Unit 3: Issue of Debentures Chapter Notes | Accounting for CA Foundation PDF Download

Unit Overview

Introduction

• In the previous sections of this chapter, we explored how companies raise funds through share capital to finance their business activities. However, as corporate needs for expansion and growth continue to increase, relying solely on equity financing is no longer sufficient. 
• As a result, companies are turning to debt financing through various means. One common method is issuing debt instruments for public subscription. Debt financing not only helps reduce the cost of capital but also aids in designing an appropriate capital structure for the company. 
• Among the various debt instruments, debentures are widely used by companies to raise funds for their business activities. 

Meaning of Debentures

• Debentures are a common way for companies to raise additional capital. They can be either: 
• Simple (or Naked) Debentures. These do not carry any charge on the company’s assets. 
• Mortgage Debentures. These carry a charge on some or all of the company’s assets, which can be either fixed or floating. 
•  A debenture is essentially a bond issued by a company, under its seal, which acknowledges a debt. It outlines the terms for repaying the principal and interest. 
•  If a charge has been created on the company’s assets, the debenture will specify the nature of the charge and the assets involved. 
•  The charge must be registered with the Registrar for it to be valid, and the certificate of registration is printed on the bond. 
• Creation of a Trusteeship. It is customary to create a trusteeship in favor of one or more persons in the case of mortgage debentures. 
• Powers of Trustees. The trustees of debenture holders have all the powers of a mortgagee and can take necessary actions to safeguard the interests of debenture holders. 
• Legal Definition. According to Section 2 (30) of the Companies Act, 2013, debentures include debenture stock, bonds, or any other instrument evidencing a debt, regardless of whether it constitutes a charge on the company’s assets. 
• Types of Debentures. From the legal definition, it is clear that debentures can be secured or unsecured. 

Note: No company shall issue any debentures carrying any voting rights.

Features of Debentures

• Evidence of Loan:. debenture is a legal document that proves a loan has been made to a company. 
• Fixed Interest: Debentures are fixed interest-bearing securities, meaning the interest is paid on specific dates. 
• Predetermined Interest: The interest is payable at a predetermined fixed rate, regardless of the company's profit levels. 
• Repayment or Conversion: The original sum is either repaid at a specified future date or converted into shares or other debentures. 
• Security Charge: Debentures may or may not create a charge on the company's assets as security. 
• Market Trading: Debentures can generally be bought or sold through the stock exchange at a price above or below their face value. 

Note:. charge refers to an encumbrance to meet the obligation under the Trust Deed, where the company agrees to mortgage a specific portion of its assets, either by way of a first or second charge. This charge gives lenders the right to secure their payment from these assets or from the liquidator in the event of winding up, or from the company when the charge becomes void. 

Distinction Between Debentures and Shares

Types of Debentures

Debentures can be classified based on various factors such as security, convertibility, permanence, negotiability, and priority. Let's explore each type in detail:

Security
Secured Debentures. These debentures are backed by a charge on some or all of the company's assets. There are two types of charges: 

• Fixed Charge. This 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 used first to repay the debenture holders. 
• Floating Charge. This type of charge generally covers all the assets of the company, including future assets. 
• Unsecured or "Naked" Debentures. These debentures are not backed by any charge on assets. The company merely promises to pay interest on due dates and to repay the principal amount on the maturity date. These debentures are considered very risky from an investor's perspective. 

Convertibility

• Convertible Debentures. These debentures can be converted into equity shares (either at par, premium, or discount) after a certain period from the date of issuance. They may be fully or partly convertible, giving debenture holders the opportunity to become shareholders in the company in the future.
• Non-Convertible Debentures. These debentures cannot be converted into shares in the future. According to the terms of issuance, these debentures are repaid at maturity.

Permanence

• Redeemable Debentures. These debentures are repayable as per the terms of issuance, for example, after a specified period, such as 8 years from the date of issue.
• Irredeemable Debentures. Also known as perpetual debentures, these are not repayable during the lifetime of the company. They are repaid only at the time of liquidation.

Negotiability

• Registered Debentures. These debentures are payable to a registered holder whose name, address, and particulars of holding are recorded in the Register of Debenture holders. They are not easily transferable, and the provisions of the Companies Act, 2013 must be complied with for transferring these debentures. Debenture interest is paid either to the order of the registered holder or to the bearer of the interest coupons.
• Bearer Debentures. These debentures are transferable by delivery and are negotiable instruments payable to the bearer. The company does not keep a record of the holders of such debentures, and interest is paid to the holder irrespective of their identity. No transfer deed is required for transferring these debentures.

Priority

• First Mortgage Debentures. These debentures have the highest priority and are payable first out of the property charged.
• Second Mortgage Debentures. These debentures are payable after satisfying the claims of first mortgage debentures.

 Issue of Debentures

1. Debentures issued at par and redeemable at par or at a discount
2. Debentures issued at a discount and redeemable at par or at a discount
3. Debentures issued at a premium and redeemable at par or at a discount
4. Debentures issued at par and redeemable at a premium
5. Debentures issued at a discount and redeemable at a premium
6. Debentures issued at a premium and redeemable at a premium

Note: Redemption at a discount is a rare occurrence in practical scenarios.

Journal Entries for Each Case

1. Debentures Issued at Par and Redeemable at Par:

When debentures are issued at par, the issue price is equal to the par value. The following entries are recorded:

(a) For receipt of application money:

Bank A/c Dr.

To Debenture Application A/c

(b) For transfer of application money to debentures account:

Debenture Application A/c Dr.

To …% Debenture A/c

ILLUSTRATION 1
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.

SOLUTION

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 :

ILLUSTRATION 2
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.

SOLUTION

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. The utilisation of premium on debentures shall be based on the provisions of Section 52 of Companies Act, 2013,

ILLUSTRATION 3
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.

SOLUTION

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:

ILLUSTRATION 4
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.

SOLUTION

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.

Alternatively, the discount on issue of debentures can be combined with loss on issue of debentures A/c as both discount and premium on redemption represent loss to the company. In that case, the journal entry will be

Alternatively, the discount on issue of debentures can be combined with loss on issue of debentures A/c as both discount and premium on redemption represent loss to the company. In that case, the journal entry will be

ILLUSTRATION 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.

SOLUTION

Working Notes:

Amount of discount on issue = 150 Lakhs X ₹100 X 6% = ₹900 lakhs
Loss on issue of debentures = 150 Lakhs X ₹100 X 5% = ₹750 Lakhs

Alternatively, the discount on issue of debentures can be combined with loss on issue of debentures A/c as both discount and premium on redemption represent loss to the company. In that case, the journal entries will be

Working Notes :

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.

The Debenture Application A/c and Debenture allotment A/c are closed after the allotment of debentures. The net effect of the above 6 situations can be summarised as given below:

When the debentures are redeemed at a premium (as per terms and conditions of issue), the premium payable on redemption should be recognised at the time of issue of debenture itself considering the principle of conservatism or prudence.
This recognition involves loss on issue of debentures A/c (i.e. discount on issue of debentures) and Premium on redemption A/c.
*Alternatively, the discount on issue of debentures, can be combined with loss on issue of debentures A/c as both discount and redemption premium represent loss to the company.

Accounting for Debentures Payable in Installments 

Debentures Payable in Full on Application

• When the amount due on debentures is payable in full at the time of application, it is common 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 the money received from applicants for debentures. 
•  If an issue is oversubscribed, these accounts can also be used to record the refund of money to unsuccessful applicants. At the time of allotment of debentures, the amount in the Debentures Application Account is transferred to the respective Debentures Account. 

Debentures Issued at Par

•  Debentures issued at par are sold at the same price as their nominal value. For example, if a debenture with a nominal value of ₹100 is issued at par, the company receives ₹100. 

 The accounting entries for debentures issued at par are as follows: 

• When cash is received:
  Bank A/c Dr.
  To Debentures Application A/c
  (Being money received on debentures @ ₹….each) 

• When excess money is refunded or adjusted for future calls:
  Debentures Application A/c Dr.
  To Bank A/c (Amount refunded)
  To Debenture Allotment A/c (Amount adjusted for allotment)
  (Being excess money debentures adjusted as per Board’s Resolution No….dated…..) 

• When the debentures are allotted:
  Debentures Application A/c Dr.
  To % Debentures A/c
  (Being the allotment of debentures of ₹….each as per Board’s Resolution No….dated….) 

• On Allotment money being called:
  Debenture Allotment A/c Dr.
  To % Debentures A/c
  (Being Allotment Money Called) 

• On Allotment money being received:
  Bank A/c Dr.
  To Debenture Allotment A/c
  (Being Allotment money received) 

• On Debenture Call money being called:
  Debenture Calls A/c Dr.
  To % Debentures A/c
  (Being Call money made due) 

• On Debenture Call money being received:
  Bank A/c Dr.
  To Debenture Calls A/c
  (Being Call money received) 

ILLUSTRATION 6
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.

SOLUTION

Debentures Issued at a Premium

•  A company opts to issue debentures at a premium when the market interest rate is lower than the interest rate offered by the debentures. 
•  Debentures issued at a premium are sold at a price higher than their nominal value. For instance, if a debenture with a nominal value of ₹100 is issued at a 10% premium, the company receives ₹110. In this case, the investor receives slightly less interest than what is stated on the debenture. 
•  For example, consider 12% debentures with a nominal value of ₹100 issued at a 10% premium. The investor pays ₹110 and receives ₹12 per annum. The effective rate of interest on the investment is calculated as (12/110 x 100) = 10.91%. 
•  The premium received on debentures is credited to the Securities Premium Account. This is because debentures fall under the definition of “securities” as per clause (h) of section 2 of the Securities Contracts (Regulation) Act. Consequently, the utilization of debentures premium is governed by Section 52 of the Companies Act, 2013. 

Accounting Entries for Debentures Issued at a Premium

(a) When Cash is Received

• Bank Account Debit 
• To Debentures Application Account 

 (Being money received on debentures at ₹… each including a premium of ₹….) 

(b) When Excess Money is Refunded

• Debentures Application Account Debit 
• To Bank Account 

(Being refund of money on debentures at ₹… each, as per Board’s Resolution No… dated….) 

(c) When the Debentures are Allotted

• Debentures Application Account Debit 
• To Debentures Account 
• To Securities Premium Account 

(Being the allotment of debentures, with premium transferred to Securities Premium Account, as per Board’s Resolution No… dated….) 

Debentures Issued at a Discount

• The Companies Act does not limit the price at which debentures can be issued. Unlike shares, there is no restriction on the discount for issuing debentures.
• As a result, it is common for debentures to be issued at a discount, meaning they are sold for less than their nominal value. For instance, if a debenture with a nominal value of ₹100 is issued at a 10% discount, the company receives ₹90.
• Issuing debentures at a discount slightly increases the effective interest rate. For example, consider 12% debentures with a nominal value of ₹100 issued at a 10% discount. The company receives ₹90 and pays ₹12 in interest, resulting in a true interest rate of (12/90 x 100) = 13.33%.
• Companies issue debentures at a discount when the market interest rate exceeds the debenture interest rate. When recording this transaction, the Debentures Account is credited with the nominal value, and the difference between the nominal value and cash received is recorded as “Discount on Issue of Debentures.”
• This discount is typically amortized over the period of benefit, usually 3 to 5 years, but cannot exceed the tenure of the debentures.
• The accounting entries for issuing debentures at a discount include recording cash received, refunding excess money, and allotting debentures with appropriate adjustments for discount and nominal value.
• The discount on issue of debentures is considered an incremental interest expense. The true net borrowing cost for an accounting period includes total interest payments and amortized discount.

(a) When Cash is received

Bank A/c Dr. [Actual cash received]

To Debentures Application A/c

(Being money received on….debentures @` ……each)

(b) When excess money is refunded

Debentures Application A/c Dr.

To Bank A/c

(Being excess money on…debentures refunded as per Board’s Resolution No…..dated….)

(c) When the debentures are allotted

Debentures Application A/c Dr. [Actual cash received] 

Discount on Issue of Debentures A/c

To% Debentures A/c

Dr. [Discount on debentures]

[Nominal value of debentures]

(Being the allotment of…debentures of ` ….each @ ` …..each as per Board’s Resolution No…..dated…) 

ILLUSTRATION 7
X Ltd. issued 1,00,000 12% Debentures of ₹100 each at a discount of 10% payable in full on application by 31st May, 2022. Applications were received for 1,20,000 debentures. Debentures were allotted on 9th June, 2022. Excess money was refunded on the same date. Pass necessary Journal Entries. Also show necessary ledger accounts.

SOLUTION

Issue of Debentures as Collateral Security

• Collateral Security: Collateral security refers to secondary or supporting security for a loan. It is an arrangement where the borrower agrees to provide a specific asset or a group of assets as security, which the lender can realize if the original loan is not repaid on time.
• Debentures as Collateral: Companies sometimes issue their own debentures as collateral security for a loan or a fluctuating overdraft. When the loan is repaid on time, these debentures are released along with the main security. If the company fails to repay the loan and interest on the due date, the lender becomes the debenture holder and can exercise all the rights of a debenture holder.
• Interest Entitlement: In such cases, the holder of the debentures is entitled to interest only on the amount of the loan, not on the debentures themselves.

Accounting Entries

Method 1

 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. 

ILLUSTRATION 8
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.

SOLUTION

In the Notes to Accounts of Balance Sheet of X Ltd., it is shown as follows:

Method 2

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.

ILLUSTRATION 9
Taking the same information of the illustration 8, the entry on issue will be as follows :

Issue of Debentures in Consideration Other Than for Cash

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:-

ILLUSTRATION 10
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.

SOLUTION

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 due to the fact that the debentures being issued as collateral security and outstanding are shown under the respective liability.

Treatment of Discount/Loss on Issue of Debentures

• The discount on the issue of debentures is amortized over the period between the issuance date and the redemption date.
• The treatment depends on the terms of redemption:

(a) For Debentures Redeemable After a Certain Period (e.g., 5 Years):

• The total discount should be written off equally over the life of the debentures using the straight-line method.
• This method spreads the burden of the discount evenly over the years.

(b) For Debentures Redeemable at Different Dates:

• The total discount should be written off in the ratio of the debenture amount outstanding in each year.
• This method is suitable for debentures redeemed by unequal instalments.

Accounting Entries:

• Profit and Loss Account
• Debit: Discount on Issue of Debentures Account
• (Being the amount of discount on issue of debentures written off)

Loss on Issue of Debentures:

• Loss on the issue of debentures is a capital loss and should be written off in a similar manner as the discount on debentures issued.
• In the balance sheet, both items (Discount and Loss) are shown as Non-current or Current assets depending on the period for which they have to be written off.

Accounting Standard 16 Borrowing Costs

• Discounts or premiums related to borrowings can be amortized over the loan period.
• Share issue expenses, discounts on shares, and ancillary costs are excluded from the scope of Accounting Standard 26 Intangible Assets.
• Amortizing these expenses over the period of benefit, typically 3 to 5 years, is generally accepted.

ILLUSTRATION 11
HDC Ltd issues 1,00,000, 12% Debentures of ₹ 100 each at ₹ 94 on 1st January, 2022. 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.

SOLUTION

Total amount of discount comes to ₹ 6,00,000 (₹6 X 1,00,000). The amount of discount to be written-off in each year is calculated as under :

ILLUSTRATION 12
HDC Ltd. issues 2,00,000, 12% Debentures of ₹10 each at ₹9.40 on 1st January, 2022. Under the terms of issue, 1/5th of the debentures are annually redeemable by drawings, the first redemption occurring on 31st December, 2022. Calculate the amount of discount to be written-off from 2022 to 2026.

SOLUTION

 Interest on Debentures 

• Interest on Coupon Debentures: Interest on coupon debentures is considered a charge against the company's profits. 
• Payment and Calculation: Interest is paid periodically and calculated at the coupon rate on the nominal value of the debentures. 
• Tax Deduction: The company pays interest net of tax to debenture holders because it is obligated to deduct tax at source according to the Income Tax Act of 1961. The deducted tax is deposited with the income tax authorities. 

Accounting Entries for Interest on Debentures
For Making Interest Due:

1.  Interest A/c Dr. 
2.  To Debenture Holders’ A/c 

For Payment of Interest and Deduction of Tax at Source (TDS):

1.  Debenture Holders A/c Dr. 
2.  To TDS Payable A/c 
3.  To Bank A/c 

For Payment of Tax Deducted at Source:

1.  TDS Payable A/c Dr. 
2.  To Bank A/c 

For Transferring Interest to Profit and Loss Account:

1.  Profit and Loss A/c Dr. 
2.  To Interest A/c 

ILLUSTRATION 13
A company issued 12% debentures of the face value of ₹10,00,000 at 10% discount on 1-1-2022. 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 2022.

SOLUTION