Redemption of Preference Shares

1. Introduction
2. Purpose of issuing Redeemable Preferance Shares
3. Provisions of the Companies Act (Section 55)
4. Methods of Redemption of Fully Paid-Up shares
5. Redemption of Partly Called-Up Preference Shares
6. Redemption of Fully Called but Partly Paid-Up Preference shares

Redemption is the process of repaying an obligation, at prearranged amounts and timings. It is a contract giving the right to redeem preference shares within or at the end of a given time period at an agreed price. These shares are issued on the terms that shareholders will at a future date be repaid the amount which they invested in the company (apart from the frequent payments of a specified amount of dividend as return on investment during the tenure of the preference shares). The redemption date is the maturity date, which specifies when repayment is scheduled to take place and is usually printed on the preference share certificate. Through the process of redemption, a company can also adjust its financial structure, for example, by eliminating preference shares and replacing those with other securities if future growth of the company makes such change advantageous.

A company may issue redeemable preference shares because of the following:

1. It is a proper way of raising finance in a dull primary market.
2. A company may face difficulty in raising share capital, as its shares are not traded on the stock exchange. Potential investors, hesitate in putting money into shares that cannot easily be sold, may be encouraged to invest if the shares are redeemable by the company.
3. The preference shares may be redeemed when there is a surplus of capital and the surplus funds cannot be utilised in the business for profitable use.
4. No dividend is required to be paid, if there is loss or no profit, whereas, interest is payable on debentures or loans even in case of loss.

In India, the issue and redemption of preference shares is governed by Section 55 of the Companies Act, 2013.

A company limited by shares if so authorised by its Articles, may issue preference shares which at the option of the company, are liable to be redeemed within a period, normally not exceeding 20 years from the date of their issue. It should be noted that:

1. no shares can be redeemed except out of divisible or distributable profit, (i.e. out of the profit of the company which would otherwise be available for dividend) or out of proceeds of fresh issue of shares made for the purpose of redemption;
2. no such shares can be redeemed unless they are fully paid;
3. (i) in case of such class of companies, as may be prescribed and whose financial statement comply with the accounting standards prescribed for such class of companies under Section 133, the premium, if any, payable on redemption shall be provided for out of the profits of the company, before the shares are redeemed:
   Provided also that premium, if any, payable on redemption of any preference shares issued on or before the commencement of this Act by any such company shall be provided for out of the profits of the company or out of the company’s securities premium account, before such shares are redeemed.
   (ii) in case of other companies (not falling under (i) above), the premium, if any payable on redemption shall be provided for out of the profits of the company or out of the company’s securities premium account, before such shares are redeemed.
4. where any such shares are proposed to be redeemed out of the profits of the company, there shall, out of the divisible profits, i.e. the profits which would otherwise have been available for dividends, be transferred to a reserve account to be called Capital Redemption Reserve Account, a sum equal to the nominal amount of the shares redeemed; and the provisions of the Act relating to the reduction of the share capital of a company shall, except as provided in the Section, apply as if the Capital Redemption Reserve (CRR) Account were the paid-up share capital of the company. The utilisation of CRR Account is further restricted to issuance of fully paid-up bonus shares only.

From the legal provision outlined above, it is apparent that on the redemption of redeemable preference shares out of accumulated divisible profits, it will be necessary to transfer to the Capital Redemption Reserve Account an amount equal to the amount repaid on the redemption of preference shares on account of face value less proceeds of a fresh issue of shares made for the purpose of redemption. The object is that with the repayment of redeemable preference shares, the security for creditors/ bankers, etc. should not be reduced. At times, a part of the preference share capital may be redeemed out of accumulated divisible profits and the balance out of a fresh issue.

 

Redemption of preference shares means repayment by the company of the obligation on account of shares issued. According to the Companies Act, 2013, preference shares issued by a company must be redeemed within the maximum period (normally 20 years) allowed under the Act. Thus, a company cannot issue irredeemable preference shares. Section 55 of the Companies Act, 2013, deals with provisions relating to redemption of preference shares. It ensures that there is no reduction in shareholders’ funds due to redemption and, thus, the interest of outsiders is not affected. For this, it requires that either fresh issue of shares is made, or distributable profits are retained and transferred to ‘Capital Redemption Reserve Account’.

The rationale behind these provisions is to protect the interest of outsiders to whom the amount is payable before redemption of preference share capital. The interest of outsiders is protected if the nominal value of capital redeemed is substituted, thus, ensuring the same amount of shareholders fund. In case of redemption of preference shares out of proceeds of a fresh issue of shares, replacement of capital and tangible assets is obvious. But, if redemption is done out of distributable profits, replacement of capital is ensured in an indirect manner by retention of profit by transfer to Capital Redemption Reserve. In this case, the amount which would have gone to shareholders in the form of dividend is retained in the business and is used for settling the claim of preference shareholders. Thus, there is no additional drain from the net assets of the Company. The transfer of divisible profits to Capital Redemption Reserve makes them non-divisible profits. As Capital Redemption Reserve can be used only for issue of fully paid bonus shares, profits retained in the business ultimately get converted into share capital.

Security cover available to outside stakeholders depends upon called-up capital as well as uncalled capital to be demanded by the company as per its requirements. To ensure that the interests of outsiders are not reduced, Section 55 provides for redemption of only fully paid-up shares.

From the above paras, it can be concluded that the ‘gap’ created in the company’s

capital by the redemption of redeemable preference shares must be filled in by:

1. the proceeds of a fresh issue of shares; or
2. the capitalisation of undistributed profits; or
3. a combination of (a) and (b) above.

One of the methods for redemption of preference shares is to use the proceeds of a fresh issue of shares. A company can issue new shares (equity shares or preference shares) and the proceeds from such new shares can be used for redemption of preference shares.

The proceeds from issue of debentures cannot be utilised for the purpose.

A problem arises when a fresh issue is made for the purpose of redemption of preference shares, at a premium. The point to ponder is that whether the proceeds of a fresh issue of shares will include the amount of securities premium for the purpose of redemption of preference shares.

For securities premium account, Section 52 of the Companies Act, 2013 provides that the securities premium account may be applied by the company;

1. Towards issue of un-issued shares of the company to be issued to members of the company as fully paid bonus securities
2. To write off preliminary expenses of the company
3. To write off the expenses of, or commission paid, or discount allowed on any of the securities or debentures of the company
4. To provide for premium on the redemption of redeemable preference shares or debentures of the company.
5. For the purchase of its own shares or other securities.

Note: It may be noted that certain class of Companies whose financial statements comply with the Accounting Standards as prescribed under Section 133 of the Companies Act, 2013, can’t apply the securities premium account for the purposes (b) and (d) mentioned above.

Any other way, except the above prescribed ways, in which securities premium account is utilised will be in contravention of law.

Thus, the proceeds of a fresh issue of shares will not include the amount of securities premium for the purpose of redemption of preference shares.

 

A company may prefer issue of new equity shares for the following reasons:

1. When the company has come to realise that the capital is needed permanently and it makes more sense to issue Equity Shares in place of Redeemable Preference Shares as Preference Shares carry a fixed rate of dividend.
2. When the balance of profit, which would otherwise be available for dividend, is insufficient.
3. When the liquidity position of the company is not good enough.

Following are the advantages of redemption of preference shares by the issue of fresh equity shares:

1. No cash outflow of money – now or later.
2. New equity shares may be valued at a premium.
3. Shareholders retain their equity interest.

The disadvantages are:

1. There will be dilution of future earnings;
2. Share-holding in the company is changed.

Bank Account Dr.

To Share Capital Account

(Being the issue of …….shares of `……each for the purpose of redemption of preference shares, as per Board’s Resolution No…… dated……. )

Bank Account Dr.

To Share Capital Account

To Securities Premium Account

(Being the issue of shares of `……each at a premium of `……each

for the purpose of redemption of preference shares as per Board’s Resolution No….. dated……)

Redeemable Preference Share Capital Account Dr.

To Preference Shareholders Account

Redeemable Preference Share Capital Account Dr.
Premium on Redemption of Preference Shares Account Dr.

To Preference Shareholders Account

Preference Shareholders Account Dr.

To Bank Account

Profit and Loss Account Dr.

To Premium on Redemption of Preference Shares Account

Sometimes, examination problem does not specify the number of shares to be issued for the purpose of redemption of preference shares and requires that the minimum number of shares should be issued to ensure that provisions of Section 55 of the Companies Act, 2013, are not violated. This is done in four steps as given below:

1. In such cases, the maximum amount of reserves and surplus available for redemption is ascertained taking into account the balances appearing in the balance sheet before redemption and the additional information provided in the problem. For example, if balance of general reserve in the balance sheet is `1,00,000 and additional information provides that the Board of Directors have decided that the balance of general reserve should not be less than `40,000 under any circumstances, then, the maximum amount of general reserve available for redemption is ` 60,000.
2. After ascertaining the maximum amount of reserves and surplus available for redemption, adjustment for premium on redemption payable out of profits is made and then it is compared with the nominal value of shares to be redeemed. By comparison, one gets the minimum proceeds of fresh issue as Section 55 permits redemption either out of proceeds of fresh issue or out of divisible profits. Thus, Minimum Proceeds of Fresh Issue of shares :
   Nominal value of preference shares to be redeemed – Maximum amount of reserve and surplus available for redemption.
3. After computation of minimum proceeds, the minimum number of shares to be issued are determined by dividing minimum proceeds by the proceeds of one share. This is done as follows:
   Minimum Number of Shares = Minimum proceeds to comply with Section 55/ face value of one share
   Proceeds of one share mean the par value of a share issued, if it is issued at par or premium. However, in case of issue of share at a discount, it refers to the discounted value.
4. Minimum number of shares calculated as per (3) above, needs to be adjusted due to various reasons. Firstly, shares fractions cannot be issued. Thus, if minimum number of shares as per (3) above includes a fraction, it must be approximated to the next higher figure to ensure that provisions of Section 55 are not violated. Secondly, if the examination problem states that the proceeds/number of shares should be a multiple of say, 10 or 50 or 100, then again the next higher multiple should be considered.

The calculation of minimum number of shares, when fresh issue is at a premium should be handled very carefully Minimum fresh issue cannot be calculated unless one knows the profits available for replacement of preference shares and profit available for replacement cannot be determined unless one knows the portion of profit available for redemption which is required for paying premium on redemption. To tackle this, assume that profits available for redemption is not required for paying premium on redemption of preference shares. In other words, it means that securities premium including premium on fresh issue is comparatively more than premium on redemption.

If the above assumption holds good, minimum number of shares can be calculated in a simple manner without use of equation. But, if above condition does not hold good, then an equation is used to determine the minimum number of shares.

Besides, ensuring compliance with Section 55, the fresh issue of shares is made to provide funds for making payment to preference shareholders. To calculate minimum number of fresh shares to be issued to provide funds, amount payable to preference shareholders is compared with funds available for redemption and the balance of funds to be raised by fresh issue of shares are calculated. The amount to be raised is divided by the issue price of a share (amount payable by shareholder including premium, if any, on fresh issue) to compute the minimum number of shares to be issued.

Another method for redemption of preference shares, as per the Companies Act, is to use the distributable profits in place of issuing new shares. When shares are redeemed by utilising distributable profit, an amount equal to the face value of shares redeemed is transferred to Capital Redemption Reserve Account by debiting the distributable profit. In other words, some of the distributable profits are kept aside to ensure that it can never be distributed to shareholders as dividend.

Profit or a portion of profit that can be otherwise legally distributed as dividend to the shareholders is known as Divisible or Distributable Profit.

In this connection, the provisions of the Companies Act state that ‘When any such shares are redeemed otherwise than out of the proceeds of a fresh issue, there shall out of profits which would otherwise have been available for dividend (i.e. out of divisible profits), be transferred to a reserve to be called the Capital Redemption Reserve Account sum equal to the nominal amount of the shares redeemed’.

Note: Only Divisible Profits can be used to create Capital Redemption Reserve, Non-Divisible Profits cannot be used for this purpose.

The advantages of redemption of preference shares by capitalisation of undistributed divisible profits are:

1. No change in the percentage of equity share-holding of the company;
2. Surplus funds can be used.

The disadvantage of redemption of preference shares by capitalisation of undistributed profits is that there may be a reduction in liquidity.

Redemption Reserve Account

General Reserve Account Dr.

Profit and Loss Account Dr.

Or any other Divisible Profits Dr.

To Capital Redemption Reserve Account

(Being the amount transferred to Capital Redemption Reserve Account as per the requirement of the Act).

Redeemable Preference Share Capital Account Dr.

To Preference Shareholders Account

(Being the amount payable on redemption of preference shares transferred to Preference Shareholders Account)

 

Redeemable Preference Share Capital Account Dr.

Premium on Redemptions of Preference Shares Account Dr.

To Preference Shareholders Account

(Being the amount payable on redemption transferred to Preference Shareholders Account)

Preference Shareholders Account Dr.

To Bank Account

(Being the payment to preference shareholders as per terms)

Divisible Profit Account Dr.

To Premium on Redemption of Preference Shares Account
(Being the premium on redemption adjusted against Profit and Loss Account)

A company can redeem the preference shares partly from the proceeds from new issue and partly out of profits. In order to fill in the ‘gap’ between the face value of shares redeemed and the proceeds of new issue, a transfer should be made from distributable profits (Profit & Loss Account, General Reserve and other Free Reserves) to Capital Redemption Reserve Account.

 

Formula:

1. Amount to be Transferred to Capital Redemption Reserve = Face value of shares redeemed - Proceeds from new issue
2. Proceeds to be collected from New Issue =Face value of shares redeemed - Profits available for distribution as dividend

Companies may have sufficient investments, which can be sold, in the market to arrange funds for redemption of preference shares.

One of the conditions of redemption is that only fully paid up preference shares can be redeemed by a company. Hence:

1. If the problem states that it is decided to redeem preference shares which are partly called up, then it is assumed that the final call on these shares is demanded and received before proceeding with redemption of these shares.
2. If information about both fully paid and partly paid preference shares is provided, then, it is presumed that only fully paid shares are to be redeemed and partly paid shares are left intact.
3. The company can forfeit the shares, if the call money is not received by the company in spite of giving opportunity to pay the same via reminders.

The problem of unpaid calls on fully called up shares may be studied under following categories:

If the amount of unpaid calls is received by the Company before redemption, the entry passed is as under:

Bank A/c Dr.

To Calls-in-Arrears A/c

After receipt of calls in arrears, the shares become fully paid up and then, company can proceed with redemption in the normal course.

If in spite of receiving a proper notice from the company, the shareholders fail to pay the unpaid calls, the Board of Directors may decide to forfeit the shares and cancel these shares instead of reissuing the forfeited shares because redemption of these shares is due immediately or in near future. In this case, the journal entry for forfeiture is passed as usual, which will be as follows:

Preference Share Capital A/c # Dr
(#Called up share capital only relating to the shares to be forfeited)

To Calls In Arrears A/c
To Shares Forfeited A/c *

(*Amount actually collected on shares forfeited. This will be equal to the balancing amount)

NOTE: But it should be noted, in this case, that the number of shares to be redeemed will be reduced by the number of shares so forfeited.