Chapter 2 Financing company operations

Prepared by Emma Holmes (with slides adapted and added by Dr Isabel Gordon)

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Lecture objectives
Understand difference between debt and equity financing Understand steps for issue of shares Understand accounting entries to issue shares: -if payable in full on application -if balance on allotment if -if balance on call -if over subscription if -if forfeiture of shares

Lecture objectives
Understand accounting entries for share options pp preference Appreciate whether redeemable p shares are debt or equity Understand that debt can also be issued to the public Understand nature of debentures and convertible notes

Lecture Outline
1. review of last weeks lecture: significance of separation of ownership and control to this weeks lecture ( ) 2. Revisit Week 1 Lecture outline point (6): accounting policy (briefly) 3. Financing company operations 4. Issue of shares 5. 5 Accounting for share issues 6. Share issue and formation costs

Lecture outline (cont d) (contd)

7. Share capital summary q 8. Subsequent issue of shares 9. Share options 10. 10 Redeemable preference share: debt versus equity 11. 11 Conversion of shares 12. Share buy-backs 13. Accounting for Debentures 14. Next week

References

LHS Text Chapter 2 p

1. review of last weeks lecture: significance of

Separation of ownership from control o nership Private company (Pty. Ltd.)

Does not raise funds from public No separation of owner from manager Normally, smaller, closely held no interested users Not a reporting entity Keep records for business Compliance with AASBs not normally necessary External audit not necessary y (usually) Generally, less regulation

P bli company (Ltd.) Public

Raises funds from public Separation of owner from manager Managers acting as agents of owners /shareholders existence of interested users E.g. Facebooks IPO Is a reporting entity Reqed to prepare financial reports
Financial reports prepared in accordance with accounting stds

Financial reports subject to audit Generally, more regulation

Topic 1: Some key terms

Separation of ownership from control Existence of interested users Reporting entity Accountability Stewardship Limited liability Incorporation Initial public offering (IPO) Seasoned equity offering (SEO) Definitions of elements of basic accounting equation Recognition versus disclosure

2. Revisit Week 1 Lecture outline point (6): accounting policy

More on item (6) from week 1 lecture: Accounting policy

(see week 1 lecture notes and text Chapter 3)

3. Financing company operations

FT July 20 2012 p. 13 Louis Dreyfus postpones IPO for ethanol unit Issue: Dreyfus first attempt to tap the capital market in its 160 year history, was set to raise up to $550m to help fund the groups ambitious group s investment plans and possible acquisitions

Financing an expansion of operations

How to finance? Do we use debt? Or do we use equity by going IPO? A = L + O
Expansion debt finance equity issue

Debt finance: repay it interest expense Equity finance: issue shares (that increases likelihood of
separation of ownership from control all else equal) control,

4. Issue of shares

A company can issue shares on any terms or conditions it determines Share capital may include different classes:

Ordinary Preference To issue preference shares a constitution setting out the rights is necessary (s254A(2))
Shares can be issued at any price, payable in full or by instalment

Key features of share capital y p

Shares may have different rights in respect of voting, sharing in profits or return of capital Rights f h h ld Ri ht of shareholders i l d include:

The right to vote for directors of the company Th right t share i assets on th windingThe i ht to h in t the i di up/liquidation of the company The right to share in new share issues (for the same class of shares)
Ordinary shareholders have no specific right to dividends. y p g

5. 5 Accounting for share issues

examples of the accounting for issues of new shares include: -if payable in full on application if bl i f ll li ti -if balance on allotment -if balance on call -if over subscription Initial Public Offering -if forfeiture of shares
assume that shares are issued due to IPO /prospectus p p p process. Such processes involve the shareholders applying for a number of shares in response to a prospectus issued by the company (full disclosure important) important). The company will then issue the shares to new shareholders based on the applications it has received.

5 ccou t g o s a e ssues 5. Accounting for share issues

Such share issues are accompanied by disclosure documents. Commonly the disclosure documents specify a minimum number of applications which must be received in order for the share issue to proceed. The Co po at o s Act requires: e Corporations ct equ es

that the minimum subscription be achieved

within 4 months of the issue of the disclosure document; and

shares be allotted within 13 months of the issue

of the disclosure document.

5. Accounting for share issues

On issuing new shares the company may require the full amount owing on the shares to be paid at the time of application. application Alternatively it may require a portion to be paid on application, with the balance being due at some time in the future (on allotment and/or at call). There are a number of different accounts used to facilitate this application, allotment and call process.

Issue of shares Payable in full on application (Example 1) ABC issued a prospectus for the issue of 100,000 $5 shares on 1 January 2012. The Th prospectus specified th t the $5 was payable i f ll on t ifi d that th bl in full application. The company received applications for a total of 100 000 shares 100,000 these applications were received throughout the month of January. On 31 January 2012 ABC issued 100,000 shares.

Required: Prepare the journal entries to account for the issue of shares by ABC.

Issue of shares Payable in full on application (Example 1) 1-30 January 2012 1 30 J Dr Cash trust 500,000 500 000

Cash account trust is used to record cash prior to the shares being issued - the cash is held in a trust account on behalf of the applicants

Cr

Application

500,000

To T record receipt of application monies prior t i d i t f li ti i i to issuing th shares i the h

Represents a liability of the company prior to the shares being issued (100,000 shares x $5)

Issue of shares Payable in full on application (Example 1) 31 January 2012 Dr Application Cr Share capital Issue of shares applied for 500,000 500,000

Dr

Cash 500,000 Cr Cash trust Transfer from cash trust on issue of shares

500,000

TIP: T-accounts are helpful to ensure that temporary accounts are cleared out correctly

For previous example, do T accounts for:

Cash trust
DR CR

Application
DR CR

Cash
DR CR

Issued capital(share capital)

DR CR

Q: what do you find?

Issue of shares Deposit on application balance on allotment (E ample 2) application, (Example

ABC issued a prospectus for the issue of 100 000 $5 shares on 100,000 1 January 2012. The prospectus specified that $3 was p y p p p payable on application, pp with the balance payable on allotment. The company received applications for a total of 120,000 shares throughout the month of January. The Directors refunded the money in relation to unsuccessful applications. applications On 31 January 2012 ABC issued 100,000 shares. Required: Prepare the journal entries to account for the issue of shares by ABC.

Issue of shares Deposit on application, balance on allotment (Example 2)

1 January 2012 Dr Cash trust 360,000 Cr Application 360,000 360 000 To record receipt of application monies prior to issuing the shares
(120,000 (120 000 shares x $3)

31 January 2012 Dr Dr Application Allotment Cr Share capital p Issue of shares applied for 300,000 200,000 500,000 ,

The allotment account is a temporary account used when further amounts are owing when shares are issued represents a receivable of the company (100,000 shares x $5)

Issue of shares Deposit on application, balance on allotment

(Example 2)

31 January 2012 Dr Application 60,000 Cr C Cash trust C ht t 60,000 60 000 Refund of application monies to unsuccessful applicants
(20,000 shares x $3) Cash 300,000 Cr Cash trust 300,000 Transfer from cash trust on issue of shares

Dr

Dr

Cash 200,000 Cr Allotment Cash received on allotment

200,000
(100,000 shares x $3)

(100,000 shares x $2)

Issue of shares Deposit on application, instalment on allotment, balance on call (Example 3)

ABC issued a prospectus for the issue of 100,000 $5 shares on 1 January 2012. The prospectus specified that $2.50 was payable on application, a further $1.25 was payable on allotment and the final $1.25 was payable at call. On 31 January 2012 ABC issued 100 000 shares 100,000 shares. On 31 May 2012, the company made the call for the outstanding balance of $1.25 per share. The call was payable by 30 June 2012. At 30 June 2012, the call on 10,000 shares remained unpaid. Required: Prepare the journal entries to account for the issue of shares for ABC.

Issue of shares Deposit on application, instalment on allotment, balance on call (Example 3)

1 January 2012 y Dr Cash trust 250,000 Cr Application 250,000 To T record receipt of application monies prior t i d i t f li ti i i to issuing th i the shares
(100,000 shares x $2.50)

31 J January 2012 Dr Dr Application Allotment Cr Share capital Issue of shares applied for 250,000 125,000 375,000
(100,000 shares x $3.75)

Dr D

Cash C h 250,000 250 000 Cr Cash trust Transfer from cash trust on issue of shares

250,000

Issue of shares Deposit on application, instalment on allotment, balance on call (Example 3)

31 January 2012 Dr Cash 125,000 Cr Allotment Cash received on allotment 125,000 125 000

31 Ma 2012 May Dr Call 125,000

The call account is a temporary account used when further amounts are owing when a call is made represents a receivable of the company

Cr Share capital 125,000 Call of $1.25 per share on 100 000 shares issued $1 25 100,000

Balance of share capital a/c now $500,000

sue of shares Deposit on application, instalment on allotment, balance on call (Example 3)

30 June 2012 Dr Cash 112,500 Cr Call 112,500 Cash received on allotment (100,000 10,000 = 90,000 shares x $1.25) The balance in the call account is $12,500, being $1.25 x 10,000 shares. shares Unpaid calls are referred to as calls in arrears and are shown as a reduction of share capital in the companys financial statements. statements The balance in the share capital account at 30 June is as follows:
Share capital (100,000 ordinary shares @ $5) Less: Calls in arrears (10 000 shares @ $1 25) (10,000 $1.25) TOTAL SHARE CAPITAL 500,000 (12,500) (12 500) 487,500

Oversubscription

The number of shares applied for may exceed the number of shares available for issue. In such cases the directors of the company may: p y y Reduce the number of share to be issued to each applicant (on a pro-rata basis) Issue shares only to certain applicants (eg on a first-in-firstserved basis)

The treatment of excess application monies depends on the terms e cess of a companys constitution. Options include: Refunding excess application monies to unsuccessful applicants; or Retaining the excess application money as an advance on future calls
The calls in advance account is treated as contributed equity even though it is legally a liability

Oversubscription (Example 4)

ABC issued a prospectus for 100 000 $5 shares on 1 January 100,000 2012. The prospectus required p y p p q payment of $3 on application and $2 in pp one years time. The company received applications for a total of 125,000 shares these applications were received throughout the month of January. On 31 January 2012 ABC issued 100 000 shares 100,000 shares. Prepare the journal entries to account for the issue of shares assuming the excess money was offset against the call due in one years time.

Required:

Oversubscription (Example 4) p

1-30 1 30 January 2012 Dr Cash trust 375,000 Cr Application 375,000 Receipt of application monies prior to issuing the shares
(125,000 x $3)

31 January 2012 Dr Application 375,000 (25,000 x $3) Cr Calls in advance 75,000 Cr Share capital 300,000 300 000 Issue of shares applied for and transfer of excess to calls in advance account Cash C h 375,000 375 000 Cr Cash trust Transfer from cash trust on issue of shares 375,000

Dr D

Forfeiture of shares

Directors may be given the power under the companys Di t b i th d th constitution to forfeit (cancel) shares in respect of which calls are not made. Possible actions that can be taken in such circumstances are:

1. The balance of paid monies may be retained by the company >In this case the balance is retained in an equity account (Forfeited Shares Reserve) 2. The amount paid may be refunded back to the forfeiting shareholder > In this case the balance is recorded in a liability account (Forfeited Shares Account).

Forfeiture of shares

Prior to refunding the balance the company could reissue the shares as fully paid shares to new shareholders with the new shareholders paying less than the fully paid value of the share. The difference, as well as any costs of reissue are deducted from the amount to be refunded back to the forfeiting shareholders. h h ld This option is only available if the companys constitution states this fact. Where the constitution is silent, the company is entitled to keep any excess (option 1).

Forfeiture of shares (Example 5)

This example continues on from example 3. On 1 July 2012 the directors of ABC decided to forfeit the 10,000 10 000 shares in respect of which the call of $1 25 was not $1.25 made. The shares were cancelled and reissued as fully paid to $ yp $5 per share on payment of $4 per share. Costs of $500 were incurred to reissue the shares. Required: Prepare the journal entries to account for the forfeiture and re issue of the 10,000 shares.

Forfeiture of shares (Example 5)

1 July 2012 Dr Share capital 50,000 Cr Call Cr Forfeited shares a/c Cancel of forfeited shares Dr Dr

(10,000 x $5)

12,500 37,500

(10,000 x $1.25) (10,000 $3 75) (10 000 x $3.75)

Cash 40,000 Forfeited shares a/c 10,000 10 000 Discount of $1/share Cr Share capital 50,000 Re-issue of forfeited shares for $4 per share (10,000 x $5 Forfeited h F f it d shares a/c / Cr Cash Costs incurred to reissue shares 500 500
- fully p ) y paid)

Dr D

Dr

Cash 2,000 Cr Forfeited shares account 2,000 Refund of balance to forfeiting shareholders
12,500 10,000 - 500

6. 6 Share issue and formation costs

Underwriting costs:

Arranging for the issue to be underwritten will avoid having to refund monies due to under-subscription g p Underwriter agrees to purchase all excess shares in return for an upfront payment of an underwriting commission Treated as a reduction against contributed equity
Other share issue costs:

Includes costs such as stamp duty, legal fees etc T t d as a reduction against contributed equity Treated d ti i t t ib t d it
Formation costs:

Treated as an expense

7. 7 Share capital - summary

The share capital equity total shown on the Balance Sheet is the net of: $

Share C it l Sh Capital Less Calls in Arrears Add Calls in Advance Less Underwriting commission Less Share issue costs Total share capital

x (x) x (x) (x) x

8. Subsequent issues of shares q

Issued to raise funds to support expansion 1. RIGHTS ISSUE

Offer of shares to existing shareholders g Rights dependent on the number of shares held Rights may be renounceable or non-renounceable
2. PRIVATE PLACEMENTS

Offer of shares to one entity only Usually issued to institutional investors

Accounting for these types of issues but does not involve the use of application/cash trust accounts The entry required is:

Dr Cr

Cash Share capital

xx xx

Subsequent issues of shares

3. BONUS ISSUE

Shares granted only to existing shareholders I Issued at no cost in lieu of cash di id d d t t i li f h dividend Number based on shareholding at date of declaration No change in the net equity of the company.
The entry required is: Dr Retained earnings OR reserve xx

Cr

Share capital

xx

9. 9 Share options

An option is a right (not obligation) to buy a certain number of shares by a set date at a set price. y p Options may be issued for free eg options may be issued to employees in lieu of cash bonuses. Options may be sold to investors similar to normal shares. Where options are not exercised by a specific date they lapse.

Share options p

( (Example 6) p )

On 30 June 2012, ABC issued 10,000 options valued at $1 each to the CEO as payment for past services Each option entitles the CEO to acquire a share in the company for $3 The options must be exercised within 12 months of issue dateafter this time they will lapse

Share options (Example 6) p ( p )

Required: Prepare the journal entries to account for the issue and exercising of th options assuming: i i f the ti i a) The options are issued for no consideration. On 1 May 2013, 2013 when the share price is $3 10 the $3.10, CEO exercises the options. The options are issued for no consideration. The options are not exercised by the CEO and lapse on 30 June 2013. c) Th options are i ) The ti issued f $1 each. B 30 J d for h By June 2013 2013, 9,000 of the options have been exercised. b) )

Share options (Example 6)

30 June 2012 (same entry for a) and b)) Dr Wages expense10,000 Cr Options 10,000 Issue Iss e of options to CEO a) 1 May 2013 Dr Cash 30,000 , Dr Options 10,000 Cr Share capital Exercising of options by CEO

40,000

b) 30 June 2013 Dr Options 10,000 Cr Lapsed options reserve 10,000 Transfer of balance to a reserve account on the lapsing of the options

Share options (Example 6)

c) 30 J ) June 2013 Dr Cash Cr Options Issuing of options

10,000 10,000
( , (10,000 x $1) $ )

1 July 2012 - 30 June 2013 y Dr Cash 27,000 Dr Options 10,000 (9,000 x $3) Cr Share capital 36,000 Cr Lapsed options reserve 1,000 (1,000 x $1) Exercising of 9,000 options to 30 June 2013 and transfer of balance to a reserve account on the lapsing of the options

10. 10 Redeemable preference shares

Such shares either:

Give the holder the right to be repaid his/her capital Or Give the company the right to repay the capital
Main issue is the classification of such shares

Are they equity, liabilities or a combination of both?

Redeemable preference shares - equity

Shares can be redeemed from:

1. Proceeds of a fresh issue of shares 2. Retained earnings Additionally, the companys constitution may specify payment of a redemption premium which is paid from profit On redemption the shares are cancelled and ca ot cannot be reissued e ssued

Redeemable preference shares - equity

Dr Share Capital - Preference p $ $x Cr Shareholders redemption

$x

Transfer of preference capital to redemption account Dr Shareholders redemption $x p Cr Cash p preference shares Redemption of p
The shareholders redemption account is a clearing account

$x

Dr

Cash/ Retained earnings $x g $ Cr Share Capital - Ordinary $x Receipt of cash on issue of new shares

Cash a/c applies to issues of new shares; retained earnings a/c applies to redemption from profits

Redeemable preference shares - liabilities

Redeemable preference shares with the following characteristics are more in the nature of liabilities:

Redeemable in cash on a certain date or at the option of the holder Cumulative as to the payment of dividends Non participating Non-participating in further dividends distributions Priority capital return rights

Accounting process required when accounting for redeemable preference shares that are classified as liabilities depends on whether the redemption is:

1. From a fresh issue of shares 1 F f hi f h 2. From profits at a premium

Illustrative example 2.10 in textbook shows the accounting for both

11. Conversion of shares

A company may change its issued capital by:

Share consolidations Involves grouping issued shares into larger parcels Eg; 2 x $1.00 consolidated into 1 x $2.00 share g Share splits Involves splitting issued shares into smaller parcels Eg; 1 x $2.00 share split into 2 x $1.00 shares Share conversions g y Involves converting an ordinary share to a preference share or vice versa Governed by constitution

12. Share buy-backs

WHY BUY BACK SHARES?

Change debt/equity ratio Defence against takeover Clear odd lots or employee share schemes
LEGAL REQUIREMENTS

C Covered b S i 2 A of C d by Section 257A f Corporations A i Act Allowed only if not prejudicial to creditors Limited types of buy-backs allowed buy backs
ACCOUNTING FOR BUY-BACKS

Shares must be cancelled Buy-back may generate a premium or a discount These are adjusted against either reserves, retained profits or both (UIG Abstract 22) Each company must adopt an accounting policy in respect of premiums or discount on buy-backs

Share buy-backs

1. 1 At a premium: i 120 000 shares initially issued at $1.20 were bought back for $1.50 each

Dr Dr Cr

Share Capital 144,000 Retained earnings 36,000 Cash

180,000 180 000

2. At a discount: 120 000 shares initially issued at $1 20 were bought back for $1.20 $1.00 each. The company had a general reserve of $20 000 at the time of the buy-back.

Dr D Cr Cr Cr

Share C it l Sh Capital 144,000 144 000 Reserves Retained earnings Cash Balance

20,000 4,000 4 000 120,000

13. Accounting for debentures

Issuing debentures May b issued at par/premium/discount M be i d t / i /di t Issue preceded by disclosure document Application monies held in trust until allotment Accounting treatment similar to issuing shares Refer Illustrative example 2.13 of textbook

Accounting for debentures

Redemption of debentures Redeemable on a set date or after a set period of time May be redeemable at companys option before maturity May be redeemed at par/premium/discount Premiums (l P i (loss t th company) t t d as expenses to the ) treated Discounts (gains to the company) treated as revenues Funds to redeem debentures may come from:

Proceeds of new share issue or borrowing Proceeds of asset sale Assets currently held
May be convertible into shares

Redemption of debentures

REDEMPTION AT A PREMIUM (LOSS)

Dr Dr D Cr

Debentures $x Redemption expense R d ti Cash

$x $ $x

REDEMPTION AT A DISCOUNT (GAIN)

Dr Cr Cr

Debentures $x Redemption revenue Cash

$x $ $x

CONVERSION TO EQUITY

Dr Cr

Debentures Share Capital

$ $x $x

Convertible notes

Debt D bt convertible t equity on maturity tibl to it t it Initial classification as liability or equity depends on y q y p characteristics. Some may be partly debt, partly equity debt Accounting for redemption depends on initial classification

Question for you

The issue of shares to the public generates (usually) a group of interested users of financial reports g Does the issue of debt to the public e.g. Debentures similarly generate a group of interested users? consider in the context of the definition of a reporting entity

Next week
Disclosure: legal requirements and accounting policy (Text Chap. 12) Disclosure: presentation of financial statements ( (Text Chap. 13) ) Good news is that most of the ideas for Topic 3 we introduced in Week 1 so... we just need to understand main principles in more depth!