Company Accounts: Shares & Debentures — Practice

Question 1

A company has an authorised capital of ₹50,00,000 in shares of ₹10. It issued 3,00,000 shares, of which the public subscribed for 2,80,000. It called ₹8 per share and received all of it except on 5,000 shares. Compute the authorised, issued, subscribed, called-up and paid-up capital.

Accepted Answer

Authorised capital — ₹50,00,000. This is the maximum the company is permitted to raise under its memorandum of association. It is disclosed but is not an amount raised, and it may be increased by following the prescribed procedure.

Issued capital — 3,00,000 shares × ₹10 = ₹30,00,000. This is the part of the authorised capital actually offered to the public for subscription.

Subscribed capital — 2,80,000 shares × ₹10 = ₹28,00,000. This is the part of the issued capital that investors agreed to take up. The 20,000 shares not subscribed remain issued but unsubscribed.

Called-up capital — 2,80,000 shares × ₹8 = ₹22,40,000. This is the amount the company has so far demanded. The remaining ₹2 per share, amounting to ₹5,60,000, is uncalled.

Paid-up capital — called-up capital less calls in arrears.
Calls in arrears = 5,000 shares × ₹8 = ₹40,000
Paid-up capital = ₹22,40,000 − ₹40,000 = ₹22,00,000

The layers narrow at every step, and the reason each is separately disclosed is capital maintenance. Because shareholders enjoy limited liability, creditors can look only to the company's assets, so they are entitled to know how much capital has been promised, how much demanded and how much actually received. The uncalled ₹5,60,000 represents a further amount the company may demand from shareholders and is therefore relevant to a creditor's assessment, which is precisely why it is not netted away.

Question 2

A company has 10% cumulative preference shares of ₹20,00,000. No dividend was paid in 2023-24 or 2024-25. In 2025-26 the company earns a large profit and wishes to pay an equity dividend. Advise, and state how the position would differ if the shares were non-cumulative.

Accepted Answer

Cumulative preference shares carry the right that where the fixed dividend is not paid in any year, the arrear carries forward and must be paid before any dividend is paid to equity shareholders.

The annual preference dividend is 10% of ₹20,00,000 = ₹2,00,000.

Arrears: ₹2,00,000 for 2023-24 and ₹2,00,000 for 2024-25, a total of ₹4,00,000.
Current year: ₹2,00,000 for 2025-26.

Before any equity dividend may be paid in 2025-26, the company must pay ₹6,00,000 to the preference shareholders — the two years of arrears together with the current year's dividend. Only the profit remaining after that is available for equity.

Note that arrears of cumulative preference dividend are not a liability of the company until declared, because no dividend is owed until it is declared. They are disclosed as a contingent liability in the notes, which is the mechanism by which a reader is informed of the claim standing ahead of equity.

If the shares were non-cumulative, the position would be materially different. A non-cumulative preference dividend not paid in a year is simply lost; it does not accumulate. The company would need to pay only the current year's ₹2,00,000 before paying an equity dividend, and the ₹4,00,000 relating to the two earlier years would never become payable.

A point worth stating: preference shares are presumed to be cumulative unless the terms of issue expressly provide otherwise. So where a question describes preference shares without specifying, the cumulative treatment applies.

Question 3

State the purposes for which the Securities Premium Account may be applied under section 52 of the Companies Act, 2013, and explain why its use is restricted at all. State also the position on issuing shares at a discount.

Accepted Answer

Permitted applications under section 52.

Issuing fully paid bonus shares to members.
Writing off the preliminary expenses of the company.
Writing off the expenses of, or the commission paid or discount allowed on, any issue of shares or debentures of the company.
Providing for the premium payable on the redemption of redeemable preference shares or of debentures.
The purchase of the company's own shares or other securities under section 68.

Why the use is restricted.

The premium is money received in exchange for shares. It is therefore capital in substance, even though it is not part of share capital in form and is disclosed separately under reserves and surplus.

A company's shareholders enjoy limited liability, so its creditors can look only to the company's assets. The law protects that fund by insisting that capital may not be returned to shareholders except by prescribed procedures. If the Securities Premium Account could be applied freely, the most obvious application would be distribution as dividend — and that would be a return of capital to shareholders under the guise of profit, leaving creditors with a diminished fund while the limited liability shield remained intact.

The permitted uses are consistent with this. Bonus shares capitalise the premium permanently rather than distributing it. Writing off preliminary expenses, issue expenses and redemption premium applies capital receipts against capital losses. Buy-back is itself a regulated return of capital with its own safeguards. What unites them is that none results in a distribution of the premium as divisible profit.

Shares issued at a discount.

Section 53 prohibits a company from issuing shares at a discount, and any share so issued is void. The single exception is sweat equity shares issued under section 54, which may be issued at a discount or for consideration other than cash to directors or employees for know-how or value additions.

The prohibition follows from the same principle: issuing a ₹10 share for ₹8 would put on the register a share described as carrying ₹10 of capital against which only ₹8 was received, overstating to creditors the fund actually contributed. Note the contrast with debentures, which may be issued at a discount because a debenture holder is a creditor rather than a member and no representation about contributed capital arises.

Question 4

Distinguish calls in arrears from calls in advance, stating the accounting treatment, the balance sheet presentation and the interest position under the model articles. Explain why the two interest rates differ.

Accepted Answer

Calls in arrears.

These are amounts that have been called up but not received from shareholders. They represent capital demanded and not paid.

Treatment: either shown as a deduction from called-up capital in arriving at paid-up capital, or maintained in a Calls in Arrears Account which is deducted from called-up capital in the balance sheet. Either presentation makes the paid-up figure correct.

Interest: under the model articles in Table F, the company may charge interest at up to 10% per annum from the due date until payment. The directors have discretion to waive it.

Calls in advance.

These are amounts paid by a shareholder before the company has called for them.

Treatment: they are not share capital, because the company has not called the money and the shareholder has no obligation to have paid it. The amount is a liability, shown separately under current liabilities, and is applied against the call when it is subsequently made.

Interest: under Table F, the company must pay interest at up to 12% per annum on calls in advance.

An important consequence for the shareholder is that calls in advance carry no right to dividend and no additional voting rights, because the amount is not part of paid-up capital until the call is made.

Why the rates differ.

The asymmetry reflects who is in default and who is doing a favour.

A shareholder in arrears has failed to meet an obligation. The company has been deprived of capital it lawfully demanded and may have had to borrow to bridge the gap. Interest is charged as compensation for that default, and the ceiling of 10% keeps the charge from becoming punitive, with the directors retaining discretion to waive it in deserving cases.

A shareholder paying in advance has done more than was required, providing the company with funds before it was entitled to them. The company has the use of money it could not lawfully have demanded, and interest at up to 12% compensates the shareholder for parting with it early.

The higher rate on advances is thus a rate paid to a lender by choice, while the lower rate on arrears is a rate charged to a defaulter with discretion to remit — the difference in rate follows from the difference in the parties' positions rather than being arbitrary.

Question 5

A company offered 60,000 shares of ₹10 payable ₹3 on application, ₹4 on allotment and ₹3 on first and final call. Applications were received for 90,000 shares and allotment was made pro-rata to all applicants. Ramesh, who was allotted 1,200 shares, failed to pay the allotment money. Compute the amount he failed to pay on allotment, showing every step.

Accepted Answer

Working Note 1 — the pro-rata ratio.
Applications 90,000 shares against 60,000 allotted.
Ratio of shares applied for to shares allotted = 90,000 : 60,000 = 3 : 2.
Every applicant received two shares for every three applied for.

Working Note 2 — shares Ramesh applied for.
Allotted 1,200 shares.
Applied for = 1,200 × 3/2 = 1,800 shares.

Working Note 3 — application money paid by Ramesh.
He paid ₹3 on every share applied for.
1,800 × ₹3 = ₹5,400

Working Note 4 — application money properly attributable to shares allotted.
1,200 × ₹3 = ₹3,600

Working Note 5 — excess application money available for adjustment.
₹5,400 − ₹3,600 = ₹1,800
This excess is not refunded. Because Ramesh was a pro-rata allottee rather than a rejected applicant, the company retains the surplus and adjusts it against the allotment money due.

Working Note 6 — amount unpaid on allotment.
Allotment money due on shares allotted = 1,200 × ₹4 = ₹4,800
Less excess application money adjusted = ₹1,800
Net amount payable by Ramesh on allotment = ₹3,000
Amount actually paid = nil
Amount unpaid on allotment = ₹3,000

The critical point is that Ramesh's default is ₹3,000, not the ₹4,800 that the allotment call nominally represented. A candidate who computes the allotment due without adjusting the excess overstates the default by ₹1,800, and every subsequent figure — the forfeiture entry, the Share Forfeiture balance, the transfer to Capital Reserve — is then wrong.

This is why the six steps should be written out as numbered working notes rather than attempted in one line. Each step is separately markable, and setting them out is also what makes the arithmetic reliable.

Question 6

Continuing the previous facts, Ramesh's 1,200 shares were forfeited after he failed to pay the allotment money of ₹3,000, the first and final call not having been made at that time. Pass the forfeiture entry. Then show the entry if 800 of these shares are re-issued at ₹8 per share as fully paid, and compute the transfer to Capital Reserve.

Accepted Answer

Forfeiture entry.

Amount called up on the 1,200 shares at the date of forfeiture: application ₹3 plus allotment ₹4 = ₹7 per share, the call not having been made.
1,200 × ₹7 = ₹8,400

Amount received from Ramesh: the application money on the shares allotted, ₹3,600, plus the excess application money of ₹1,800 adjusted against allotment = ₹5,400.

Amount unpaid: ₹3,000, being the net allotment default computed earlier.

Check: ₹5,400 + ₹3,000 = ₹8,400, which equals the amount called up.

Entry:
Share Capital A/c Dr. ₹8,400
To Share Forfeiture A/c ₹5,400
To Calls in Arrears (Allotment) A/c ₹3,000

Share Capital is debited with the amount called up, since only that much had been credited to capital in respect of these shares. There is no Securities Premium entry because the shares were issued at par.

Re-issue of 800 shares at ₹8 as fully paid.

The shares are re-issued as fully paid at ₹10 face value, for ₹8, so the discount allowed is ₹2 per share.
Discount on re-issue = 800 × ₹2 = ₹1,600

Maximum discount permissible: the amount forfeited on the shares being re-issued.
Forfeited amount per share = ₹5,400 ÷ 1,200 = ₹4.50
On 800 shares = ₹3,600
The discount of ₹1,600 is well within this limit.

Entry:
Bank A/c Dr. ₹6,400
Share Forfeiture A/c Dr. ₹1,600
To Share Capital A/c ₹8,000

Transfer to Capital Reserve.
Amount forfeited on the 800 shares re-issued = ₹3,600
Less discount allowed on their re-issue = ₹1,600
Transfer to Capital Reserve = ₹2,000

Entry: Share Forfeiture A/c Dr. ₹2,000 / To Capital Reserve A/c ₹2,000

Balance remaining in the Share Forfeiture Account = ₹5,400 − ₹1,600 − ₹2,000 = ₹1,800, which relates to the 400 shares not yet re-issued (400 × ₹4.50). It stays there until those shares are re-issued.

Why Capital Reserve rather than the Profit and Loss Account. The surplus arises from a transaction in the company's own shares — a capital transaction — and not from trading. Crediting it to revenue profit would make it available for distribution as dividend, which would return capital to shareholders in the guise of profit and defeat capital maintenance.

Question 7

Distinguish a share from a debenture under five heads, and explain how the single underlying difference generates all of them.

Accepted Answer

The underlying difference is status. A shareholder is a member and part-owner of the company; a debenture holder is a creditor who has lent it money. Every distinction below follows from that.

Return. A shareholder receives a dividend, which is an appropriation of profit — payable only out of profits and only if declared by the company. A debenture holder receives interest, which is a charge against profit — payable at the contracted rate whether or not the company earns a profit, and enforceable as a debt if unpaid.

Tax treatment. Debenture interest is an expense deductible in computing taxable profits, because it is the cost of borrowed money. Dividend is a distribution of profit already taxed and is not deductible. This gives debt a tax advantage over equity as a source of finance.

Repayment. Debentures are normally repayable on a fixed date, and the debt must be discharged. Equity share capital is not repayable during the company's life except by prescribed procedures such as buy-back or a court-approved reduction, because capital maintenance requires the fund to remain available to creditors.

Control. Shareholders have voting rights and elect the directors, since they own the company. Debenture holders ordinarily have no voting rights, since they have lent to it rather than bought it, though the trust deed may confer rights on default.

Security. Debentures may be secured by a fixed or floating charge on the company's assets, so the holder has recourse to identified property. Shares cannot be secured, because a member's return is by definition the residual after all claims.

Ranking on winding up. Debenture holders are paid before any shareholder, secured debenture holders first out of their security. Preference shareholders rank ahead of equity, and equity takes only what remains.

How the single difference generates all of these. A lender bargains for a fixed and certain return and wants it protected, so interest is contractual, ranks ahead of owners, is deductible as a business cost, and may be secured. An owner takes the residual: the return is uncertain and comes only from profit, is not deductible because it is a distribution of profit, ranks last, and in exchange for bearing that risk the owner gets control through voting. Issuing shares at a discount is prohibited while issuing debentures at a discount is not, for the same reason — a share represents contributed capital on which creditors rely, whereas a debenture merely records a debt.

Question 8

Pass the journal entries for the issue of 5,000 debentures of ₹100 each in the following cases: (a) issued at par, redeemable at par; (b) issued at a discount of 5%, redeemable at par; (c) issued at par, redeemable at a premium of 10%; (d) issued at a discount of 5%, redeemable at a premium of 10%.

Accepted Answer

Face value throughout is 5,000 × ₹100 = ₹5,00,000.

The governing principle is that any discount on issue and any premium payable on redemption are recognised immediately at issue, because the obligation to pay the redemption premium arises the moment the debentures are issued even though payment falls due years later. This is prudence: a known future obligation is provided for as soon as it arises.

(a) Issued at par, redeemable at par.
Bank A/c Dr. ₹5,00,000
To Debentures A/c ₹5,00,000
No loss arises. The company receives face value and will repay face value.

(b) Issued at a discount of 5%, redeemable at par.
Cash received = ₹5,00,000 × 95% = ₹4,75,000; discount ₹25,000.
Bank A/c Dr. ₹4,75,000
Discount on Issue of Debentures A/c Dr. ₹25,000
To Debentures A/c ₹5,00,000
The discount is a capital loss, written off over the life of the debentures.

(c) Issued at par, redeemable at a premium of 10%.
Premium payable on redemption = ₹5,00,000 × 10% = ₹50,000.
Bank A/c Dr. ₹5,00,000
Loss on Issue of Debentures A/c Dr. ₹50,000
To Debentures A/c ₹5,00,000
To Premium on Redemption of Debentures A/c ₹50,000
The premium payable is recognised as a liability at once, even though it will be paid only on redemption.

(d) Issued at a discount of 5%, redeemable at a premium of 10%.
Bank A/c Dr. ₹4,75,000
Discount on Issue of Debentures A/c Dr. ₹25,000
Loss on Issue of Debentures A/c Dr. ₹50,000
To Debentures A/c ₹5,00,000
To Premium on Redemption of Debentures A/c ₹50,000
Both losses are recognised at issue. The total capital loss of ₹75,000 represents the full cost of the borrowing beyond the interest, and it is written off over the life of the debentures — ordinarily against the Securities Premium Account where one exists, since section 52 expressly permits that application, and otherwise against profits.

Some presentations combine the discount and the redemption premium into a single Loss on Issue of Debentures Account, which is equally acceptable provided the components are shown in the working.

Question 9

A company issued 9% debentures of ₹10,00,000 face value at a discount of 4%. Interest is payable annually and tax is deducted at source at 10%. Compute the annual interest and pass the entries for the interest becoming due, the tax withheld and the payment to debenture holders. Explain the base on which interest is computed.

Accepted Answer

Computation of interest.
Interest = Face value × coupon rate = ₹10,00,000 × 9% = ₹90,000 per annum.

The base is face value, not the ₹9,60,000 actually received. This is the point most often missed. The coupon rate is a contractual term attaching to the instrument's nominal value: a debenture of ₹100 carrying 9% entitles the holder to ₹9 a year whatever the company received on issue. The discount affects the company's effective cost of borrowing, which is higher than 9%, but it does not alter the contractual interest payable.

Tax deducted at source at 10% = ₹90,000 × 10% = ₹9,000.
Net amount payable to debenture holders = ₹90,000 − ₹9,000 = ₹81,000.

Entries.

Interest becoming due, with tax withheld:
Debenture Interest A/c Dr. ₹90,000
To Debenture Holders A/c ₹81,000
To Tax Deducted at Source A/c ₹9,000
The full gross interest of ₹90,000 is the company's expense, because that is the amount earned by the holders. The company is merely an agent for the ₹9,000 it withholds.

Payment to debenture holders:
Debenture Holders A/c Dr. ₹81,000
To Bank A/c ₹81,000

Payment of tax to the government:
Tax Deducted at Source A/c Dr. ₹9,000
To Bank A/c ₹9,000

At the year end, Debenture Interest is transferred to the Profit and Loss Account:
Profit and Loss A/c Dr. ₹90,000
To Debenture Interest A/c ₹90,000

Note that debenture interest is a charge against profit, not an appropriation. It is debited to the Profit and Loss Account and is payable whether or not the company earns a profit, because the holders are creditors and not members. Any tax deducted but not yet remitted is a current liability at the balance sheet date.

Question 10

Explain how limited liability makes capital maintenance necessary, and give two specific accounting rules in this chapter that follow from it.

Accepted Answer

Limited liability means that a shareholder's liability is confined to the amount unpaid on their shares. Once shares are fully paid, the shareholder may lose the investment but cannot be pursued for the company's debts, however large.

The consequence for creditors is decisive. A creditor of a sole proprietor or a partnership can proceed against the proprietor's or partners' personal assets. A creditor of a company cannot. The company's own assets are the entire fund available to satisfy claims.

Capital maintenance follows directly. If shareholders could freely withdraw the capital they contributed, the fund on which creditors rely would be depleted while the shield of limited liability remained intact. The law therefore treats share capital as a fund that must be raised in prescribed ways, disclosed in detail, and not returned to members except by procedures with their own safeguards.

Two rules that follow.

First, the restriction on the Securities Premium Account under section 52. The premium is money received for shares and so is capital in substance, even though it sits under reserves rather than share capital. If it were freely distributable it would be paid out as dividend, which would return capital to members disguised as profit. Section 52 therefore confines it to applications that do not distribute it — bonus shares, writing off preliminary and issue expenses, providing for redemption premium, and buy-back.

Second, the transfer of the surplus on re-issued forfeited shares to Capital Reserve rather than to the Profit and Loss Account. The gain arises from a transaction in the company's own shares, which is a capital transaction, not from trading. Crediting it to revenue profit would make it distributable as dividend, again returning capital under the guise of profit.

A third example, if needed, is the prohibition in section 53 on issuing shares at a discount: recording a ₹10 share against which only ₹8 was received would overstate to creditors the capital actually contributed.

Question 11

A company issued shares of ₹10 at a premium of ₹4, payable ₹5 on application including ₹1 premium, ₹6 on allotment including ₹3 premium, and ₹3 on call. A shareholder holding 500 shares paid the application money but failed to pay the allotment money, and the shares were forfeited before the call was made. Pass the forfeiture entry, and contrast the treatment if the default had been on the call instead.

Accepted Answer

Analysis of the amounts.
Per share: application ₹5, of which ₹4 is capital and ₹1 premium. Allotment ₹6, of which ₹3 is capital and ₹3 premium. Call ₹3, all capital.

At the date of forfeiture the call had not been made, so only application and allotment had been called.
Capital called up per share = ₹4 + ₹3 = ₹7. On 500 shares = ₹3,500.
Premium called up per share = ₹1 + ₹3 = ₹4. On 500 shares = ₹2,000.

Amounts received: application only.
Capital received = 500 × ₹4 = ₹2,000
Premium received = 500 × ₹1 = ₹500
Total received = ₹2,500

Amounts called but not received: the whole allotment of ₹6 per share.
Capital unpaid = 500 × ₹3 = ₹1,500
Premium unpaid = 500 × ₹3 = ₹1,500
Total unpaid = ₹3,000

Forfeiture entry.
Share Capital A/c Dr. ₹3,500
Securities Premium A/c Dr. ₹1,500
To Share Forfeiture A/c ₹2,500
To Calls in Arrears (Allotment) A/c ₹3,000

Share Capital is debited with the capital called up, ₹3,500. Securities Premium is debited with ₹1,500 only — the premium that was called up but not received. The ₹500 of premium received with the application money is not touched, because the company has that money and section 52 governs its use thereafter. Debiting the whole ₹2,000 of premium called would be wrong and is the standard error in this question type.

Share Forfeiture is credited with the ₹2,500 actually received, which is the maximum discount available if these shares are later re-issued.

Contrast if the default had been on the call.

If the shareholder had paid application and allotment in full and defaulted only on the call of ₹3, the entire premium of ₹4 per share would have been received. In that case the Securities Premium Account is not debited at all.

The entry would be:
Share Capital A/c Dr. ₹5,000, being the full ₹10 called up on 500 shares
To Share Forfeiture A/c ₹3,500, being ₹7 per share of capital received
To Calls in Arrears A/c ₹1,500, being ₹3 per share unpaid

The governing rule in both cases is that Securities Premium is written back only to the extent it was called up and not received. Where the premium has been received it stays, whatever subsequently happens to the shares.

Question 12

Explain why the surplus on re-issue of forfeited shares is credited to Capital Reserve, why the maximum discount on re-issue is limited to the amount forfeited, and why only the proportion relating to shares actually re-issued is transferred.

Accepted Answer

Why Capital Reserve.

When shares are forfeited the company retains money paid by the defaulting shareholder. When those shares are re-issued, the company receives a further amount. If the total exceeds what the shares would have brought in had they simply been issued once and paid for, a surplus arises.

That surplus is not a trading profit. It has not been earned by selling goods or rendering services; it arises from a transaction in the company's own shares, which is a capital transaction. Under the capital maintenance principle, amounts of a capital nature must not be made available for distribution to shareholders, because distributing them would return capital in the guise of profit and reduce the fund on which creditors rely, while limited liability leaves those creditors without recourse to the members.

Crediting the surplus to Capital Reserve achieves exactly this. A capital reserve is not available for distribution as dividend, so the amount stays within the company permanently.

Why the discount on re-issue is capped at the amount forfeited.

The cap exists so that the company is never worse off on the shares than if they had been fully paid on the original issue.

Suppose a ₹10 share on which ₹6 had been received is forfeited. The company holds ₹6. If it re-issues the share as fully paid for ₹4, it will have received ₹10 in total and is exactly whole. If it were permitted to re-issue for ₹3, it would have received only ₹9 against a share credited as fully paid at ₹10, and the register would represent to creditors ₹10 of contributed capital where only ₹9 was contributed.

So the maximum discount is the amount forfeited on those shares, and the rule is another application of the same principle that prohibits issuing shares at a discount under section 53.

Why only the proportion relating to re-issued shares is transferred.

The surplus is only determinable once it is known what the shares realised on re-issue. Until a forfeited share is re-issued, the company does not know whether it will be re-issued at a small discount, at the maximum discount, or at a premium, so the amount of surplus attributable to it is unknown.

The Share Forfeiture Account therefore continues to carry the amount relating to shares still held forfeited, and each tranche is transferred as and when it is re-issued.

Illustrating: if ₹5,400 was forfeited on 1,200 shares, that is ₹4.50 a share. On re-issuing 800 of them at a discount of ₹1,600, the transfer is ₹3,600 less ₹1,600, which is ₹2,000. The remaining ₹1,800, being ₹4.50 on the 400 shares not yet re-issued, stays in the Share Forfeiture Account, which is disclosed under share capital in the balance sheet until those shares are dealt with.

Question 13

A director proposes that the company fund a large dividend by transferring the Securities Premium Account and the Capital Reserve to the Profit and Loss Account. Advise, explaining the principle at stake and the consequences if such transfers were permitted.

Accepted Answer

The proposal is unlawful and should not be implemented.

The Securities Premium Account. Section 52 of the Companies Act, 2013 confines its application to a closed list: issuing fully paid bonus shares, writing off preliminary expenses, writing off the expenses, commission or discount on an issue of shares or debentures, providing for the premium payable on redemption of redeemable preference shares or debentures, and the buy-back of the company's own securities. Distribution as dividend is not among them, and transferring the balance to the Profit and Loss Account in order to distribute it would achieve indirectly precisely what the section forbids directly.

The Capital Reserve. A capital reserve arises from capital profits — here, the surplus on the re-issue of forfeited shares — and is by its nature not available for distribution as dividend. Its function is to keep such amounts permanently within the company.

The principle at stake.

A company's shareholders enjoy limited liability. Once their shares are fully paid they cannot be pursued for the company's debts, so creditors can look only to the company's assets. The law compensates creditors for that exposure by protecting the capital fund: capital may be raised only in prescribed ways, must be disclosed layer by layer so its extent is visible, and may not be returned to members except by procedures with their own safeguards, such as buy-back under section 68 or a reduction of capital under section 66, each of which carries protections for creditors.

Both accounts the director proposes to distribute are capital in substance. The securities premium is money received in exchange for shares; the capital reserve is a gain on a transaction in the company's own shares. Neither was earned by trading, and distributing either would be a return of capital dressed as profit.

Consequences if such transfers were permitted.

Creditors would be systematically misled. Amounts disclosed as capital and reserves, on which a lender relies in extending credit, could be paid away to members at will, leaving the disclosure meaningless.

The safeguards on capital reduction would be circumvented entirely. Sections 66 and 68 prescribe procedures precisely because returning capital affects creditors; a company able to route capital through the Profit and Loss Account would bypass all of them.

Distributable profit would cease to measure performance. A reader comparing years could no longer tell whether a dividend was funded by earnings or by capital, which is the central thing the distinction between capital and revenue exists to communicate.

What may properly be done. Dividend may be paid out of profits of the current year, out of accumulated profits of previous years transferred to reserves, or out of both, subject to the Companies (Declaration and Payment of Dividend) Rules. If the company wishes to use the securities premium, the lawful route is to issue fully paid bonus shares, which capitalises the amount permanently rather than distributing it — the shareholders receive shares rather than cash, and the fund available to creditors is undiminished.

Question 14

A company needs ₹50,00,000 of long-term finance and is choosing between an issue of equity shares and an issue of 10% debentures. Advise on the accounting and financial consequences of each, and identify the circumstances favouring one over the other.

Accepted Answer

The choice is between admitting new owners and incurring a debt, and every consequence follows from that.

Equity issue.

The ₹50,00,000 becomes permanent capital. It is not repayable during the company's life except by buy-back or a court-approved reduction, so it imposes no obligation to find cash at any future date.

The return to the new shareholders is a dividend, an appropriation payable only out of profits and only if declared. In a poor year the company can pay nothing, and no default arises.

Dividend is not deductible in computing taxable profits, because it is a distribution of profit already taxed.

The new shareholders acquire voting rights, so control is diluted and existing shareholders' proportionate stake falls. Earnings per share is diluted immediately, because profit is spread over more shares.

Debenture issue.

The ₹50,00,000 is a liability repayable on a fixed date, so the company must plan for redemption and may need to build a fund or refinance.

Interest of ₹5,00,000 a year is a charge against profit, payable whether or not the company earns a profit and enforceable as a debt if unpaid. Failure to pay can lead to enforcement of security and, in a bad year, to insolvency.

Interest is deductible in computing taxable profits, so the after-tax cost is materially lower than the coupon rate — at a 25% tax rate the effective cost of ₹5,00,000 of interest is ₹3,75,000.

Debenture holders have no voting rights, so control is undiluted. Where debentures are secured, a charge is created on the company's assets, which restricts its freedom to deal with them and to raise further secured borrowing.

The debentures may be issued at a discount, which shares may not, though any discount and any redemption premium are recognised as a capital loss at the time of issue and written off over the term.

Circumstances favouring debentures.

Where earnings are stable and predictable, so that fixed interest can be met reliably in any foreseeable year.

Where the return on the funds employed comfortably exceeds 10%, since the surplus over the interest cost accrues entirely to the existing equity shareholders — this is trading on equity, and it magnifies returns.

Where existing shareholders wish to preserve control.

Where the company is profitable and can use the tax deduction, which reduces the effective cost.

Where the company has assets available to secure the issue and a modest existing debt burden.

Circumstances favouring equity.

Where earnings are volatile or the business is young, so a fixed annual charge would be dangerous.

Where the company is already substantially geared and further fixed obligations would threaten solvency.

Where the return on the project is uncertain or expected to be below the cost of debt, in which case gearing magnifies losses just as it magnifies gains.

Where the funds are needed for a long-gestation project with no early cash flows to service interest.

A balanced answer notes that the two are not exclusive. Convertible debentures offer interest and security initially with conversion to equity later, and a mixed issue can moderate both the fixed charge and the dilution.

Question 15

Explain why a company's share capital is disclosed in five separate layers when a sole proprietor's capital is a single figure, and what a creditor learns from each layer.

Accepted Answer

The reason for the difference is limited liability and the capital maintenance that follows from it.

A sole proprietor is personally liable for the debts of the business without limit. A creditor assessing the proprietor looks to the proprietor's whole estate, and the capital figure in the books is of secondary importance — it records what the proprietor has left in the business, but it does not bound the creditor's recourse. A single figure suffices.

A company's shareholders are liable only for the amount unpaid on their shares. A creditor has recourse to the company's assets and to nothing else. The capital position is therefore the principal thing a creditor needs to understand, and a single figure would conceal most of what matters. So the law requires it to be presented as a series of layers, each answering a different question.

Authorised capital. The maximum the company may raise under its memorandum. A creditor learns the headroom available: a company that has issued far less than it is authorised to issue can raise further equity without altering its constitution, which is relevant to whether it can strengthen its position if trading deteriorates.

Issued capital. How much of that maximum has actually been offered to investors. The gap between authorised and issued is the unused headroom just described.

Subscribed capital. How much of the issue investors actually took up. A large gap between issued and subscribed indicates that the market declined the offer, which is information about how the company is regarded.

Called-up capital. How much of the subscribed capital the company has so far demanded. The difference — uncalled capital — is money the company has a right to demand from members and is therefore a real further resource available to meet debts. A creditor lending to a company with substantial uncalled capital has more comfort than the paid-up figure alone would suggest. Where part of it is reserve capital, called only on winding up, it is available precisely when a creditor is most likely to need it.

Paid-up capital. How much has actually been received. This, and not any of the earlier layers, is the money that has genuinely come into the company. The difference between called-up and paid-up is calls in arrears, and a large arrears figure signals that members are defaulting, which is both a shortfall in the fund and a warning sign about the shareholder base.

The cumulative picture. Reading the five layers together, a creditor learns how much capital has been promised, how much demanded, how much received, how much remains demandable, and how much further could be raised without constitutional change. That is a far richer account of the fund available to satisfy claims than a single figure, and it exists because the creditor has no other fund to look to.

The same logic explains the separate disclosure of forfeited share amounts, of the Securities Premium Account and of capital reserves: each is capital in substance and the reader is entitled to know how much of the company's reserves can be distributed and how much cannot.

Practice — Company Accounts: Shares & Debentures

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