Updated July 10, 2023
What is Share Premium?
The term “share premium” (SP) refers to the account created when an issuing company can sell its stock at a price higher than its price or face value.
Since the face value of a stock is set at a minimal value, companies often end up recording the amount of the difference between the face value and the issuing price of the stock as an (SP) account.
Explanation
The share premium account arises when a company issues its shares in the public for the first time and can sell the stocks well above their face value as the investors see long-term value. In other words, the shareholders pay or promise to pay the (SP) account an amount of money for the issued stocks which exceeds the par value. Usually, investors are ready to pay a premium over and above the face value of the stock of companies that have been able to establish their goodwill, brand, or reputation over a period that is not reflected in the company’s current financials.
Purpose of Share Premium
It is important to note that the (SP) account restricts the amount, allowing its use only for certain specific purposes and prohibiting distribution for any other use. The purposes established in the company’s bylaws dictate the use of the (SP). For example, it prohibits using it to make dividend payments to shareholders or offset business losses. Most companies use share premium accounts to pay off expenses about equity, such as underwriting fees, or to cover the costs incurred for issuing bonus shares.
The Formula for Share Premium
The formula for the (SP) account represents the difference between the face value of the issued stock and the stock’s issue price, multiplied by the number of stocks. Mathematically, it shows the calculation as follows:
Examples
Different examples are mentioned below:
Example #1
Let us take the example of a company that sold its share of common stock to investors for $8.00 per stock. First, determine the (SP) per stock if the stock’s par value is $2.00.
Solution:
- Given, Issue price per stock = $8.00
- Par value per stock = $2.00
(SP) per stock calculate using the formula given below:
Share Premium per Stock = Issue Price per Stock – Par Value per Stock
- Share Premium per Stock = $8.00 – $2.00
- Share Premium per Stock = $6.00
Therefore, the company generated an (SP) of $6.00 per stock.
Example #2
Let us take the example of SDF Inc., which issued 500 shares during the year. The par value of the shares was valued at $2.00 each; however, the company could sell each stock at $7.00. First, determine the (SP) generated from the transaction.
Solution:
- Given, Issue price per stock = $8.00
- Par value per stock = $2.00
- No. of shares issued = 500
(SP) calculate using the formula given below:
Share Premium = (Issue Price per Stock – Par Value per Stock) * No. of Shares Issued
- Share Premium = ($7.00 – $2.00) * 500
- Share Premium = $2,500
Therefore, the company could generate $2,500 (SP) from the stock issue.
Issue of Share Premium
Some of the essential points about the issue of (SP) are as follows:
- Issuance of stocks at the Premium is purely a commercial decision, and the issuing company is not obligated to provide any justification under any law in force.
- The amount of share premium doesn’t require any valuation certificate, and it primarily depends on business terms.
- The decision related to the amount of (SP) is the prerogative of the issuing company.
- Lastly, it is up to the investor whether or not they like to subscribe to the shares at such a premium.
Share Premium vs. Share Capital
Some of the significant differences between (SP) and share capital are as follows:
- (SP) is the difference between the stock’s issue price and face value, while share capital is merely the face value of the stock.
- The value of (SP) changes with the change in the issue price, while the value of share capital is indifferent to the movements in the issue price.
Advantages
Some of the significant advantages are as follows:
- It facilitates raising additional funds but doesn’t dilute the shareholders’ voting rights.
- The excess money does not recognize as income for the company but instead captured under the head of equity on the balance sheet. As such, it doesn’t result in any tax obligations.
- Another significant advantage of (SP) is that it reduces the cost of capital because the additional fund doesn’t require any additional cost.
Disadvantages
Some of the major disadvantages are as follows:
- The use of the amount in the (SP) account is very restricted. It can only be used for purposes mentioned in the company’s bylaws.
- The (SP) account is a non-distributable reserve, so the amount in this account doesn’t form part of the free reserves.
Conclusion
So, a share premium account is a non-distributable reserve that can only be utilized for specific activities mentioned in the company’s bylaws. Nevertheless, it is an essential part of shareholder equity and is an additional source of funds.
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