Tutorials – Page 11 – Financial Memos

In particular, dealing with shares, or common stock, can be daunting for the accounting student and small business owner alike. You have par values, share premiums, applications, allotments, calls and all sorts of things that can go on. So there is a complication to deal with, but with our comprehensive guide, preparing a journal entry for issue of common stock is very straightforward. At this point, we typically try and provide a quick answer to the question we are addressing. But this time, I'm afraid there isn't a quick few words or a single journal entry to mention here. But please scroll down to the example that matches the problem you are dealing with; we should have them all covered. What is Common Stock? At its most basic, common stock is a financial instrument representing a share of ownership in a company. And hence we also use the word shares as well. You will hear the words "stock market" and "share market" used interchangeably. In each country, there are different laws and regulations that govern how shares can be traded and owned. There are different requirements for shares exchanged privately compared to when shares are traded publicly on exchanges, like the New York Stock Exchange or the London Stock Exchange. Common stock forms part of the equity section of a company - or sometimes referred to as the capital of a company. Therefore you will find common stock disclosed in the balance sheet (often referred to as the statement of financial position). We are not going to get into them here, but there are a number of different International Financial Reporting Standards (IFRS) that govern how shares should be presented in a reporting entity's financial statements. If you would like some lite bedtime reading, you may like to look at IFRS 7 Financial Instruments: Disclosures and International Accounting Standard (IAS) 32 Financial Instruments: Presentation. Types of Common Stock Transactions There are three types of transactions you will need to know when preparing a journal entry for common stock. These are issuing stock exchange for cash, for other non-cash assets or companies buying back their own stock. Each of these we'll discuss briefly below. Common stock Issued for Cash Exchange The most common example of common stock being sold by a company is for the exchange of cash. A company will take those funds and invest them into the business by applying the cash to new investments. In the most simple form, you will see a deposit into the firm's bank account and then issuance of common stock, i.e. an increase in the company's capital. In the example below, we will look at when this transaction takes place and how to issue stock above par value. As a quick refresh, par value is the face-value or legally issued price of the share. Typically, shares have a par value of $0.01 or $1.00 etc., normally a round figure. From an accounting point of view, the actual par value matters little until we get to an issue price that is different to the par value. And we'll look at this very thing in the examples coming up below. Common Stock Issued for Non-Cash Exchange The issuance of common stock for a non-cash exchange is less common than for cash, but you will often see this either say in a merger or acquisition or closely held companies. In an acquisition situation, we will often see the exchange of shares for shares. For example, company A will acquire company B, giving company B shareholders a mix of company A shares and cash. Whereas with someone buying into a closely held company, you will often see fixed assets or a sales book being used as the buy-in for the shares acquired. Common Stock Buy-Back And in the last example, we will look at is a company buying back its own stock. This process is often referred to as a share buy-back or a Treasury stock purchase. Once the shares are purchased back from shareholders, the company can either hold them as Treasury stock or cancel them, which is the permanent retirement of the shares. We'll look at two examples under the buy-back. The first will be using the cost method where a company is buying some of their own shares and later reissues them. In this case, we need to consider any gains or losses the company experienced in the transaction. In the second example, we'll assume the company will retire the shares it buys back, so we'll be using the constructive retirement method. Examples With Journal Entries Now we are into the exciting part of the article, the journal entries. I always say if you don't like the debits and credits, you shouldn't be an accountant. In my current career as an airline pilot, it's the same with aircraft; if you don't like aircraft, you shouldn't be a pilot. And yes, I do fly with people who don't care much for aircraft! Perhaps all of that for another article one day. Back to the journal entries. The first example we will go through is the sale of common stock by ABC Ltd for cash. Issuing Common Stock for Cash ABC Ltd, the company we always use in our examples, is an SME working in the American mid-west as a small construction, project management and landscaping business. It has a few other activities, but we make these up as we go along. ABC's Board has decided to issues to local investors, and with the capital raised, it will invest into its heavy equipment fleet and retire some long-term debt. With this in mind, we have the following facts: there are 100,000 shares being sold at $20.00;each share has a par value of $1.00;all shares are class A, carrying equal rights;he shares are being sold in 10,000 bundles;on application 10 per cent of the money is due, 50 per cent due on allotment and the remaining 40 per cent split over two future calls;applications open on July 1 and closed July 30;the future calls are due September 30 and December 31;the shares were over subscribed by 100,000 (a good problem to have). Receipt of Share Application Money Over July, ABC received 20 applications for the 10,000 class A share bundles. This means they received: 20 applications x (10,000 shares x $20 issue price x 10 per cent due on application) = $400,000 So in July, ABC would prepare the following journal entry (we have shown the aggregate of the journal entry that ABC would have otherwise been done 20 times). DateAccount NameDebitCreditJuly 30Bank400,000Class A Share Application400,000 The debit to the bank account reflects the additional cash ABC now has from the share offering. The credit entry to the Class A Share Application reflects the liability the company also holds. It can't do as it wishes with this money at the moment. And as we'll see, some people will be getting their money back. Allotment of the Shares In the case of an oversubscription, the prospectus stated that the share bundles would be allocated on a first-come-first-serve basis. But no one shareholder allowed an allocation of more than one bundle. So we now have to prepare two journal entries - which we'll combine into one. The first is the allotment of the shares, and the second is to return the monies to those not awarded any shares. We also now have to start dealing with the premium or the additional capital above par. We know we have $400,000 sitting in the application account, but how much do we allocate to share capital account and a new account, Additional Paid-in Capital. This account is also often called a Share Premium account, so you may see that in an exam. But it all means the same thing for this type of exercise. We know we have $200,000 in monies to be allocated (the other $200,000 is going back to the applicants as they weren't awarded any shares). So of the remaining $200,000, how much of this is the premium component? The following calculation answers that question: $200,000 x ($1 par value / $20 issue price) = $10,000 DateAccount NameDebitCreditAugust 1Class A Share Application400,000Class A Share Capital10,000Class A Additional Paid-in Capital190,000Bank200,000 The first debit entry takes the $400,000 in application money out of the application account. If then splits this across the Class A Share Capital account, being the allotted money. Then the Class A Additional Paid-in Capital account, as we calculated above. And the Bank account, being the return of the monies that were not allotted. We now have to create the Class A Share Allotment account with the following journal entry. This entry creates an entry for the 50 per cent that due from those who were allotted shares in the funding round. This entry is created through the following calculation: 10 applications x (10,000 shares x $20 issue price x 50 per cent due on allotment) = $1,000,000 And as we know before, 5 per cent of this is the par value, and the remaining 95 per cent is the additional paid-in capital or premium the shareholders are paying above par value. $1,000,000 x 5 per cent = $50,000 DateAccount NameDebitCreditAugust 1Class A Share Allotment1,000,000Class A Share Capital50,000Class A Additional Paid-in Capital950,000 The debit to the allotment account creates monies that are now due to ABC Ltd. The allotment account is an asset for ABC. The credit to the share capital account and the additional paid-in capital reflects where is money is coming from, i.e. from people investing equity into the company. Receipt of Allotment Monies The prospectus stated that on allotment of shares, the shareholder would have 30 days to deposit the required 50 per cent of the share price. So over August, we would see the entry below prepared by ABC Ltd each time allotment money is received. We have aggregated the entries into a month-end total. DateAccount NameDebitCreditAugust 1Bank1,000,000Class A Share Allotment1,000,000 First Call on Shares As stated in the prospectus, the first call of 20 per cent is due from the Class A shareholders by September 30. We have two journal entries to prepare to record this event. First, we need to create the call account, the asset receivable of monies due. And then second, the receipt of those monies from the shareholders. The calculation for the first call on class A shares is: 10 applications x (10,000 shares x $20 issue price x 20 per cent due on first call) = $400,000 And the premium component is: $400,000 x 5 per cent = $20,000 DateAccount NameDebitCreditSeptember 1Class A Share First Call400,000Class A Share Capital20,000Class A Additional Paid-in Capital380,000 As before, the following entry would be prepared by ABC Ltd each time a shareholder paid during the month; but the aggregate would look like the following: DateAccount NameDebitCreditSeptember 30Bank400,000Class A Share First Call400,000 The debit to the bank account reflects the $400,000 ABC now has from its first call on the class A shares. And the credit to the call account can now be closed as this money is no longer due from shareholders. Second Call on Shares We have now reached December, and the second and final call for class A shares is now coming due. We would repeat the journal entries we created for the first call. So for completeness of the example, the following journal entries would be made by ABC's accounts team. DateAccount NameDebitCreditDecember 1Class A Share Second Call400,000Class A Share Capital20,000Class A Additional Paid-in Capital380,000 DateAccount NameDebitCreditDecember 31Bank400,000Class A Share Second Call400,000 Common Stock Issued for Non-Cash Exchange Because we have worked through a lot of the detail you would be expected to know in the cash example; we will keep this example much simpler. And one reason for this is often these types of transactions don't involve the application, allotment and call process that you would see in an offering of shares for cash. In this example, ABC Ltd is acquiring an allotment of equipment from XYZ Ltd that is closing down. However, the sole owner of XYZ Ltd (we'll call him Kevin), in his retirement, would like to invest some of his money into ABC Ltd and enjoy continued involvement in the local industry and a passive dividend income stream. ABC Ltd and Kevin engaged the services of a third-party valuer and agreed on a sale price of $1,500,000 for the equipment. For his $1,500,000, Kevin is allocated 100,000 class A shares. So a summary of the facts of the example we have to prepare journal entries for are: the purchase of the equipment takes place on June 30, along with the allocation of shares;Kevin is to receive 100,000 class A shares with a par value of $1, and;the total value of the exchange is $1,500,000, no exchange of cash is involved; What is the Additional Paid-in Capital? This is a much simpler process compared to the first example, as we will have one exchange taking place. So the share capital at par value is 100,000 x $1 par value = $100,000. This means we have additional paid-in capital of $1,400,000. The journal entry to record this transaction is: DateAccount NameDebitCreditJune 30Fixed Assets1,500,000Class A Share Capital100,000Class A Additional Paid-in Capital1,400,000 We have a debit to the fixed assets account, with an increase of $1,500,000. This records the cost price for ABC Ltd. We then have two credit entries, the first being $100,000 to the Class A Share Capital, which records the par value of the shares exchanged. And then the $1,400,000, which records the addition paid-in capital, or the share premium Kevin paid. And that would be it. There are no application or allotment accounts we have to deal with. You certainly could, but when only dealing with one new shareholder and the balance is paid in full at the exchange, these additional accounts would only add complication. Common Stock Buy-Back The last example we will look at in the journal entry for the issue of common stock is company share buy-backs. We will be dealing with two accounting methods. The first of these is the cost method. The Cost Method The cost method of accounting for common stock buy-backs is the simplest approach and caters well for the three scenarios you might face. We'll look at each scenario providing the journal entries and calculations required. Buy and Hold Some years after Kevin brought shares in ABC Ltd, the company has agreed to buy the 100,000 class A shares back for $15. You will remember that these shares had a par value of $1 and were exchanged for fixed assets worth $1,500,000. This means the shares were sold for $15 each. The ABC accounts team would prepare this journal entry: DateAccount NameDebitCreditJune 30Treasury Stock1,500,000Cash1,500,000 The debit to the Treasure Stock account reflects the new asset ABC Ltd holds in its own stock. This is equivalent to it owning shares in another company. And the credit reflects the company pays Kevin to buy his position out. Kevin is now off to play golf and travel. Retirement of Treasury Stock After buying back Kevin's shares, ABC decides to retire the shares on July 31. After Board approval, ABC's accounts team would prepare the following journal entry. DateAccount NameDebitCreditJuly 31Class A Share Capital100,000Additional Paid-in Capital1,400,000Treasury Stock1,500,000 The debit to the share capital account removes the 100,000 class A shares from ABC's equity. The $1,400,000 debit to the additional paid-in capital account also reduces ABC's equity section. And to balance the accounting equation, we see the removal of the treasury stock from the asset side. Resell of Treasury Stock Let us say that instead of ABC retiring the shares it bought back from Kevin, but instead, it resold them. ABC found another buyer for 100,000 shares and so sold them back into the market. The shares par value stays at $1, but this time they can sell them for $2,000,000 or $20 per share. The sale of the shares, fully paid on allocation to the buyer, took place on August 15. The transaction would generate the following journal entry: DateAccount NameDebitCreditAugust 15Cash2,000,000Additional Paid-in Capital500,000Treasury Stock1,500,000 So in this journal entry, we have the deposit of $2,000,000 into ABC's bank account. And from here, we split the credit into $500,000 for the additional capital paid by the new investor. This was $5 per share x 100,000 shares = $500,000. And the credit to the Treasury Stock account removes this asset from ABC's balance sheet (statement of financial position). Constructive Retirement Method In our final example, we are going to look at the use of the constructive retirement method. It is typical for this method to be used to retire the shares as they are repurchased, rather than moving those shares into Treasury Stock initially. But you could use it in that case too. However, for today, we'll be assuming the Board at ABC Ltd has decided to repurchase Kevin's shares as he wants to cash in and go and play golf and see the world. However, in this example, ABC and Kevin agree on a price of $18 per share (Kevin was well pleased). Once the Board approves the transaction and the paperwork is complete, the ABC accounts team would prepare the following journal entry. DateAccount NameDebitCreditJune 30Class A Share Capital100,000Additional Paid-in Capital1,400,000Retained Earnings300,000Bank1,800,000 Our first debit entry is to the Class A Share Capital for $100,000, being 100,000 at $1 par value. The second debit entry is to Additional Paid-in Capital, which is the premium Kevin paid when he exchanged the equipment for the ABC shares. And the third debit entry is $300,000 to retained earnings. This is the effective loss that ABC is taking for the premium it is paying Kevin. That premium is calculated by 100,000 shares x ($18 - $15) = $300,000. Conclusion Well, this guide turned out longer than it was meant to be. But once we started to look into the different scenarios a reader could face, we had to keep going. We trust that all the examples and explanations will be helpful and cover what you need. If you have any questions or comments, please use our Ask a Question section or our contact us page.