Navigating Company Finances: Understanding the Share Premium Account

Navigating Company Finances: Understanding the Share Premium Account

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.

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:

Share Capital=1,000×10=10,000 \text{Share Capital} = 1,000 \times 10 = 10,000 Share Premium Account=1,000×5=5,000 \text{Share Premium Account} = 1,000 \times 5 = 5,000

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.

PurposeDescription
Legal Capital ProtectionActs as a financial cushion, often restricted from direct distribution as dividends.
Issue Bonus SharesCompanies can capitalize share premium to issue additional shares to existing shareholders.
Cover Share Issue ExpensesThe costs of issuing shares, such as underwriting fees, can be deducted from the share premium account.
Redemption of Preference SharesHelps 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.

FeatureShare CapitalShare PremiumRetained Earnings
SourceFrom issuing shares at nominal valueFrom selling shares above nominal valueFrom net profits after expenses and dividends
UsabilityCan be used for dividend paymentsRestricted use by lawUsed for reinvestment or dividends
Impact on EquityIncreases equity directlyIncreases reserves in equity sectionAffects 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:

AccountDebitCredit
Cash (or Bank)TotalAmountRaisedTotal Amount Raised
Share CapitalNominalValueofSharesNominal Value of Shares
Share Premium AccountExcessOverNominalValueExcess Over Nominal Value

For example, if a company issues 5,000 shares at $12 per share with a nominal value of $10:

Total Cash Received=5,000×12=60,000 \text{Total Cash Received} = 5,000 \times 12 = 60,000 Nominal Value Recorded in Share Capital=5,000×10=50,000 \text{Nominal Value Recorded in Share Capital} = 5,000 \times 10 = 50,000 Share Premium Recorded=5,000×(1210)=10,000 \text{Share Premium Recorded} = 5,000 \times (12 - 10) = 10,000

The journal entry:

  • Debit: Cash $60,000
  • Credit: Share Capital $50,000
  • Credit: Share Premium Account $10,000

In the U.S., the treatment of share premium depends on state laws and corporate policies. Some key restrictions include:

  1. Cannot be Used for Dividends: Unlike retained earnings, share premium funds cannot be distributed as dividends.
  2. Restricted Use for Share Buybacks: Some states require share premium to be used only for issuing new shares or covering expenses.
  3. 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

ComponentWith Share PremiumWithout Share Premium
Total EquityHigherLower
Financial StabilityStrongerWeaker
Investor ConfidenceHigher due to surplus fundsMay 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.

  1. Capitalization of Reserves: Issuing bonus shares maintains liquidity while rewarding shareholders.
  2. Debt Reduction: Some companies use share premium to offset liabilities, improving their leverage ratio.
  3. 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.