Module 2 – Shareholders’ Equity

(Stock rights and quasi-reorganization)

Learning Outcomes:
 Identify of stock rights transactions
 Prepare journal entries on issuance, exercise and expiration of stock rights
 Understand quasi-reorganization using revaluation surplus and share premium

Core Value/Biblical Principles:

Shareholders’ equity of a corporation consists of the investments of the shareholders. It is the obligation of the
management to protect this wealth in order to build trust between the investors. In line with this, here is a bible
verse that you can reflect on regarding this lesson:

Proverbs 13:11

Wealth gained hastily will dwindle, but whoever gathers little by little will increase it.

(Stop and Think):

 What benefits do shareholders get other than profits? Companies provide additional incentives to
shareholders like pre-emptive right. This can be used at the option of the shareholders. Also, as discussed
in the previous module, the Company is required to protect the shareholders’ wealth. In effect, if the
Company suffers losses and encounters bankruptcy, they cannot simply close the operations without
exhausting other solutions to continue the operations.
Introduction:
Corporations are characterized by absentee ownership and limited liability. They have a separate personality from
its owners. Meeting financial needs of a corporation involves generating funds from public investors. Protecting the
interest of this investors is the primary reason why corporations are subjected to government regulation and
control.

Body:

A corporation may issue rights, warrants, or options that permit the purchase of the company’s shares for a specified
period (exercise period) at a certain price (exercise price/strike price). Although these terms are used interchangeably,
a distinction may be made as follows:

Stock rights

Stock rights are issued to existing shareholders entitling them to maintain a proportionate interest in the
ownership of the corporation when new shares are to be issued. The issuance of these new shares is offered first to the
existing shareholders, proportionate to the shareholders’ previous holdings, before it is offered to other interested
investors. This is called pre-emptive right.

At the time of these rights are issued, only a memorandum entry is done, listing the number of additional shares
that may be acquired through the exercise of rights. When the rights are exercised, the usual journal entry is made to
record issuance of shares for cash. If the rights expire, another memo entry is done.

Example:

ABC Corporation had 100,000 outstanding ordinary shares with P50 par value and decided to issue additional 50,000
shares. It issued 100,000 stock rights to its existing shareholders, giving them the right to purchase one ordinary share
at P80 per share for every 2 stock rights held. On the date of distribution, each share sells at P90 per share. Out of the
100,000 rights distributed, 50,000 rights were exercised. The remaining rights expired. The following entries shall be
made in the books of ABC Corporation.

For the issuance of rights:

Memo: Issued 100,000 stock rights to shareholders permitting them to purchase one share of P50 par ordinary
share at P90 for every 2 rights submitted.

For the exercise of 50,000 rights:

Cash (50,000/2 x P80) 2,000,000

Ordinary Share Capital (25,000 shares x P50) 1,250,000
Share Premium – Ordinary (25,000 shares x P30) 750,000

For the expiration of 50,000 rights,

Memo: 50,000 of the 100,000 stock rights issued to shareholders expired.

Share Warrants Attached to Other Securities

Share warrants are sold by the corporation for cash in conjunction with the issue of another security, usually
preference shares or bonds. This action done by companies to make the issuance of their preference shares or bonds
more attractive to investors as well as to be able to dictate better price for these securities.

When preference shares are issued with detachable warrants, the proceeds should be allocated to both
preference shares and warrants based on the fair values of the two securities at the time of issuance. The value
attached to the warrants is credited to Ordinary Share Warrants Outstanding or any appropriately described account
(e.g. Share Premium from Warrants, or Share Warrants Outstanding).

For example, a corporation issues 2,000 shares of P50 par value preference shares at P90 per share. Each share
issued includes 1 detachable warrant that entitles the holder to purchase one share of P40 par value ordinary shares at
P60 per share. At that time, the market values follows:

 Preference Share without warrant attached – P80

 Warrant – P10
 Ordinary Share - P70

Subsequently, all of the warrants were exercised.

Journal entries follows:

Issuance of preference shares:

Cash (2,000 shares x P90) 180,000

Preference Share Capital (2,000 shares x P50) 100,000
Ordinary Share Warrants Outstanding (2,000 warrants x P10) 20,000
Share Premium – Preference 60,000

Allocation of issue price:

To preference shares: (2000 shares x 90) x 80/90= 160,000
To warrants: (2000 shares x 90) x 10/90 = 20,000

Exercise of warrants:

Cash (2000 x P60) 120,000

Ordinary Share Warrants Outstanding 20,000
Ordinary Share Capital (2,000 x P40) 80,000
Share Premium – Ordinary 60,000

Assume instead that only 1,200 warrants were exercised and the remaining expired.

Exercise of warrants

Cash (1200 x P60) 72,000

Ordinary Share Warrants Outstanding 12,000
Ordinary Share Capital (1,200 x P40) 48,000
Share Premium – Ordinary 36,000
 Expiration of Share Warrants

Ordinary Share Warrants Outstanding 8,000

Share Premium from Expired Warrants 8,000

QUASI-REORGANIZATION

When a company enters bankruptcy, it may be more beneficial for the corporation to establish a new
management group and engage in quasi-reorganization. A quasi-reorganization is an accounting procedure that
involves a revaluation of corporate assets and liabilities and a restatement of the corporate capital structure to enable
the corporation to have a “fresh start” toward financial solvency and profitability.

SEC guidelines on quasi-reorganization require that only financially distressed companies may apply and that
they should have substantial surplus in the market value of its property, plant and equipment as established by
appraisers. The amount of the revaluation surplus set up through appraisal should be adequate to absorb the deficit
that is intended to be eliminated in the quasi-organization.

After the quasi-reorganization, the company must have a zero balance in retained earnings. In its subsequent
financial statements, the retained earnings should be “dated” for a period of approximately 10 years to show the fact
and the date of the quasi-reorganization. Moreover, at least three years from quasi-reorganization date, the amount of
the accumulated deficit eliminated should be disclosed in the financial statements.

For example, assume CDE Corporation suffered losses and the management decided to undergo a quasi-
reorganization. This was approved by the shareholders, creditors of the corporation as well as the SEC. An independent
appraisal of property, plant and equipment was recommended on the valuation of these assets. The following
information was found relevant to the quasi-reorganization:

1. The property, plant and equipment costing P5,000,000 with accumulated depreciation of P1,500,000 are
determined to have a fair value of P5,250,000.
2. The inventory should be written down by P200,000.
3. Accounts payable amounting to P150,000 are not recognized in the accounts.
4. The Retained Earnings account has a debit balance (deficit) of P1,000,00 prior to quasi-reorganization.

Journal entries:

1. Property, Plant and Equipment 2,500,000

Accumulated Depreciation 750,000
Revaluation Surplus 1,750,000

Cost % Fair Value Adjustment

PPE 5,000,00 100.00% 7,500,000 2,500,000 inc
0
Accumulated Depreciation 1,500,00 30.00% 750,000 inc
0 2,250,000
Book Value 3,500,00 70.00% 5,250,000 1,750,000 inc
0

2. Retained Earnings 200,000

Inventory 200,000
 3. Retained Earnings 150,000
Accounts Payable 150,000

4. Revaluation Surplus 1,350,000

Retained Earnings 1,350,000
(1,000,000 + 200,000+150,000)

After quasi-reorganization, retained earnings account has a zero balance. The amount of the retained earnings to
the extent of the deficit wiped out shall be restricted and cannot be declared as dividends. Following the example
above, in case the company was able to recover P1,500,000 in the following year, P1,350,000 is not allowed to be
declared as dividends.

Quasi-reorganization may also be effected through recapitalization. This is a change in the corporate capital
structure that may be accomplished by any or combination of the following:

 Change in par or stated value;

 Exchange of par to no par share or vice-versa.

When quasi-reorganization is effected through recapitalization, accounting procedures normally involve the
following steps:

1. Write down of assets to fair values or realizable values;

2. Effecting recapitalization, creating enough share premium to absorb the resulting deficit; and
3. Cancellation of the resulting deficit against the share premium.

For example, assume that Company X has suffered losses and decided to undergo a quasi-reorganization that
was approved by the shareholders and creditors of the corporation as well as by the SEC. As a result, the Company’s PPE
with total carrying amount of P2,000,000 (valued at cost of P4,000,000 less accumulated depreciation of P2,000,000),
have been determined to have recoverable amount of P1,500,000.

Before write-down of assets, the company’s shareholders’ equity balances are as follows:

Ordinary Share Capital, P50 par P3,000,000

Share Premium 150,000
Retained Earnings (deficit) (600,000)

The company will redeem its P50 par ordinary shares and will issue equal number of ordinary shares with par
value of P30.

The following are the entries for the write down of property, plant and equipment and for recapitalization:

Retained Earnings 500,000

Accumulated Depreciation 500,000
Property, Plant and Equipment 1,000,000

Cost % Fair Value Adjustment

PPE 4,000,000 100% 3,000,000 1,000,000 dec
Accumulated (2,000,000) 50% (1,500,000) 500,000 dec
Depreciation
Book Value 2,000,000 50% 1,500,000 500,000 dec
 Ordinary Share Capital, P50 par 3,000,000
Ordinary Share Capital, P30 par 1,800,000
Share Premium – Ordinary 1,200,000
(P3,000,000/P50 par=60,000 shares)
(60,000 shares x P30 par)

After recording the impairment in value of property, plant and equipment, the balance of the deficit increased to
P1,100,000 (P600,000 + P500,000), whereas total share premium after recapitalization is now P1,350,000 (i.e.,
P150,000 + P1,200,000). The deficist is then cancelled against the share premium account in the following entry:

Share Premium – Ordianry 1,100,000

Retained Earnings 1,100,000

The shareholders’ equity balances after the quasi-reorganization are as follows:

Ordinary Share Capital P1,800,000

Share Premium – Ordinary 250,000
Retained Earnings 0
Total Shareholders’ Equity P2,050,000
COMPREHENSIVE PROBLEM:

Lenovo Corporation was organized at the beginning of 2018 with 300,000 authorized shares of P100 par value ordinary
share capital. At December 31, 2018 the shareholders’ equity section of Lenovo Corporation was as follows:

Ordinary Share Capital, P100 par, 30,000 shares issued P3,000,000

Share Premium 300,000
Retained Earnings 450,000
Total Shareholders’ Equity 3,750,000

On June 15, 2019, Lenovo issued 50,000 ordinary shares for P6,000,000. A 5% bonus issue was declared on
September 30, 2019 and issued on November 10, 2019 to shareholders of record on October 31, 2019. The market
value of the ordinary share was P110 each on declaration date. The profit of Lenovo for the year ended December 31,
2019 was P1,175,000.

During 2020, Lenovo had the following transactions:

March 1 Lenovo acquired 3,000 of its own ordinary share for P95 each.

May 1 Lenovo sold 1,500 shares of its treasury for P120 per share.

August 10 Issued shareholders one stock right for each share held to purchase two additional ordinary
shares of P125 per share. The rights expire on December 31, 2020.

September 15 15,000 stock rights were exercised when the market value of ordinary share was P130 each.

October 31 40,000 stock rights were exercised when the market value of ordinary share was P140 each.

December 10 Declared cash dividends of P5 per share payable on January 5, 2021.

December 20 Retired 1,000 shares of its treasury and reverted them to an unissued basis. On this date, the
market value of the ordinary share was P150 each.

Profit for 2020 was P1,200,000.

REQUIRED:
a. Prepare the journal entries for 2019 and 2020
b. Number of outstanding shares as of Dec 31, 2019 and Dec 31, 2020
c. Number and cost of Treasury Shares as of Dec 31, 2019 and Dec 31, 2020
d. Ordinary share capital as of Dec 31, 2019 and Dec 31, 2020
e. Retained Earnings as of Dec 31, 2019 and Dec 31, 202
f. Total shareholders’ equity as of Dec 31, 2019 and Dec 31, 2020