Additional Guidance Relative to Share Issuances and Related Matters
IFRS provides only minimal guidance regarding the actual accounting for share‐based transactions, including the issuance of shares of various classes of equity instruments. In the following paragraphs suggestions are made concerning the accounting for such transactions, which are within the spirit of IFRS, although largely drawn from other authoritative sources. This is done to provide guidance which conforms to the requirements under IAS 8 (hierarchy of professional standards), and to illustrate a wide array of actual transactions that often need to be accounted for.
Accounting for the issuance of shares
The accounting for the sale of shares by a corporation depends on whether the share capital has a par or stated value. If there is a par or stated value, the amount of the proceeds representing the aggregate par or stated value is credited to the ordinary or preferred share capital account.
The aggregate par or stated value is generally defined as legal capital not subject to distribution to shareholders. Proceeds in excess of par or stated value are credited to an additional contributed capital account or share premium. The additional contributed capital represents the amount in excess of the legal capital that may, under certain defined conditions, be distributed to shareholders. A corporation selling shares below par value, when allowed by regulations in it's local jurisdiction, credits the share capital account for the par value and debits an offsetting discount account for the difference between par value and the amount actually received.
If there is a discount on the original issue of share capital, it serves to notify the actual and potential creditors of the contingent liability of those investors. As a practical matter, corporations avoided this problem by reducing par values to an arbitrarily low amount. This reduction in par eliminated the chance that shares would be sold for amounts below par. Where corporation laws make no distinction between par value and amounts in excess of par, the entire proceeds from the sale of shares may be credited to the ordinary share capital account without distinction between the share capital and the additional contributed capital accounts. The following entries illustrate these concepts:
Facts: A corporation sells 100,000 shares of €5 per ordinary share for €8 per share cash
Cash €800,000
Ordinary share capital €500,000
Additional contributed capital/share premium €300,000
Facts: A corporation sells 100,000 shares of no‐par ordinary share for €8 per share cash
Cash €800,000
Ordinary share capital €800,000
Preferred shares will often be assigned a par value because in many cases the preferential dividend rate is defined as a percentage of par value (e.g., 5%, €25 par value preferred share will have a required annual dividend of €1.25). The dividend can also be defined as a euro amount per year, thereby obviating the need for par values.
Share capital issued for services
If the shares in a corporation are issued in exchange for services or property rather than for cash, the transaction should be reflected at the fair value of the property or services received. If this information is not readily available, the transaction should be recorded at the fair value of the shares that were issued. Where necessary, appraisals should be obtained to properly reflect the transaction. As a final resort, a valuation by the board of directors of the shares issued can be utilised. Shares issued to employees as compensation for services rendered should be accounted for at the fair value of the shares issued. (See discussion of IFRS 2 within Chapter 17.)
Occasionally, particularly for start‐up operations having limited working capital, the controlling owners may directly compensate certain vendors or employees. If shares are given by a major shareholder directly to an employee for services performed for the entity, this exchange should be accounted for as a capital contribution to the company by the major shareholder and as compensation expense incurred by the company. Only when accounted for in this manner will there be conformity with the general principle that all costs incurred by an entity, including compensation, should be reflected in its financial statements.
Issuance of share units
In certain instances, ordinary and preferred shares may be issued to investors as a unit (e.g., a unit of one share of preferred and two ordinary shares can be sold as a package). Where both of the classes of shares are publicly traded, the proceeds from a unit offering should be allocated in proportion to the relative market values of the securities. If only one of the securities is publicly traded, the proceeds should be allocated to the one that is publicly traded based on its known market value. Any excess is allocated to the other. Where the market value of neither security is known, appraisal information might be used. The imputed fair value of one class of security, particularly the preferred shares, can be based on the stipulated dividend rate. In this case, the amount of proceeds remaining after the imputing of a value of the preferred shares would be allocated to the ordinary shares.
The foregoing procedures would also apply if a unit offering were made of an equity and a non‐equity security such as convertible debentures, or of shares and rights to purchase additional shares for a fixed time period.
Share subscriptions
Occasionally, particularly in the case of a newly organised corporation, a contract is entered into between the corporation and prospective investors, whereby the latter agree to purchase specified numbers of shares to be paid for over some instalment period. These share subscriptions are not the same as actual share issuances, and the accounting differs accordingly. In some cases, laws of the jurisdiction of incorporation will govern how subscriptions have to be accounted for (for example, when pro rata voting rights and dividend rights accompany partially paid subscriptions).
The amount of share subscriptions receivable by a corporation is sometimes treated as an asset in the statement of financial position and is categorised as current or non‐current in accordance with the terms of payment. However, most subscriptions receivable are shown as a reduction of shareholders' equity in the same manner as treasury shares. Since subscribed shares do not have the rights and responsibilities of actual outstanding shares, the credit is made to a share subscribed account instead of to the share capital accounts.
If the ordinary shares have par or stated value, the ordinary shares subscribed account is credited for the aggregate par or stated value of the shares subscribed. The excess over this amount is credited to additional contributed capital or share premium. No distinction is made between additional contributed capital relating to shares already issued and shares subscribed for. This treatment follows from the distinction between legal capital and additional contributed capital. Where there is no par or stated value, the entire amount of the ordinary shares subscribed is credited to the shares subscribed account.
As the amount due from the prospective shareholders is collected, the share subscriptions receivable account is credited, and the proceeds are debited to the cash account. Actual issuance of the shares, however, must await the complete payment of the share subscription. Accordingly, the debit to ordinary shares subscribed is not made until the subscribed shares are fully paid for and the shares are issued.
The following journal entries illustrate these concepts:
1. 10,000 preferred shares of €50 par are subscribed at a price of €65 each; a 10% down payment is received.
Cash €65,000
Share subscriptions receivable €585,000
Preferred share subscribed €500,000
Additional contributed capital/share premium €150,000
2. 2,000 shares of no‐par ordinary shares are subscribed at a price of €85 each, with one‐half received in cash.
Cash €85,000
Share subscriptions receivable €85,000
Ordinary shares subscribed €170,000
3. All preferred subscriptions are paid, and one‐half of the remaining ordinary subscriptions are collected in full and subscribed shares are issued.
Cash [€585,000 + (€85,000 × 0.50)] €627,500
Shares subscriptions receivable €627,500
Preferred shares subscribed €500,000
Preferred shares issued €500,000
Ordinary shares subscribed €127,500
Ordinary shares issued (€170,000 × 0.75) €127,500
When the company experiences a default by the subscriber, the accounting will follow the provisions of the jurisdiction in which the entity is incorporated. In some of these, the subscriber is entitled to a proportionate number of shares based on the amount already paid on the subscriptions, sometimes reduced by the cost incurred by the entity in selling the remaining defaulted shares to other shareholders. In other jurisdictions, the subscriber forfeits the entire investment on default. In this case the amount already received is credited to an additional contributed capital account that describes its source.
Distinguishing additional contributed capital from the par or stated value of the shares
For largely historical reasons, entities sometimes issue share capital having par or stated value, which may be only a nominal value, such as €1 or even €0.01. The actual share issuance will be at a much higher (market‐driven) amount, and the excess of the issuance price over the par or stated value might be assigned to a separate equity account referred to as premium on capital (ordinary) shares or additional contributed (paid‐ in) capital. Generally, but not universally, the distinction between ordinary shares and additional contributed capital has little legal import, but may be maintained for financial reporting purposes nonetheless.
Additional contributed capital represents all capital contributed to an entity other than that defined as par or stated value. Additional contributed capital can arise from proceeds received from the sale of ordinary and preferred shares in excess of their par or stated values. It can also arise from transactions relating to the following:
1. Sale of shares previously issued and subsequently reacquired by the entity (treasury shares).
2. Retirement of previously outstanding shares.
3. Payment of share dividends in a manner that justifies the dividend being recorded at the market value of the shares distributed.
4. Lapse of share purchase warrants or the forfeiture of share subscriptions, if these result in the retaining by the entity of any partial proceeds received prior to forfeiture.
5. Warrants that are detachable from bonds.
6. Conversion of convertible bonds.
7. Other gains on the entity's own shares, such as that which results from certain share option plans.
When the amounts are material, the sources of additional contributed capital should be described in the financial statements.
Examples of various transactions giving rise to (or reducing) additional contributed capital accounts are set forth below.
Examples of additional contributed capital transactions
Alta Vena Company issues 2,000 shares of ordinary shares having a par value of €1, for a total price of €8,000. The following entry records the transaction:
Cash €8,000
Ordinary shares €2,000
Additional contributed capital/share premium €6,000
Alta Vena Company buys back 2,000 shares of its own ordinary share for €10,000 and then sells these shares to investors for €15,000. The following entries record the buyback and sale transactions, respectively:
Treasury shares €10,000
Cash €10,000
Cash €15,000
Treasury shares €10,000
Additional contributed capital/share premium €5,000
Alta Vena Company buys back 2,000 shares of its own €1 par value ordinary shares (which it had originally sold for €8,000) for €9,000 and retires the shares, which it records with the following entry (assuming there are no national requirements for capital maintenance):
Ordinary shares €2,000
Additional contributed capital/share premium €6,000
Retained earnings €1,000
Cash €9,000
Alta Vena Company issues a small share dividend of 5,000 ordinary shares at the market price of €8 per share. Each share has a par value of
€1. The following entry records the transaction:
Retained earnings €40,000
Ordinary shares €5,000
Additional contributed capital/share premium €35,000
Alta Vena Company previously has recorded €1,000 of share options outstanding as part of a compensation agreement. The options expire a year later, resulting in the following entry:
Share options outstanding €1,000
Retained earnings €1,000
Alta Vena's bondholders convert a €1,000 bond with an unamortised premium of €40 and a market value of €1,016 into 127 shares of €1 per ordinary share whose market value is €8 per share. This results in the following entry:
Bonds payable €1,000
Premium on bonds payable €40
Ordinary shares €127
Additional contributed capital—warrants €913 Donated capital
Donated capital can result from an outright gift to the entity (for example, a major shareholder donates land or other assets to the company in a non‐reciprocal transfer) or may result when services are provided to the entity. Such a transaction may be treated as a capital contribution in the books of the receiving entity as it is received from a shareholder, the argument being that it is a capital injection from the shareholder. The dangling “credit” when recognising a below market‐interest rate or interest‐free long‐term loan from a related party is commonly recorded as donated capital.
Compound and Convertible Equity Instruments
Entities sometimes issue preferred shares which are convertible into ordinary shares. Where the preferred shares are non‐redeemable, the accounting for both the preferred and ordinary shares is similar as they both represent equity in the issuer. The treatment of convertible preferred shares at its issuance is no different from that of non‐convertible preferred shares. When it is converted, the book value approach is used to account for the conversion. Use of the market value approach would entail a gain or loss for which there is no theoretical justification, since the total amount of contributed capital does not change when the share capital is converted. When the preferred shares are converted, the “Preferred shares” and related “Additional contributed capital—preferred shares” accounts are debited for their original values when purchased, and
“Ordinary shares” and “Additional contributed capital—ordinary shares” (if an excess over par or stated value exists) are credited. If the book value of the preferred shares is less than the total par value of the ordinary shares being issued, retained earnings is charged for the difference.
This charge is supported by the rationale that the preferred shareholders are offered an additional return to facilitate their conversion to ordinary share. Some jurisdictions require that this excess instead reduces additional contributed capital from other sources.
On the other hand, the issuance of debt that is convertible into equity (almost always into ordinary shares) does trigger accounting complexities.
Under IAS 32, it is necessary for the issuer of non‐derivative financial instruments to ascertain whether it contains both liability and equity components. If the instrument does contain both elements (for example, debentures convertible into ordinary shares), these components must be separated and accounted for according to their respective natures.
In the case of convertible debt, the instrument is viewed as being constituted of both an unconditional promise to pay (a liability) and an option granting the holder the right, but not the obligation, to obtain the issuer's shares under a fixed conversion ratio arrangement. (Under the provisions of IAS 32, unless the number of shares that can be obtained on conversion is fixed, the conversion option is not an equity instrument.) This option, at issuance date, is an equity instrument and must be accounted for as such by the issuer, whether subsequently exercised or not.
The amount allocated to equity is the residual derived by deducting the fair value of the liability component (typically, by discounting to present value the future principal and interest payments on the debt by the relevant interest rate) from the total proceeds of issuance. It would not be acceptable to derive the amount to be allocated to debt as a residual, on the other hand. This is a conservative rule that effectively maximises the allocation to debt and minimises the allocation to equity.
Retained Earnings
Accounting traditionally has clearly distinguished between equity contributed by owners (including donations from owners) and that resulting from the operating results of the reporting entity, consisting mainly of accumulated earnings since the entity's inception less amounts distributed to shareholders (i.e., dividends). Equity in each of these two categories is distinct from the other, and financial statement users need to be informed of the composition of shareholders' equity so that, for example, the cumulative profitability of the entity can be accurately gauged.
Legal capital (the defined aggregate par or stated value of the issued shares), additional contributed capital and donated capital collectively represent the contributed capital of the entity. The other major source of capital is retained earnings, which represents the accumulated amount of earnings of the entity from the date of inception (or from the date of reorganisation) less the cumulative amount of distributions made to
shareholders and other charges to retained earnings (e.g., from treasury share transactions). The distributions to shareholders generally take the form of dividend payments, but may take other forms as well, such as the reacquisition of shares for amounts in excess of the original issuance proceeds. The key events impacting retained earnings are:
Dividends;
Certain sales of shares held in the treasury at amounts below acquisition cost;
Certain share retirements at amounts in excess of book value;
Prior period adjustments;
In consolidated financial statements, changes in ownership stake of the non‐controlling interests which do not result in a loss of control of the subsidiary; and
Recapitalisations and reorganisations.
Examples of retained earnings transactions
Baking Bread Co. declares a dividend of €84,000, which it records with the following entry:
Retained earnings €84,000
Dividends payable €84,000
Baking Bread acquires 3,000 shares of its own €1 par value ordinary shares for €15,000 and then resells them for €12,000. The following entries record the buyback and sale transactions, respectively, assuming the use of the cost method of accounting for treasury shares:
Treasury shares €15,000
Cash €15,000
Cash €12,000
Retained earnings €3,000
Treasury shares €15,000
Baking Bread buys back 12,000 shares of its own €1 par value ordinary shares (which it had originally sold for €60,000) for €70,000 and retires the shares, which it records with the following entry (assuming there are no national requirements for capital maintenance):
Ordinary shares €12,000
Additional contributed capital €48,000 Retained earnings €10,000
Cash €70,000
Baking Bread's accountant makes a mathematical mistake in calculating depreciation, requiring a prior period reduction of €30,000 to the accumulated depreciation account and corresponding increases in its income tax payable and retained earnings accounts. Baking Bread's income tax rate is 35%. It records this transaction with the following entry:
Accumulated depreciation €30,000
Income taxes payable €10,500
Retained earnings €19,500
An important rule relating to retained earnings is that transactions in an entity's own shares can result in a reduction of retained earnings (i.e., a deficiency on such transactions can be charged to retained earnings) but cannot result in an increase in retained earnings (any excesses on such transactions are credited to contributed capital, never to retained earnings).
If a series of operating losses have been incurred or distributions to shareholders in excess of accumulated earnings have been made and if there is a debit balance in retained earnings, the account is generally referred to as accumulated deficit.
Dividends and Distributions
Cash dividends
Dividends represent the pro rata distribution of earnings to the owners of the entity. The amount and the allocation between the preferred and ordinary shareholders is a function of the stipulated preferential dividend rate, the presence or absence of: (1) a participation feature, (2) a cumulative feature and (3) arrears on the preferred shares, and the wishes of the board of directors. Dividends, even preferred share dividends where a cumulative feature exists, do not accrue. Depending on the jurisdiction, one may find that dividends become a liability of the entity only