How are shares treated in the accounting records?


What are shares?

If you want to have a cake, you can have all of it, or you can have a part of it and share the rest with others.

It is the same in the context of companies.

You can have a company all to yourself and be a 100% owner or share the ownership of a company with others. You can have a 50% slice or share of a company or 20% or 1%.

That means any profits the company makes will have to be shared with those other people. If you have a 50% share of a company, you are entitled to 50% profit. If you have 20% of a company, you are entitled to 20% profit. If you have 1% of a company, you are entitled to 1% of the profit and so on. This is like having your cake and eating it provided the company does make profits that it distributes to shareholders, which is never a guarantee. Sometimes a company may be in loss, in which case there are no slices of profit to share, or the directors may choose to not pay dividends out of profits that year but retain the profit in the business.

In the world of business and finance, 'shares' are also sometimes referred to as stocks (which may be a little confusing as in the UK, inventory can also be referred to as stock), or equity or ownership securities (as opposed to bonds which are a type of debt securities).

Ultimately companies issue shares to raise funds. When a company is incorporated, the founding investors give some money (usually it is money, but in theory, it could be other assets too), and in exchange, they get shares. Later on in the life of a company, when funds are needed, more shares can be issued in exchange for funding from private investors.

When companies grow significantly and significant pots of funds are needed, the company may list on a stock exchange in an Initial Public Offering (IPO). The shares then become traded on the stock market. Over time, shares change hands as some investors may sell their shares in exchange for cash.

Accounting entries

All of those scenarios result in accounting entries made in the financial records of companies that issue the shares and those who buy the shares (who may be individuals or companies themselves).

For example, suppose New Company Ltd is incorporated, and An Investor Ltd becomes the sole shareholder (in other words, you have 100% ownership) by providing funding of, say, £1,000 in exchange for ten shares of £100 nominal value each. In that case, the company will record the following in its records:

Dr Cash £1,000

Cr Share Capital  (10 x £100) £1,000

This is how the transaction looks from the point of view of the issuer of the shares (the company that has received the funding).

From the investor’s point of view, though, the transaction looks differently.

The investor has parted with cash to provide the funding and is now in possession of shares which are assets – something the investor owns, controls as a result of a past transaction and can sell on to others in the stock market. So this is what the accounting entry will look like for the investor:

Dr Investments (Asset) £1,000

Cr Cash £1,000

If the investor sells the shares for, say, £120 each, months later, they will record a gain in their accounting records. The entry will look as follows:

Dr Cash (10 x £120) £1,200

Cr Investments (Asset) £1,000

Cr Profit on sale of shares £200

The new investor who is now in possession of the shares will have the following entry in their books:

Cr Cash (10 x £120) £1,200

Dr Investments (Assets) £1,200

Can you see how business is a bit of a “zero-sum” game? When one issues shares, another provides funding: cash is going out of the pocket of one to go into the pocket of another. The same happens when one sells their shares to someone else.

Note the company that has issued shares does not recognise any accounting entries when the shares are traded on the secondary market (meaning when the shares change hands between investors who buy and sell them on the stock exchange). The company will only recognise an accounting entry when it is part of the transaction – initially issuing the shares.

It is possible (but much rarer) for companies to buy back their shares and even cancel them. In that case, the company will be paying cash to get possession of the shares.

Auditing the entries

Suppose the company that has issued shares has a sufficiently large turnover or net assets or several employees and meets the requirements of the law for companies to have their financial records audited. In that case, the auditors will be interested in whether accounting for the shares has been done appropriately.

Auditors are like inspectors: they look for evidence to confirm entries in the books. In the example above, the auditors will likely look in bank statements to confirm the amount of money received as funding (£1,000) and legal documentation surrounding the share issue (to confirm the number of shares issued and their nominal value).

Suppose the investor (or the holder of the shares) is also a company with a sufficiently large turnover or net assets or several employees and meets the requirements of the law for companies to have their financial records audited. In that case, their auditors will be interested in whether accounting for the shares has been done appropriately from that company’s point of view. The auditors will likely look in bank statements to confirm the amount of money paid for the shares (£1,000), and they will also want to see the shares.

In the past, investors would have received share certificates when they invested, and they would have held onto the certificates (which is why they are share 'holders'). Nowadays, no paper certificates are issued, but there will be an electronic trail and ownership confirmation that the auditors can inspect.

Topics: ACCA, CIMA, CPD, AAT, FRM