Download What is Preference Shares - Oman College of Management

Company Accounting
Dr S.M.Tariq Zafar
M.Com, PGDMM, PhD (Social Sector Investment)
[email protected],
[email protected]
Chapter - II
Issue of Bonus, Right and
Preference Shares
Chapter II- Issue of Bonus and Right Shares
Chapter Outcomes:
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Issue of Bonus and Right Shares
Objective of Bonus Shares:
Advantages and Disadvantages of the Issue of Bonus Shares:
Right Share Issue
What is Preference Shares
Preference shares can be subdivided in different classes.
Redemption of Preference Shares
Method of Redemption
Issue of Bonus and Right Shares:
Bonus shares are shares issued by a company free of charges to
its existing share holders on a prorata basis. These shares are
created by the conversion of retained earnings or otherwise
reserves into equity share capital. Issue of bonus share does not
represent a source of fund to the company. When bonus shares
are issued, the size of the company does not change and in effect,
the assets side of the Balance remains unaffected. On the
liabilities side, the reserves are reduced by the amount of the
increase in the equity share capital. Reserves capitalized in this
way no longer become available for distribution as dividend. In
principle, shareholders are primarily no better off as a result of
bonus issue, though no cash is paid to acquire these shares. And
because of this the total value of the company remains
unaffected, though the numbers of shares held by shareholders is
increased by a bonus issue.
Objective of Bonus Shares:
Bonus shares are issued by the company for the following reasons.
 The management may opt for an issue of bonus shares in order to make
the paid up capital correspond to the capital actually employed in the
business.
 By issue of bonus shares the cash reserves of the company are conserved.
When a new project is under implementation which may take a few years
to start giving increasing returns, it may be prudent to wait till the project
is completed and increased returns start coming.
 Issue of bonus shares will reduce the chance of take over bids.
 Issue of bonus shares is an indication to the investors that the company
has good prospects.
 Issue of bonus shares is an inexpensive method of raising capital base of
the company.
 Issue of bonus shares reduces the market price of the share, thus
rendering them more marketable.
Advantages of the Issue of Bonus Shares:
 The shareholders get back their undistributed profit in the shape of
shares.
 Company can keep its shareholders happy without impairing the
financial position and liquidity of the company
 The security of the creditors will increase owing to increase in share
capital.
 It will increase the number of shares in the hands of existing shareholders
without any extra payment, thus it will increase the marketability of
shares.
Disadvantage of the Issue of Bonus Share:
 The rate of dividend in future will decline sharply, which may create
confusion in the minds of the investors.
 It will encourage speculative dealing in the company’s shares.
 Prior approval of the government must be obtained before the bonus
issue. The lengthy procedures, some times, may delay the issue of bonus
shares.
Example:
A company has the following capital structure:
1,00,000 Equity Shares of RO each
10,00,000
Securities Premium Account
1,00,000
Profit and Loss Account
5,00,000
The company decides to make a bonus issue of 1 for 4 basis (this shareholders
will receive one new share for every four existing shares they own) by
making use of Shares Premium Account and Profit and Loss Account.
Therefore, the company requires RO 2,50,000 (RO 1,00,000 from
Securities Premium Account and RO 1,50,000 from Profit and Loss
Account).
After the bonus issue, the capital structure of the company will appear as
below.
RO
1,25,000 Equity Share of RO 10 Each
12,50, 000
Profit and Loss Account
3,50, 000
After the issue of bonus shares, the market price of shares will drop initially
but in the long run the market price will gradually climb up to its former
value.
Right Share Issue:
 Aright issue is a cheapest form of raising finance. It is an issue
in which the existing shareholders have a pre emptive right to
subscribe for new shares. In right issue no prospectus is issued
or offer for sale of shares is made; instead, existing equity
shareholders are given the rights certificate. The price of the
share so offered is usually below listed price to make the offer
attractive and encourage shareholders to subscribe more shares.
Company can raise more money by issuing greater number of
right issue. An existing shareholder who does not wish to
exercise any or all of the rights is at liberty to sell them to third
parties who can purchase such shares at a specified price.
 Right issue are raised by the company mainly due to two
reason, firstly right issue is the only way for the company to
raise the finance when it is in need of cash to carry out existing
operations. In this condition the share price of the company
may fall due to the reason that same profit will be distributed to
more number of shareholders.
 Secondly if expansion is slated then it is assumed that it will
generate the same return as existing operation then market price of
the share will be unaffected. The existing shareholders will be
neither better nor worse off, since the value of the company
remains unchanged.
 The accounting entries in the books of the company for a rights
issue are same as those required for a new issue of shares to the
public. Existing shareholders know in advance the number of
shares to which they are entitled thus question of under
subscription does not arise.
What is Preference Shares:
 Preference shares, more commonly referred to as Preferred
Stock are shares of a company’s stock with dividends that are paid
out to shareholders before common Stock Dividends are issued. If
the company enters bankruptcy, the shareholders with preferred
stock are entitled to be paid from company assets first. Most
preference shares have a fixed dividend, while common stocks
generally do not. Preferred stock shareholders also typically do not
hold any Voting Rights, but common shareholders usually do.
Preference shares can be subdivided in different classes.
 Cumulative and Non Cumulative Preference Shares: Cumulative
preferred stock includes a provision that requires the company to
pay preferred shareholders all dividends, including those that were
omitted in the past, before the common shareholders are able to
receive
their
dividend
payments.
 Redeemable and Non Redeemable Preference Shares: Noncumulative preferred stock does not issue any omitted or unpaid
dividends. If the company chooses not to pay dividends in any
given year, the shareholders of the non-cumulative preferred stock
have no right or power to claim such forgone dividends at any
time
in
the
future.
 Participating and Non Participating Preference Shares:
Participating preferred stock provides its shareholders with the
right to be paid dividends in an amount equal to the generally
specified rate of preferred dividends plus an additional dividend
based on a predetermined condition. This additional dividend is
typically designed to be paid out only if the amount of dividends
received by common shareholders is greater than a predetermined
per-share amount. If the company is liquidated, participating
preferred shareholders may also have the right to be paid back the
purchasing price of the stock as well as a pro-rata share of
remaining proceeds received by common shareholders.
Cumulative Convertible Preference Shares:
 Convertible preferred stock includes an option that
allows shareholders to convert their preferred shares
into a set number of common shares, generally any time
after a pre-established date. Under normal
circumstances, convertible preferred shares are
exchanged in this way at the shareholder's request.
However, a company may have a provision on such
shares that allows the shareholders or the issuer to force
the issue. How valuable convertible common stocks are
is based, ultimately, on how well the common stock
performs.
Redemption of Preference Shares:
 Redemption is the process of repaying an obligation, usually at
prearranged amounts and times. The conditions of the issue of
preference shares include a call provision, i.e., a contract given
the right to redeem preference shares within or at the end of a
given time period at an agreed price. These shares are issue on the
terms that holders will at some future date be repaid the amount
which they invested in the company.
 The redemption date is the maturity date, which specifies when
repayment take place and is usually printed on the preference
share certificate. By the process of redemption, a company can
also adjust its financial structure, for example, by eliminating
preference shares and replacing those with other securities if
future growth of the company makes such change advantageous.
Method of Redemption:
The ‘gap’ created in the company’s capital by the redemption of
redeemable preference shares must be filled in by
 The proceeds of a fresh issue of shares
 The capitalization of undistributed profits’ or
 A combination of (a) and (b)
Fresh Issue of Shares: One of the prescribed methods for
redemption is to use the proceeds of a fresh issue of shares. A
company can issue new shares (Equity and Preference Share)
and the proceeds from such new shares can be used for
redemption of preference shares.
The Capitalization of Undistributed Profits:
Another method of redemption of preference shares, allowed
by the companies Act, is to use the distributable profit instead
of issuing new shares. When shares are redeemed by utilizing
distributable profit, an amount equal to the face value of share
redeemed is transferred to Capital redemption Reserves
Account by taking part of the distributable profit. In other
words, some of the distributable profits are frozen to ensure
that it can never be distributed to shareholders as dividend.
Combination of Both Methods:
A company can redeem the preference shares partly from the
proceeds from new issue and partly out of profits. In order to
fill the gap between the face value of shares redeemed and the
proceeds of new issue, a transfer to be made from distributable
profit (Profit & Loss Account, general reserves and free
reserves) to Capital Redemption Reserves Account.