Unit – 6: Accounting for Debentures (Issue and Redemption)
Q.1. What do you mean by “Debentures”? Mention its features. What are its advantages and disadvantages? 2007, 2013, 2015
Ans: Meaning of Debentures: According to Sec. 2 (30) of the companies Act, 2013, debentures include “debenture stock, bonds and any other securities of a company evidencing a debt, whether constituting a charge on the assets of the company or not.”
Debentures are debt instruments issued by a joint stock company. Amounts collected by way of debentures form part of the loan capital of a company. They are repayable after a fixed period. Debenture holders get interest on their debentures. They are creditors of the company. They do not get dividend. Only shareholders get dividend.
The characteristics of debentures can be summarised as follows:
a) Debentures are debt instruments.
b) Interest is payable on debentures at a fixed rate irrespective of the profit earned by the business.
c) In the event of winding up of the company the debenture holders are treated as creditors and given priority in repayment of their money.
d) Debenture holders normally do not have representation in the Board of the company.
Advantages of debentures
a) Less Costly: It involves less cost to the firm than the equity financing.
b) Long Term Source of Fund: Debentures provide Funds to the company for a long period.
c) Definite period of Finance: Debentures provide funds to the company for a specific period.
d) Fixed interest Rate: In a period of rising prices, debenture issue is advantageous.
Disadvantages of Debentures
a) Debenture interest and capital repayment are obligatory payments. Failure to meet these payments jeopardizes the solvency of the firm.
b) In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. It becomes a great burden on the finances of the company.
c) Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital.
Q.2. What are various Types of Debentures? Explain them briefly.
Ans: Types of Debentures: Debentures are classified as follows:
1. On the Basis of Repayment
a. Redeemable Debentures: These debentures are paid off or redeemed after the prescribed period.
b. Irredeemable or Perpetual Debentures: These debentures are permanent debentures of a company. They are paid back only in the event of winding up of a company.
2. On the Basis of Transferability
a. Registered Debentures: These are debentures for which the company maintains record of debenture holders.
b. Bearer Debentures: These debentures are transferable by mere delivery. There is no need or registration of transfer with the company.
3. On the Basis of Security
a. Simple or Naked Debentures: These are debentures not secured by any asset of the company.
b. Mortgage Debentures: Mortgage debentures are issued on the security of certain assets of the company.
4. On the basis of Conversion
a. Convertible Debentures: These debentures are issued with an option to debenture holders to convert them into shares after a fixed period.
b. Non Convertible Debentures: These are debentures issued without conversion option.
5. On the Basis of Pre-Mature Redemption Rights:
a. Debenture with “Call” option: A callable debenture is one in which the issuing company has the option of redeeming the security before the specified redemption date at a pre-determined price.
b. Debenture with “Put” option: This is a debenture in which the holder has the option of getting it redeemed before maturity.
6. On the Basis of Coupon Rate (interest rate)
a. Fixed Rate Debentures: Most of the time debentures are issued with a prefixed rate interest. These debentures are called fixed interest debentures
b. Floating rate Debentures: Floating rate as the names suggests keeps changing.
c. Zero Coupon Bonds: These are debentures issued with no interest specified. They are issued at a substantial discount to compensate the investors. These bonds are known as deep discount bonds.
Q.3. What do you mean by Issue of Debenture as Collateral Security? Explain its accounting treatment.
Ans: Issue of Debentures as Collateral security and Its accounting Treatment
When debentures are issued as security in addition to any other security against a loan or bank overdraft such an issue of debentures is known as issue of debentures as collateral security. The use of such an issue is that if the company does not repay the loan and the interest and the main security is not sufficient, the bank will be entitled to sell the debentures in the market or the bank may keep the debentures with it. If the company repays the loan, the bank will return the debentures issued as collateral security to the company.
Debenture issued as Collateral security can be dealt in two ways:
First Method: No entry needs to be passed in the books of the company because debentures are issued only as a collateral security. Debentures become alive only when loan is not repaid. The fact of such an issue of debentures must be clearly stated in the Balance Sheet by way of a note under the loan and debentures.
Second Method: Under this method, a journal entry is passed for the issue of debentures as collateral security:
When debentures are issued
Debenture Suspense A/c Dr.
To Debenture A/c
(Being the issue of _____ debentures of Rs. _ each issued against ____ loan as collateral securities)
When the loan is Repaid
Debentures A/c Dr.
To Debenture Suspense A/c
(Being the cancellation of ________ debentures of Rs. _____ each issued as collateral security against ____ loan as the same is repaid)
Q.4. What do you mean by Redemption of Debentures? Explain its sources and Methods. 2012, 2014, 2015
Ans: Meaning of Redemption of Debentures: Redemption of debenture is the discharge of debenture liability. It can be done either by repaying the money to debenture holders or converting the debenture into shares. The conditions of redemption are clearly stated at the time of issue of debenture in the prospectus. Debentures can be redeemed at par, premium or discount as per the terms of issue. The period of maturity, redemption amount, yield on redemption etc. will be mentioned in the prospectus. In case the non convertible debentures proposed to be rolled over (repayment extended for an additional period), a compulsory option should be given to the debenture holders who wish to withdraw from the debenture programme, as per the guidelines issued by SEBI.
Sources of Funds for Redemption of Debentures
Redemption of debentures is an important commitment to be fulfilled by a joint stock company. Failure to redeem debentures will disqualify the directors of the company. Moreover, such a default will invite strict penalties and loss of reputation. As the redemption of debentures drains a large amount of resources, companies will make advance preparations to meet this need.
i. Redemption of Debentures - from the proceeds of fresh issue of share capital and debentures
ii. Redemption of Debentures - out of accumulated profits
Methods of Redemption of Debentures
i) Redemption In lump-sum, at the end of stipulated period: Under this method the entire debentures are redeemed at the stipulated date stated in the prospectus for the issue of debentures. The drawback of this method is that the company has to arrange a large amount at the time of redemption.
ii) By Draw of Lots: Under this method the company does not redeem all the debentures at the same time. Instead it will call back only a portion of its debentures in the market for redemption each year. The company selects the debentures of a predetermined value, by drawing lot and they are redeemed that year.
iii) By Purchasing in the Open Market: Debentures can be redeemed by purchasing them from the open market. If a company finds its debentures are available in the open market at cheap rate it will purchase those debentures and cancel them.
iv) By Conversion into New Debentures or Shares: Conversion of debentures into shares is another method of redemption. When debentures are converted to shares, the company does not pay money to debenture holders. Instead the company issues share certificates in place of debentures.
Q.5. What do you mean by “Discount on Issue of Debenture” and “Loss on Issue of Debenture”? Explain its treatment. 2012, 2013, 2014
Ans: When debentures are issued at a price lower than its face value, then such debentures are said to be issued as “Debentures issued at a Discount”. Discount on issue of debentures is a Capital loss and is show in the Balance sheet on the Assets side under the head “Miscellaneous Expenditure” till it is written off.
When debentures are redeemable at a premium, the extra amount payable over and above the nominal value on redemption is called “Loss on Issue of Debenture”. Again when debentures are issued at a discount, the discount on issue of debenture is also a loss on issue of debentures. Thus when debentures are issued at a discount and redeemable at a premium both the losses are amalgamated under the head “Loss on Issue of Debenture Account”. It is a Capital loss and is show in the Balance sheet on the Assets side under the head “Miscellaneous Expenditure” till it is written off.
The amount of debenture discount/Loss on issue of debenture can be written off in two ways:
1. All debentures are to be redeemed after a fixed period: When the debentures are to be redeemed after a fixed period, the amount of discount will be distributed equally within the number of years spreaded between the issue of debentures and their redemption. The amount of discount on issue of debentures to be written off each year is calculated as: Amount of discount to be written off annually = Amount of Discount / No of Years
2. Debentures are redeemed in installments: Debentures may also be redeemed in installments but over a fixed period. In that case the amount of debenture discount will be written off each year in proportion to the amount of debentures redeemed.
Journal Entry for Writing of Discount on issue of Debentures/Loss on issue of Debentures is:
Profit and Loss Account Dr.
To Discount on issue of Debentures Account
To Loss on Issue of Debentures Account
Q.6. What is Sinking Fund? Why and How it is created? 2013
Ans: Sinking fund is a into which a sets aside over time, in order to its , or . Such fund is created mainly for some specific purposes which are:
1. To redeem or repay long term liabilities. For example: debentures, long term loans etc.
2. To replace wasting assets. For example: mines etc.
Creation of Sinking fund for redemption of debentures:
For redemption of debentures or other long term liabilities, a fixed amount is kept aside yearly as sinking fund for the specific purpose and the same amount is invested in securities etc. for a specific period so that the sufficient amount is available at the time of redemption of long term liabilities. The amount to be set aside can be determined with the help of Sinking fund table. The amount kept aside should not be debited to but to Profit and loss appropriation account because the same is an allocation of profit not expenditure.