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Equity Financing 2
3. Repurchase of Shares
3.1 Purchase and Redemption of Shares
3.2 Journal Entries for Purchase or Redemption of Shares
4. Distribution of Profits
4.1 Distributable Profits
4.2 Cash Dividend
4.3 Property Dividend
4.4 Stock Dividend and Stock Split
5. Statement of Changes in Shareholders Equity
Accounting methods discussed in the lecture notes are somewhat
different from those of the textbook, especially the part on the
issuance and repurchase of shares.
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Remarks:
The New Companies Ordinance, which has been
come into operation since 3 March 2014, abolishes
the concept of par (or nominal) value for all
shares in Hong Kong companies.
Consequently, the concepts of share premium,
capital redemption reserve and authorized share
capital have also been abolished.
These changes apply to shares issued before and
after the new legislation takes effect, and both
existing and new companies.
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1. Overview of Shareholders Equity
Shareholders Equity (also called Shareholders Funds in
HK) represents the residual claim on the assets of the firm by
its owners/shareholders.
Retained Earnings/Profits
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1.2 Characteristics and Rights of Ordinary
Shareholders
To share proportionately
1. in profits (via dividends if management decides to
distribute profits),
2. in management (the right to vote/to choose
management at shareholder meetings),
3. in corporate assets upon liquidation (if any are left!).
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Preemptive rights:
rights to acquire a pro-rata amount of any new issues of
capital share (shareholders can maintain their percentage of
ownership).
Limited liability:
creditors of the corporation have claims only on the assets
owned by the corporation, not on the assets of the owners
of the corporation.
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1.3 Characteristics and Rights of Preference
Shareholders
1. Nonvoting specification (typically no voice in choosing
management).
2. Preference as to dividend, which is usually fixed (rights
regarding priority): If no dividend is paid on preference
share, no dividend may be paid on ordinary share.
3. Preference as to assets (over ordinary shareholders but not
creditors) in the event of liquidation.
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1.4 Different Kinds of Preference Share
Cumulative preference share: If the company fails to pay a
(fixed) dividend to preference shareholders, its obligation
accumulates and dividends not declared in a year become
dividends in arrears which must be paid in the future before
any dividends to ordinary shareholders are paid.
A participating preference share ordinarily receives a
minimum dividend payment but also receives higher
dividends when the company has a good year and pays
substantial dividends on ordinary shares. That is, dividends in
excess of the stated dividend amount may be paid to
preference shareholders.
A callable preference share gives the issuing company the
right to purchase the share back from the owner upon
repayment of a call price.
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A convertible preference share gives the owner the option to
exchange preference share for ordinary share.
A redeemable preference share is redeemable at a specified
redemption price at the option of the owner or upon other
conditions not within the control of the issuer (e.g.,
redemption on a specified date or upon reaching a certain
level of earnings).
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2. Accounting for Sale and Issuance of Shares
Shares can be issued in exchange for cash or noncash
consideration.
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2.1 Issuance of Share for Cash
Two accounts are affected when shares are sold for
cash:
1) Cash is debited for the sale price.
2) The amount received for issuing equity shares is
credited to an appropriately designated share
capital account for each type of share.
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Example 1 (Issuance of Share for Cash):
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2.2 Issuance of Share for Noncash Consideration
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Example 2 (Issuance of Share for Noncash Consideration):
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The currently quoted exchange price is more representative
fair value of the transaction since organized exchanges are
efficient markets for valuing companies shares.
The real estate appraisal is a less reliable indication of
value.
Hence, the issuing companys entry would be:
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If ABC is not a listed company, then the appraisal might yield
the more representative estimate. The journal entry would be:
Building $500,000
Land 200,000
Share capital ordinary $ 700,000
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2.3 Conversion of Preference Share to
Ordinary Share
Like the accounting for convertible bonds, the accounting
for convertible preference share must be done using the
book value method (i.e., treated as an exchange of one
capital share to another capital share without recognizing
any gain or loss).
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Example 3 (Conversion of Preference Share to Ordinary
Share):
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The journal entry for conversion in the issuers book is:
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2.4 Rights Issue, Warrants, and Options
A corporation may issue rights, warrants, or options that
permit the purchase of the companys shares for a specified
period (the exercise period) at a certain price (the exercise
price).
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A. Rights to existing shareholders (at no charge):
Right to purchase more shares at a price usually below the
current market price.
Permit existing shareholders to maintain their proportionate
ownership interests (i.e., preemptive rights).
Short exercise period.
No formal entry is made when rights are issued. Only a
memorandum entry is made on the issuing companys books
stating the number of shares that may be claimed under the
outstanding rights.
If rights are exercised, an entry is made to record the
issuance of additional shares at the exercise price.
A memorandum entry is also made to record the decrease in
the number of rights outstanding.
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B. Share warrants:
Sold by the company for cash, usually with the issuance of
another security.
Share capital from warrants (an equity account) is increased
for the sale price of the warrants.
Long exercise period.
Under HKAS 32 and IAS 32, the two equity components
(i.e., share capital and warrant) should be allocated to two
separate accounts.
Allocate the lump-sum received based on the relative fair
values of the two securities.
If only one fair value is known, allocate a portion of the
lump-sum received based on that fair value and allocate
the remainder to the other security.
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If fair values of both securities are known, the value assigned
to the warrants is determined by the following equation:
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The proceeds of $58,000 should be allocated by the Wing Hing
Co. as follows:
Value assigned $3
= $58,000 $57+$3 = $2,900
to the warrants
Cash $58,000
Share Capital Preference (plug-in) $55,100
Ordinary Share Warrants 2,900
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If the warrants are exercised, the entry to record the issuance
of ordinary shares would be (regardless of the market price
of the ordinary share at the issuance date):
Ordinary Share Warrants $2,900
Cash (1,000 $25) 25,000
Share Capital Ordinary (plug-in) $27,900
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C. Share options granted to officers or employees:
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In March 2004, the HKICPA issued HKFRS 2 Share-
based Payment on accounting for share-based payment
transactions, including grants of share option to employees.
According to HKFRS 2, starting from 1 January 2005,
companies have to report stock-based option compensation
using the fair value method at the time of grant.
Under the fair value method, compensation cost is based on
the fair value of the stock option (using, e.g., the Black-
Scholes option pricing model) at the date of the grant and is
recognized as expenses over the vesting period.
ADDITIONAL READINGS: HKFRS 2 (it can be found in
http://www.hkicpa.org.hk. Click Standards & Technical,
then Accounting & Financial Reporting, and then choose
Hong Kong Financial Reporting Standards (HKFRS)).
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For example, suppose the fair value of the employee stock
option is $100,000 at the date of the grant and these
options vest at the end of a four-year period. Then in each
of the 4 years, we have the following year-end entry:
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3. Repurchase of Shares
Companies repurchase their own shares to:
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5. Remove some shares from the open market in order to
protect against a hostile takeover.
6. Improve per-share earnings by reducing the number of
shares outstanding and returning inefficiently-used assets
to shareholders.
7. Display confidence that the share price is currently
undervalued by the market.
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3.1 Purchase and Redemption of Shares
The difference between a redemption and a purchase:
Journal entries are the same except for the amount of cash
involved.
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Before 1991, only preference shares were redeemable in HK.
The Companies (Amendment) Ordinance 1991, which came
into operation on Sept 1, 1991, permits a company, of
authorized by its articles, to issue redeemable shares of any
class, not merely redeemable preference shares (s 49(1)).
The Companies Ordinance contains the following provisions
relating to the issue and redemption of shares:
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the shares may not be redeemed unless they are fully paid;
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The Companies Ordinance states that for listed companies,
share redemption must be made from either:
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A solvency statement is a statement that each of the directors
has formed the opinion that the company satisfies the
following solvency test:
a) Immediately after the share capital reduction there will be no ground
on which the company could be found unable to pay its debt; and
b) Either:
i. If it is intended to commence winding up of the company within 12 months after
the date of the capital reduction, the company will be able to pay its debts in full
within 12 months after the commencement of the winding up; or
ii. In any other case, the company will be able to pay its debts as they become due
during the period of 12 months immediately following the date of the transaction.
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The company intends to purchase or redeem 200 shares for
$320 out of distributable profits. The journal entry for the
redemption would be:
Note:
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Original Redemption Ending
Balance Balance
Share Capital 2,000 2,000
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Example 6 (Redeem Entirely out of Fresh Issues):
Cash $ 200
Share capital $200
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Example 7 (Redeem Partly Financed by Fresh Issues):
ABC Ltd. intends to redeem the 100 shares at $1.5 each. 80
new shares are issued at $1.25 to finance the redemption.
The difference is paid out of distributable profits.
The journal entry for the new issue:
Cash $100
Share capital $100
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Example 8 (Purchase or Redeem out of Share Capital):
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4.Distribution of Profits
This usually means cash dividends, but it could include
other types of assets. For example, Disney Corporation has
distributed Disneyland tickets to their shareholders. Also,
the purchase or redemption of the companys own shares
out of retained profits is considered distribution of profits.
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4.1 Distributable Profits
A company can only make a distribution of profits when it
has distributable reserves. In HK, there are specific rules
(Company Laws) that govern the maximum amount of
distributable profits in a company:
Unlisted Company:
Net realized profits = Accumulated realized profits
Accumulated realized losses
Listed Company:
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What are considered undistributable reserves?
a. any accumulated unrealized profits in excess of its
accumulated unrealized losses
b. any other reserve which the company is prohibited from
distribution either by statute or articles of association
(e.g., in China, Employees Welfare Fund)
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Example 9 (Distributable Profits):
The following are details of three separate listed companies
balance sheets at 31 December 2015.
A B C
Net assets (NA) 2,700 3,000 2,000
Share capital 200 500 1,000
Reserves:
Unrealized profits 1,300 500 1,000
Unrealized losses (100) (1,000) (1,000)
Net realized profits 1,300 3,000 1,000
Shareholders equity 2,700 3,000 2,000
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Distributable profits:
Company Net realized profits NA (Share capital +
(unrealized loss in undistributable reserves)
excess of unrealized
profits)
A 1,300 (0) = 1,300 2,700 (200 + 1,200) =
1,300
B 3,000 (500) = 2,500 3,000 (500 + 0) =
2,500
C 1,000 (0) = 1,000 2,000 (1,000 + 0) =
1,000
If these were unlisted companies, the distributable profits
would be equal to net realized profits.
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4.2 Cash Dividend
Dividends are proportional distributions of assets to
shareholders to satisfy their claim arising from the
generation of net income.
Declaration date: the date on which the board formally
announces that it will pay a dividend.
Date of record: a future date that determines which
shareholders will receive the dividend.
The person who holds the share on declaration date but
sells before the date of record will not receive the
dividend.
The person who owns the share on the date of record
will receive it.
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Accounting for Cash Dividend
Journal entries:
On Declaration Date: Dividend Declared xxx
Dividends Payable xxx
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Example 10 (Property Dividend):
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21/9/2014
Dividends (or Retained Profits) $1,400,000
Property Dividends Payable $1,400,000
Investment in Sticky Rice Shares 525,000
Gain on Appreciation of Securities 525,000
The second entry will mark the security up to market, recording
the gain for the appreciation at the time the dividend is
declared. We dont take the security off the books until it is
physically distributed.
23/10/2014
Property Dividends Payable $1,400,000
Investment in Sticky Rice Shares $1,400,000
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4.4 Stock Dividend and Stock Split
Stock Dividend (It is called "Bonus Shares" in Hong Kong)
A stock dividend is a distribution of additional shares of a
corporation's own capital stock on a pro-rata basis to its
shareholders at no cost (i.e., each shareholder receives
additional shares equal to the percentage of shares already held).
It does not
1) change the proportionate ownership of any shareholder;
2) involve the distribution of any assets of the corporation to
the shareholder;
3) affect the total shareholders' equity of the issuing
corporation.
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Reasons for Stock Dividend:
Stock
1. Dividends: Small or Large?
To maintain dividend consistency. Stock dividends
satisfy the demands of shareholders for continuing
dividends and yet avoid the demand on cash. Also, a stock
dividend is not considered as revenue to the shareholder
for income tax purposes. (There is no tax on dividend or
capital gain in Hong Kong.)
2. To capitalize retained income. A stock dividend is used
to transfer retained profits to permanent capital and thus
remove such earnings from cash dividend availability.
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Stock Dividend (Contd)
62
Stock Dividend (Contd)
63
Stock Dividend (Contd)
64
Stock Split
Stock splits are usually larger than stock dividends, but
theoretically the same, i.e., both of them are distribution of a
proportional amount of shares to stockholders.
In a stock split, the total number of shares is increased by a
specified amount (such as a 2-for-1 stock split) but the total
share capital remains unchanged. No accounting entry is needed.
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Example 11 (Stock Split):
Before After
Split Split
Ordinary Shares 5,000 10,000 Increase
No
Total Value $ 5,000 $ 5,000
Change
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5. Statement of Changes in Shareholders
Equity
A schedule that reconciles change in Shareholders Equity
during a period of time
e.g., the impact of profit or loss, dividend and issue
or redemption of shares
It provides information about the reasons behind the
developments that value has taken, for all equity accounts
of a company.
67
Example 12 (Statement of Changes in Shareholders Equity):
Below is the statement of shareholders equity of Carson Manufacturing Company:
Dec. 31, 2014
Shareholders equity
Preference share capital Class A $60,000
(1,200 shares)
Preference share capital Class B 50,000
(500 shares)
Ordinary share capital (3,000 shares) 70,000
Retained profits 150,000
Total shareholders equity 330,000