Financial Accounting-II

Comprehensive Assignment

Submitted To: Submitted By:

Sir Daniyal Hashmi Bushra Naz (20105)

Question: (1)

 Assume that you are starting a business. What are the possible sources of financing
you can look for? Briefly explain each with its advantages and disadvantages.

Sources of financing
 Long-Term Sources of Finance
 Medium Term Sources of Finance
 Short Term Sources of Finance
 Owned Capital
 Borrowed Capital
 Internal Sources
 External Sources

Source Of Finance Advantages Disadvantages

Owners Capital o Quick and o The owner not have
convenient might enough
o Does not requiring savings or may
borrowing money need the cash for
o No interest personal use
payment to make o Once the money is
gone, it gone
Retained Profits o Quick and o Once the money is
convenient gone it is not
o Easy access to the available for any
money future unforeseen
o No interest problems the
payment to make business might face
Selling Assets o Can create space for o Might not get the full
more profitable uses market value of the
o Can be quick assets or even be able
o Raise money from to sell them at all
unused equipment o Might need the assets
 in the future

Family And Friends o Low interest o Money may be lost if

o Money may not need
to be paid back
the business fails
o Arguments may occur
between family
members

Bank Loans o Easy and quick to o Have to pay interest

access o Difficult for a new
o Can get a significant business to access
amount of money at
one time

Overdraft o Quick access o High interest rates

o Allows emergency o Is only a short term
purchases solution

Venture Capitalists And o Gain money quickly o Owner must give

Business Angels away part of the
o Potential to raise huge
business
amount of money
o They may have a
o They may offer advice
different vision for the
and help
business than the
owner does

 Why is preferred stock called as “hybrid security”?

Preferred stock is referred to a hybrid security because it has similarities to both

common stock and bonds. Common stocks aren't paid regularly, and their value is dependent on
the growth rate of their dividends. Preferred stock is paid regularly, and their value is fixed.
Preferred stock is a hybrid security because it combines features of common stocks and bonds.
At the same time, it has several unique features that set it apart from both. Preferred
stocks combine features of common stocks and bonds.

 How can you differentiate between “company” from other forms of business?
A company is a legal entity formed by a group of individuals to engage in and operate
a business, commercial or industrial enterprise. A company may be organized in various ways
for tax and financial liability purposes depending on the corporate law of its jurisdiction.

The three basic types of companies:

 Private Companies
 Public Companies
 One Person Company (to be formed as Private Limited).

Difference Between Company & Corporation:

 The main difference between corporations and companies is the size. The corporation is a
big business or entity whereas the company is a small business or entity.
 The owners of a corporation are the shareholders whereas the owner of the company is its
members.
 The corporation is a legal entity but the company is an invisible legal entity that exists
only on a paper.
 The corporation is more structured and complex than a company.
 The management and owners don’t interfere in the daily functions of the business in the
corporation but on the other hand, the company owners interfere and run the daily tasks
of the business.
 There are more professionals observed in the corporation as employees than the
company.
 The types of corporations are C Corporation and S Corporation and the types of
companies are sole proprietorship, partnership, limited liability corporation, limited
liability partnership, and corporation.
 The corporation could only be incorporated but the company can be both incorporated
and corporate.

Question: (2)
 What is meant by “initial public offering”? Explain the process in detail.

An initial public offering (IPO) refers to the process of offering shares of a private corporation to
the public in a new stock issuance. Public share issuance allows a company to raise capital from
public investors. The transition from a private to a public company can be an important time for
private investors to fully realize gains from their investment as it typically includes share
premiums for current private investors. Meanwhile, it also allows public investors to participate
in the offering.

7 steps in process IPO:

Step 1: Choose an IPO Underwriter
The first step of the IPO process requires the company to select an investment bank. These banks
are registered with the SEC (Securities and Exchange Commission) and act as underwriters. IPO
underwriters are specialists who work alongside the company issuing the IPO. They help
determine the initial offer price, buy the shares from the issuing company and then sell the shares
to investors. Usually, they have a network of potential investors to reach out to in order to sell
the shares. There a few things to consider when choosing an underwriter:

 Reputation
 Quality of research
 Industry expertise
 Network distribution reach
 The company’s prior relationship with the investment bank
 The underwriter’s past relations with other companies.

Underwriting an IPO can be a long and expensive process. It requires time, money and a team of
experts. But a good underwriter can be the difference between a successful IPO and an IPO
failure.

 Step 2: Due Diligence

Due diligence is the most time-consuming part of the IPO process. In this step, there’s a pile of
paperwork the company and underwriters fill out. The issuing company needs to register with the
SEC. Then, there are contracts between the company and the underwriter.

 Firm Commitment. This agreement states the underwriter will purchase all shares from
the issuing company. They will resell them to the public.

 Best Efforts Agreement. The underwriter does not guarantee an amount of money but

will sell the shares on behalf of the issuing company.

 Syndicate of Underwriters: Sometimes IPOs come with large risk, and the bank doesn’t
want all of it. In this case, a group of banks will come together under the leading bank to
form an alliance. This alliance allows each bank to sell part of the IPO, diversifying the
risk.

 Engagement Letter: There are usually two parts of an engagement letter:

The reimbursement clause states the issuing company will cover the underwriter’s out-of-pocket
expenses.

The gross spread, also known as the underwriting discount, is typically used to pay the
underwriter’s fee and/or expenses. It can be found by taking the price the underwriter paid for
the shares and subtracting it from the price they sell them for. Think of it as wholesale. Because
the underwriter is buying all of the shares, they receive a discounted price.
For example, there are 1,000 shares each priced at $10. The underwriter purchases them for $8
per share, spending $8,000. Then, the underwriter sells the shares on the market at their $10
value, making $10,000. That’s a gross spread of $2,000.

Letter of Intent: There are three parts to a letter of intent:

Underwriter’s commitment to the company

Company’s agreement to provide all information and cooperate

Company’s agreement to offer underwriter a 15% overallotment option.

Red Herring Document: This is a preliminary prospectus that includes information about the
company’s operations and prospects except for key issue details, such as price and number of
shares.

Underwriting Agreement: Once the price of shares is determined, the underwriter is legally

bound to purchase the shares at the agreed-upon price.

S-1 Registration Statement. This is required to be submitted to the SEC. There are two parts:

Information Required in Prospectus — The prospectus is a legal document provided to everyone

who is offered and/or buys the stock. It must clearly describe the company’s business operations,
financial state, operations results, risk factors and management. Audited financial statements
must also be included.

Information Not Required in Prospectus – Includes additional information and exhibits that the
company is not required to deliver to investors but must file with the SEC.

 Step 3: The IPO Roadshow

An IPO roadshow is a traveling sales pitch. The underwriter and issuing company travel to
various locations to present their IPO. They market the shares to investors to see what demand, if
any, there is. Looking at investor interest, the underwriter can better estimate the number of
shares to offer.

 Step 4: IPO Price

Once approved by the SEC, the underwriter and company can decide the effective date, number
of shares and the initial offer price. Typically, the price is determined by the value of the
company. This is done by the valuation process and occurs before the IPO process even begins.

There are a couple factors to consider when pricing an IPO:

 Value of issuing company

  Reputation of issuing company
 Success/failure of the IPO roadshow
 The issuing company’s goals (i.e., amount of money to raise)
 The condition of the economy.

It’s common for an IPO to be underpriced. When underpriced, investors will expect the price to
rise, increasing demand. It also reduces the risk investors take by investing in an IPO, which
could potentially fail.

 Step 5: Going Public

Now that everything is decided, it’s time for the IPO to go live! On the agreed-upon date, the
underwriter will release the initial shares to the market.

 Step 6: IPO Stabilization

There is a short window of opportunity where the underwriter can influence the share price.
During the 25-day “quiet period,” which occurs immediately after the IPO, there are no rules
preventing price manipulation. The underwriter ensures there’s a market and buyers to maintain
an ideal share price. There are a couple of strategies used by underwriters:

Green shoe Option

In the letter of intent, there is a clause that allows an overallotment option. Also known as
the green shoe option, this allows underwriters to sell more shares than originally planned. Then
the underwriter buys them back at the original IPO price.

If the share price decreases, the underwriter buys back the over-allotted shares. The underwriter
will make a profit because the price is less than what they originally sold it for.

If the share price increases, the underwriter has the option to buy the shares at the original IPO
price, avoiding loss. This is stated in the contract with the company under the overallotment
clause.

Overallotment is a popular choice because it’s both SEC-permitted and risk-free. While
overallotment is the legal term, it’s commonly referred to as the green shoe option because Green
Shoe Manufacturing (now Stride Rite) was the first company to do it.

Lock-Up Period

At the beginning of this article, it was mentioned that when a company goes public, anyone who
already owned shares could cash out. However, those shares can only be sold following a lock-
up period.
A lock-up period is a predetermined amount of time, usually lasting between 90 and 180 days,
when insiders who owned shares before the company went public are not allowed to sell their
stock. This avoids flooding the market with the company’s shares and driving the price down.

 Step 7: Transition to Market Competition

This is the final stage of the IPO process. After the 25-day quiet period, the underwriter and
investors transition from relying on the prospectus to looking at the market.

Everything is now public and out of the underwriter’s hands. The underwriter can provide the
company with estimates on the company’s earnings and post-IPO valuation. The underwriter
also moves into the role of advisor as the shares fluctuate in the public market.

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Question: (3) (Marks=05)

Khuzdar Mines ltd. has a nominal capital of Rs. 2,400,000 divided into 240,000 ordinary shares
of Rs. 10 each. The whole of the capital was issued at par on the following terms:

Payable on application Rs. 4

Payable on allotment Rs. 3
First call Rs. 2
Second call Rs. 1

Application were received for 300,000 shares and it was decided to allot the shares on
proportionate basis. The balance of application monies was applied to the allotment, no cash
being refunded. The subscribers paid the balances of allotment monies.

The calls were made and paid in full by the subscribers, with the exception of a subscriber who
failed to pay the first and second calls on the 1000 shares allotted to him. A resolution was
passed by the directors to forfeit the shares. The fortified shares were later issued at Rs 9 each.

Show the ledger accounts recording all the above transactions and the relevant extracts from a
balance sheet after all the transactions had been completed.
Cash account 1200,000

Share application 1200,000

Share application 1200,000

Bank a/c 480,000

Equity share capital 1680,000

Bank a/c 478000

Equity share capital 478000

Bank 239000

Equity share capital 239000

Equity share capital 7000

Forfeited share 7000

Bank a/c 9000

Forfited share 1000

Equity share capital 10,000

Forfited share as 6000

Capital reserve 6000

Question: (4) (Marks:04)

What do you understand by term “reserves”? Differentiate between revenue and capital
reserves.
Reserves is known as retained earnings or portions of a business’s profits which have been set
aside to strengthen the business's financial position.
Revenue reserves: Revenue reserves are portions of profits earned by a company’s normal
operations which are then set aside.

Capital reserves: Capital reserves are created out of capital profits – profits which arise from
sources other than normal trading activities. Capital reserves are usually set aside for capital
losses.

Capital Reserve Revenue Reserve

                                                                               Definition

A capital reserve is created to finance long term Revenue reserve is created to meet unforeseen
projects for a business events in a business organization

                                                                            Reserve Source

To meet the specific purpose of meeting the To be used as reinvestment for company
accounting principles

                                                                                   Tenure

Can be used for long term projects Can be used for short term purpose

                                                                    For dividend payout

Cannot be distributed as dividend Can be used for dividend payout

                                                                                   Example

Capital reserve is created by the sale of fixed Revenue reserve is created from retained earnings
assets