The Share Premium Account represents the amount received by a company over and above the nominal (or par) value of its issued shares. When a company issues shares at a price higher than their nominal value, the excess amount is credited to the share premium account. This account forms part of shareholders’ equity and is subject to specific legal restrictions regarding its use. It reflects the additional capital contributed by shareholders, indicating investor confidence in the company’s future prospects.
1. Understanding the Share Premium Account
When a company issues shares, each share has a nominal value, which is the face value stated in the company’s charter. However, shares are often issued at a price higher than this nominal value, especially if the company has a strong reputation or growth prospects. The excess amount paid over the nominal value is recorded in the share premium account. This account is part of the capital reserves and is not distributable as dividends under most jurisdictions.
A. Key Features of the Share Premium Account
- Represents Additional Capital: Reflects the amount paid by shareholders over the nominal value of shares.
- Part of Shareholders’ Equity: Recorded under the equity section of the balance sheet, contributing to the company’s financial strength.
- Restricted Use: Subject to legal restrictions, the funds in the share premium account cannot be freely distributed as dividends.
- Indicates Investor Confidence: A significant share premium suggests that investors are willing to pay more for ownership in the company, reflecting strong market confidence.
2. Calculation of the Share Premium
The share premium is calculated by subtracting the nominal value of the shares from the issue price and multiplying by the number of shares issued.
Formula:
Share Premium = (Issue Price – Nominal Value) × Number of Shares Issued
Example:
- Nominal Value per Share: $1
- Issue Price per Share: $3
- Number of Shares Issued: 100,000
- Share Premium: ($3 – $1) × 100,000 = $200,000
3. Accounting Treatment of the Share Premium Account
The share premium account is recorded in the company’s financial statements during the issuance of shares. It is a capital reserve and must be presented separately from the nominal share capital.
A. Journal Entry for Share Issuance at a Premium
When shares are issued at a premium, the following journal entry is made:
- Debit: Bank Account (Total amount received from shareholders)
- Credit: Share Capital Account (Nominal value of shares)
- Credit: Share Premium Account (Excess over nominal value)
B. Example of Journal Entry
For a company issuing 100,000 shares at $3 each with a nominal value of $1 per share:
- Debit: Bank Account $300,000
- Credit: Share Capital Account $100,000
- Credit: Share Premium Account $200,000
4. Uses of the Share Premium Account
The share premium account is subject to legal restrictions and cannot be used freely like retained earnings. However, there are specific purposes for which these funds can be utilized:
A. Issuing Bonus Shares
- Companies can issue bonus shares to existing shareholders using the share premium account. Bonus shares are free additional shares given to shareholders based on their existing holdings.
B. Writing Off Preliminary Expenses
- Preliminary expenses, such as the costs of forming the company, legal fees, and underwriting commissions, can be written off using the share premium account.
C. Writing Off Expenses or Discounts on Issue of Shares or Debentures
- Any expenses or discounts related to the issuance of shares or debentures can be offset using the share premium account.
D. Redemption of Redeemable Preference Shares or Debentures
- The share premium account can be used to fund the redemption of redeemable preference shares or debentures.
5. Legal and Regulatory Considerations
The use of the share premium account is governed by corporate laws and accounting standards to ensure that it is not misused. These regulations vary by jurisdiction but generally impose strict limitations on how share premium funds can be applied.
A. Restrictions on Dividend Distribution
- The share premium account cannot be used to pay dividends to shareholders. Dividends must be paid from distributable profits or retained earnings.
B. Disclosure Requirements
- Companies must disclose the share premium account separately in their financial statements, showing how the funds were generated and utilized.
C. Compliance with Company Law
- Companies must adhere to legal guidelines regarding the use of the share premium account, ensuring transparency and protecting shareholder interests.
6. Example of the Share Premium Account in Financial Statements
Consider a company, XYZ Ltd, that issued 200,000 shares at $5 each with a nominal value of $1 per share:
- Nominal Value: 200,000 shares × $1 = $200,000
- Share Premium: (5 – 1) × 200,000 = $800,000
A. Balance Sheet (Equity Section)
| Equity | Amount ($) |
|---|---|
| Share Capital (200,000 shares at $1 each) | 200,000 |
| Share Premium Account | 800,000 |
| Retained Earnings | 500,000 |
| Total Equity | 1,500,000 |
7. Advantages and Disadvantages of the Share Premium Account
A. Advantages
- Additional Capital: Provides the company with additional funds without diluting control through new share issuance.
- Financial Strength: Increases the equity base, enhancing the company’s financial stability and creditworthiness.
- Flexible Use (within legal limits): Can be used for specific purposes such as issuing bonus shares or writing off preliminary expenses.
B. Disadvantages
- Restricted Use: Legal restrictions limit how the share premium account can be used, reducing financial flexibility compared to retained earnings.
- No Direct Benefit to Shareholders: Funds in the share premium account cannot be distributed as dividends, which may not align with shareholder expectations.
8. Differences Between Share Premium and Retained Earnings
| Feature | Share Premium Account | Retained Earnings (Profit and Loss Reserve) |
|---|---|---|
| Source | Excess amount received over the nominal value of shares issued. | Accumulated net profits retained in the business after dividends. |
| Usage | Restricted to specific purposes like issuing bonus shares or writing off preliminary expenses. | Flexible use, including dividend distribution, reinvestment, or debt repayment. |
| Dividend Distribution | Cannot be used for paying dividends. | Can be used to pay dividends to shareholders. |
| Legal Restrictions | Subject to strict legal restrictions. | Fewer restrictions compared to the share premium account. |
The Role of the Share Premium Account in Corporate Finance
The Share Premium Account plays a crucial role in strengthening a company’s equity base and reflecting investor confidence. While its use is legally restricted, it serves essential functions such as funding bonus shares and covering preliminary expenses. By understanding the share premium account’s purpose and limitations, companies can manage their capital effectively, ensuring financial stability and compliance with legal requirements.