Accounting Treatment of Premium on Redemption of Preference Shares: Current Liability Classification and Impact
Understanding how to classify and account for the premium on the redemption of preference shares is a critical aspect of financial reporting. This article delves into the nuances of this process, offering a comprehensive guide for financial professionals and business owners.
Classification as a Current Liability
When dealing with the redemption of preference shares, a key consideration is the classification of the premium on redemption as either a current or a long-term liability. Preference shares are typically seen as a long-term financing source. However, if these shares are redeemable within the next 12 months, the associated premium may be classified as a current liability.
Nature of Preference Shares
Preference shares are a type of equity investment that typically pay a fixed dividend and have a higher claim on assets and earnings than common shares. They are often redeemable after a certain period, with the redemption amount being the nominal value plus any applicable premium.
Timing of Redemption
The classification of the premium on redemption as a current liability is contingent on the timing of the redemption. If the company has announced a redemption date that falls within the next accounting period, the obligation to pay the premium must be recognized as a current liability. This is because the payment is expected to be settled within the near term, meeting the definition of a current liability.
Accounting Treatment
Initial Recognition
When preference shares are issued, the company does not record the premium on redemption immediately. The focus is on recognizing the proceeds from the issuance of the shares. The premium, if any, is only recorded retrospectively when the shares are redeemed.
Recording the Premium on Redemption
Redemption: When the company redeems the preference shares, the premium on redemption is recorded as a liability. This premium is typically calculated as a specified amount over the nominal value of the shares.
Journal Entry
At the time of redemption, the following journal entry is made:
Dr. Preference Share Capital (Nominal Value)Dr. Premium on Redemption of Preference Shares (Premium Amount)Cr. Bank/Cash (Total amount paid)
Financial Statement Presentation
Balance Sheet
Current Liabilities: If the premium is classified as a current liability, it will appear under current liabilities on the balance sheet. If the redemption is not expected within 12 months, it may be classified as a long-term liability.
Profit and Loss Statement
The premium on redemption does not directly affect the profit and loss statement at the time of redemption. However, if the preference shares were issued at a discount, the loss incurred on redemption might be recognized as an expense.
Impact on Retained Earnings
The premium on redemption may be charged against retained earnings or a specific reserve, depending on the company’s accounting policies and applicable accounting standards.
Summary
The premium on the redemption of preference shares is classified as a current liability if redemption is expected within 12 months. At the time of redemption, the appropriate journal entry is made to record the payment of the premium. On the balance sheet, the premium is reflected as a current liability. The redemption does not directly impact the profit and loss statement, and any subsequent charges might affect retained earnings.
Advice to Companies: Adhering to these guidelines ensures accurate accounting for the premium on redemption of preference shares, leading to more transparent and reliable financial statements.