Redemption of Preference Shares

What is redemption of Preference Shares?

Redemption of preference shares is a capital engineering process where a company falls under an obligation to purchase back the redeemable preference shares issued by them. Such redeemable preference shares are issued upon agreed terms and conditions which are redeemable at a specific period not more than 20 years. The date of maturity (termination of the instrument by realizing cash) is the date of redemption which is mentioned in the preference share certificate. 

Why issue Redeemable Preference Shares?

A Company issues Redeemable Preference Shares for the following reasons:

1. Creates an option for the company to exercise an option of repurchasing from the redeemable preference share holders

2. Companies issue RPS to maintain a favorable Debt Equity ratio in order to convince equity funders / financers to draw a positive image on the company. A company can avoid debt and its cost by issuing such RPS. 

3. Facilitates specific period funding from a dull market.

4.  A company can retain maximum voting rights as RPS holders are not given any voting rights.

5. As preference shares are entitled to fixed dividend, a company earning high profits will be able to leverage its earning by paying out only a certain fixed percentage of its profits to the RPS holders, thereby having a control on maximum profit amount. 

Provisions of Redemption of Preference Shares as per Section 55 of the Indian Companies Act, 2013

A company can issue redeemable preference shares only if it is authorized in the Articles of Association, normally not exceeding 20 years from the date of its issue. The following points must be considered:

1. RPS can be redeemed only out of the profits of the company which is usually available for dividend or out of the proceeds of fresh issue of shares (equity / preference).

2. No RPS can be redeemed until they are fully paid up.

3. Any premium on redemption of preference shares shall be paid out of divisible profits or securities premium of the company before the redemption process.

4. A sum equivalent to the nominal value of the redemption less fresh issue shall be transferred to Capital Redemption Reserve out of the divisible profits (and not securities premium), which can be further utilized for issue of bonus shares only. This reserve is created in order to block the free reserves (divisible profits) from getting distributed as dividends in the near future which may exhaust the value of equity and may also choke the creditors significantly. Also, this reserve makes sure that the equity of the company remains intact which can be further used for issuing bonus shares. This in turn will add more capital in to the company in the future. 

5. Premium payable by Companies required to follow Financial Accounting and Reporting as per Ind AS guided by Section 133 of the Indian Companies Act 2013 cannot utilize Securities Premium Balance for paying premium on RPS. 

6. However, other Companies who are not required to adhere Ind AS can utilize Securities Premium Balance for paying premium on RPS. Also, premium payable on Preference Shares issued on or before the commencement of Indian Companies Act, 2013 can be provided out of profits or securities premium. 

Note:

As per Section 52 of the ICA 2013, Securities Premium can be used exclusively for issuing bonus shares, writing off preliminary expenses, writing off discount / commission / share issue expenses, premium on redemption and premium on buyback. But companies listed on stock exchanges with a Net Worth of Rs. 250 Crores or more and unlisted companies with a Net Worth of Rs. 500 Crores or more are required to comply with Ind AS.

Redumption of Preference Shares-1553331361.pdf (gc11.ac.in) 

Divisible Profits

Divisible profits are those profits disclosed under Reserves and Surplus which can be legally used for distribution of dividends to the shareholders. The profits derived here are after providing for all charges, expenses and transfers, mainly depreciation. However, non-divisible profits cannot be utilized for dividend distribution.

A list of divisible and non-divisible profits reserves are mentioned below:

Divisible Profits (considered as sources of funds and can be used for creating Capital Redemption Reserve)

1. Retained Earnings

2. General Reserve

3. Dividend Equalization Reserve

4. Reserve Fund

5. Investment Fluctuation Reserve

Non-Divisible Profits (not considered as source of funds and cannot be used for creating Capital redemption Reserve)

1. Securities Premium (However as per Section 52, Securities Premium can be used to pay premium at the time of redemption of preference shares, debentures and even buyback of equity shares of Companies not complying Ind AS guided by Sec 133.) 

2. Capital Reserves

3. Capital Redemption Reserve

4. Investment Allowance Reserve

5. Profits Prior Incorporation

6. Share Forfeited Account

7. Debenture Redemption Reserve

8. Revaluation Reserve

Methods of Redemption of Preference Shares

Preference Shares can be redeemed either out of profits of a company including Securities Premium (refer Note above) or by way of issuing fresh equity shares at par, premium or discount or even both. This funding is in the form of making an arrangement to the extent of nominal value of redemption which does not include premium. When the amount of fresh equity is known, it has to be deducted from the nominal value of the total amount of redemption which may give a balance. For this balance, Capital Redemption Reserve will have to be created out of the divisible profits. This way, redemption can be done applying both the methods where the company not only raises its equity by issuing fresh equity shares, but also creates a CRR out of its divisible profits. 

Points to remember:

1. When redemption is made out of profits

Capital Redemption Reserve is created to the extent of nominal value of redemption. 

2. When redemption is made fully out of fresh issue

Capital Redemption Reserves need not be created.

3. When redemption is made out of both profits and fresh issue

Capital Redemption Reserve is created to the extent of nominal value of redemption less nominal value of fresh equity issued (without including premium collected, if any.)

Journal Entries

I. If the redeemable preference shares are not fully paid, then make a final call and make them fully paid. 

a. Making of final call

Preference Share Final Call A/c ... Dr

To Preference Share Capital A/c 

b. Receipt of final call amount

Bank A/c ... Dr

To Preference Share Final Call A/c

II. Sale of assets / investments to arrange cash for financing redemption.

Bank A/c ... Dr

To Assets or Investment A/c 

(Asset / Investment can be sold at profit or loss which will have a reflection in the profit and loss a/c under reserves and surplus)

III. Issue of Equity Shares for the purpose of Redemption of Preference Share Capital

a. Equity Shares issued at par

(i) Receipt of Application, Allotment and Call money

Bank a/c ... Dr (actual money received)

To Equity Share Application / Allotment a/c (applications received which needs confirmation, hence liability created)

(ii) Capitalization of Application, Allotment and Call money

Equity Share Application / Allotment / Call a/c ... Dr (liability adjusted by transferring to Equity Share Capital a/c)

To Equity Share Capital a/c (actual nominal Value of capital created)

b. Equity Shares issued at premium

(i) Receipt of Application, Allotment, Call money and Premium

Bank a/c ... Dr (actual money received)

To Equity Share Application / Allotment a/c (applications received which needs confirmation, hence liability created)

(ii) Capitalization of Application, Allotment, Call money and Premium

Equity Share Application / Allotment / Call a/c ... Dr (liability adjusted by transferring to Equity Share Capital a/c)

To Equity Share Capital a/c [No. of Shares X Paid Up Value or Face Value] (actual nominal Value of capital created)

To Securities Premium a/c [No of Shares X Premium Value] (amount collected over and above the Face Value)

c. Equity Shares issued at Discount

(i) Receipt of Application, Allotment and Call money

Bank a/c ... Dr (actual money received)

To Equity Share Application / Allotment a/c (applications received which needs confirmation, hence liability created)

(ii) Capitalization of Application, Allotment and Call money

Equity Share Application / Allotment / Call a/c ... Dr (liability adjusted by transferring to Equity Share Capital a/c)

Discount on Issue of Equity Shares a/c ... Dr (difference of face value and amount actually collected)

To Equity Share Capital a/c (actual nominal Value of capital created)

IV. Preference Shares due for Redemption

a. At par

Preference Share Capital a/c ... Dr (reduction in capital nominal value)

To Preference Shareholders a/c (creation of liability towards preference shareholders)

b. At premium

Preference Share Capital a/c ... Dr (reduction in capital nominal value)

Premium on Redemption of Preference Shares a/c ... Dr (expenditure recorded in the form of premium)

To Preference Shareholders a/c (creation of liability towards preference shareholders)

V. Adjusting Premium on Redemption of Preference Shares

Securities Premium a/c ... Dr (Utilization for setting off PRPF)

To Premium on Redemption of Preference Shares a/c (Premium amount adjusted and closed)

VI. Creation of Capital Redemption Reserve

General Reserve a/c ... Dr (utilized)

Profit and Loss a/c ... Dr (utilized)

To Capital Redemption Reserve a/c (created)

VII. Payment made to Preference Shareholders

Preference Shareholders a/c ... Dr (receiver against account created earlier for due)

To Bank a/c (bank being the giver)