Statement of changes in equity explained

 

One overlooked aspect of a financial report is the statement of changes in equity. The statement tells more on how Equity shareholders benefit or lose from the business. For a potential investor, the importance of the changes in equity cannot be overemphasized.

1. What's statement of changes in Equity

A statement of changes in equity is part of a company's financial statement that explains the transactions that either increase or decrease shareholders' funds. The statement is prepared mostly by companies. However, sole traders and partnership entities can also present this statement. It helps explain how profit and drawings increase or reduce the capital contributed by the business owner(s).

For companies and large entities the main transactions that can cause a change in the company's equity are profit or loss, dividends and items presented under other comprehensive income. For example, if a company earns profit for a financial year, it increases equity. However, dividend payout results in a failure in equity.

2. Transactions that affects equity

2.1 Profit or loss

As stated earlier, if an entity earns profit after taxes, this will increase the shareholders fund and vice versa. When a company's equity is eroded by losses it means that the entity is on the verge of collapse. And the only probable solution is to pump in more equity. This can be done by either converting loan capital to equity or injecting fresh equity to the firm.

2.2 Dividend

Dividend is paid out of profit. What this implies is that shareholders will receive a dividend only when the entity earns profit. However, when a dividend is proposed it reduces the profit available for the business growth and causes a change in equity. 

2.3 Equity contribution

When an entity shareholders introduce more capital it increases the shareholders fund. The manner in which the funds are bought into the business is immaterial. Whether it is by introduction, public offering, or right issue this fund will soar the equity of the company.

2.4 Share premium

Another section of the statement of changes in equity is the share premium. This represents the excess amount a company sold its shares above the authorized or par price. A company will sell at a premium when it has positive Goodwill. However, it will sell at a discount if it has negative Goodwill. Shares premium increases equity but shares discount decreases it. 

2.5 Transactions treated under the equity method

There are certain transactions that are treated using the equity method in various IFRS standards. For example, some financial assets are treated using the equity method (in IFRS 9) and a gain on the disposal of non-current assets are treated using this method. When this is mentioned, it means that such transactions should be posted to the other comprehensive income rather than the profit or loss statement.

Transactions such as the gains or losses of foreign exchange transactions, revaluation of non current assets and other fair value reserves items affect equity. These items can also be classified as capital and fair value (revenue) reserves. A loss in foreign exchange transactions reduces equity but a revaluation gain increases it.