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Monday, January 14, 2013

Journal Entries of Redemption of Preference Shares & Methods of Redemption of Debentures


For recording the redemption of preference shares in the books of company who issued the shares, we see whether these preference shares are fully paid or not. Only fully paid up shares can be redeemed. In redemption, we repay the amount of preference shareholders. Following are the main journal entries which are passed for redemption of preference shares.

1. When preference shares are due on the maturity date with its premium amount. At that time, we will pass following journal entry. 

Redeemable preference share capital account Dr. ( With face value)
Premium on Redemption Account Dr. ( with the premium to be paid on redemption )
Preference Shareholders Account or Preference Share Redemption Account Credit 

Understanding of this Journal Entry :

Main aim of debiting redeemable preference share capital account is to reduce this capital from business. When any capital is reduced from business it will be debited when any capital is increased, it will be debited. In previous post, I told that capital is the liability of business. So, we have applied journal entry rule of liability. Every decrease in the liability will be debited and every increase in the liability will be credited in the journal entry. Like preference share capital, premium on redemption is also our liability and we are reducing it by debiting it.

 We are crediting preference shareholders account because we have transfer all capital liability to the personal liability of shareholders. Because our personal liability to pay the amount of redeemable preference shareholder is increased due to decrease the same capital from our books, we have credited preference shareholders account. By this entry company can get the benefit to pay each shareholders personally. After passing above entry preference shareholders account or preference share redemption account will show in the liability side before payment to same shareholders.

 One of main reason of credit the preference of shareholders account instead credit of cash or bank account is to get time for getting cash from different resources. Repayment to preference share capital may be the big project of any company because if we pay them without getting fund from any big resource, our working capital and cash flow will be affected. So, after passing this entry, whole management starts to search the fund for repaying to preference shareholders.

Example of this Journal Entry  

On 1st January, 2012, The company decided to redeem 10000 7% redeemable preference shares at $ 13 which had issued at $ 10 each were fully paid up. Pass the journal entry of transferring same capital and premium to shareholders account.

7% Redeemable Preference Share capital account Dr. 1,00,000
Premium on Redemption Account Dr. 30000
7% Redeemable Preference Shareholders' Account Cr. 1,30,000
 2. When Fund is managed for Repayment to Preference Shareholders.

There is not any magic that we pay the money the shareholders within one second. Management make the resources for repayment to preference shareholders. It may be the reserve of old profits of company or company may issue new equity shares or taken of new loan or selling his assets  for repayment the preference shareholders.

(i) If company uses his old profit reserves for repayment to preference shareholders. It means, company has saved money out of his profit for this day. We take this money by passing following journal entry.

Profit and loss account Dr. or General Reserve Account Dr.
Capital Redemption Reserve Account Cr.
(ii) If company issues new equity shares for redemption of preference shareholders.

Bank Account Dr.
Equity Share Capital Account Cr. 

(iii) If company sells its assets on the loss for getting fund for repayment to preference shareholders.

Bank Account Dr
Profit and Loss Account Dr. ( Loss on sales of assets )
Particular Asset Account Cr. 

(iv) If company gets new loan for repayment to preference shareholders. 

Bank Account Dr.
Loan Account Cr. 

 3. When Company Pays  to Redeemable Preference Shareholders. 

Preference Shareholders Account  or Preference Redemption Account Dr.
Bank Account Cr.
 4. When Company converts preference share capital into equity share capital. 

At that time, we will not pass above entries, we will pass only following entry.

Preference Share Capital Account Dr.
New Equity Share Capital Account Cr. 

5. Premium on Redemption Account is Closed through Stock Premium Account or General Reserve 

We can fulfill payable amount of premium on redemption account through stock premium account or our general reserve account.

  Example of this Journal Entries

On 1st January, 2012, The company decided to redeem 10000 7% redeemable preference shares at $ 13 which had issued at $ 10 each were fully paid up. To provide redemption, the company decided to issue 5000 equity shares of $ 10 each at $ 14  each. The profit and loss account showing the credit balance of $ 1,00,000.

This is the part of first example. So, please see the journal entry of first example (above).

(i) Money from issue of equity share capital 

Bank Account Dr. 70,000
Equity Share Capital Dr. 50,000
Share premium Account Dr. 20,000

Total payable amount to preference shareholders = 130,000

Less money from equity shareholders + share premium = - 70,000
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balance $ 60000
=================================================

(ii)  Rest 60,000 will be managed from credit balance of profit and loss account. Transferring the Profit and loss account's Credit balance to Capital Redemption Reserve account 

Profit and loss account Dr. 60,000
Capital Redemption Reserve Account Cr. 50,000
Premium on Redemption Account Cr. 10,000

(iii) For paying the preference shareholders

Bank Account Dr. 130,000
Preference Shareholders Account Cr. 130,000

Methods of Redemption of Debentures

 When a company gets loan, company issues debentures. Company gets this loan through debentures for a fixed time. After that fixed time, company will return the money of debentures to debenture holders. The refund of money to debenture holders is called redemption of debentures. Following are the various methods of redemption of debentures giving accounting treatment.

1st Method of Redemption of Debentures - Redemption Out of Profit

In this method, we repay the money of debentures out of profit. Now, understand, how is it possible? Suppose, you have estimated that you will get $ 1,00,0000 profit in march 2011 and in same month, you have to redeem $ 10,000 debentures. Now, one side, you will pay $ 10000 through your cash or bank account and other side, you will deduct same $ 10000 from your profit and loss account by making redemption reserve account. Following entry will be passed :

A) Transfer of Profit to debenture redemption reserve account 

Profit and loss appropriation account Dr. 10000

Debentures Redemption account Cr. 10000

B) Redemption of Debentures 

Debentures account Dr. 10000

Bank account Cr. 10000

2nd Method of Redemption of Debentures - Redemption Out of Capital 

It means we directly repay the debentures out of capital. We just pass following entry after repay of debentures by cheque.

Debentures account Dr.

Bank account Cr.

This entry's effect on our capital and it will reduce by same amount. There is no need to transfer of profit to redemption reserves in this method.

3rd Method of Redemption of Debentures - Redemption by Conversion 

Company can also redeem the old debentures by conversion these into new debentures or equity or pref. shares. At that time, we will pass following entry

Old Debentures account Dr.

New Debentures account Cr

or

Equity Share capital account Cr.

or

Pref. Share capital account Cr.

4th Method of Redemption of Debentures - Redemption by Buying Own Debentures 

In this method, directors go to debenture market and for redemption of debentures, they have bought own debentures. For this, following entry will be passed.

Own Debenture or investment in own debentures account Dr.

Bank account Cr.

Investment in own debentures account or simply own debentures account will be shown on the assets side of the balance sheet. Debentures will continue to be shown on the liabilities side of the balance sheet. Here, it is assumed that the debentures are purchased immediately after the payment of interest.

As and when the company wants to cancel investment in own debentures, the following entry is done.

Debentures account Dr.

Loss on redemption of debentures account Dr.

Own debentures account Cr.

Profit on redemption of debentures account Cr.


5th Method of Redemption of Debentures - Redemption by Making Provision 

In this method, we create provision for redemption of debentures when we issue debentures. To making provision for redemption is good method to repay the amount of debenture on the time. We keep a small amount of provision and invest in good scheme. At the time of redemption, we liquidate our provision and repay the amount of debentures, it has two sub-methods.

(A) Sinking Fund for Redemption Method

(B) Insurance Policy Method

In this method, we invest provision for redemption of debentures in insurance company, we pay premium of insurance annual. When we have to redeem the debentures, we collect all the money of insurance policy. After this, we repay the debenture amount.

Following entry will be passed in this method

First year


a) For amount of premium appropriated from profit and loss account

profit and loss account appropriated account Dr.

debenture redemption fund account Cr.

b) For amount of premium paid to insurance company

Debenture redemption fund policy account Dr.

bank account Cr.

Note : these entries will be passed every year including the last year also )

The following entries will also be passed at the end of the specific period on realization of the policy:

a) For the amount received from insurance company

bank account Dr.

debenture redemption fund policy account Cr.

b) For the balance of debenture redemption fund policy account, excess amount received is transferred to debenture redemption fund account.

Debenture redemption fund policy account Dr.

debenture redemption fund account Cr.

c) For amount paid to debentures

debentures account Dr.

bank Cr.

d) For balance of debenture redemption fund account transferred to general reserve 

debentures redemption fund account Dr

general reserve account Cr.