Businesses need money to eliminate the gap between a company’s goals and the current state of affairs. The needs of a business are fulfilled by hiring people, implementation of business projects, and operational activities. So, what is needed to execute these activities successfully?
It’s the money or capital, and by effectively using capital, the business can ultimately achieve financial targets.
The question arises here “how to raise finance without incurring a liability?” That’s possible via the sale of the stock. Let’s discuss detailed aspects of the process and logical reasons to raise finance via the sale of shares.
Why does a business sell stock?
Businesses sell stock to generate cash for running operations and continuing business projects. Cash is a necessary and integral item to continue any business. The sale of business shares is one of the techniques by which a business can generate significant cash.
If a company wants to generate cash without taking a loan, selling shares is considered a prime source of financing. Further, stocks represent the ownership in a company, and stockholders are entitled to their respective share of dividends out of distributable profits of a company.
Shareholders/stockholders are given the right to vote on certain matters (voting rights are associated with some type of shares). These shareholders are also given a proportionate share to any residual assets in case of liquidation of a company. However, shareholders stand second in the line, and debtors are given the first right to claim over assets of the company.
Difference between the sale of shares and sale of business
When shares are sold, all the rights and responsibilities associated with shares are transferred to new owners. So, all the assets and liabilities of the company are transferred to the buyer. On the other hand, when the business is sold, the buyer does not take on the company’s liabilities (certain exemptions are applicable).
In this article, we shall discuss three different transactions that involve the trading of shares. These transactions include the following.
- Sale of shares for cash
- Repurchasing of a company’s share
- Sale of shares in exchange for non-cash assets
Sale of shares for cash
It means that the company has received cash by selling its shares. The recording of the sale of shares for cash is dependent on the par value. Par value of a share is basically a legal capital per share, and it is usually printed on the face of a share certificate. The amount received equivalent to par value is recorded in the common stock account. On the other hand, the amount received above par value is recorded as additional paid-in capital.
In other words, additional paid-in capital is the difference between cash receipt from the sale of shares and cash equivalent to the par value of shares sold.
Accounting treatment for the sale of shares
Accounting treatment for the sale of shares depends on if shares are issued at par value or above par. If a company sells its common stock at par value, the common stock account is credited by debiting the cash account. The journal entry to record the sale of common stock is as depicted below.
| Particulars | Debit | Credit |
| Cash account | xxx | |
| Common Stock account | xxx |
But usually, the companies sell the shares at a price higher than the par value of shares. In such a case, the additional paid-in capital account is introduced in the books. The value above the par value of shares is recorded by crediting additional paid-in capital along with the credit of common stock. In this case, the following journal entries will be recorded in books of accounts by debiting cash and crediting two heads of common stock and additional paid-in capital)
| Particulars | Debit | Credit |
| Cash account | Xxx | |
| Common Stock account | xxx | |
| Additional paid capital account | xxx |
However, if the company issues preferred shares, the common stock account will be replaced with preferred stock.
| Particulars | Debit | Credit |
| Cash account | xxx | |
| Preferred Stock account | xxx | |
| Additional paid-in capital account | xxx |
Example – 1
Let’s understand the concept with the help of a hypothetical example. Suppose TPL. Ltd has issued 50,000 common stocks for $1 per share which is par value. The TPL will calculate the value of its common stock and additional paid-in capital as:
Calculation of Cash Received
=50,000 shares * $1
= $ 50,000
Calculation of Common stock value
=50,000 shares * $ 1
=$ 50,000
| Particulars | Debit | Credit |
| Cash account | $50,000 | |
| Common Stock account | $ 50,000 |
(Journal entry when shares are issued at par)
Example – 2
TPL. Ltd has issued 50,000 common stocks for $10 per share. The par value of shares is $1 per share. The TPL will calculate the value of its common stock and additional paid-in capital as:
Calculation of Cash Received
=50,000 shares * $10
= $ 500,000
Calculation of Common stock value
=50,000 shares * $ 1
=$ 50,000
Calculation of Additional paid-in capital
=50,000 shares* ($ 10 – $1)
=$ 450,000
Journal entries will be posted as follows,
| Particulars | Debit | Credit |
| Cash account | $500,000 | |
| Common Stock account | $ 50,000 | |
| Additional paid capital account | $450,000 |
(Journal entry for the issue of common shares above par)
If TPL ltd. want to sell the shares at par value, then no calculation would be required for additional paid-in capital. Further, if the company is interested in issuing preferred stock, then we will replace the word common stock with preferred stock in the journal entry.
Example – 3
Suppose TPL. Ltd has issued 60,000 preferred stocks for $10 per share. The par value of shares is $1 per share. The TPL will calculate the value of its preferred stock and additional paid-in capital as:
Calculation of Cash Received
=60,000 shares * $10
= $ 600,000
Calculation of Common stock value
=60,000 shares * $ 1
=$ 60,000
Calculation of Additional paid-in capital
=60,000 shares* ($ 10 – $1)
=$ 540,000
The following journal entry will be posted in the books.
| Particulars | Debit | Credit |
| Cash account | $ 600,000 | |
| Preferred Stock account | $ 60,000 | |
| Additional paid-in capital account | $ 540,000 |
(Journal entry for the issue of preferred shares above par)
Repurchasing of a company’s share
Repurchase of the shares is a reverse phenomenon of the shares purchases. In this case, the cash is given back to the shareholders, and capital accounts are reversed to reflect the transaction. There might be different goals behind companies buying back their own shares. However, generally, it’s done when the company’s share is undervalued in the market. It helps to limit the supply, leading to an increase in the share value. Journal entries for the repurchase lead to an outflow of cash and reduction of share capital. It’s like revers of issuing shares.
Shares sale in exchange for non-cash assets
Sometimes, the companies may issue shares against receipt of the assets. These assets may be tangible or intangible. An accounting entry for the sale of the share against non-cash consideration is the same. However, the asset received is debited instead of cash. Further, the fair market value of the transaction needs to be calculated.
Conclusion
Raising finance via equity is one of the most important aspects of business management. Allocation of shares to the investors makes them shareholders and owners of the business. During the initial issue of the shares, the company sets a legal price which is called the par value of the shares.
The cash received to the extent of par value is recorded as common/preferred capital. On the other hand, cash received above par value is recorded as additional paid-in capital. Likewise, the company can issue shares against receipt of non-cash consideration. Similarly, the company can buy back its shares, and the journal entry is reversed in this case.
Frequently asked questions
How to determine the value of capital in case of selling shares for a non-cash asset?
Following is a general rule,
- The value of the shares is to be determined from trading market.
- If the market does not exist for the shares, the fair market value of the consideration received needs to be assessed.
What’s the impact of shares repurchase on paid-in capital?
Share repurchase leads to a reduction of paid-in capital. It’s a simple reversal of the capital. Hence, it’s debited from the capital account.
What’s the difference between common stock and preferred stock?
The main difference is that preference shares are given preference at the time of dividend distribution. However, they do not have voting rights. Hence, it does not impact the decision-making process.