A company’s financial structure includes various accounts that track capital, revenue, and reserves. One such account, the share premium account, plays a crucial role in corporate finance. Understanding how the share premium account functions helps investors, accountants, and business owners make informed financial decisions.
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What is a Share Premium Account?
A share premium account records the additional amount received from issuing shares above their nominal (par) value. When a company issues shares at a price higher than their face value, the excess amount is credited to the share premium account rather than the ordinary share capital account.
Example:
A company issues 1,000 shares with a nominal value of $10 per share. Investors purchase them at $15 per share. The total share capital and share premium calculation would be:
- Nominal value per share = $10
- Issued price per share = $15
- Share premium per share = $15 – $10 = $5
- Total premium = $5 × 1,000 = $5,000
The company records:
Purpose of the Share Premium Account
The share premium account serves multiple financial and strategic purposes. Companies use it to strengthen their balance sheet, comply with regulations, and finance specific activities.
Purpose | Description |
---|---|
Legal Capital Protection | Acts as a financial cushion, often restricted from direct distribution as dividends. |
Issue Bonus Shares | Companies can capitalize share premium to issue additional shares to existing shareholders. |
Cover Share Issue Expenses | The costs of issuing shares, such as underwriting fees, can be deducted from the share premium account. |
Redemption of Preference Shares | Helps finance the repurchase of preference shares without using retained earnings. |
Share Premium vs. Other Capital Accounts
Companies maintain several capital accounts, each with specific functions. Understanding the differences helps in financial analysis.
Feature | Share Capital | Share Premium | Retained Earnings |
---|---|---|---|
Source | From issuing shares at nominal value | From selling shares above nominal value | From net profits after expenses and dividends |
Usability | Can be used for dividend payments | Restricted use by law | Used for reinvestment or dividends |
Impact on Equity | Increases equity directly | Increases reserves in equity section | Affects total retained profits |
Accounting Treatment of the Share Premium Account
The share premium account is recorded under shareholders’ equity in the balance sheet. It follows specific accounting rules to ensure compliance with financial regulations.
Journal Entry for Share Issue with Premium
When a company issues shares at a premium, the journal entry is:
Account | Debit | Credit |
---|---|---|
Cash (or Bank) | TotalAmountRaisedTotal Amount Raised | |
Share Capital | NominalValueofSharesNominal Value of Shares | |
Share Premium Account | ExcessOverNominalValueExcess Over Nominal Value |
For example, if a company issues 5,000 shares at $12 per share with a nominal value of $10:
The journal entry:
- Debit: Cash $60,000
- Credit: Share Capital $50,000
- Credit: Share Premium Account $10,000
Legal and Regulatory Restrictions on Share Premium Use
In the U.S., the treatment of share premium depends on state laws and corporate policies. Some key restrictions include:
- Cannot be Used for Dividends: Unlike retained earnings, share premium funds cannot be distributed as dividends.
- Restricted Use for Share Buybacks: Some states require share premium to be used only for issuing new shares or covering expenses.
- Disclosure Requirements: Companies must report share premium transactions in their financial statements under GAAP guidelines.
Effects of Share Premium on Financial Statements
The share premium account influences a company’s financial position. It strengthens equity, providing flexibility for future expansion.
Impact on Balance Sheet
Component | With Share Premium | Without Share Premium |
---|---|---|
Total Equity | Higher | Lower |
Financial Stability | Stronger | Weaker |
Investor Confidence | Higher due to surplus funds | May raise concerns about low reserves |
Impact on Shareholder Value
Investors perceive a high share premium as a sign of demand and confidence in the company. However, excessive premium without proper utilization may indicate inefficiency.
How Companies Use Share Premium Strategically
Companies employ various strategies to utilize share premium effectively.
- Capitalization of Reserves: Issuing bonus shares maintains liquidity while rewarding shareholders.
- Debt Reduction: Some companies use share premium to offset liabilities, improving their leverage ratio.
- Mergers and Acquisitions: Extra capital can finance business expansion through acquisitions.
Conclusion
The share premium account is a critical component of corporate finance, reflecting investor confidence and financial health. Understanding its purpose, accounting treatment, and legal restrictions enables businesses and investors to make sound financial decisions. By leveraging share premium effectively, companies enhance their financial stability, attract investments, and ensure long-term growth.