Whenever a company redeems its preference shares then the nominal value or face value of the shares is put into capital redemption reserve fund. There after this fund becomes the part of the paid capital of the company.

Capital Redemption Revere is also created when a company buys it owns shares which reduces its share capital.

Suppose, the fresh equity shares or preference shares are issued to redeem the old preference shares, in this case the difference between the face value of preference shares and fresh shares issued will be transferred to capital redemption reserve account.

The capital redemption reserve fund is transferred from undistributed profitsĀ  i.e general reserves, profit or loss account.

The amount of capital reserve cannot be used for redemption of preference shares. Therefore, no amount is transferred in to capital redemption reserves out of capital reserves.

This fund can be utilized only for issuing fully paid bonus shares. No dividend can be distributed out of this fund.

The importance of creation of capital redemption reserve account is due to following reasons:-

Redemption of preference shares involves repayment of capital before paying creditors of the company. It may affect the interest of creditors. In addition to that the working capital of the company will be depleted as a result of outflow of cash due to redemption. The amount is capitalized by creating the capital redemption reserve account. As a result, this amount will not be available for distribution of dividend. It helps to protect the interest of creditors and on the other hand it does not disturb the working capital.

Accounting Treatment of Capital Redemption Reserves

Capital redemption reserves is shown in liability side of balance sheet.