MCom I Semester Corporate Accounting Redemption Debentures Study Material notes

MCom I Semester Corporate Accounting Redemption Debentures Study Material notes: Methods of Redemption of Debentures Mobilisation fo Funds for Redemption of  Debentures Journal Entries Table  A , B Ledger Accounts Debentureholder Account Discount on Issue of Debentures Account Cumulative Sinking Fund Insurance Policy Method

CTET Paper Level 2 Set X Model Paper Multiple Questions Answer in English

Redemption of Debentures

Redemption of debentures refers to the discharge of the liability in respect of the debentures issued by a company. From a redemption point of view, debentures are divided into two categories – redeemable and irredeemable. While irredeemable debentures are perpetual in nature and are not redeemed during the lifetime of the company whereas redeemable debentures can be redeemed at any time according to the terms of the issue without complying with any legal formalities.

Redemption Debentures Study Material

SEBI Guidelines for the Protection of Interest of Debenture holders

In 1982, SEBI issued guidelines to protect the interest of debenture holders, which were revised from time to time till 2000. The main points of guidelines are as follows:

1 Purpose of Debenture Issue : Companies can issue debentures for any purpose. However, debentures issued by a company for financing replenishing funds or acquiring shareholding of other companies in the same group is not permitted. This restriction is not applicable to the issue of equity shares for this purpose or to the issue of fully convertible debentures providing conversion within a period of 18 months.

2. Issue of Fully Convertible Debentures (FCDs) within a period of more than 36 months : For such issues, the conversion is to be made optional with “put and call’ option.

3. Compulsory Credit Rating : The company should obtain credit rating from CRISIL or any other recognized credit rating agency if conversion of FCDs is after 18 months or the maturity period of NCDs / PCDs exceeds 18 months.

4. Pre-determination of Premium on Conversion and Time of Conversion : The premium on conversion of FCDs and PCDs and the time of conversion is to be pre-determined and stated in the prospectus.

5. Interest Rate : The interest rate is freely determinable.

6. Appointment of Debenture Trustees : In case of debentures with maturity period more than 18 months, the names of debenture trustees must be stated in the prospectus.

7. Creating Debenture Redemption Reserve : SEBI has made it obligatory for all companies raising resources through debentures with maturity period exceeding 18 months to create Debenture Redemption Reserve (DRR) equivalent to 50% of the amount of debenture issue before the company intends to redeem the debentures. The object of creating DRR is to facilitate the serviceability and repayment of debentures on time. The following entry is passed for the creation of DRR: Profit & Loss Appropriation Account

Dr. To Debenture Redemption Reserve Account The creation of DRR is required to be done on the following basis:

Redemption Debentures Study Material

(1) A moratorium upto the date of commercial production can be provided for creation of DRR in respect of debentures raised for project finance.

(ii) The DRR may be created either in equal installments for the remaining period or higher amounts if profits permit

(iii) DRR is not required if the maturity period of debentures is 18 months or less.

(iv) DRR is not required for fully convertible debentures and convertible portion of partly convertible debentures.

(v) DRR is not required if the company has created a sinking fund for the redemption of debentures. over, no redemption can begin unless sinking fund accumulates a sum of 50% of the amount of debenture issue.

(vi) Companies may distribute dividends out of general reserve in certain year if residual profits after transfer to DRR are inadequate to distribute reasonable dividends.

(vii) DRR will be treated as a part of general reserve for consideration of bonus issue proposals and for price fixation related to post tax return.

(viii) Draw out from DRR is permissible only after 10% of the debenture liability has been actually redeemed by the company.

The Companies (Amendment) Act, 2000 has introduced Sec. 117 C, which provides for the creation of Debenture Redemption Reserve for the redemption of debentures to which adequate amounts shall be credited from out of its profit every year until such debentures are redeemed. The amount of CRR shall be utilised by the company for the purpose of redemption only and not otherwise. Summary of SEBI Guidelines, Sec. 117 C of Companies Act and Clarifications Issued by Department of Company Law Affairs

The applicable rules of SEBI guidelines and Sec. 117 C may be summarised as follows:

(1) The creation of DRR is compulsory only for non-convertible debentures and non-convertible portion of partly convertible debentures and that too for issue of debentures with a maturity period exceeding 18 months. Thus, for issue of debentures with a maturity period of 18 months or less, for fully convertible debentures and for convertible portion of partly convertible debentures, DRR is not required.

(2) No DRR is required for debentures issued by All India Financial Institutions regulated by R.B.I. and Banking Companies for both public as well as privately placed debentures.

Redemption Debentures Study Material

(3) For Non-banking Financial Companies registered with R.B.I., the adequacy of DRR will be 50% of the value of debentures issued through public issue and no DRR is required in case of privately placed debentures.

(4) For manufacturing and infra-structure companies, the adequacy of DRR is 50% of the value of debentures issued through public issue and 25% for privately placed debentures.

(5) A company can not redeem its debentures purely out of capital or out of profits. (These terms are discussed later in this chapter). The redemption through these sources is merely of academic interest.

(6) Since the guidelines require the creation of DRR equivalent to 50% of the amount of debenture issue before debenture redemption commences, it means that rest 50% of the redemption may be carried out either from the accumulated profits or out of capital.

(7) If the company has created a sinking fund of the equivalent amount of debenture issue, creation of DRR is not needed. However, no redemption can begin unless sinking fund accumulates a sum of 50% of the amount of debenture issue. Mobilisation of Funds for Redemption of Debentures

The amount required for the redemption of debentures is usually large, so unless adequate provision is made, the company may not have sufficient cash to repay the debentures at their maturity date. Even if it were assumed that the liquid position of the company would permit such redemption, it would not be prudent to withdraw a large sum of money from the business at a time because this would adversely affect the working capital of the company. It is, therefore, necessary to make adequate provision for additional funds required for the redemption of debentures. For this purpose, the following courses are open to a company –

1 Utilising profits – A part of the profits of the company may be withheld and utilised for this purpose. The profits so withheld may be either retained in the business itself as owned capital in the form of General Reserve or invested outside the business.

2. Raising further capital – A company may issue new shares or debentures and the proceeds of the new issue are utilized for redeeming the debentures. In such a case, new share capital or debentures takes the place of the old debentures.

3. Disposing of the assets – A company may also utilise the sale proceeds of its fixed assets for redeeming the debentures. As it is an unusual source of finance, this device is rarely followed.

Redemption Debentures Study Material

Methods of Redemption of Debentures

Debentures may be redeemed in a number of ways. So, the method of redemption of debentures is laid down at the time of their issue. The following are the main methods

(1) Redemption at the expiry of a specified period.

(2) Redemption by conversion.

(3) Redemption at the option of the company after a specified period.

(4) Redemption by annual drawings.

(5) Redemption by purchase in the open market.

Redemption of Debentures at the expiry of a specified period

Under this method, the whole amount of the debenture debt is paid to the debenture holders in one lump sum at the expiry of a specified period, i.e., at maturity. Such redemption of debentures may be (a) out of capital (b) out of profits (c) by conversion into new shares or debentures or (d) by disposing of assets.

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(A) Redemption of debentures out of capital

In this case, profits of the company are not utilized to replace the debentures redeemed, so the assets of the company are reduced by the amount paid. This affects the working capital of the business adversely. The scheme of entries is as follows :

(1) If debentures are redeemed at par –

(a) On debentures becoming due for payment:

Debentures Account  with the nominal value of

To Debentureholders Account debentures to be redeemed or Debenture Redemption Account

(b) On redemption : Debentureholders Account with the or Debenture Redemption Account amount paid

To Bank Account

(ii) If debentures are redeemed at premium –

(a) On debentures becoming due for payment: Debentures Account (with the nominal value) Premium on Redemption of Debentures A/C (with the amount of premium)

To Debentureholders Account (with the total)

(b) On redemption : Debentureholders Account Dr. with the To Bank Account amount paid

Note : Premium on redemption of debentures is a capital loss. It may be written off by Securities Premium Account or any capital or revenue reserve and till it is written off, the balance of premium on redemption account is shown on the assets side of the balance sheet under the head “Miscellaneous Expenditure”.

(iii) If debentures are redeemed at discount – Although it is an unreal situation, however in such a case accounting entries will be as follows :

(a) On debentures becoming due for payment:

Debentures Account                                        Dr. (with the nominal value)

To Debentureholders Account                       (with the amount payable)

To Profit on Redemption of Debentures Alc   (with discount on redemption)

(b) On redemption :                                    Dr. with the Debentureholders Account

Note : Profit on redemption of debentures is a capital profit. It may be used to write off the unwritten off amount of discount on debentures, otherwise it will be transferred to capital reserve account as follows:

Profit on Redemption of Debentures Account      Dr. with the amount of

profit on redemption To Capital Reserve Account Note : In view of the SEBI guidelines and Section 117 C requiring creation of DRR equivalent to 50% of the amount of debenture issue before redemption commences, it is now not possible to redeem debentures purely out of capital. This method can be applied only upto the rest 50% of the amount of debenture issue.

Illustration 1. On January 1, 2001, A Ltd. issued 5,000, 14% Debentures of Rs. 100 each at a discount of 3%. These debentures were redeemable at 2% premium at the end of fifth year. Give the necessary journal entries for the issue and redemption of debentures.

Note : Loss on Issue of Debentures Account has to be written off by the company against its P. & L. Account over the period of 5 years at the rate of 25,000 = Rs. 5,000 per year.

Redemption Debentures Study Material

(B) Redemption of debentures out of profit

In this case, profits of the company are withheld from distributing as dividend and utilised for the purpose of the redemption of the debentures. For this purpose an amount equivalent to the nominal value of the debentures redeemed is transferred to General Reserve Account against P. & L. Appropriation Account As debentures are redeemed out of assets represented by profits, such redemption of debentures is called as out of profits. Here, the company is having the following two options regarding employment of profits withheld

(1) Retaining the amount of profits withheld in the business itself.

(ii) Investing the amount of profits withheld outside the business.

(1) Retaining profits in the business itself – The amount of profits withheld by the company may be retained in the business itself as owned capital in the form of “debenture redemption reserve” or “general reserve”. In such a case, the following entries are passed :

(a) On debentures becoming due for payment:

Debentures Account                                         Dr. with the nominal value of

To Debentureholders Account                           debentures to be redeemed

Note: If debentures are redeemed at a premium, premium on redemption account will also be debited with the amount of premium payable. Similarly, if redemption is at a discount, profit on redemption account be credited with the amount of discount on redemption.

(b) On redemption :

Debenture holders Account                                   Dr. with the

To Bank Account   amount paid

(c) On transfer of profits:

Profit & Loss Appropriation Account                   Dr. with the rest 50% of the nominal

To General Reserve Account                           value of debentures redeemed

In view of the SEBI guidelines and Section 117C, it is not possible to redeem debentures purely out of profits, as there must be a DRR A/c with a credit balance of 50% of the nominal value of the debenture issue before redemption commences. Hence, only 50% of the debentures can be redeemed out of profits.

Illustration 2. Rathi Ltd. issued Rs. 20,00,000, 14% Debentures in 1999 and the same were redeemed on January 1, 2006 out of profits. The Debenture Redemption Reserve stood at Rs. 5,40,000 on that date. Show the entries presuming that debentures were redeemed at a premium of 5 per cent.

 (ii) Investing the amount of profits withheld outside the business – As the amount required for the redemption of debentures is usually large and the date of redemption is known to the company well in advance, it is prudent for a company to make necessary arrangement from the very beginning to ensure the availability of sufficient cash required for the redemption of debentures at their maturity date. Transfer to D.R.R. Account or General Reserve Account may not guarantee availability of cash for the redemption of debentures because cash so set aside might have been locked up in some asset(s) which can not be realised immediately for redemption purpose. Hence, to overcome this problem, the best method is to set aside every year throughout the life of the debentures a part of the divisible profits of the company and to invest the same outside the business so that cash required for the redemption of debentures may be arranged by realising the investments. There are two main methods of investing the funds outside the business:

Redemption Debentures Study Material

(1) Debenture Redemption Fund Method and

(2) Insurance Policy Method.

Debenture Redemption Fund Method

This method is also known as Sinking Fund Method. A Sinking Fund may be defined as a fund created Appropriation of certain profits and represented by specific investments. Under Sinking Fund method ilxed amount is set aside out of profits each year and the same is invested outside the business in cuged securities. If in any year the profits of the company are not sufficient to provide for the fixed annual Sinking fund contribution, the deficiency (known as sinking fund arrears) is provided from the profits of succeeding years. When the debentures become due for payment, the securities (i.e. Sinking Fund Investments) are sold off and the proceeds are utilised in paying off the debentures. Profit or loss on sale of investments is transferred to Sinking Fund Account. After the debentures have been paid off, the Sinking Fund Account is set free. It represents the profits kept back from shareholders from time to time in the past. So the balance of the Sinking Fund Account is transferred to General Reserve. This reserve can be used for any purpose other than paying a cash dividend to shareholders because there would not be necessary cash available for that purpose.

Here, a question arises. Why a debenture sinking fund is created at all when it remains there even after the repayment of the debentures ? The main purpose of creating this fund is to arrange cash for making sinking fund investments. By setting aside a portion of the company’s profit each year, the amount available for dividend is reduced to that extent and thereby corresponding amount of cash is retained which is used for making investment. If no such sinking fund is created, higher dividend will be paid and more cash will go out of the business. Therefore, to conserve the cash resources of the company, the device of sinking fund is adopted.

Types of Sinking Fund – The sinking fund for the redemption of debentures may be cumulative or noncumulative.

Cumulative Sinking Fund

It is a sinking fund, which grows each year with the aid of periodical contributions and interest. The interest received on sinking fund investments is credited to sinking fund account and invested in securities together with the annual amount of contribution made. The amount to be set aside out of profits and invested each year is such that which when allowed to accumulate with compound interest will become equal to the total sum payable on debentures at the date of their redemption. The amount of the annual contribution is found by reference to the sinking fund tables. These tables are of two types, which are given below:

Method of using Table A: This table shows the amount of annual instalment to provide Re. of cream year. Suppose a company has to redeem debentures of Rs. 10.000 after 6 years. If the company expects a return of 4% per annum on its investments then in the above table in the sixth years 496 column we find that Re. 0.150761 annual investment is required to get Re. 1 at the end of Hence, in order to get Rs. 10,000 at the end of sixth vear 10.000 x 0.150761. i.e. Rs. 1,507.01 provided each year.

(ii) After the investments are sold, there will be no corresponding investment to justify the use of the term ‘fund

(2) While transferring the balance of Debenure Redemption Fund Account to General Reserve Account, capital profits such as profit on sale of investments and profit on redemption or cancellation of debentures should be transferred to Capital Reserve Account (since they result from transactions unconnected with the usual business of the company) and only the balance to General Reserve Acco

Redemption Debentures Study Material

(3) Where only a part of debentures are redeemed, it must be ensured that the balance in the striking fund is at least equal to 50% of the amount of debenture issue on the date of redemption.

(4) In case only a part of the debentures are redeemed then only an amount equal to the paid-up value of debentures redeemed is transferred to General Reserve Account. If, however, the balance in Debenture Redemption Fund Account is less than the paid-up value of debentures redeemed then only the balance is transferred to General Reserve Account.

(5) This method assumes the availability of profits and sufficient cash for investments.

(6) Until the debentures are paid off, the Debenture Redemption Fund Account appears on the liabilities side and the Debenture Redemption Fund Investment Account on the assets side of the Balance Sheet. Illustration 3. A company issued 1,000 10% Debentures of Rs. 100 each at 3% discount on 1st January 2003 repayable at the end of 3 years at a premium of 5%. It was decided to set up a Sinking Fund for the purpose, the investments being expected to realise 5% p.a. Sinking Fund table shows an amount of Re. .317208 set aside every year and invested in 5% securities will yield Re. 1 after 3 years. Investments were made in multiples of Rs.10 only.

On 31st December 2005, the balance at bank was Rs. 49,000 and the investments were sold for Rs. 68,000 and the debentures were redeemed.

Give journal entries and prepare the relevant ledger accounts in the books of the company. Ignore debenture interest.

(c) The balance left in the Debenture Sinking Fund Account, set free by redemption of debentures, is transferred to general reserve. If the directors so desire, it may be transferred to capital reserve.

Insurance Policy Method

This method is very much similar to the Debenture Redemption Fund Method. Each year profits are set aside and credited to Debenture Redemption Fund Account in the same way as is done in the case of Debenture Redemption Fund Method. But instead of investing the amount of profit set aside in securities, an endowment policy is taken out from an insurance company for the sum required for the redemption of debentures. This policy is taken for such a period that it will mature on the date when debentures become due for redemption. The sum received at maturity of policy is used for redeeming the debentures.

This method differs from the Debenture Redemption Fund Method in two respects. Firstly, the premium on policy is paid at the beginning each year and debited to Debenture Redemption Policy Account; the amount of profit to be set aside each year shall be equal to the amount of annual premium and is debited to Profit and Loss Appropriation Account and credited to Debenture Redemption Fund Account at the end of the accounting year. Secondly, unlike Debenture Redemption Fund Method, interest will not be received every year under this method but will accrue at a fixed rate and so generally it is not recorded yearly in this method. The total amount of premiums will always be less than the amount of policy and the excess of policy amount over the total amount of premium paid on the policy represents the total amount of interest earned on premiums which is transferred to Debenture Redemption Fund Account after the policy has been realized.

This method has the same points in favor as the Debenture Redemption Fund Method, with the additional advantage that this investment is not subject to any fluctuation in prices unlike securities in the Debenture Redemption Fund Method and as such the exact sum insured is available at maturity. Besides, there is no botheration of selecting proper securities for investment and of realizing and re-investing the interest

Redemption Debentures Study Material

Accounting Entries: In the first and subsequent years –

(1) On payment of premium at the beginning of the year:

Debenture Redemption Policy Account                         Dr. with the amount

To Bank Account

(ii) On transfer of profit to Do transfer of profit to Debenture Redemption Fund Account at the end of the year :

Profit & Loss Appropriation Account                              Dr. with the amount

To Debenture Redemption Fund Account of profit set aside the last year – In addition to the above two entries, the following entries are also passed at the end of last year :

On receiving the policy amount from the insurance company: Bank Account  Dr. with the

To Debenture Redemption Policy Account policy amount

(iii) On transfer of accrued interest (i.e. the excess amount received on realisation of policy) to Debenture Redemption Fund Account:

Debenture Redemption Policy Account                         Dr. with the

To Debenture Redemption Fund Account excess amount

(iii) On debentures becoming due for payment: Debentures Account  with the nominal value

To Debentureholders Account of debentures redeemed

(iv) On redemption : Debentureholders Account        Dr. with the To Bank Account amount paid

(v) On transfer of the balance of Debenture Redemption Fund Account to General Reserve :

Debenture Redemption Fund Account                             Dr. with the balance

To General Reserve Account

Note: If it is desired to bring interest into account each year as is done in Debenture Redemption Fund Method, then at the end of each year interest will be calculated at the expected rate on the opening balance in the Policy Account together with the amount of current year’s premium and it is debited to Debenture Redemption Policy Account and credited to Debenture Redemption Fund Account. If this is done, then Policy Account will not show any profit because interest adjustments made each year will make the Policy Account equal to its maturity value.

Illustration 10. On January 1, 2003, a company issued 1,000 14% Debentures of Rs. 100 each redeemable at 4% premium after three years. The company took an insurance policy of Rs. 1,04,000 for the redemption of debentures and paid Rs. 32,500 annual premiums. At the end of the third year, policy amount was received and debentures redeemed. Show necessary ledger accounts.

Redemption Debentures Study Material

Redemption of Debentures out of sale proceeds of assets of the company

Sometimes, a company arranges funds required for the redemption of debentures by disposing of some of its surplus fixed assets. In such a case, following entries are passed :

On sale of assets :

Bank Account                                       Dr. with the amount

To Respective Asset Account                of sale proceeds

Profit or loss on sale of the asset is transferred to Profit and Loss Account.

In this case, before redemption of debentures, an amount equal to 50% of the amount of the debenture issue will have to be transferred to Debenture Redemption Reserve Account for complying with the SEBI guidelines and provisions of Section 117C of Companies Act. The entries for the redemption of debentures will be the same as given in point no. 2 on page 4.22.

Redemption of Debentures by Conversion – Convertible Debentures

It is not unusual for a public company to issue convertible debentures.

The terms of issue of such debentures provide the debentureholders the right to exercise the option to convert these debentures into shares at a stipulated rate within a specified period. In practice the conversion is usually effected at a discount on the market price of the shares. If the debentureholders find the offer beneficial to them they will exercise their option otherwise they will be repaid in cash at the maturity of the debentures. On exercising their right of conversion, the debentureholders are issued new shares as per the terms of conversion and the following entry is passed :

Debentures Account                                               Dr.

To Share Capital Account

The new share can be issued at par, at premium or at discount. In case new shares are issued at premium. Securities Premium account is credited and in case they are issued at discount, Share Discount White Here, it is to be noted that creation of D.R.R. is not required in case of fully convertible debentures.

If the convertible debentures provisions of Section 79 of the Com a case, the actual proceeds of the determining the number of issue price of the shares must debentures were originally issued at discount, it is to be carefully noted that the on 79 of the Companies Act, 1956 are not violated in the process of conversion. In such actual proceeds of the issue and not the face value) of debentures should be considered in ng the number of shares to be issued in exchange of the debentures to be converted because the

ice of the shares must be equal to the amount actually received from the debentureholders at the Ne of issue of those debentures. While passing entry for conversion of such debentures, Discount on Issue Debentures Account should be credited with the amount of discount allowed on those debentures. See

In case, the debentures are due for redemption, conversion of debentures into shares may be made on the basis of terms mutually agreed upon at the time of redemption. In such a case, even debentures originally issued at a discount can be converted into shares on the basis of the nominal value of debentures.

Illustration 13. On 1st January 2005, A Ltd. issued 25,000 12% Debentures of Rs. 100 each at Rs. 95. Holders of these debentures have an option to convert their holdings into 14% Preference Shares of Rs. 100 each at a premium of Rs. 25 per share at any time within five years.

On 31st December 2005, the interest on debentures was outstanding. Holders of 5,000 debentures notified their intention to exercise the option.

Give journal entries and show these items in the Balance Sheet of the Company.

Redemption Debentures Study Material