Microsoft Word - F1_FRT_Chapter

Share Capital

Transactions and

Financial Instrument

(IAS 32 & IAS 39)

Chapter

15.1

Issue of shares

Incorporated organisations can raise finance by issuing shares.

1

Ordinary share capital (UK)

A limited company issues shares, which investors buy and then these investors become owners of
the company.  These shares may be issued privately (ltd) or to the public (plc).  Ownership in the
company is through the issue of shares.  The shareholders have an equity stake in the business and
have voting rights.

Usually  for  large  organisations  the  shareholders  do  not  run  the  business.    The  directors  do  this.
The shareholders are entitled to dividends declared by the directors.  The dividends are declared at
the discretion of the directors and depend on how much profit the company has made.

Authorised share capital

This is the number of shares that the company is allowed to issue
and is stipulated in its memorandum or articles of association.

Issued share capital

This is the number of shares that the company actually issues. This
cannot exceed the authorised share capital

Called up share capital

This is the issued share capital for which the shareholders are
required to pay to the company.

Paid up share capital

This is the amount of share capital paid up by the shareholders

Nominal value

This is the value of the each share which the company will originally
issue the shares at, (also known as face or par value)

Market value

This is the trading value of the shares, and is the price an individual
pays for the shares

Share premium

This is the increase from nominal value to market value of the share

The double entry to record issue of ordinary share capital is:

Debit

Bank (statement of financial position)

Credit Ordinary share capital – nominal value(statement of financial position)

Credit Share premium (issue value less nominal value)

(statement of financial position)

Procedures for new issue of equity shares

Issue and forfeiture

Application

Potential shareholders apply for shares in the company and send
cash to cover the amount applied for.

Allotment

The company allocates shares to the successful applicants and
returns cash to unsuccessful applicants.

Call

Where purchase price is payable in instalments, the company will
‘call’ for instalments on their due dates of payment

Forfeiture

If  shareholders  fail  to  pay  a  call,  their  shares  may  be  forfeited
without  the  need  to  return  the  money  they  have  paid;  the  forfeited
shares may then be reissued to other shareholders

Rights issue of ordinary shares

If a company issues ordinary shares for cash it must first offer them to its existing ordinary
shareholders in proportion to their shareholdings. This is called a rights issue because members
may obtain new shares in right of their existing holdings.

Double entry to record issue of ordinary share capital under a rights issue:

Debit

Bank (statement of financial position)

Credit Ordinary share capital – nominal value(statement of financial position)

Credit Share premium (rights issue price less nominal value)

(statement of financial position)

Bonus issue of ordinary shares

A bonus issue is when new shares are issued to existing shareholders but no money is received.
Instead the company capitalises its reserves, this is only permitted to the extent that the articles
permit it and the correct procedure must be observed.

Double entry to record issue of ordinary share capital under a bonus issue:

Debit

Share premium (to its extent) - (statement of financial position)

Debit

Distributable profit (remainder) - (statement of financial position)

Credit Ordinary share capital (nominal value) - (statement of financial position)

Preference shares

Preference  shares  are  issued  by  companies  to  raise  finance.    These  shares  are  different  from
ordinary  shares.    Preference  shares  do  not  give  voting  rights  and  therefore  holders  of  preference
shares do not have a stake in the business.

Preference shares usually carry a fixed dividend.  This means the company has to pay dividends on
the  preference  shares  (obligation  to  pay  dividends  if  the  company  makes  profits).    The  company
has the option to pay dividends on ordinary shares (no obligation).

Direct issue costs of all share issues are never treated as an expense, but instead are debited to the
share premium (i.e. the direct costs of raising capital finance is capitalised).

15.2

Reserves

Revenue reserves arise when a company makes profits and does not pay out all the profits to the
shareholders.  There is no statutory requirement for a company to have any amounts in its revenue
reserve.    These  non-statutory  reserves  take  various  names  like  “retained profits”,  “profit  and  loss
reserves”, “un-appropriated profits” etc.

A  company can  make dividend payments out of revenue reserves  i.e. they are distributable to the
shareholders

Capital  reserves  must  be  established  in  certain  circumstances  by  law.  These  statutory  reserves
include:

§ Share premium account (set up when ordinary shares issued)
§ Revaluation reserve (set up when fixed assets revalued)

A company cannot make dividend payments out of capital reserves, i.e. they are un-distributable

Reserves

Statutory

(capital)

Non-statutory

(revenue)

15.3

Distributable profits

Distribution to shareholders can only be made out of distributable profits. This is the law.

Distributable  profits  are  realised  profits,  for  example  profits  earned  on  sale  of  goods  or  returns
from  investments.    Unrealised  profits  or  gains  include  revaluation  of  non  current  assets.    This
revaluation gain  is  not realised because the organisation  hasn’t sold the asset, it  is  still continuing
to use it.

All accumulated profits are distributable profits.

The reason  for  making  distribution  to  shareholders  only  from  distributable profits  is  to  safeguard
the rights of creditors.  Any amounts owing to creditors must be paid first before capital is returned
to the shareholders, this is also known as the “creditors’ buffer”.

15.4

Redemption of shares

A company may decide to buy back some of its issued ordinary shares and then cancel them.  For
this  to  happen,  their  must  be  authorisation  from  articles  of  association,  special  resolutions  and
sometimes from the court.

Redemption of shares from capital

The accounting treatment for the redemption of shares is strict.  A company must set up a “capital
redemption  reserve”  to  protect  the  creditors.    This  is  done  by  utilising  the  accumulated  realised
profits (distributable reserves).  The amount taken to the capital redemption reserve is the nominal
value of the shares redeemed.

Journal entry for redemption of shares is done in 2 stages:

1

To record the share-buy back

Debit

Ordinary share capital (nominal value) - (statement of financial position)

Debit

Share premium (but restricted) - (statement of financial position)

Debit

Retained profits (with remainder) - (statement of financial position)

Credit Bank (statement of financial position)

To record the capital maintenance by setting up a capital redemption reserve

Debit

Retained profits (nominal value) - (statement of financial position)

Credit Capital redemption reserve - (statement of financial position)

The rule on share premium account

When the shares are redeemed at a premium, the excess redemption value is debited to the share
premium account but the amount debited is the lower of:

(i)

Share premium originally received from the issue

(ii)

Current balance of the share premium account

(iii)

Actual premium on redemption

Redemption of shares out of new issue of shares

If the redemption of share is financed entirely by a new issue of shares, then no capital redemption
reserve is set up as the capital is maintained.

New issue of shares

Debit

Bank - (statement of financial position)

Credit Ordinary share capital - (statement of financial position)

Credit Share premium - (statement of financial position)

Redemption of share

Debit

Ordinary share capital - (statement of financial position)

Debit

Share premium - (statement of financial position)

Credit Bank (statement of financial position)

Redemption of share out of partial new issue

If the redemption of shares is financed partly by a new issue of shares, then the amount of offset
against the new issue is also partial. A capital redemption reserve needs to be created but only to
the extent that the nominal value of shares redeemed exceed the total proceeds from the new issue
(nominal plus premium).

Note that the rules also apply to preference shares.

Worked example

The following are extracts from Sebastian plc’s statement of financial position.

Equity and reserves

$’000

Ordinary share capital ($1 equity shares fully paid up)

8,000

Share premium

2,000

Retained profits

5,000

The company buys back 2 million shares for $1.30. The shares were originally issued at a price of
$1.25.

Scenario 1

Redemption through capital

The total value of share buy back is 2 million shares x $1.30 = $2.6 million, of which $2 million is
nominal value and $600,000 is share premium.

But only $500,000 can be used from the share premium (original share premium was $0.25 x 2
million shares), the rest will be taken from retained profits

The accounting entry is:

Debit Ordinary share capital

$2,000,000

Debit Share premium

$ 500,000

Debit Retained profits

$ 100,000

Credit

Bank

$2,600,000

An amount equal to the nominal value of the shares redeemed will be credited to the capital
redemption reserve from retained profits.

Credit

Capital redemption reserve

$2,000,000

Debit

Retained profits

$2,000,000

The total amount of retained profits utilised = $2,100,000

Statement of financial position after redemption of shares

Equity and reserves

$’000

Ordinary share capital ($1 equity shares fully paid up)

6,000

Share premium

1,500

Capital redemption reserve

2,000

Retained profits

2,900

Scenario 2 – Redemption through issue of new shares

The company issues 1.5 million new shares at a price of $1.00 each.

New issue of shares
Debit Bank

$1,500,000

Credit Ordinary share capital

$1,500,000

Redemption of shares
Debit Ordinary share capital

$2,000,000

Debit Share premium

$ 500,000

Debit Retained profits

$ 100,000

Credit

Bank

$2,600,000

A capital redemption reserve needs to be created but only to the extent that the nominal value of
shares redeemed exceed the total proceeds from the new issue (nominal plus premium).

$2 million - $1.5 million = $0.5 million

Debit Retained profits

$500,000

Credit Capital redemption reserve

$500,000

The total amount of retained profits utilised = $600,000

Statement of financial position after redemption of shares

Equity and reserves

$’000

Ordinary share capital ($1 equity shares fully paid up)

7,500

Share premium

1,500

Capital redemption reserve

500

Retained profits

4,400

15.5

IAS 32 and IAS 39 – financial instruments

(Tutor note:  IAS 32 and IAS 39 are not examinable in this paper, this is additional reading for
better understanding).

Financial instruments

Financial instruments are all instruments that are issued by companies as a means of raising finance
(capital)  including  shares,  debentures,  loans,  debt  instruments,  options  and  warrants  that  give the
holder  the  right  to  subscribe  for  or  obtain  capital  instruments.    It  also  includes  derivative
instruments such as options and futures.

Definitions according to the relevant accounting standards

Financial instrument A financial instrument gives rise to both a financial asset of one company

and a financial liability or equity instrument of another entity.

Financial asset

A financial asset can be cash, equity or contractual right to receive cash
or exchange financial instrument in the company’s favour. This also
includes derivatives.

Financial liability

A contractual obligation to make payments in the future. This could be
cash or exchange financial instrument which are not in the company’s
favour

Equity instrument

Any contract that gives entitlement to the residual interest in a company
after all the liabilities have been settled

Derivatives

These  are  financial  instruments  that  derive  their  value  from  the
underlying  asset.    They  are  used  mainly  for  hedging  against  adverse
movements  in  prices,  exchange  rates  and  interest  rates.    Examples
include  future contracts,  forward contracts, options and swaps.  There is
usually very little outlay on investment initially and are settled at a future
date.

Fair value

The amount for which an asset could be exchanged or a liability settled,
at an arm's length transaction between willing parties

The accounting standards that deal with financial instruments are:

(i)

IAS 32 financial instruments - presentation

(ii)

IAS 39 financial instruments - recognition and measurement

(iii)

IFRS 7 financial instruments - disclosures

15.5.1

IAS 32 financial instruments: presentation

This  accounting  standard  states  that  companies  must  classify  financial  instruments  as  either  a
financial  liability  or  as  equity.    The  classification  is  important  because  it  has  an  impact  on  the
appearance  of  the  balance  sheet  and  therefore  major  ratios  like  gearing.    Gearing  measures  the
company’s  debt  capital  to  its  equity  capital  and  shows  how  risky  or  stable  the  company  is.    The
correct  classification  will  enhance the  financial  statements  for  user’s  of  these accounts  in  helping
them assess the organisation’s financial position, performance and cash flows according to IAS 32.

IAS 32 achieves its objectives by:

§  Clarifying the classification of a financial instrument as either a liability or equity
§  Gives the treatment for treasury shares (a company's own repurchased shares).
§  Gives strict conditions under which assets and liabilities may be offset in the statement of

financial position

§ Additional disclosure requirements about financial instruments, including information as to

their fair values. However there is a new disclosure accounting standard IFRS 7 which is
applicable in addition to IAS 32 from January 2007.

Equity instruments

Financial liabilities

Ordinary shares
Share warrants
Some type of preference shares

Trade payables
Bonds
Loan stock
Debentures
Bank loans
Some type of preference shares

The substance of the instrument is looked when assessing what the classification is.  If there is an
obligation to transfer economic benefit, then this meets the definition of a liability and therefore
must be classified as such.

Normal  equity  shares  and  debt,  like  bank  loans,  long  term  debentures  and  loan  stock are straight
forward  with  their  classification.    The problem  arises  on  unusual  financial  instruments  which  are
discussed below.

Tradable debt securities

Compound (hybrid) financial instruments

Some financial  instruments have both equity  and  liability elements.  IAS 32 requires that liability
element and equity element be identified and classified separately.  An example is convertible debt
which is debt that can be converted into equity shares at some point in the future. Another example
is debt issued with detachable share purchase warrants

IAS  32  requires  the  liability  component  be  calculated.    This  amount  is  then  deducted  from  the
whole value (or fair value) of the instrument, which leaves the equity element.

Worked example – convertible bonds / debt

A company issues 400 convertible bonds on 1

January 20X6. The bonds were issued at par value

of $100 per bond. Interest is paid annually in arrears at 8% pa, and the bonds are redeemable at par
on 31

December 20X9.

The bonds can be converted into ordinary shares at 5 shares per bond any time until maturity of the
bond.

The market interest rate for similar convertible bonds is 10%.

Establishing the liability and equity component
(i)

Find present value (PV) of redeemable value

(ii)

Find present value of interest payments

(iii)

Deduct (1 + 2) from the value of proceeds now

(iv)

The result of 3 is the equity component

The liability is calculated first. This is the present value (PV) of the redeemable value plus the
present value of the interest payments. The bonds will be redeemed in 4 years time.

PV of redeemable ($100 x 400)

$40,000 x 0.683 (DF @ 10% 4yrs)

$27.320

PV of interest payments ($40,000 x 8% x 3.17 (CDF @ 10% for 4 yrs)

$10,144

Total present value

$37,464

Proceeds of bond issue ($100 x 400)

$40,000

Equity component

$ 2,536

Debit Bank $40,000

Credit Bond liability $37,464

Credit Equity

$ 2,536

The split between the liability and equity component remains the same throughout the term of the
bond. The split is made when the financial instrument is issued and doesn’t change even if market
interest rates and share prices change. Even the changes in the likelihood of conversion won’t
change the initial split

Fair value of

bond

Warrants and options

These financial instruments give the holder the right to subscribe for equity shares at some point in
the future at a specified price.   A common  form  of remuneration  for senior  staff  is  share options.
Traditionally  when  share  options  were  granted,  there  was  no  accounting  entry  in  the  financial
statements.    It  was  only  once  the  options  were  exercised  that  the  financial  statements  would  be
affected.

This old method would result in companies with different remuneration policies showing different
results, thus making financial statements incomparable.

IFRS 2 share based payments was introduced by the IASB, which states that when the company
offers share options or warrants, it must treat this as a financial instrument and recognise them in
the financial statements at fair value, the charge going to the income statement and the credit going
either to equity or liabilities.

3

Irredeemable debt

This  is  debt  that  is  issued  without  a  redemption  date.    The  holder  of  the  debt  receives  interest
indefinitely and will not receive back the principle amount.  This is classified as liability under IAS
32, although it does have the same characteristics of equity shares, which are not redeemable.  But
with  irredeemable  debt,  there  is  an  obligation  to  pay  the  interest.    There  is  no  obligation  to  pay
dividends on equity shares.

With redeemable debt, there is an obligation to pay to repay the principal amount.  So therefore this
is classified as liability.

4

Preference shares

Redeemable preference shares
The  issuer  has  the  obligation  to  pay  preference  dividends  and  redeem  the  shares.    This  gives  the
characteristic of a liability and therefore should be classified as such.  However in some country’s
(like UK), preference shares have to be shown as part of equity, so for the provisions of IAS 32 to
apply, the law had to change.

Irredeemable preference shares
The preference dividends are paid  indefinitely and the shares are never redeemed (just  like equity
shares).  If the there is an obligation to pay the preference dividends then classify as debt (liability).
If there is no obligation to pay preference dividends they are then classified as equity.

5

Interest, dividends, losses and gains

IAS 32 states that:
1

Interest, dividends, gains and losses relating to financial instruments that are classified as

financial liabilities must be recognised as income or expense in the income statement.

Distributions made to equity instrument holders, must be debited to equity (i.e. reduce

retained profits).

Transaction costs on equity instruments are also debited to equity.

Transaction costs on all financial instruments are capitalised (debited to the relevant item in

the statement of financial position)

Treasury shares

Treasury  share  are  shares  held  by  the  company  that  issued  them.  A  company  acquires  treasury
shares by buying them in the market. The cost of buying back these shares is deducted from equity.
Gains  or  losses  are  not  recognised on  the purchase,  sale,  issue,  or  cancellation  of  treasury  shares.
Consideration paid or received is recognised directly in equity.

Treasury shares are commonly used in employee share (or share option) schemes. Treasury shares
do not receive dividends or rights and they cannot be used to vote at or attend company meetings.
They  are  shown  in  the  statement  of  financial  position,  but  they  are  deducted  from  share  capital.
Treasury shares are not used in the calculation of basic EPS.

Offsetting

IAS 32 states financial asset and financial liability can only be offset against each other when:

§  Has a legal right to set off the amounts.
§  Intends to settle on a net basis.
§  Intends to realise the asset and settle the liability simultaneously.

15.5.2

IAS 39 financial instruments: recognition and measurement

IAS 39 deals with recognition and de-recognition, the measurement of financial instruments and
hedge accounting. IAS 39 is a very controversial accounting standard and is still under review.

IAS  39  states  that  initially  ALL  financial  instruments  must  be  stated  at  their  fair  value.    This
includes  financial  derivatives  (the  main  area  of  disapproval).    This  rule  is  different  from  the
recognition  rule of  the  framework,  which  states  that  items  should  only  be recognised  if  there  is  a
probable inflow or outflow and can be measured reliably.

The standard states that a financial asset or a financial liability must be recognised in the statement
of  financial  position  only  when  the organisation  becomes  a party  to the contractual  provisions  of
the instrument.

The definitions  of  financial  instrument,  financial  asset  and  financial  liability  are the  same as  IAS
32.  Examples of financial instruments within the scope of IAS 39 are:

§  Cash and cash in time deposits.
§  Loans receivable and payable.
§  Debt and equity securities. These are financial instruments from the perspectives of both the

holder and the issuer. This category includes investments in subsidiaries, associates, and
joint ventures.

§ Asset backed securities (e.g. mortgage obligations)
§ Derivatives (options, rights, warrants, futures contracts, forward contracts, and swaps).

IAS 39 does not deal with equity instruments; it only deals with financial assets and financial
liabilities. Therefore it is very important that the classification between equity and liability is done
accurately under IAS 32.

IAS 39 states that all financial assets and all financial liabilities must be recognised in the statement
of  financial  position.  This  includes  all  derivatives.  In  the  past  derivatives  were  not  recognised  in
the  statement of  financial  position.  This  is  because at the time the derivative  financial  instrument
was entered into, the consideration paid or received was immaterial. This justified non-recognition
at that time.  However the value of the derivative changes due to changes  in the underlying asset,
which means the derivative, has a positive (asset) or negative (liability) value.

Financial assets

IAS 39 requires financial assets to be classified in one of the following categories:

§  Financial assets at fair value through profit or loss.
§  Loans and receivables.
§  Held-to-maturity investments
§  Available-for-sale financial assets

(i)

Financial assets at fair value through profit or loss

This category has two subcategories:

§ Designated. This is a financial asset that is designated on initial recognition as one to be

measured at fair value with fair value changes in profit or loss. Any financial instrument
can have this designation except for equity instruments with no market value.

§ Held for trading. These are all derivatives (except those designated and effective hedging

instruments)  and  financial  assets  acquired  or  held  for  the  purpose  of  selling  in  the  short
term  or  for  which  there  is  a  recent  pattern  of  short-term  profit  taking  are  held  for  trading
(i.e. part of a portfolio).

Once a financial instrument has been designated as a financial asset at fair value through profit or
loss, it can never be re-classified.

Example: shares purchased which are quoted on the stock market and which are held for
trading purposes.

(ii)

Loans and receivables

These are non-derivative financial assets, which are not quoted in an active market, not held for
trading, and not designated on initial recognition as assets at fair value through profit or loss or as
available-for-sale. The payments tend to be fixed or determinable. An example would be loan
issued to other companies, which can be sold or exchanged before maturity date.

(iii)

Held-to-maturity investments

These are non-derivative financial assets that are held to maturity date, with fixed or determinable
payments, that do not meet the definition of loans and receivables and are not designated on initial
recognition as  assets at fair  value through profit or  loss or as available for sale.  The organisation
intends and  is able to hold to maturity this  financial asset.  An example would be loan issued to
other companies, which will be held until maturity.

Held-to-maturity  investments  are  measured  at  amortised  cost.  If  the  organisation  sells  held-to-
maturity investments before maturity (unless it is of insignificant amount or it’s a one off isolated
event beyond their control), then all of  its other held-to-maturity  investments  must be reclassified
as available-for-sale for the current and next two financial reporting years.  This would then mean
that re-measurement is on fair value basis and amortised cost method can no longer be used.

(iv)

Available-for-sale financial assets

These are financial assets that do not fit into the above categories (e.g. shares purchased which
are quoted on the stock market, but which are not held for trading purposes)

1

Initial classification

Before the financial asset or liability is recognised, it needs to be classified. Financial assets are
classified as above and financial liabilities are more straightforward to classify.

2

Initial recognition

The financial asset or financial liability must initially be recognised at FAIR VALUE less direct
transaction costs.

Fair value can be derived from:
(i)

Quoted prices

(ii)

Where there is no active market, then use valuation techniques with references to market

conditions, e.g. discounted cash flows using market discount factor.

(iii)

If none of the above 2 is possible, then fair value is cost less any impairment.

Subsequent measurement

Subsequent measurement depends on the initial classification.  This is the area that was revised by
IAS 39 in December 2003, as before this, the standard proposed subsequent measurement to be at
fair  value,  which  caused  a  great  deal  of  backlash,  as  this  introduced  volatility  to  financial
statements.  The standard now gives a choice.

IAS 39 now states that subsequent measurement can either be fair value and/or the following:

Classification of financial

instrument

Subsequent measurement

Change taken to

Financial assets at fair value
through profit or loss

Fair value

Gains and losses taken to the
income statement at each re-
measurement

Loans and receivables

Amortised cost, using the
effective

interest

rate

method, or fair value

Gains and losses taken to the
income statement at each re-
measurement

Held to maturity investments

Amortised cost, using the
effective

interest

rate

method, or fair value

Gains and losses taken to the
income statement at each re-
measurement

Available for sale financial
assets

Fair value

Gains and losses shown under
other comprehensive income
and

recognised

equity

(reserves).    When  the  item  is
sold or removed, the cumulative
gains  or  losses  are  reclassified
as  part  of  the  retained  profit  in
the  statement  of  changes  in
equity.

Amortised cost

Amortised cost is calculated using the effective interest method.

The effective interest rate is calculated by taking into consideration the life of the financial asset or
liability, all the payments and all the receipts. It is effectively a discount rate which when applied
will give the carrying value of the financial asset or liability (see the illustrative worked examples
later in this chapter).

Worked example - Financial assets – fair value

David plc has the following investments:

Date

Details

Market
value

31/12/X5

Market
value

disposal
during 20X6

Classification

July
20X5

5,000 shares in Andy
plc at £4.50 each

£5

£5.50

Financial assets at fair value
through profit or loss / held for
trading

August
20X5

3,000 shares in Lucas
plc at £16.50 each

£15

£12.50

Available for sale financial
asset

Initial recognition will be at fair value:

Andy plc investment (current asset)

Debit Financial assets at fair value through profit or loss (£4.50 x 5,000) £22,500

Credit Bank

£22,500

Lucas plc investment (non current asset)

Debit Financial assets available for sale (£16.50 x 3,000) £49,500

Credit Bank

£49,500

Year end
At the year end both the investments will be re-valued to fair

Andy plc – 5,000 x £5 = £25,000

This results in a gain of (25,000 – 22,500) = £2,500. This will go to the income statement as a
gain.

Debit Financial assets at fair value through profit or loss £2,500

Credit Income statement

£2,500

Lucas plc – 3,000 x £15 = £45,000

This results in a loss of (49,500 – 45,000) = £4,500. This will go other comprehensive income and
shown under equity (reserves).

Credit Financial assets available for sale

£4,500

Debit Other comprehensive income

£4,500

Disposal

Andy  plc  disposal  proceeds  are  5,000  x  £5.50  = £27,500.    This  is  a  gain  of  (27,500  –  25,000)  =
£2,500.   This  will  go  to the  income  statement  as  a gain.  Note how the gain  or  loss  is  established
with reference to the last fair valuation

Debit  Bank

£27,500

Credit Financial assets at fair value through profit or loss

£25,000

Credit Gain – income statement

£ 2,500

For Lucas plc, the gain or loss on disposal is calculated with reference the initial valuation.

Disposal proceeds 3,000 x £12.50 = £37,500.  This is a loss of (49,500 – 37,500) = £12,000.

The  loss  will  be  recognised  in  the  income  statement,  and  the  previous  loss  of  £4,500  will  be
transferred from reserves to the income statement.

Debit  Bank

£37,500

Credit Financial assets available for sale

£45,000

Credit Reserves

£ 4,500

Debit Income statement

£12,000

Effectively the entire loss over the term of the financial asset is recognised when the asset is sold in
the income statement (which then forms part of the retained profits under equity).

Transaction costs

Financial assets at fair value through profit or loss / held for trading – expensed in the income
statement:

Dr Expense, Cr bank

Available for sale financial asset – capitalised in the statement of financial position

Dr Available for sale financial asset, Cr bank

Financial liabilities

Financial liabilities are initially recognised at fair value (just like financial assets).  This would be
issue  proceeds  less  direct  costs.    The  subsequent  measurement  is  at  amortised  cost  using  the
effective interest rate method.

Worked Example - Financial liability – amortised cost

A company issued bonds with a nominal value of £10 million at the beginning of its financial year.
Issue  costs  were  £200,000  and  interest  payable  on  the  bonds  is  5%  at  the  end  of  the  year.  The
bonds will be redeemable in 3 years time for a total value of £12.264 million.

Show how the company will account for the bond over the 3 years.

Answer

Firstly  the  interest  rate  implicit  on  the  bond  needs  to  be  calculated  as  follows  (this  is  normally
given in exams):

£’000

Net proceeds

(£10,000 - £200)

9,800

Total payable
Interest payments (£10m x 5% x 3 yrs)

1,500

Redemption value

12,264

13,764

Total finance cost (13,764 – 9,800)

3,964

Net proceeds

9,800 / 13,764 = 0.712

Total payable

Using the present value tables, for 3 years the discount rate is 12%. This means 12% will be used
to  allocate  the  finance  cost  over  3  years.  The  effective  cost  of  the  bond  is  12%  compared  to  the
coupon  interest  rate  of  5%.    To  ensure  that  the  cost  of  the  bond  is  spread  over  the  term  in  a
systematic manner, 12% finance charge is used.

At inception  Debit  Bank (statement of financial position)

£9,800,000

Credit Liability (statement of financial position)

£9,800,000

Year

Open liability

£’000

(1)

Finance cost x 12%

£’000

(2)

Interest payment

(10m x 5%)

£’000

(3)

Closing

liability

£’000

1 + 2 - 3

9,800

1,176

(500)

10,476

1,257

(500)

11,233

(bal)1,531

(500)

12,264

Total

3,964

The statement of financial position liability has increased to £12.264 million and when the bonds
are redeemed (Cr Cash £12.264m, Dr Liability £12.264m)

Each year the finance cost on the outstanding liability is charged to the income statement. The
outstanding liability is increased with the finance charge and reduced by the interest payments.

For year one the journal entry would be:

£’000

Dr Finance charge – income statement

1,176

Bond

676

Cash

500

The above workings would also be used for other items, such as loan stock, debentures and
preference shares.

IAS 39 is being replaced with IFRS 9 as part of the convergence program to bring US GAAP
and IASB in line. The IASB decided at its meeting to set 1 January 2018 as the effective date
for the mandatory application of IFRS 9. Please view IASB website for all the latest
developments www.iasb.org

Summary of chapter “share capital transaction”

A limited company issues shares, which investors buy and then these investors become owners of
the company.  These shares may be issued privately (ltd) or to the public (plc).  Ownership in the
company is through the issue of shares.  The shareholders have an equity stake in the business and
have voting rights.

Usually  for  large  organisations  the  shareholders  do  not  run  the  business.    The  directors  do  this.
The shareholders are entitled to dividends declared by the directors.  The dividends are declared
at the discretion of the directors and depend on how much profit the company has made.

Authorised share capital

This is the number of shares that the company is allowed to issue
and is stipulated in its memorandum or articles of association.

Issued share capital

This is the number of shares that the company actually issues. This
cannot exceed the authorised share capital

Called up share capital

This is the issued share capital for which the shareholders are
required to pay to the company.

Paid up share capital

This is the amount of share capital paid up by the shareholders

Nominal value

This is the value of the each share which the company will
originally issue the shares at, (also known as face or par value)

Market value

This is the trading value of the shares, and is the price an
individual pays for the shares

Share premium

This is the increase from nominal value to market value of the
share

Procedures for new issue of equity shares

Issue and forfeiture

Application

Potential shareholders apply for shares in the company and send
cash to cover the amount applied for.

Allotment

The company allocates shares to the successful applicants and
returns cash to unsuccessful applicants.

Call

Where purchase price is payable in instalments, the company will
‘call’ for instalments on their due dates of payment

Forfeiture

If  shareholders  fail  to  pay  a  call,  their  shares  may  be  forfeited
without the need to return the money they  have paid; the forfeited
shares may then be reissued to other shareholders

Rights issue of ordinary shares
If  a  company  issues  ordinary  shares  for  cash  it  must  first  offer  them  to  its  existing  ordinary
shareholders  in proportion to their  shareholdings.  This  is called a rights issue  because  members
may obtain new shares in right of their existing holdings.

Bonus issue of ordinary shares
A  bonus  issue  is when  new shares are issued to existing  shareholders  but  no  money  is received.
Instead the company  capitalises  its  reserves,  this  is  only  permitted to  the extent  that the articles
permit it and the correct procedure must be observed.

Preference shares
Preference  shares  are  issued  by  companies  to  raise  finance.    These  shares  are  different  from
ordinary shares.  Preference shares do not give voting rights and therefore holders of preference
shares do not have a stake in the business.

Revenue reserves arise when a company makes profits and does not pay out all the profits to the
shareholders.  There is no statutory requirement for a company to have any amounts in its revenue
reserve.  These non-statutory reserves take various names like “retained profits”, “profit and loss
reserves”, “un-appropriated profits” etc..  A company can make dividend payments out of revenue
reserves i.e. they are distributable to the shareholders

Capital  reserves  must be established  in  certain circumstances  by  law. These  statutory reserves
include share premium account (set up when ordinary shares issued) and revaluation reserve (set
up  when  fixed  assets  revalued).  A  company  cannot  make  dividend  payments  out  of  capital
reserves, i.e. they are un-distributable

Redemption of shares
A company may decide to buy back some of its issued ordinary shares and then cancel them.  For
this  to  happen,  their  must  be  authorisation  from  articles  of  association,  special  resolutions  and
sometimes from the court.

Redemption of shares from capital
The accounting treatment for the redemption of shares is strict.  A company must set up a “capital
redemption  reserve”  to  protect  the creditors.    This  is  done  by  utilising  the  accumulated realised
profits (distributable reserves).  The amount taken to the capital redemption reserve is the nominal
value of the shares redeemed.

Redemption of shares out of new issue of shares
If  the  redemption  of  share  is  financed  entirely  by  a  new  issue  of  shares,  then  no  capital
redemption reserve is set up as the capital is maintained.

Redemption of share out of partial new issue
If the redemption of shares is financed partly by a new issue of shares, then the amount of offset
against the new issue is also partial.  A capital redemption reserve needs to be created but only to
the extent that the nominal value of shares redeemed exceed the total proceeds from the new issue
(nominal plus premium).

IAS 32 and IAS 39 – financial instruments

Financial instruments

Financial  instruments  are  all  instruments  that  are  issued  by  companies  as  a  means  of  raising
finance (capital)  including shares, debentures,  loans, debt  instruments, options and warrants that
give the holder the right to subscribe for or obtain capital instruments.  It also includes derivative
instruments such as options and futures.

The accounting standards that deal with financial instruments are:

(i)

IAS 32 financial instruments - presentation

(ii)

IAS 39 financial instruments - recognition and measurement

(iii)

IFRS 7 financial instruments – disclosures