In order to provide a bonus issue, the company must have this thing called "RESERVES" which can be turned into new paid-up capital to be used for the creation of new shares for paying out as bonus.
Surely this "Reserves" thing must be something of value?
This term "Reserves" is very confusing to people who are not familiar with accounting concepts.
The "Reserves: of a company is purely a paper entry, purely an accounting convention. There is absolutely nothing solid behind the term "Reserves". The "Reserves" you see in the balance sheet of a company belongs in the realm of an accountant's imagination; this is something which exists purely as a written line on the company's accounts books.
The real strength of a company is not shown by how much it has under the item "Reserves" but under the "Cash" and/or "Short term Investments" items as well as its undisclosed borrowing capacity. Many a company have gone bankrupt with lots of "Reserves" still on its balance sheet.
What then does this term "Reserves" mean? The reason why there is an item of "Resreves" in the balance sheet of most companies is due to the nature of our accounting system.
Assets = Liabilities + Shareholders' Equity*
(*defined as Paid up Capital + Reserves)
Under this system of accounting, whenever, there is an increase in the total assets of the firm which is caused by either the purchase of a new asset or an increase in the book value of an asset (the "book value" of an asset is the value which is recorded in the accounting books of the company, it is not necessarily the same as its real value or its purchase price), a similar entry has to be placed on the opposite side of the balance sheet to keep it in balance.
Let us assume that the left hand side of the Balance Sheet goes up beause the company has purchased an asset. We know that whenever there is an increase in the left hand side of the Balance Sheet, there must be a corresponding increase on the right hand side. The right hand side would go up in accordance with how the company has financed this particular purchase. There are three ways by which it can finance the purchase:
(1) It can borrow the money;
(2) It can obtain the money from its shareholders; and
(3) It can earn the money.
If the firm borrows the money, its Liabilities would go up by an equal amount as the cost of the asset. Hence both sides are still in balance. If it obtains money from its shareholders, its Paid-up Capital would increase. Using these two ways of financing an increase in asset results in no nett change in the value of the company in the hands of the shareholders.
If however, the company has earned enough profit to pay for the purchase, the balancing entry will be put under "Reserves". Such an increase in the asset of the company will result in an increase in the nett worth of the company. As the asset purchased will earn more profit for the company which can pay more dividend to the shareholders, the increased dividend payment will increase the price of the share. Under normal circumstances, the value of a company would increase if it earns money to buy new assets. But this is a "difficult" way of increasing one's assets for the company must make some money in the first place; there are other easier methods.
The easiest way by which the assets of a company can be increased in its book value is by revaluation. When the assets of a company are revalued, an imbalance is created in the balance sheet because there is no corresponding increase on the other side. In order to keep the balance sheet in balance, a similar amount is therefore added to the Reserves item.
Whenever this happens, Malaysian speculators usually become very excited because they feel sure that a bonus issue is forthcoming since the company now has reserves which can be converted to bonus shares for distribution. The price of such shares therfore tends to go up. But why should the price of a company's share go up just because it has undergone a revaluation of its assets? Is it not true to say that even after the revaluation, the true value of the assets of the company remains unchanged? What is changed is the value shown in the accounting books of the company. Surefly, we should price the shares of a company according to its true value rather than the value after a revaluation.
Furthermore, how can we be sure that the revaluation has been properly carried out? The experience of many local companies in this respect does not give one cause to have confidence in their ability to value their assets correctly. In past years, many companies had to reduce the book value of their assets by a huge amount after having previously written them up to an unrealistic level. Many of them suffer diminution in their assets of $50 million or more. Valuation is an extremely subjective exercise and no two persons can agree exactly on the value of a piece of asset.
Another method of increasing the reserves of a company which was commonly practised in the past but which is more difficult (because of changes to regulations) to practise nowadays is by the overvaluation of assets to be swapped into the company by an exchange of shares. We may define a share swap as when a company issues new shares to an outsider in exchange for a piece of asset. In many of the share swaps carried otu, the assets to be swapped were valued very highly. As a result, a lot of new shares had to be created to "pay" for the assets. In some cases, instead of issuing the new shares at its par value or at the nett asset value of the shares, the shares were issued at a highly inflated value, say, $10 per share. This means that for every share issued, $9.00 can be added to the Reserves of the company. The company therefore had a lot of reserves for the issue of bonus shares.
Thus, it can be seen that the reserves of a company can be created out of almost thin air. Such reserves can then be used for the creation of bonus shares which in turn must be regarded as being virtually wothless as well. Thus we can see that it is very difficult for a layman to known how the reserves of a company come into being. Very often such reserves are created at the stroke of a pen. Unless you can separate the "good" reserves from the "bad", you should not be excited by the prospect of a bonus issue as a result of an increase in Reserves.
Ref: Stock Market Investment by Neoh Soon Kean
