Understanding Share Capital: Equity and Preference Shares

When a company is formed, a group of people called promoters contribute initial capital in exchange for equity shares. Companies can raise additional capital later by issuing more shares, following the regulations outlined in the Companies Act.

Share capital comes in two main forms:

• Equity Share Capital: Represents ownership in the company.
• Preference Share Capital: Offers certain preferential rights over equity shares.

Equity Shares

Preference Shares

Share Capital Table Components

A company's share capital structure is typically summarized in a table with key components:

• Authorized Share Capital: This is the maximum number of shares a company is legally permitted to issue. If the company needs to issue more shares than authorized, it must obtain shareholder approval to increase the authorized capital.
• Issued and Subscribed Capital: This represents the number of shares that the company has actually issued to investors, and which have been subscribed (purchased) by them. The company can issue the remaining amount up to the authorized capital limit at any time.

Example: Asian Paints (Illustrative)

Let's consider an example based on the provided information about Asian Paints:

This indicates that Asian Paints has already issued and investors have subscribed to 95.92 crore equity shares out of the authorized 99.5 crore. The company can issue the remaining shares later. The fact that these values haven't changed in the past two years suggests no new share issuance has occurred.

Although Asian Paints has the provision for preference shares in its authorized capital, it currently has no outstanding preference shares. This implies they had issued and subsequently repaid preference shares in the past.

Key Takeaways

• Equity shares represent ownership and carry higher risk but also higher potential reward.
• Preference shares offer preferential rights like fixed dividends and priority in dividend payments and liquidation.
• Limited liability is a crucial protection for both equity and preference shareholders.
• Understanding the components of a share capital table (authorized, issued, and subscribed capital) is essential for analyzing a company's financial structure.

Understanding Bonus Shares

Bonus shares are additional shares given to existing shareholders free of charge. No money is collected from the shareholders for these shares.

Accounting Treatment

When bonus shares are issued, the company's accountant transfers a sum from retained earnings (accumulated profits) or general reserves to the equity share capital. The accounting entry is:

• Increase in Equity Share Capital
• Decrease in Retained Earnings/General Reserves

This is simply a transfer within the shareholders' equity section of the balance sheet. There is no impact on the company's assets or liabilities. Consequently, the overall wealth of the shareholders remains unchanged immediately after the bonus issue.

Why Issue Bonus Shares?

The primary reason for issuing bonus shares is to improve the liquidity of the stock. When a company performs well, its stock price tends to rise. Over time, the price can become very high, making it difficult for small investors to buy the shares. This also makes it harder for existing shareholders to sell their shares.

Example: High Stock Price and Liquidity Issues

Consider MRF, a tire manufacturing company, whose stock price has been around ₹150,000. Such a high price discourages many potential buyers.

Bonus Shares and Stock Price Adjustment

When a company issues bonus shares, the stock price adjusts proportionally downwards. This makes the shares more affordable and increases trading activity.

Example: Impact of Bonus Shares on Stock Price and Holdings

Let's say you hold 100 shares of a company with a market price of ₹1,000 per share. Your total investment is ₹100,000 (100 shares * ₹1,000/share).

• Scenario 1: 1:1 Bonus Issue

  The company issues one bonus share for every share held (1:1). You now have 200 shares. The stock price adjusts to ₹500 per share. Your total investment remains ₹100,000 (200 shares * ₹500/share).

• Scenario 2: 9:1 Bonus Issue

  The company issues nine bonus shares for every share held (9:1). You now have 1,000 shares. The stock price adjusts to ₹100 per share. Your total investment still remains ₹100,000 (1,000 shares * ₹100/share).

In both scenarios, your wealth remains the same, but the lower stock price makes the shares more accessible to a wider range of investors, improving liquidity.

Bonus Shares vs. Stock Splits: Enhancing Liquidity

Indian companies frequently use bonus shares and stock splits as tools to improve the liquidity of their stock in the market. While both achieve a similar outcome (increased trading activity), they operate differently.

Bonus Shares

As explained previously, bonus shares are additional shares issued to existing shareholders free of charge. This involves an accounting transfer from retained earnings or general reserves to the equity share capital.

Stock Splits

A stock split involves reducing the face value of existing shares. For example, a company might split a ₹10 share into ten ₹1 shares.

Example: Stock Split Mechanics

If you own 100 shares with a face value of ₹10 each, and the company performs a 10-for-1 stock split, your existing shares are canceled, and you receive 1,000 shares with a face value of ₹1 each.

Key Differences between Bonus Shares and Stock Splits:

Feature	Bonus Shares	Stock Split
Issuance	Issuance of additional shares	Reduction in face value of existing shares
Accounting Entry	Transfer from retained earnings to share capital	No accounting entry required within equity section
Impact on Shares	Increases the number of outstanding shares	Increases the number of outstanding shares
Impact on Price	Stock price adjusts downwards proportionally	Stock price adjusts downwards proportionally
Impact on Wealth	No immediate change in shareholder wealth	No immediate change in shareholder wealth

Similarities:

Both bonus shares and stock splits aim to:

• Increase the number of outstanding shares.
• Reduce the price per share.
• Improve stock liquidity by making shares more affordable to a wider range of investors.

Share Buybacks (Repurchase of Shares)

Just as a company can issue shares to raise capital, it can also buy back its own shares using surplus cash. This is known as a share buyback or share repurchase.

Reasons for Share Buybacks

A company might choose to repurchase its shares for several reasons:

• Returning Surplus Cash to Shareholders: When a company has a significant amount of cash on hand but lacks immediate profitable investment opportunities, it may choose to return that cash to shareholders. Increasing dividends is one way to do this, but share buybacks are another option.
• Increasing Earnings Per Share (EPS): By reducing the number of outstanding shares, a company can increase its earnings per share (EPS), which is a key metric for investors.
• Boosting Share Price: A buyback can create demand for the company's shares, potentially driving up the stock price.
• Signaling Confidence: A buyback can signal to the market that the company's management believes the shares are undervalued and has confidence in the company's future prospects.
• Preventing Hostile Takeovers: In some cases, a buyback can be used as a defensive tactic to prevent a hostile takeover by reducing the number of shares available in the market.
• Optimizing Capital Structure: A buyback can help a company optimize its capital structure by adjusting the mix of debt and equity.

Accounting Treatment for Share Buybacks

When a company repurchases its own shares, the accounting entry involves:

• Decrease in Cash/Bank: The cash used for the buyback is deducted from the company's cash or bank account.
• Decrease in Equity Share Capital: The equity share capital is reduced by the face value of the repurchased shares.

Accounting Treatment When Repurchase Price Exceeds Face Value

If the company buys back shares at a price higher than their face value (which is usually the case), an additional accounting entry is required:

• Decrease in Retained Earnings or Share Premium Account: The difference between the repurchase price and the face value is deducted from retained earnings (accumulated profits) or the share premium account (the amount received above the face value when shares were initially issued).

Example: Accounting Entry for Share Buyback

Let's assume a company has shares with a face value of ₹100. It buys back its own shares at a price of ₹200 per share. The accounting entry would be:

• Debit (Decrease): Cash/Bank ₹200 (for each share repurchased)
• Credit (Decrease): Equity Share Capital ₹100 (for each share repurchased)
• Credit (Decrease): Retained Earnings/Share Premium Account ₹100 (for each share repurchased)

Explanation:

• The cash/bank account is reduced by ₹200 for each share bought back, reflecting the outflow of cash.
• The equity share capital is reduced by the face value of ₹100 for each share.
• The remaining ₹100 (₹200 repurchase price - ₹100 face value) is charged against retained earnings or the share premium account. This reflects the premium paid for the shares above their face value.

Example with multiple shares:

If the company buys back 10 shares at ₹200 each, the total cash outflow is ₹2,000. The accounting entries would be:

• Debit (Decrease): Cash/Bank ₹2,000
• Credit (Decrease): Equity Share Capital ₹1,000 (10 shares * ₹100 face value)
• Credit (Decrease): Retained Earnings/Share Premium Account ₹1,000 (10 shares * ₹100 premium)

Understanding "Other Equity" (Reserves and Surplus)

In a company's balance sheet, under the broad heading of "Equity," there are typically two main components:

1. Equity Share Capital: Represents the capital raised through the issuance of shares.
2. Other Equity: This category encompasses various items, including reserves and surplus.

Other Equity (formerly Reserves and Surplus)

Previously known as "Reserves and Surplus," this section is now termed "Other Equity" to provide a more comprehensive view. It includes reserves, surplus, and some other specific items.

What are Reserves?

Reserves represent amounts set aside from profits for specific purposes. They are created out of the company's earnings. This means that after generating profit, a portion is retained as reserves, while the remainder may be distributed as dividends to shareholders.

Why Create Reserves?

The primary purpose of creating reserves is to provide funds for future business needs, such as:

• Business Expansion: Reserves are often used to finance growth initiatives, such as purchasing new equipment, expanding operations, or entering new markets.

The company's management determines the appropriate balance between retained earnings (reserves) and dividend payouts based on factors like growth opportunities and financial stability.

Misconception about Reserves

A common misconception, especially among non-accounting professionals, is that reserves are held as cash in a bank account. This is not necessarily true.

Reserves are not a separate pool of cash. They represent a portion of the company's assets that have been financed by retained earnings. These assets could be in various forms, such as:

• Fixed Assets (e.g., machinery, buildings): Profits may have been used to purchase these assets.
• Current Assets (e.g., inventory, accounts receivable): Profits might be tied up in working capital.
• Repayment of Liabilities (e.g., loans): Profits could have been used to reduce debt.

Example: Allocation of Profits and the Nature of Reserves

Let's illustrate this with an example:

A company earns a profit of ₹1,000, all realized in cash. It then allocates these funds as follows:

• Dividends: ₹200
• Purchase of New Machines: ₹700
• Purchase of Additional Raw Materials: ₹50
• Repayment of Existing Loan: ₹20
• Remaining Cash: ₹30

In this scenario, the company has set aside ₹800 as reserves (₹1,000 profit - ₹200 dividends). However, this ₹800 is not sitting as cash in a bank account. Instead, it has been used to:

• Purchase machines (₹700)
• Purchase raw materials (₹50)
• Repay a loan (₹20)
• The remaining ₹30 is held as cash.

If someone asks where the ₹800 reserve is, the answer is that it's represented by the increased value of the company's assets (machines, raw materials) and the reduction in its liabilities (loan repayment), with a small portion still in cash.

Understanding Reserves, Other Comprehensive Income (OCI), and Shareholder's Equity

This explanation clarifies various components within the "Equity" section of a balance sheet, including reserves (both capital and general), retained earnings, and other comprehensive income (OCI).

Types of Reserves

Reserves are created from profits (revenue reserves) or from capital transactions (capital reserves).

• Revenue Reserves (e.g., General Reserve, Retained Earnings): These are created out of a company's operating profits.
• Capital Reserves: These arise from transactions that are not part of the company's normal operating activities, such as:
  • Bargain Purchases: When a company acquires another company for less than the fair value of its net assets. For example, if a company acquires assets worth ₹100 crore for ₹70 crore, a capital reserve of ₹30 crore is created.

Example of Capital Reserve Creation:

• Acquired company's assets: ₹100 crore
• Purchase price: ₹70 crore
• Accounting Entry:
  • Cash: -₹70 crore
  • Assets: +₹100 crore
  • Capital Reserve: +₹30 crore

Importance of Reserve Classification

The classification of reserves is important because of restrictions on their usage, particularly regarding dividend payments.

• General Reserve: Can be used to pay dividends, even if the company incurs a loss in a particular year.
• Capital Reserve: Cannot be used to pay dividends.

Example:

A company has a capital reserve of ₹300 and a general reserve of ₹100. If the company incurs a loss but wants to pay a dividend, it can use the ₹100 from the general reserve. However, it cannot use the ₹300 from the capital reserve for this purpose.

Other Equity Components

Besides capital and general reserves, "Other Equity" includes:

• Retained Earnings: This represents the accumulated profits of the company over time, after deducting dividends and taxes. It's essentially the cumulative undistributed profit.
• Other Comprehensive Income (OCI): This represents certain gains and losses that are not recognized in the income statement (profit and loss account) but are directly recognized in equity.

Understanding Other Comprehensive Income (OCI)

OCI primarily relates to unrealized gains and losses on certain investments.

Example of Unrealized Profit:

Asian Paints uses surplus cash to buy ₹100 crore worth of State Bank of India (SBI) stock. At the end of the year, the market value of the SBI stock is ₹140 crore. This creates an unrealized profit of ₹40 crore.

Accounting Treatment of Unrealized Profit (Post-IFRS):

Under IFRS, companies must recognize this unrealized profit. There are two ways to do this:

1. Recognize in Profit and Loss Account: The unrealized profit is included in the income statement, which subsequently increases retained earnings within Other Equity.
2. Recognize Directly in Other Equity (OCI): The unrealized profit is directly recorded in OCI within the equity section of the balance sheet.

General Rule:

• Unrealized profits on debt instruments are usually recognized directly in OCI.
• Unrealized profits on equity instruments can be recognized either in the profit and loss account or directly in OCI.

Accounting Entries for Unrealized Profit (OCI Method):

1. Purchase of SBI Stock:
   • SBI Investment: +₹100 crore
   • Cash: -₹100 crore
2. Revaluation at Year-End (Unrealized Profit):
   • SBI Investment: +₹40 crore
   • Other Comprehensive Income (OCI): +₹40 crore
3. Sale of SBI Stock (Realized Profit): Assume the stock is sold for ₹150 crore.
   • Cash: +₹150 crore
   • SBI Investment: -₹140 crore
   • Revenue/Profit on Sale: +₹10 crore

If the unrealized profit were recognized in the profit and loss account:

The second entry would change to:

• SBI Investment: +₹40 crore
• Other Comprehensive Income through Profit and Loss (OCI TPL): +₹40 crore

Practical Application for Financial Analysis

For the purpose of analyzing a company's financial performance, the various classifications within "Other Equity" (capital reserve, general reserve, retained earnings, OCI) are often combined.

Shareholder's Equity (or Equity): This is calculated as:

Shareholder's Equity = Equity Share Capital + Other Equity

This simplified approach provides a comprehensive view of the total equity attributable to shareholders.

Key Takeaways:

• Reserves are created from profits (revenue reserves) or capital transactions (capital reserves).
• General reserves can be used for dividends, while capital reserves cannot.
• OCI represents unrealized gains and losses on certain investments.
• For financial analysis, the sum of equity share capital and other equity is used as shareholder's equity.

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