In the earlier units of this chapter, we have studied the issue of share capital as a means of raising funds for financing the business activities. But with increasing and ever growing needs of the corporate expansion and growth, equity source of financing is not suffcient. Hence corporates turn to debt financing through various means. Issuing debt instruments by offering the same for public subscription is one of the sources of financing the business activities. Debt financing does not only helps in reducing the cost of the capital but also helps in designing appropriate capital structure of the company. Debenture is one of the most commonly used debt instrument issued by the company to raise funds for the business.
The most common method of supplementing the capital available to a company is to issue debentures which may either be simple or naked carrying no charge on assets, or mortgage debentures carrying either a fixed or a floating charge on some or all of the assets of the company.
A debenture is a bond issued by a company under its seal, acknowledging a debt and containing provisions as regards repayment of the principal and interest. If a charge* has been created on any or on the entire assets of the company, the nature of the charge and the assets charged are described therein. Since the charge is not valid unless registered with the Registrar, and the certificate registering the charge is printed on the bond. It is also customary to create a trusteeship in favour of one or more persons in the case of mortgage debentures. The trustees of debenture holders have all powers of a mortgage of a property and can act in whatever way they think necessary to safeguard the interest of debenture holders.
Section 2 (30) of the Companies Act, 2013 defines debentures as “Debenture” includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.
Thus, It is clear from definition that debenture may be Secured Debenture or Unsecured Debenture.
Note: No company shall issue any debentures carrying any voting rights.
3.3 FEATURES OF DEBENTURES
1. It is a document which evidences a loan made to a company.
2. It is a fixed interest-bearing security where interest falls due on specific dates.
3. Interest is payable at a predetermined fixed rate, regardless of the level of profit.
4. The original sum is repaid at a specified future date or it is converted into shares or other debentures.
5. It may or may not create a charge on the assets of a company as security.
6. It can generally be bought or sold through the stock exchange at a price above or below its face value.
3.4 DISTINCTION BETWEEN DEBENTURES AND SHARES
|1. Debenture holders are the creditors of the company.||1. Shareholders are the owners of the company.|
|2. Debenture holders have no voting rights and consequently do not pose any threat to the existing control of the company.||2. Shareholders have voting rights and consequently control the total aairs of the company.|
|3. Debenture interest is paid at a pre- determined fixed rate. It is payable, whether there is any profit or not. Debentures rank ahead of all types of shares for payment of the interest due on them.||3. Dividend on equity shares is paid at a variable rate which is vastly affected by the profits of the company (however, dividend on preference shares is paid at a fixed rate).|
|4. Interest on debentures are the charges against profits and they are deductible as an expense in determining taxable profit of the company.||4. Dividends are appropriation of profits and these are not deductible in determining taxable profit of the company.|
|5. There are different kinds of debentures, such as Secured/Unsecured; Redeemable/ Irredeemable; Registered/Bearer; Convertible / Non-convertible, etc.||5. There are only two kinds of shares–Equity Shares and Preference Shares.|
|6. In the Company’s Balance Sheet, Debentures are shown under “Long Term Borrowings”.||6. In the Company’s Balance Sheet, shares are shown under “Shareholder’s Fund” detailed in ‘Share Capital’ of Notes to Accounts.|
|7. Debentures can be converted into other debentures or shares as per the terms of issue of debentures.||7. Shares cannot be converted into other shares in any circumstances.|
|8. Debentures cannot be forfeited for non-payment of call moneys.||8. Shares can be forfeited for non-payment of allotment and call moneys.|
|9. At maturity, debenture holders get back their money as per the terms and conditions of redemption.||9. Equity shareholders cannot get back their money before the liquidation of the company (however, preference shareholders can get back their money before liquidation).|
|10. At the time of liquidation, debenture holders are paid-of before the shareholders.||10. At the time of liquidation shareholders are paid at last, after paying debenture holders, Trade payable, etc.|
3.5 TYPES OF DEBENTURES
The following are the types of debentures issued by a company. They can be classified on the basis of: (1) Security; (2) Convertibility; (3) Permanence; (4) Negotiability; and (5) Priority.
(a) Secured Debentures: These debentures are secured by a charge upon some or all assets of the company. There are two types of charges:
(i) Fixed charge; and (ii) Floating charge. A fixed charge is a mortgage on specific assets. These assets cannot be sold without the consent of the debenture holders. The sale proceeds of these assets are utilized first for repaying debenture holders. A floating charge generally covers all the assets of the company including future one.
(b) Unsecured or “Naked” Debentures: These debentures are not secured by any charge upon any assets. A company merely promises to pay interest on due dates and to repay the amount due on maturity date. These types of debentures are very risky from the view point of investors.
(a) Convertible Debentures: These are debentures which will be converted into equity shares (either at par or premium or discount) after a certain period of time from the date of its issue. These debentures may be fully or partly convertible. In future, these debenture holders get a chance to become the shareholders of the company.
(b) Non-Convertible Debentures: These are debentures which cannot be converted into shares in future. As per the terms of issue, these debentures are repaid.
(a) Redeemable Debentures: These debentures are repayable as per the terms of issue, for example, after 8 years from the date of issue.
(b) Irredeemable Debentures: These debentures are not repayable during the life time of the company. These are also called perpetual debentures. These are repaid only at the time of liquidation.
(a) Registered Debentures: These debentures are payable to a registered holder whose name, address and particulars of holding is recorded in the Register of Debenture holders. They are not easily transferable. The provisions of the Companies Act, 2013 are to be complied with for effecting transfer of these debentures. Debenture interest is paid either to the order of registered holder as expressed in the warrant issued by the company or the bearer of the interest coupons.
(b) Bearer Debentures: These debentures are transferable by delivery. These are negotiable instruments payable to the bearer. No kind of record is kept by the company in respect of the holders of such debentures. Therefore, the interest on it is paid to the holder irrespective of any identity. No transfer deed is required for transfer of such debentures.
(a) First Mortgage Debentures: These debentures are payable first out of the property charged.
(b) Second Mortgage Debentures: These debentures are payable after satisfying the first mortgage debentures.
3.6 ISSUE OF DEBENTURES
3.6.1 Accounting entries for issue of redeemable debentures
The issue of redeemable debentures can be categorized into the following:
1. Debentures issued at a par and redeemable at par or at a discount;
2. Debentures issued at a discount and redeemable at par or at discount;
3. Debentures issued at premium and redeemable at par or at discount;
4. Debentures issued at par and redeemable at premium;
5. Debentures issued at a discount and redeemable at premium.
6. Debentures issued at premium and redeemable at premium.
Note: Redemption at a discount may be a rare circumstance in practical life.
Journal entries in each of the above cases are discussed below:
1. Debentures issued at par redeemable at par: When debenture are issued at par, the issue price is equal to par value, in this regard the following entries are recorded:
Amol Ltd. issued 40,00,000, 9% debentures of ₹50 each, payable on application as per term mentioned in the prospectus and redeemable at par any time after 3 years from the date of issue. Record necessary entries for issue of debentures in the books of Amol Ltd.
2. Debentures issued at Discount and Redeemable at par or at discount: When debentures are issued at discount, issue price will be less than par value. The difference between the two is considered as loss on issue on debentures and is to be written-off over the life of debentures. The entries with regards to issue are given below:
Atul Ltd. issued 1,00,00,000, 8% debenture of ₹100 each at a discount of 10% redeemable at par at the end of 10th year. Money was payable as follows:
₹30 on application
₹60 on allotment
Record necessary journal entries regarding issue of debenture.
3. Debentures Issued at Premium and Redeemable at par or at discount
When debenture are issued at premium, the issue price is more than the par value. The premium is transferred to securities premium account. In this regard, the following journal entries are recorded:
When premium amount is received at the time of application;
When debentures are issued at par or premium value but redeemed at discount, then it means that the company will gain by paying less. This gain will not be recognised in the books at the time of issue of debentures as per the conservatism concept.
Koinal Chemicals Ltd. issued 15,00,000, 10% debenture of ₹50 each at premium of 10%, payable as ₹20 on application and balance on allotment. Debentures are redeemable at par after 6 years. All the money due on allotment was called up and received. Record necessary entries when premium money is included in application money
4. Debentures issued at par and redeemable at a premium
Where debentures are to be redeemed at premium, an extra entry is to be made at the time of issue and allotment of debentures. This extra entry is to be passed for providing premium payable on redemption. Debenture Redemption Premium Account is a personal account which represents a liability of the company in respect of premium payable on redemption.
In this case, the issue price is same as par value but the redemption value is more than the par value, therefore redemption premium is recorded as a loss on issue of debentures at the time of allotment of debentures. Following journal entries are recorded in this regard:
Modern Equipments Ltd. issued 4,00,000, 12% debentures of ₹ 100 payable as follows:
On application ₹30
On allotment ₹70
The debenture were fully subscribed and all the money was duly received. As per the terms of issue, debentures are redeemable at ₹110 per debenture. Record necessary entries regarding issue of debentures.
5. Debentures Issued at discount and redeemable at premium
In this situation the issue price is less than par value but redemption value is more than par value. The difference between the redemption price and the issue price is treated as discount/loss on issue of debentures. Suppose, a 10% debentures of ₹1,000 is issued at a discount of ₹100 and redeemable at a premium of `5 per debenture, the amount of loss will be equal to ₹1,005 – ₹900 = ₹105. This is to be treated as loss on issue. It is to be noted that premium on redemption of debentures is also credited by ₹5.
Agrotech Ltd. issued 150 lakh 9% debentures of ₹100 each at a discount of 6%, redeemable at a premium of 5% after 3 years payable as : ₹50 on application and ₹44 on allotment. Record necessary journal entries for issue of debentures.
Loss on issue of debentures =(Amount of discount on issue + Premium payable on redemption) x No. of Debentures
= (6% of ₹100 + 5% of ₹100) x 150 lakh
= (₹6 + ₹ 5) x 150 lakh
= ₹1,650 lakh
6. Debentures Issued at premium and redeemable at premium
In this situation, the issue price is more than par value and also redemption value is more than par value. The premium received at the time of issue of debentures is credited to Securities premium account and premium paid at the time of redemption is a loss to be provided at the time of issue of debentures. Suppose, a 10% debenture of ₹1,000 is issued at a premium of ₹100 and redeemable at a premium of ₹50 per debenture. In the given case ₹100 is to be credited to Securities premium account and ₹50 will be the loss to be provided at the time of issue of debentures. It is to be noted that premium on redemption of debentures is also credited by ₹50.
3.6.2 Accounting for issue of debentures payable in instalments
Just like shares, money payable on debentures may be paid either in full with application or by instalments. Accounting entries will differ to some extent in either case.
18.104.22.168 Debentures Payable in Full on Application
Where the amount due on debentures are payable in full on application, it is usual to open a separate Debentures Application Account for each class of debentures, such as 10% Debentures Application Account or 12% Debentures Application Account. These accounts record moneys received from the applicants of debentures. If an issue is over-subscribed, these accounts can be used to record the refund of moneys to the unsuccessful applicants. At the time of allotment of debentures, the amount in Debentures Application Account is transferred to the respective Debentures Account.
As discussed above, debentures may be issued at par, at a premium, or at a discount.
22.214.171.124 Debentures Issued at Par
The debentures which are issued at par are issued at the same price as their nominal value; that is, if a debenture with a nominal value of ₹ 100 is issued at par, the company receives ₹100.
The accounting entries would be as follows:
Simmons Ltd. issued 1,00,000, 12% Debentures of ₹100 each at par payable in full on application by 1st April, Application were received for 1,10,000 Debentures. Debentures were allotted on 7th April. Excess money refunded on the same date.
You are required to pass necessary Journal Entries (including cash transactions) in the books of the company.
126.96.36.199 Debentures Issued at a Premium
A company issues debentures at a premium when the market rate of interest is lower than the debentures interest rate. The debentures, which are issued at a premium, are issued at a higher price than their nominal value; that is, if a debenture with a nominal value of ₹ 100 is issued at 10% premium, the company receives at ₹110 where the investor gets slightly less interest than stated in the debenture. For example, 12% Debentures of ₹100 issued at a premium of 10%. The investor will get ₹12 p.a. for his investment of 110. Therefore, the effective rate of interest on investment is (12/110x 100) = 10.91%.
The premium on debentures is credited to ‘Securities Premium Account’ as ‘Debentures’ are covered in the definition of ‘securities’ specified in the clause (h) of section 2 of the Securities Contracts (Regulation) Act. Therefore, restriction of utilization of debentures (securities) premium will also be governed by Section 52 of the Companies Act, 2013.
The accounting entries would be as follows:
188.8.131.52 Debentures Issued at a Discount
The Companies Act does not impose any restriction on the price at which debentures can be issued. Unlike shares, there is no limit for discount on issue of debentures. This is why it is very common for debentures to be issued at a discount. The debentures which are issued at a discount are issued at a lower price than nominal value, that is, if a debenture with a nominal value of ₹100 is issued at 10% discount, the company receives ₹90 only. The issue of debentures at a discount slightly increases the true rate of interest payable. For example, 12% Debentures of ₹100 issued at a discount of 10%. The Company will have to pay ₹12 for a loan of ₹90. Therefore, the true rate of interest is (12/90 x 100) = 13.33%.
The company issues debentures at a discount when the market rate of interest is higher than the debenture interest rate. Like shares, Debentures Account is credited with the nominal value. The difference between the nominal value of debentures and cash received is transferred to “Discount on Issue of Debentures Account. In the subsequent years, Discount on Issue of Debentures is written-off proportionately by charging to the Statement of Profit and Loss. It is considered a normal practice to amortize discount on issue of debentures over the period of benefit, i.e., normally 3 to 5 years.
In fact, the discount on issue of debentures is considered as incremental interest expense. The true expense (net borrowing cost) for a particular accounting period is, therefore, the total interest payment plus the discount written off.
X Ltd. issued 1,00,000 12% Debentures of ₹100 each at a discount of 10% payable in full on application by 31st May, 2017. Applications were received for 1,20,000 debentures. Debentures were allotted on 9th June, 2017. Excess monies were refunded on the same date. Pass necessary Journal Entries. Also show necessary ledger accounts.
3.7 ISSUE OF DEBENTURES AS COLLATERAL SECURITY
Collateral security means secondary or supporting security for a loan, which can be realised by the lender in the event of the original loan not being repaid on the due date. Under this arrangement, the borrower agrees that a particular asset or a group of assets will be realized and the proceeds there from will be applied to repay the loan in the event that the amount due, cannot be paid.
Sometimes companies issue their own debentures as collateral security for a loan or a fluctuating overdraft. When the loan is repaid on the due date, these debentures are at once released with the main security. In case, the company cannot repay its loan and the interest thereon on the due date, the lender becomes the debenture holder who can exercise all the rights of a debenture holder.
The holder of such debentures is entitled to interest only on the amount of loan, but not on the debentures.
There are two methods of showing these types of debentures in the accounts of a company.
Under this method, no entry is made in the books of account of the company at the time of making issue of such debentures. In the ‘Notes to Accounts’ of Balance Sheet, the fact of the debentures being issued and outstanding is shown by a note under the liability secured.
X Ltd. obtains a loan from IDBI of ₹1,00,00,000, giving as collateral security of ₹1,50,00,000 (of ₹ 10 each), 14%, First Mortgage Debentures.
In the Notes to Accounts of Balance Sheet of X Ltd., it is shown as follows:
Under this method, the following entry is made to record the issue of such debentures:
The Debentures Suspense Account will appear on the assets side of the Balance Sheet under Other Non- Current Assets and Debentures on the liabilities side of the Balance Sheet. When the loan is repaid, the entry is reversed in order to cancel it.
Taking the same information of the illustration 8, the entry on issue will be as follows:
Students should note that the Method 1 is much more logical from the accounting point of view. Therefore, it is advised to follow Method 1.
3.8 ISSUE OF DEBENTURES IN CONSIDERATION OTHER THAN FOR CASH
Just like shares, debentures can also be issued for consideration other than for cash, such as for purchase of land, machinery, etc. In this case, the following entries are passed:
Further it should be noted that these debentures can be issued at par, premium and at discount. In each case the second entry for issue of debentures would be done accordingly. Number of debentures to be issued is calculated as follows:-
X Company Limited issued 10,000 14% Debentures of the nominal value of ₹50,00,000 as follows:
(a) To sundry persons for cash at 90% of nominal value of ₹25,00,000.
(b) To a vendor for purchase of fixed assets worth ₹10,00,000 – ₹12,50,000 nominal value.
(c) To the banker as collateral security for a loan of ₹10,00,000 – ₹12,50,000 nominal value.
Pass necessary Journal Entries.
Note: No entry is made in the books of account of the company at the time of making issue of such debentures. In the Balance Sheet the fact that the debentures being issued as collateral security and outstanding are shown under the respective liability.
3.9 TREATMENT OF DISCOUNT/LOSS ON ISSUE OF DEBENTURES
The discount on issue of debentures is amortised over a period between the issuance date and redemption date. It should be written-off in the following manner depending upon the terms of redemption:
(a) If the debentures are redeemable after a certain period of time, say at the end of 5 years, the total amount of discount should be written-off equally throughout the life of the debentures (applying the straight line method). The main advantage of this method is that it spreads the burden of discount equally over the years.
(b) If the debentures are redeemable at different dates, the total amount of discount should be written-off in the ratio of benefit derived from debenture loan in any particular year (applying the sum of the year’s digit method). This method is suitable when debentures are redeemed by unequal instalments.
Loss on issue of debentures is also a capital loss and should be written off in a similar manner as discount on debentures issued. In the balance sheet both the items (Discount and Loss) are shown as Non-current/ current assets depending upon the period for which it has to be written off.
HDC Ltd issues 1,00,000, 12% Debentures of ₹100 each at ₹94 on 1st January, 2017. Under the terms of issue, the debentures are redeemable at the end of 5 years from the date of the issue. Calculate the amount of discount to be written-off in each of the 5 years.
HDC Ltd. issues 2,00,000, 12% Debentures of ₹10 each at ₹9.40 on 1st January, 2010. Under the terms of issue, 1/5th of the debentures are annually redeemable by drawings, the first redemption occurring on 31st December, 2010. Calculate the amount of discount to be written-off from 2010 to 2014.
3.10 INTEREST ON DEBENTURES
Interest payable on coupon debenture is treated as a charge against the profits of the company. Interest on debenture is paid periodically and is calculated at coupon rate on the nominal value of debentures. The company will pay interest net of tax to the debenture holders because the company is under obligation to deduct tax at source at the rates applicable under tax rules from time to time. The companies will deposit the tax so deducted with income tax authorities. Following accounting entries are to be recorded in this regard:
A company issued 12% debentures of the face value of ₹10,00,000 at 10% discount on 1-1-2017. Debenture interest after deducting tax at source @ 10% was payable on 30th June and 31st of December every year. All the debentures were to be redeemed after the expiry of five year period at 5% premium.
Pass journal entries for the accounting year 2017.