Expert: Consuelo Herrera, International Accountant and Fraud Examiner - 4/22/2009

Question
What is the procedure followed by a company while making an issue of bonus shares? What
are the duties of an auditor in respect thereof?

Answer
Dear Arifur,

When a company has accumulated large reserves which cannot be disrtibuted as dividends in cash either due to legal restrictions, it converts this surplus capital & allocates the capital among the existing shareholders in proportion to the share capital held by issuing fully paid bonus shares.

The share of bonus shares soes not constitute a source of income to the company or the financial position of the company remains the same. Issue of bonus shares is not for distribution of profits among the shareholders. Are not a gift.


The Legal Service India.com published a great explanation of bonus share. Here are some highlights of their article:

Issue of Bonus Shares : A Lucrative Preposition

A bonus share is a free share of stock given to current shareholders in a company, based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. An issue of bonus shares is referred to as a bonus issue. Depending upon the constitutional documents of the company, only certain classes of shares may be entitled to bonus issues, or may be entitled to bonus issues in preference to other classes.

A bonus issue (or scrip issue) is a stock split in which a company issues new shares without charge in order to bring its issued capital in line with its employed capital (the increased capital available to the company after profits). This usually happens after a company has made profits, thus increasing its employed capital. Therefore, a bonus issue can be seen as an alternative to dividends. No new funds are raised with a bonus issue.

Unlike a rights issue , a bonus issue does not risk diluting your investment. Although the earnings per share of the stock will drop in proportion to the new issue, this is compensated by the fact that you will own more shares. Therefore the value of your investment should remain the same although the price will adjust accordingly. The whole idea behind the issue of Bonus shares is to bring the Nominal Share Capital into line with the true excess of assets over liabilities.

Whether Bonus shares are miraculous?
Few things match the sheer joy of getting a fat bonus at work. That is what shareholders of a good company feel when their company decides to throw a few shares (free of cost) in their direction. Here’s explaining what bonus shares are all about and why investors like investing in such companies. Free shares are given to you and are called bonus shares. Make money with shares. They are additional shares issues given without any cost to existing shareholders. These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company.

If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you.

Bonus shares are issued by cashing in on the free reserves of the company. The assets of a company also consist of cash reserves. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.

What is the biggest benefit in issuing bonus shares is that its adds to the total number of shares in the market. Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares. This is referred to as a dilution in equity.

Now the earnings of the company will have to be divided by that many more shares. Since the profits remain the same but the number of shares has increased, the EPS (Earnings per Share = Net Profit/ Number of Shares) will decline. Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen.

A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future.

A bonus issue is taken as a sign of the good health of the company.
When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus.

Issue of bonus shares
Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. There are some conditions which need to be satisfied before issuing Bonus shares:
1) Bonus shares can be issued by a company only if the Articles of Association of the company authorizes a bonus issue. Where there is no provision in this regard in the articles, they must be amended by passing special resolution act at the general meeting of the company.
2) It must be sanctioned by shareholders in general meeting on recommendations of BOD of company.
3) Guidelines issue by SEBI must be complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of association. If the company has availed of any loan from the financial institutions, prior permission is to be obtained from the institutions for issue of bonus shares. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the non-resident members, prior consent of the Reserve Bank should be obtained.

Only fully paid up bonus share can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares.

It is important to note here that Issue of bonus shares does not entail release of company’s assets. When bonus shares are issued/credited as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company.

Issue of Bonus Shares by Public Sector Undertakings
It has come to the notice of the Government that a number of Central Government Public Sector Undertakings are carrying substantial reserves in their balance sheets against a relatively small paid up capital base. The question of the need for these enterprises to capitalize a portion of their reserves by issuing Bonus Shares to the existing shareholders has been under consideration of the Government. The issue of Bonus Shares helps in bringing about at proper balance between paid up capital and accumulated reserves, elicit good public response to equity issues of the public enterprises and helps in improving the market image of the company. Therefore, the Government has decided that the public enterprises, which are carrying substantial reserves in comparison to their paid up capital sold issue Bonus Shares to capitalize the reserves for which the certain norms/conditions and criteria may be followed and fulfilled. There are some SEBI guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000 which should be followed in deciding the correct proportion of reserves to be capitalized by issuing Bonus Shares.

Private sector banks, whether listed or unlisted, can also issue bonus and rights shares without prior approval from the Reserve Bank of India. Liberalising the norms for issue and pricing of shares by private sector banks, the RBI said that the bonus issue would be delinked from the rights issue. However, central bank approval will be required for Initial Public Offerings (IPOs) and preferential shares. These measures are seen as part of the RBI's attempt to confine itself to banking sector regulation and leave the capital market entirely to the SEBI. Under the guidelines, private sector banks have also been given the freedom to price their subsequent issues once their shares are listed on the stock exchanges. The issue price should be based on merchant bankers' recommendation, the RBI has said. It means though RBI approval is not required but pricing should be as per SEBI guidelines. The RBI, however, clarified that banks will have to meet SEBI's requirements on issue of bonus shares. As per current regulations, private sector banks whose shares are not listed on the stock exchange are required to obtain prior approval of the RBI for issue of all types of shares such as public, preferential, rights or special allotment to employees and bonus. Banks whose shares are listed on the stock exchanges need not seek prior approval of the RBI for issue of shares except bonus shares, which was to be linked with rights or public issues by all private sector banks.

According to Auting - Principles and Practice by Ravinder Kumar and Virender Sharme, some audit procedures with respect to bonus shares are:
1. Verify that the Bylaws allow its issuance
2. Examine the sources from which the bonus shares are issued
3. Verify that the company has sufficient unissued shares for allotment as bonus shares
4. Review journal entries to ensure their correctness
5. Ensure that the company has followed the SEBI guidelines for bonus shres issuance.

Hope it helps. Please grade my response.

I wish you success in your endeavors.

Sincerely,


Consuelo Herrera