IFRS provides insufficient guidance regarding the actual accounting for share capital transactions, including the issuance of shares of various classes of equity instruments. This post offers suggestions concerning the accounting for such transactions, which are within the spirit of IFRS, although largely drawn from other authoritative sources (particularly the U.S. GAAP which is widely adopted in many other countries). This is I made, however, to illustrate a wide array of actual transactions that often need to be accounted for.
Ownership interest in a corporation is made up of common and, optionally, preferred shares. The common shares represent the residual risk-taking ownership of the corporation after the satisfaction of all claims of creditors and senior classes of equity. It is important that the actual common ownership be accurately identified, since the computation of earnings per share requires that the ultimate residual ownership class be properly associated with that calculation, regardless of what the various equity classes are nominally called.
Preferred shareholders are owners who have certain rights superior to those of common shareholders. These rights will pertain either to the earnings or the assets of the corporation.
Preferences as to earnings exist when the preferred shareholders have a stipulated dividend rate (expressed either as a dollar amount or as a percentage of the preferred share’s par or stated value). Preferences as to assets exist when the preferred shares have a stipulated liquidation value. If a corporation were to liquidate, the preferred holders would be paid a specific amount before the common shareholders would have a right to participate in any of the proceeds.
In practice, preferred shares are more likely to have preferences as to earnings than as to assets. Some classes of preferred shares may have both preferential rights, although this is rarely encountered.
Preferred shares may also have the following features: participation in earnings beyond the stipulated dividend rate; a cumulative feature, affording the preferred shareholders the protection that their dividends in arrears, if any, will be fully satisfied before the common shareholders participate in any earnings distribution; and convertibility or callability by the corporation. Whatever preferences exist must be disclosed adequately in the financial statements, either in the statement of financial position or in the notes.
In exchange for the preferences, the preferred shareholders’ rights or privileges are limited. For instance, the right to vote may be limited to common shareholders. The most important right denied to the preferred shareholders, however, is the right to participate without limitation in the earnings of the corporation. Thus, if the corporation has exceedingly large earnings for a particular period, these earnings would accrue to the benefit of the common shareholders.
That is true even if the preferred shares are participating (itself a fairly uncommon feature) because even participating preferred shares usually have some upper limitation placed on its degree of participation. For example, preferred may have a 5% cumulative dividend with a further 3% participation right, so in any one year the limit would be an 8% return to the preferred shareholders (plus, if applicable, the 5% per year prior year dividends not paid).
Occasionally, several classes of share capital will be categorized as common (e.g., Class A common, Class B common, etc.). Since there can be only one class of shares that constitutes the true residual risk-taking equity interest in a corporation, it is clear that the other classes, even though described as common shares, must in fact have some preferential status.
Not uncommonly, these preferences relate to voting rights, as when a control group holds common shares with “super voting” rights (e.g., ten votes per share). The rights and responsibilities of each class of shareholder, even if described as common, must be fully disclosed in the financial statements.
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 common 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. 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 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 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 common share capital account without distinction between the share capital and the additional contributed capital accounts. The following entries illustrate these concepts:
Dharma Corporation sells 100,000 shares of $5 par common share for $8 per share cash.
[Debit]. Cash = 800,000
[Credit]. Common share = 500,000
[Credit]. Additional contributed capital = 300,000
Dharma Corporation sells 100,000 shares of no-par common share for $8 per share cash.
[Debit]. Cash = 800,000
[Credit]. Common share = 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 utilized. Shares issued to employees as compensation for services rendered should be accounted for at the fair value of the services performed, if determinable, or the value of the shares issued.
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, common and preferred shares may be issued to investors as a unit (e.g., a unit of one share of preferred and two shares of common 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 common shares.
The foregoing procedures would also apply if a unit offering were made of an equity and a nonequity security such as convertible debentures, or of shares and rights to purchase additional shares for a fixed time period.
Accounting For Share Subscriptions
Occasionally, particularly in the case of a newly organized 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 installment 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 (e.g., 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 categorized as current or noncurrent 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 shares subscribed account instead of to the share capital accounts.
If the common shares have par or stated value, the common shares subscribed account are credited for the aggregate par or stated value of the shares subscribed. The excess over this amount is credited to additional contributed capital. 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 common share 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 common share 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 shares of $50 par preferred are subscribed at a price of $65 each; a 10% down payment is received.
[Debit]. Cash = 65,000
[Debit]. Share subscriptions receivable = 585,000
[Credit]. Preferred share subscribed = 500,000
[Credit]. Additional contributed capital = 150,000
2. 2,000 shares of no par common shares are subscribed at a price of $85 each, with one-half received in cash.
[Debit]. Cash = 85,000
[Debit]. Share subscriptions receivable = 85,000
[Credit]. Common share subscribed = 170,000
3. All preferred subscriptions are paid, and one-half of the remaining common subscriptions are collected in full and subscribed shares are issued.
[Debit]. Cash [$585,000 + ($85,000 × 0.50)] = 627,500
[Credit]. Shares subscriptions receivable = 627,500
[Debit]. Preferred shares subscribed = 500,000
[Credit]. Preferred share = 500,000
[Debit]. Common shares subscribed = 127,500
[Credit]. Common shares ($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 corporation is chartered. 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 corporation 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.
How To Distinguish 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 (common) shares or additional contributed (paid-in) capital.
Generally, but not universally, the distinction between common 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 a corporation other than that defined as par or stated value. Additional contributed capital can arise from proceeds received from the sale of common and preferred shares in excess of their par or stated values. It can also arise from transactions relating to the following:
- Sale of shares previously issued and subsequently reacquired by the corporation (treasury shares)
- Retirement of previously outstanding shares
- Payment of share dividends in a manner that justifies the dividend being recorded at the market value of the shares distributed
- Lapse of share purchase warrants or the forfeiture of share subscriptions, if these result in the retaining by the corporation of any partial proceeds received prior to forfeiture
- Warrants that are detachable from bonds
- Conversion of convertible bonds
- Other gains on the company’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 Additional Contributed Capital Transactions
Lie Dharma Company issues 2,000 shares of common shares having a par value of $1, for a total price of $8,000. The following entry records the transaction:
[Debit]. Cash = 8,000
[Credit]. Common shares = 2,000
[Credit]. Additional contributed capital = 6,000
Lie Dharma Company buys back 2,000 shares of its own common share for $10,000 and then sells these shares to investors for $15,000. The following entries record the buyback and sale transactions, respectively, assuming the use of the cost method of accounting for treasury share:
[Debit]. Treasury shares 10,000
[Credit]. Cash 10,000
[Debit]. Cash = 15,000
[Credit]. Treasury shares = 10,000
[Credit]. Additional contributed capital = 5,000
Lie Dharma Company buys back 2,000 shares of its own $1 par value common shares (which it had originally sold for $8,000) for $9,000 and retires the shares, which it records with the following entry:
[Debit]. Common shares = 6,000
[Debit]. Additional contributed capital = 2,000
[Debit]. Retained earnings = 1,000
[Credit]. Cash = 10,000
Lie Dharma Company issues a small share dividend of 5,000 common shares at the market price of $8 per share. Each share has a par value of $1. The following entry records the transaction:
[Debit]. Retained earnings = 40,000
[Credit]. Common shares = 5,000
[Credit]. Additional contributed capital = 35,000
Lie Dharma 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:
[Debit]. Share options outstanding = 1,000
[Credit]. Additional contributed capital = 1,000
Lie Dharma Company sells 2,000 of par $1,000 bonds, as well as 2,000 attached warrants having a market value of $15 each. Pro rata apportionment of the $2,000,000 cash received between the bonds and warrants results in the following entry:
[Debit]. Cash = 2,000,000
[Debit]. Discount on bonds payable = 29,557
[Credit]. Bonds payable = 2,000,000
[Credit]. Additional contributed capital—warrants = 29,557
Lie Dharma’s bondholders convert a $1,000 bond with an unamortized premium of $40 and a market value of $1,016 into 127 shares of $1 par common share whose market value is $8 per share. This results in the following entry:
[Debit]. Bonds payable = 1,000
[Debit]. Premium on bonds payable = 40
[Credit]. Common shares = 913
[Credit]. Additional contributed capital—warrants = 127
Accounting For Donated Capital
Donated capital can result from an outright gift to the corporation (e.g., a major shareholder donates land or other assets to the company in a nonreciprocal transfer) or may result when services are provided to the corporation. Under current US GAAP, such nonreciprocal transactions will be recognized as revenue in the period the contribution is received. IFRS does not, at present, address contributions or donations.
In these situations, historical cost is not adequate to reflect properly the substance of the transaction, since the historical cost to the corporation would be zero. Accordingly, these events should be reflected at fair value.
If long-lived assets are donated to the corporation, they should be recorded at their fair value at the date of donation, and the amount so recorded should be depreciated over the normal useful economic life of such assets. If donations are conditional in nature, they should not be reflected formally in the accounts until the appropriate conditions have been satisfied.
However, disclosure might still be required in the financial statements of both the assets donated and the conditions required to be met.
Example Of Donated Capital
A board member of the for-profit organization Putra Social Services donates land to the organization that has a fair market value of $1 million. Putra Social Services records the donation with the following entry:
[Debit]. Land = 1,000,000
[Credit]. Revenue—donations = 1,000,000
The same board member donates one year of accounting labor to Putra Social Services. The fair value of services rendered is $75,000. Putra Social Services records the donation with the following entry:
[Debit]. Salaries—accounting department = 75,000
[Credit]. Revenue—donations = 75,000
The board member also donates one year of free rent of a local building to Putra Social Services. The annual rent in similar facilities is $45,000. Putra Social Services records the donation with the following entry:
[Debit]. Rent expense = 45,000
[Credit]. Revenue—donations = 45,000
Finally, the board member pays off a $100,000 debt owed by Putra Social Services. Putra Social Services records the donation with the following entry:
[Debit]. Notes payable = 100,000
[Credit]. Revenue—donations = 100,000
Following the closing of the fiscal period, the effect of all the foregoing donations will be reflected in Putra Social Services’ retained earnings account.
Note that IFRS explicitly addresses the proper accounting for government grants, which may differ from the foregoing illustrative example, which involved private donations only. You should be alert to further developments in this area.