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3.3. Equity: value, meaning, components

3.3.1. Value and its meaning

The value of the equity is the result of total assets less total liabilities. It represents the 'book value' of the entity, i.e. its value according to the accounting books, which has a very weak link with the value attributed to it by actual and potential investors.

The equity is normally a positive value. A negative equity is not sustainable in the long run, hence, in such case, an entity's management will have to either raise more capital by issuing new shares or wind up the entity.

Ultimately the equity, being the excess of assets over liabilities, represents the amount of capital that, according to the books, guarantees an entity's solvency in case of winding up. However, given the definition of assets and their valuation criteria, it is apparent that a positive equity might, in fact, become negative in the very moment when the entity is being wound up. This is the effect of the going concern assumption fading away and the assets being, therefore, valued at their realizable value as opposed to their potential contribution to the entity in operation.

3.3.2. Components

Not only the total value of the equity, but also its components convey valuable information for the readers of the accounts. The main message you want to obtain from the analysis of the components of the equity is what part of it is made of 'realized' profits, the remaining part being made of 'recognized' (but not realized) profits. Realized profits are values calculated yearly, and accumulated year on year, as the excess of revenues over expenses. We will address this concept in the next chapter on income statement, however it is worth knowing that only the profits that have been realized can be distributed to the shareholders as dividends, whilst non-realized profits cannot be distributed. The rationale underpinning this rule is that only realized profits objectively represent value added to the entity's wealth, as they are the result of transactions with third parties. Recognized profits, instead, are the results of assumptions which, no matter how much they have been substantiated by sophisticated procedures and credible and certified experts, they still remain assumptions.

Typically the equity includes the following:

o Share capital, which represents the nominal value of all the shares issued by the entity

o Share premium reserve, which represents the accumulated value of all premia paid by new shareholders as they bought shares at higher than their nominal values

o Retained profits, or reserve of profits, which represent the accumulated profits that have been retained in the entity over its whole life. This value is often split in more reserves, called 'other statutory reserves'

o Retained profit or loss, which represents the retained profit or the loss of the current year

o Revaluation reserve, which represents the sum of all the recognized increases in value of non-current assets over the whole life of the entity

o Gains and losses that have been accounted for directly in the equity, as opposed to having been included in the profit, i.e. not reported in the income statement. These are technical reserves made from the changes in value of financial instruments under certain circumstances or changes in value of other assets or liabilities due to changes in the rate of exchange between the currency used for the accounts and other denomination currencies of credits, debts and other items.

You might come across other components of the equity, which are less significant and for which some explanation is likely to be given in the notes to the accounts.

3.4. Overall informational value of the balance sheet

The balance sheet provides you with an insight about how much capital the entity's management can count on or, in more appropriate terms, the total value of the assets, which the management can employ to operate the business, and what these assets are. On the other hand, the balance sheet also indicates where the capital to finance these assets has come from; liabilities represent capital that is borrowed by the entity and equity represents capital that is owned by the entity. The capital coming from both liabilities and equity is invested in the entity's assets.

Hence, the accounting equation that underpins the balance sheet can be read with two perspectives:

o the first is "Total assets - total liabilities = equity", which highlights the message of the balance sheet that the equity is the excess of assets over liabilities, making the equity the entity's 'net book value', i.e. the entity's value, as reported in the books kept according to accounting rules, net of all liabilities (see section 3.3. above and figure 3)

the accounting equation as

Figure 3 - the accounting equation as "Total assets - total liabilities = equity"

the second is "Total assets = total liabilities + equity", which highlights the message that all assets must be financed by capital raised either through debt, i.e. liabilities, or through owner's investment, i.e. equity. (See figure 4)

the accounting equation as

Figure 4 - the accounting equation as "Total assets = total liabilities + equity"

 
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