As of December 31, 2016, Company A held 160 million shares of its subsidiary A (a listed company), with a par value of RMB 0.5 per share and a total investment of RMB 80 million, representing 80% of Subsidiary A's equity (the remaining 40 million shares were freely circulating shares in the market).

On September 30, 2017, Subsidiary A increased its share capital by RMB 700 million through the issuance of fully tradable rights, issuing a total of 1.4 billion rights at an issue price of RMB 0.5 per right. Since Company A held 80% of Subsidiary A's equity, it was entitled to subscribe for 1.12 billion rights. These rights were traded separately on the stock exchange for a trading period of one month, from November 6, 2017 to the end of trading on December 5, 2017.

On November 12, 2017, Company A sold 168 million of these rights to Company B at a price of RMB 2.8 per right, for a total consideration of RMB 470.4 million. This price was the market price per right on that day.

On December 6, 2017, Company A exercised the remaining 952 million rights to subscribe for shares of Subsidiary A at RMB 0.5 per share (i.e., par value), with a total subscription amount of RMB 476 million.

Statement of the Problem

Regarding the above transactions, the following accounting treatment questions commonly arise in practice:

  1. Generally, for the granting of rights, an enterprise does not make any accounting entries. For tradable rights, is it also unnecessary to record them in the accounts?
  2. How should the sale of rights on November 12, 2017 be accounted for? Should the sale be recognized as income, or as a reduction in the carrying amount of the investment in the subsidiary (because the sale will dilute Company A's ownership percentage in Subsidiary A)?

Analysis and Discussion

I. Accounting Treatment on the Grant Date of the Rights

Under current accounting standards, when a subsidiary declares a rights issue, the rights obtained by the parent company as an existing shareholder are generally regarded as a derivative financial instrument or an equity instrument. For tradable rights, since they are traded separately on a stock exchange and have an active market quotation, they meet the definition of a financial instrument. However, on the grant date (i.e., the issue date of the rights), the parent company has not actually paid any consideration, and the rights have not yet been exercised or sold, so their fair value may be zero or minimal. Therefore, the common practice is: no asset or liability is recognized on the grant date, because the right is derived from the original equity interest and its value is already implicit in the carrying amount of the long-term equity investment. Unless the fair value of the rights can be reliably measured and is material, they are not recognized separately.

Therefore, for tradable rights, there is also no need to make accounting entries on the grant date, but the number of rights and the exercise conditions should be recorded in the memorandum book.

II. Accounting Treatment for the Sale of Rights

On November 12, 2017, Company A sold 168 million rights and received proceeds of RMB 470.4 million. This sale constitutes a disposal of a financial asset. Since the rights were not recognized on the grant date, their carrying amount is zero, so the proceeds received upon sale should be recognized as current-period income (investment income or gains/losses from changes in fair value). However, it should be noted that this sale causes Company A's ownership percentage in Subsidiary A to decrease (from 80% to approximately 79.3%, calculation omitted), but Company A still retains control. Therefore, this transaction is an equity transaction with minority shareholders. Under accounting standards, gains or losses arising from equity transactions should be recognized in capital reserve (other capital reserve), rather than in current-period profit or loss.

Specifically, the difference between the proceeds from the sale of rights and the proportionally calculated net asset share should be adjusted to capital reserve. However, here what is sold is the rights themselves, not a direct sale of equity. Therefore, a distinction must be made: the proceeds from the sale of rights should first be recognized as income from the disposal of a financial asset, but the substance of this income is the dilution of the equity interest in the subsidiary. Therefore, it should be treated as part of an equity transaction, with the net income recognized in capital reserve.

However, if Company A uses the cost method for Subsidiary A (in the parent company's separate financial statements), the sale of rights does not affect the carrying amount of the long-term equity investment, but the proceeds received should be recognized as investment income. At the consolidated financial statement level, this transaction should be treated as an equity transaction, adjusting capital reserve.

Therefore, the recommended treatment is: in the parent company's separate financial statements, the proceeds from the sale of rights are recognized as investment income; in the consolidated financial statements, this income is adjusted to capital reserve (other capital reserve), while also adjusting minority interest.

III. Accounting Treatment for Exercising the Remaining Rights

On December 6, 2017, Company A exercised the remaining 952 million rights and paid a subscription amount of RMB 476 million. This subscription increases the investment cost in Subsidiary A and should be recorded by debiting "Long-term Equity Investment" for RMB 476 million and crediting "Cash at Bank" for RMB 476 million. Since the subscription price equals the par value and the rights themselves were not recognized, no special treatment is required.

In summary, for the granting of tradable rights, no accounting entries are needed; upon sale, the proceeds are recognized as investment income in the separate financial statements and adjusted to capital reserve as an equity transaction in the consolidated financial statements; upon exercise, the long-term equity investment cost is increased by the actual amount paid.