Elements of Financial Statements – Part 1
Capital/Equity
When a transaction occurs, it affects one or more aspects of financial statements which are called elements of financial statements. The analysis of the transactions is carried out to decide which one or more elements needs updating as a result of the transaction. There are five elements of financial statements;
- Capital/Equity
- Assets
- Liabilities
- Income
- Expense
These elements can also be called head of accounts as usually each element would have many accounts under it. Let’s explore each of these elements one by one.
Capital/Equity
Capital or equity is owners’ money in the business. Although both terms have same meaning, the term equity is only used for limited companies and capital is usually used for sole traders and partnerships.
In case of sole traders and partnerships, capital is invested in the business when owners invest their own funds into the business to buy good like stocks, machinery etc. Sometimes owners invest goods or motor vehicles like a van in form of capital. A money value of those goods is determined at this stage which is usually the market value to record these transactions. As the scope of this book deals with limited companies only, we will not discuss the above types of businesses in more details.
For limited companies, this concept is different and broad. As per the definition by International Accounting Standard Boards (IASB), “Equity is the residual interest in the assets of the entity after deducting all its liabilities”. This means everything in a limited company belongs to shareholders if it does not belong to other parties e.g., lenders, suppliers etc.
A limited company raises capital by selling its shares. However, before that, owners/incorporators would need to register the company with a relevant authority (The Companies House in the UK). The Companies House issues an incorporations certificate which confirms the name of the company and date of incorporation (like a birth certificate) and a legal entity comes into existence. A Company would have a specified value of authorised share capital (capital) at its initiation which can be calculated as
Authorised Share capital is the maximum amount of share capital which companies can raise from their owners. It fixes two elements of it i.e., numbers of shares and value of each share, as the formulas above suggests. This amount cannot be exceeded unless a permission has been taken from the Companies House. A company does not have to issue all of the authorised share capital but can choose to issue only part of it which is known as “Issued share capital”. The value of each share is called the nominal/face value of the share and any value could be set for one share although it is mostly 10p, 25p, 50p and £1 in the UK.
The company would be considered as a separate legal person and even the dealings involving money between owners and the company would be recorded as transactions. The first transaction is the investment of capital by the owners which occurs at the time of incorporation of the company. Therefore, we can say that a company is born with some cash in its hands. At that time, the owners/incorporators buy the company’s shares by investing cash which is usually done by depositing the money into the company’s bank account at a later date when a bank account is opened for the company.
Most of the companies which we encounter in our daily life e.g., Tesco, Vodafone, British Gas are public limited companies which are usually bigger than private limited companies and have shareholders in larger numbers than private limited companies. These companies are registered at a stock exchange and are allowed to sell their shares to general public. These companies started off as small business and grew overtime. A private limited company becomes a public limited company to attract more investors and increase its equity by selling its shares to public. However, before applying to become a public limited company, a company must have authorised and allotted share capital of at least £50,000 (along with other conditions), which suggests that only bigger companies are encouraged to go public.
However, as the company grows, the capital structure and the shape of equity would get complicated.