It is quite natural that every prudent company would like to create reserve out of its profit for the purpose of future expansion as-well-as for declaring dividend in the lean periods.
A company that has built up substantial reserves some decides to capitalize a part of these reserves:
(i) By issuing fully paid bonus shares to existing shareholders and/or
(ii) By converting partly paid-up shares into fully paid- up shares without the shareholders to pay anything.
All successful companies increase their capital base by giving free shares to its existing shareholders out of the reserves when there are large accumulated, which cannot, either by law or as a matter of financial prudence, be distributed as dividend in cash to shareholders. Since bonus shares are created by conversion of retained earnings or other reserves into equity share capital, issue of bonus shares does not represent a source of fund to the company.
The following circumstances warrant issue of bonus shares:
(i) Accumulated large reserves:
When a company has accumulated large reserves (whether capital or revenue) and it wants to capitalize these reserves by issuing bonus shares.
(ii) Not in a position to give cash bonus:
When the company is not in a position to give cash bonus because it adversely effects its working capital.
(iii) Value of fixed assets far exceeds the amount of capital:
When the value of fixed assets for exceeds the amount of capital.
(iv) Higher rate of dividend is not advisable:
When the higher rate of dividend is not advisable for the distribution of the accumulated reserves because shareholders will demand the same rate of dividend in future, which the directors may not be able to give. To get rid of this difficulty, bonus shares are issued to facilitate the payment of the regular dividend from year to year.
(v) Big difference between the market value and paid-up value:
When there is a bit value of the shares of a company i.e. market value of shares far exceeds the paid up value of the shares. A company issuing bonus shares is better placed in the market. There is a sharp rise in the price of equity shares following the declaration of bonus issue.
Objects of Bonus Issue:
Issue of bonus shares is an inexpensive mode of raising capital by which the cash resources of company are conserved.
(ii) More Marketable:
Issue of bonus shares reduces the market price of the shares, thus rendering them more marketable.
(iii) Indicator of Good Prospects:
Issue of bonus shares is an indication to the investors that the company has good prospects.
Procedure of Bonus Issue:
- The authorized capital should be increased, if necessary, by passing ordinary resolution.
- After passing necessary entries in the books of accounts, additional share certificates are distributed among the existing shareholders, free of charge.
Types of Bonus Issue:
- Fully Paid Bonus Shares:
When bonus shares are distributed free of cost in proportion of holding, it is called Fully Paid Bonus Shares.
- Partly Paid Bonus Shares:
When bonus is applied for converting partly paid shares into fully paid shares, it is called Partly Paid-up Bonus Shares.
Source of Bonus Issue:
Fully paid-up bonus shares can be issued out of following sources:
(i) Capital redemption reserve
(ii) Security premium** (realised in cash)
(iii) Capital reserve* (realised in cash)
(iv) Profit and loss account
(v) General reserve
(vi) Investment allowance reserve
(vii) Sinking fund for redemption of debentures (after redemption)
(viii) Development rebate reserve.
*Capital reserve not realised in cash cannot be utilised for issuing bonus shares e.g. capital reserve created by revaluation of fixed assets.
** Security premium not realised in cash cannot be utilised for issuing bonus shares.
Partly paid-up bonus shares can be issued from the following sources:
(i) Capital Reserve* (realised in cash)
(ii) Profit and loss account
(iii) General reserve
(iv) Investment allowance reserve
(v) Development rebate reserve
(vi) Sinking fund for redemption of debentures (after redemption)
- Security premium account and capital redemption reserve account cannot be utilised for issuing partly paid bonus shares.
- If a choice is to be made between revenue reserves and capital reserves; the capital reserves are normally utilised first as far as legally permissible.