Redemption of Preference Shares

Section 80

• In India the issue and redemption of preference shares is governed by Section 80 of the Companies Act.

• Company limited by shares can issue preference shares if authorised by its articles.

• Company if does so, is liable to redeem the preference shares.

Sources of Redemption

• Out of profits of the company which would otherwise be available for dividend.

• Out of the fresh issue of shares made for the purpose of the redemption.

• The premium on redemption shall be provided out of the profits or out of the company’s Securities Premium Account before the shares are redeemed.

Conditions

• No such shares shall be redeemed unless they are fully paid.

• Where the redemption is other then out of the proceeds of fresh issue, amount equal to the nominal amount of shares redeemed will be transferred from the profit (which otherwise is available for dividend) to Capital redemption reserve account.

Methods of Redemption

• The gap created in the company’s capital by the redemption of redeemable preference shares must be filled-in by:

a. The proceeds of a fresh issue of shares;

b. The capitalization of undistributed profits; or

c. Combination of ‘a’ and ‘b’

(a) Fresh Issue of shares

• One of the prescribed method

• Proceeds of new equity or preference shares can be used for redemption

• The proceeds from issue of debentures cannot be used for this purpose.

Fresh Issue of shares at premium

• The word proceeds suggest that the proceeds of the issue would also include the money received on account of securities premium too.

• Section 78(2) clause ‘d’ of Securities premium provides that: securities premium account can be used in providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company.

• Thus the above clause allows the premium on redemption to be adjusted against securities premium account but the entire redemption itself cannot be financed out of premium.

Conclusion

• Thus it can be concluded that securities premium money out of fresh issue cannot be treated as ‘proceeds’ for the purpose of redemption of preference shares.

Fresh Issue at Discount

• Proceeds in this case would only mean the net amount received, that is the face value less the discount.

• Thus, when the shares are issued at a discount, then the number if shares to be issued at a discount should be manipulated to ensure that at least the face value of shares to be redeemed has been procured out of the proceeds of fresh issue at discount.

Grounds for Issue of New Equity Shares

• When company realizes that permanent capital is needed; then it makes more sense to issue Equity shares in place of Redeemable Preference shares which carry a fixed rate of dividend.

• When the balance of profit for payment of dividend is insufficient.

• When the liquidity position of the company is not good enough.

Advantages of fresh issue of equity for redemption

• No cash outflow – Now or later

• New equity shares may be valued at premium

• No capital gains tax for shareholders.

• Shareholders retain their equity interest.

Disadvantages of fresh issue of equity for redemption

• Possibility of dilution of future earnings

• Share holdings in the company are changed.

Accounting Entries

• When shares are redeemed at par:

Redeemable Pref share cap A/c Dr

To Preference Shareholder A/c

• When shares are redeemed at a premium

Redeemable Pref Sh.Cap. A/cDr

Premium on Redemption A/c Dr

To Preference Shareholder A/c

Accounting Entries

• When payment is made to preference shareholdersPreference Shareholders A/c Dr

To Bank Account

• For adjustment of premium on redemptionProfit & Loss A/c DrSecurities Premium A/c Dr

To Prem. on redemption A/c

Premium on Redemption of Preference shares

• Companies Act states that the premium, if any, payable on redemption shall be provided out of profits of the company or out of the company’s securities premium account, before the shares are redeemed.

• Thus Act says that any premium collected from the new issue cannot be utilised for the purpose of paying premium on redemption.

Premium on Redemption of Preference shares

• It should be considered here that resolution for fresh issue of shares and for redemption of preference shares are passed simultaneously. So we cannot treat premium of new issues as premium before redemption.

• In practice, every company makes provision for premium on redemption well in advance

(b) The capitalization of undistributed profits

• According to the provision of section 80 (1) (d) When shares are redeemed by utilizing distributable profit, an amount equal to the face value of shares redeemed is transferred to Capital Redemption Reserve Account by taking part of the distributable profit.

Advantages of Capitalization of Undistributed profits

• No change in the percentage share holdings of the company

• Future earnings are not diluted

Disadvantages of Capitalization of Undistributed profits

There may be a reduction in liquidity

Accounting Entries

All the entries above in the first method and – For transferring nominal amount of shares redeemed to CRR account

General Reserve Account Dr

Profit and Loss Account Dr

To Capital Redemption Reserve Account

Issue of Bonus Shares

• Sometimes, bonus shares are issued by utilizing capital redemption reserve account and other reserves.

• Capital Redemption Reserve A/c DrOther Reserve A/c Dr

To Bonus to shareholders A/c

• Bonus to shareholders A/c DrTo Equity Share Capital A/c

CRR

• Why create CRR? To maintain capital intact.

Company was geared with a scale of capital just before redemption.

The willingness of the company to redeem its preference share would suggest the company’s period of recovery was over. But the shortage of capital may reappear.

CRR

• So the government would not like to take any chance.

• Section 80 of the companies Act ensures, first, the maintenance of that capital which helped the company to overcome the financial crisis by issuing preference shares.

• This has been achieved by giving only two statutory methods for redemption, either out of proceeds of fresh issue of shares or creating the required CRR out of profits.

CRR

• The utilization of CRR is restricted to issue of fully PAID-UP BONUS SHARES ONLY TO COMPLETE THE PICTURE OF CAPITALIZATION.

• The another reason for the creation of CRR is for the protection of the company’s creditors, since the directors of the company may distribute divisible profits by way of dividend.

ExampleBalance Sheet of ABC Ltd as on

31 December, 2006

Liabilities Rs Assets Rs

25000 equity shares

250000 Fixed Assets 210000

5000 Redeemable preference shares

50000 Stock in trade 100000

Profit & Loss Account

150000 Debtors 100000

Creditors 160000 Cash 200000

TOTAL 610000 TOTAL 610000

Example

• As per the terms and condition of the issue, preference shares were redeemed on 1 January, 2007. Now, the effects of the transfer to a capital redemption reserve can be as follows:

Amount available to creditors31 December 2006

1 Jan 2007

Without transfer to CRR

1 Jan 2007

After transfer to CRR

Total Assets 610000 560000

(cash reduced)

560000

Less: Retained profits available

150000 150000 100000(trf to CRR)

Net amount for creditors (security)

460000 410000 460000

(c) A combination of both methods

• Amount to be transferred to CRRFace value of shares redeemed -----------Less: Proceeds from new shares -----------

-----------• ‘Proceeds’ to be collected from new issue

Face value of shares redeemed ----------Less: Profits available for distribution ----------

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