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Companies purchasing and redeeming their own shares and debentures

Learning objectivesAfter you have studied this chapter, you should be able to:l explain, in the context of shares and debentures, the difference between theterms purchasing and redeemingl describe the alternative ways in which a company may purchase or redeem itsown shares and debenturesl explain the difference between the purchase/redemption opportunities availableto private companies, and those available to other companiesl record the accounting entries relating to the purchase and the redemption ofshares and debentures

Introduction

In this chapter, youll learn the difference between the terms redemption and pur-chase of a companys own shares and debentures and the rules relating to com-panies that do either of these things. You will learn how to record such activities inthe ledger accounts and of the effects of such activities upon the balance sheet.

Purchasing and redeeming own sharesIn the context of shares and debentures, to all intents and purposes, the words purchasing and redeeming may appear to be identical and interchangeable. They both involve an outflow of cash incurred by a company in getting back its own shares so that it may then cancel them. However, legally, redeeming means the buying backof shares which were originally issued as redeemable shares. That is, the companystated when they were issued that they would or could be bought back at sometimein the future by the company. The actual terms of the redemption are declared at the time when the shares are issued. In contrast, when shares issued are not stated to be redeemable, if they are subsequently bought back by the company, thecompany is said to be purchasing its own shares rather than redeeming them.Until 1981, a company in the UK could not normally purchase its own ordinary share

s.Redemption was limited to one type of share, redeemable preference shares. This had not beenthe case in the USA and much of Europe where, for many years, companies had, with certainrestrictions, been allowed to buy back their own ordinary shares. The main reason why this wasnot allowed in the UK prior to 1981 was the fear that the interests of creditorscould be adversely affected if the company used its available cash to buy its own ordinary shares, thus leaving less to satisfy the claims of the creditors inthe event that the company had to be wound up. The possibilities of abuse with preference shares was considered to be less than with ordinary shares, thus it was possible to have redeemable preference shares.

Since 1981, under the Companies Acts, if authorised by its Articles of Association, a companymay:(a) issue redeemable shares of any class (preference, ordinary, etc.). Redeemable shares include

those that are to be redeemed on a particular date as well as those thatare merely liable to

be redeemed at the discretion of the shareholder or of the company. There is an important

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proviso that a company can only issue redeemable shares if it has in issue shares that are not

redeemable. Without this restriction a company could issue only redeemable shares, then

later redeem all of its shares, and thus finish up without any shareholders;(b) purchase its own shares (i.e. shares that were not issued as being redeemable shares).

Again, the company must, after the purchase, have other shares in issueat least some of

which are not redeemable. This again prevents a company redeeming its whole share capital

and thus ceasing to have any shareholders.

Activity

Why do you think the rules concerning purchase and redemption were changed in 1981?

Advantages to companies of being able to purchase andredeem their own shares

There are many possible advantages to a company arising from its being able to buy back its own shares. For public companies, the main advantage is that those with surplus cash resources can return some of this surplus cash back to its shareholders by buying back some of their own shares, rather than being pressurisedto use such cash in other, less economic ways.However, the greatest advantages are for private companies and relate to overcoming prob-lems which occur when shareholders cannot sell their shares on the open market. This meansthat:1 They can help shareholders who have difficulties in selling their shares to r

ealise their valuewhen needed.2 People will be more willing to buy shares from private companies. The fear ofnot being able

to dispose of them previously led to finance being relatively difficultfor private companies to

obtain from people other than the original main proprietors of the company.3 In many family companies, cash is needed to pay for taxes on the death of a shareholder.4 Shareholders with grievances against the company can be bought out, thus contributing to the

more efficient management of the company.

5 Family-owned companies are helped in their desire to keep control of the company when a

family shareholder with a large number of shares dies or retires.6 As with public companies, private companies can return unwanted cash resources to their

shareholders.7 For both private companies, and for public companies whose shares are not listed on a stock

exchange, it may help boost share schemes for employees, as the employees would know that

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they could dispose of the shares fairly easily.