How does Stock Exchange Functions?

The following article will guide you about how does stock exchange functions.

The stock exchange is an organised and centralised market for the purchase and sale of industrial and financial securities of all descriptions, viz., Stocks, Shares, and Debentures etc. It is a market for transactions in old securities. Practically, it is a place where the buyer of a security may find a seller who is ready to sell his holdings at a fair and reasonable price provided the security has been listed.

According to the Securities Contracts (Regulations,) Act of 1956, a stock exchange is ‘an association, organisation or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities’.

Functions and Services:

The stock exchange is almost indispensable for the proper functioning of corporate enterprise.

Its economic functions and services are enumerated below:

(a) Ready market for securities;

(b) Evaluation of securities;

(c) Convincing place for transfer of ownership of securities;

(d) Safeguards for investors and encouragement of savings;

(e) Flow of capital into industry;

(f) Liquidity of securities;

(g) Facility for speculation;

(h) Flow of savings into sound undertakings; and

(i) Mirror of national economy.

Organisation and Working of Stock Exchange:

Practically, the organisation and working of a stock exchange differs from exchange to exchange in technical details although the general pattern of all exchanges is almost the same.

The general pattern of a stock exchange is noted below:

(a) Constitution:

It is an association of members which may be a voluntary and non- profiteering association or company limited by shares or guarantee.

(b) Membership:

Membership is a ‘must’ for transacting business since non-members are not allowed to enter into the stock-exchange. Membership is strictly limited, i.e., no one is allowed to be a member unless there is a vacancy. Membership is acquired outright by the payment of membership fees prescribed by the stock exchange.

(c) Management:

The general administration of a stock exchange is administered by a committee of management and is called by different names in different exchanges. The selected Executive Committee of different stock exchanges carries on management of their day-to-day activities through sub­committees, such as, Listing Committee, Defaulters’ Committee, Arbitration Committee, etc.

(d) Nature of Transactions:

Two types of transactions, viz., cash or forward, are made in a stock exchange. Cash transaction is one which reveals the delivery of securities within a short time which is settled by the payment of price.

This type of transaction is also known as investment transaction since it is based on bona fide intention of purchase and sale of securities. On the contrary, a forward transaction is one which reveals forward delivery contracts and fixed settlement days. It is a speculative transaction and the settlement is made by the payment of price differences.

Jobbers and Brokers:

The members of London Stock Exchange are divided into two classes, viz., (i) Jobbers and (ii) Brokers. Every member of the exchange has to express clearly whether he would act as a Jobber or as a Broker at the time of his admission. He, however, cannot change his position during the course of the year.

A Jobber is an independent dealer in securities, i.e. he deals in securities in his own account. He has no direct contact with the intending purchaser and seller. In other words, a jobber can deal either with a broker or with another jobber.

He cannot work on commission basis but can do so for profit which is known as turn in technical language. A broker, on the other hand, is a Commission Agent who transacts business in securities on behalf of non-members. He has a direct contact with the intending purchaser and seller.

Therefore, broker is a link between the general public and the jobber while a jobber is a dealer in his own right. A jobber is a professional speculator who deals in a limited number of shares while a broker acts for a large number of his non-member clients dealing in a large number and variety of securities.

Causes of Price Fluctuations in Price of Stocks and Shares in the Stock Exchange:

Some of the causes of fluctuation are:

(a) Position of demand and supply;

(b) Role of investors and speculators and underwriters;

(c) Buying and selling securities by different financial institutions, e.g. Bank, Insurance Company, etc.;

(d) Bank rate;

(e) Position of the company;

(f) Change in the boards (i.e., the board of directors of a Company);

(g) Trade Cycle;

(h) Political factors;

(i) The position of loanable funds;

(j) Unfavourable balance of trade;

(k) Speculative pressures;

(l) Miscellaneous factors (i.e. war, revolution, strike, etc.)

Business Terminology:

Cash Shares:

When shares are purchased and sold only on cash basis, the same should be given delivery against the full payment. It is also known as hand delivery system.

Cleared Shares:

When shares are purchased and sold on forward basis an adjustment is made for the settlements or payment at the end of the fortnight with the help of a clearing house.

Blue Chip:

First Class shares of companies comparable to gilt-edged securities are known as Blue Chips.

Kerb Market:

When purchases and sales of securities are made by the jobbers and brokers after or before the official hours outside the stock exchange, the same is known as Kerb Market.

Bull:

A bull is a speculator who expects a rise in the price of a certain security in near future. He buys up the security without taking actual delivery in order to sell them at a higher price. He is also known as tejiwala.

Bear:

A bear is also a speculator who expects a fall in the price of a certain security. He agrees to sell for delivery on a fixed date the security which he processes or not in order to avoid the expected loss that may occur due to the fall in price of shares. He is also known as mandiwala.

Contago:

Contango is the charge paid by the buyer (bull speculator) when the transaction is postponed or carried over from one settlement day to the next settlement day.

Backwadation:

The said charge — if it is paid by the seller — is known as backwadation.

Books of Accounts:

The Books of Accounts which are to be maintained are:

Investment Account:

Investment means to spend money outside the business in order to earn some income which are non- trading in nature. Usually, money is invested in Govt. Bonds, Securities, Shares and Debentures of companies etc.

Investments are made in two following ways:

(a) As Trade Investments:

The investments which are made permanently for a regular income outside the business is known as Trade Investment. These are treated as fixed assets. That is why if this type of investments are sold at a profit, profit on such sale of investment is transferred to Capital Reserve Account and not to Profit and Loss Account.

(b) As Marketable Securities:

Sometimes a business wants to invest its idle cash purely on a temporary basis (of course, if the rate of earning is higher than cost of capital). This type of investment is known as Marketable Securities and are treated as Current Assets. That is why profit or sale of such investments are transferred to Profit and Loss Account and not to Capital Reserve.

In the present chapter we are going to highlight in details the second type of investment, i.e., Marketable Securities.

Again, this type of securities are of two following types:

A. Fixed Interest Bearing Securities

B. Variable Interest Bearing Securities.

A. Fixed Interest Bearing Securities:

Fixed interest bearing securities mean where the rate of return is fixed, say 10%, 12% or 15%. The returns or income of such securities usually falls due on certain specific dates, as 30th June or 31st Dec. This is particularly appropriate in case of Govt. Bonds and Securities. For example, if we purchase 1,000, 10% Govt. Bonds @ Rs. 100 (interest is payable on 30th September or 31st March), we will have an income of Rs. 10,000; Rs. 5,000 falls due on 30th Sept and Rs. 5,000 on 31st March.

Each investment is headed with the name of the security and, at the same time, if the rate of interest or dividend and the date at which it is payable are fixed such rates and dates are also to be mentioned.

The Ruling of Investment Account will be as under:

B. Variable Interest Bearing Securities:

Variable Interest bearing securities mean where the rate of return is not fixed, i.e., variable. It is applicable in case of shares. The rate of dividend on share is not at all fixed, rather fluctuating. In one year the return may be 10% whereas, in the next year, it may be 15%. Usually, shares are purchased as investment through brokers who charge a small rate of commissions on both purchase and on sales.

Note:

It must be remembered in this respect that in case of purchase of shares, brokerage or commissions will be added with the cost price of shares whereas in case of sale, brokerage and commission will be deducted from sale price.

The ruling is same as shown above.

Transactions relating to Investment Account:

Purchase and Sale of Investments:

It has been explained in earlier paragraph that investments are made in various securities, e.g. Government, Semi-government, Corporation or Trust Securities, such as Shares, Bonds, Debentures, etc. in long or short-term. The long-term investment is normally made for earning interest or dividend whereas the short-term investment is meant for making profit by selling the same when market price becomes favourable.

The aforesaid investments are maintained in the General Ledger (since they are real accounts) when they are few in number. But when they are substantial, a separate ‘Investment Ledger’ is to be opened for each individual class of securities in addition to interest or dividend. The Investment Account is maintained in a columnar form with three amount columns on each side—viz. Nominal, Interest/Income and Principal/Capital.

The face value or nominal value of securities purchased or sold are recorded, however, in ‘Nominal’ column. The accrued Interest/Dividend on purchase or sale of securities including the Interest/Dividend so received are recorded, however, in the ‘Interest/Income’ column. The third column ‘Capital/Principal’ reveals the true cost or true sales consideration.

Brokerage and Other Expenses:

Generally, investment transactions are made through brokers. They charge a certain small commission against their services which is known as ‘Brokerage’. But the stamp duty at the prescribed rates is also to be paid in executing the transaction.

Since the brokerage and stamp duty are capital in nature, these are to be added with the cost price of the investments, i.e. brokerage will be added at the time of purchasing the securities and the same will be deducted from the sale price of the investment at the time of sale. As a result, only the net price is to be recorded in the ‘capital’ column of the Investment Account.

Accounting Treatment:

(a) Purchase of Investment:

When investment is purchased, its face value is recorded on the debit side of Investment Account and the actual cost (including brokerage, stamp duty, etc.) is recorded in the principal column.

But if the same is purchased under cum-interest/dividend basis, the accrued interest must be recorded in ‘Interest’ column and will be deducted from the purchase price as the real cost is to be recorded in ‘Principal’ column. But, if the investment is purchased under ex-interest/dividend basis, the quoted price together with brokerage and stamp duty will be recorded in the ‘Principal’ column. The accrued interest is, however, entered on the Interest/Income column.

(b) Sale of Investment:

When investment is sold, the same is recorded on the credit side of Investment Account, the face value being recorded in ‘Nominal’ column, the net selling price is entered, however, in the ‘Principal’ column. But if the investment is sold as cum-interest/dividend, the accrued interest will be recorded in ‘Interest/Income’ column and the net selling price (capital portion) on the ‘Principal’ column.

On the contrary, if the same is sold as ex-interest/dividend, the accrued interest/dividend is received by the seller in addition to quoted sale price. The accrued interest/dividend is entered on the ‘Interest/Income’ column and the quoted sale price in the ‘Capital’ column.

(c) Profit or Loss on sale of investment:

The difference between the capital cost of securities and the consideration received towards capital at the time of sale reveals the profit or loss on sale of investment. The profit or loss may be ascertained either for each individual sale or may be ascertained all selling transaction at the end of the year as a whole.

And if the entire investments are sold, the difference between these two ‘Principal’ columns represents profit or loss, as the case may be. But if a part of investments is sold, the balance of investments on hand should be ascertained first.

Therefore, the balance is either valued at cost if the investment is treated as fixed asset, or the balance is valued at cost or market price, whichever is less if the investment is treated as current asset. Naturally, the value of investments at hand is entered on the credit side of the Investment Account in ‘Principal’ column and the difference represents the profit or loss on sale of investment.

The profit or loss on such sale is transferred to Profit and Loss Account if the investment is treated as a current asset or the profit or loss on such sale is treated separately if the investment is treated as a fixed asset.

(d) Balancing Investment Account:

The Balance of Investment account is ascertained at the end of the accounting period. The balance of ‘Nominal’ column reveals the face value of the investment in hand and, after recording the closing balance of investment in ‘Principal’ column, the profit or loss is to be ascertained (which has been explained earlier). And the difference between the two ‘Interest/Income’ columns represents income/interest from Investment Account which is ultimately transferred to Profit and Loss Account.

But, in the true sense of the term, Accounting Treatment depends on the date of purchase and sale of investment.

It may, again, be of two types:

A. Purchase and Sale of Investment just at the date of payment of interest; and

B. Purchase and Sale of Investment before the date of payment of interest.

A. When Purchase and Sale of Investment are made just at the date of payment of interest:

Under the circumstances, there will be no problem as to the cost of investment, because the quoted price does not include the amount of interest. The quoted price represents the cost of investment.

Entries in the books of Investor:

Note:

The closing balance of investment will be computed on the basis of Cost price or Market Price, whichever is lower (as investment is treated here as a current asset).

B. Purchase and Sale of Investment before the date of payment of interest:

Under the circumstances, question arises before us whether the quoted price of investment is inclusive of interest/dividend or exclusive of interest/dividend. In short, we are to face the problem of Cum-Interest and Ex-Interest.

Cum-interest or Cum-Dividend:

Where the right to receive interest or dividend from the issuer of security passes from the seller to the buyer, the transaction is known as ‘Cum-Interest’ or ‘Cum-Dividend’ purchases or sale. In other words, when the accrued interest or dividend from the last interest or dividend date up to the date of transaction is included in the quoted price, the capital cost of investment purchased or sold is ascertained by deducting the accrued interest/dividend from the quoted prices. And the difference between the quoted price and the actual cost may be represented as ‘Cum-Interest’ or ‘Cum-Dividend’.

Ex-Interest or Ex-Dividend:

When the seller retains the right to receive the interest/dividend, the transaction is called ‘Ex- Interest’ or ‘Ex-dividend’ purchase or sale. In other words, when the price quoted is exclusive of accrued interest/dividend, the price so quoted is treated as the capital cost of investment, i.e. the buyer has to pay accrued interest due from the last interest date to the date of transaction to the seller along with the cost price of investment.

For Cum-Interest Purchase and Sales:

To Sum up:

When investments are purchased at Cum-Interest it means quoted price is inclusive of accrued interest. So, we are to ascertain the amount of interest and the same must be deducted from the quoted price in order to find out the cost. Investment will be debited with actual cost (to be posted in principal column) and accrued interest will be debited with the amount of interest (to be posted in interest column) and Bank Account will be credited for the total (i.e. quoted price).

Same principle is to be followed also in case of sale of investment which includes Cum-Interest, i.e. from the quoted selling price, the amount of interest will be deducted in order to ascertain the cost/principal for this purpose, Bank Account will be debited with total amount or quoted price and Investment Account will be credited at cost and Interest Account will be credited with the amount of interest.

Entries for Cum-Interest Purchases:

Entries for Cum-Interest Sales:

Ex-Interest Purchases and Sales:

When investments are purchased at Ex-Interest, it means quoted price is exclusive of accrued interest. In that case, the Investment Account will be debited with quoted prices, Interest Account will be debited with accrued interest and Bank Account will b£ credited with total amount (i.e. quoted price plus interest).

Entries in Case of Ex-Interest Purchase:

But when investment are sold at Ex-interest, quoted price is exclusive of interest. In other words, Investment Account will be credited with quoted price and Interest Account will be credited with Accrued Interest and Bank Account will be credited with total i.e., quoted price plus interest.

Entries in the case of Ex-Interest Sale:

Profit or Loss on sale of investment should be transferred to Profit and Loss Account. The entries for this purpose we have shown earlier.

Investment in Shares:

If has already been stated earlier that in the case of Variable Interest on securities, the return from such securities fluctuates, i.e. vary from year to year. This is possible in the case of investments which are made on shares. The rate of dividend on shares depends on the profit-earning capacity of the company. Since the profit-earning capacity of a company is always fluctuating so also the fluctuation in the rate of dividend.

The following points should carefully be remembered:

(a) For Dividend Received:

(i) If we receive dividend from Pre-incorporation profit, the same must be recorded in Nominal Column.

(ii) If we receive dividend from Post-acquisition profit/Current Profit, such dividend must be recorded in Interest Column.

(b) For Bonus Shares and Right Shares:

If bonus shares are received, entry is made in the debit side of Investment Account in ‘Nominal’ column only and nothing is to be recorded in ‘Principal’ column. In other words, when bonus shares are received, their face value is simply shown in the Investment Account stated above. But in the case of Right shares, the shareholders have the right to avail the ‘Right’ himself or he can refer to third party.

The face value of such right shares are recorded in the ‘Nominal’ column and the amount so paid in this regard is to be entered in the ‘Principal’ column. But in the case of sale, the amount so received against the sale of ‘Right’ will be entered on the credit side of Investment Account in ‘Principal’ column.