Companies purchasing and redeeming their own shares and debentures Learning objectives After you have studied

this chapter, you should be able to: l explain, in the context of shares and debentures, the difference between the terms purchasing and redeeming l describe the alternative ways in which a company may purchase or redeem its own shares and debentures l explain the difference between the purchase/redemption opportunities availabl e to private companies, and those available to other companies l record the accounting entries relating to the purchase and the redemption of shares and debentures Introduction In this chapter, you ll learn the difference between the terms redemption and purchase of a company s own shares and debentures and the rules relating to companies that do either of these things. You will learn how to record such activit ies in the ledger accounts and of the effects of such activities upon the balance sheet . Purchasing and redeeming own shares In the context of shares and debentures, to all intents and purposes, the words p urchasing and redeeming may appear to be identical and interchangeable. They both i nvolve an outflow of cash incurred by a company in getting back its own shares s o that it may then cancel them. However, legally, redeeming means the buying back of shares which were originally issued as redeemable shares . That is, the company stated when they were issued that they would or could be bought back at sometime in the future by the company. The actual terms of the redemption are declared a t the time when the shares are issued. In contrast, when shares issued are not s tated to be redeemable, if they are subsequently bought back by the company, the company 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 ha d not been the case in the USA and much of Europe where, for many years, companies had, wit h certain restrictions, been allowed to buy back their own ordinary shares. The main reaso n why this was not allowed in the UK prior to 1981 was the fear that the interests of creditors could be adversely affected if the company used its available cash to buy its o wn ordinary shares, thus leaving less to satisfy the claims of the creditors in the event that the company had to be wound up. The possibilities of abuse with p reference shares was considered to be less than with ordinary shares, thus it wa s possible to have redeemable preference shares. Since 1981, under the Companies Acts, if authorised by its Articles of Associati on, a company may: (a) issue redeemable shares of any class (preference, ordinary, etc.). Redeemab le shares include those that are to be redeemed on a particular date as well as those that are merely liable to be redeemed at the discretion of the shareholder or of the company. Ther e is an important

proviso that a company can only issue redeemable shares if it has in iss ue shares that are not redeemable. Without this restriction a company could issue only redeemab le shares, then later redeem all of its shares, and thus finish up without any sharehold ers; (b) purchase its own shares (i.e. shares that were not issued as being redeema ble shares). Again, the company must, after the purchase, have other shares in issue at least some of which are not redeemable. This again prevents a company redeeming its wh ole share capital and thus ceasing to have any shareholders.

Activity Why do you think the rules concerning purchase and redemption were changed in 19 81?

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 b uy back its own shares. For public companies, the main advantage is that those w ith surplus cash resources can return some of this surplus cash back to its shar eholders by buying back some of their own shares, rather than being pressurised to use such cash in other, less economic ways. However, the greatest advantages are for private companies and relate to overcom ing problems which occur when shareholders cannot sell their shares on the open market . Th is means that: 1 They can help shareholders who have difficulties in selling their shares to r ealise their value when needed. 2 People will be more willing to buy shares from private companies. The fear of not being able to dispose of them previously led to finance being relatively difficult for private companies to obtain from people other than the original main proprietors of the compa ny. 3 In many family companies, cash is needed to pay for taxes on the death of a sha reholder. 4 Shareholders with grievances against the company can be bought out, thus cont ributing to the more efficient management of the company. 5 Family-owned companies are helped in their desire to keep control of the comp any when a family shareholder with a large number of shares dies or retires. 6 As with public companies, private companies can return unwanted cash resource s to their shareholders. 7 For both private companies, and for public companies whose shares are not lis ted on a stock exchange, it may help boost share schemes for employees, as the employee s would know that

they could dispose of the shares fairly easily.