The world of corporate finance can seem complex, full of specialized terms and intricate regulations. One such term you might encounter is the Capital Redemption Reserve (CRR). If you're wondering how this crucial reserve is created and why it matters, you've come to the right place! This comprehensive guide will walk you through the process, step by step, ensuring you understand every nuance.
Understanding the "Why": The Purpose of Capital Redemption Reserve
Before we dive into the "how," let's quickly grasp the "why." Imagine a company that has issued redeemable preference shares. These are shares that the company promises to buy back from the shareholders at a future date. When the company redeems these shares, it's essentially returning capital to the shareholders.
So, why the need for a CRR? The Companies Act (specifically, Section 55 of the Companies Act, 2013 in India, or similar provisions in other jurisdictions) mandates that if a company redeems preference shares out of profits (and not out of a fresh issue of shares), an amount equal to the nominal value of the shares redeemed must be transferred to a Capital Redemption Reserve.
This is a critical protective measure for the company's creditors. It ensures that the capital base of the company is not eroded simply because preference shares are being redeemed. By creating the CRR, the company effectively retains profits that could otherwise have been distributed as dividends, thus maintaining its financial strength and protecting the interests of its long-term creditors.
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| How Capital Redemption Reserve Is Created |
Step 1: Identify the Need for Redemption - Are You Ready to Redeem?
Hello there! So, you're contemplating redeeming preference shares, are you? This is the very first step in the journey towards creating a Capital Redemption Reserve.
Before any accounting entries or calculations, the company's management and board of directors must decide when and if they will redeem outstanding preference shares. This decision is typically driven by factors such as:
- Maturity Date: Most redeemable preference shares have a specified redemption date.
- Financial Health: The company must be in a strong enough financial position to redeem the shares.
- Cost of Capital: Sometimes, companies may redeem preference shares if they can raise capital through cheaper means (e.g., debt at a lower interest rate).
- Compliance: Adhering to the terms and conditions outlined in the share issuance agreement.
Think of it this way: This initial stage is all about strategic planning. It's about looking at your balance sheet and asking, "Do we have the funds, and is now the right time to fulfill our commitment to our preference shareholders?"
Step 2: Ensure Sufficient Distributable Profits - The Fuel for Your CRR
Now that you've decided to redeem, the next crucial step is to ascertain if your company has enough distributable profits to fund the redemption. This is vital because, as mentioned earlier, the CRR is primarily created out of profits otherwise available for distribution as dividends.
2.1 What are Distributable Profits?
Distributable profits are essentially the profits of the company that are legally available to be paid out as dividends to shareholders. These typically include:
QuickTip: Focus more on the ‘how’ than the ‘what’.
- Profit and Loss Account (Credit Balance): The accumulated profits shown in your company's P&L statement.
- General Reserve: Any general reserves that have been created out of past profits.
- Dividend Equalization Reserve: Reserves specifically set aside to stabilize dividend payments.
It's important to note what cannot be used:
- Share Premium Account: Money received in excess of the face value of shares cannot be used for this purpose (except for specific, limited circumstances not relevant here).
- Capital Reserve: Reserves arising from capital transactions, not revenue profits.
- Revaluation Reserve: Reserves created from the revaluation of assets.
2.2 Calculate the Redemption Amount
You'll need to know the total nominal (face) value of the preference shares you intend to redeem. For example, if you have 10,000 preference shares with a face value of ₹100 each, the total nominal value is ₹1,000,000. This is the amount that will eventually be transferred to the Capital Redemption Reserve.
Action Point: Go through your latest financial statements and identify your distributable profits. Are they sufficient to cover the nominal value of the preference shares you plan to redeem?
Step 3: Pass a Board Resolution - The Formal Go-Ahead
Once the financial readiness is confirmed, the company's Board of Directors must formally approve the redemption of preference shares and the creation of the Capital Redemption Reserve.
3.1 Contents of the Resolution
The Board Resolution should typically include:
- The number and nominal value of preference shares to be redeemed.
- The source of funds for redemption (i.e., out of distributable profits).
- A clear directive to transfer an equivalent amount to the Capital Redemption Reserve.
- The effective date of redemption.
Why is this important? This resolution provides the legal and internal authority for the company to proceed with the redemption and the creation of the CRR. It's a key governance step.
Step 4: Make the Journal Entries for Redemption - The Accounting Mechanics
Now we get to the core accounting entries. This is where the actual transfer of funds and the creation of the reserve take place.
4.1 Entry for Redemption of Preference Shares
When the preference shares are redeemed, the following journal entry is passed:
QuickTip: Skim the intro, then dive deeper.
- Redeemable Preference Share Capital A/c Dr. (with the nominal value of shares redeemed)
- Preference Share Premium on Redemption A/c Dr. (if shares are redeemed at a premium)
- To Bank/Cash A/c (if paid immediately)
- To Preference Shareholders A/c (if payment is due later)
This entry reduces the preference share capital liability on the balance sheet.
4.2 Entry for Creating Capital Redemption Reserve
This is the most critical entry for our topic. An amount equal to the nominal value of preference shares redeemed out of profits is transferred from distributable profits to the Capital Redemption Reserve.
- Profit and Loss Account A/c Dr. (or General Reserve A/c Dr., etc.)
- To Capital Redemption Reserve A/c
Example:
Let's say a company redeems 10,000 preference shares of ₹100 each (total nominal value ₹1,000,000) entirely out of its accumulated profits.
The entry to create CRR would be:
- Profit and Loss Account A/c Dr. ₹1,000,000
- To Capital Redemption Reserve A/c ₹1,000,000
Remember: If a portion of the redemption is financed by a fresh issue of shares, then the CRR is only created for the portion redeemed out of profits. For instance, if ₹400,000 worth of new shares were issued, and ₹600,000 came from profits, then only ₹600,000 would be transferred to CRR.
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Step 5: Utilize the Capital Redemption Reserve (If Applicable) - The Future of CRR
The Capital Redemption Reserve is not just a static entry on your balance sheet. While its primary purpose is to ensure capital protection, the Companies Act does permit its use for a very specific purpose: issuing fully paid-up bonus shares to the members of the company.
5.1 The Logic Behind Bonus Shares
When bonus shares are issued, it means that shareholders receive additional shares without paying for them. This effectively converts a portion of the company's reserves into share capital. Using the CRR for bonus issues aligns with its original purpose of retaining profits within the company's capital structure. It allows the company to capitalize its profits without distributing cash, while still rewarding shareholders.
QuickTip: Pay close attention to transitions.
5.2 Journal Entry for Issuing Bonus Shares from CRR
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Capital Redemption Reserve A/c Dr.
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To Bonus to Shareholders A/c
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Bonus to Shareholders A/c Dr.
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To Equity Share Capital A/c
Important Note: The CRR cannot be used for any other purpose, such as paying dividends, writing off losses, or issuing partly paid bonus shares. Its usage is strictly restricted to issuing fully paid-up bonus shares.
Step 6: Update Financial Statements - Reflecting the Change
The creation of the Capital Redemption Reserve will have a direct impact on your company's financial statements.
6.1 Balance Sheet Impact
- Reduction in Preference Share Capital: The "Share Capital" section will show a decrease in redeemable preference share capital.
- Increase in Reserves and Surplus: The "Reserves and Surplus" section will now include the "Capital Redemption Reserve." There will be a corresponding decrease in the Profit and Loss Account balance or General Reserve.
The overall total of equity and liabilities will remain unchanged, as it's an internal transfer of funds from one reserve to another within equity.
6.2 Notes to Accounts
Detailed notes to the financial statements should explain:
- The redemption of preference shares.
- The amount transferred to the Capital Redemption Reserve.
- The purpose of the Capital Redemption Reserve.
Transparency is key here. Your financial statements should clearly reflect these changes, providing stakeholders with an accurate picture of the company's capital structure.
10 Related FAQ Questions
How to calculate the amount to be transferred to Capital Redemption Reserve?
The amount to be transferred to the Capital Redemption Reserve is equal to the nominal (face) value of the preference shares redeemed out of distributable profits.
How to use Capital Redemption Reserve?
The Capital Redemption Reserve can only be used for one specific purpose: to issue fully paid-up bonus shares to the members of the company.
How to treat premium on redemption of preference shares?
Any premium paid on the redemption of preference shares is not transferred to the Capital Redemption Reserve. It is typically written off against the securities premium account or, if that's insufficient, against the Profit and Loss Account.
Reminder: Revisit older posts — they stay useful.
How to redeem preference shares if there are insufficient profits?
If a company does not have sufficient distributable profits, it must issue a fresh issue of shares (either equity or new preference shares) to the extent of the shortfall in profits, to redeem the preference shares. The CRR is then created only for the portion redeemed out of profits.
How to distinguish Capital Redemption Reserve from other reserves?
The Capital Redemption Reserve is a statutory reserve created specifically under the Companies Act upon redemption of preference shares out of profits, while other reserves (like General Reserve, Revenue Reserve) are created for general purposes or specific future needs and have broader usage.
How to show Capital Redemption Reserve in the Balance Sheet?
The Capital Redemption Reserve is shown under the "Reserves and Surplus" section within the "Shareholders' Funds" or "Equity and Liabilities" part of the Balance Sheet.
How to ensure compliance with Companies Act for CRR creation?
Ensure strict adherence to Section 55 of the Companies Act, 2013 (or relevant local legislation), including having sufficient distributable profits, passing a board resolution, and making correct accounting entries.
How to handle CRR if the company goes into liquidation?
In the event of liquidation, the Capital Redemption Reserve would be available to meet the claims of creditors, as it represents profits retained within the business. However, its specific use for bonus shares typically precedes liquidation scenarios.
How to differentiate between capital reserve and capital redemption reserve?
A Capital Reserve arises from capital profits (e.g., profit on sale of fixed assets), while a Capital Redemption Reserve is created specifically from distributable profits upon redemption of preference shares. Their purposes and permissible uses are different.
How to reverse or reduce Capital Redemption Reserve?
The Capital Redemption Reserve cannot be reversed or reduced once created, unless it is utilized for its permitted purpose of issuing fully paid-up bonus shares. It's a permanent appropriation of profits until such utilization occurs.
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