Issue and Redemption of Debentures

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part II), Chapter 2.

Borrowing from the public without giving up ownership

BrightPath Ltd needs ₹5 crore for a new plant. If it issues more shares, its present owners share the control and the profits with new people. A bank loan is another option, but BrightPath would rather borrow from many small lenders at a fixed rate. So it issues debentures. Each investor lends a small amount, say ₹100, and in return gets a written promise of interest every year and repayment of the principal at a fixed date.

The word comes from the Latin debere, to owe. A debenture is a certificate of debt issued under the company's seal, with a promise to pay interest at a fixed rate and to repay the principal after a stated period. Under the Companies Act, 2013 it includes debenture stock, bonds and any other securities of a company, whether or not they create a charge on its assets. A bond is the same idea; governments traditionally issue bonds, and the two words are now used loosely for each other.

The chapter follows the life of a debenture: how it is issued, how interest is accounted for, how issue costs are written off, and how it is redeemed at the end.

Debentures versus shares

A shareholder is an owner who shares the risk. A debentureholder is a lender who must be paid before any shareholder, whatever the company earns. That is why interest is a charge against profit and not an appropriation of it.

Kinds of debentures

Beyond the textbook. For the exam: the rate of interest on a debenture is fixed by its coupon rate. In reality: the rate depends on how risky the lender thinks the company is. Credit rating agencies rate listed debentures, and a company with a higher rating can borrow at a lower rate. Why it matters: this is why two companies issuing debentures on the same day pay different interest, and why the coupon rate in a question is an agreed number and not a natural law.

Issue of debentures

Money is collected as for shares, in one payment or in instalments on application, allotment and calls. The company can issue a debenture at three prices.

Worked example: issuing 5,000 debentures of ₹100 at three prices. The debentures carry 12% interest and are redeemable at par.

Each entry balances. Common wrong entry. Crediting Debentures A/c with the amount received (₹4,75,000 in the second entry). The liability is always the face value, because that is what must be repaid. The discount is the cost of borrowing.

Redeemable at a premium: the Loss on Issue

Some debentures promise to repay more than the face value, say ₹107 for every ₹100. That extra ₹7 is a future cost of borrowing, and the company must record it on the day it borrows. It does so in two steps. First, it credits Premium on Redemption of Debentures A/c, a liability payable in future, shown under Long term Borrowings and not under Reserves. Second, it debits Loss on Issue of Debentures A/c with the same amount. If the debentures were also issued at a discount, the discount joins it.

$$\text{Loss on issue} = \text{Discount on issue} + \text{Premium on redemption}$$

So there are six combinations, and a simple rule decides which accounts appear.

The rule: if redemption is at a premium, the debit is Loss on Issue. If it is at par, the debit is Discount on Issue.

Worked example: discount and premium together. BrightPath issues 5,000 debentures of ₹100 at a 9% discount, redeemable at a 7% premium.

Debit side: 4,55,000 + 80,000 = ₹5,35,000. Credit side: 5,00,000 + 35,000 = ₹5,35,000. Common wrong entry. Debiting Discount on Issue of Debentures A/c with ₹45,000 and ignoring the premium on redemption. The moment redemption is at a premium, both go into Loss on Issue.

Pause and predict: Debentures of ₹100 are issued at par and redeemable at a 5% premium. Which account is debited besides Bank, and for how much per debenture?

Check your answer: Loss on Issue of Debentures A/c, ₹5 per debenture. There is no discount, so the loss equals the premium on redemption alone.

Writing off the loss

The discount or loss on issue is a capital loss. It is written off in a fixed order: first against the balance in Securities Premium Reserve (the Companies Act allows this), and then the rest from the Statement of Profit and Loss. Until it is written off it appears as an asset, under other current assets if it will be written off within 12 months and under other non current assets if after.

Worked example. Loss on Issue is ₹80,000 and Securities Premium Reserve has a balance of ₹50,000.

Common wrong step. Writing off against the Statement of Profit and Loss first. That charges profit unnecessarily, when a capital reserve stands ready to absorb a capital loss.

Premium on redemption: a liability, not a reserve

Students often file Premium on Redemption with the reserves because the word premium sounds like securities premium. It is the opposite. Securities Premium Reserve is money the company has already received and holds. Premium on Redemption is money the company will have to pay out. It is a liability, and it is paid at redemption.

Debentures for something other than cash

A company can pay a vendor with debentures. As with shares, the number of debentures depends on the issue price, not the face value.

$$\text{Number of debentures} = \dfrac{\text{Purchase consideration}}{\text{Issue price per debenture}}$$

Worked example: machinery bought for debentures. The company buys machinery for ₹2,88,000 and issues 12% debentures of ₹100 at a 4% discount.

Common wrong step. Dividing by the face value, which gives 2,880 debentures. The vendor accepts debentures worth ₹96 each, so more of them are needed.

When a business is bought, the assets and liabilities are taken over and the consideration is compared with the net assets. If the consideration is more, the excess is Goodwill. If it is less, the difference is Capital Reserve.

Worked example: a business bought, with debentures at a premium. A company takes over machinery of ₹4,00,000 and stock of ₹2,00,000, and assumes creditors of ₹80,000, for a consideration of ₹5,00,000. It is paid by 12% debentures of ₹100 at a 25% premium.

The first entry balances at ₹6,00,000 and the second at ₹5,00,000.

Collateral security

Sometimes a company takes a loan from a bank and, as an additional guarantee on top of its main security, issues debentures to the bank. These are collateral security. The bank can claim on them only if the company fails to repay the loan, and interest is paid on the loan, not on those debentures. There are two accepted ways to record them.

Interest on debentures

Interest is calculated on the face value at the coupon rate, whatever price the debenture was issued at. It is a charge against profit and is payable even if the company has a loss. The company deducts tax at source (TDS) at the prescribed rate and pays the balance to the debentureholders.

$$\text{Interest} = \text{Face value} \times \dfrac{\text{Rate}}{100} \times \dfrac{\text{Months}}{12}$$

Worked example. A company has 12% debentures of ₹5,00,000 (face value), issued at a discount of 5%. TDS is 10%.

Common wrong step. Calculating interest on the cash raised (₹4,75,000), which gives ₹57,000. The promise is on the face value.

Pause and predict: A company makes a loss in the year. Does it still pay the debenture interest?

Check your answer: Yes. Interest is a charge that must be paid whether or not there is a profit. A dividend, in contrast, can be paid only out of profit.

Beyond the textbook. For the exam: debentures are secured by a charge on assets, and the debentureholder is paid ahead of the shareholders. In reality: when debentures are offered to the public, a debenture trustee is appointed to protect the holders. The trustee holds the security and acts for the holders if the company defaults. Why it matters: thousands of small lenders cannot each chase the company, so the trustee is the link that makes the promise enforceable.

Redemption of debentures

Redemption means repaying the debentures. A company can do it in four ways.

Redemption can be made out of capital or out of profits, depending on the rules.

DRR and DRI. Two rules protect debentureholders. A Debenture Redemption Reserve is created out of profits, so that cash is not paid out as dividend when debentures are due.

Worked example: redeeming at a premium, in a lump sum. 5,000 debentures of ₹100 are redeemed at a 7% premium.

The premium of ₹35,000 is the same figure that was credited when the debentures were issued, so the liability now disappears.

Worked example: open market purchase. The company buys 1,000 of its own 12% debentures of ₹100 at ₹95 each and cancels them. Had it paid ₹105, the entry changes.

Common wrong step. Taking the profit on cancellation to General Reserve or to the Statement of Profit and Loss. It arises from a capital dealing, so it goes to Capital Reserve. If the debentures are held and not cancelled, they are shown as investment in own debentures.

Worked example: conversion into shares. Debentures of ₹2,40,000 are converted into equity shares of ₹10 issued at a 20% premium.

The entries are 12% Debentures A/c Dr ₹2,40,000, To Debentureholders A/c ₹2,40,000. Then Debentureholders A/c Dr ₹2,40,000, To Equity Share Capital A/c ₹2,00,000, To Securities Premium Reserve A/c ₹40,000. No cash moves.

If the issue of debentures attracts more applicants than offered, the company cannot allot more than it offered. Money on wholly rejected applications is refunded, and any excess on accepted ones is adjusted against allotment or calls.

Exam traps

Format and formula sheet

60-second revision

Where this chapter connects

Debentures are the borrowing side of company funding, and Accounting for Share Capital is the owners' side. Premium, discount, over subscription and non cash issue behave in the same way in both. The debenture balances appear in the balance sheet under long term borrowings, as set out in Financial Statements of a Company, and the interest cost and redemption payments appear in the Cash Flow Statement. A company with a lot of debentures will also show a high debt equity position in Accounting Ratios.