Accounting Methods for Redeeming Preference Shares

Every company that issues redeemable preference shares eventually has to honour that promise and pay the holders back. That repayment is called redemption, and it is not as simple as writing a cheque. The Companies Act, 2013 lays down strict conditions on how the money for redemption is raised, how much reserve a company must set aside, and how any premium is funded. Get any of these steps wrong, and the transaction can be treated as an unlawful reduction of share capital. This post breaks down the accounting methods for redeeming preference shares step by step, so you can follow the logic instead of memorising journal entries.

What redemption really means 🔗

Redemption is the cancellation of preference share capital in exchange for repayment to shareholders. Under Section 55 of the Companies Act, 2013, companies are not allowed to issue irredeemable preference shares at all, and redeemable ones must be paid off within a maximum of 20 years, extendable to 30 years for select infrastructure projects. Because this repayment reduces the company’s capital base, the law builds in safeguards so that creditors and other stakeholders are not left worse off.

Ground rule 1: partly paid shares must become fully paid first 🔗

Before any redemption can happen, the shares in question must be fully paid up. This condition is non-negotiable under the Act, which sets out that no preference shares can be redeemed unless they are fully paid. If some shareholders still owe a call amount, the company must first make a call, collect the money, and record it before moving to the redemption entries.

The accounting here is routine share-call accounting:

Ground rule 2: choosing the source of funds 🔗

Once shares are fully paid, the company has to decide where the redemption money comes from. Section 55 permits only two sources: profits that would otherwise have been available for dividend, or the proceeds of a fresh issue of shares made specifically for the purpose. A company can also use a mix of both. Notably, redeemable preference shares cannot be redeemed by issuing debentures, so borrowing money for this purpose does not satisfy the legal requirement, even though it may work commercially.

Redeeming out of divisible profits 🔗

When a company uses free reserves or retained earnings, the accounting entry cancels the preference capital and creates a liability to the shareholders, which is then settled through the bank:

Redeeming out of a fresh issue of shares 🔗

Alternatively, a company can raise fresh equity or preference capital and use those proceeds to pay off the old preference shareholders. The new shares can be issued at par or at a premium, but never at a discount, since Section 53 of the Act bars companies from issuing shares at a discount. If the new shares carry a premium, that amount is credited to the Securities Premium Account, not treated as part of the redemption proceeds.

Here is a detail students often miss: only the nominal or face value of the freshly issued shares counts toward the “proceeds” used for redemption purposes. The premium collected on the new issue cannot be used to fund the redemption of the old shares, even though it sits in the same bank account.

Step 3: setting aside the Capital Redemption Reserve 🔗

This is the safeguard that protects the company’s capital base. Whenever preference shares are redeemed out of profits rather than a fresh issue, the company must transfer an amount equal to the nominal value of the shares redeemed into a reserve called the Capital Redemption Reserve, or CRR. This requirement comes directly from Section 55 of the Companies Act, and the reserve is treated, for most purposes, as if it were paid-up share capital.

The journal entry is straightforward:

If redemption is funded partly by fresh shares and partly by profits, only the portion covered by profits needs a corresponding CRR transfer. For example, if shares worth ₹10 lakh are being redeemed and ₹6 lakh worth of new shares are issued for the purpose, only the remaining ₹4 lakh needs to be backed by a CRR transfer from profits.

The CRR is not free money the company can use however it likes. It can only be applied for one purpose: paying up unissued shares to be allotted as fully paid bonus shares, as clarified under the Act’s provisions on the use of the Capital Redemption Reserve Account. Using it for anything else amounts to an unauthorised reduction of capital.

Step 4: accounting for the premium on redemption 🔗

Many preference shares are redeemable at a premium, meaning shareholders receive more than the face value. This premium has to be “provided for” before the shares are actually redeemed, and the law is specific about where that provision can come from.

Companies whose financial statements comply with the prescribed Accounting Standards, which covers the vast majority of Indian companies today, must fund the premium entirely out of profits. They cannot dip into the Securities Premium Account for this purpose. The one exception applies to preference shares that were issued before the 2013 Act came into force; for those legacy shares, the premium can still be drawn from either profits or the securities premium account. Separately, Section 52 of the Act lists providing for premium on redemption of redeemable preference shares as one of the permitted uses of the Securities Premium Account, which is why this nuance trips up so many students.

*Securities Premium can be used only for pre-2013 Act shares issued by companies not required to comply with the prescribed Accounting Standards; otherwise, use Surplus or General Reserve.

Putting the whole process together 🔗

A typical redemption, therefore, moves through four stages in sequence: make any partly paid shares fully paid, decide how much of the redemption will be met from profits versus a fresh issue, transfer the profit-funded portion to the Capital Redemption Reserve, and provide for any premium out of the appropriate source. Once these entries are passed, the final settlement entry closes out the liability to preference shareholders:

Where a company does not specify how many new shares to issue and simply wants to comply with the law using the minimum possible fresh issue, examiners typically expect you to first calculate the maximum profits available for redemption from the balance sheet, and then work out the balancing figure that must come from a fresh issue. This is a common numerical variation of the same four-step logic explained above, so once the core method is clear, the calculation becomes a matter of arithmetic rather than a new concept.

Why this framework matters beyond the exam 🔗

These rules exist to stop companies from quietly shrinking their capital base to pay off one class of investors while leaving creditors and equity shareholders exposed. The Capital Redemption Reserve effectively locks in an equivalent amount of capital even after the preference shares disappear from the books, and the premium provisioning rules ensure that profits, not borrowed money, absorb the cost of paying more than face value. Understanding this logic makes it much easier to handle variations, such as combined redemption using both profits and fresh issues, or cases involving pre-2013 shares with different premium rules.

What do you think? 🔗

What do you think? If a company has healthy reserves but chooses to redeem preference shares entirely through a fresh issue instead of using profits, what impact does that have on its balance sheet compared to funding the redemption out of profits? And why might a company deliberately prefer one route over the other even when both are legally available?

References

1. http://ebook.mca.gov.in/Actpagedisplay.aspx?PAGENAME=17434
2. https://ibclaw.in/section-55-of-the-companies-act-2013-issue-and-redemption-of-preference-shares/
3. https://www.caclubindia.com/articles/redemption-of-preference-shares-as-per-companies-act-2013-and-its-latest-amendments-43313.asp
4. https://www.mca.gov.in/mca/html/mcav2_en/home/actsandrules/companies+act++2013/companiesact2013.html
5. https://www.credencecorpsolutions.com/blog/companies-act-section-55-bg1436