Types of Shares

An ownership interest in a corporation is often represented through ownership of share capital, which may include varies classes of shares such as ordinary (common) shares or preferred (preference) shares. The ordinary shares represent the residual risk-taking ownership of the corporation after the satisfaction of all claims of creditors and senior classes of equity. It is important that the actual common ownership be accurately identified, since the computation of earnings per share (described in Chapter 27) requires that the ultimate residual ownership class be properly associated with that calculation, regardless of what the various equity classes are nominally called.

Preferred shareholders are owners who have certain rights that are superior to those of common shareholders. These rights will pertain either to the earnings or the assets of the entity. Preferences as to earnings exist when the preferred shareholders have a stipulated dividend rate (expressed either as an amount or as a percentage of the preferred share's par or stated value). Preferences as to assets exist when the preferred shares have a stipulated liquidation value. If a corporation were to liquidate, the preferred holders would be paid a specific amount before the ordinary shareholders would have a right to participate in any of the proceeds.

In practice, preferred shares are more likely to have preferences as to earnings than as to assets. Some classes of preferred shares may have both preferential rights, although this is rarely encountered. Preferred shares may also have the following features:

• Participation in earnings beyond the stipulated dividend rate;
• A cumulative feature, affording the preferred shareholders the protection that their dividends in arrears, if any, will be fully satisfied before the ordinary shareholders participate in any earnings distribution; and
• Convertibility or callability by the entity.

Whatever preferences exist must be disclosed adequately in the financial statements, either in the statement of financial position or in the notes.

In exchange for the preferences, the preferred shareholders' rights or privileges are limited. For instance, the right to vote may be limited to ordinary shareholders. The most important right denied to the preferred shareholders, however, is the right to participate without limitation in the earnings of the corporation. Thus, if the corporation has exceedingly large earnings for a particular period, these earnings would accrue to the benefit of the ordinary shareholders. This is true even if the preferred shares are participating (itself a fairly uncommon feature) because even participating preferred shares usually have some upper limitation placed on the degree of participation. For example, preferred shares may have a 5% cumulative dividend with a further 3% participation right, so in any one year the limit would be an 8% return to the preferred shareholders (plus, if applicable, the 5% per year prior year dividends not paid).

Occasionally, several classes of share capital will be categorised as ordinary (e.g., Class A ordinary, Class B ordinary, etc.). Since there can be only one class of shares that constitutes the true residual risk-taking equity interest in a corporation, it is clear that the other classes, even though described as ordinary shares, must in fact have some preferential status. Not uncommonly, these preferences relate to voting rights, as when a control group holds ordinary shares with “super voting” rights (e.g., 10 votes per share). The rights and responsibilities of each class of shareholder, even if described as ordinary, must be fully disclosed in the financial statements.

Presentation and Disclosures Relating to Share Capital

The number of shares authorised, issued and outstanding. It is required that a company disclose information relating to the number of shares authorised, issued and outstanding. Authorised share capital is defined as the maximum number of shares that a company is permitted to issue, according to its articles of association, its charter or its bylaws. The number of shares issued and outstanding could vary, based on the fact that a company could have acquired its own shares and is holding them as treasury shares (discussed below under reacquired shares).

Capital not yet paid in (or unpaid capital). In an initial public offering, subscribers may be asked initially to pay in only a portion of the par value, with the balance due in instalments, which are known as calls. Thus, it is possible that at the end of the reporting period a certain portion of the share capital has not yet been paid in. The amount not yet collected must be shown as a contra (i.e., a deduction) in the equity section, since that portion of the subscribed capital has yet to be issued. For example, while the gross amount of the share subscription increases capital, if the due date of the final call falls on February 7, 202X+1, following the accounting year-end of December 31, 202X, the amount of capital not yet paid in should be shown as a deduction from shareholders' equity. In this manner, only the net amount of capital received as of the end of the reporting period will be properly included in shareholders' equity, averting an overstatement of the entity's actual equity.

IAS 1 requires that a distinction be made between shares that have been issued and fully paid, on the one hand, and those that have been issued but not fully paid, on the other hand. The number of shares outstanding at the beginning and at the end of each period presented must also be reconciled.

Par value per share. This is also generally referred to as legal value, nominal value or face value per share. The par value of shares is specified in the corporate charter or bylaws and referred to in other documents, such as the share application and prospectus. Par value is the smallest unit of share capital that can be acquired unless the prospectus permits fractional shares (which is very unusual for commercial entities). In certain jurisdictions, it is also permitted for corporations to issue no-par shares (i.e., shares that are not given any par value). In such cases, again depending on local corporation laws, sometimes a stated value is determined by the board of directors, which is then accorded effectively the same treatment as par value. IAS 1 requires disclosure of par values or of the fact that the shares were issued without par values. If the shares do not have a par value, this must be stated.

Movements in share capital accounts during the year. This information is usually disclosed in the financial statements or the footnotes to the financial statements, generally in a tabular or statement format, although in some circumstances merely set forth in a narrative. Reporting entities must present a statement showing that changes in all the equity accounts (including issued capital, retained earnings and reserves transactions with owners in their capacity as owners) are reported in the statement of changes in equity, while all changes other than those resulting from transactions with owners are to be reported in the statement of comprehensive income. The statement of changes in equity highlights the changes during the period in the various components of shareholders' equity. It also serves the purpose of reconciling the beginning and the ending balances of shareholders' equity, as shown in the statement of financial position.

Rights, preferences and restrictions with respect to the distribution of dividends and to the repayment of capital. When there is more than one class of share capital having varying rights, adequate disclosure of the rights, preferences and restrictions attached to each such class of share capital will enhance understandability of the information provided by the financial statements.

Cumulative preference dividends in arrears. If an entity has preferred shares outstanding and does not pay cumulative dividends on the preference shares annually when due, it will be required by statute to pay such arrears in later years, before any distributions can be made on common (ordinary) shares. Although practice varies, most preference shares are cumulative in nature. Preference shares that do not have this feature are called non-cumulative preference shares.

Treasury shares. Shares that are issued but then reacquired by a company are referred to as treasury shares. The entity's ability to reacquire shares may be limited by its corporate charter or by covenants in its loan and/or preferred share agreements (for example, it may be restricted from doing so as long as bonded debt remains outstanding) or by local legislation. In those jurisdictions where company law permits the repurchase of shares, such shares, on acquisition by the company or its consolidated subsidiary, become legally available for reissue or resale without further authorisation.

Shares outstanding refers to shares other than those held as treasury shares. That is, treasury shares do not reduce the number of shares issued but affect the number of shares outstanding. It is to be noted that certain countries prohibit companies from purchasing their own shares, since to do so is considered as a reduction of share capital that can be achieved only with the express consent of the shareholders in an extraordinary general meeting, and then only under certain defined conditions.

IAS 1 requires that shares in the entity held in its treasury or by its subsidiaries be identified for each category of share capital and be deducted from contributed capital. IAS 32 states that the treasury share acquisition transaction is to be reported in the statement of changes in equity. When later resold, any difference between acquisition cost and ultimate proceeds represents a change in equity and is therefore not to be considered a gain or loss to be reported in the statement of comprehensive income. Accounting for treasury shares is discussed in further detail later in this chapter.

IAS 32 also specifies that the costs associated with equity transactions are to be accounted for as reductions of equity if the corresponding transaction was a share issuance, or as increases in the contra equity account when incurred in connection with treasury share reacquisitions. Relevant costs are limited to incremental costs directly associated with the transactions. If the issuance involves a compound instrument, the issuance costs should be associated with the liability and equity components, respectively, using a rational and consistent basis of allocation.

Shares reserved for future issuance under options and sales contracts, including the terms and amounts. Companies may issue share options that grant the holder of these options rights to a specified number of shares at a certain price. Share options have become a popular means of employee remuneration, and often the top echelon of management is offered this non-cash perquisite as a major part of their remuneration packages. The options grant the holder the right to acquire shares over a defined time horizon for a fixed price, which may equal fair value at the grant date or, less commonly, at a price lower than fair value. Granting options usually is not legal unless the entity has enough authorised but unissued shares to satisfy the holders' demands, if made, although in some instances this can be done, with management thus becoming bound to the reacquisition of enough shares in the market (or by other means) to enable it to honour these new share option commitments. If a company has shares reserved for future issuance under option plans or sales contracts, it is necessary to disclose the number of shares, including terms and amounts, so reserved. These reserved shares are not available for sale or distribution to others during the terms of the unexercised options.

IAS 32 deals with situations in which entity obligations are to be settled in cash or in equity securities, depending on the outcome of contingencies not under the issuer's control. In general, these should be classed as liabilities, unless the part that could require settlement in cash is not genuine, or settlement by cash or distribution of other assets is available only in the event of the liquidation of the issuer. If the option holder can demand cash, the obligation is a liability, not equity.

The accounting for share options, which was introduced by IFRS 2, is dealt within Chapter 17. As will be seen, it presents many intriguing and complex issues.

Presentation and Disclosures Relating to Other Equity

Capital contributed in excess of par value. This is the amount received on the issuance of shares that is the excess over the par value. It is called “additional contributed capital” in the US, while in many other jurisdictions it is referred to as “share premium.” Essentially the same accounting would be required if a stated value is used in lieu of par value, where permitted.

Revaluation/fair value reserve. When a company carries property, plant and equipment or intangible assets under the revaluation model, as is permitted by IAS 16 and IAS 38 (revaluation to fair value), the difference between the cost (net of accumulated depreciation) and the fair value is recognised in other comprehensive income and accumulated in equity. The difference will be net of any associated deferred tax, which is also recognised within other comprehensive income.

IAS 1 requires that movements of this revaluation reserve during the reporting period (year or interim period) be disclosed in the other comprehensive income section of the statement of comprehensive income. Increases in an asset's carrying value are recognised in other comprehensive income and accumulated in equity. Decreases are recognised in other comprehensive income only to the extent of any credit balance existing in the revaluation reserve in respect of that asset and additional decreases are taken to profit or loss. Also, restrictions as to any distributions of this reserve to shareholders should be disclosed. Note that in some jurisdictions the directors may be empowered to make distributions in excess of recorded book capital, and this often will require a determination of fair values.

Reserves. Reserves include capital reserves as well as revenue reserves. Also, statutory reserves and voluntary reserves are included under this category. Finally, special reserves, including contingency reserves, are included herein. The use of general reserves and statutory reserves, once common or even required under company laws in many jurisdictions, is now in decline.

Statutory reserves (or legal reserves, as they are called in some jurisdictions) are created based on the requirements of the law or the statute under which the company is incorporated. For instance, many corporate statutes in Middle Eastern countries require that companies set aside 10% of their net income for the year as a “statutory reserve,” with such appropriations to continue until the balance in this reserve account equals 50% of the company's equity capital. The intent is to provide an extra “cushion” of protection to creditors, such that even significant losses incurred in later periods will not reduce the entity's actual net worth below zero, which would, were it to occur, threaten creditors' ability for repayment of liabilities.

Sometimes a company's articles, charter or bylaws may require that each year the company set aside a certain percentage of its net profit (income) by way of a contingency or general reserve. Unlike statutory or legal reserves, contingency reserves are based on the provisions of corporate bylaws. The use of general reserves is not consistent with IFRS.

The standard requires that movements in these reserves during the reporting period be disclosed, along with the nature and purpose of each reserve presented within shareholders' equity.

Retained earnings. By definition, retained earnings represent an entity's accumulated profits (or losses) less any distributions that have been made therefrom. However, based on provisions contained in IFRS, other adjustments are also made to the amount of retained earnings. IAS 8 requires the following to be shown as adjustments to retained earnings:

1. Correction of accounting errors that relate to prior periods should be reported by adjusting the opening balance of retained earnings. Comparative information should be restated, unless it is impracticable to do so.
2. The adjustment resulting from a change in accounting policy that is to be applied retrospectively should be reported as an adjustment to the opening balance of retained earnings. Comparative information should be restated unless it is impracticable to do so.

Disclosure of dividends proposed but not formally approved is required by IAS 1. Dividends declared after the end of the reporting period, but prior to the issuance of the financial statements, must be disclosed but cannot be formally recognised via a charge against retained earnings. Also, the amount of any cumulative preference dividends not recognised as charges against accumulated profits must be disclosed (i.e., arrears), either parenthetically or in the footnotes.

IAS 1 mandates that an entity should present in a statement of changes in equity the amount of total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent (controlling interest) and to the non-controlling interest. Comprehensive income includes all components of what was formerly denoted as “profit or loss” and of “other recognised income and expense.” The latter category will henceforth be known as “other comprehensive income.” This topic is covered in more detail in a separate discussion within Chapter 5.

Puttable Instruments

A puttable financial instrument includes a contractual obligation for the issuer to repurchase or redeem that instrument for cash or another financial asset on exercise of the put. As an exception to the definition of a financial liability, an instrument that includes an obligation is classified as an equity instrument if it has all the following features:

• The instruments' holders are entitled to their pro rata share of the entity's net assets upon the liquidation of the entity.
• The instrument is in the class of instruments that is most subordinate (i.e., is among the residual equity interests in the entity) and all instruments in that class have identical features.
• All financial instruments in the class of instruments that is subordinate to other classes of instruments have identical features. For example, they must all be puttable, and the formula or other method used to calculate the repurchase or redemption price is the same for all instruments in that class.
• Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity, and it is not a contract that will or may be settled in the entity's own equity instruments as set out in IAS 32's definition of a financial liability.
• The total expected cash flows attributable to the instrument, over its life, are based substantially on profit or loss, or changes in recognised net assets, or changes in the fair value of recognised or unrecognised net assets.
• For an instrument to be classified as an equity instrument, in addition to the instrument having all the above features, the issuer must have no other financial instrument or contract that has:
  • total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognized net assets of the entity (excluding any effects of such instrument or contract) and
  • the effect of substantially restricting or fixing the residual returns to the puttable instrument holders.

For the purposes of applying condition 6 above, the entity shall not consider non-financial contracts with a holder of an instrument described in IAS 32 paragraph 16A that have contractual terms and conditions that are similar to the contractual terms and conditions of an equivalent contract that might occur between a non-instrument holder and the issuing entity. If the entity cannot determine that this condition is met, it shall not classify the puttable instrument as an equity instrument.

IAS 1 requires the following expanded disclosures in circumstances when puttable instruments are included in equity. These disclosures include:

• Summary quantitative data about the amount classified as equity;
• The entity's objectives, policies and processes for managing the obligation to repurchase or redeem such instruments, including any changes from the previous period;
• The expected cash outflow on redemption or repurchase of that class of financial instruments; and
• Information on the means of determining such cash outflows or redemption.

Compound Financial Instruments

Increasingly, entities issue financial instruments that exhibit attributes of both equity and liabilities. Instruments which contain both a liability and an equity component are known as compound instruments. IAS 32 stipulates that an entity that issues such financial instruments, should classify the component parts of the financial instrument separately as equity or liability as appropriate. (For a detailed discussion on financial instruments, refer to Chapter 24.) In terms of IAS 32, the full fair value of the liability component(s) must be reported as liabilities, and only the residual value, at issuance, should be included as equity.

Additional Guidance Relative to Share Issuances and Related Matters

IFRS provides only minimal guidance regarding the actual accounting for the issuance of shares of various classes of equity, except for share-based transactions discussed in the next chapter. In the following paragraphs suggestions are made concerning the accounting for such transactions, which are within the spirit of IFRS, although largely drawn from other authoritative sources. This is done to provide guidance which conforms to the requirements under IAS 8 (hierarchy of professional standards), and to illustrate a wide array of actual transactions that often need to be accounted for.

Compound and Convertible Equity Instruments

Entities sometimes issue preferred shares which are convertible into ordinary shares. Where the preferred shares are non-redeemable, the accounting for both the preferred and ordinary shares is similar as they both represent equity in the issuer. The treatment of convertible preferred shares at their issuance is no different from that of non-convertible preferred shares. When it is converted, the book value approach is used to account for the conversion. Use of the market value approach would entail a gain or loss for which there is no theoretical justification, since the total amount of contributed capital does not change when the share capital is converted. When the preferred shares are converted, the “Preferred shares” and related “Additional contributed capital—preferred shares” accounts are debited for their original values when purchased, and “Ordinary shares” and “Additional contributed capital—ordinary shares” (if an excess over par or stated value exists) are credited. If the book value of the preferred shares is less than the total par value of the ordinary shares being issued, retained earnings is charged for the difference. This charge is supported by the rationale that the preferred shareholders are offered an additional return to facilitate their conversion to ordinary shares. Some jurisdictions require that this excess instead reduces additional contributed capital from other sources.

On the other hand, the issuance of debt that is convertible into equity (almost always into ordinary shares) does trigger accounting complexities. Under IAS 32, it is necessary for the issuer of non-derivative financial instruments to ascertain whether it contains both liability and equity components. If the instrument does contain both elements (for example, debentures convertible into ordinary shares), these components must be separated and accounted for according to their respective natures.

In the case of convertible debt, the instrument is viewed as being constituted of both an unconditional promise to pay (a liability) and an option granting the holder the right, but not the obligation, to obtain the issuer's shares under a fixed conversion ratio arrangement. (Under the provisions of IAS 32, unless the number of shares that can be obtained on conversion is fixed, the conversion option is not an equity instrument.) This option, at issuance date, is an equity instrument and must be accounted for as such by the issuer, whether subsequently exercised or not.

The amount allocated to equity is the residual derived by deducting the fair value of the liability component (typically, by discounting to present value the future principal and interest payments on the debt by the relevant interest rate) from the total proceeds of issuance. It would not be acceptable to derive the amount to be allocated to debt as a residual, on the other hand. This is a conservative rule that effectively maximises the allocation to debt and minimises the allocation to equity.

Retained Earnings

Accounting traditionally has clearly distinguished between equity contributed by owners (including donations from owners) and that resulting from the operating results of the reporting entity, consisting mainly of accumulated earnings since the entity's inception less amounts distributed to shareholders (i.e., dividends). Equity in each of these two categories is distinct from the other, and financial statement users need to be informed of the composition of shareholders' equity so that, for example, the cumulative profitability of the entity can be accurately gauged.

Legal capital (the defined aggregate par or stated value of the issued shares), additional contributed capital and donated capital collectively represent the contributed capital of the entity. The other major source of capital is retained earnings, which represents the accumulated amount of earnings of the entity from the date of inception (or from the date of reorganisation) less the cumulative amount of distributions made to shareholders and other charges to retained earnings (e.g., from treasury share transactions). The distributions to shareholders generally take the form of dividend payments, but may take other forms as well, such as the reacquisition of shares for amounts in excess of the original issuance proceeds. In addition to the net effect of an entity's operational income and expenditure, the retained earnings can be impacted by the following items which may be related to owners of share capital:

• Dividends;
• Certain sales of shares held in the treasury at amounts below acquisition cost;
• Certain share retirements at amounts in excess of book value;
• Related prior period adjustments;
• In consolidated financial statements, changes in ownership stake of the non-controlling interests which do not result in a loss of control of the subsidiary; and
• Recapitalisations and reorganisations.

An important rule relating to retained earnings is that transactions in an entity's own shares can result in a reduction of retained earnings (i.e., a deficiency on such transactions can be charged to retained earnings) but cannot result in an increase in retained earnings (any excesses on such transactions are credited to contributed capital, never to retained earnings).

If a series of operating losses have been incurred or distributions to shareholders in excess of accumulated earnings have been made and if there is a debit balance in retained earnings, the account is generally referred to as accumulated deficit.

Dividends and Distributions

Accounting for Treasury Share Transactions

The term treasury share refers to the entity's shares that were issued but subsequently reacquired and are being held (“in the company's treasury”) without having been cancelled. An entity may buy back its own shares, subject to laws of the jurisdiction of incorporation, for possibly many different and legitimate business purposes, such as to have on hand for later share-based payments to employees or vendors, or to decrease the “float” of shares outstanding—which may be done to provide upward pressure on the quoted price of the share or increase the earnings per share by decreasing the number of outstanding shares.

IFRS addresses treasury shares and sets as a general principle that “earnings” cannot be created by transactions in an entity's own shares, and thus the proper accounting would be to report these as capital transactions only.

Treasury shares do not reduce the number of shares issued but do reduce the number of shares outstanding, as well as total shareholders' equity. These shares are not eligible to receive cash dividends. Treasury shares are not an asset.

Reacquired shares that are awaiting delivery to satisfy a liability created by the firm's compensation plan or reacquired shares that are held in a profit-sharing trust may still be considered outstanding and, thus, may not be considered treasury shares. The terms and conditions of the compensation plan would need to be considered in the light of IFRS 10, Consolidated Financial Statements, which is addressed in Chapter 15.

Members' Shares in Co-operative Entities

Certain organisations are dubbed membership organisations or co-operatives. These are often entities providing services to a group having common membership or interests, such as labour unions or university faculty and staff. Credit unions (a form of savings and loan association) are a common example of this form of organisation. Other co-operatives may serve as marketing vehicles, as in the case of farmers' co-ops, or as buying organisations, as in co-operatives formed by merchants in certain types of businesses, generally to gain economies of scale and market power to compete with larger merchant chains. Generally, these types of organisations will refund or rebate profits to the members in proportion to the amount of business transacted over a time period, such as a year.

Ownership in co-operatives is represented by shares. Members' shares in co-operative entities have some characteristics of equity, but also, often, characteristics of debt, since they are not permanent equity which cannot be withdrawn. Members' shares typically give the holder the right to request redemption for cash, although that right may be subject to certain limitations or restrictions, imposed by law or by the terms of the membership agreement. IFRIC 2, Members' Shares in Co-operative Entities and Similar Instruments, gives guidance on how those redemption terms should be evaluated in determining whether the shares should be classified as financial liabilities or as equity.

Under IFRIC 2, shares for which the member has the right to request redemption are normally liabilities. Even when the intent is to leave in the equity interest for a long period, such as until the member ceases business operations, this does not qualify as true equity as defined in the Framework. However, the shares qualify as equity if:

• The co-operative entity has an unconditional right to refuse redemption; or
• Local law, regulation, or the entity's governing charter imposes prohibitions on redemption.

However, the mere existence of law, regulation or charter provisions that would prohibit redemption only if conditions (such as liquidity constraints) are met, or are not met, does not result in members' shares being treated as equity.