Issue of Debentures — Study Notes

1. Introduction

A debenture is a written instrument acknowledging a debt taken by a company from the public. Debenture holders are the creditors of the company, not its owners. They are entitled to a fixed rate of interest irrespective of the company's profits, and their claim is prior to that of shareholders. Debentures may be issued at par, at a premium, or at a discount, and they may be redeemable after a fixed period or irredeemable.

Debentures can be issued for cash, as consideration for the purchase of assets, or as collateral security for a loan. Debentures may also be issued with or without a specific charge on the assets of the company, giving rise to secured and unsecured debentures. The terms of issue, including the rate of interest, the redemption date, and the security, are stated in the debenture trust deed.

The accounting for the issue of debentures involves recording the amount received, the treatment of premium and discount on issue, the accounting for debentures issued as collateral, and the presentation of debenture interest in the accounts. The chapter also covers the distinction between debentures and shares, and the conditions under which debentures may be issued at a discount under the Companies Act.

2. Types of Debentures

Debentures may be classified on several bases:

1. On the basis of security: Secured debentures (backed by a charge on assets) and unsecured debentures (naked or plain debentures).
2. On the basis of redemption: Redeemable debentures (redeemable after a specified period) and irredeemable (perpetual) debentures.
3. On the basis of convertibility: Convertible debentures (convertible into equity shares) and non-convertible debentures.
4. On the basis of registration: Registered debentures and bearer debentures.
5. On the basis of priority: First mortgage debentures and second mortgage debentures.

3. Distinction Between Shares and Debentures

Shares represent ownership capital, while debentures represent loan capital. Shareholders are owners and vote in general meetings; debenture holders are creditors and generally do not vote. Dividend on shares is paid only when profits exist, while interest on debentures is a charge and is paid irrespective of profits. Shareholders are paid last on winding up; debenture holders are paid before shareholders.

4. Issue of Debentures for Cash

4.1 Issue at Par

When debentures are issued at par, the issue price equals the face value. The journal entry is:

Bank A/c Dr.
    To Debentures A/c

4.2 Issue at Premium

When the issue price is more than the face value, the excess is credited to the Debenture Premium (Premium on Issue of Debentures) Account, which is a capital profit:

Bank A/c Dr. (total amount)
    To Debentures A/c (face value)
    To Premium on Issue of Debentures A/c (premium)

4.3 Issue at Discount

When the issue price is less than the face value, the discount is debited to the Discount on Issue of Debentures Account, which is a capital loss written off over the life of the debentures:

Bank A/c Dr. (issue price)
Discount on Issue of Debentures A/c Dr.
    To Debentures A/c (face value)

5. Issue of Debentures for Consideration Other Than Cash

Debentures are sometimes issued as consideration for the purchase of fixed assets or a business. In such a case, the asset or the purchase consideration is debited and the Debentures Account is credited:

Sundry Assets A/c Dr.
    To Vendor A/c

Vendor A/c Dr.
    To Debentures A/c

6. Issue of Debentures as Collateral Security

Collateral security is an additional security offered for a loan. When debentures are issued as collateral, no entry is needed if the loan is repaid on time. If the debentures are to be shown in the books, a journal entry is passed and a disclosure is made in the notes. The two methods are:

Method 1: No entry passed

The debentures are merely recorded in a memorandum and disclosed in the notes to accounts.

Method 2: Entry passed

Debentures Suspense A/c Dr.
    To Debentures A/c

On repayment of the loan, the Debentures Suspense Account is credited and the Debentures Account is debited.

7. Interest on Debentures

Interest on debentures is paid at a fixed rate. The company deducts tax at source (TDS) on the interest paid. The accounting treatment involves the Interest on Debentures Account, which is a nominal account debited with the gross interest, with the tax deducted credited to the TDS payable account.

$$\text{Interest on Debentures} = \text{Debentures Outstanding} \times \frac{\text{Rate}}{100}$$

8. Conditions for Issue of Debentures at Discount

Under Section 53 of the Companies Act, 2013, debentures cannot be issued at a discount except as prescribed, and if issued, the amount of discount is not allowed to be written off immediately but is shown as a capital loss. Discount on issue of debentures is shown on the asset side of the Balance Sheet as a deferred charge and written off over the life of the debentures.

Quick Revision Tables

Table 1: Issue of Debentures - Journal Summaries

Table 2: Shares vs Debentures

Table 3: Types of Debentures

Mind Map

Important Diagrams (SVG)

Diagram 1: Modes of Issue of Debentures

Diagram 2: Debentures as Collateral Security - Two Methods

Common Mistakes

1. Crediting the full amount received to the Debentures Account when debentures are issued at a premium; the premium must be credited separately.
2. Forgetting to write off the discount on issue of debentures over the life of the debentures.
3. Confusing debenture holders with shareholders; they are creditors, not owners.
4. Recording interest on debentures as an appropriation instead of a charge against profit.
5. Ignoring TDS while recording the payment of interest on debentures.
6. Treating premium on the issue of debentures as revenue profit; it is a capital profit.
7. Failing to reverse the Debentures Suspense Account entry when the loan is repaid.

Exam Tips

1. Distinguish clearly between premium and discount on issue; the premium is capital profit and the discount is capital loss.
2. When debentures are issued at a discount, remember the discount is a deferred charge written off over the redemption period.
3. Practise questions on debentures issued for consideration other than cash, where the vendor account is settled with debentures.
4. For collateral security, use the no-entry method unless the question explicitly asks for the entry to be passed.
5. Calculate interest on debentures on the face value, not the issue price.
6. Show the notes to accounts properly for debentures issued as collateral security.
7. Remember that convertible debentures may be converted into shares at the option of the holder or the company.

Conclusion

Debentures are an important source of long-term loan capital for companies. The issue of debentures at par, at a premium, or at a discount, and the issue for consideration other than cash, are the main accounting events in this chapter. Understanding the distinction between shares and debentures, the treatment of premium and discount, and the accounting for debentures issued as collateral security is essential. The concepts of interest and its tax treatment set the stage for the next chapter, which deals with the redemption of debentures and the creation of debenture redemption reserve.