Debentures

Debentures

🟢 Lite — Quick Review (1h–1d)

Definition: A debenture is a document under the common seal of a company acknowledging a debt, specifying the repayment terms of principal and the rate of interest payable. It represents long-term borrowed capital, not equity.

Key Formulas:

• Issue at Par: Issue Price = Face Value
• Issue at Premium: Issue Price = Face Value + Premium Amount
• Issue at Discount: Issue Price = Face Value − Discount Amount
• Annual Interest = Face Value × Coupon Rate %

Classification Quick Reference:

Basis	Types
Redemption	Redeemable / Irredeemable
Convertibility	Convertible / Non-convertible
Security	Secured (fixed/floating charge) / Unsecured
Priority	First charge / Second charge

Exam High-Yield Pointers:

1. Debenture holders are creditors, not owners — they receive interest, not dividends.
2. Interest on debentures is a deductible expense for tax purposes; calculated on face value regardless of issue price.
3. Discount on issue is a capital loss recorded in the books immediately — not deferred as an asset under CA Foundation treatment.
4. For listed companies, Debenture Redemption Reserve (DRR) must be created before redemption (as per Section 71 of Companies Act 2013).

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🟡 Standard — Regular Study (2d–2mo)

Nature of Debentures

A debenture operates as a formal loan instrument. The company borrows funds from the public or institutional investors and promises to repay the principal on a specified redemption date, while paying periodic interest at the contracted coupon rate. Unlike share capital, debenture financing does not dilute ownership — debenture holders hold no voting rights and cannot claim residual assets on liquidation until all creditors are settled.

Types of Debentures

On the Basis of Redemption

• Redeemable Debentures: Repayable on a fixed future date or redeemable at company’s option after a lock-in period.
• Irredeemable (Perpetual) Debentures: No fixed redemption date; company is not obligated to repay except in winding up.

On the Basis of Convertibility

• Convertible Debentures: Holders have the option to convert into equity shares after a specified period.
• Non-Convertible Debentures (NCDs): Cannot be converted into equity; purely debt instruments.

On the Basis of Security

• Secured Debentures: Backed by a charge on company assets — either a fixed charge (on specific assets like land/buildings) or a floating charge (on current assets generally).
• Unsecured Debentures (Debenture Stock): No specific asset backing; rely on general creditworthiness.

Journal Entries at Issue

Transaction	Debit	Credit
Issued at par	Bank A/c	Debentureholders A/c
Issued at premium	Bank A/c	Debentureholders A/c (Face Value) / Security Premium Reserve A/c (Premium)
Issued at discount	Bank A/c / Discount on Issue A/c	Debentureholders A/c

Illustrative Entry — Issue at Discount: When 1,000 debentures of ₹100 each are issued at 10% discount:

• Bank A/c Dr: ₹90,000
• Discount on Issue A/c Dr: ₹10,000
• To Debentureholders A/c: ₹1,00,000

(Discount on Issue is treated as a capital loss and written off immediately or over the debenture life per company policy.)

Interest on Debentures

Interest accrues on the face value at the coupon rate stated in the debenture certificate, regardless of the issue price. It is paid half-yearly or annually as per terms.

Calculation: Annual Interest = Face Value of Debentures × Coupon Rate % For ₹5,00,000 debentures at 8% p.a.: Interest = ₹5,00,000 × 8% = ₹40,000 per year

Debenture Redemption Reserve (DRR)

Section 71 of the Companies Act 2013 mandates that listed companies must create a Debenture Redemption Reserve (DRR) equal to at least 25% of the value of outstanding non-convertible debentures before the due date of redemption. This reserve is a restriction on distributable profits and ensures funds are available for repayment.

Typical Exam Trap: Students often confuse DRR creation with the actual redemption transaction — DRR is a provision out of profits, not a cash set-aside.

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🔴 Extended — Deep Study (3mo+)

Effective Interest Rate vs Coupon Rate

When debentures are issued at a discount, the effective cost of borrowing exceeds the stated coupon rate. This is because the borrower receives less than face value but repays the full face value at redemption.

Formula for Effective Interest Rate: $$\text{Effective Interest Rate} = \frac{\text{Interest Amount} + \text{Discount Allowed}}{\text{Net Proceeds Received}} \times 100$$

Worked Example:

• Face Value: ₹1,00,000
• Issue Price: ₹90,000 (discounted ₹10,000)
• Coupon Rate: 10%
• Annual Interest: ₹10,000

$$\text{Effective Rate} = \frac{₹10,000 + ₹10,000}{₹90,000} \times 100 = 22.22%$$

This distinction is frequently examined in assertion-reasoning and numerical questions — ignoring the discount element when computing yield is a common error.

Collateral Security

Sometimes debentures are issued as collateral security for a loan taken from a bank or financial institution. In this arrangement:

• The debentures are issued to the lender as security.
• The lender holds the debenture certificates but cannot trade them.
• Interest may not be paid until the principal loan is repaid.
• If the loan defaults, the lender can realise the collateral.

Accounting Treatment: No entry is made when collateral debentures are lodged. If the borrower defaults and the lender exercises rights over the security, the debentures are transferred to the lender’s name at their nominal value.

Charge on Assets

A fixed charge attaches to specific, identifiable assets (land, machinery) and prevents the company from disposing of those assets without lender consent. A floating charge covers the general pool of current assets (stock, debtors, cash) — the company can use these assets in its ordinary course of business until an event of default crystallises the charge into a fixed charge.

Exam questions frequently test the distinction: “Which type of charge protects debenture holders more effectively?” The answer hinges on the nature of assets and crystallisation risk.

Redemption of Debentures

Debentures can be redeemed through:

1. Lump-sum repayment on maturity date.
2. Annual instalments (sinking fund method) — a portion retired each year, funded by annual transfers from profits to a Debenture Redemption Fund.
3. Purchase in the open market — when market price falls below face value, the company buys back debentures and cancels them.
4. Conversion — holders exercise conversion rights into equity shares.

Sinking Fund Method Journal:

• Each year: Profit & Loss Appropriation A/c Dr to Debenture Redemption Fund A/c
• On redemption: Debenture Redemption Fund A/c Dr to Bank A/c

Common Mistakes to Avoid

Error	Correct Treatment
Treating discount on issue as deferred expense	Discount is a capital loss; expensed immediately or over redemption period
Computing interest on net proceeds instead of face value	Interest always calculated on face value at coupon rate
Forgetting DRR when required	DRR mandatory for listed companies before redemption of NCDs
Confusing debenture holders with shareholders	Debenture holders are creditors; no ownership rights
Omitting premium payable on redemption in effective cost	Redemption premium increases true cost of borrowing

Adjacent Topic Connections

• Redemption and Sinking Fund: Links to accounting for provisions and fund-based reserves.
• Charge Creation and Book Debts: Connects to registration of charges under Companies Act 2013 (Section 77) — a compliance area tested in CA Foundation.
• Interest as Finance Cost: Connects to preparation of Statement of Profit and Loss under Schedule III.
• Debentures vs Bonds: Debentures are the UK/Indian corporate equivalent of bonds; the underlying mechanism is identical but terminology differs.

Practice Prompts

1. Numerical: A company issued 5,000, 12% debentures of ₹100 each at 95% on 1 January 2025. Interest is payable half-yearly on 30 June and 31 December. Show the journal entries for the first year and calculate the effective interest rate.

2. Conceptual: Distinguish between a fixed charge and a floating charge on assets, and explain the circumstances under which a floating charge crystallises into a fixed charge. How does this distinction affect the priority of debenture holders in a winding-up?

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