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Unit 1: Redemption of Preference Shares
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Redemption of Preference Shares
Chapter Outline
1.0 Introduction
1.1 Objectives
1.2 Types of Preference shares
1.3 Conditions for redemption of preference shares
1.4 Capital Redemption Reserve (CRR) Account
1.5 Journal for accounting entries
1.6 Worked out Examples
1.7 Let us sum up
1.8 Answer to the Check Your Progress
1.9 Further Readings
Introduction
You have already learnt various aspects of accountancy and corporate accounting in the previous units. The fund
provided by the owners in to a business is known as capital. You know that capital of the business depends upon
the form of business organization. From ownership point of view, there are number of business organizations like,
sole proprietorship business, partnership business, cooperative societies, joint stock companies etc. Total capital of
the company is divided into a number of small units of fixed amount and each such unit is called a share. The fixed
value of a share register with the registrar of Companies is called face/ nominal value. However, a company can
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issue shares at a price different from its nominal value or face value. As the total capital of the company is divided
into shares, the capital of the company is known as share capital. A company can issue two types shares equity
shares and preference shares. The issue of preference shares is one of the important sources of capital of a
company. Redemption is the process of repaying an obligation at predetermined amounts and timings. The
redeemable preference shares are issued on the terms that share holders will at a future date be repaid amount
which they invested in the company. According to the Companies Act, 1956, a company can issue only redeemable
shares i.e. at present a company cannot issue irredeemable preference shares.
Now, in this unit we are going to discuss about the redemption of preference shares.
Learning Objectives
After reading this chapter, you are expected to learn about:
Identify the different types of preference shares;
Describe how companies redeem its preference shares;
Prepare account for the scheme of redemption; and
Utilize the capital redemption reserve account.
1.2 Types 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:
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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) Nonconvertible 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 nonconvertible.
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) Nonparticipating 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 nonparticipating.
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) Noncumulative 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.
SelfAssessment Questions (SAQs) 1
Notes:
(i) Write your answer in about 50 words in the space given.
(ii)Compare your answer with the model answer given in the Answer section.
1. What do you mean by share and share capital?
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2. What are the different types of share capital?
3. What is meant by redeemable preference shares?
4. Mark True (T) or False (F) for the following statements.
(i) Redeemable preference shares can be redeemed either at par or at premium.
(ii) Preference share holders enjoy voting rights.
(iii) Noncumulative preference shareholders can get arrear dividend.
(iv) Participating preference shareholders have no right to get an additional dividend.
1.3 Conditions for redemption of preference shares
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.
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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.
SelfAssessment Questions (SAQs) 2
Notes:
(i) Write your answer in about 50 words in the space given.
(ii)Compare your answer with the model answer given in the Answer section
1. Can a company redeems its preference shares out of fresh issue of shares?
2. When the Capital Redemption Reserve account is created?
3. Mark True (T) or False (F) for the following statements
(i) Sale proceeds of investment can be utilized for redemption of preference shares.
(ii) For the purpose of redemption, debenture can be issued.
(iii) Capital Reserve cannot be used for the purpose of capital Redemption
1.4 Capital Redemption Reserve (CRR) 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
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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.
SelfAssessment Questions (SAQs) 3
Notes:
(i) Write your answer in about 50 words in the space given.
(ii)Compare your answer with the model answer given in the Answer section
1. How the Capital Redemption Reserve Account is created?
2. Why the CRR account is created?
1.5 Journal for accounting entries
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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
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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
1.6 Worked out Examples
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.
Solution:
Journal Entries in the Books of XY Ltd.
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(Rs.) (Rs.)
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.
Solution:
Journal Entries in the Books of Kitkat Ltd.
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(Being amount payable on redemption of 3000
preference shares, with premium of 5%).
To 6% Preference Share Capital A/c 150,000
(Being the amount received on issue of 1500, 6%
Preference shares of Rs.100 each made for the purpose
of redemption of preference shares as per Board’s
Resolution dated…………).
To Premium on Redemption of Preference shares 15,000
capital A/c
(Being the amount written off against general reserve)
To Bank 315,000
(Being the amount due to preference shareholders paid).
Example 3.
The King Kong Ltd.’s Balance sheet shows the following balance s on 31308. 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 14.08 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.
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Solution:
Note: Partly paid up preference shares cannot be redeemed.
Journal Entries in the Books of King Kong Ltd.
Example 4.
The preference shares were redeemed on April 1, 2008 at a premium of Rs.5.00 per share, the whereabouts of the
holders of 1500 such shares not being known. At the same time, a bonus issue of equity share was made at par, one
share being issued for every four equity shares held. Show the journal entries to record the above transactions and
the Balance sheet as it would appear after the redemption. The following is the balance sheet of Black Diamond
Co. Ltd. As at 31 st March,2008.
11,00,000 11,00,000
Solution:
Journal Entries in the Books of Black Diamond Ltd.
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To Premium on Redemption of Preference shares 90,000
capital A/c
(Being the amount written off against Profit And Loss
A/c)
To Capital Redemption Reserve A/c 1,80,000
( Being amount transferred equal to the nominal value
of shares redeemed and proceeds of new issue).
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Balance sheet of Black Diamond Co. Ltd. as at 1st April, 2008.
Profit & Loss Account (Rs.48000090000
180000)
Current Liabilities: 40,000
Sundry Creditors 22,500
Outstanding claim (Pref. Shareholders)
8,52,500 8,52,5000
Results
Answers to SAQs
SelfAssessment Quesitons1:
1. What do you mean by share and share capital?
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The amount provided by the owner is known as capital. The capital of a company is share capital. Total capital id
divided into a number of small indivisible units of a fixed amount and each such unit is known as share.
2. What are the different types of share capital?
Share capital are of two types, viz. equity share capital and preference share capital. A company can issue eight
types preference share capital. These are i) Redeemable Preference Shares, ii) Irredeemable Preference Shares, iii)
Convertible Preference Shares, iv) Nonconvertible Preference Shares, v) Participating Preference Shares , vi)
Nonparticipating Preference Shares, vii) Cumulative Preference Shares, viii) Noncumulative Preference Share.
3. What is meant by redeemable preference shares?
Redemption is the process of repaying an obligation at predetermined amount. The redeemable preference shares
are issued on the terms that the shareholders will be repaid the amount which they invested at future date.
4. (i) T, (ii) F, (iii) F, (iv) F .
SelfAssessment Questions2:
1. Yes. A company can redeem its redeemable preference shares out of fresh issue of shares. For the purpose of
redemption of preference shares, a company may issue either equity shares or preference shares. But remember, a
company cannot issue debenture for redemption of preference shares.
2. A company can redeem its preference share out of either fresh of shares or from accumulated profit. When the
company redeems its preference shares out of accumulated profit, it is necessary to create the capital redemption
reserve account. The basic purpose of creation of this account is to protect the interest of sundry creditors and
maintain the working capital.
3. (i) False, (ii) False, (iii) True .
SelfAssessment Questions3:
1. How the Capital Redemption Reserve Account is created?
By transferring the amount of general reserve, profit and loss account, the Capital redemption reserve account is
created.
General Reserve A/c …………….Dr.
Profit and Loss A/c …………..….Dr.
Investment Allowance Reserve…..Dr.
To Capital Redemption Reserve A/c
2. Why the CRR account is created?
The main purpose of creating CRR is to protect the interest of sundry creditors and to maintain the 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. That is why, the amount is capitalized by creating the capital redemption
reserve account.
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References and Further Readings
Basu & Das (2006). Practice in Accountancy, Calcutta, Rabindra Library.
Bhattacharyya (2008). Essentials of Financial Accounting, New Delhi, PHI.
Gupta. R.L., & Gupta, V.K. (2006). Principles and Practice of Accountancy, New Delhi, S. Chand & Co.
Sukla & Grewal ( 2007). Advanced Accountancy, New Delhi, S. Chand & Co.
Jain & Narang (2007). Advanced Accountancy, New Delhi, Kalyani Publishers.
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