Journal Entries for Redemption of Preference Shares

A Detailed Guide on Accounting for Redemption Using Equity Shares

Key Takeaways

Equity Issuance as a Redemption Fund: Equity shares are issued to raise the exact amount required for redeeming the preference shares including the premium.
Separate Treatment of Premium: The premium payable on redemption, which is ₹5 per share in this case, is recorded separately and is generally funded through available reserves or profits.
Accurate Redemption Accounting: The redemption entry combines the cancellation of the preference share capital and the premium, balanced by the cash outflow from the bank account.

Background Information

Bombay Ltd had in its books a balance of 4,000 fully paid redeemable preference shares of ₹100 each amounting to ₹4,00,000. On 1st July 2020, these preference shares were redeemed at a premium of ₹5 per share. Thus, the total redemption amount is calculated by adding:

₹4,00,000 (for the principal) + ₹20,000 (premium component, calculated as 4,000 shares × ₹5 per share) = ₹4,20,000.

To meet this redemption outlay, the company issued equity shares of ₹10 each. These equity shares were fully subscribed and allotted to raise funds exclusively for the redemption process. Additionally, the company had a Profit and Loss Account balance of ₹1,00,000 and a Capital Reserve of ₹20,000 available, which can be used to meet any premium requirements or adjustments related to the redemption.

Detailed Journal Entries

1. Issuance of Equity Shares for Redemption

Since the redemption of the preference shares necessitated funding, the company issued equity shares to raise the equivalent cash amount. The redemption amount is ₹4,20,000. With each equity share having a face value of ₹10, the number of equity shares issued can be computed as follows:

Number of equity shares = ₹4,20,000 / ₹10 = 42,000 shares.

The journal entry to record the receipt of funds via equity share issuance is:

Journal Entry - Equity Share Issue


// Debit Bank with the amount raised from equity issue
Dr. Bank A/c                     ₹4,20,000
   Cr. Equity Share Capital A/c        ₹4,20,000
// (Being equity shares of ₹10 each issued to raise funds for redemption)

2. Premium on Redemption Adjustment

The redemption is accompanied by a premium of ₹5 per preference share. The total premium is:

4,000 shares × ₹5 = ₹20,000.

This premium is generally adjusted through transfers from the Profit and Loss Account or other reserves. In this instance, considering the available Profit and Loss balance of ₹1,00,000 and a Capital Reserve of ₹20,000, the company can opt to adjust the premium outlay through these sources.

One common practice is to transfer the requisite premium from the Profit and Loss Account to a designated Premium on Redemption account. The journal entry is:

Journal Entry - Premium Adjustment


// Transfer premium amount from Profit and Loss to Premium on Redemption 
Dr. Profit & Loss A/c              ₹20,000
   Cr. Premium on Redemption A/c            ₹20,000
// (Being premium on redemption for preference shares adjusted from profits)

Here, the premium is recorded separately ensuring transparency and adherence to accounting standards related to redemption transactions.

3. Redemption of Preference Shares

The final step is to cancel the existing preference share capital and record the corresponding cash outflow. The accounting treatment involves eliminating the balance of the redeemed preference share capital and the premium liability:

Preference Share Capital: ₹4,00,000
Premium on Redemption: ₹20,000
Total: ₹4,20,000

The journal entry to record the redemption payment is:

Journal Entry - Redemption of Preference Shares


// Canceling the preference share capital and premium on redemption
Dr. Preference Share Capital A/c    ₹4,00,000
Dr. Premium on Redemption A/c         ₹20,000
   Cr. Bank A/c                                 ₹4,20,000
// (Being the redemption of 4,000 8% redeemable preference shares at a premium of ₹5 per share)

Additional Considerations in Accounting for Redemption

Role of Reserves and Profits

In many redemption transactions, the premium payable is funded from the profits available or the Capital Reserve. In Bombay Ltd’s case, the Profit and Loss Account has a balance of ₹1,00,000 and there exists a Capital Reserve of ₹20,000. While only ₹20,000 is needed to pay the premium, companies might consider the following:

Utilizing a part of the Profit and Loss surplus to adjust for the premium.
If required, augmenting the Premium on Redemption account with entries from the Capital Reserve.

The entry provided above for the premium adjustment is one standard method and ensures that the premium is correctly accounted for before the actual redemption entry is passed.

Sequence of Transactions

For clarity and proper audit trail, the transactions are generally recorded in the following sequence:

Recording the receipt of funds from the equity share issue, which facilitates the redemption payment.
Transferring the premium amount from the Profit and Loss Account into a segregated Premium on Redemption account.
Recording the redemption of the preference shares by cancelling both the share capital and the premium liability and reflecting the corresponding outflow from the bank account.

Summary of Journal Entries

Transaction	Debit	Credit	Explanation
Issuance of Equity Shares	Bank A/c ₹4,20,000	Equity Share Capital A/c ₹4,20,000	Funds raised by issuing 42,000 equity shares of ₹10 each for redemption purposes.
Premium on Redemption Adjustment	Profit & Loss A/c ₹20,000	Premium on Redemption A/c ₹20,000	Transfer of premium amount from available profits to cover the premium on redemption.
Redemption of Preference Shares	Preference Share Capital A/c ₹4,00,000 Premium on Redemption A/c ₹20,000	Bank A/c ₹4,20,000	Cancellation of 4,000 preference shares with redemption premium payable at ₹5 per share.

Additional Journal Entry Insights

Double-Entry System and Transparency

In compliance with the double-entry bookkeeping system, each transaction affecting the company’s balance sheet is adequately mirrored. The funds raised via equity share issuance not only facilitate the redemption but also maintain the integrity of the company’s capital structure. The separation of the premium using a distinct account is essential. It helps clarify that the premium payable is not part of the preference share capital but an additional cost incurred in the redemption process.

Moreover, this systematic approach benefits auditing and proper disclosure in the financial statements. By clearly showing the sources and uses of funds, stakeholders are provided with transparent insights into the capital management strategies of Bombay Ltd.

Importance of Timing and Correct Valuation

In this particular case, the redemption took place on 1st July 2020. All the entries must reflect the correct valuation of amounts as per the redemption date. Issuance of equity shares and recording cash flows on the same date avert any discrepancies in the financial period reporting, ensuring that the books accurately mirror the transactions' economic realities.

Maintaining the correct sequence validates the accounting process in scenarios where redemption affects both the capital structure and cash balances. Furthermore, these practices comply with statutory requirements and accounting standards where fully paid-up shares are mandatory before redemption.