Tag: Equity Accounting

The buyback of shares is an important financial decision that reduces a company’s equity share capital and impacts its reserves and liquidity. The Companies Act, 2013 (Section 68) and Accounting Standards (AS) govern the buyback process in India. The company must ensure that it follows proper accounting treatment while recording buyback transactions.

Step-by-Step Accounting Treatment of Buyback:

The following journal entries are recorded for buyback transactions:

illustration with Example

Let’s assume XYZ Ltd. decides to buy back 10,000 equity shares of ₹10 face value at ₹50 per share using free reserves.

Step 1: Identify Key Values

Step 2: Pass Accounting Entries

1. Transfer Buyback Amount to a Separate Account

2. Cancellation of Equity Share Capital

3. Adjust Premium Paid on Buyback

4. Transfer Nominal Value to Capital Redemption Reserve (CRR)

5. Payment to Shareholders

Effect on Financial Statements:

The buyback of shares affects the company’s financial statements in the following ways:

1. Balance Sheet (Post Buyback)

2. Cash Flow Statement

The buyback results in a cash outflow under financing activities of ₹5,00,000.

3. Notes to Accounts

• Buyback of 10,000 equity shares at ₹50 each was completed.

• Capital Redemption Reserve of ₹1,00,000 was created.

• Securities Premium Reserve was reduced by ₹4,00,000.

Direct Negotiation or Targeted Buyback of Shares is a method where a company repurchases its shares directly from specific shareholders instead of offering a general buyback to all. This approach is typically used to buy shares from large investors, promoters, or institutional shareholders who wish to exit their holdings. The price is negotiated between the company and the seller, often at a Premium to the market price. This method allows companies to Regain control, Consolidate ownership, or Eliminate dissenting Shareholders, ensuring strategic benefits while complying with SEBI Buyback Regulations and the Companies Act, 2013.

Characteristics of Direct Negotiation /Targeted Buyback of Shares:

• Selective Shareholder Participation

In a targeted buyback, the company repurchases shares from specific shareholders, such as promoters, institutional investors, or large stakeholders, rather than offering the buyback to all shareholders. This method is useful for removing dissenting investors, consolidating ownership, or regaining control over the company. Unlike open market repurchases, this buyback is not available to the general public, making it a strategic tool for restructuring ownership in a controlled manner.

• Privately Negotiated Price

The price of shares in a direct negotiation buyback is determined through mutual agreement between the company and the selling shareholders. It is often higher than the prevailing market price to incentivize shareholders to sell their stakes. This premium ensures that key investors willingly participate in the buyback, making the process more efficient. However, the company must ensure that the buyback price aligns with regulatory guidelines under the Companies Act, 2013 and SEBI Buyback Regulations.

• Regulatory Compliance and Approvals

The targeted buyback must comply with regulations outlined in the Companies Act, 2013, SEBI Buyback Regulations, and, if applicable, stock exchange listing requirements. The company must obtain necessary board and shareholder approvals before executing the buyback. Additionally, regulatory bodies may require disclosure of the buyback price, purpose, and impact on financial statements to ensure transparency and prevent misuse of funds.

• Reduction in Free Float and Market Impact

Since a targeted buyback involves purchasing shares directly from specific investors, it reduces the number of publicly available shares (free float). This may lead to a rise in the stock price due to a supply-demand imbalance. Unlike open market buybacks, targeted buybacks have less direct impact on daily stock trading, making them a preferred choice when a company wants to avoid excessive market fluctuations.

• Efficient Use of Corporate Resources

Companies often use targeted buybacks to utilize surplus cash efficiently while providing an exit route to select investors. This method allows the company to strengthen financial ratios such as earnings per share (EPS) and return on equity (ROE) by reducing outstanding shares. However, businesses must ensure that buyback funding does not strain financial liquidity or impact future investment plans.

• Strategic Control and Ownership Consolidation

A direct negotiation buyback is commonly used for ownership consolidation, particularly when promoters or major shareholders want to increase their stake. It helps prevent hostile takeovers by limiting external ownership and aligning voting rights with strategic objectives. By selectively purchasing shares, companies can strengthen governance structures and improve decision-making power for core stakeholders.

Components of Direct Negotiation /Targeted Buyback of Shares:

1. Identified Shareholders

In a targeted buyback, the company identifies specific shareholders from whom shares will be repurchased. These may include promoters, institutional investors, venture capitalists, or dissenting stakeholders. Unlike general buybacks, which are open to all shareholders, this method focuses on selected participants to achieve strategic goals like ownership consolidation, removing activist investors, or rewarding long-term investors.

2. Negotiated Price

The buyback price is not determined by market forces but is privately negotiated between the company and the selling shareholders. This price is often higher than the market price to make the offer attractive. The agreed price takes into account factors like book value, earnings potential, and market conditions, ensuring that both parties benefit from the transaction.

3. Board and Shareholder Approval

Since a targeted buyback involves a selective purchase of shares, it requires approval from the Board of Directors and, in some cases, the shareholders. The buyback proposal must outline details such as the number of shares, pricing, funding source, and impact on financial statements. The process is governed by Section 68 of the Companies Act, 2013 and SEBI guidelines.

4. Regulatory Compliance

The buyback must adhere to regulatory requirements, including SEBI Buyback Regulations, Companies Act, 2013, and stock exchange listing norms. The company must ensure that:

• • The buyback does not exceed 25% of the total paid-up equity capital and free reserves.

  • The debt-equity ratio does not exceed 2:1 after the buyback.

  • All disclosures and filings are submitted as per regulations.

5. Funding Mechanism

The buyback is funded through free reserves, securities premium, or proceeds from fresh issue of shares/debentures. Companies cannot use borrowed funds for buybacks. The financial impact must be assessed to ensure that the buyback does not harm the company’s liquidity or investment plans.

6. Impact on Shareholding Structure

Targeted buybacks result in changes in ownership patterns, often leading to higher promoter holding and reduced public float. This can impact stock liquidity and influence stock prices in the long term. Companies must disclose post-buyback shareholding patterns in their regulatory filings.

7. Execution and Settlement

Once approvals are secured, the company executes the buyback as per the agreed terms. Shares are transferred to the company and extinguished, reducing the outstanding share capital. The transaction is settled either through cash or other negotiated terms, ensuring compliance with legal and financial obligations.

Tender offer buyback is a method where a company repurchases its shares from existing shareholders at a fixed price, usually higher than the market price. The buyback is made on a proportionate basis, ensuring fair participation for all eligible shareholders. Companies announce the buyback details, including Offer price, Record date, and Acceptance ratio. Shareholders can tender their shares within the specified period. This method helps companies Reduce excess capital, Enhance earnings per share (EPS), and Improve shareholder value while ensuring transparency under the Companies Act, 2013, and SEBI Buyback Regulations.

Characteristics of Tender offer of Buyback of Shares:

• Fixed Offer Price

In a tender offer buyback, the company offers to purchase shares at a pre-determined price, usually at a premium over the market price. This price is announced in advance, encouraging shareholders to tender their shares for a profitable exit. The premium incentivizes participation and ensures a fair value for shareholders who wish to sell. The offer price is determined based on financial performance, stock valuation, and regulatory guidelines under the Companies Act, 2013, and SEBI Buyback Regulations.

• Proportionate Acceptance

The buyback is conducted on a proportionate basis, meaning shareholders cannot sell all their shares unless the total tendered quantity is lower than the buyback size. Each eligible shareholder receives an acceptance ratio, which determines how many of their tendered shares will be accepted. If more shares are tendered than the buyback size, the excess shares are returned to the shareholders, ensuring a fair and equitable process.

• Specified Time Frame

The tender offer process follows a strict timeline, including an announcement date, record date, opening, and closing of the tender period. Shareholders must tender their shares within this limited window, usually ranging from ten to fifteen days. The process ensures efficiency and adherence to regulatory guidelines, preventing prolonged uncertainty in the market.

• Participation by Eligible Shareholders

The tender offer is open only to eligible shareholders, as defined by the company’s buyback criteria. Typically, shareholders holding shares as of the record date are eligible to participate. The eligibility criteria ensure that the buyback benefits long-term investors rather than short-term traders or speculators. The eligibility list is compiled based on shareholding records from depositories and registrars.

• Reduction of Share Capital

A successful tender offer buyback results in a reduction of the company’s outstanding share capital, leading to a higher earnings per share (EPS) and improved return on equity (ROE). Since the repurchased shares are extinguished or canceled, the total number of shares in circulation decreases, benefiting remaining shareholders by increasing their proportional ownership in the company.

• Regulatory Compliance

The tender offer buyback is strictly governed by the Companies Act, 2013, SEBI Buyback Regulations, and other applicable laws. The company must obtain board and shareholder approval and adhere to limits on buyback size, pricing, and funding. SEBI mandates disclosure of the source of funds, impact on financials, and post-buyback shareholding structure to ensure transparency and protect investor interests.

Components of Tender offer of Buyback of Shares:

• Offer Price

The company offers to repurchase shares at a pre-determined price, usually higher than the current market price. This premium provides an incentive for shareholders to tender their shares. The price is determined based on market trends, financial performance, and valuation metrics, ensuring fairness and regulatory compliance under the Companies Act, 2013, and SEBI Buyback Regulations.

• Record Date

A specific record date is set to determine eligible shareholders. Only those holding shares as of this date can participate in the buyback. The record date ensures clarity on ownership and prevents speculative trading in anticipation of the buyback announcement.

• Offer Size

The buyback offer specifies the number of shares or total monetary value the company intends to repurchase. It is subject to regulatory limits—typically 25% of the total paid-up equity capital and free reserves as per SEBI and Companies Act, 2013 norms.

• Tender Period

The tender offer remains open for a specific timeframe (usually 10-15 days), during which eligible shareholders can submit their shares for buyback. The limited window ensures an efficient and timely process.

• Acceptance Ratio

If shareholders tender more shares than the buyback size, the company accepts them on a proportionate basis. This means each shareholder gets a fixed percentage of their tendered shares accepted while the excess shares are returned.

• Payment Process

Upon acceptance, the company transfers the buyback consideration directly to shareholders via electronic transfer, bank cheques, or demand drafts. The payment timeline is regulated to ensure prompt settlements, usually within seven working days after closure of the offer.

• Share Cancellation and Extinguishment

The repurchased shares are canceled or extinguished after the buyback, leading to a reduction in the company’s share capital. This increases earnings per share (EPS) and benefits remaining shareholders by improving their proportional ownership.

• Regulatory Compliance and Disclosures

The tender offer must comply with SEBI Buyback Regulations, Companies Act, 2013, and other stock exchange guidelines. The company must make detailed disclosures regarding funding sources, financial impact, and post-buyback ownership structure to maintain transparency.

Buyback of Shares refers to the process where a company repurchases its own shares from existing shareholders, reducing the total number of outstanding shares in the market. This is done to improve earnings per share (EPS), enhance shareholder value, and utilize surplus cash effectively. Companies may buy back shares to prevent hostile takeovers, adjust capital structure, or signal confidence in their financial health. The buyback can be conducted through Open market purchases, Tender offers, or Book-building processes, following regulatory guidelines set by SEBI (Securities and Exchange Board of India) under the Companies Act, 2013.

Objectives of buyback under the Companies Act, 2013:

• Enhancing Shareholder Value

Buyback helps improve Earnings Per Share (EPS) by reducing the number of outstanding shares in the market. With fewer shares available, the company’s profits are distributed among a smaller number of shares, leading to higher EPS. This makes the company more attractive to investors, increasing market confidence. Moreover, if shares are undervalued, the buyback can help correct the market price, ensuring that shareholders receive better returns on their investment.

• Utilization of Surplus Cash

Companies often generate excess cash that may not be immediately required for expansion or operational activities. Instead of letting the cash remain idle, firms use buybacks as a means to distribute excess funds to shareholders. This improves capital efficiency and signals strong financial health. By reducing idle cash, companies also lower the risk of inefficient investments that may not yield significant returns.

• Capital Restructuring

Buyback of shares is a strategic tool for optimizing the capital structure by reducing equity capital and increasing the proportion of debt. This helps maintain an optimal debt-to-equity ratio, which can lead to better financial stability. A balanced capital structure also helps companies take advantage of tax benefits associated with debt financing, leading to a lower overall cost of capital.

• Preventing Hostile Takeovers

Companies buy back shares to prevent external entities from gaining a controlling stake through open market purchases. A higher percentage of promoter holding after the buyback strengthens control over decision-making and governance. This strategy protects the company from unwanted acquisitions, ensuring that management retains autonomy over business operations and future strategic plans.

• Boosting Market Perception

Buybacks are often viewed as a positive market signal, indicating that the company believes its shares are undervalued. This enhances investor confidence, attracting more investments. Additionally, reducing the number of outstanding shares increases demand, which can push up stock prices. A well-executed buyback often results in better market sentiment and higher overall valuation.

• Tax-Efficient Way of Distributing Profits

Compared to dividends, which are taxed at both the company and shareholder levels, buybacks offer a more tax-efficient alternative for distributing excess funds. Under the Companies Act, 2013, buybacks are subject to capital gains tax instead of dividend distribution tax, which may result in lower tax liabilities for shareholders, making it a preferred mode of rewarding investors.

Legal framework for buyback under the Companies Act, 2013:

The Companies Act, 2013 regulates the buyback of shares under Section 68, 69, and 70, along with the Companies (Share Capital and Debentures) Rules, 2014. The legal framework ensures that companies comply with the provisions while repurchasing shares.

1. Conditions for Buyback (Section 68)

A company can buy back its shares or other specified securities if:

• The buyback is authorized by its Articles of Association (AOA).

• A special resolution (SR) is passed in a general meeting (if buyback exceeds 10% of paid-up capital and free reserves).

• The buyback does not exceed 25% of the total paid-up capital and free reserves.

• The debt-to-equity ratio does not exceed 2:1 after the buyback (except for government companies).

• The buyback is completed within 12 months from the date of passing the special resolution or board resolution.

• The buyback can be done through free reserves, securities premium account, or proceeds from fresh issue of shares (not through borrowed funds).

2. Methods of Buyback

The buyback can be carried out through:

• Open market purchases (Stock exchange or book-building process).

• Tender offer to existing shareholders on a proportionate basis.

• Buyback from employees under an Employee Stock Option Scheme (ESOS).

3. Prohibition on Buyback (Section 70)

A company cannot buy back its shares if:

• It has defaulted in repaying deposits or interest on deposits.

• It has defaulted in redemption of debentures or preference shares.

• It has defaulted in payment of dividends or repayment of loans.

• It has not complied with SEBI regulations (if the company is listed).

4. Compliance and Reporting Requirements

• The company must file Form SH-9 (Declaration of Solvency) with the Registrar of Companies (ROC) before initiating the buyback.

• The company must extinguish the bought-back shares within 7 days from the date of completion.

• A return in Form SH-11 must be filed with the ROC within 30 days of buyback completion.

5. Penalty for Non-Compliance

If a company violates the buyback provisions:

• The company is fined up to ₹1 lakh to ₹3 lakh.

• Every officer in default may be fined ₹1 lakh or imprisoned for up to 3 years, or both.

The Companies Act, 2013, mandates that all companies incorporated in India follow Schedule III while preparing their financial statements. Schedule III provides the format and structure for presenting the Balance Sheet, Statement of Profit and Loss, Cash Flow Statement, and Notes to Accounts.

1. Private Limited Companies

All private limited companies registered under the Companies Act, 2013, must prepare their financial statements as per Schedule III, ensuring proper financial disclosures and compliance with Indian accounting norms. These include:

• Small Private Limited Companies

• Large Private Limited Companies

• Subsidiary Private Companies of Public Limited Companies

2. Public Limited Companies

Public Limited Companies, which raise capital from the public and are subject to stricter financial regulations, must follow Schedule III. These include:

• Listed Public Companies (traded on stock exchanges like NSE & BSE)

• Unlisted Public Companies (not listed but still follow corporate governance norms)

3. One Person Companies (OPCs)

• These are companies with a single shareholder.

• OPCs must follow Schedule III while preparing their financial statements, ensuring they comply with legal financial reporting requirements.

4. Holding and Subsidiary Companies

• Holding Companies (which control one or more subsidiaries) must consolidate financial statements per Schedule III.

• Subsidiary Companies (controlled by holding companies) also adhere to Schedule III.

5. Associate Companies

Associate companies (where a parent company holds significant influence but not full control) must present financial reports in the prescribed format of Schedule III.

6. Section 8 Companies (Non-Profit Organizations – NPOs)

Section 8 Companies, which are non-profit organizations engaged in charity, education, and social welfare, must follow Schedule III while maintaining transparency in financial reporting.

7. Government Companies

Companies where the Central or State Government holds a majority stake must comply with Schedule III for financial disclosure and corporate governance.

8. Foreign Companies Operating in India

Foreign subsidiaries or joint ventures registered under Indian law must follow Schedule III to align with Indian financial reporting standards.

9. Manufacturing Companies

Companies involved in production, processing, and manufacturing of goods in sectors like automobiles, textiles, pharmaceuticals, FMCG, and heavy machinery must prepare their financial statements per Schedule III.

10. Service Sector Companies

Companies engaged in IT services, banking, consulting, hospitality, healthcare, and telecommunications must follow Schedule III for financial reporting.

11. Real Estate and Infrastructure Companies

Real estate developers and infrastructure firms involved in construction, housing, highways, and commercial projects comply with Schedule III while preparing their financial reports.

12. Energy and Power Companies

Companies in renewable energy, electricity generation, oil and gas, and mining must adhere to Schedule III in their financial disclosures.

13. Trading and Retail Companies

Companies engaged in wholesale, retail, and e-commerce, such as FMCG distributors, supermarket chains, and online platforms, must comply with Schedule III.

14. Pharmaceutical and Healthcare Companies

Companies in drug manufacturing, hospitals, medical device production, and biotech research must present financial statements per Schedule III.

15. Education and Research Institutions (Private Limited Companies)

Universities, private schools, and educational firms operating as corporate entities must prepare financial statements as per Schedule III.

16. Entertainment and Media Companies

Companies involved in film production, digital media, publishing, and broadcasting follow Schedule III for financial reporting.

17. Transport and Logistics Companies

Companies offering freight services, warehousing, aviation, and shipping must comply with Schedule III for financial transparency.

Exceptions: Companies Not Following Schedule III

Some companies are exempted from following Schedule III, such as:

1. Banking Companies (Regulated by RBI and follow Banking Regulation Act, 1949)

2. Insurance Companies (Regulated by IRDAI and follow Insurance Act, 1938)

3. Non-Banking Financial Companies (NBFCs) (Regulated by RBI and follow a separate format)

The Companies Act, 2013, under Schedule III, provides a standardized format for the preparation and presentation of financial statements to ensure transparency, consistency, and comparability across companies. The financial statements must include the Balance Sheet, Statement of Profit and Loss, Statement of Changes in Equity, Cash Flow Statement, and Notes to Accounts.

1. Applicability of Schedule III

• Schedule III applies to all companies registered under the Companies Act, 2013, except banking, insurance, and non-banking financial companies (NBFCs).

• Companies must follow the format prescribed in Division I for companies following Accounting Standards (AS) and Division II for companies following Indian Accounting Standards (Ind AS).

2. Components of Financial Statements

As per Section 129 of the Companies Act, 2013, every company must prepare financial statements, which include:

1. Balance Sheet

2. Statement of Profit and Loss

3. Cash Flow Statement (for specified companies)

4. Statement of Changes in Equity (for Ind AS companies)

5. Notes to Accounts

3. Balance Sheet Format

Schedule III provides a structured format for presenting the Balance Sheet as follows:

(A) Equity and Liabilities

1. Shareholders’ Funds

   • Share Capital

   • Reserves & Surplus

   • Money Received Against Share Warrants

2. Non-Current Liabilities

   • Long-term Borrowings

   • Deferred Tax Liabilities

   • Long-term Provisions

3. Current Liabilities

   • Short-term Borrowings

   • Trade Payables

   • Other Current Liabilities

   • Short-term Provisions

(B) Assets

1. Non-Current Assets

   • Fixed Assets (Tangible & Intangible)

   • Non-Current Investments

   • Deferred Tax Assets

   • Long-term Loans & Advances

2. Current Assets

   • Inventories

   • Trade Receivables

   • Cash & Cash Equivalents

   • Short-term Loans & Advances

4. Statement of Profit and Loss Format

• Revenue from Operations

• Other Income

• Total Revenue

• Expenses (Employee Benefits, Depreciation, Finance Costs, etc.)

• Profit Before Tax (PBT)

• Tax Expenses (Current & Deferred)

• Profit After Tax (PAT)

• Earnings Per Share (EPS)

5. Cash Flow Statement (As per Ind AS-7)

• Operating Activities

• Investing Activities

• Financing Activities

6. Statement of Changes in Equity (For Ind AS Companies)

• Reconciliation of opening and closing balances of each equity component.

• Details of changes in reserves and surplus.

7. Notes to Accounts

• Summary of accounting policies.

• Explanatory notes on financial statement items.

• Contingent liabilities and commitments.

8. Other Key Provisions

• True & Fair View: Statements must give a true and fair view of financial position.

• Compliance with Accounting Standards: Companies must comply with Indian Accounting Standards (Ind AS) or AS based on their classification.

• Board Approval: Financial statements must be approved by the Board of Directors before filing.

Warrants are financial instruments that give the holder the right, but not the obligation, to purchase a company’s stock at a predetermined price within a specified period. The valuation of warrants depends on factors like the current stock price, exercise price, time to expiration, volatility, risk-free interest rate, and expected dividends. The Black-Scholes model and the Binomial model are commonly used for valuation. Warrants derive their value from both intrinsic value (difference between stock price and exercise price) and time value (potential for future gains). Proper valuation helps investors and companies assess their financial impact and investment potential.

Assumptions of Valuation of Warrants:

• Efficient Market Assumption

The valuation of warrants assumes that financial markets operate efficiently, meaning that all available information is reflected in the security prices. Investors make rational decisions based on market trends, company performance, and economic indicators. This assumption ensures that the value of a warrant is determined fairly and accurately, based on market demand and supply. Any changes in the underlying stock price immediately impact the warrant’s price, ensuring transparency and proper risk assessment in pricing.

• No Arbitrage Condition

The valuation model assumes that arbitrage opportunities do not exist. If mispricing occurs, traders will quickly exploit it, bringing prices back to their fair value. This condition ensures that the warrant’s price aligns with its intrinsic value and prevents market manipulation. Without arbitrage, the price of a warrant is determined purely by its economic and financial factors, rather than speculative discrepancies. It ensures that investors engage in fair trading practices and that warrant prices remain consistent.

• Constant Volatility of Underlying Stock

It is assumed that the volatility of the underlying stock remains stable over the warrant’s life. Since the price of a warrant is highly sensitive to stock price fluctuations, constant volatility allows for accurate valuation. Changes in volatility affect the premium of the warrant, making this assumption crucial for reliable pricing. However, real-world markets experience fluctuations, and analysts must adjust for unexpected market changes when applying this assumption in financial models.

• Risk-Free Interest Rate Stability

The valuation model assumes that the risk-free interest rate remains constant during the warrant’s tenure. Since warrants derive their value from the time value of money, changes in interest rates impact their valuation. A stable risk-free rate simplifies calculations and ensures predictable discounting of future cash flows. However, in practice, interest rates fluctuate due to monetary policies and economic conditions, requiring adjustments in valuation models to reflect realistic market conditions.

• No Early Exercise Before Expiry

Warrants are typically European-style options, meaning they can only be exercised at expiry. This assumption simplifies valuation since there is no need to factor in early exercise decisions. It allows for the application of standard pricing models like the Black-Scholes model. However, real-world investors might exercise their warrants early due to sudden stock price surges or liquidity needs, affecting valuation accuracy and requiring adjustments in advanced financial models.

Models:

1. Australian Model

The Australian Model of valuation is a widely used approach to determine the value of financial securities, including shares, options, and warrants. It emphasizes market efficiency and fair value pricing, ensuring that securities reflect their intrinsic worth. This model considers factors like the historical performance of the asset, expected future earnings, and risk factors to provide a balanced valuation.

One of the key aspects of the Australian Model is its focus on regulatory compliance and investor protection. The Australian Securities and Investments Commission (ASIC) ensures that valuation methods adhere to strict financial reporting standards. The model often employs discounted cash flow (DCF) analysis, earnings-based valuation, and market-based approaches to assess the fair value of an asset.

Another important factor in the Australian Model is its integration of risk assessment techniques. It considers systematic risks (such as economic downturns) and unsystematic risks (company-specific risks) in valuation calculations. Additionally, the model takes into account dividend payments, growth potential, and inflation-adjusted returns, ensuring a comprehensive valuation process.

By applying the Australian Model, companies, investors, and financial analysts can make well-informed decisions regarding investments, mergers, and acquisitions. The emphasis on market trends, regulatory compliance, and risk evaluation makes this model a reliable approach for valuation in both domestic and international financial markets.

2. Shivaraman-Krishnan Model

The Shivaraman-Krishnan Model is an advanced valuation framework designed for complex financial instruments such as warrants, rights issues, and convertible securities. Developed by financial experts Shivaraman and Krishnan, this model integrates economic and financial variables to provide a realistic valuation of securities.

One of the defining features of the Shivaraman-Krishnan Model is its multi-factor approach. Unlike traditional models that rely solely on price movements or earnings, this model incorporates macroeconomic indicators, market sentiment, and corporate governance factors to determine a security’s fair value. This makes it particularly useful for valuing assets in emerging markets where volatility is higher, and financial data may be inconsistent.

Another key component of this model is its use of probability-weighted scenarios. It assesses various potential future outcomes for an asset, assigning probabilities to each scenario to estimate its expected value. This enhances the model’s accuracy, making it effective for pricing derivatives, equity-linked securities, and long-term investment instruments.

The Shivaraman-Krishnan Model also accounts for regulatory influences and tax implications, ensuring that the valuation aligns with financial reporting standards. By incorporating sensitivity analysis and Monte Carlo simulations, it enables analysts to test different risk factors and predict future price movements with greater confidence.

This model is widely used by investment banks, fund managers, and corporate financial planners for decision-making in capital markets, making it a powerful tool for financial analysis and valuation.

The Fair Value Method of share valuation determines the worth of a share by averaging the Intrinsic Value Method and the Yield Method. It provides a balanced valuation by considering both the assets of the company and its profit-generating ability. The formula used is:

Fair Value per Share = [Intrinsic Value + Yield Value] / 2​

This method ensures that neither the book value of assets nor the earning potential is solely relied upon. It is widely used in cases of mergers, acquisitions, and investment decisions where a realistic valuation of shares is required. The Fair Value Method is more comprehensive than standalone methods, making it ideal for determining the true market worth of a company. However, its accuracy depends on reliable financial data and stable market conditions to ensure a fair and justifiable valuation.

Assumptions of Fair Value Method:

• Combination of Intrinsic and Yield Value

The Fair Value Method assumes that the true value of shares lies between the Intrinsic Value (based on assets) and the Yield Value (based on earnings). By taking the average of both, it ensures a balanced valuation approach. This assumption is crucial because relying on just one method may not provide an accurate estimate of the share’s worth, especially in fluctuating market conditions.

• Stable Market and Economic Conditions

The method assumes that the market conditions, economic environment, and industry trends remain relatively stable over time. Sudden changes, such as recessions, inflation, or policy changes, can affect both the intrinsic and yield values, making the fair value less reliable. This assumption helps in maintaining consistency and predictability in share valuation.

• No Significant Business Disruptions

It assumes that the company’s business operations will continue smoothly without major disruptions like bankruptcy, litigation, or regulatory penalties. If the company faces serious operational or financial difficulties, the valuation derived using the Fair Value Method may not reflect the actual market scenario. Investors and analysts use this assumption to maintain a consistent valuation framework.

• Reliable Financial Data is Available

The accuracy of the Fair Value Method depends on the availability of reliable and audited financial statements. It assumes that the balance sheet, profit and loss statements, and earnings reports are free from manipulation or errors. Any discrepancies or misreporting in financial data can lead to an incorrect fair value assessment, affecting investor confidence.

• No Drastic Changes in Future Earnings or Asset Value

The method assumes that the company’s future earnings potential and asset values will not change drastically. It does not account for unforeseen events like major technological advancements, industry shifts, or external economic crises. This assumption ensures that fair value remains stable and provides a reliable benchmark for investors and stakeholders.

The Earning Capacity Method of share valuation determines a company’s worth based on its ability to generate future earnings. It focuses on sustainable profits and compares them to the expected rate of return. The formula used is:

Value per Share = [Average Maintainable Profit / Normal Rate of Return] × 100

This method is useful in mergers, acquisitions, and investment decisions, as it reflects the company’s profitability rather than just its assets. It is widely preferred by investors seeking long-term financial stability and growth potential in a business.

Assumptions of Earning Capacity Method:

• Stable and Maintainable Earnings

This method assumes that the company’s past earnings represent its future earning potential. It considers average maintainable profits over several years to ensure stability and consistency in valuation. Fluctuations in profits are adjusted by excluding abnormal gains and losses, making the valuation process more realistic for investors and stakeholders.

• Consistent Business Operations

It assumes that the company’s business operations will continue in the future without significant disruptions. External factors such as economic downturns, technological changes, or regulatory shifts are not considered unless they permanently impact earnings. This helps in maintaining the reliability of estimated future earnings.

• Normal Rate of Return Remains Constant

The method assumes that the normal rate of return (NRR) remains stable over time. NRR is based on industry averages, market conditions, and investor expectations. If interest rates or risk factors fluctuate significantly, the valuation may not reflect the actual market value of shares.

• Profits are Distributed to Shareholders

It is assumed that the company distributes profits fairly in the form of dividends or reinvestment for future growth. Investors rely on these profits to assess the value of shares. If a company retains all earnings without benefiting shareholders, the valuation might not be relevant.

• No Extraordinary Gains or Losses

The method assumes that the company’s financial performance does not include one-time income or expenses such as asset sales, lawsuits, or restructuring costs. Only regular business operations are considered, ensuring that the valuation reflects the true earning power of the firm.

• Future Business Conditions Resemble the Past

This assumption states that market conditions, competition, and industry dynamics will remain similar to past trends. Any significant economic, political, or technological changes that could impact the company’s future earnings are generally ignored, making the valuation less sensitive to uncertainty.

The Underwriter’s Account is a ledger account that records financial transactions between a company and its underwriters. It includes commission expenses, liabilities arising due to under-subscription, payments made, and settlements. This account helps in tracking the financial obligations of both parties, ensuring a clear record of underwriting transactions in the company’s books.

Components of the Underwriter’s Account:

The Underwriter’s Account consists of the following key components:

• Underwriting Commission

The company pays a commission to the underwriter for guaranteeing the issue of shares or debentures. The underwriting commission is recorded as an expense in the company’s books and credited to the underwriter’s account.

• Liability for Unsubscribed Shares

If the issue is not fully subscribed, the underwriter is responsible for purchasing the unsubscribed shares. This liability is recorded in the underwriter’s account, ensuring that the company receives the necessary funds.

• Payment to Underwriters

Payments made to underwriters for their services are recorded in this account. These payments may include underwriting commissions or amounts payable for unsubscribed shares.

• Adjustments and Settlements

If an underwriter purchases unsubscribed shares, the commission may be adjusted against their liability. The remaining balance is settled either through cash payments or other agreed terms.

Journal Entries for Underwriter’s Account:

a) Recording Underwriting Commission

📌 Entry:
Underwriting Commission A/c 🡺 Dr. (With the commission amount)
To Underwriter’s A/c

Explanation: This entry records the commission payable to the underwriter as an expense in the company’s books.

b) Payment of Underwriting Commission

📌 Entry:
Underwriter’s A/c 🡺 Dr.
To Bank A/c

Explanation: This entry records the payment of commission to the underwriter.

c) Recording Liability for Unsubscribed Shares

📌 Entry:
Underwriter’s A/c 🡺 Dr.
To Share Capital A/c
To Securities Premium A/c (if applicable)

Explanation: If the issue is under-subscribed, the underwriter is liable to purchase the remaining shares. This liability is recorded in the books of the company.

d) Adjusting Underwriting Commission Against Liability

📌 Entry:
Underwriting Commission A/c 🡺 Dr.
To Underwriter’s A/c

Explanation: If the underwriter is also purchasing the unsubscribed shares, their commission may be adjusted against the liability.

e) Final Settlement with Underwriters

📌 If the company pays the underwriter:
Underwriter’s A/c 🡺 Dr.
To Bank A/c

📌 If the underwriter pays the company (in case of excess commission adjustment):
Bank A/c 🡺 Dr.
To Underwriter’s A/c

Explanation: This entry records the final settlement between the company and the underwriter, ensuring all liabilities are cleared.

Importance of Underwriter’s Account:

• Ensures Transparency

The Underwriter’s Account provides a transparent record of financial transactions between the company and the underwriter, reducing disputes.

• Helps in Financial Management

By maintaining a proper record of underwriting commissions and liabilities, companies can manage their financial obligations efficiently.

• Compliance with SEBI Guidelines

Proper accounting ensures compliance with SEBI regulations and the Companies Act, 2013, which specify commission limits and liability treatment.

• Facilitates Audit and Tax Compliance

A well-maintained Underwriter’s Account simplifies audits and tax assessments, ensuring accurate reporting of financial statements.