 | 450,000 | |||||
| ––––––– ––––––– | ||||||
| (W2) Bank account | $ | |||||
| Overdraft | (36,713) | |||||
| New equity share issue | 200,000 × $0.30 | 60,000 | ||||
| New debenture issue | 9,000 at par value | 9,000 | ||||
| Sale of investment – Cord | 60,000 | |||||
| ––––––– | ||||||
| 92,287 | ||||||
| ––––––– | ||||||
| (W3) Shareholdings | ||||
| Equity shares | Share | |||
| Number | premium | |||
| $ | $ | |||
| Redesignated existing shares | 200,000 | 50,000 | ||
| ($0.25 each) | ||||
| New issue ($0.30 each) | 200,000 | 50,000 | 10,000 | |
| Part-exchange of 5% debenture | 140,000 | 35,000 | ||
| Debenture interest (12,800 – | 20,000 | 5.000 | 7,800 | |
| 5,000)** | –––––– –––––– | –––––– | ||
| 560,000140,000 | 17,800 | |||
| –––––– –––––– | –––––– | |||
| **8% deb interest on $80,000 p.a. for 2 years = $12,800 – $5,000 | ||||
| (20,000 × $0.25) = $7,800 share premium. | ||||
| (W4) Debenture loan | $ | |||
| 8% debenture 20X4 deferred to 20X9 with 9.5% interest | 80,000 | |||
| rate | ||||
| New 9.5% debentures 20X9 – nominal value | 9,000 | |||
| New 9.5% debentures 20X9 – part conversion of 5% | 35,000 | |||
| debenture | –––––– | |||
| 124,000 | ||||
| –––––– | ||||
Advice to equity and debt holders:
Based upon the situation at 30 June 20X1 before the reconstruction scheme was devised, the following can be ascertained:
- There are sufficient assets to repay the secured debentures and perhaps most of the arrears of interest.
- Unsecured creditors would be unlikely to receive payment in full for amounts owed.
- Equity shareholders are unlikely to receive anything upon liquidation.
If a reconstruction scheme is to be agreed between the various parties, those who are in the strongest position (secured creditors) would expect to give up the least. Those in the weakest position (unsecured creditors and equity holders), would be expected to sacrifice more of their current entitlement to have any chance of recovery in the future.
The position of Wire if it was to go into liquidation is as follows:
| $ | |||
| Land and buildings | 160,000 | ||
| Plant and equipment | 30,000 | ||
| Investment | 60,000 | ||
| Inventory | 50,000 | ||
| Receivables (70,962 × 90%) | 63,623 | ||
| ––––––– | |||
| Assets available | 363,263 | ||
| Secured liabilities (80,000 + 70,000) | (150,000) | ||
| ––––––– | |||
| Current liabilities: | 213,623 | ||
| Overdraft | 36,713 | ||
| Interest | 12,800 | ||
| Trade payables | 112,247 | ||
| ––––––– | (161,760) | ||
| ––––––– | |||
| Available to equity holders | 51,863 | ||
| ––––––– |
The above summary identifies the position of the various stakeholders if there was no reconstruction scheme and Wire was liquidated. The debenture holders would be sure to receive their loan repayment, together with probably all of the arrears of interest, depending upon realised values of the assets and no other significant liabilities being uncovered.
The equity holders would not receive a full return of the nominal value of their capital, receiving only approximately (51,863/200,000) $0.26 per share.
Consequently, if the reconstruction scheme is implemented:
- The debenture holders are to be offered an increased rate of interest, but must also accept extension of the lending period to 20X9. It continues to be secured against land and buildings. Their position is relatively strong and safe.
- Some of the debenture holders have exchanged some of their legal rights as creditors for rights as equity holders. They must hope that Wire becomes profitable so that they can receive dividends in future years and that the share price increases. In addition, they must hope that, even if Wire gets into financial difficulties at a later date, there are still sufficient assets available to repay them, after the secured creditors have been repaid.
- It would appear that Wire will make profit after tax if the reconstruction goes ahead. If the profit forecast is reliable, this will be as follows:
| $ | |
| Profit before tax and interest | 50,000 |
| Less: debenture interest (9.5% × $124,000) | 11,780 |
| –––––– | |
| Profit before tax | 38,220 |
| Tax (× 25%) | (9,555) |
| –––––– | |
| Profit available to equity holders | 28,665 |
| –––––– |
Earnings per share would therefore be: $28,665/560,000 = 5.1 cents per share (i.e. $0.051 per share).
