Journal Entries for Redemption of Preference Shares

Comprehensive guide to recording Bombay Ltd transactions on 1st July 2020

Key Highlights

Redemption at a Premium: Preference shares redeemed at ₹5 premium per share requires proper debit to premium account.
Equity Issue Utilization: Equity shares issued at ₹10 each to raise funds for the redemption transaction.
Reserve Adjustments: Use of Capital Reserve and Profit & Loss Account to comply with statutory requirements linked to redemption.

Detailed Analysis and Journal Entries

Bombay Ltd’s books, dated 30th June 2020, present the following balances:

4,000 fully paid-up 8% redeemable preference shares of ₹100 each - ₹4,00,000.
Profit and Loss Account balance - ₹1,00,000.
Capital Reserve - ₹20,000.

The redemption transaction, effective on 1st July 2020, is executed at a premium of ₹5 per share. In addition, the company has issued fully subscribed equity shares of ₹10 each for the purpose of redeeming these preference shares.

Understanding the Components of the Journal Entries

In the redemption process, several key actions are performed:

1. Redemption of Preference Shares

The primary step involves recording the cancellation of the 4,000 preference shares. Given that each share has a face value of ₹100, the total preference share capital is ₹4,00,000. In addition, for every share, a premium of ₹5 needs to be paid, leading to an aggregate premium amount of ₹20,000 (4,000 shares × ₹5 per share). The journal entry effectively removes the preference share capital from the books and recognizes the liability to the shareholders.

2. Payment to Preference Shareholders

The payment is made through the bank account. The total cash outflow equals the sum of the face value of the shares plus the premium. Hence, the overall cash requirement is ₹4,20,000.

3. Issue of Equity Shares to Fund Redemption

To fund the redemption, Bombay Ltd issues equity shares priced at ₹10 each. As the funds need to exactly cover the redemption, the number of equity shares issued is calculated by dividing the redemption amount by the issue price. Specifically, ₹4,20,000 ÷ ₹10 equals 42,000 equity shares. The corresponding journal entry records the inflow of cash through the bank account plus the increase in Equity Share Capital along with an additional entry into the Securities Premium account if a premium had been involved. In our scenario, the transaction is straightforward due to the fully subscribed and allotted nature of the equity issues.

4. Transfer Considerations from Reserves

Although the Profit and Loss Account and Capital Reserve balances are provided (₹1,00,000 and ₹20,000, respectively), journal entries may also reflect transfers into the Capital Redemption Reserve, if required. However, in this particular redemption scenario, only the premium on redemption has been transferred to the Capital Reserve and not the entire profit or loss balances. It is important to note that the conversion of the premium on redemption into a capital reserve is typically due to its capital nature.

Comprehensive Journal Entries

Based on the above analysis, the following are the necessary journal entries for the redemption of preference shares and the associated transactions:

A. Journal Entry for Redemption of Preference Shares

This entry accounts for:

The cancellation of the 4,000 preference shares at their face value.
The premium payable at ₹5 per share.
The aggregate payment of ₹4,20,000 through cash.

Account	Debit (₹)	Credit (₹)
Preference Share Capital A/c	4,00,000
Premium on Redemption of Preference Shares A/c	20,000
Cash/Bank A/c		4,20,000

Explanation: The redemption of 4,000 preference shares at face value totals ₹4,00,000. An additional premium of ₹20,000 is expensed, leading to a total cash outflow of ₹4,20,000.

B. Journal Entry for Transfer of Premium Amount to Capital Reserve

By virtue of its nature as a capital profit, the premium on redemption is transferred to the capital reserve.

Account	Debit (₹)	Credit (₹)
Premium on Redemption of Preference Shares A/c	20,000
Capital Reserve A/c		20,000

Explanation: Transferring the premium to the Capital Reserve underscores that this is a capital transaction rather than an operating expense.

C. Journal Entry for Issuance of Equity Shares to Fund Redemption

The funds necessary to redeem the preference shares are raised by issuing new equity shares:

Total cash raised: ₹4,20,000.
Number of equity shares issued = ₹4,20,000 ÷ ₹10 = 42,000 shares.

Account	Debit (₹)	Credit (₹)
Bank A/c	4,20,000
Equity Share Capital A/c		4,20,000

Explanation: Issuing 42,000 equity shares at ₹10 each secures the necessary funds for redemption, with the increase in the bank balance offset by a rise in equity share capital.

D. Optional Journal Entries Related to Reserves

Although the provided balances include Profit and Loss Account ₹1,00,000 and Capital Reserve ₹20,000, explicit entries for utilizing the Profit & Loss Account funds are not directly required in the redemption process as per the given scenario. In some cases, a portion of profits might be transferred to a Capital Redemption Reserve (CRR) if legal requirements mandate. However, for Bombay Ltd’s transaction, only the premium transfer to the Capital Reserve is effected.

Should there be scenarios where profit is converted into a CRR or where additional adjustments from the P&L account are necessary, separate journal entries would be recorded. These might include entries such as:

Debit Profit & Loss A/c and Credit Capital Redemption Reserve A/c.
Debit Capital Reserve A/c and Credit Capital Redemption Reserve A/c if applicable.

In our current transaction, the focus remains on the redemption and issuance processes, thus only the three entries described above are mandatory.

Step-by-Step Rationalization of Transactions

Each journal entry plays a strategic role in ensuring that the redemption process satisfies statutory and accounting requirements. Here is a brief breakdown:

Step 1: Removal of Redeemable Preference Shares

The primary effect is to remove the preference share capital from the balance sheet, signifying that the liability towards preference shareholders has been discharged. The premium on redemption is also separately tracked due to its capital nature.

Step 2: Capitalizing the Premium on Redemption

Writing off the premium on redemption into the Capital Reserve transforms what might have been viewed as an expense into a capital profit. This step ensures that the balance sheet accurately reflects the capital structure of the company.

Step 3: Financing via Equity Shares

By issuing equity shares, Liberty is raised without incurring further liabilities. This step is pivotal because it highlights the company’s capacity to self-finance its redemption process through capital market instruments rather than using additional debt.

Overall, the transaction emphasizes effective cash management and strategic capital structuring.

Additional Insights and Context

In scenarios involving redemption of preference shares, it is essential to consider the following:

Shareholder Communication: Appropriate disclosure in financial statements ensures investors understand the impact of the redemption on the company’s capital structure.
Legal Compliance: Certain jurisdictions mandate that premium portions or profits used in the redemption process must be transferred to a Capital Redemption Reserve to preserve the company’s net worth.
Market Perception: The method of financing the redemption—whether through equity or debt—can influence market perceptions regarding the financial health and strategic planning of the company.

In the case of Bombay Ltd, issuing fully subscribed equity shares at a nominal value of ₹10 each exemplifies a sound financing strategy that does not overleverage the company’s position.

Transaction Component	Account Impact	Amount (₹)
Redemption of Preference Shares	Preference Share Capital A/c and Premium on Redemption	4,00,000 + 20,000
Payment to Preference Shareholders	Cash/Bank A/c	4,20,000
Issuance of Equity Shares	Equity Share Capital A/c	4,20,000 (42,000 shares @ ₹10 each)

References

Journal Entries of Redemption of Preference Shares - SV Tuition
Redemption of Preference Shares Problem & Solutions - Finance Strategists
Accounting and Reporting for Redeemable Preference Shares - Accounting Insights
Redemption of Preference Shares (Accounting Entries) - YourArticleLibrary
Redemption of Preference Shares - Dynamic Tutorials