ICAI Notes 9.3: Redemption of Preference Shares - 2 - CA Foundation PDF Download

4.  METHODS OF REDEMPTION OF FULLY PAID-UP SHARES

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 allowed under the Act. Thus, a company cannot issue irredeemable preference shares. Section 55 of the Companies Act, 2013, deals with rules 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 impaired. 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 claim on net assets of the Company. The transfer of divisible profits to Capital Redemption Reserve makes them non-distributable 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 much be filled in by:

(a) the proceeds of a fresh issue of shares;
(b) the capitalisation of undistributed profits; or
(c) a combination of (a) and (b).

4.1 REDEMPTION OF PREFERENCE SHARES BY FRESH ISSUE OF SHARES

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 share or preference share) 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 security premium account, Companies Act provides that the securities premium account may be applied by the company; 

(a) Towards issue of unissued shares of the company to be issued to members of the company as fully paid bonus securities.
(b) To write off preliminary expenses of the company.
(c) To write off the expenses of, or commission paid, or discount allowed on any of the securities or debentures of the company.
(d) To provide for premium on the redemption of redeemable preference shares or debentures of the company.
(e) For the purchase of own shares or other securities.

Note : If 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.

4.1.1 Reasons for issue of New Equity Shares

A company may prefer issue of new equity shares for the following reasons: (a) 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 which carry a fixed rate of dividend. (b) When the balance of profit, which would otherwise be available for dividend, is insufficient. (c) When the liquidity position of the company is not good enough.

4.1.2 Advantages of redemption of preference shares by issue of fresh equity shares 

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) No capital gains tax for shareholders.
(4) Shareholders retain their equity interest.

4.1.3 Disadvantages of redemption of preference shares by issue of fresh equity shares 

The disadvantages are:

(1) There is a possibility of dilution of further earnings;
(2) Share holdings in the company are changed.

4.1.4 Accounting Entries

Illustration 1

Hinduja Company Ltd. had 5,000, 8% Redeemable Preference Shares of Rs 100 each, fully paid up. The company decided to redeem these preference shares at par by the issue of sufficient number of equity shares of Rs 10 each fully paid up at par. You are required to pass necessary Journal Entries including cash transactions in the books of the company.

Solution

In the books of Hinduja Company Ltd.

Journal Entries

Illustration 2 

C Ltd. had 10,000, 10% Redeemable Preference Shares of Rs 100 each, fully paid up. The company decided to redeem these preference shares at par, by issue of sufficient number of equity shares of Rs 10 each at a premium of Rs 2 per share as fully paid up. You are required to pass necessary Journal Entries including cash transactions in the books of the company.

Solution 

In the books of C Ltd.

Journal Entries

Note: Amount required for redemption is Rs 10,00,000. Therefore, face value of equity shares to be issued for this purpose must be equal to Rs 10,00,000. Premium received on new issue cannot be used to finance the redemption.

Illustration 3 

G India Ltd. had 9,000 10% redeemable Preference Shares of Rs 10 each, fully paid up. The company decided to redeem these preference shares at par by the issue of sufficient number of equity shares of Rs 9 each fully paid up.

You are required to pass necessary Journal Entries including cash transactions in the books of the company. 

Solution

In the books of G India Limited

Journal

4.1.5 Calculation of Minimum Fresh Issue of Shares 

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 Rs 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 Rs 40,000 under any circumstances, then, the maximum amount of general reserve available for redemption is Rs 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 80 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:

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.

Illustration 4

The Board of Directors of a Company decide to issue minimum number of equity shares of  Rs 9 to redeem Rs 5,00,000 preference shares. The maximum amount of divisible profits available for redemption is Rs 3,00,000. Calculate the number of shares to be issued by the company to ensure that provisions of Section 55 are not violated. Also determine the number of shares if the company decides to issue shares in multiples of Rs 50 only.

Solution

As fractional shares are not permitted, the minimum number of shares to be issued is 22,223 shares.

If shares are to be issued in multiples of 50, then the next higher figure which is a multiple of 50 is 22,250. Hence, minimum number of shares to be issued in such a case is 22,250 shares.

Illustration 5 

The Balance Sheet of a Company on 30.6.2014 is as follows:

The share capital of the company consists of Rs 10 each equity shares of Rs 5,00,000 and Rs 100 each Preference shares (issued on 1.4.2012) of Rs 2,00,000.  Reserves and Surplus comprises Securities Premium of Rs 10,000 and Profit and Loss Account Rs 90,000. 

Compute the minimum number of equity shares of Rs 10 each that the company must issue at par to redeem preference shares at a premium of 10%.

Solution

4.1.6 Fresh Issue at a Premium and Minimum Fresh Issue

The calculation of minimum number of shares, when fresh issue is at a premium should be handled very carefully because premium of fresh issue of shares is available for writing off premium on redemption also. Minimum fresh issue cannot be calculated unless one knows the profits available for replacement of capital 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.

4.1.7 Minimum Fresh Issue to Provide Funds for Redemption

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.

Illustration 6

The Balance Sheet of X Ltd. as on 31st March, 2014 is as follows:

The share capital of the company consists of Rs 50 each equity shares of Rs 2,25,000 and Rs 100 each Preference shares of Rs 65,000  (issued on 1.4.2012). Reserves and Surplus comprises Profit and Loss Account only. In order to facilitate the redemption of preference shares at a premium of 10%, the Company decided:

(a) to sell all the investments for Rs 15,000.
(b) to finance part of redemption from company funds, subject to, leaving a bank balance of Rs 12,000.
(c) to issue minimum equity share of Rs 50 each at a premium of Rs 10 per share to raise the balance of funds required.

You are required to pass: The necessary Journal Entries to record the above transactions and prepare the balance sheet as on completion of the above transactions.

Solution

Journal

Balance Sheet (after redemption)

Notes to accounts

Working Note:

4.2 REDEMPTION OF PREFERENCE SHARES By CAPITALISATION OF  UNDISTRIBUTED PROFITS

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.

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, be transferred to a reserve fund to be called the Capital Redemption Reserve Account sum equal to the nominal amount of the shares redeemed’.

4.2.1 Advantages of redemption of preference shares by capitalisation of undistributed profits

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

(1) No change in the percentage share holdings of the company;
(2) Future earnings are not diluted;
(3) Surplus funds can be used.

4.2.2 Disadvantages of redemption of preference shares by capitalisation of undistributed profits

The disadvantages of redemption of preference shares by capitalisation of undistributed profits are:

(1) There may be a reduction in liquidity;
(2) Capital gains tax liability for preference shareholders.

Accounting Entries

Illustration 7

The following are the extracts from the Balance Sheet of ABC Ltd. as on 31st December, 2010.

Share capital: 40,000 Equity shares of Rs 10 each fully paid - Rs 4,00,000; 1,000 10% Redeemable preference shares of Rs 100 each fully paid – Rs 1,00,000.

Reserve & Surplus: Capital reserve – Rs 50,000; Securities premium – Rs 50,000; General reserve – Rs 75,000; Profit and Loss Account – Rs 35,000 On 1st January 2011, the Board of Directors decided to redeem the preference shares at par by utilisation of reserve.

You are required to pass necessary Journal Entries including cash transactions in the books of the company.

Solution

In the books of ABC Limited

Journal Entries

Note: Securities premium cannot be utilised for transfer to Capital Redemption Reserve because dividend cannot be paid out of Securities Premium Account.

4.3 REDEMPTION OF PREFERENCE SHARES By COMBINATION OF FRESH ISSUE  AND CAPITALISATION OF UNDISTRIBUTED PROFITS

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 to be made from distributable profits (Profit & Loss Account, General Reserve and other Free Reserves) to Capital Redemption Reserve Account. 

Formula:

Illustration 8

C Limited had 3,000, 12% Redeemable Preference Shares of Rs 100 each, fully paid up. The company had to redeem these shares at a premium of 10%.

It was decided by the company to issue the following:

(i) 25,000 Equity Shares of Rs 10 each at par,
(ii) 1,000 14% Debentures of Rs 100 each.

The issue was fully subscribed and all amounts were received in full .The payment was duly made. The company had sufficient profits. Show Journal Entries in the books of the company.

Solution 

In the books of C Limited 

Journal Entries

Working Note: 

Amount to be transferred to Capital Redemption Reserve Account

Illustration 9

The capital structure of a company consists of 20,000 Equity Shares of Rs 10 each fully paid up and 1,000 8% Redeemable Preference Shares of Rs 100 each fully paid up (issued on 1.4.2012).

Undistributed reserve and surplus stood as: General Reserve Rs 80,000; Profit and Loss Account Rs 10,000; Investment Allowance Reserve out of which Rs 5,000, (not free for distribution as dividend) Rs 10,000; Securities Premium Rs 12,000, Cash at bank amounted to Rs 98,000. Preference shares are to be redeemed at a Premium of 10% and for the purpose of redemption, the directors are empowered to make fresh issue of Equity Shares at par after utilising the undistributed reserve and surplus, subject to the conditions that a sum of Rs 20,000 shall be retained in general reserve and which should not be utilised.

Pass Journal Entries to give effect to the above arrangements and also show how the relevant items will appear in the Balance Sheet of the company after the redemption carried out.

Solution

In the books of ……….

Journal Entries

Balance Sheet as on ………[Extracts]

Working Note:

(1) No of Shares to be issued for redemption of Preference Shares:

Therefore, No. of shares to be issued = 25,000/Rs 10 = 2,500 shares. 

Illustration 10

The books of B Ltd. showed the following balance on 31st December, 2013:

30,000 Equity Shares of Rs 10 each fully paid; 18,000 12% Redeemable Preference Shares of Rs 10 each fully paid; 4,000 10% Redeemable Preference Shares of Rs 10 each, Rs 8 paid up (all shares issued on 1st April, 2012).

Undistributed Reserve and Surplus stood as: Profit and Loss Account Rs 80,000; General Reserve Rs 1,20,000; Securities Premium Account Rs 15,000 and Capital Reserve Rs 21,000.
Preference shares are redeemed on 1st January, 2011 at a premium of Rs 2 per share. The whereabouts of the holders of 100 shares of Rs 10 each fully paid are not known.

For redemption, 3,000 equity shares of Rs 10 each are issued at 10% premium. At the same time, a bonus issue of equity share was made at par, two shares being issued for every five held on that date out of the Capital Redemption Reserve Account.

Show the necessary Journal Entries to record the transactions.

Solution

In the books of B Limited 

Journal Entries

Working Note:

(1) Partly paid-up preference shares cannot be redeemed.

(2) Amount to be Transferred to Capital Redemption Reserve Account 

4.4 SALE OF INVESTMENTS TO PROVIDE SUFFICIENT FUNDS FOR REDEMPTION

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