Company Account: Issue of Share

Q.7. What is Reserve Capital? Does it differ from Capital Reserve? (All India 1986)

Answer: Reserve Capital: A company may by special resolution determine that any portion of its share capital which has not been already called up, shall not be capable of being called-up, except in the event of winding up of the company. Such type of share capital is known as reserve-capital.

Difference between Reserve Capital and Capital Reserve

Q.8. Write short notes on the following:

1. Prospectus
2. Issue of share in consideration other than cash
3. Calls-in-Arrears
4. Calls-in-Advance
5. Minimum Subscription
6. Preliminary Expenses
7. Statement in lieu of Prospectus

Answer:

1. Prospectus: Prospectus is an invitation to the public to subscribe for its shares or debentures. A prospectus has been defined as "any document described or issued as a prospectus and included notice, circular advertisement or other document inviting offers from the public for the subscription or purchase of any shares in, or debentures of, a body corporate." The main purpose of the prospectus is to pursue the public to purchase the shares or debentures of the company.

A public company is required to publish a prospectus whenever it wants to make a public issue of its shares or debentures. Everything stated in the prospectus must be correct because prospectus is the basis of contract between the company and the intending purchaser of shares who buys shares on the faith of a prospectus. Therefore, a shareholder has the right to rescind the contract within a reasonable time and before the winding up of the company if the prospectus contains a misleading statement.

2. Issue of Shares in consideration other than cash: A company may issue shares for consideration other than cash to the vendors who sell their whole business or some assets to the company or to the promoters for rendering services to the company. When shares are so issued, there is no receipt of cash and hence it is termed as issue of shares for consideration other than cash. The fact of such issues must be stated in the balance sheet of the company and must be distinguished from the shares issued for cash as per requirement of Schedule VI Part 1 of the Companies Act pertaining to the prescribed balance sheet.

3. Calls-in-Arrears: It often happens that some shareholders fail to pay the amount on allotment and or calls due on the shares held by them. The total of the unpaid amounts on account of one or more instalments is known as ‘Calls-in-Arrears’.

It is not mandatory to maintain a separate account for calls in arrears. The debit balance on the Allotment or Calls Account will be presented in the balance sheet not as an asset but by way of deduction from the called up capital.

The Articles of Association of a company usually empower the directors to charge interest at a stipulated rate on calls in arrears. In case the Articles are silent in this regard, the rule contained in Table A shall be applicable. Table A represents the model Articles of Association framed under Companies Act 1956. It provides the rate of interest must not exceed 5 per cent.

4. Calls-in-Advance: Sometimes, it so happens that a shareholder may pay the entire amount on his shares even though the whole amount has not been called up. The amount received in advance of calls from such a shareholder should be credited to "calls in advance" account and should be shown separately from the called up capital in the Balance Sheet. The company can receive calls in advance if the article permits. Interest is usually paid on calls in advance and the article specifies the rate of interest. The maximum rate of interest allowed on calls in advance is 6% per annum. It should be noted that calls in advance are not entitled to any dividend.

5. Minimum Subscription: However a company invites the general public to subscribe to its share capital. An individual who is interested to subscribe to the share capital of the company sends an application to the company with application money. The Company Act 1956 provides that the directors of the company fix the amount of the application money but it can in no case be less than 5 per cent of the face value of the shares.

Therefor no allotment shall be made unless the amount of share capital stated in the prospectus as the minimum subscription has been subscribed and the company thereof has received the sum of at least 5 per cent in cash.

Minimum Subscription is that amount of money which in the opinion of directors, must be made available to meet the financial need of the business of the company for the following operations:

1. The purchase price of any property acquired or to be acquired out of the proceeds of the issue of shares.
2. For Working Capital
3. Preliminary Expenses payable by the company.
4. Underwriting Commission payable by the company.
5. Repayment of any money borrowed by the company in respect of any of the forgoing matters.
6. Any other expenditure required for the conduct of usual business operations.

6. Preliminary Expenses: Expenses incurred to the formation of a company are called ‘Preliminary Expenses’. Preliminary expenses include the following: -

1. Expenses incurred in order to get the company registered.
2. Expenses incurred for the preparation, printing and issue of prospectus.
3. Cost of preliminary books and Common Seal.
4. Duty payable on Authorised Capital.
5. Underwriting Commission etc.

Preliminary Expenses are to be written off out Securities Premium Account or it may be written off out of the Profit & Loss A/c gradually over some period. The balance left of preliminary expenses is to be shown in the asset side of the balance sheet of the company under the heading of ‘Miscellaneous Expenditure’.

7.Statement in lieu of Prospectus: A public company, which does not raise its capital by public issue, need not issue a prospectus. In such a case a statement in lieu of prospectus must be filed with the Registrar 3 days before the allotment of shares or debentures is made. It should be dated and signed by each director or proposed director and should contain the same particulars as are required in case of prospectus proper.

Q.9. Briefly Explain:

1. Right Issue
2. Issue of Bonus Shares
3. Buy – Back of Shares
4. Sweat Equity Shares
5. Escrow Account
6. Preferential Allotment

Answer:

1. Right Issue: Section 81 of the Companies Act dealing with Right Issue, provides that whenever a company proposes to increase its subscribed capital (within the limits of the authorized capital) by allotment of further shares any time after the expiry of two years of its formation or any time after the expiry of one year from the first allotment of shares whichever is earlier, then –

1. Such further shares (i.e., new shares) must be offered to the existing holders of equity shares in the company in proportion, as nearly as the circumstances admit, to the capital paid up on those shares.
2. The offer is to be made giving a notice specifying the number of shares offered. The notice must fix a time, which should not be less that 15 days from the date of the offer within which the offer must be accepted. The notice must also inform the shareholder that if the offer is not accepted within the specified time it shall be deemed to have been declined.
3. Unless the articles of the company otherwise provide, the offer aforesaid shall be deemed to include a right exercised by the person concerned to renounce the shares offered to him or any of them in favour of any other person; and the notice referred to in clause (b) shall contain a statement of this right.
4. After the expiry of the time specified in the notice aforesaid or on receipt of earlier intimation from the person to whom such notice is given that he declines to accept the shares offered, the Board of Directors may dispose of them in such a manner as they think most beneficial to the company.

Thus, the company is under legal obligation to offer first the further issue of the shares to its existing shareholders. But the holders have option either to accept it or to reject or renounce it. This right is called the ‘Right Issue’. The object of Section 81 obviously is that there should be an equitable distribution of shares and the issue of new shares should not affect the holding of shares by each shareholder. The operation of this section can, however, be excluded and new shares may be offered to outsiders to the total exclusion of the existing shareholders in the following two cases mention in Section 81 (1A):

1. If the company at a general meeting passes a special resolution authorizing the board to allot shares to outsiders; or
2. If an ordinary resolution to that effect has been passed and the Central Government is satisfied on an application made by the Board of Directors that the proposed offer of shares to the outsiders is most beneficial to the company.

Calculation of the Value of Right

There is a specific advantage available to the existing shareholders of a company because of this legal right especially when the market value of the share is more than the issue price. Thus there is good demand for the shares in such cases. The quotations of the existing shares tend to go up whenever there is a ‘right issue’. In examination problem the student is often required to compute the money value of this right. The procedure outlined below is adopted to calculate the value of this right:

1. Calculate the market value of the shares held by a shareholder. While calculating the market value, it is essential to find out the rate or basis of ‘right issue’. For example, if the company makes a right issue of one share for every five shares held, then a shareholder must hold five shares to claim one share under right issue. Suppose a shareholder holds only four shares, he will have to buy one more share from the market in order to get himself entitled to one share under the right. If the market value of one share of Rs. 100 each, fully paid is Rs. 150, the total market value of five shares is 5 x Rs. 150 = Rs. 750.
2. The amount paid to the company for the right share should be added to the total market value of required number of shares held [This is done to find out the total price of all the shares]. For example, if the company is issuing a fresh share under right issue at a premium of Rs. 25, the shareholder will add Rs. 125 to the market value of five shares held by him. Thus the total amount is Rs. 750 + Rs. 125 = Rs. 875.
3. The total number of shares including the fresh share should divide the total value, that is, Rs. 875. In other words, the average price has to be ascertained, that is Rs. 875/6 = Rs. 145.84.
4. The value of the right is calculated by deducting the average price from the market value of the share. In the instant case the value of right is Rs. 4.16 (i.e. Rs. 150 – Rs. 145.84).

2. Issue of Bonus Shares:The undistributed profits, after the necessary provisions for taxation, are the property of the equity shareholders and the same may be used by the company for distribution as dividends to them. But the sound financial policy demands that some of the profits at least must be ploughed back into the business. Thus when a company has accumulated substantial amount of past profits as might be found in the credit of capital reserves, revenue or general reserve of profit and loss account, it is desirable to bring the amount of issued share capital closer to the actual capital employed as represented by the net assets (Assets – Liabilities) of the company. This would reflect the true amount of capital invested by the shareholders in the company. For example, the capital, which the shareholders have contributed for shares, is clearly visible since this was contributed in cash. But the capital, which they have contributed in the form of accumulated profits, remains unknown because this was not a direct contribution in cash. In order to rectify these, accumulated profits in full or in part are capitalized, that is, accumulated profits are converted into shares. Shares are distributed free of charge and therefore are known as Bonus Shares, which are given to existing shareholders pro rata to their holdings. It may be added the bonus shares may be issued to make up the existing partly paid shares as fully paid. According to Section 78 and Section 80, however, the share premium account and capital redemption reserve account respectively could be used only for issuing fully paid bonus shares. But, the partly paid shares can be made fully paid up by using distributable profits.

Accounting Treatment: The book – keeping entries to record the issue of fully paid bonus shares out of accumulated profits would be:

1.

General Reserve Account Dr.
Profit and Loss Account Dr.
Share Premium Account Dr.
Capital Redemption Reserve Account Dr.
To Bonus Issue Account

2.

Bonus Issue Account Dr.
To Share Capital Account

In case the partly paid shares are converted into fully paid shares, the following accounting entries are made:

1.

Share Final Call Account Dr.
To Share Capital Account

2.

Profit and Loss Account Dr.
General Reserve Account Dr.
Other Distributable Profits Account Dr.
To Share Final Call Account

3. Buy – Back of Shares: Buy-back means the repurchase of its own shares by the company. When a company has substantial cash resources, it may like to buy its own shares from the market, particularly when the prevailing rate of its shares in the market is much lower that the book or what the company perceives to be its true value. This is known as buy back of shares. Buy back procedure thus enables a company to go back to the holders of its shares and offers to purchase from them the shares they hold. The shares thus bought back have to be cancelled.

There are several reasons why a company would opt for repurchase of its own shares:

1. The buy back facility enables the companies to manage their surplus cash. Although the surplus cash can be distributed in the form of more dividends yet the two, that is, ‘buy back’ and more dividends are viewed differently. If the companies distribute cash as dividends, they have to pay corporate dividends tax too, while the investors are saved from the tax liability. So, the companies would prefer buy back in order to avoid corporate dividend tax.
2. The next reason is to improve the value of the shares held by the investors. A reduction in the capital base as a result to buy back would generally result in higher earning per share.
3. The buy back decision expresses clearly the management’s view that the future prospects are good and investing in its own shares is the best option and it also signals that the market is undervaluing the company’s shares in relation to their intrinsic worth or book value. The basic objective is to facilitate capital restructuring of companies through the mechanism of buy back, of courses, in accordance with SEBI guidelines. Buy back is likely to benefit not only the shareholders and the companies but also the economy as a whole.

Dangers of Buy Back

Despite the various merits of buy back shares, there are serious apprehensions about this facility. It is feared that the buy back may be misused by the corporate entities at the cost of innocent investors. The inherent dangers may be listed as:

1. It will provide an ample opportunity for inside trading. The promoters, before the buy back, may understate the earnings by manipulating accounting policies, say in respect of depreciation, valuation of inventories etc., and highlight other unfavorable factors affecting the earnings. This would lead to a fall in the quoted prices of shares and promoter would buy them at low quotations. In this manner, the insiders would make extra money when the company buys back these shares at higher price.
2. Buy back may lead to artificial manipulations of stock prices.
3. The position of the minority shareholders is weakened as buy back enables the management to increase their control over the company.

4. Sweat Equity Shares: The expression ‘sweat equity shares’ means equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available right in the nature of intellectual property rights or value additions, by whatever name called. The companies will be allowed to issue Sweat Equity Shares if authorized by a resolution passed by a general meeting. The resolution should specify the number of shares, their value and class or classes of directors or employees to whom such equity is proposed to be issued. The issue of sweat equity shares will be further subject to regulations made by SEBI in this behalf. All limitations, restrictions and provisions relating to equity shares shall be applicable to sweat equity shares as well.

5. Escrow Account: A reference has been made about Escrow Account in the context of buy back of shares. Escrow Account means an account in which money is held until a specified duty is performed e.g., a document is sighed or goods are delivered. SEBI’s Regulation 10(1) provides that a company shall, as and by way of security for performance of its obligations on or before the opening of repurchase, deposit in an escrow.

6. Preferential Allotment: Preferential Allotment means placing a bulk of fresh shares with individuals, companies, financial institutions and venture capitalists. The placement is made at a pre-determined price to such parties, who wish to have strategic stake in the company. Such placements have to seek approval from the shareholders by way of special resolution, i.e., it must be approved by at least 75% shareholders foregoing their rights to subscribe to fresh issue and also approving the preferential allotment. A listed company making the preferential allotment shall have to follow the guidelines issued by SEBI in this regard. Mainly the guidelines prescribe that the minimum price of such an issue should be average of highs and lows of 26 weeks preceding the date on which the Board of Directors resolves to make the preferential allotment. Also, if the preferential allotment is above 15 per cent of the equity, an open offer is mandated by SEBI. It may be noted that such shares carry a lock-in period of three years from the date of allotment, i.e., the holders cannot sell the shares for a period of three years. In case, shares have been allotted by an unlisted company, the lock-in period is one year from the date of commercial production or the date of allotment in the public issue, whichever is earlier.

Reservation for Small Individual Applicants

In Case the issue is over subscribed, the applicants will have to be allotted lesser number of shares than applied for. The Board of Directors may adopt either the lottery method, or pro rata method. SEBI Guidelines, 2000, in this regard, stipulate that the allotment shall be subject to allotment in marketable lots on a proportionate basis. In order to protect the interest of small investors, SEBI Guidelines stipulate a minimum reservation of 50% of the net offer or securities to be allotted to small individual applicants who have applied upto ten marketable lots.