Meaning and Nature of Debentures

While a company raises its foundational capital by issuing shares (owned capital), these funds are often insufficient to meet all of its long-term financial needs, especially for large-scale projects, modernization, or expansion. To bridge this gap, companies frequently turn to borrowing. One of the most common methods of raising long-term debt is by issuing debentures to the public, which represent the borrowed or loan capital of the company.

The word ‘debenture’ is derived from the Latin word ‘debere’, which means 'to borrow'. In essence, a debenture is a formal, written certificate issued by a company under its common seal, serving as an acknowledgement of a debt owed to the holder. It is a legally binding contract between the company (the borrower) and the debenture holder (the lender). The key elements of this contract are:

• Repayment of Principal: The company promises to repay the principal amount (the face value of the debenture) at a specified future date, known as the maturity date.

• Payment of Interest: The company agrees to pay interest at a pre-fixed rate (e.g., 9%, 10%) on the principal amount at regular intervals (usually half-yearly or yearly) until the debenture is repaid. This interest payment is a charge against profit, meaning it must be paid irrespective of whether the company earns a profit or not. This makes it fundamentally different from dividends on shares, which are an appropriation of profit.

The legal definition provided by Section 2(30) of The Companies Act, 2013, is quite broad. It states that ‘Debenture’ includes debenture stock, bonds, and any other securities of a company, whether constituting a charge on the assets of the company or not. This implies that debentures can be secured (backed by company assets) or unsecured, adding to their versatility as a financial instrument.

Bond

A bond is another type of debt instrument that is functionally very similar to a debenture. Both are written acknowledgements of debt that promise to pay interest and repay the principal. Historically, the term 'bond' was typically associated with debt issued by government entities (like government bonds or municipal bonds), while 'debenture' was used for corporate debt.

However, in modern corporate finance, this distinction has blurred significantly. Many companies and semi-government organizations now issue instruments they call bonds. For practical and accounting purposes, the terms ‘debentures’ and ‘bonds’ are often used interchangeably to refer to long-term debt instruments issued by a company. For example, 'Zero Coupon Bonds' are a type of debenture that does not pay periodic interest but is instead issued at a deep discount to its face value.

Distinction between Shares and Debentures

Although both shares and debentures are primary long-term financial instruments used by a company to raise funds from the public, they are fundamentally different in their nature, rights, and risks. The core distinction lies in their identity: a share represents ownership capital, making the shareholder an owner of the company, while a debenture represents loan or debt capital, making the debenture holder a creditor or lender to the company. This single difference gives rise to all other points of distinction.

An owner (shareholder) participates in the profits and losses of the company and has a say in its management. A lender (debenture holder), on the other hand, is entitled only to a fixed return in the form of interest and the repayment of their principal amount, regardless of the company's profitability, and has no control over its affairs.

Types of Debentures

A company can issue various kinds of debentures to cater to the diverse needs of the capital market and different types of investors. These debentures are classified based on key features related to their security, tenure, convertibility, interest rate (coupon), and the method of transfer.

1. From the Point of View of Security

This classification is based on whether the debentures are backed by the company's assets, which provides security to the debenture holders.

(a) Secured Debentures

These are debentures that are secured by a charge on the assets of the company. A charge is a legal claim on the assets, which means that if the company defaults on paying interest or principal, the debenture holders (through a trustee) can take possession of these assets and sell them to recover their dues. This makes the investment safer for the debenture holder. The charge can be:

• Fixed Charge: A charge created on a specific, identifiable, and usually non-current asset like land, a particular building, or a specific plant. The company cannot sell or mortgage this asset without the permission of the debenture holders. It provides a very high degree of security.

• Floating Charge: This charge is not attached to any specific asset but floats over a class of the company's general assets, such as inventory (stock-in-trade), trade receivables (debtors), etc. The company can freely use, sell, or deal with these assets in the ordinary course of business. The charge becomes fixed (or 'crystallizes') only when the company defaults or goes into liquidation.

(b) Unsecured Debentures

These debentures, also known as Naked Debentures, are not secured by any specific charge on the company's assets. In case of default, the holders of these debentures are treated as ordinary unsecured creditors of the company. Due to the higher risk involved for investors, such debentures are not commonly issued in India and are generally not preferred by the public.

2. From the Point of View of Tenure

This classification is based on the repayment period of the debentures.

(a) Redeemable Debentures

These are the most common type of debentures. They are issued for a fixed period of time, and the company is legally bound to repay the principal amount at the end of that specific period (maturity). The repayment, known as redemption, can be made either in a lump sum or in instalments through a draw of lots. The Companies Act, 2013 mandates that all debentures issued by a company must be redeemable.

(b) Irredeemable Debentures (Perpetual Debentures)

These debentures do not have a fixed maturity date for repayment. The company does not undertake to repay the principal amount during its lifetime. Such debentures are repayable only when the company goes into liquidation or upon the expiry of a very long period. However, under the current Companies Act, companies are generally not permitted to issue irredeemable debentures.

3. From the Point of View of Convertibility

This classification depends on whether the debenture holder has an option to convert their holding into shares.

(a) Convertible Debentures

These debentures give the holder an option to convert them into equity shares (or another class of security) of the company at a predetermined price and after a specified period. This offers investors the dual benefit of the safety of a debt instrument (fixed interest) and the potential for capital appreciation associated with equity shares. They can be:

• Fully Convertible Debentures (FCDs): The entire face value of the debenture is converted into shares.
• Partly Convertible Debentures (PCDs): A portion of the debenture is converted into shares, and the remaining non-convertible portion is redeemed at maturity.

(b) Non-Convertible Debentures

These are pure debt instruments that cannot be converted into shares or any other security. The holder receives regular interest payments throughout the tenure and gets the principal amount back on the maturity date. Most debentures issued by companies fall into this category, appealing to investors who seek a fixed, stable income without equity risk.

4. From Coupon Rate Point of View

This is based on the nature of the interest payment.

(a) Specific Coupon Rate Debentures

These are debentures that carry a specified rate of interest, which is known as the coupon rate. The name of the debenture usually includes this rate (e.g., 9% Debentures, 12% Debentures). The interest rate can be either fixed (remaining the same throughout the life of the debenture) or floating (linked to a benchmark rate like the bank rate and reset at periodic intervals).

(b) Zero Coupon Rate Debentures

These debentures do not carry a specific rate of interest. To compensate the investors, they are issued at a substantial discount to their face value, and are redeemed at their full face value. The difference between the issue price and the redemption value (face value) represents the total interest earned by the investor over the entire duration of the debenture.

5. From the Point of View of Registration

This classification is based on how the ownership of the debenture is recorded and transferred.

(a) Registered Debentures

For these debentures, the company maintains a formal register of debenture holders, which contains their names, addresses, and particulars of their holdings. Ownership can only be transferred by executing a proper transfer deed. Interest and principal are paid only to the person whose name appears in this register, making them safe and secure.

(b) Bearer Debentures

These debentures are transferable by mere delivery and are treated as negotiable instruments. The company does not keep any record of the holders. The debenture certificate has interest coupons attached to it. The person who holds the debenture at the time of interest payment can present the relevant coupon to the company's bank and receive the interest. Ownership passes by simple handover, making them easy to transfer but risky if lost or stolen.

Issue of Debentures

The procedure for issuing debentures to the public is broadly similar to that of issuing shares. A company typically starts by issuing a prospectus, which is an invitation to the public to subscribe to its debentures. Interested investors then apply for the debentures, and the company proceeds with allotment. The issue price can be collected in a lump sum (all at once with the application) or in instalments (e.g., on application, allotment, and calls).

Debentures can be issued under various conditions:

• For Cash: The most common method, where debentures are issued in exchange for money.

• For Consideration Other than Cash: When debentures are issued to settle the purchase of assets or a business.

• As Collateral Security: When debentures are issued to a lender as additional security against a loan.

Furthermore, when issued for cash, the pricing can be at par, at a premium, or at a discount.

Issue of Debentures for Cash

This section details the accounting treatment when debentures are issued for cash at different price points. The accounting entries are similar to those for share issues, with the key difference being that amounts are credited to a liability account (e.g., '12% Debentures A/c') instead of 'Share Capital A/c'.

1. Issue of Debentures at Par

Debentures are said to be issued at par when their issue price is exactly equal to their nominal or face value. This is the simplest issue scenario, where the cash received by the company equals the liability (debt) it acknowledges.

Journal Entries (when amount is received in instalments):

(i) On receipt of application money:

(ii) On allotment (transferring application money):

Subsequent entries for making the allotment and call money due, and then recording their receipt, follow the same pattern.

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2. Issue of Debentures at a Discount

Debentures are said to be issued at a discount when the issue price is less than their face value. For example, issuing a $\text{₹} \ 100$ debenture for $\text{₹} \ 95$. The $\text{₹} \ 5$ difference represents a loss to the company because it receives less cash than the amount it will have to repay at maturity.

The Discount on Issue of Debentures is a capital loss. It is debited to a separate account, 'Discount on Issue of Debentures A/c'. This loss must be written off during the financial year in which the debentures are allotted. It should be written off against the Securities Premium Account (if any balance exists), and the remaining amount should be written off against the Statement of Profit and Loss. Unlike shares, the Companies Act, 2013 does not impose any restrictions on the rate of discount for the issue of debentures.

Journal Entry (assuming discount is adjusted on allotment):

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3. Issue of Debentures at a Premium

Debentures are said to be issued at a premium when the issue price is more than their face value. For example, issuing a $\text{₹} \ 100$ debenture for $\text{₹} \ 110$. The extra $\text{₹} \ 10$ is a capital profit for the company.

This premium amount is credited to a special reserve account called the 'Securities Premium Account'. This reserve is not a free reserve and its use is restricted by Section 52(2) of the Companies Act, 2013. In the Balance Sheet, it is shown under the head 'Equity and Liabilities' as part of 'Reserves and Surpluses'.

Journal Entry (assuming premium is collected on allotment):

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Over Subscription of Debentures

Over subscription occurs when a company receives applications for more debentures than it has offered to the public for subscription. This is a common scenario for financially sound companies and indicates strong investor demand for its debt instruments. However, a company is legally bound not to allot more debentures than it has invited for subscription through its prospectus.

The company must therefore decide on a basis for allotment. Similar to the over subscription of shares, the excess application money received must be dealt with in one of the following ways:

• Rejection: Some applications are fully rejected and their application money is refunded in full.

• Pro-rata Allotment: A proportionate allotment is made to applicants, and the excess application money is retained and adjusted towards the amount due on allotment and subsequent calls.

• Combination: A mix of the above two methods is applied, which is the most common practice.

The key accounting step is the journal entry passed on the date of allotment to dispose of the total application money received.

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Issue of Debentures for Consideration other than Cash

In addition to issuing debentures for cash, a company can also issue debentures in exchange for non-cash items. This is known as issuing debentures for consideration other than cash. This method is a common financial strategy used to acquire assets or entire businesses without an immediate cash outflow. Instead of paying the seller (vendor) in cash, the company settles the purchase price by issuing its own debentures.

These debentures can be issued at par, at a premium, or at a discount. The number of debentures to be issued is determined by dividing the purchase consideration by the issue price per debenture.

Journal Entries for Issue of Debentures

The accounting process involves two primary steps:

1. On purchase of assets: First, the assets acquired are recorded, and a liability is created in the name of the vendor.

2. On issue of debentures to the vendor: Second, the liability to the vendor is settled by issuing debentures.

(a) When issued at par:

(b) When issued at a premium:

(c) When issued at a discount:

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Issue of Debentures as a Collateral Security

A collateral security is a secondary or additional security provided by a borrower to a lender, over and above the primary security. When a company takes a loan from a bank or financial institution, it usually pledges some of its assets (like land, building, or plant) as the primary security.

Sometimes, the lender may not be satisfied with the value of the primary security and may insist on additional security to safeguard their loan. In such a situation, the company may issue its own debentures to the lender as collateral. This issue is known as 'Debentures issued as Collateral Security'. These debentures are not 'sold' to the lender; they are merely pledged. The lender does not receive interest on these debentures.

The lender's rights over these debentures are contingent. If the company repays the loan on time, the lender must return the debentures to the company, which are then cancelled. However, if the company defaults on the loan repayment, the lender has the right to first recover the amount by selling the primary security. If there is still a shortfall, the lender can then exercise their rights over the collateral debentures, either by becoming a debenture holder themselves or by selling them in the open market to recover the remaining dues.

Accounting Treatment

There are two accepted methods for accounting for the issue of debentures as collateral security.

First Method: No Journal Entry (Disclosure Only)

Under this method, no journal entry is passed in the books of accounts at the time of issuing debentures as collateral security. The logic is that no actual liability for the debentures has been created; they are only pledged as a contingent security. The primary liability remains the loan itself.

However, this fact must be disclosed in the company's Balance Sheet. A note is appended to the loan item in the 'Notes to Accounts' under 'Long-term Borrowings'.

Example of Disclosure:

Balance Sheet (Extract)

Notes to Accounts

Second Method: Recording the Issue via Journal Entry

This method involves recording the issue of debentures as collateral security through a journal entry. To ensure that this does not inflate the company's liabilities on the Balance Sheet, a new account called 'Debenture Suspense Account' is opened. This account is a dummy or notional account that acts as a contra-liability to the Debentures Account.

(i) Journal entry on issue of debentures as collateral:

(ii) Journal entry on repayment of the loan: When the loan is repaid, the above entry is reversed to cancel the debentures and the suspense account.

Example of Disclosure:

Balance Sheet (Extract)

Notes to Accounts

As seen above, the net effect on the total borrowings is nil, and only the actual loan is reflected in the final Balance Sheet figure, same as in the first method.

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Terms of Issue of Debentures

When a company issues debentures, the terms of issue are not limited to the issue price alone. Crucially, the company must also specify the terms on which these debentures will be redeemed (repaid) at maturity. Redemption of debentures means the discharge of the liability by repaying the principal amount to the debenture holders.

From an accounting perspective, the terms of redemption are of paramount importance at the time of issue itself. This is governed by the prudence principle (or conservatism concept), which dictates that all anticipated future losses must be accounted for immediately, but potential future gains should be ignored. A promise to redeem debentures at a premium represents a future loss for the company, and this loss must be recognized in the books at the very time the debentures are issued.

Depending on the combination of issue and redemption terms, there are six possible scenarios.

The Six Scenarios of Issue and Redemption

The accounting treatment for the issue of debentures varies based on the terms of both issue and redemption. The six common scenarios are:

1. Issued at Par and Redeemable at Par

2. Issued at a Discount and Redeemable at Par

3. Issued at a Premium and Redeemable at Par

4. Issued at Par and Redeemable at a Premium

5. Issued at a Discount and Redeemable at a Premium

6. Issued at a Premium and Redeemable at a Premium

Note: Redemption at a discount is not a practical scenario as no investor would agree to receive less than the face value at maturity.

Journal Entries at the Time of Issue

Case 1: Issued at Par, Redeemable at Par

The company receives the face value and repays the same face value. No loss or gain is anticipated.

Case 2: Issued at a Discount, Redeemable at Par

The company receives less than the face value but repays the full face value. The discount is a capital loss recorded at the time of issue.

Case 3: Issued at a Premium, Redeemable at Par

The company receives more than the face value and repays only the face value. The premium is a capital profit credited to Securities Premium Account.

Case 4: Issued at Par, Redeemable at a Premium

The company receives the face value but will repay more than the face value. The extra amount to be paid on redemption is an anticipated loss. This loss must be recorded at the time of issue by debiting 'Loss on Issue of Debentures A/c' and creating a liability 'Premium on Redemption of Debentures A/c'.

Case 5: Issued at a Discount, Redeemable at a Premium

The company suffers two losses: the discount on issue (a current loss) and the premium on redemption (a future loss). Both losses are clubbed together and debited to a single account: 'Loss on Issue of Debentures A/c'.

Case 6: Issued at a Premium, Redeemable at a Premium

The company receives a premium on issue (a gain) but will also pay a premium on redemption (a loss). These are not netted off. The premium on issue is credited to 'Securities Premium A/c', while the premium on redemption is debited as a loss to 'Loss on Issue of Debentures A/c'.

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Interest on Debentures

When a company issues debentures, it enters into a contractual obligation to pay interest to the debenture holders at a fixed percentage, periodically, until the debentures are repaid. This interest rate is usually part of the debenture's name (e.g., 8% Debentures, 10% Debentures). Interest is a fundamental cost of borrowing for the company.

Key Characteristics of Debenture Interest

• Charge Against Profit: Interest on debentures is a charge against the profit of the company. This is a crucial distinction from dividends on shares, which are an appropriation of profit. It means that interest must be paid regardless of whether the company has earned any profit or not. It is treated as an expense and is debited to the Statement of Profit and Loss.

• Calculation on Nominal Value: Interest is always calculated on the nominal (face) value of the debentures, irrespective of the price at which they were issued (par, premium, or discount). For example, if a 10% debenture of $\text{₹} \ 100$ face value is issued at a discount for $\text{₹} \ 95$, the interest payable will still be 10% of $\text{₹} \ 100$, i.e., $\text{₹} \ 10$.

Tax Deducted at Source (TDS)

According to the provisions of the Income Tax Act, 1961, a company is required to deduct income tax at a prescribed rate from the interest payable to debenture holders before making the payment. This is known as Tax Deducted at Source (TDS). The company then deposits this TDS amount with the government on behalf of the debenture holders. The debenture holders receive the net interest amount and can claim credit for the TDS when filing their own income tax returns.

Accounting Treatment and Journal Entries

The following journal entries are recorded in the books of a company for the payment of interest:

1. When interest becomes due:

2. For payment of net interest to debenture holders:

3. For payment of TDS to the Government:

4. On transferring the interest expense to the Statement of Profit and Loss (at year-end):

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Writing off Discount/Loss on Issue of Debentures

The 'Discount on Issue of Debentures' or 'Loss on Issue of Debentures' represents a capital loss for the company. This loss arises from two main components:

• Discount on Issue: The amount by which the issue price is less than the face value of the debentures.

• Premium on Redemption: The extra amount the company promises to pay back over and above the face value at the time of redemption.

When debentures are issued at a discount and are also redeemable at a premium, both these losses are clubbed together and debited to a single account: "Loss on Issue of Debentures A/c". Accounting principles and legal provisions require that this capital loss should not be carried in the books for an indefinite period; it must be written off.

Nature and Accounting Treatment

As per the guidance provided by Accounting Standard (AS) 16 "Borrowing Costs" and the provisions of the Companies Act, 2013, the entire amount of discount or loss on the issue of debentures must be written off in the financial year in which the debentures are allotted.

Modern Practice vs. Older Method

Previously, it was common practice to amortize (write off) this loss over the life of the debentures, often using methods like the straight-line method or the effective interest rate method. However, the current practice, mandated by accounting standards, is to treat it as a one-time charge in the year of issue. This ensures that the financial statements reflect the full impact of the borrowing cost in the period the liability is incurred.

Sources for Writing Off the Loss

A company should write off the 'Discount/Loss on Issue of Debentures' in the following order of preference:

1. Securities Premium Account: As per Section 52(2) of the Companies Act, 2013, the balance in the Securities Premium account can be utilised to write off such losses. This is the first source that should be used.

2. Statement of Profit and Loss: If the balance in the Securities Premium Account is insufficient to cover the entire loss, the remaining amount of the loss must be written off by debiting it to the Statement of Profit and Loss for the year.

In essence, capital profits (like Securities Premium) are used first, and any remaining loss is charged against revenue profits.

Journal Entry for Writing Off

The composite journal entry to write off the discount or loss at the end of the financial year is as follows:

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Redemption of Debentures

Redemption of debentures refers to the process of repaying the amount of debentures to the debenture holders. It is the discharge of the liability on account of debentures as per the terms of issue. The company must repay the principal amount, along with any premium on redemption if applicable, on the specified maturity date.

The terms of redemption, including the timing and the amount payable, are decided at the time the debentures are issued and are mentioned in the prospectus. The redemption process is governed by the provisions of the Companies Act, 2013, and guidelines issued by the Securities and Exchange Board of India (SEBI) to protect the interests of the debenture holders.

Sources for Redemption of Debentures

A company can redeem its debentures from two main sources:

1. Redemption out of Capital

When a company uses its existing capital and resources to redeem debentures without specifically setting aside profits for this purpose, it is known as redemption out of capital. This method is generally permissible for certain types of companies (like banking companies and listed companies) that are exempt from creating a Debenture Redemption Reserve. However, even these companies must meet the Debenture Redemption Investment requirement.

2. Redemption out of Profits

This method involves setting aside a portion of the company's distributable profits to a specific reserve, known as the Debenture Redemption Reserve (DRR), before the redemption begins. This ensures that the company does not use all its liquid funds for redemption, which could weaken its financial position. By transferring profits to DRR, the company reduces the amount available for dividends, thereby retaining funds within the business. This method provides greater security to the debenture holders.

Legal Provisions for Redemption (As per Companies Act, 2013)

To ensure companies have sufficient funds to repay their debenture holders, the law mandates the creation of two key financial safeguards: the Debenture Redemption Reserve (DRR) and the Debenture Redemption Investment (DRI).

1. Debenture Redemption Reserve (DRR)

DRR is a reserve created out of profits available for distribution as dividend. The purpose is to earmark profits for the redemption of debentures. The rules are as follows:

• Who must create DRR? Only specified unlisted companies are required to create DRR.

• How much DRR? These companies must create a DRR equivalent to at least 10% of the value of the outstanding debentures.

• Exemptions: The following companies are exempted from the requirement of creating DRR:

  • All India Financial Institutions (AIFIs) regulated by RBI.
  • Banking Companies.
  • Other Financial Institutions (OFIs) specified by RBI.
  • All listed companies.
  • Housing Finance Companies registered with the National Housing Bank.

• After the debentures are redeemed, the amount standing in the DRR account is transferred to the General Reserve.

2. Debenture Redemption Investment (DRI)

This provision requires companies to invest a certain amount in specified liquid securities to ensure ready availability of cash for redemption. The rules apply to all companies issuing debentures, unless specifically exempted.

• How much DRI? A company must, on or before the 30th day of April each year, invest or deposit a sum which shall not be less than 15% of the amount of its debentures maturing during the year ending on the 31st day of March of the next year.

• Timeline: The investment must be made on or before April 30th of the financial year preceding the date of redemption.

• Specified Securities: The investment can be made in deposits with scheduled banks, securities of the Central or State Government, or other specified securities.

• Utilisation: This investment cannot be used for any purpose other than the redemption of debentures. It is encashed at the time of redemption to provide the necessary funds.

Methods of Redemption of Debentures

A company can redeem its debentures in any of the following four ways:

1. Payment in Lump Sum

This is the most common method, where the company repays the entire amount of debentures in a single payment at the end of the specified period (at maturity). For example, if debentures are issued for 5 years, the full amount is repaid at the end of the 5th year.

2. Payment in Instalments (Draw of Lots)

Under this method, the company redeems its debentures in specified instalments over a period of time. For instance, a company might redeem 20% of its debentures every year for five years. The specific debentures to be redeemed each year are typically selected randomly through a process called draw of lots.

3. Purchase in the Open Market

If authorised by its Articles of Association, a company can purchase its own debentures from the open stock market. This is usually done when the market price of the debentures is lower than their face value. Purchasing debentures below their face value results in a profit on cancellation, which is a capital profit and is transferred to the Capital Reserve. This method allows the company to redeem debentures as and when it has surplus funds.

4. By Conversion into Shares or New Debentures

This method is only applicable to convertible debentures. On the specified date, the debenture holders are given an option to convert their holdings into new shares or a new class of debentures at a pre-determined rate. If the holders exercise this option, their liability as creditors is extinguished, and they become either owners (shareholders) or holders of new debentures. This method does not involve any cash outflow.

Redemption by Payment in Lump Sum

Redemption by payment in a lump sum is the most straightforward and common method of redeeming debentures. Under this method, the company repays the entire outstanding amount of a particular series of debentures in a single instalment on the specified date of maturity as per the terms of issue. For example, if 10% Debentures were issued on April 1, 2018, for a period of 5 years, the company will repay the full amount to all debenture holders on March 31, 2023.

Accounting Procedure and Journal Entries

The accounting process for lump-sum redemption involves recognizing the amount due to debenture holders and then making the payment. The entries depend on whether the debentures are redeemable at par or at a premium.

Prior to redemption, the company must also comply with the legal requirements of creating a Debenture Redemption Reserve (DRR) and making a Debenture Redemption Investment (DRI), if applicable.

Step 1: Compliance with DRR and DRI Requirements (if applicable)

(i) Creation of Debenture Redemption Reserve (DRR): For unlisted companies, a DRR of at least 10% of the face value of debentures must be created out of profits before redemption commences.

(ii) Making Debenture Redemption Investment (DRI): On or before April 30 of the year of redemption, an amount equal to at least 15% of the face value of debentures to be redeemed must be invested in specified securities.

Step 2: Journal Entries at the Time of Redemption

(i) Encashment of DRI: Just before redemption, the investments made are sold to make funds available.

(ii) Making Amount Due to Debenture holders:

Case A: Redeemable at Par

Case B: Redeemable at a Premium

(iii) For Paying the Amount to Debenture holders:

Step 3: Transfer of DRR to General Reserve

After all the debentures of a particular series have been redeemed, the balance in the Debenture Redemption Reserve (DRR) account is no longer required and is transferred to the General Reserve.

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Redemption by Payment in Instalments

Instead of repaying the entire debenture amount in a single lump sum at maturity, a company may opt for redemption in instalments. Under this method, a fixed portion of the debentures is redeemed periodically (usually annually) over a specified number of years. This method spreads the financial burden of redemption over several years, making cash flow management easier for the company.

The specific debentures to be redeemed each year are typically selected on a random basis from the entire pool of outstanding debentures through a process known as a draw of lots. This ensures fairness to all debenture holders, as no single holder is given preference for early redemption.

Key Accounting Considerations

• Interest Payments: A significant feature of this method is that the total interest expense for the company decreases each year. As a portion of debentures is redeemed, the outstanding principal amount on which interest is calculated reduces, leading to lower interest payments in subsequent periods.

• Debenture Redemption Reserve (DRR): If DRR is required, the company must create the reserve based on the total value of debentures before the first redemption begins. After each instalment of redemption is completed, a proportionate amount of the DRR is transferred to the General Reserve.

• Debenture Redemption Investment (DRI): The DRI requirement of investing 15% is calculated based on the nominal value of debentures to be redeemed in the upcoming year. For instance, before April 30 of Year 1, an investment of 15% of the debentures maturing at the end of Year 1 is made. This investment is then encashed to fund the redemption at the end of Year 1. A new investment is made before April 30 of Year 2 for the redemption due at the end of Year 2, and so on.

Journal Entries for Redemption

The core journal entries for redemption are passed each year when an instalment becomes due. These entries are similar to the lump-sum method but are for a smaller, partial amount.

(i) For making the redemption amount due for the current instalment:

(ii) For paying the amount to debenture holders:

(iii) For transferring proportionate DRR to General Reserve:

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Redemption by Purchase in Open Market

If authorised by its Articles of Association, a company has the option to redeem its debentures by purchasing them from the open market (i.e., a stock exchange where they are listed and traded). When a company purchases its own debentures for the purpose of immediate cancellation, this act constitutes redemption.

Advantages of this Method

• Flexibility: The company can redeem its debentures as and when it has surplus funds, rather than waiting for a fixed maturity date. This allows for better cash flow management.

• Cost Savings (Profit on Redemption): If the market price of the debentures is lower than their face value (i.e., they are trading at a discount), the company can purchase them for less than what it is obligated to pay at maturity. This results in a direct profit for the company.

• Reduced Interest Burden: Once the debentures are purchased and cancelled, the company's liability to pay future interest on them is extinguished, leading to a reduction in interest expense.

Accounting Treatment

The accounting treatment depends on whether the company pays more or less than the face value of the debentures.

Case 1: Purchase at a Discount (Purchase Price < Face Value)

When the company buys its debentures for a price lower than their face value, the difference is a capital profit. This profit is first credited to a temporary account, 'Profit on Redemption of Debentures A/c', and then transferred to the Capital Reserve.

Journal Entries:

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Case 2: Purchase at a Premium (Purchase Price > Face Value)

If the company buys its debentures for a price higher than their face value, the excess amount paid is a capital loss. This loss is debited to a temporary account, 'Loss on Redemption of Debentures A/c', and then written off against the Statement of Profit and Loss in the same year.

Journal Entries:

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Alternative Method (Using 'Own Debentures' Account)

Some companies prefer a two-step approach where the purchase is first treated as an investment. An asset account called 'Own Debentures A/c' is opened.

Step 1: Purchase of Own Debentures

Step 2: Immediate Cancellation

The profit is then transferred to Capital Reserve as in the first method.

Redemption by Conversion

Redemption by conversion is a non-cash method of settling debenture liability. Under this method, the company gives debenture holders an option to convert their holdings into new securities, which are typically equity shares or a new class of debentures. This option is only available for debentures that were originally issued as 'convertible debentures'.

When a debenture holder exercises this option, their status changes from a creditor of the company to an owner (shareholder) or a holder of new debentures. This method is attractive to companies as it allows them to extinguish a significant liability without any cash outflow, thereby preserving liquidity and strengthening their balance sheet.

Key Features and Advantages

• No Cash Outflow: This is the primary advantage for the company. It can settle a large debt without impacting its cash reserves, which can then be used for operational or expansion activities.

• Improved Debt-Equity Ratio: By converting debt into equity, the company reduces its liabilities and increases its shareholders' funds. This improves its debt-equity ratio, making the company appear less risky to future lenders and investors.

• Benefit to Debenture Holders: Investors are attracted to convertible debentures because they offer the safety of a fixed interest income (as a creditor) along with the potential for capital appreciation if they convert their holdings into equity shares and the company performs well.

• DRR and DRI Exemption: As per the rules, for the portion of debentures that are to be redeemed by conversion, the company is exempted from the legal requirements of creating a Debenture Redemption Reserve (DRR) and making a Debenture Redemption Investment (DRI).

Accounting Treatment and Calculation

The core of the accounting process is to determine the number of new shares or debentures to be issued in exchange for the old debentures being redeemed. The new shares can be issued at par or at a premium.

Calculating the Number of Shares to be Issued

The fundamental principle is that the value of the liability being settled must equal the value of the securities being issued. The formula is:

$ \text{Number of Shares to be Issued} = \frac{\text{Amount Payable to Debenture Holders}}{\text{Issue Price per Share}} $

Where:

• Amount Payable to Debenture Holders is the face value of the debentures being converted. If the debentures are to be redeemed at a premium, this premium must also be included in the amount payable.

• Issue Price per Share is the price at which the new shares are issued. It will be the face value if issued at par, or face value plus premium if issued at a premium.

Journal Entries

The redemption process involves two main journal entries:

1. For making the amount due to debenture holders on conversion:

2. For the issue of new shares or debentures to settle the claim:

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Do it yourself (Page No. 92)

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Do it yourself (Page No. 97)

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Do it yourself (Page No. 103)

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Do it yourself (Page No. 106)

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Test your Understanding - I

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Test your Understanding - II

Select the correct answer for the following multiple choice questions:

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Test your Understanding – III

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Do it yourself (Page No. 136)

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Do it yourself (Page No. 137)

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