LECTURE NOTS

Last lecture -Lecture 4

Equity:
Companies: Formation and
Operations
 OBJECTIVES
1. Describe the different types of companies permitted to exist by law in
the Australian business environment and summarise the advantages
and disadvantages of the corporate form of organisation
2. Describe the documentation required for forming a company and identify the
management structure commonly used for administering a company
3. Describe the three main categories of equity in a company
4. Account for the issue of shares
5. Account for the declaration and payment of cash dividends on shares,
share dividends and share splits
6. Account for the creation and reduction of the different types of reserves that are
included in equity
7. Prepare basic entries of income tax expense in a company
PART 1
 TYPES OF COMPANIES
A company is a legal entity or artificial person, separate and
distinct from its owners.

1. Limited companies
– Proprietary companies – shares
– Public companies - shares
– Companies limited by guarantee – no shares
2. Unlimited companies
3. No-liability companies
4. Special companies
– Investment
– Banking
– Life insurance
 LIMITED COMPANIES
• The shareholders in a limited company are
liable only to the extent of the amount
unpaid on their shares up to the full issue
price of those shares.

5
 ADVANTAGES OF
THE CORPORATE
ENTITY
• Limited liability
• Broad source of capital
• Continuity of existence
• Ready transferability of shares
• Use of professional
management
 DISADVANTAGES OF
COMPANIESCORPORATE
ENTITY
• Greater governmental regulation
• Separation of ownership and
management
• Can be costly
 FORMING A COMPANY
• Application lodged to reporting body in
the domiciled country e.g. China
– Application requirements
• Replaceable rules and constitution
• Certificate of registration
• The prospectus
– Raising funds
ADMINISTERING A COMPANY
ADMINISTERING A COMPANY
• Shareholders are owners, but administration
rests with directors
• Duties of the board of directors include
– Protecting rights of shareholders
– Setting officers’ salaries
– Recommending and declaring dividends
– Authorising long-term borrowing, additional
share issues and major capital projects
– Reviewing the system of internal control
 CATEGORIES OF EQUITY IN A
COMPANY
• The equity of a typical company split into 3
major categories:
– Share capital
• Fully or partly paid shares
• Ordinary or preference shares
– Retained earnings
• Or accumulated losses
– Other reserves
 ACCOUNTING FOR SHARE
ISSUES
Number of choices available:
• Types of shares
– Ordinary shares
– Preference shares
• Payment for shares
– Payable in full on application
– Deposit payable on application and the remainder
on allotment
– Part payment on application, part on allotment,
and remainder in one or more instalments or calls
 PRIVATE SHARE ISSUES (similar to
Debenture issues)
• Money may be raised privately by prospective
shareholders contributing funds to the
company
• Example – Two shareholders each contribute
$50,000 to buy shares in a proprietary
compan General Journal
yJul 1 Cash at Bank 100 000
Share Capital 100 000
(Cash contributed to the company by its
two shareholders)
 PUBLIC SHARE ISSUE, PAYABLE
INFULL ON APPLICATION
• Shares issued via a prospectus
• Example – Sept 30: Brazil Ltd received applications
for 100,000 shares at an issue price of $10 each
General Journal
Sept 30 Cash Trust 1 000 000
Application 1 000 000
(Receipt of cash of $10 per share on
100 000 shares)
 PUBLIC SHARE ISSUE, PAYABLE
INFULL ON APPLICATION
• If the number of shares applied for exceed the
number being issued excess funds must be
refunded
General Journal
Sept 30 Application X
Cash Trust X
(Refund excess application money to
unsuccessful applicants)
PUBLIC SHARE ISSUE, PAYABLE IN
FULL ON APPLICATION
• When the shares are allotted
– Application money becomes available for use
– Share capital is recognised

General Journal
Oct 1 Cash at Bank 1 000 000
Cash Trust 1 000 000
(Application money transferred to cash
account)

Application 1 000 000

Share Capital 1 000 000
(Allocation of 100 000 shares paid in
full) 16
 PUBLIC SHARE ISSUE, PAYABLE BY
INSTALMENT INSTALMENTS

• Example – Sept 15: Brazil Ltd decides to issue

100 000 shares, payable in three instalments
– $4 on application
– $3 payable on 15 October
– $3 payable on 1 December
General Journal
Sept 30 Cash Trust 400 000
Application 400 000
(Receipt of cash of $4 per share on
100 000 shares)
 PUBLIC SHAREISSUE,
INSTALMENTS
• Transfer to Cash at Bank of application money
General Journal
Oct 1 Cash at Bank 400 000
Cash Trust 400 000
(Application money transferred to cash
account)
 PUBLIC SHARE ISSUE, PAYABLE BY
INSTALMENTS
• Allotment of shares and amounts due
General Journal
Oct 1 Application 400 000
Share Capital 400 000
(Allocation of 100 000 shares paid to $4)

Oct 1 Allotment 300 000

Share Capital 300 000
(Allotment fee of $3 receivable on
100 000 shares)
 PUBLIC SHAREISSUE, PAYABLE
BY INSTALMENTS
• Receipt after allotment
General Journal
Oct 15 Cash at Bank 300 000
Allotment 300 000
(Cash received on allotment)
 PUBLIC SHARE ISSUE, PAYABLE BY
INSTALMENTS
• Amounts due on call and receipt
General Journal
Nov 15 Call 300 000
Share Capital 300 000
(Call of $3 receivable on 100 000 shares)

Dec 1 Cash at Bank 285 000

Call 285 000
(Call money
received on
95 000
shares)
 PUBLIC SHARE ISSUE, PAYABLE BY
INSTALMENTS
• Note that holders of 5 000 shares have not
paid the call.
– Also known as calls in arrears
– Deducted from share capital in balance sheet
Balance Sheet (partial)
Share Capital
- 100 000 ordinary shares called to $10 $1 000 000
Less: Unpaid calls (5 000 shares @ $3) 15 000
Total share capital $ 985 000
 UNDERSUBSCRIPTION AND
OVERSUBSCRIPTION
• Undersubscription
– Applicants for fewer shares than offered (but
above minimum subscription)
• Oversubscription
– Applicants in excess of shares
– Treatment depends on constitution and
prospectus
– Excess monies may be refunded or held against
future calls
 RIGHTS ISSUE OF SHARES
• An issue of new shares giving existing
shareholders the right to an additional number
of shares in proportion to current
shareholding
• If renounceable, then 3 options:
1. Exercise rights and acquire more shares
2. Decline to exercise rights and let lapse
3. Sell rights on stock exchange
 EXAMPLE – RIGHTS
ISSUE OF SHARES
• Mexico Ltd
– Planned to raise $4.2 million from existing shareholders
through a renounceable 1-to-6 rights issue
– Terms were 6 478 611 shares to be issue at 65c each
– Market price of company’s shares was 80c
General Journal
Cash at Bank 4 211 097
Share Capital 4 211 097
(Receipt of 65c per share on rights issue of
6 478 611 shares)
 BONUS SHARE ISSUE
• An issue of shares to existing shareholders in
proportion of their current shareholdings, at no
cost to shareholder
• Reasons for bonus share issue
– Provide ‘return’ to shareholder without cash outlay
– Capitalise reserves or retained earnings by converting
to share issue
– Signal to capital market that company expects good
future profitability levels
 EXAMPLE– BONUS
SHARE ISSUE
• Assuming that a bonus issue of $60 000 is
declared and paid out of general reserve, the
accounting entry is:
General Journal
General Reserve 60 000
Share Capital 60 000
(Payment of bonus share issue out of
general reserve)
END OF PART 1
10 MINUTE
BREAK
PART 2
 FORMATION COSTS AND
SHARE ISSUE COSTSSTS
• Formation Costs
– Also known as preliminary or start-up costs
– Include registration, legal, accounting fees etc.
– Must be expensed as incurred
• Share Issue Costs
– Stamp duty, broker and underwriter fees etc.
– These costs are treated as a deduction from equity
(contra-equity)
 PREFERENCE SHARES
• Preferential treatment
– Dividend distribution (at fixed rate)
– Distribution of assets on liquidation
– Redemption
• Usually no voting rights
• Debt or equity?
– Substance vs Form
 DIVIDENDS

• Distribution of cash or other assets or shares

• May be interim or final
• Must not be paid unless
– Assets exceed liabilities
• Move from “Profits” test toward “Solvency” test
– Payment of dividend is fair and reasonable
– Payment does not prejudice creditors
• Directors determine if dividend is payable and fix amount, payment time and payment
method
 CASH DIVIDENDS
• Declaration and Payment of Final Dividends
General Journal
Aug 25 Retained Earnings 80 000
Final Dividend Payable 80 000
(Declared a cash dividend of 20c per share
on 400 000 ordinary shares)

Sept 20 Final Dividend Payable 80 000

Cash at Bank
80 000
(Payment of dividend declared on 25
August)
 PREFERENCE DIVIDENDS
• Dividends must be paid on preference shares
before any are paid on ordinary shares
• Preference shares may be cumulative
– Any undeclared dividends accumulate
– Accumulated amount plus current year’s preference
dividend must be paid before any dividend to ordinary
shareholders
• Participating Preference Shares
– Rights to further dividends under certain conditions
 SHARE DIVIDENDS
(Bonus Share Issue)
• Pro rata distribution of additional shares to
shareholders
• No effect on corporate assets or total
equity
• “Capitalising” profits
General Journal
General Reserve 12 500
Share Capital 12 500
(Distribution of a 1-for-20 share dividend
on 250 000 ordinary shares, at a value of
$1 each)
 SHARE SPLITS
• Share splits
– Reduce the market price of shares
– Make shares available to wider range of investors
• No journal entry necessary because no change in
balance in any of the equity accounts
 RESERVES
• Represent those items of equity other than capital
contributed by owners
• Retained Earnings
– Others created by ‘transfers’ from retained earnings
• Examples:
– Revaluation surplus
– General reserve
– Options reserve
– Plant replacement reserve
 CREATION OF RESERVES
• Basic journal entry
General Journal
Jun 30 Retained Earnings X
Reserve X
(Creation of reserve from profits)

• Creation of revaluation surplus

General Journal
Jun 30 Asset X
Accumulated Depreciation X
Revaluation Surplus X
(Revaluation upwards of the carrying
amount of a non-current asset to fair value) 36
 DISPOSAL OF RESERVES
• Reserve accounts may be written off or
reduced through
– Payment as a dividend (refer previous
discussion)
– Transferring back to retained earnings
General Journal
Jun 30 Reserve X
Retained Earnings X
(Transfer of reserve to profits)
 INCOME TAX
• Deducted after all other expenses before
arriving at final profit after tax
• Based on ‘taxable income’
– Income Tax Assessment Act
• Tax-effect accounting
 FINANCIAL STATEMENTS
Income Statement Shows all relevant income and
(Statement of Profit or Loss and Other expenses to measure profit
Comprehensive Income) performance for the period

Shows how equity accounts have

Statement of Changes in Equity
changed in the period

Balance Sheet Shows assets, liabilities and equity

(Statement of Financial Position) on last day of period

Statement of Cash Flows Shows sources and uses of cash

resources during the current period
 !!!

See you Monday

(workshop 5)