Meaning of the term Capitalisation

[TheMotorcycleBoy]

I was trying to get my head around what things in a business are tax-deductible and what's not, and the term "capitalised" reared it's head.

Some stuff/terminology from the capital expenditure wiki page as follows:

Accounting rules
For tax purposes, capex is a cost that cannot be deducted in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property's useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question. Further to the above, capex creates or adds basis to the asset or property, which once adjusted, will determine tax liability in the event of sale or transfer.

I've heard this term mentioned elsewhere, i.e. capitalisation of profits.

The capitalization of profits refers to the process of converting a company's retained earnings, which represent the profits held in the business over time, into capital stock. The capitalization of profits process involves issuing a stock dividend, or bonus shares, to existing shareholders. This allocation is done proportionally to existing stockholder ownership levels, similar to a rights issue.

So I'm guessing, all the term really means is "turning this into an asset".

Correct?

[doug2500]

I don't feel I can say for sure you're correct but that's roughly my take on it.

What I would be aware of is when companies capitalize 'normal' costs so they appear on the balance sheet rather than income statement, so reducing costs and inflating profits.

Normally these would be dressed up as R & D costs.

[Gengulphus]

I've heard this term mentioned elsewhere, i.e. capitalisation of profits.

The capitalization of profits refers to the process of converting a company's retained earnings, which represent the profits held in the business over time, into capital stock. The capitalization of profits process involves issuing a stock dividend, or bonus shares, to existing shareholders. This allocation is done proportionally to existing stockholder ownership levels, similar to a rights issue.

So I'm guessing, all the term really means is "turning this into an asset".

Correct?

No, because it isn't that broad. All sorts of things turn profits into assets, but it specifically means making it turning it into additional share capital of the company by issuing more shares, which then belong to the existing shareholders of the company. In terms of what happens on the balance sheet, it's basically a transfer within the equity section of the balance sheet, from the distributable "Retained earnings" reserve to the non-distributable "Share capital" and "Share premium" reserves.

If you're wondering why companies do it, given that it doesn't affect either assets or liabilities, but just the notional (though legally important) division of the net assets between various sums that the company can do different things with, I don't fully understand that myself. But I believe one aspect of it is that it effectively promises not to distribute the profits concerned to the shareholders, at least not without court approval or at the end of winding up the company, and so it makes the company more credit-worthy.

Gengulphus

[Charlottesquare]

I was trying to get my head around what things in a business are tax-deductible and what's not, and the term "capitalised" reared it's head.

Some stuff/terminology from the capital expenditure wiki page as follows:

Accounting rules
For tax purposes, capex is a cost that cannot be deducted in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property's useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question. Further to the above, capex creates or adds basis to the asset or property, which once adjusted, will determine tax liability in the event of sale or transfer.

I've heard this term mentioned elsewhere, i.e. capitalisation of profits.

The capitalization of profits refers to the process of converting a company's retained earnings, which represent the profits held in the business over time, into capital stock. The capitalization of profits process involves issuing a stock dividend, or bonus shares, to existing shareholders. This allocation is done proportionally to existing stockholder ownership levels, similar to a rights issue.

So I'm guessing, all the term really means is "turning this into an asset".

Correct?

1.Re capex it is acquiring items that are fixed assets, assets that give benefit to the enterprise over a number of accounting periods. You need to consider this in light of accounting concepts like matching, accruals etc

To be clear things like stock, debtors, bank balances are all assets but they are usually current assets not fixed assets.

Note that there may be tax relief for Capex, depending on the quantum and whether the capex is for say plant and machinery. Annual investment Allowance may be claimable in the year of purchase, Writing Down Allowances may be claimed year on year from when the fixed asset comes into use

Imho You really need to be pretty comfortable with accountancy before getting into the detail of tax reliefs re corporation tax, assets quite often whizz around within groups with little tax and in the corporate world very often parts of groups to be sold have the necessary assets and liabilities placed within particular companies and it is the companies that are sold rather than the assets.

2.Re capitalization of profits,this is merely converting part of capital and reserves from reserves to capital.


In essence a Balance sheet has three main parts, Assets, Liabilities and Equity ( Capital and Reserves), these are related as A-L=E.

Within Equity changing R into C, say by a bonus issue, is merely adjusting what may possibly be distributed (By dividend etc) from Reserves to Capital (which latter cannot normally be distributed). Note, not all reserves are distributable.


3.It is really worthwhile getting your head around the five categories of accounts, Income, Expenditure, Assets,Liabilities, Equity (capital and reserves), every transaction impacts these categories at least twice,

eg. Buy a Fixed Asset on Credit for £1 million is Dr Fixed assets £1million, Cr Liabilities £1 million,
paying the supplier is Dr Liability £1million Cr Bank Million.

A basic book re double entry and company accounts cuts out a lot of learning because once mastered the basics can pretty much be applied to any transaction and over time you intuitively understand what is happening, accounting students firstly get taught double entry because it is the single most significant building block on which all accountancy is built, you possibly ought to learn it first and then imho understanding financial statements will become a whole lot simpler.

[Alaric]

So I'm guessing, all the term really means is "turning this into an asset".

I suspect there are various uses of the term "capitalisation" in different contexts.

If you want it placed in a personal context, capital expenditure can be regarded as if it's money you've spent, but pretend you haven't.

So buy a car for cash for £ 10,000, your bank account or investment portfolio is £ 10,000 down. If you treat it as a capital expenditure, you argue that you might get 5 years use out of it before it becomes valueless, so you've only really spent £ 2,000 with the remaining £ 8,000 to be "spent" over the next 4 years.

That can be a problem with reading balance sheets, they can be full of stuff that isn't really there, or stuff that's valuable but treated as having no value.

[TheMotorcycleBoy]

No, because it isn't that broad. All sorts of things turn profits into assets, but it specifically means making it turning it into additional share capital of the company by issuing more shares, which then belong to the existing shareholders of the company. In terms of what happens on the balance sheet, it's basically a transfer within the equity section of the balance sheet, from the distributable "Retained earnings" reserve to the non-distributable "Share capital" and "Share premium" reserves.

Thanks for this Geng,

Yes, it seems what you are saying is in accord with Charlottesquare's remarks:

2.Re capitalization of profits,this is merely converting part of capital and reserves from reserves to capital.

In essence a Balance sheet has three main parts, Assets, Liabilities and Equity ( Capital and Reserves), these are related as A-L=E.

Within Equity changing R into C, say by a bonus issue, is merely adjusting what may possibly be distributed (By dividend etc) from Reserves to Capital (which latter cannot normally be distributed). Note, not all reserves are distributable.

However, (Geng), what do you mean when you say turning it into additional share capital of the company by issuing more shares, which then belong to the existing shareholders of the company? I'm reading this as meaning that if we hold 21 Next (NXT) shares now, and then they for accounting purposes move retaining some money from retained earnings into share capital, then somehow we have been assured a very slightly bigger stake in Next, even though we didn't purchase any more shares at that time. Is that what you meant?

[TheMotorcycleBoy]

Thanks Charlottesquare,

1.Re capex it is acquiring items that are fixed assets, assets that give benefit to the enterprise over a number of accounting periods. You need to consider this in light of accounting concepts like matching, accruals etc

To be clear things like stock, debtors, bank balances are all assets but they are usually current assets not fixed assets.

Note that there may be tax relief for Capex, depending on the quantum and whether the capex is for say plant and machinery. Annual investment Allowance may be claimable in the year of purchase, Writing Down Allowances may be claimed year on year from when the fixed asset comes into use

Imho You really need to be pretty comfortable with accountancy before getting into the detail of tax reliefs re corporation tax, assets quite often whizz around within groups with little tax and in the corporate world very often parts of groups to be sold have the necessary assets and liabilities placed within particular companies and it is the companies that are sold rather than the assets.

Funnily enough the whole reason for me posting in this thread in the first place was actually because I was trying to figure out another puzzle, which I'd thought I'd asked in an earlier thread that day, but me being me I'd forgotten to. What I'd been mulling over was that whenever I look at the concept of "Free Cash Flow" I note that it is frequently defined, starting off as:

Net cash from Operations - Capex -/+ other_things

and it occurred to me that the Capex right there above, is not a tax deductible component. This surprised me at first since whenever I talk to my neighbour (who is a self-employed property maintainer) and mention that what he has just bought he could have bought for less at X&Y.co etc. he just replies "it doesn't matter, it's the company that bought it, so I'll claim the cost back against tax".

But then I read the wiki on capex, and see that along with the observation from CS that things like stock, debtors, bank balances are all assets but they are usually current assets not fixed assets, then this makes complete sense. That is, in general terms, purchases whose useful life is less than a year can get booked as a "cost", whereas those with a longer life in the firm are booked as "capex".

An example in the mechanical engineering world being that oils and drill bits are costs, but a new lathe is capex. I assume.

3.It is really worthwhile getting your head around the five categories of accounts, Income, Expenditure, Assets,Liabilities, Equity (capital and reserves), every transaction impacts these categories at least twice,

eg. Buy a Fixed Asset on Credit for £1 million is Dr Fixed assets £1million, Cr Liabilities £1 million,
paying the supplier is Dr Liability £1million Cr Bank Million.

A basic book re double entry and company accounts cuts out a lot of learning because once mastered the basics can pretty much be applied to any transaction and over time you intuitively understand what is happening, accounting students firstly get taught double entry because it is the single most significant building block on which all accountancy is built, you possibly ought to learn it first and then imho understanding financial statements will become a whole lot simpler.

I know, I know. I'm currently actually trying to sell stuff (books) back via Amazon, and restrain my purchasing from them right now!

[Alaric]

I'm reading this as meaning that if we hold 21 Next (NXT) shares now, and then they for accounting purposes move retaining some money from retained earnings into share capital, then somehow we have been assured a very slightly bigger stake in Next, even though we didn't purchase any more shares at that time.

Perhaps with no paper share certificates, it's possible to overlook this, but all shares have a nominal value, usually something small like 5p. The share capital reported in the accounts is the product of the nominal value and the number of shares in issue. If for accounting reasons, there's need to increase or decrease the reported share capital, this can be done either by increasing the number of shares in issue or by increasing or reducing the nominal value. In the former case, you get bonus shares, in the latter the existing shares are cancelled and you get new ones.

In neither case, does the proportion you own of the Company as a whole change. That's because share capital and retained earnings both belong to shareholders, so shuffling between the two doesn't change anything. Rights issues, where the Company raises extra money by issuing new shares will change ownership percentages.

[Charlottesquare]

No, because it isn't that broad. All sorts of things turn profits into assets, but it specifically means making it turning it into additional share capital of the company by issuing more shares, which then belong to the existing shareholders of the company. In terms of what happens on the balance sheet, it's basically a transfer within the equity section of the balance sheet, from the distributable "Retained earnings" reserve to the non-distributable "Share capital" and "Share premium" reserves.

Thanks for this Geng,

Yes, it seems what you are saying is in accord with Charlottesquare's remarks:

2.Re capitalization of profits,this is merely converting part of capital and reserves from reserves to capital.

In essence a Balance sheet has three main parts, Assets, Liabilities and Equity ( Capital and Reserves), these are related as A-L=E.

Within Equity changing R into C, say by a bonus issue, is merely adjusting what may possibly be distributed (By dividend etc) from Reserves to Capital (which latter cannot normally be distributed). Note, not all reserves are distributable.

However, (Geng), what do you mean when you say turning it into additional share capital of the company by issuing more shares, which then belong to the existing shareholders of the company? I'm reading this as meaning that if we hold 21 Next (NXT) shares now, and then they for accounting purposes move retaining some money from retained earnings into share capital, then somehow we have been assured a very slightly bigger stake in Next, even though we didn't purchase any more shares at that time. Is that what you meant?

On a bonus share issue Next might say that for every 7 shares you now hold you are to be issued an extra share, so for your 21 you are issued three more and you now have 24. But everyone else got the same so you still own the same percentage of Next but just more shares. If before the bonus Next had in total 210 shares in issue you had 10%, after the bonus you have 24 shares but there are now 240 in issue, still 10%.

Now this is where your debit and credit understanding would be useful, the company has issued say 30 shares of £1 nominal each, it needs to

Dr Reserves £30
Cr Share Capital £30

The company is worth the same as it was before the bonus it just has more shares in issue and less reserves, but its equity (C+R) is the same.

[TheMotorcycleBoy]

In the former case, you get bonus shares, in the latter the existing shares are cancelled and you get new ones.

On a bonus share issue Next might say that for every 7 shares you now hold you are to be issued an extra share, so for your 21 you are issued three more and you now have 24. But everyone else got the same so you still own the same percentage of Next but just more shares. If before the bonus Next had in total 210 shares in issue you had 10%, after the bonus you have 24 shares but there are now 240 in issue, still 10%.

I did not realise that companies did this. That is, that benefit of being a shareholder, is that at some stage in time, you can be awarded extra shares.

I assume that that this practice happens infrequently? Also when it does happen is each shareholder sent a notification?

Now this is where your debit and credit understanding would be useful,

I'll get there in the end CS (I'm currently reading "The Intelligent Investment" and a Harlen Coben fiction book)

the company has issued say 30 shares of £1 nominal each, it needs to

Dr Reserves £30
Cr Share Capital £30

The company is worth the same as it was before the bonus it just has more shares in issue and less reserves, but its equity (C+R) is the same.

Yup, makes sense. Thanks!

Matt

[Alaric]

I assume that that this practice happens infrequently? Also when it does happen is each shareholder sent a notification?

It's now really quite rare. In the days of privatisation sales, extra shares might be issued as a loyalty bonus to those who held for a year or more after the IPO.

Slightly more common is where they multiply your shareholding by 10. That's where the price per share has got inconveniently large, given that shares can only be dealt in whole numbers.

There's a formal notification process for changes to share capital, shareholders may even be asked to vote to allow it to go ahead.

[TheMotorcycleBoy]

Slightly more common is where they multiply your shareholding by 10. That's where the price per share has got inconveniently large, given that shares can only be dealt in whole numbers.

Any idea what the usual threshold is before the 10x event happens? At £100 per share, £200?

Kinda curious as to that since we often set a max purchase of about £1000 worth, and for a few stocks we've eyeballed that doesn't equate to that many shares....which itself means our ISA schemes cheap divi reinvestment scheme doesn't work on these ones. (Which we find unfortunate, since we appreciate just letting divs push our holdings up).

[Alaric]

Any idea what the usual threshold is before the 10x event happens? At £100 per share, £200?

I would expect it somewhat lower than that, £ 10 or £ 20 perhaps.

It's going to depend on the Company and who it sees as its prospective shareholders.

You make an interesting point about the lack of viability of share reinvestment schemes where the price per share is on the high side. Perhaps you could write to Companies that offer dividend reinvestment schemes that aren't usable for small shareholdings.

[TheMotorcycleBoy]

Any idea what the usual threshold is before the 10x event happens? At £100 per share, £200?

I would expect it somewhat lower than that, £ 10 or £ 20 perhaps.

Lots of others (off the top of my head) extend these threshold, RDSB about £26, SPX about £70, GAW about £38

We bought Next Plc (NXT) shares at about £56 each recently.

You make an interesting point about the lack of viability of share reinvestment schemes where the price per share is on the high side. Perhaps you could write to Companies that offer dividend reinvestment schemes that aren't usable for small shareholdings.

Thanks that's a good idea. I may well email a few of them. Perhaps I'll start off a thread on TLF and describe events as they pan out, or something.

Matt

[Charlottesquare]

[quote="TheMotorcycleBoy"

I did not realise that companies did this. That is, that benefit of being a shareholder, is that at some stage in time, you can be awarded extra shares.

I assume that that this practice happens infrequently? Also when it does happen is each shareholder sent a notification?

[/quote]


Hate to say all a share split may do is make shares more marketable, the value of the holding tends not to change that much, the multiple of shares being matched by the drop in share price.

As an example my most recent was European Asset Trust in May this year, and given its current share price the ten for one issue of shares has not done me much good (though I expect other matters are impacting the EAT price.)

https://quoteddata.com/2018/03/stock-sp ... ets-trust/

[TheMotorcycleBoy]

I did not realise that companies did this. That is, that benefit of being a shareholder, is that at some stage in time, you can be awarded extra shares.

I assume that that this practice happens infrequently? Also when it does happen is each shareholder sent a notification?

Hate to say all a share split may do is make shares more marketable, the value of the holding tends not to change that much, the multiple of shares being matched by the drop in share price.

As an example my most recent was European Asset Trust in May this year, and given its current share price the ten for one issue of shares has not done me much good (though I expect other matters are impacting the EAT price.)

https://quoteddata.com/2018/03/stock-sp ... ets-trust/

Hi CS,

The post of mine which you quoted pertained to "bonus" shares. However I believe that your post referred to 10x reduction in price + multiplication in holdings.

Correct?

TBH I think a stock split thing (i.e. 10x multiplier thing that Alaric) would be great for me and Mel. Sticking the example of NXT. We have 21 shares (I think!) and the DY is about 3.3% (I think!). Which would mean that currently if they subdivide their div payout to being 2x a year we'd get 2 bungs of about 16 quid. Not enough for the DRIP to purchase a single share. However, surely if the price was about £5.60 ps , then the div payouts would still be the same total amounts but our DRIP could add about 6 NXT shares to our holding per year. We like idea, since with iWeb ISAs charging structure, their DRIP is a nice cheap way of slowly building our holdings. The only bummer being when one or two of those holdings are in high numerically valued shares.

Matt

[gryffron]

Any idea what the usual threshold is before the 10x event happens? At £100 per share, £200?

For many years USA companies used to do this all the time. Often splitting or consolidating to keep the share price within the $10-20 range. Sometimes splitting one year and consolidating the next as the value varied. Low value shares (<$10) are viewed in the US as "penny shares" = small company = high risk. So companies don't like having a <$10 share price. But such frequent changes could be a right pain for investors. Thankfully it is much less common in the UK, and appears to be becoming less so in the USA as investors get used to tech shares frequently priced at >$100 each.

Very high value individual shares makes it harder for small investors to buy into the company. Such as your NXT problem.

Gryff

[Alaric]

Very high value individual shares makes it harder for small investors to buy into the company. Such as your NXT problem.

NXT is Next the clothing retailer is it not?

You might think they would value having small investors as also being their customers. M&S in particular would historically cultivate having a wide shareholding.

[TheMotorcycleBoy]

Thanks Gryf and Alaric,

Yes NXT is clothing/fashion accessories retailer. I know a little about them (more than our other investments), mother-in-law has worked there for about 15 years! They are gradually moving more and more into online, and in my naive view have a highly profitable card scheme which customers link to both online and instore sales. Plus it's a well known brand. Well if we get spare cash and we think it's worthwhile it's probably a case of a top-up not DRIP.

Matt

[Charlottesquare]

Very high value individual shares makes it harder for small investors to buy into the company. Such as your NXT problem.

Gryff

Like Berkshire Hathaway A shares at $323,000 per share, showing down $12,630 today as I type.