Debentures 2 Meaning of Debenture Debenture is an

Debentures

2 Meaning of Debenture • Debenture is an instrument in writing given by a company acknowledging the liability for the total amount received as a result of issue of debentures and agreeing thereby to pay the money raised after the expiry of the stipulated period at a certain rate of interest per annum. • The Companies Act defines debenture as “debenture includes debenture stock, bonds or any other securities of a company, whether constituting a charge on the assets of the company or not. ”

DEBENTURES • The word debenture is used to signify-A written acknowledgement of a debt by a company under its seal generally containing a provision as to payment of interest and repayment of principal.

PURPOSE OF ISSUING DEBENTURES • For meeting expenditure on modernisation of capital assets. • Expansion and diversification of fixed assets. • For meeting long term requirements of working capital. • For setting up new projects.

Q 1) Can debentures issued for consideration other than cash? • Yes debentures can be issued for consideration other than cash as sometimes a company purchases running business(assets and liabilities)and issues to vendor.

Q 2 -Treatement of debenture discount • It is a capital loss, such discount shall be written off against securities premium and the unwritten off portion of discount on issue of debentures will be shown on the asset side of balance sheet under the head miscellaneous expenditure.

Q 3 -Sinking Fund Method of Redemption of Debentures. • Under this method, Sinking Fund or Debenture Redemption Fund of an equal amount is created out of profits every year. The amount to be credited to sinking fund is calculated with the help of Sinking Fund Table. This fund is invested out-side the business in securities every year.

Q 4 -Distinguish between debenture holders and shareholders. DEBENTUREHOLDERS SHAREHOLDERS 1) A debenture holder is only a creditor of the company. 2) Debenture holders are not concerned with the management and regulation of the company. 1) A shareholder or member is the joint owner of a company 2) Shareholders control the affairs of the company. It is managed by the Board of Directors, the elected representatives of the shareholders

Q 6 -Debentures issued as collateral security Issue of Debentures as a Collateral Security. • Collateral security means supporting security for a loan which can be realized by the lender in case of default in repayment of the original loan. • Sometimes a company issues its own debentures as a collateral security for a loan availed by it.

Q 7 -Convertible debentures • Convertible debentures can be term as debt security or loan that can be converted into equity shares after a stipulated period. The conversion of debentures into equity shares is at the option of the holder. However, in special circumstances, the issuer holds such conversion rights.

Q 8 -When should a company buy debenture from open market? • Debentures can be purchased from open market for 2 purposes: 1. For the purpose of cancellation 2. For the purpose of investment. • When a company purchase its debentures from the open market then that process of purchase is called redemption of debentures by purchase of own debentures in open market.

12 Types of Debentures may be classified from different points of view: 1. From security point of view: (a) Naked or Simple Debentures (b) Mortgage Debentures 2. From permanence point of view: (a) Redeemable Debentures (b) Irredeemable Debentures

13 3. From priority point of view: (a) First Debentures (b) Second debentures 4. From recording point of view: (a)Bearer Debentures (b)Registered Debentures 5. From conversion point of view: (a)Convertible Debentures (b)Non Convertible Debentures

14 Distinction between Debenture and Share Debentures Shares A person having the A person holding the shares debentures is called a shareholder. debentureholder. Debentureholder is a creditor of the company. He cannot take part in the management of the company Shareholder is the owner of the company, has voting right and also takes part in the management of the company.

15 Debentures Shares Interest is paid on Shareholders get dividend debentures. Interest has to be which is dependent on the paid whethere are profits of the company. profits or loss. Debentures can be Shares cannot converted into shares. converted debentures. be into Debentureholders will get Shareholders are paid after priority in getting the payment has been made to money back. debentureholders. No restrictions on issue of Shares at discount can be debentures at a discount issued only after observing certain legal formalities.

16 Debentures Shares There can be mortgage There can be no mortgage debentures i. e. Assets of the shares. company can be mortgaged in favour of debentureholders.

17 Difference between Debenture and Debenture Stock Debenture stock Debentures need not be fully Debenture stock must be paid. fully paid. Debenture can transferred wholly be Debenture stock can be transferred in fraction also. Debentures are identified by No such distinct numbers their distinct numbers are there incase of debenture stock.

18 Debenture Trust Deed • To look after the interests of debentureholders , the company may appoint some persons as trustees. For this purpose , a trust deed is executed with the company. • A Trust Deed can be defined as an agreement between the company and the trustees to look after the interests of debenture holders.

19 Trust Deed contains provisions about the respective rights of the company and the debentureholders. Trustees are watchdogs of debentureholders to make sure that the company is carrying out its obligations under the trust deed faithfully.

20 Stages of Accounting of Debentures 1. Issue of debentures. 2. Provision for redemption of debentures. 3. Redemption of debentures.

21 Issue Of Debentures The issue aspect of debentures can be studied from different angles 1. From consideration point of view: Debentures can be issued either (a) For consideration in cash: Debentures can be issued either at par, discount or premium Bank A/c Dr. Discount on Issue of Debentures A/c Dr. To Debentures A/c To Debenture Premium A/c

22 (b) For consideration other than cash: Debentures are issued to the vendors in lieu of purchase consideration. (i)Purchase of assets Sundry Assets A/c Dr. To vendor A/c (ii)Issuing debentures for purchase consideration Vendor A/c Dr. To Debentures A/c payment of

23 (c) As collateral security: Debentures are issued as subsidiary or secondary security in addition to the principal security against a loan or a bank security. Debentures issued as collateral security can be dealt in two ways: (i) First Method: No entry. However the fact of such an issue must be clearly mentioned in the Balance Sheet by way of a note under the loan and debenture. (ii) Second Method: Pass following journal entry: Debenture Suspense A/c To Debentures A/c

24 2. From price point of view: Debentures can be issued either at par or at discount or at premium. 1) When debentures are issued at par. Bank A/c Dr. To Debentures A/c 2) When debentures are issued at premium. Bank A/c Dr. To Debentures A/c To Premium on Issue of Debentures 3) When debentures are issued at discount. Bank A/c Dr. Debenture Discount A/c Dr. To Debentures A/c

25 3. From condition of redemption point of view: Conditions of Issue Conditions of Redemption Issued at par Repayable at par Issued at premium Repayable at par Issued at discount Repayable at par Issued at par Repayable at premium Issued at discount Repayable at premium Issued at premium Repayable at premium

26 Case 1 - When debentures are issued at par and repayable at par: On issue of debenture Bank A/c Dr. To Debentures A/c On redemption of debenture Debentures A/c Dr. To Bank A/c Case 2 - When debentures are issued at premium and repayable at par: On issue of debenture Bank A/c Dr. To Debentures A/c To Debentures Premium A/c On redemption of debenture Debentures A/c Dr. To Bank A/c

27 Case 3 - When debentures are issued at discount and repayable at par: On issue of debenture Bank A/c Dr. Discount on issue of Debenture A/c Dr. To Debentures A/c On redemption of debenture Debentures A/c Dr. To Bank A/c Case 4 - When debentures are issued at par and repayable at premium: On issue of debenture Bank A/c Dr. Loss on Issue of Debentures A/c Dr. To Debentures A/c To Premium on Redemption of debentures A/c On redemption of debenture Debentures A/c Dr. Premium on Redemption of deb A/c To Bank A/c

28 Case 5 - When debentures are issued at discount and repayable at premium On issue of debenture Bank A/c Dr. Loss on Issue of Debentures A/c Dr. To Debentures A/c To Premium on Redemption of debentures A/c On redemption of debenture Debentures A/c Dr. Premium on Redemption of deb A/c To Bank A/c Case 6 - When debentures are issued at premium and repayable at premium On issue of debenture Bank A/c Dr. Loss on Issue of Debentures A/c Dr. To Debentures A/c To Premium on Redemption of debentures A/c To Capital Reserve A/c On redemption of debenture Debentures A/c Dr. Premium on Redemption of deb A/c Dr. To Bank A/c

29 If Debentures are redeemable at discount which rarely happens in practice, no credit for the profit should be taken at the time of issue of debentures as per the convention of conservatism. At the time of redemption of debentures , the following entry should be recorded: Debentures A/c Dr. To Bank A/c To Capital Reserve A/c

30 Debenture Discount • Debenture Discount is a fictitious asset. It is shown on the assets side of the Balance Sheet. • It should be written off as early as possible by passing the following entry: Profit & Loss A/c Dr. To Discount on Debenture There are two methods of writing off the discount on the issue of debentures: 1) The total amount of discount is spread equally on the number of years for which the debentures are issued. 2) The amount of discount written off is proportionate to debentures outstanding in that year or in the ratio of effective utilisation of funds.

31 Interest on Debentures • Interest on debentures is charged to the profit and loss account. While paying the interest on debentures, it is the obligation of the company concerned to deduct the income tax before making payment of interest to debenture holders. Following entries are passed: 1) When interest on debentures is due: Interest on Debentures A/c To Income payable A/c To Debentureholders A/c

32 2) When net amount due is paid: Debentureholders A/c Dr. To Bank A/c Income Tax Payable account is shown on the liabilities side of the Balance Sheet till tax is paid to the government. 3)When Income Tax Payable is paid to the government: Income Tax Payable A/c Dr. To Bank A/c

33 Redemption of Debentures • Redemption of debentures refers to the discharge of liability on account of debentures. • Three problems which require attention when a company wants to redeem the debentures: 1. Time of redemption of Debentures: a) At expiry of their period b) If AOA allow before expiry either by installment method (Drawing a lot) or Purchase of own debentures in open market.

34 2. Amount to be paid on redemption: Can be either at par or premium. If debentures are redeemed by purchaing them in the open market, then the amount paid depends on the market quotation which is generally lower than the face value to take advantage of depressed prices. 3. Sources of finance: Major sources of finance for redemption are • Out of profits • Out of capital • Out of provisions made for redemption • Converting them into shares or new debentures

35 Redemption out of profits Following entries are passed a) Amount paid on redemption: Debentures A/c Dr. To Bank A/c b) Transfer of Profit & loss Appropriation A/c Dr. To Debenture Redemption Reserve A/c c) When balance of D. R. R. A/c is not required for redemption and is transferred to G/R account. D. R. R. A/c Dr. To General Reserve A/c

36 Redemption out of Capital • No amount of divisible profit is kept aside for redeeming debentures. The entry passed is Debentures A/c Dr. To Bank A/c • However according to SEBI guidelines , a company has to create DRR equivalent to 50% of the amount of debenture issue before redemption commences. Thus, redemption wholly out of capital is not possible now except with 1) Debentures with a maturity of 18 months or less. 2) Fully convertible debentures or part portion of partly convertible debentures.

37 Redemption by conversion • Sometimes the debentureholders of a company are given the option to convert their debentures into shares or new debentures within a stipulated period. • The new shares or debentures can be issued either at par or at premium or at discount. The following entry is passed: Old Debentures A/c Dr. Discount on Issue of shares/ Deb A/c Dr. To New Share Capital/ Deb A/c To Premium on Issue of Shares/ Deb A/c

38 Redemption out of Provision • Sinking Fund Method • Insurance Policy Method Sinking fund method Sinking fund is created out of profits and invested in readily realisable securities with the purpose of providing a definite amount of money needed for redemption of debentures at a particular date.

39 Accounting entries for sinking fund method At the end of the 1 st year (i) For the amount set aside every year Profit and Loss Appropriation A/c Dr. To Sinking fund / DRF A/c For the amount kept aside for redemption invested in securities (ii) Sinking Fund Investment A/c / DRFI A/c Dr. To Bank A/c

40 At the end of the 2 nd and subsequent years (i) For interest received on investment Bank A/c Dr. To Interest on Sinking Fund Investment A/c (ii) For interest transferred to Sinking Fund To Interest on Sinking Fund Investment A/c Dr. To Sinking Fund A/c

41 (iii) For the amount set aside every year Profit and Loss Appropriation A/c Dr. To Sinking fund / DRF A/c (iv) For annual installment plus interest invested in securities Sinking Fund Investment A/c / DRFI A/c Dr. To Bank A/c All entries except entry (iv) in second and subsequent year should be passed.

42 At the end of Last Year(When debentures are to be redeemed) (i) For the amount realised on the sale of securities Bank A/c Dr. Sinking Fund Investment A/c (ii) For profit on sale of investment Sinking Fund Investment A/c Dr. To sinking Fund A/c (Reverse entry is passed incase of loss on sale of investment)

43 (iii) For amount paid to debentureholders to redeem the debentures Debentures A/c Dr. To Bank A/c (iv) For balance of sinking fund transferred to general reserve account Sinking Fund A/c Dr. To General Reserve A/c

44 Insurance Policy Method Under this method a fixed amount of premium is paid every year to the insurance company which in turn agrees to pay the necessary amount for redemption of debentures at the end of a specified period.

45 Journal Entries First Year (i) For amount of premium appropriated from profit and loss A/c Profit & Loss Appropriation Account Dr. To Debenture Redemption Fund A/c (ii) For amount of premium paid to insurance company Debenture Redemption Fund Policy A/c To Bank A/c These entries will be passed every year including the last year also.

46 The following entries will also be passed at the end of the specific period on realisation of the policy: (i) For the amount received from insurance Co. Bank A/c Dr. To Redemption Fund Policy A/c

47 iii) For amount paid to Debentureholders Debentures account Dr. To Bank A/c (iv)For balance of Debenture Redemption Fund A/c transferred to General Reserve Debenture Redemption Fund A/c Dr. To General Reserve A/c

48 Own Debentures If authorised by the terms of the contract , company can purchase debentures whenever they find the market price favourable to the company. Such purchased debentures can either be (i) Cancelled by the company or (ii) May be kept as an investment, called own debentures and may be utilised for reissue when needed afterwards.

49 Treatment of own Debentures Purchase of own debentures is treated in accounts in the same way as an ordinary investment. Investment in Own Debentures A/c OR Own Debentures A/c To Bank A/c Own Debentures account or simply Own Debentures A/c will be shown on the assets side of the Balance Sheet. Debentures will continue to be shown on the liabilities side of the Balance Sheet. Here it is assumed that the debentures are purchased immediately after the payment of interest.

50 For cancellation of investment in own debentures, the following entry is done: Debentures A/c Dr. Loss on Redemption of Debentures Account Dr (for loss) To Own Debentures A/c To Profit on Redemption of Debentures A/c (for Profit)

51 Interest on Own Debentures The total amount of interest due on debentures( including held by the company as own investment ) is deemed to be outstanding. But payment of interest on debentures is made only to the outsiders. The portion of interest on own debentures will be credited to Interest on Own Debentures Account. Debenture Interest A/c Dr. (on whole Debentures) To Bank A/c (payable to outsiders) To Interest on Own Debentures A/c (due to company)

52 Ex- Interest and Cum Interest Quotations Amount paid towards the price of the debentures is capital expenditure. Amount paid for interest is revenue expenditure. • If the quotation is Cum-Interest that means it is with interest and for recording purposes interest is deducted from the total price paid. • If the quotation is Ex-Interest that means it excludes interest and for recording purposes interest is calculated and added separately to the quotation.

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