U3

COMPANY
FORMATION AND
SHARE CAPITAL

Unit 3: Company formation and share capital 3.1

Unit 3: Company formation and share capital 3.2
 Companies

Debt Require

Can be
Equity obtained Finance
through

Can be Publicly
raised
Invites
Using Prospectus application for

Shares
Privately Underwriter Buys any
shortfall
May be
Through
Ordinary Preference
Receives
Shareholders may
receive
Private Rights issues Share Commission Bonus shares
placement options

Unit 3 concept map

This map represents the core concepts that we’ll be covering
in this unit, and the relationships between them.

Unit 3: Company formation and share capital 3.3

Unit 3: Company formation and share capital 3.4
Study organiser
Before you begin this unit, please check through your study organiser. It shows
the topics that we’ll be covering, the skills you need to acquire (learning
objectives) and the activities you’ll do to help you acquire these skills.

Topic Learning Objectives Activities

3.1 Different classes of  Understand that the equity of an
shares organisation can consist of several
different accounts.
 Understand that within equity
there can be various classes of
shares, each providing different
rights to holders.
3.2 Accounting for the  Be able to provide the journal Activity 3.1
issue of share capital entries to recognise the issue of
both fully paid and partly paid
shares by a company.
3.3 Accounting for  Be able to provide the journal Activity 3.2
distributions entries to account for distributions.

3.4 Redemption of  Be able to provide the journal

shares entries necessary when preference
shares are to be redeemed.
3.5 Forfeited shares  Be able to provide the necessary Activity 3.3
journal entries when shares are
forfeited by their owners.
3.6 Share splits and  Understand what constitutes a
bonus issues share split and a bonus issue of
shares.
3.7 Rights issues and  Be able to provide the journal Activity 3.4
share options entries to account for rights issues
and option issues.
3.8 Required disclosures  Know the disclosure requirements
for share capital of IAS 1 Presentation of Financial
Statements in relation to share
capital and reserves.

You should spend approximately 10-12 hours studying this unit.

Please refer to the glossary section of chapter 13 for important terms.

Unit 3: Company formation and share capital 3.5

Introduction
In Unit 1, you learnt about the company form of business structure. You also
learnt about the various legislations governing the company form of business
structure.
In this unit, you will learn about the formation of companies through issue of
shares. You will also learn about the various classes of shares that a company can
issue and how to account for such share issues in the books of the company.
Before we start please take note of the references that will be utilized throughout
this unit.

You should read the introduction to accounting for

share capital from your course text book chapter 13
pages 435-458.

References
Textbook
Chapter Thirteen
Australian Financial Accounting, Craig Deegan, 7th Edition, McGraw-Hill.

Unit 3: Company formation and share capital 3.6

3.1 Different classes of shares
A company may issue various classes of shares. These are generally divided into
ordinary shares and preference shares.

Ordinary Shares
Ordinary shares are made up of shares issued at different points in time by a
particular company at different prices. Ordinary shares have many features
including the right of ordinary shareholders to vote at annual general meetings.
This entitles them to participate in important decisions about the company.
However, they also take a higher risk than preference shareholders, since their
dividends fluctuate according to company profits. What does this mean?
 If the company does not perform well in a particular year, ordinary
shareholders may not receive any dividend because their dividends are not
cumulative.
 However, in a good year, they may receive higher dividends than preference
shareholders, because they can participate in surplus profits.

Preference Shares
As the name suggests, preference shares have some special features, which
ordinary shares do not.
First of all, preference shares normally carry a fixed dividend, which means that
preference shareholders are guaranteed a fixed level of dividends every year. For
example, the holder of a 6% preference share is entitled to a 6% dividend every
year, for as long as he/she holds the share. This is quite different from ordinary
shareholders whose dividends may fluctuate from one year to the next.
Preference shares may also differ from ordinary shares in some of the following
ways:

Feature which means

priority of Preference dividends may be paid before dividends to ordinary
payment shareholders are paid.
cumulative A company may be unable to pay a dividend in a particular year, due to
dividends low levels of profits or cash. If this happens, the dividend will be carried
forward until such time as the company is in a position to pay it.
non-participatory Preference shareholders may not be allowed to participate in surplus
profits, in which case their dividend cannot exceed the fixed percentage.
non-voting Preference shareholders may not be entitled to vote at an Annual General
Meeting.
Redeemable The company may buy the shares back at some point in the future.

priority in If the company is wound-up, preference shareholders may receive

liquidation priority over ordinary shareholders. Once the assets have been sold and
all the creditors paid off, preference shareholders are refunded the value
of their shares (if there are sufficient funds), before any payment is made
to ordinary shareholders.

You should read section 13.1 from your course

Unit 3: Company formation and share capital 3.7
textbook chapter 13.
3.2 Accounting for the issue of share
capital
Share capital represents the owners’ contribution in a business. Shares issues in
Fiji have a par value. This is the hypothetical value of the shares. The shares can
be issued at a price equal to the par value, lower than the par value or higher than
the par value. If shares are issued at prices in excess of par value the excess is
referred to as share premium.

In Australia shares do not have a par value (the corporations law prohibits the
issue of shares that have a par value); hence, the textbook which is set in the
Australian environment does not consider share premium or discount. We will
need to consider share premiums and discounts as it is still permissible to issue
shares that have a par value in Fiji. We will now look at the accounting entries
required on share issue.

Shares issued for cash

Shares may be issued for a cash consideration, which may be payable in full on
application or in installments. The corporations act requires that all contributed
capital must be held in a trust account until such a time when the shares are
allotted. There are exceptions to this rule when shares are issued on a private
placement basis.

You should now work through worked example 13.2, which illustrates
accounting of shares issued for cash and payable in full on application.

Partly paid shares

As stated earlier, shares may be issued on an installment basis. Amounts may be
payable on application, while further payments due at specified future dates.
Worked example 13.3 on page 441 provides an illustration of the accounting for
partly paid shares. You should now work through this example.

Issue of shares other than for Cash

Shares may be issued for a cash consideration, all examples that we have looked
at so far was based on a cash consideration in exchange for the shares. However,
shares may also be issued for other consideration such as contracts for future
services, real or personal property and so on. The accounting for issue of shares
other than for a cash consideration is illustrated in worked example 13.4 on page
442; you should now work through this example.

Shares oversubscribed
It is also possible that a company may receive more applications and funds than it
expected for a share issue. This could be due to:
 Popularity of the shares. For instance, the prospects may seem very attractive,
in relation to the share price.

Unit 3: Company formation and share capital 3.8

 Investors may pay allotment money at the time of application, which
effectively means they have paid more than the required amount.
In this situation, the company has two options

Option which means

refund It may return the excess money to the applicants.

retain It may include a clause in the prospectus, which allows it to

transfer excess money to allotment. This reduces the
paperwork and time involved in making refunds to individual
investors. After all, these same investors will be required to
pay allotment money in future.

The worked example 13.5 on page 442, provides an illustration of oversubscribed

shares, and the relevant accounting entries, you should now work through this
example.

Shares Undersubscribed
In the prospectus, the company may set a minimum subscription level for its
Initial Public Offer (IPO). If the minimum amount is not reached, it may not be
viable to proceed with the company formation, so all application money must be
refunded to the applicants.
To avoid this situation, the company may engage an underwriter, who agrees to
buy any shares not taken up by prospective applicants. After acquiring the shares
from the company, the underwriter will sell the shares to individual and
institutional investors. The underwriter is entitled to a commission.

Share Issue Costs

There are various costs involved in issuing shares. Share issue costs which are
incurred directly as a result of the issue are to be deducted from the proceeds of
the share issue. All indirect costs associated with a share issue are to be expensed.
Worked example 13.6 on page 444 provides an illustration of the accounting
treatment for share issue costs. You should now work through this example.
Now that we have looked at the accounting for share issues, you should attempt
the following activity, which follows on from the worked example that you have
looked at so far.

Unit 3: Company formation and share capital 3.9

 Activity 3.1

Attempt Review question 16 from the course text book chapter 13. The solutions
to this exercise are provided towards the end of this unit, you should attempt this
exercise on your own before looking at the solutions.

3.3 Accounting for distributions

A company usually distributes profits earned to the owners. This may take
various forms. The usual form is through payment of dividends.

Accounting for cash dividends

Dividends are simply the distribution of profit to the shareholders, which is paid
out during the course of the year. Companies may pay out an interim dividend
sometime during the financial year and a final dividend at the end of the year.
The accounting entries required on the payment of dividends is as follows:

Dr Dividends paid XXX

Cr Cash XXX

At the end of a reporting period the dividend paid must be closed off to the
retained earnings account. This is achieved through the following entry:

Dr Retained earnings XXX

Cr Dividends paid XXX

Accounting for distributions other than cash

A company may also make a distribution other than in cash. The distribution will
be recorded at the fair value of the consideration on the date of the distribution.

You should read section 13.3 from your course

textbook chapter 13.

Activity 3.2

Attempt the challenging question 19 from the course text book, chapter 13. The
solutions to this exercise are provided towards the end of this unit, you should
attempt this exercise on your own before looking at the solutions.

Unit 3: Company formation and share capital 3.10

3.4 Redemption of preference shares
Preference share are usually redeemable. That is a company after issuing the
shares will buy it back after some time. The accounting entries required on the
issue and redemption of preference shares are illustrated in the worked example
13.7, you should now work through this example.

You should read section 13.4 from your course

textbook chapter 13.

3.5 Forfeited Shares

When a company issues partly paid shares, there may be instances when the
shareholders fail to pay up the amounts due on the calls. In such situations the
company may forfeit these shares. The shareholder whose shares are forfeited
will subsequently cease to be a member of the company and may be entitled to a
full or partial refund.
The worked example 13.8 on page 449 provides an illustration of forfeiture of
shares. You should now work through this example.
After you have read section 13.5 and worked through example 13.8 you should
attempt the following activity.

Activity 3.3

Attempt the challenging question 21 from the course text book, chapter 13. The
solutions to this exercise are provided towards the end of this unit, you should
attempt this exercise on your own before looking at the solutions.

3.6 Share splits and bonus issues

A company may elect to (after a resolution at the annual general meeting)
undertake a share split. A share split is where the shares of a company are split
into smaller value shares.

A company may also issue bonus shares. This is very similar to a rights issue
because existing shareholders receive additional shares in the company, in
proportion to the number of shares which they already hold.

However, in a bonus issue, shareholders are not required to pay for the additional
shares. The shares are normally issued out of retained profits, just like a dividend.
Bonus share issues present benefits to the company as well as its shareholders:
a) If a company wishes to conserve its cash, it may decide to issue bonus shares
rather than paying a cash dividend. In that way, cash remains available for
capital expenditure.

Unit 3: Company formation and share capital 3.11

b) Shareholders who prefer a cash return may sell the bonus shares in exchange
for cash. Those who keep the shares will enjoy cash dividends from the bonus
shares in future periods.

When a company issues bonus shares, the following journal entry is passed.
Dr Retained Profits (or Reserves) XXX
Cr Share Capital XXX

You should now read section 13.6 from your course

textbook chapter 13.

3.7 Rights issue and share options

Rights issue
A rights issue is an offer made by the company to its existing shareholders. They
are offered extra shares, in proportion to the number of shares which they already
hold. For example, in a 1 for 3 rights issue, a shareholder with 3,000 shares
would be invited to buy an additional 1,000 shares (1/3 x 3,000 = 1,000).
Shareholders then have two choices.
a) Exercise the options, by paying the required amount; or
b) Decline the offer, in which case the option is said to have lapsed. To ensure
that it still raises the required amount of capital, a company may decide to
underwrite the rights issue.

One reason for conducting a rights issue is to protect the rights of the existing
shareholders. No new shareholders are involved so if all the shareholders exercise
their rights, there is no change to the percentage of shares which they own. In
other words, the rights of existing shareholders are not diluted or weakened.
In a rights issue, shareholders are given the opportunity to buy shares below the
market price, to encourage them to exercise their rights.
When a company makes a rights issue, the following journal entry is passed.
Dr Cash XXX
Cr Share Capital XXX
The worked example 13.9 provides an illustration of a rights issue; you should
now work through the example.

Unit 3: Company formation and share capital 3.12

Share Options
A share option gives the holder the right to buy a certain number of shares at a
stipulated price by a specific date. Similar to the rights issue, the holder has the
choice of exercising the option or not. The holder will usually study movements
in the share price and exercise his options when he believes he can make the
highest capital gain.
Share options are normally used for two reasons
Reasons which means
reward To reward employees for good performance, such as meeting
performance targets

align To align employees’ interests with those of the company.

For instance, when management is innovative, productive and
efficient, the company’s share price is likely to increase. This
is obviously good for shareholders, since they experience a
capital gain. But managers benefit as well, because they are
able to exercise their share options and purchase shares at a
price lower than the market price.

Share options are usually priced below the market price, to encourage exercise of
the options. There may be an additional fee for the option itself and this can be
added to share capital.
When share options are exercised, the following journal entry is passed.
Dr Cash XXX
Cr Share Capital XXX

The worked example 13.10 illustrates the accounting treatment for share options;
you should now work through the example.

You should read section 13.7 from your course

textbook chapter 13.

After you have read section 13.7, and worked through the two examples in the
section you should attempt the following activity.

Activity 3.4

Attempt review questions 17 and 18 from the course text book, chapter 13. The
solutions to this exercise are provided towards the end of this unit, you should
attempt this exercise on your own before looking at the solutions.

Unit 3: Company formation and share capital 3.13

3.8 Required disclosures for share
capital
IAS/FAS 1 requires a number of disclosures in relation to share capital. In
summary the disclosures required are specified in section 13.8 of chapter 13 in
the course textbook.

Summary of the Unit

In this unit we looked at accounting for company formation and subsequent
issues of shares. It is not every day that you would be required to account for
company formation and issue of shares in an IPO. However, accounting for
subsequent share issue is common and it is important that you are well versed
with the accounting issues related to share issues and company formation.

Unit 3: Company formation and share capital 3.14

End of Unit Exercise
Exercise 1

Date Details
May 1 Luganville Ltd issues a prospectus inviting the public to subscribe
for 500,000 shares of $4.00 each.
2009
$3.00 is to be paid on application and the remaining $1.00 is due
within one month of allotment.

June 30 Applications are received for 600,000 shares.

July 10 The directors allot the shares and all applicants receive shares on a
pro rata basis.
Excess application money is used to offset funds due on allotment.

August 10 All remaining allotment money is received.

Required:

a) Prepare a table to analyse the issue of shares.

b) Prepare journal entries to record the transactions and events shown above.
Narrations are not required.

c) Briefly outline whether Luganville Ltd should have hired an underwriter for
this share issue.

On 1 December 2008, the directors of Luganville Ltd declare a bonus share

d)
issue of 2 shares for every 5 shares held in the company. This is funded from a
general reserve. Prepare the journal entry to record the issue of bonus shares.

Unit 3: Company formation and share capital 3.15

Feedback to Activities
Activity 3.1
15 July 2015

Dr Bank trust 11 000 000

Cr Application account 11 000 000
(To recognise the aggregate receipt of application monies. The application
account is considered to be a liability.)

20 July 2015

Dr Application account 10 000 000

Cr Share capital 10 000 000
(To allot 10 million shares as paid to $1 per share.)

Dr Allotment 10 000 000

Cr Share capital 10 000 000
(To recognise the amount of $1 per share that is due following the allotment of
the shares. The allotment account is like a receivable, but is shown in the
statement of financial position as a deduction from share capital.)

Dr Application account 1 000 000

Cr Allotment 1 000 000
(To use the excess application monies to offset some of the amount that is due on
allotment. $9 million is now due on allotment or $0.90 per share)

Dr Cash at bank 11 000 000

Cr Bank trust 11 000 000
(Once the shares have been allotted, the company can then transfer the cash to its
usual operating account.)

20 August 2015

Dr Cash at bank 8 100 000

Cr Allotment 8 100 000
(To recognise the amount of cash received from the holders of 9 million shares at
the rate of $0.90 per share.)

31 August 2015

Dr Share capital 2 000 000

Cr Allotment 900 000
Cr Forfeited shares account 1 100 000
(To record the forfeiture of 1 million shares. Each forfeited share had been paid
to $1.10.)

Dr Cash at bank 1 500 000

Unit 3: Company formation and share capital 3.16

 Dr Forfeited share account 500 000
Cr Share capital 2 000 000
(To recognise the amount received on the auction of the forfeited shares.)

Dr Forfeited shares account 600 000

Cr Cash at bank 600 000
(Return of the balance of the forfeited shares account to the defaulting
shareholders.)

Activity 3.2
Once the final profit for the year has been calculated, which is after the end of the
financial year, the directors are in a position to decide on the amount of final
dividends to allocate to shareholders. Accounting Standards prohibit the
recognition of a dividend at the end of the reporting period unless the dividend
has been declared prior to year end and the payment of the dividend does not
require further ratification by other parties, such as by the shareholders at the
annual general meeting (which is typically held after the year end).

IAS 10 Events After the Reporting Period specifically prohibits the recognition of
dividends as a liability at the end of the reporting period if the dividends have
been declared after the end of the reporting period. As paragraphs 12 and 13
state:

12. If an entity declares dividends to holders of equity instruments (as defined in

IAS 32 Financial Instruments: Presentation) after the end of the reporting
period, the entity shall not recognise those dividends as a liability at the
reporting date.

13. If dividends are declared (i.e. the dividends are appropriately authorised and
no longer at the discretion of the entity) after the reporting date but before the
financial report is authorised for issue, the dividends are not recognised as a
liability at the reporting date because they do not meet the criteria of a present
obligation in IAS 37. Such dividends are disclosed in the notes in the
financial report in accordance with IAS 1 Presentation of Financial
Statements.

The rationale behind this is that dividends declared after the reporting periods do
not meet the definition of a present obligation at the end of the reporting period
because the entity has the discretion rather than an unavoidable commitment at
the end of the reporting period to pay the dividends. However, it is again stressed
that if a final dividend is declared at or before the end of the reporting period and
requires no further ratification (the payment is binding), then it should be
recorded as a liability.

Unit 3: Company formation and share capital 3.17

Activity 3.3
July 2015
Dr Bank trust 12 000 000
Cr Application account 12 000 000
(To recognise the aggregate receipt of application monies. The application
account is considered to be a liability.)

5 August 2015
Dr Application account 10 000 000
Cr Share capital 10 000 000
(To allot 10 million shares as paid to $1 per share.)

Dr Allotment 10 000 000

Cr Share capital 10 000 000
(To recognise the amount of $1 per share which is due following the allotment of
the shares. The allotment account is like a receivable but will be disclosed as a
deduction against share capital.)

Dr Application account 2 000 000

Cr Allotment 2 000 000
(Assumed that the company elects to use the excess application monies to offset
some of the amount that is due on allotment. $8 million is now due on allotment,
or $0.80 per share.)

Dr Cash at bank 12 000 000

Cr Bank trust 12 000 000
(Once the shares have been allotted the company can then transfer the cash to its
usual operating account.)

5 September 2015
Dr Cash at bank 6 400 000
Cr Allotment 6 400 000
(To recognise the amount of cash received from the holders of 8 million shares at
the rate of $0.80 per share.)

10 September 2015
Dr Share capital 4 000 000
Cr Allotment 1 600 000
Cr Forfeited shares account 2 400 000
(To record the forfeiture of 1 million shares. Each forfeited share had been paid
to $1.20 per share.)

15 September 2015
Dr Cash at bank 3 600 000
Dr Forfeited share account 400 000
Cr Share capital 4 000 000
(To recognise the amount received on the auction of the forfeited shares.)

Unit 3: Company formation and share capital 3.18

 Dr Forfeited shares account 2 000 000
Cr Cash at bank 2 000 000
(Return of the balance of the forfeited shares account to the defaulting
shareholders.)

Activity 3.4
Question 17
As with the public issue of shares, the monies received from the rights issue must
initially be placed in the trust account.

10 September 2015
Dr Bank Trust 39 000 000
Cr Application 39 000 000

Because of the under-subscription, the underwriter is required to acquire the

additional two million shares. The amount due from the underwriter is a receivable.

Dr Receivable – underwriter 6 000 000

Cr Application 6 000 000

17 September 2015
Dr Cash at Bank 45 000 000
Cr Receivable – underwriter 6 000 000
Cr Bank Trust 39 000 000

Dr Application 45 000 000

Cr Share Capital 45 000 000

Question 18
The initial provision of options to the chief executive officer is to be treated as part
of total salaries cost. Therefore the entry is:

1 July 2015
Dr Salaries expense 1 000 000
Cr Share options 1 000 000

Given that the options are exercised by the chief executive officer the following
entries are required:

31 December 2017
Dr Cash at Bank 7 000 000
Cr Share Capital 7 000 000

Dr Share options 1 000 000

Cr Share Capital 1 000 000
As we can see from the above entry, the cost attributed to the options at the date of
the issue of the options will be transferred to share capital when the options are
exercised.

Unit 3: Company formation and share capital 3.19

End-of-unit Exercise Solution
Exercise 1
Part a
Shares Shares Cash Application Allotment Refund
applied for allotted received money money
600,000 500,000 (1)1,800,000 (2) 1,500,000 (3) 300,000 Nil
1. 600,000 shares @ $3.00 = $1,800,000
2. 500,000 shares @ $3.00 = $1,500,000
3. $1,800,000 - $1,500,000 = $300,000

Part b
Date Particulars Debit Credit
2009 Cash Trust 1,800,000
June 30 Application 1,800,000

Application money received

June 30 Application 1,500,000

Share Capital 1,500,000

Application fees due

July 10 Allotment 500,000

Share Capital 500,000

Allotment of 500,000 shares @ $1.00

Jul 10 Cash 1,800,000

Cash Trust 1,800,000

Transfer cash to main account

July 10 Application 300,000

Allotment 300,000

Transfer excess money to allotment

Aug 10 Cash 200,000

Allotment 200,000

Balance of allotment money received ($500,000 less $300,000)

Unit 3: Company formation and share capital 3.20

Part c
No, there was no need for an underwriter, since the share issue was over-
subscribed.

Part d
Date Particulars Debit Credit
2008 General Reserve 800,000
Dec 1 Share Capital 800,000

Issue of 200,000 bonus shares out of general reserve

Calculations
2/5 x 500,000 = 200,000 shares
200,000 shares @ $4 = $800,000

Unit 3: Company formation and share capital 3.21

Unit 3: Company formation and share capital 3.22