Equity Financing

Dr. Derek K. Chan

HKU
Outline
1. Overview of Shareholders Equity
1.1 Share Capital Accounts
1.2 Characteristics and Rights of Ordinary Shareholders
1.3 Characteristics and Rights of Preference Shareholders
1.4 Different Kinds of Preference Share
2. Accounting for Sale and Issuance of Shares
2.1 Issuance of Share for Cash
2.2 Issuance of Share for Noncash Consideration
2.3 Conversion of Preference Share to Ordinary Share
2.4 Rights Issue, Warrants, and Options

Equity Financing 2
 3. Repurchase of Shares
3.1 Purchase and Redemption of Shares
3.2 Journal Entries for Purchase or Redemption of Shares
4. Distribution of Profits
4.1 Distributable Profits
4.2 Cash Dividend
4.3 Property Dividend
4.4 Stock Dividend and Stock Split
5. Statement of Changes in Shareholders Equity
Accounting methods discussed in the lecture notes are somewhat
different from those of the textbook, especially the part on the
issuance and repurchase of shares.
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Remarks:
The New Companies Ordinance, which has been
come into operation since 3 March 2014, abolishes
the concept of par (or nominal) value for all
shares in Hong Kong companies.
Consequently, the concepts of share premium,
capital redemption reserve and authorized share
capital have also been abolished.
These changes apply to shares issued before and
after the new legislation takes effect, and both
existing and new companies.
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1. Overview of Shareholders Equity
Shareholders Equity (also called Shareholders Funds in
HK) represents the residual claim on the assets of the firm by
its owners/shareholders.

Shareholders Equity = Assets Liabilities

Issued Capital Net Assets

Retained Earnings/Profits

Reserves (other gains/losses not included in net profits)

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1.1 Share Capital Accounts
There are two major categories of issued share capital:
1. Ordinary Shares (Common Stock in US) is the share
required to be issued under the corporate form of
ownership.
2. Preference Shares (Preferred Stock in US), when issued,
have certain preferences as to dividend payments and
rights in liquidation.

Remark: Preference shares are not better than, but

different from ordinary shares. Preference shareholders
gain some preferences at the sacrifice of some benefits.

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1.2 Characteristics and Rights of Ordinary
Shareholders
To share proportionately
1. in profits (via dividends if management decides to
distribute profits),
2. in management (the right to vote/to choose
management at shareholder meetings),
3. in corporate assets upon liquidation (if any are left!).

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Preemptive rights:
rights to acquire a pro-rata amount of any new issues of
capital share (shareholders can maintain their percentage of
ownership).

Limited liability:
creditors of the corporation have claims only on the assets
owned by the corporation, not on the assets of the owners
of the corporation.

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1.3 Characteristics and Rights of Preference
Shareholders
1. Nonvoting specification (typically no voice in choosing
management).
2. Preference as to dividend, which is usually fixed (rights
regarding priority): If no dividend is paid on preference
share, no dividend may be paid on ordinary share.
3. Preference as to assets (over ordinary shareholders but not
creditors) in the event of liquidation.

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1.4 Different Kinds of Preference Share
Cumulative preference share: If the company fails to pay a
(fixed) dividend to preference shareholders, its obligation
accumulates and dividends not declared in a year become
dividends in arrears which must be paid in the future before
any dividends to ordinary shareholders are paid.
A participating preference share ordinarily receives a
minimum dividend payment but also receives higher
dividends when the company has a good year and pays
substantial dividends on ordinary shares. That is, dividends in
excess of the stated dividend amount may be paid to
preference shareholders.
A callable preference share gives the issuing company the
right to purchase the share back from the owner upon
repayment of a call price.
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A convertible preference share gives the owner the option to
exchange preference share for ordinary share.
A redeemable preference share is redeemable at a specified
redemption price at the option of the owner or upon other
conditions not within the control of the issuer (e.g.,
redemption on a specified date or upon reaching a certain
level of earnings).

REMARKS: If an entity issues preference shares that pay a

fixed amount of dividend and that have a mandatory
redemption feature at a future date, the substance is that they
are a contractual obligation to deliver cash and, therefore,
should be recognized as a liability rather than an equity.
Moreover, dividends payments on preference shares classified
as liabilities are treated as expenses.

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2. Accounting for Sale and Issuance of Shares
Shares can be issued in exchange for cash or noncash
consideration.

Before the issue of shares, a public company in HK

must first issue a prospectus containing the detailed
financial information as required by the Companies
Ordinance.

A prospectus is not an offer by the company to the

public, but is only an invitation to offer, i.e., inviting
prospective investors to apply for shares in the
company.
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2. Accounting for Sale and Issuance of Shares
According to the new Companies Ordinance issued in
March 2014 (see parts 4 & 5 of sections 134 to 289
and part 13 of sections 666 to 721), the concepts of
nominal value and share premium (additional
paid-in capital in US) are abolished, i.e., all shares
are issued without a par value.

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2.1 Issuance of Share for Cash
Two accounts are affected when shares are sold for
cash:
1) Cash is debited for the sale price.
2) The amount received for issuing equity shares is
credited to an appropriately designated share
capital account for each type of share.

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Example 1 (Issuance of Share for Cash):

ABC Corporation has issued 60,000 ordinary shares for $6

per share and 40,000 preference shares for $5 per share. The
journal entry would be:

Cash (360,000 + 200,000) $560,000

Share capital - ordinary share $360,000
Share capital - preference share 200,000

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2.2 Issuance of Share for Noncash Consideration

If assets or services are received in payment for capital

share issued, the assets received or expenses incurred
should be recorded by the issuing corporation at the market
value of shares issued or the fair value of the consideration
received at the date of transaction, whichever is more
determinable.

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Example 2 (Issuance of Share for Noncash Consideration):

ABC Corporation has issued 20,000 ordinary shares in

exchange for a building and land.
A commercial real estate appraisal placed the estimated
fair values of the building and land as $500,000 and
$200,000, respectively.
The ABC ordinary share is currently trading at $28 per
share in the HK Stock Exchange.

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The currently quoted exchange price is more representative
fair value of the transaction since organized exchanges are
efficient markets for valuing companies shares.
The real estate appraisal is a less reliable indication of
value.
Hence, the issuing companys entry would be:

Building (560,000 5/7) $400,000

Land (560,000 2/7) 160,000
Share capital - ordinary $560,000

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If ABC is not a listed company, then the appraisal might yield
the more representative estimate. The journal entry would be:

Building $500,000
Land 200,000
Share capital ordinary $ 700,000

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2.3 Conversion of Preference Share to
Ordinary Share
Like the accounting for convertible bonds, the accounting
for convertible preference share must be done using the
book value method (i.e., treated as an exchange of one
capital share to another capital share without recognizing
any gain or loss).

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Example 3 (Conversion of Preference Share to Ordinary
Share):

Holders of 1,000 shares of Top Pop Corporations convertible

preference share exercised conversion at a time when the
market value of ordinary share was $12 per share.

The preference shares were originally issued at $8 per share.

Each preference share is convertible into two shares of

ordinary share.

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The journal entry for conversion in the issuers book is:

Share capital - convertible preference

shares $8,000
Share capital - ordinary shares $8,000
Share conversion, preference to ordinary

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2.4 Rights Issue, Warrants, and Options
A corporation may issue rights, warrants, or options that
permit the purchase of the companys shares for a specified
period (the exercise period) at a certain price (the exercise
price).

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A. Rights to existing shareholders (at no charge):
Right to purchase more shares at a price usually below the
current market price.
Permit existing shareholders to maintain their proportionate
ownership interests (i.e., preemptive rights).
Short exercise period.
No formal entry is made when rights are issued. Only a
memorandum entry is made on the issuing companys books
stating the number of shares that may be claimed under the
outstanding rights.
If rights are exercised, an entry is made to record the
issuance of additional shares at the exercise price.
A memorandum entry is also made to record the decrease in
the number of rights outstanding.
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B. Share warrants:
Sold by the company for cash, usually with the issuance of
another security.
Share capital from warrants (an equity account) is increased
for the sale price of the warrants.
Long exercise period.
Under HKAS 32 and IAS 32, the two equity components
(i.e., share capital and warrant) should be allocated to two
separate accounts.
Allocate the lump-sum received based on the relative fair
values of the two securities.
If only one fair value is known, allocate a portion of the
lump-sum received based on that fair value and allocate
the remainder to the other security.
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 If fair values of both securities are known, the value assigned
to the warrants is determined by the following equation:

Market value of warrants

Value Total
assigned to = issue Market value of
Market value
warrants price security without +
of warrants
warrants

Once assigned, the reported value of the warrants does not

change with market conditions (historical cost principle).
If the warrants are exercised, the value assigned to the
ordinary shares is the value allocated to the warrants plus
the cash proceeds from the issuance of the ordinary shares.
If the warrants are allowed to expire, the value assigned to
the warrants will be transferred to a share capital account.
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Example 4 (Share Warrants):
Assume the Wing Hing Co. sells 1,000 preference shares
for $58 per share.
As an incentive to purchase the shares, Wing Hing Co.
gives the purchaser warrants enabling holders to subscribe
to 1,000 shares of ordinary shares for $25 per share.
The warrants expire after one year.
Immediately following the issuance of the preference
shares, the warrants are selling at $3, and the fair market
value of each preference share without the warrant
attached is $57.

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 The proceeds of $58,000 should be allocated by the Wing Hing
Co. as follows:

Value assigned $3
= $58,000 $57+$3 = $2,900
to the warrants

The entry on Wing Hings books to record the sale of the

preference shares with warrants is:

Cash $58,000
Share Capital Preference (plug-in) $55,100
Ordinary Share Warrants 2,900

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If the warrants are exercised, the entry to record the issuance
of ordinary shares would be (regardless of the market price
of the ordinary share at the issuance date):
Ordinary Share Warrants $2,900
Cash (1,000 $25) 25,000
Share Capital Ordinary (plug-in) $27,900

If the warrants were allowed to expire, the following entry

would be made:

Ordinary Share Warrants $2,900

Share Capital - Ordinary $2,900

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C. Share options granted to officers or employees:

Usually as part of a compensation plan.

Various conditions are specified:
o the time period during which the share may be
purchased (usually after the vesting period);
o the number of shares; and
o the price per share.
Vesting usually occurs when an employee has been
employed for a specified period of time and is eligible to
receive the specified benefits.
A typical firm grants the option holder the right to
purchase shares (exercise the option) during some
specified time in the future at todays market price.

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In March 2004, the HKICPA issued HKFRS 2 Share-
based Payment on accounting for share-based payment
transactions, including grants of share option to employees.
According to HKFRS 2, starting from 1 January 2005,
companies have to report stock-based option compensation
using the fair value method at the time of grant.
Under the fair value method, compensation cost is based on
the fair value of the stock option (using, e.g., the Black-
Scholes option pricing model) at the date of the grant and is
recognized as expenses over the vesting period.
ADDITIONAL READINGS: HKFRS 2 (it can be found in
http://www.hkicpa.org.hk. Click Standards & Technical,
then Accounting & Financial Reporting, and then choose
Hong Kong Financial Reporting Standards (HKFRS)).
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For example, suppose the fair value of the employee stock
option is $100,000 at the date of the grant and these
options vest at the end of a four-year period. Then in each
of the 4 years, we have the following year-end entry:

Compensation expense* $25,000

Paid-in capital from stock option $25,000
* Closed to Retained Profits at the end of the period.

When options are exercised, an entry is made to record the

issuance of shares at the exercise price.

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3. Repurchase of Shares
Companies repurchase their own shares to:

1. Provide shares for incentive compensation and employee

savings plans.
2. Obtain shares needed to satisfy requests by holders of
convertible securities (bonds and preference shares).
3. Reduce the amount of equity relative to the amount of
debt.
4. Distribute excess cash to shareholders (share redemption
vs. cash dividend).

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5. Remove some shares from the open market in order to
protect against a hostile takeover.
6. Improve per-share earnings by reducing the number of
shares outstanding and returning inefficiently-used assets
to shareholders.
7. Display confidence that the share price is currently
undervalued by the market.

Whatever the reason, a companys shares may be

reacquired by exercise of call (at the issuers discretion) or
redemption provisions (beyond the issuers control), or by
repurchase of the shares in the open market.

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3.1 Purchase and Redemption of Shares
The difference between a redemption and a purchase:

In redemption the shares will be reacquired on specified terms

when the shares were issued.

In purchase the amount payable on purchase will depend on

conditions prevailing at the date of purchase.

Journal entries are the same except for the amount of cash
involved.

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Before 1991, only preference shares were redeemable in HK.
The Companies (Amendment) Ordinance 1991, which came
into operation on Sept 1, 1991, permits a company, of
authorized by its articles, to issue redeemable shares of any
class, not merely redeemable preference shares (s 49(1)).
The Companies Ordinance contains the following provisions
relating to the issue and redemption of shares:

redeemable shares may be issued only if the company has

already issued shares that are not redeemable (otherwise all
shares can be redeemed easily by company --- this is to
protect the creditors);

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the shares may not be redeemed unless they are fully paid;

shares redeemed shall be treated as cancelled on

redemption;

Share capital can only be reduced once the directors have

followed a series of approval and publicity steps, as well as
making a solvency statement primarily for the purposes of
protecting creditors.

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The Companies Ordinance states that for listed companies,
share redemption must be made from either:

1. the distributable profits (mainly retained profits) of the

company; or
2. the proceeds of a fresh share issue made for the purpose
of a redemption; or
3. Share capital, provided that the necessary procedures (e.g.,
the solvency statement and publicity) are followed. These
procedures are required for preventing companies from
redeeming shares which would reduce their share capital
and thereby putting creditors of the company at risk.

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A solvency statement is a statement that each of the directors
has formed the opinion that the company satisfies the
following solvency test:
a) Immediately after the share capital reduction there will be no ground
on which the company could be found unable to pay its debt; and
b) Either:
i. If it is intended to commence winding up of the company within 12 months after
the date of the capital reduction, the company will be able to pay its debts in full
within 12 months after the commencement of the winding up; or
ii. In any other case, the company will be able to pay its debts as they become due
during the period of 12 months immediately following the date of the transaction.

In forming an opinion for the purpose of making a solvency

statement, a director must:
a) Inquire into the companys state of affairs and prospects, and
b) Take into account all the liabilities of the company (including
contingent and prospective liabilities).
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3.2 Journal Entries for Purchase or Redemption
of Shares
Example 5 (Purchase or Redeem out of Distributable
Profits only):

ABC Ltd. has the following shareholders equity accounts:

Share capital $2,000
Retained profits $1,000

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The company intends to purchase or redeem 200 shares for
$320 out of distributable profits. The journal entry for the
redemption would be:

Retained profits $320

Cash $320

Note:

Since the company purchased or redeemed its own

shares entirely out of distributable reserves (retained
profits), there is no change in the share capital account.

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 Original Redemption Ending
Balance Balance
Share Capital 2,000 2,000

Retained 1,000 -320 680

Profits

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Example 6 (Redeem Entirely out of Fresh Issues):

ABC Ltd. intends to redeem 200 shares out of the proceeds of a

new issue of 160 shares at $1.25 per share.

The journal entry for the new issue:

Cash $ 200
Share capital $200

The journal entry for the redemption:

Share capital $ 200

Cash $200
Equity Financing 43
 Original New Redemption Ending
Balance Issue Balance
Share Capital 2,000 +200 -200 2,000

Retained 1,000 1,000

Profits

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Example 7 (Redeem Partly Financed by Fresh Issues):
ABC Ltd. intends to redeem the 100 shares at $1.5 each. 80
new shares are issued at $1.25 to finance the redemption.
The difference is paid out of distributable profits.
The journal entry for the new issue:
Cash $100
Share capital $100

The journal entry for the redemption:

Share capital $100
Retained profits (plug-in) 50
Cash $150
Equity Financing 45
 Original New Ending
Redemption
Balance Issue Balance
Share
2,000 +100 -100 2,000
Capital
Retained
1,000 -50 950
Profits

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Example 8 (Purchase or Redeem out of Share Capital):

The company intends to purchase or redeem 200 shares for

$300 out of share capital. The journal entry for the
redemption would be:

Share capital $300

Cash $300

Original Redemption Ending

Balance Balance
Share Capital 2,000 -300 1,700

Retained Profits 1,000 1,000

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4.Distribution of Profits
This usually means cash dividends, but it could include
other types of assets. For example, Disney Corporation has
distributed Disneyland tickets to their shareholders. Also,
the purchase or redemption of the companys own shares
out of retained profits is considered distribution of profits.

However, there are other types of distribution that are NOT

considered distribution of profits. For example, stock
dividends (bonus/scrip issues) are considered capitalization
of profits because they are used to transfer retained profits
to permanent capital and thus remove retained profits from
cash dividend availability.

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4.1 Distributable Profits
A company can only make a distribution of profits when it
has distributable reserves. In HK, there are specific rules
(Company Laws) that govern the maximum amount of
distributable profits in a company:
Unlisted Company:
Net realized profits = Accumulated realized profits
Accumulated realized losses
Listed Company:

Net realized profits Any unrealized losses in excess of

unrealized gains
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Since distributable reserves equal total shareholders equity
minus the sum of share capital and undistributable reserves,
an alternative rule that can be used to determine the
maximum amount of distributable profits for the listed
company is:

(Total assets Total liabilities)

(Share capital + Undistributable reserves)

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 What are considered undistributable reserves?
a. any accumulated unrealized profits in excess of its
accumulated unrealized losses
b. any other reserve which the company is prohibited from
distribution either by statute or articles of association
(e.g., in China, Employees Welfare Fund)

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Example 9 (Distributable Profits):
The following are details of three separate listed companies
balance sheets at 31 December 2015.
A B C
Net assets (NA) 2,700 3,000 2,000
Share capital 200 500 1,000
Reserves:
Unrealized profits 1,300 500 1,000
Unrealized losses (100) (1,000) (1,000)
Net realized profits 1,300 3,000 1,000
Shareholders equity 2,700 3,000 2,000

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Distributable profits:
Company Net realized profits NA (Share capital +
(unrealized loss in undistributable reserves)
excess of unrealized
profits)
A 1,300 (0) = 1,300 2,700 (200 + 1,200) =
1,300
B 3,000 (500) = 2,500 3,000 (500 + 0) =
2,500
C 1,000 (0) = 1,000 2,000 (1,000 + 0) =
1,000
If these were unlisted companies, the distributable profits
would be equal to net realized profits.
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4.2 Cash Dividend
Dividends are proportional distributions of assets to
shareholders to satisfy their claim arising from the
generation of net income.
Declaration date: the date on which the board formally
announces that it will pay a dividend.
Date of record: a future date that determines which
shareholders will receive the dividend.
The person who holds the share on declaration date but
sells before the date of record will not receive the
dividend.
The person who owns the share on the date of record
will receive it.
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Accounting for Cash Dividend
Journal entries:
On Declaration Date: Dividend Declared xxx
Dividends Payable xxx

On Record Date Nothing is required

On Payment Date: Dividends Payable xxx

Cash xxx

On end of fiscal year

(Closing entry) Retained Profits xxx
Dividends Declared xxx
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4.3 Property Dividend
Property Dividends (Dividends in Kind) are paid in assets of
the corporation other than cash.
The payment of a property dividend can be broken down into
three events which need to be reflected on the books:
1) The corporation has paid a dividend. What is the value of
the dividend paid? Dividend is valued at fair market value
(FMV) of property given up at the date of declaration.
2) The corporation has disposed of an asset. We must remove
this asset from the books. We dont own it anymore. The
asset was carried at historical cost and must be removed
from the books.
3) The corporation may have realized a gain or loss on the
disposition of an asset. How do we calculate the gain/loss?
Its the difference between the FMV of the asset and its net
book value (NBV).
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Common Sense Perspective:
Economically it is no difference than if the corporation
sold the asset for its FMV and then turned around and
distributed the cash received.

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Example 10 (Property Dividend):

On September 21, 2014, Renren Company declares a

property dividend in which it will distribute an investment
in Sticky Rice Corporations ordinary shares on October
23, 2014:
FMV of shares: $1,400,000
Book value of shares: $875,000

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21/9/2014
Dividends (or Retained Profits) $1,400,000
Property Dividends Payable $1,400,000
Investment in Sticky Rice Shares 525,000
Gain on Appreciation of Securities 525,000
The second entry will mark the security up to market, recording
the gain for the appreciation at the time the dividend is
declared. We dont take the security off the books until it is
physically distributed.
23/10/2014
Property Dividends Payable $1,400,000
Investment in Sticky Rice Shares $1,400,000
Equity Financing 59
4.4 Stock Dividend and Stock Split
Stock Dividend (It is called "Bonus Shares" in Hong Kong)
A stock dividend is a distribution of additional shares of a
corporation's own capital stock on a pro-rata basis to its
shareholders at no cost (i.e., each shareholder receives
additional shares equal to the percentage of shares already held).
It does not
1) change the proportionate ownership of any shareholder;
2) involve the distribution of any assets of the corporation to
the shareholder;
3) affect the total shareholders' equity of the issuing
corporation.
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 Reasons for Stock Dividend:
Stock
1. Dividends: Small or Large?
To maintain dividend consistency. Stock dividends
satisfy the demands of shareholders for continuing
dividends and yet avoid the demand on cash. Also, a stock
dividend is not considered as revenue to the shareholder
for income tax purposes. (There is no tax on dividend or
capital gain in Hong Kong.)
2. To capitalize retained income. A stock dividend is used
to transfer retained profits to permanent capital and thus
remove such earnings from cash dividend availability.

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Stock Dividend (Contd)

As shares have no nominal value under the new

Companies Ordinance, companies are no longer required
to transfer an amount to share capital if the company issues
shares for no consideration, but it could choose to do so.
So a company may allot and issue bonus shares either with
or without increasing its share capital.
The amount capitalized is at the discretion of the company
and does not depend on the number of shares issued as
bonus shares.

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Stock Dividend (Contd)

Issue of bonus shares without capitalizing retained

profits
Suppose ABC Company decides to issue 1 bonus share for each 10
shares held on December 31st 2015. ABC originally had 110
shares. In 2015 the company earns profits of $15. So the balance
sheet as of December 31st, 2015 should be:
2015 2014

Share capital: 121 shares in issue and

fully paid (2014: 110 shares) 450 450
Retained profits 90 75
Total equity 540 525

63
Stock Dividend (Contd)

Issue of bonus shares by capitalizing retained

profits
Same as previous example, but the company decides to capitalize
1/3 of its brought forward retained profits of $75 without issuing
any further shares
2015 2014

Share capital: 121 shares in issue and

fully paid (2014: 110 shares) 475 450
Retained profits 65 75
Total equity 540 525

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Stock Split
Stock splits are usually larger than stock dividends, but
theoretically the same, i.e., both of them are distribution of a
proportional amount of shares to stockholders.
In a stock split, the total number of shares is increased by a
specified amount (such as a 2-for-1 stock split) but the total
share capital remains unchanged. No accounting entry is needed.

Reasons for Stock Split:

A stock split reduces the market price per share, which
tends to increase the market activity of the shares.

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Example 11 (Stock Split):

Assume that a corporation had 5,000 shares of ordinary share

outstanding before a 2-for-1 stock split.

Before After
Split Split
Ordinary Shares 5,000 10,000 Increase

No
Total Value $ 5,000 $ 5,000
Change

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5. Statement of Changes in Shareholders
Equity
A schedule that reconciles change in Shareholders Equity
during a period of time
e.g., the impact of profit or loss, dividend and issue
or redemption of shares
It provides information about the reasons behind the
developments that value has taken, for all equity accounts
of a company.

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Example 12 (Statement of Changes in Shareholders Equity):
Below is the statement of shareholders equity of Carson Manufacturing Company:
Dec. 31, 2014
Shareholders equity
Preference share capital Class A $60,000
(1,200 shares)
Preference share capital Class B 50,000
(500 shares)
Ordinary share capital (3,000 shares) 70,000
Retained profits 150,000
Total shareholders equity 330,000

The following transactions happen during 2015:

a) Issuance of preference shares Class A: 300 shares @ $55 per share
b) Repurchase 100 shares of preference share Class B at $120 per share, out of distributable
profits
c) Issue 2 bonus ordinary shares for each 10 ordinary shares. The company has decided not to
capitalize any retained profits.
d) Announce a 2-for-1 stock split for its ordinary shares.
e) Net income is $35,000 for the year.

Prepare the statement of changes in shareholders for year 2015.

Equity Financing 68
 CARSON MANUFACTURING COMPANY
Statement of Changes in Shareholders Equity
For Year Ended December 31, 2015

Preference Preference Ordinary Total

share capital share capital share Retained shareholders
- Class A - Class B capital profits equity
Balance, Jan. 1, 2015 $60,000 $50,000 $ 70,000 $150,000 $330,000
Issuance of preference
shares - Class A 16,500 16,500
Repurchase of preference
shares - Class B --- (12,000) (12,000)
Bonus issue --- ---
2-for-1 stock split --- ---
Net income 35,000 35,000
Balance, Dec. 31, 2015 $76,500 $50,000 $70,000 $173,000 $369,500
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