When a company is flush with cash and feels its shares are undervalued, it can buy back its own shares from existing shareholders — cancelling them, reducing the share count, and boosting Earnings Per Share (EPS). That's the practical purpose. Now let's see how the rules and accounting work.
Under Sections 68–70 of the Companies Act, 2013, a buy-back can be funded from only two sources: (a) free reserves (which includes Securities Premium Account) or (b) proceeds of a fresh issue of shares. It cannot be funded from bank loans or proceeds of a prior buy-back. There's also a 25% cap — in any financial year, the buy-back cannot exceed 25% of the company's total paid-up equity capital plus free reserves. Additionally, the debt-equity ratio post buy-back must stay at or below 2:1.
The accounting entries are what examiners love. When shares are bought back, three things happen in sequence: (1) Debit Equity Share Capital for the face value of shares cancelled. (2) Adjust the premium on buy-back (i.e., buy-back price minus face value) — first exhaust the Securities Premium Account, then dip into free reserves. (3) Create a Capital Redemption Reserve (CRR) — this is the most exam-tested step. Whenever buy-back is funded out of free reserves (including Securities Premium), the company must transfer an amount equal to the nominal value of shares bought back into CRR, sourced from General Reserve or Profit & Loss Account. Think of CRR as a legal substitute for the share capital that has just been extinguished — it's a capital reserve that can only be used to issue fully paid bonus shares later.
Important exception: if the buy-back is funded purely from proceeds of a fresh issue, no CRR is needed — because share capital hasn't decreased in net terms. This is a favourite trick question. This topic appears as 8–12 mark problems in Paper 1, typically asking for journal entries plus a revised balance sheet post buy-back. Nail the CRR transfer and you'll rarely lose marks here.