Unit 1: Redemption of Preference Shares

In previous sections we have discussed different sources of capital. Equity shares get dividend at a rate fixed at the Annual General Meeting (AGM) depending on the profit available for a particular year. The rate of dividend also varies from year to year. The preference shareholders contribute capital to the company. According to section 85 of the Companies Act, 1956, persons holding preference shares, called preference shareholders. They are assured of a preferential dividend at a fixed rate during the life of the company. This type share holders carry preferential right over other shareholders to be paid first in case of liquidation of the company. Companies use this mode of financing as it is cheaper than raising debt. The preference shares can be of various types. These are:

i)	Redeemable Preference Shares: A company may issue this type of shares on the condition that the company will repay the amount of share capital to the holders of this category of shares after the fixed period or even earlier at the discretion of  the company. Section 80 of the  Companies Act, 1956 deals with the redemption of preference shares.

ii)	Irredeemable Preference Shares: The preference shares, which do not carry the agreement of redemption are known as irredeemable preference shares.

iii)	Convertible Preference Shares: This type of shares enjoy the right to the holder to get them converted into equity shares according to the terms and conditions of the issue.

iv)	Non-convertible Preference Shares: The holders of these shares do not enjoy the right to get the shares converted into equity shares. Unless otherwise stated, Preference shares are non-convertible.

v)	Participating Preference Shares: The holder of this type of preference shares enjoy the right to participate in the surplus profits, if any, after the equity shareholders have been paid dividend at a rate fixed in the AGM. So the shareholders get additional dividend with their normal dividend.

vi)	Non-participating Preference Shares: These shares carry only a fixed rate of dividend without any right to get additional dividend. Unless otherwise stated, The preference shares are non-participating.

vii)	Cumulative Preference Shares: The cumulative preference shares carry the right to a fixed amount of dividend. The holders of these shares are entitled to get dividend out of future profit if current year’s profit is insufficient for the same. So, the dividend on these shares accumulates till the final payment.

viii)	Non-cumulative Preference Share: In this case the dividend for the shareholders does not accumulate. If there is no sufficient profit, this type of preference shareholders will not get any dividend. In this case, the dividend will be lapsed and there will be no arrear dividend.

Before going to redeem the preference shares as per section 80 of the Companies Act, 1956, a company should have to follow the conditions: i)	There must be a provision in the Articles of Association regarding the redemption of preference shares. ii)	The redeemable preference shares must be fully paid up. If there is any partly paid share, it should be converted in to fully paid shares before redemption. iii)	The redeemable preference shareholders should be paid out of undistributed profit/ distributable profit or out of fresh issue of shares for the purpose of redemption. iv)	If the shares are redeemed at a premium, it should be should be provided out of securities premium or profit and loss account or general reserve account. v)	The proceeds from fresh issue of debentures cannot be utilized for redemption. vi)	The amount of capital reserve cannot be used for redemption of preference shares. vii)	If the shares are redeemed out of undistributed profit, the nominal value of share capital, so redeemed should be transferred to Capital Redemption Reserve Account. This is also known as capitalization profit.

So, you may understand that a company must follow the above conditions for the purpose of redemption of its redeemable preference shares. In the next section we shall discuss about the Capital Redemption Reserve account.

If you go through the conditions as discussed in the previous section, it will be clear that, if the preference shares are redeemed out of accumulated profit, it will be necessary to transfer an amount equal to the amount repaid on the redemption to Capital Redemption Reserve Account. If the company issues any fresh shares for redemption purpose, the transferred amount will be the difference between nominal value of shares redeemed and the nominal value of shares issued (i.e. amount transferred to CRR = Nominal value of shares redeemed – Nominal value of shares issued). The capital redemption reserve account can be used for issuing fully paid bonus shares.

The importance of creation of capital redemption reserve account are to a) protect the interest of creditors and b) maintain working capital. Redemption of preference shares involves repayment of capital before paying creditors of the company. It may affect the interest of creditors. In addition to that the working capital of the company will be depleted as a result of outflow of cash due to redemption. The amount is capitalized by creating the capital redemption reserve account. As a result this amount will not be available for distribution of dividend. It help protect the interest of creditors and on the other hand it replenishes working capital.

The redeemable preference shares can be redeemed by a) the proceeds of a fresh issue of equity shares/ preference shares, b) the capitalization of undistributed profit i.e. creating capital redemption reserve account, or c) a combination of both (a) and (b). let us see the accounting entries required for redemption of preference shares.

i)	When new shares are issued at par:         Bank A/c …………………Dr.             To Share Capital A/c.

ii)	When new shares are issued at premium:         Bank A/c ……………………..Dr.            To Share Capital A/c            To Share Premium A/c

iii)	When new shares are issued at a discount:         Bank A/c ………………Dr.          Discount on Issue of Share Capital………..Dr.            To Share Capital A/c.

iv)	Conversion of partly paid shares into fully paid shares:        a)	Share Call A/c ………..Dr. To Share Capital A/c b)	Bank A/c ……………..Dr.                  To Share Call A/c.

v)	When preference shares are redeemed at par:         Redeemable Preference Share Capital A/c ………………Dr.            To Preference shareholders A/c.

vi)	When preference shares are redeemed at a premium:        Redeemable Preference Share Capital A/c ………………Dr         Premium of Redemption Preference Share Capital A/c….Dr.           To Preference shareholders A/c.

vii)	Adjustment of premium on redemption:           Profit and Loss A/c………………..Dr.            Share Premium A/c ……………….Dr.               To Premium of Redemption Preference Share Capital A/c

viii)	Transferring the amount to Capital Redemption Reserve Account:        General Reserve A/c …………….Dr.         Profit and Loss A/c …………….Dr.             To Capital Redemption Reserve A/c

ix)	Expenses on issue of shares:        Expenses on Issue of shares A/c…………….Dr.            To Bank A/c.

x)	When payment is made to preference shareholders:         Preference Shareholders A/c ……………Dr.              To Bank A/c.

xi)     When the fully paid bonus shares are issued:                 Capital Redemption Reserve A/c …………….Dr.                 General Reserve A/c …………………………..Dr.                 Share Premium A/c ……………………………Dr.                  Profit & Loss A/c …………………………….. Dr.                            To Bonus to Shareholders A/c

xii)	Capitalization of profit:         Bonus to Shareholders A/c ………………Dr.             To Equity share capital A/c

Example 1.

XY Co. Ltd. had part of its share capital in 2000 preference shares of Rs.10 each fully paid up and these have become due for redemption. The preference share capital was to be redeemed out of a fresh issue of equity shares at par made particularly for this purpose and the general reserve of the company stood at Rs.25,000. Show the journal entries for the above transactions.

Example 2. Kitkat Co. Ltd. Issued 50,000 Equity shares of Rs.10 each and 3000, 10% Preference shares of Rs.100 each, all shares being fully paid. On 31.3.08, Profit and Loss Account showed an undistributed profit of rs.50,000 and General Reserve Account stood at Rs.1,20,000. On 2.4.08, the directors decided to issue 1500, 6% Preference shares of Rs.100 each for cash and to redeem the existing preference shares at Rs.105 utilizing as much as would be required for the purpose. Show the journal entries to record the transactions.

Example 3.

The King Kong Ltd.’s Balance sheet shows the following balance s on 31-3-08. 30,000 equity shares of Rs.10 each fully paid; 18,000 10% Redeemable Preference shares of Rs.10 each fully paid; 4000, 15% Redeemable Preference shares of Rs.10 each, Rs.8 paid up. General Reserve Rs.12,000; Securities Premium Rs.15,000; Profit Loss Account Rs.80,000 and capital Reserve Rs.20,000.

Preference shares are redeemed on 1-4.08 at a premium of Rs.2 per share. For redemption, 4000 equity shares of Rs.10 each are issued at 10% premium. A bonus issue of equity share was made at par, two shares being issued for every five held on that date. Show the journal entries to record the above transactions.

Example 4.