Company Accounting Dr S.M.Tariq Zafar M.Com, PGDMM, PhD (Social Sector Investment)

Chapter - II Issue of Bonus, Right and Preference Shares

Chapter II- Issue of Bonus and Right Shares Chapter Outcomes:  Issue of Bonus and Right Shares  Objective of Bonus Shares:  Advantages and Disadvantages of the Issue of Bonus Shares:  Right Share Issue  What is Preference Shares  Preference shares can be subdivided in different classes.  Redemption of Preference Shares  Method of Redemption

Issue of Bonus and Right Shares: Bonus shares are shares issued by a company free of charges to its existing share holders on a prorata basis. These shares are created by the conversion of retained earnings or otherwise reserves into equity share capital. Issue of bonus share does not represent a source of fund to the company. When bonus shares are issued, the size of the company does not change and in effect, the assets side of the Balance remains unaffected. On the liabilities side, the reserves are reduced by the amount of the increase in the equity share capital. Reserves capitalized in this way no longer become available for distribution as dividend. In principle, shareholders are primarily no better off as a result of bonus issue, though no cash is paid to acquire these shares. And because of this the total value of the company remains unaffected, though the numbers of shares held by shareholders is increased by a bonus issue.

Objective of Bonus Shares: Bonus shares are issued by the company for the following reasons.  The management may opt for an issue of bonus shares in order to make the paid up capital correspond to the capital actually employed in the business.  By issue of bonus shares the cash reserves of the company are conserved. When a new project is under implementation which may take a few years to start giving increasing returns, it may be prudent to wait till the project is completed and increased returns start coming.  Issue of bonus shares will reduce the chance of take over bids.  Issue of bonus shares is an indication to the investors that the company has good prospects.  Issue of bonus shares is an inexpensive method of raising capital base of the company.  Issue of bonus shares reduces the market price of the share, thus rendering them more marketable.

Advantages of the Issue of Bonus Shares:  The shareholders get back their undistributed profit in the shape of shares.  Company can keep its shareholders happy without impairing the financial position and liquidity of the company  The security of the creditors will increase owing to increase in share capital.  It will increase the number of shares in the hands of existing shareholders without any extra payment, thus it will increase the marketability of shares. Disadvantage of the Issue of Bonus Share:  The rate of dividend in future will decline sharply, which may create confusion in the minds of the investors.  It will encourage speculative dealing in the company’s shares.  Prior approval of the government must be obtained before the bonus issue. The lengthy procedures, some times, may delay the issue of bonus shares.

Example: A company has the following capital structure: 1,00,000 Equity Shares of RO each 10,00,000 Securities Premium Account1,00,000 Profit and Loss Account5,00,000 The company decides to make a bonus issue of 1 for 4 basis (this shareholders will receive one new share for every four existing shares they own) by making use of Shares Premium Account and Profit and Loss Account. Therefore, the company requires RO 2,50,000 (RO 1,00,000 from Securities Premium Account and RO 1,50,000 from Profit and Loss Account). After the bonus issue, the capital structure of the company will appear as below. RO 1,25,000 Equity Share of RO 10 Each12,50, 000 Profit and Loss Account3,50, 000 After the issue of bonus shares, the market price of shares will drop initially but in the long run the market price will gradually climb up to its former value.

Right Share Issue:  Aright issue is a cheapest form of raising finance. It is an issue in which the existing shareholders have a pre emptive right to subscribe for new shares. In right issue no prospectus is issued or offer for sale of shares is made; instead, existing equity shareholders are given the rights certificate. The price of the share so offered is usually below listed price to make the offer attractive and encourage shareholders to subscribe more shares. Company can raise more money by issuing greater number of right issue. An existing shareholder who does not wish to exercise any or all of the rights is at liberty to sell them to third parties who can purchase such shares at a specified price.  Right issue are raised by the company mainly due to two reason, firstly right issue is the only way for the company to raise the finance when it is in need of cash to carry out existing operations. In this condition the share price of the company may fall due to the reason that same profit will be distributed to more number of shareholders.

 Secondly if expansion is slated then it is assumed that it will generate the same return as existing operation then market price of the share will be unaffected. The existing shareholders will be neither better nor worse off, since the value of the company remains unchanged.  The accounting entries in the books of the company for a rights issue are same as those required for a new issue of shares to the public. Existing shareholders know in advance the number of shares to which they are entitled thus question of under subscription does not arise.

What is Preference Shares:  Preference shares, more commonly referred to as Preferred Stock are shares of a company’s stock with dividends that are paid out to shareholders before common Stock Dividends are issued. If the company enters bankruptcy, the shareholders with preferred stock are entitled to be paid from company assets first. Most preference shares have a fixed dividend, while common stocks generally do not. Preferred stock shareholders also typically do not hold any Voting Rights, but common shareholders usually do. Preference shares can be subdivided in different classes.  Cumulative and Non Cumulative Preference Shares: Cumulative preferred stock includes a provision that requires the company to pay preferred shareholders all dividends, including those that were omitted in the past, before the common shareholders are able to receive their dividend payments.

 Redeemable and Non Redeemable Preference Shares: Non- cumulative preferred stock does not issue any omitted or unpaid dividends. If the company chooses not to pay dividends in any given year, the shareholders of the non-cumulative preferred stock have no right or power to claim such forgone dividends at any time in the future.  Participating and Non Participating Preference Shares: Participating preferred stock provides its shareholders with the right to be paid dividends in an amount equal to the generally specified rate of preferred dividends plus an additional dividend based on a predetermined condition. This additional dividend is typically designed to be paid out only if the amount of dividends received by common shareholders is greater than a predetermined per-share amount. If the company is liquidated, participating preferred shareholders may also have the right to be paid back the purchasing price of the stock as well as a pro-rata share of remaining proceeds received by common shareholders.

Cumulative Convertible Preference Shares:  Convertible preferred stock includes an option that allows shareholders to convert their preferred shares into a set number of common shares, generally any time after a pre-established date. Under normal circumstances, convertible preferred shares are exchanged in this way at the shareholder's request. However, a company may have a provision on such shares that allows the shareholders or the issuer to force the issue. How valuable convertible common stocks are is based, ultimately, on how well the common stock performs.

Redemption of Preference Shares:  Redemption is the process of repaying an obligation, usually at prearranged amounts and times. The conditions of the issue of preference shares include a call provision, i.e., a contract given the right to redeem preference shares within or at the end of a given time period at an agreed price. These shares are issue on the terms that holders will at some future date be repaid the amount which they invested in the company.  The redemption date is the maturity date, which specifies when repayment take place and is usually printed on the preference share certificate. By the process of redemption, a company can also adjust its financial structure, for example, by eliminating preference shares and replacing those with other securities if future growth of the company makes such change advantageous.

Method of Redemption: The ‘gap’ created in the company’s capital by the redemption of redeemable preference shares must be filled in by  The proceeds of a fresh issue of shares  The capitalization of undistributed profits’ or  A combination of (a) and (b) Fresh Issue of Shares: One of the prescribed methods for redemption is to use the proceeds of a fresh issue of shares. A company can issue new shares (Equity and Preference Share) and the proceeds from such new shares can be used for redemption of preference shares.

The Capitalization of Undistributed Profits : Another method of redemption of preference shares, allowed by the companies Act, is to use the distributable profit instead of issuing new shares. When shares are redeemed by utilizing distributable profit, an amount equal to the face value of share redeemed is transferred to Capital redemption Reserves Account by taking part of the distributable profit. In other words, some of the distributable profits are frozen to ensure that it can never be distributed to shareholders as dividend.

Combination of Both Methods: A company can redeem the preference shares partly from the proceeds from new issue and partly out of profits. In order to fill the gap between the face value of shares redeemed and the proceeds of new issue, a transfer to be made from distributable profit (Profit & Loss Account, general reserves and free reserves) to Capital Redemption Reserves Account.