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Chapter 14

Share capital and reserves


14.1

A share split involves the subdivision of a companys shares into shares of a smaller value.
Share splits do not affect the balance of share capital, and therefore do not affect the balance
of owners equity. A share split does not require any accounting journal entries.

14.2

A share split does not involve any inflow of funds. The assets and liabilities of the entity are
not altered by a share split, so prima facie, the total market capitalisation of the entity would
not be expected to change. However, as the textbook indicates, there is some evidence to
suggest that the total market capitalisation of an entity will increase following a share split.
One explanation for this (and there could be many explanations) is that companies typically
maintain the same absolute amount of dividend payment per share after a share split. With
this in mind, a company that undertakes a share split may, in effect, be signaling that they are
able to pay a greater total quantum of dividends in the future. This may in turn be interpreted
as a signal that the entity expects increases in positive net cash flows in future periods. If we
accept that the value of a share is a function of expectations about the present value of future
cash flows, then we may be prepared to accept that a share split will impact share prices. One
issue for students to discuss would be the timing of the share price change. Would they
expect the share price to change at the time of the announcement of the share split, or after
the share split has actually occurred?

14.3

The Application account would be considered to be a liability account. The entity is obliged
to either issue shares to the applicant, or to refund the application monies if no shares are
allotted.
The Allotment account is similar to a receivable, but it is disclosed in the balance sheet as a
reduction against share capital. It represents the amount that is due to the company by
subscribers following the allotment of the shares.
Companies often issue shares on the basis that the share price will be paid in instalments.
Under the terms of the share issue the company may, at a certain time, make a call for
amounts that are unpaid on the shares. Once the call is made, the amount of the call
represents the amount that is due from the shareholders within a specified time period.
Hence, it is like a receivable. However, it is disclosed in the balance sheet as a reduction in
share capital.

14.4
14.5

Dr
Cr

Retained earnings
Share capital

10 000 000
10 000 000

The prospectus will typically state what will be done in the event of an over-subscription for
shares. The alternatives would include:

satisfying the full demand of a limited number of subscribers (perhaps the favoured
clients of an underwriter) and refunding the monies of the unsuccessful applicants.

issuing shares on a pro-rata basis. If shares are issued on a pro-rata basis the company
then has a number of alternatives as to what it will do with the excess monies paid on
application for the shares. If the shares are to be paid for in instalments the excess
monies paid on application may be offset against the amount that would otherwise be
due following allotment. Alternatively, excess monies may be refunded.

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14.6

Because owners equity is defined as the excess of the amount assigned to a reporting entitys
assets over the amount assigned to its liabilities (that is, it is represented by the net assets of
the entity, with net assets being calculated as the total assets less the total liabilities of the
entity), the way assets and liabilities are measured will directly impact the owners equity
balance which is a residual amount. For example, if a reporting entity elects to value its assets
at market value, and market value is greater than cost, then this will increase the reported
assets of the entity. The net assets of the entity (or owners equity) will correspondingly
increase.

14.7

The disclosure requirements depend upon whether the shares exhibit the characteristics of
debt or equity. If the shares have the characteristics of liabilities they are to be disclosed as
liabilities and the associated payments are to be disclosed as an interest expense. If they are
deemed to be more like equity, the preference shares are to be disclosed in the shareholders
funds section of the balance sheet and the associated payments are to be treated as dividends
which are considered appropriations of profits, rather than expenses. This is consistent with
the requirements of part (a) of paragraph 18 of AASB 132 Financial Instruments: Disclosure
and Presentation which states:
The substance of a financial instrument, rather than its legal form, governs its
classification on the entitys balance sheet. Substance and legal form are
commonly consistent, but not always. Some financial instruments take the legal
form of equity but are liabilities in substance and others may combine features
associated with equity instruments and features associated with financial
liabilities. For example:
(a)
a preference share that provides for mandatory redemption by the issuer
for a fixed or determinable amount at a fixed or determinable future date,
or gives the holder the right to require the issuer to redeem the instrument
at or after a particular date for a fixed or determinable amount, is a
financial liability;
Where securities have both a debt and an equity component AASB 139 Financial
Instruments: Recognition and Measurement requires that the equity component is assigned
the residual amount after deducting from the fair value of the instrument as a whole the
amount separately determined for the equity component. This treatment is also described in
AASB 132; paragraph 31 provides that:
AASB 139 deals with the measurement of financial assets and financial liabilities.
Equity instruments are instruments that evidence a residual interest in the assets of
an entity after deducting all of its liabilities. Therefore, when the initial carrying
amount of a compound financial instrument is allocated to its equity and liability
components, the equity component is assigned the residual amount after deducting
from the fair value of the instrument as a whole the amount separately determined
for the liability component. The value of any derivative features (such as a call
option) embedded in the compound financial instrument other than the equity
component (such as an equity conversion option) is included in the liability
component. The sum of the carrying amounts assigned to the liability and equity
components on initial recognition is always equal to the fair value that would be
ascribed to the instrument as a whole. No gain or loss arises from initially
recognising the components of the instrument separately.

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The decision to classify a security as debt or equity in turn impacts whether a related payment
is deemed to be interest or dividends. As paragraph 36 of AASB 132 states:
The classification of a financial instrument as a financial liability or an equity instrument
determines whether interest, dividends, losses and gains relating to that instrument are
recognised as income or expense in profit or loss. Thus, dividend payments on shares
wholly recognised as liabilities are recognised as expenses in the same way as interest
on a bond. Similarly, gains and losses associated with redemptions or refinancings of
financial liabilities are recognised in profit or loss, whereas redemptions or refinancings
of equity instruments are recognised as changes in equity. Changes in the fair value of
an equity instrument are not recognised in the financial statements.
14.8

In considering the substance of the issue we see that the shares are redeemable at the option
of the company. As such, the company does not have any obligation to redeem the shares for
cash, and consistent with the definitions of equity and liabilities provided in the AASB
Framework, they would be treated and disclosed as equity. However, if the management of
the company makes the formal decision to redeem the shares and notifies the shareholders
accordingly, the company would then have an obligation to transfer cash to the shareholders
in exchange for the shares. If such an election has been made by the company, the preference
shares would then be reclassified to debt.

14.9

Preference shares can take on a myriad of forms. The preferential treatment may include:

preferential treatment in relation to the receipt of dividends (for example, if there are
limited profits, preference shareholders may get their dividend payments first);

if preference shareholders are not able to be paid in a given year their dividend
entitlements may accrue and the accrued entitlements are then to be paid before
ordinary shareholders are paid any dividends (these are called cumulative preference
shares);

preference shareholders may be given preferential treatment on asset distributions in


the event of the company winding up;

preference shares may come with the right that shareholders can redeem the shares for
cash if they wish, and this right may be supported by various letters of credit, or
guarantees provided by other companies (referred to as redeemable preference
shares).

Students should be encouraged to consider how some of the above preferential treatments
impact a judgement about whether the preference share would be considered as debt or
equity (or perhaps a bit of both).
14.10 There is no absolute answer to this question. We must consider the economic substance of
each particular share issue before we can determine whether the specific preference shares
are more like debt or equity. For example, if the shares are not redeemable and they have
voting rights then they may be deemed to be equity-like. If the shares are redeemable on a
fixed date, offer a fixed rate of return, and have no voting rights then they would typically be
considered to be debt-like.
14.11 AASB 101 Presentation of Financial Statements requires a number of disclosures in relation
to the reserves of a company. These disclosures include:

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Paragraph 68 requires that the face of the balance sheet shall include line items that
present the issued capital and reserves attributable to equity holders of the parent;
Paragraph 76 requires an entity to disclose on the balance sheet or in the notes a
description of the nature and purpose of each reserve within equity;
Paragraph 96 requires entities to disclose a statement of changes in equity that,
among other things, shows each item of income and expense for the period that is
recognised directly in equity as well as showing for each component of equity, the
effects of changes in accounting policies and correction of errors recognised in
accordance with AASB 108;
Paragraph 97 requires that an entity shall also present, either on the face of the
statement of changes in equity or in the notes the balance of retained earnings (i.e.
accumulated profit or loss) at the beginning of the period and at the reporting date,
the changes during the period; and a reconciliation between the carrying amount of
each class of contributed equity and each reserve at the beginning and the end of the
period, separately disclosing each change.

14.12 Because not all gains and losses (such as gains associated with revaluations, corrections of
prior period errors, and so forth) go though the income statement we perhaps need to
consider another alternative to find a more comprehensive picture of an entitys financial
performance this is the role of the statement of changes in equity.
In relation to providing a comprehensive overview of an entitys financial performance,
paragraph 99 of AASB 101 Presentation of Financial Statements states:
This Standard requires all items of income and expense recognised in a period to be
included in profit or loss (that is, in the income statement) unless another
Australian Accounting Standard requires otherwise. Other Australian Accounting
Standards require some gains and losses (such as revaluation increases and
decreases, particular foreign exchange differences, gains or losses on remeasuring
available-for-sale financial assets, and related amounts of current tax and deferred
tax) to be recognised directly as changes in equity. Because it is important to
consider all items of income and expense in assessing changes in an entitys
financial position between two reporting dates, this Standard requires the
presentation of a statement of changes in equity that highlights an entitys total
income and expenses, including those that are recognised directly in equity.
Because many gains and losses do not go through the income statement, a review of the
income statement will therefore tend to provide an incomplete picture of the financial
performance of a reporting entity. With this in mind there is a requirement for a reporting
entity to disclose a statement of changes in equity. According to paragraphs 96 and 97 of
AASB 101:
96. An entity shall present a statement of changes in equity showing on the face of
the statement:
(a) profit or loss for the period;
(b) each item of income and expense for the period that, as required by other
Australian Accounting Standards, is recognised directly in equity, and the total
of these items;

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(c)

total income and expense for the period (calculated as the sum of (a) and (b)),
showing separately the total amounts attributable to equity holders of the
parent and to minority interest; and
(d) for each component of equity, the effects of changes in accounting policies and
corrections of errors recognised in accordance with AASB 108.
A statement of changes in equity that comprises only these items shall be titled a
statement of recognised income and expense.
As the above paragraph indicates, if the statement of changes in equity only includes the
components listed in paragraph 96 of AASB 101, then the statement shall be referred to as a
statement of recognised income and expense, and will not be referred to as a statement of
changes in equity. For the statement to be referred to as a statement of changes in equity it
must also include the requirements of paragraph 97 of AASB 101 as well as the requirements
of paragraph 96. Paragraph 97 of AASB 101 requires:
97. An entity shall also present, either on the face of the statement of changes in
equity or in the notes:
(a) the amounts of transactions with equity holders acting in their capacity as
equity holders, showing separately distributions to equity holders;
(b) the balance of retained earnings (i.e. accumulated profit or loss) at the
beginning of the period and at the reporting date, and the changes during the
period; and
(c) a reconciliation between the carrying amount of each class of contributed
equity and each reserve at the beginning and the end of the period,
separately disclosing each change.
14.13 31 July 2009
Dr
Bank trust
1 400 000
Cr
Application account
1 400 000
(To recognise the aggregate receipt of application monies. The application account is
considered to be a liability.)
4 August 2009
Dr
Cr

Application account
Share capital

1 400 000
1 400 000

(Once the shares are allotted, the company no longer has a liability to the subscribers. The
subscribers become owners of the entity, rather than creditors.)
Dr
Cr

Cash at bank
Bank trust

1 400 000
1 400 000

(Once the shares have been allotted the company can then transfer the cash to its usual
operating account.)
14.14 15 July 2009
Dr
Cr

Bank trust
Application account

11 000 000

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11 000 000
145

(To recognise the aggregate receipt of application monies. The application account is
considered to be a liability.)
20 July 2009
Dr
Cr

Application account
Share capital

10 000 000
10 000 000

(To allot 10 million shares as paid to $1 per share.)


Dr
Cr

Allotment
Share capital

10 000 000
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 is shown in the balance sheet as a deduction
from share capital.)
Dr
Cr

Application account
Allotment

1 000 000
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
Cr

Cash at bank
Bank trust

11 000 000
11 000 000

(Once the shares have been allotted, the company can then transfer the cash to its usual
operating account.)
20 August 2009
Dr
Cr

Cash at bank
Allotment

8 100 000
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 2009
Dr
Cr
Cr

Share capital
Allotment
Forfeited shares account

2 000 000
900 000
1 100 000

(To record the forfeiture of 1 million shares. Each forfeited share had been paid to $1.10.)
Dr
Dr
Cr

Cash at bank
Forfeited share account
Share capital

1 500 000
500 000
2 000 000

(To recognise the amount received on the auction of the forfeited shares.)

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Dr
Cr

Forfeited shares account


Cash at bank

600 000
600 000

(Return of the balance of the forfeited shares account to the defaulting shareholders.)
14.15 As with the public issue of shares, the monies received from the rights issue must initially be
placed in the trust account.
10 September 2009
Dr Bank Trust
Cr Application

39 000 000
39 000 000

Because of the undersubscription, the underwriter is required to acquire the additional two
million shares. The amount due from the underwriter is a receivable.
Dr
Cr

Receivable underwriter
Application

17 September 2009
Dr Cash at Bank
Cr Receivable underwriter
Cr Bank Trust
Dr
Cr

Application
Share Capital

6 000 000
6 000 000
45 000 000
6 000 000
39 000 000
45 000 000
45 000 000

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14.16 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 2009
Dr Salaries expense
Cr Share options

1 000 000
1 000 000

Given that the options are exercised by the chief executive officer the following entries are
required:
31 December 2011
Dr Cash at Bank
7 000 000
Cr Share Capital
7 000 000
Dr Share options
Cr Share Capital

1 000 000
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.
14.17 (a)

Because the shares offer a fixed rate of return and are redeemable at the option of the
shareholder they would be more debt-like than equity-like. They would be disclosed
as a liability.

(b)

If we assume that this is a private placement of shares and that the shares are
redeemed out of profits rather than through the issue of additional preference shares,
then the entries would be as follows:
1 July 2009
Dr
Cr

Cash at bank
Share capitalpreference shares

2 000 000
2 000 000

30 June 2011
Dr
Cr
Dr
Cr

Share capitalpreference shares


Capital redemption reserve
Retained earnings
Cash

2 000 000
2 000 000
2 000 000
2 000 000

There is also a requirement that any balance in the capital redemption reserve be transferred
to share capital. Hence the following entry is also required on 30 June 2011:
Dr
Cr

Capital redemption reserve


Share capital

2 000 000
2 000 000

Because the preference shares would have been treated as debt, the effect of the combined
entries on 30 June 2011 is that share capital has increased.
14.18 July 2009
Dr

Bank trust

12 000 000

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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 2009
Dr
Cr

Application account
Share capital

10 000 000
10 000 000

(To allot 10 million shares as paid to $1 per share.)


Dr
Cr

Allotment
Share capital

10 000 000
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
Cr

Application account
Allotment

2 000 000
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
Cr

Cash at bank
Bank trust

12 000 000
12 000 000

(Once the shares have been allotted the company can then transfer the cash to its usual
operating account.)
5 September 2009
Dr
Cr

Cash at bank
Allotment

6 400 000
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 2009
Dr
Cr
Cr

Share capital
Allotment
Forfeited shares account

4 000 000
1 600 000
2 400 000

(To record the forfeiture of 1 million shares. Each forfeited share had been paid to $1.20 per
share.)
15 September 2009
Dr
Dr

Cash at bank
Forfeited share account

3 600 000
400 000

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Cr

Share capital

4 000 000

(To recognise the amount received on the auction of the forfeited shares.)
Dr
Cr

Forfeited shares account


Cash at bank

2 000 000
2 000 000

(Return of the balance of the forfeited shares account to the defaulting shareholders.)

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