What it means
The usual mechanism is a bonus issue, also called a scrip issue, in which the company issues new shares to current holders at no cost. The accounting entry reduces retained earnings and increases share capital, so total equity is identical before and after.
Each shareholder simply owns more shares, each worth proportionately less. Boards do this for several practical reasons.
It signals that the retained profits are being treated as permanent rather than distributable, it brings a high share price down to a more tradeable level, and it aligns issued capital with the scale the business has reached. In some jurisdictions it is also used to meet a minimum capital requirement.
The effect on per-share figures is purely arithmetic but still catches people out. Earnings per share, dividend per share and book value per share all fall in proportion to the increase in the share count, so historical comparisons must be restated.
A chart showing earnings per share dropping after a bonus issue is not showing a deterioration. It is worth separating this from a dividend and from a share split.
A dividend takes cash out of the company, a share split divides existing shares without touching reserves, and capitalisation of profits converts reserves into capital. Only the first of the three puts money in a shareholder's pocket.
The real consequence is a loss of flexibility. Once profits sit in share capital they are generally protected by company law and cannot simply be released as a dividend later without a formal capital reduction, which is often supervised by a court or regulator.
A board holding reserves it may want for future distributions should think carefully before capitalising them.
In practice
Real-world examples.
Example
A family manufacturing business has built up $2,400,000 of retained earnings over twenty years and wants to make clear that the money is staying in the company. It capitalises $1,500,000 of it through a bonus issue, so the funds become share capital that cannot be drawn out as dividends.
Example
A listed consumer goods company sees its share price reach a level where small investors struggle to buy meaningful amounts. A one-for-one bonus issue doubles the share count and roughly halves the price, improving liquidity without the company raising or spending a single dollar.
Example
An analyst comparing five years of earnings per share for a construction group sees a sudden 40% drop in year four. Checking the notes, she finds a bonus issue that year, restates the earlier years on the new share count, and the apparent collapse disappears.
Formula
Calculation
Amount capitalised = number of bonus shares issued x par value per share
Earnings per share after the issue = profit after tax / total shares after the issue
A company has 1,000,000 ordinary shares of $1 par value, share capital of $1,000,000 and retained earnings of $800,000, giving total equity of $1,800,000. It makes a one-for-two bonus issue, so it issues 1,000,000 / 2 = 500,000 new shares and capitalises 500,000 x $1 = $500,000. Share capital rises to $1,500,000, retained earnings fall to 800,000 - 500,000 = $300,000, and total equity stays at $1,800,000. If profit after tax is $600,000, earnings per share falls from 600,000 / 1,000,000 = $0.60 to 600,000 / 1,500,000 = $0.40, even though the company earned exactly the same amount.Case study
Seen in the real world.
Thornbeck Mills is a fictional, illustrative textile manufacturer with 2,000,000 shares of $1, share capital of $2,000,000 and retained earnings of $3,600,000. The board wanted to reassure a new lender that profits were being retained in the business rather than extracted by the founding shareholders.
It capitalised $2,000,000 of reserves through a one-for-one bonus issue, taking share capital to $4,000,000 and leaving retained earnings of $1,600,000. Total equity was unchanged at $5,600,000, and the lender was satisfied that a large part of accumulated profit was now legally locked in.
Three years later, a shareholder wanted a special dividend and the board discovered that distributable reserves were far thinner than expected. The illustrative lesson is that capitalisation is easy to do and difficult to undo, so the decision should be taken with future distribution plans in mind.
Watch out
Common mistakes.
- Believing a bonus issue makes shareholders wealthier, when each holder owns more shares of proportionately lower value and total equity has not moved.
- Comparing earnings per share before and after a capitalisation without restating the earlier figures on the new share count.
- Capitalising reserves without checking how much distributable profit the company will need for planned dividends, since reversing the move usually requires a formal capital reduction.
Questions
People also ask.
Is capitalisation of profits the same as a share split?
No, a split divides existing shares and leaves reserves untouched, while capitalisation transfers reserves into share capital and issues genuinely new shares.
Does it create a tax charge for shareholders?
In many jurisdictions a bonus issue is not treated as income because no value is received, but the rules differ by country, so local advice is needed before the issue is declared.
Can capitalised profits ever be returned to shareholders?
Only through a formal capital reduction or on a winding up, and such a reduction normally needs shareholder approval plus court or regulatory consent.
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