REDEMPTION OF DEBENTURE

Redemption of Debentures: Sources and Methods

Redemption of debentures means payment of the amount of debentures by the company. When debentures are redeemed, liability on account of debentures is discharged. Amount of funds required for redemption of debentures is quite large and, therefore, prudent companies make sufficient provision out of profits and accumulate funds to redeem debentures.

In this connection, The Companies (Amendment) Act, 2000 has introduced section 117 C which provides that:

1. Where a company issues debentures after the commencement of this Act, it shall create a debenture redemption reserve for the redemption of such debentures, to which adequate amounts shall be credited, from out of its profits every year until such debentures are redeemed.

2. The amounts credited to the debenture redemption reserve shall not be utilized by the company except for the purpose aforesaid.

It should also be noted that before the introduction of this section, there was no provision in the Companies Act 1956 for the redemption of debentures. However Securities and Exchange Board of India has provided some guidelines.

The relevant points of these guidelines are:

(i) Every company shall create DRR in case of issue of debentures redeemable after a period of more than 18 months from the date of issue.

(ii) The creation of DRR is obligatory only for non-convertible debentures and non-convertible portion of partly convertible debentures.

(iii) A company shall create DRR equivalent to 50% of the amount of debenture issue before starting the redemption of debenture.

(iv) Drawal from D.R.R. is permissible only after 10% of the debenture liability has already been redeemed by the company.

SEBI has no powers to administer the provisions of section 117 C. But Sec. 117 C does not specify the amount up to which D.R.R. should be created. In the absence of any such details, one may refer to guidelines issued by SEBI.

Sources of Funds for Redemption of Debentures:

So, far as sources of funds for the redemption of debentures are concerned, the company may choose any one of following courses:

1. Redemption of Debentures out of Capital:

Under this method the company may dispose off some fixed asset and may use the sale proceeds for redemption of debentures. However, it is a very unusual source of finance and is rarely followed. Again the company may utilize its working capital to redeem the debentures. This adversely affects the working capital of the company. In either case, the assets of the company are reduced. However, in view of the legal provisions with regard to creation of DRR, redemption of debentures purely out of capital is not possible. In this case, the basic entries for redemption of debentures are passed.

They are as follows:

2. Redemption of Debentures out of Profits:

Redemption of debenture out of profits implies that an amount equal to the face value of the debentures redeemed is transferred to DRR. Thus, a part of the profits of company are withheld from distribution to shareholders.

Methods of Redemption of Debentures:

Debentures may be redeemed in a number of ways. Procedure for redemption of debentures is laid down at the time of issue of debentures and it is in accordance with the provisions of articles of association.

The following are the main methods of redemption of debentures:

I. Redemption of debentures in lump-sum at maturity

II. Redemption of debentures by draw of lots

III. Redemption of debentures by purchasing them in the open market

IV. Redemption of debentures by conversion

I. Redemption of Debentures in Lump-sum at Maturity:

In this case, debentures are redeemed in one lump-sum at the end of stipulated period.

The basic accounting entries for redemption of debentures are:

Debentures may be redeemed at par, at premium or at a discount. When debentures are redeemed at par, the above two entries are passed. When debentures are redeemed at premium, the following accounting entries are passed.

It may be noted here that ‘premium on redemption of debentures a/c’ may have opened and credited at the time of issue of debentures. If so, then premium payable on redemption of debentures has only to be transferred to debenture holders account as per first entry. If it has not been opened earlier, it will be debited now and later closed by transferring it to securities premium a/c or profit and loss account.

Debentures may be redeemed at discount though it is an unreal situation and not found in practice.

However, in such a case the following entries are passed:

Profit on redemption of debentures is a capital profit. It is used to write-off discount on issue of debentures/shares; otherwise it will be transferred to capital reserve. Debentures may be redeemed out of capital or out of profits. Prudent companies make arrangements for the redemption of debentures from the very beginning. They set aside a certain sum of money out of profits every year and invest an equivalent amount in first class securities so that necessary funds are available for redemption of debentures at the appropriate time.

For investing funds outside the business, the company may follow any of the following two methods:

(a) Sinking fund method/debenture redemption fund method

(b) Insurance policy method

(a) Sinking Fund Method/Debenture Redemption Fund Method:

Under this method every year the company sets aside a certain part of profits and credits the same to debenture redemption fund. To collect the required funds at the time of redemption, it invests the same in first-class securities. The interest earned in the investments is also invested when the debentures fall due for redemption; investments are sold and sale proceeds utilized for redeeming the debentures.

Under this method, the following accounting entries are passed:

4. Last year entry for purchase of investments will not be passed as investments are not purchased.

Instead entry for sale of investment and redemption of debentures will be passed which are as follows:

For loss on sale of investments reverse entry will be passed. On redemption of debentures, the following entries will be passed.

The credit balance in DRF a/c will be transferred to general reserve account. It may be noted here that profit on sales of investment which was earlier transferred to DRF account will be transferred to capital reserve from DRF, these facts are recorded by means of following accounting entry.

(b) Insurance policy method:

Under this method, the company instead of purchasing investments takes an insurance policy for an amount which would be adequate for the redemption of debentures.

Accounting entries, under this methods are as follows:

First year and subsequent years (including last year)

In the last year, when policy amount is realized and debentures are redeemed, the following accounting entries are passed.

II. Redemption of Debentures by Draw of Lots:

Under this method, the company redeems debentures each year. The debentures to be redeemed are selected by draw of lots. Accounting entries for redemption of debentures are the same as passed in case debentures are redeemed out of profits.

They are as follows:

When all the debentures are redeemed, the balance in DRR account will be transferred to general reserve.

III. Redemption of Debentures by purchasing them in the Open Market:

Sometimes the company purchases the debentures in the open market at its convenience and redeems them. The company may purchase the debentures at par or at premium or at discount.

Accounting entries for the purchase of debentures at par will be as follows:

If the company purchases the debentures at a premium, the amount paid in excess of the face value will be debited to ‘loss on redemption of debentures’ which will be transferred to profit and loss account and closed, the entry will be

If the company pays a price which is less than the nominal value of the debentures, the company will make a profit. The entry will be

Own Debentures:

Sometimes the company may purchase its debentures from the market and, instead of cancelling them, may keep them as investments. In such a case, the cost price of debentures purchased is debited to a new account known as ‘own debentures account’. Own debentures may be utilised for reissue when needed afterwards.

Accounting entries for own debentures are:

On Cancellation of Own Debentures:

When the actual price paid on purchase of own debentures is less than the face value of debentures, there will profit on cancellation of own debentures.

Accounting entry will be:

However, if price paid on own debentures is more than the face value of debentures, company will make a loss on cancellations of own debentures.

Accounting entry will be as under:

Loss on cancellation of own debentures will be transferred to P&L account.

IV. Redemption of Debentures by Conversion:

Sometimes a company redeems debentures by converting them into a new class of shares or debentures. If new debentures are issued in place of old debentures, the accounting entry will be

In case debentures are redeemed by converting them into equity shares, the entry will be

If the debentures are converted into equity shares at a premium the accounting entry will be

Ex-Interest and Cum-Interest Quotations:

Sometimes debentures are purchased in the open market on a date other than the date of payment of interest on debentures. In such a case, distinction must be made between capital and revenue parts of the price paid for debentures. Of the price paid for the debenture, what is capital part and what is revenue part will depend upon the quotation made for the debentures.

Quotation price of the debentures may be cum-interest or ex-interest. If the price quoted is cum-interest, it means price quoted for the debentures includes interest for the expired period. If the quotation is ex-interest, it means price of the debenture does not include interest for the expired period and, therefore, the buyer in addition to the quotation price, has to pay interest for the expired period. At the time of passing entries for the purchase of own debentures, capital part of the price are debited to ‘own debentures account’ and revenue part of the price is debited to interest account.

Example:

X Co. Ltd. buys its own 9 per cent debentures of the nominal value of Rs. 40,000 at Rs. 97 on March 31, 2002. Record the transaction in the books of the company if quotations price is:

(i) Cum-interest

(ii) Ex-interest.

Company pays interest on debentures on June 30, and Decem­ber 31.

Note:

Interest for the expired period = Rs. 40,000 x 9 x 3/100 x 100 x 12 = Rs. 900

Non-Convertible Debentures (NCD) with Detachable Warrants:

A recent innovation in the Indian stock market is the issue of non-convertible debentures with detachable warrants attached to them. These warrants can be exchanged by the investors for equity shares of the company. The number of equity shares that would be allotted to the investors against the warrants and the time period within which the option is to be exercised by the investors is specified by the company at the time of issue of the non-convertible debentures.

When the time for exercising the option comes, the holders of these warrants who wish to exchange them for shares should pay the specified price and will be allotted the specified number of shares. The dividend warrants are intended to act as sweeteners to the NCD issue, and are considered beneficial to the investors because of the potential increase in the market prices of the company’s shares. For instance, Mangalore Refineries and Petrochemicals Ltd. came out with a large issue in May 1992 comprising the issue of equity shares, PCDs and NCDs with detachable warrants.

The terms of the issue of NCDs aggregating Rs. 500 crore were as follows:

NCDs—Rs. 200 each

Rate of interest—17.5%

Redemption—5-9 years

Detachable equity warrants to carry the right to apply for one equity share of Rs. 10 at par between eighteen to twenty four months from the date of allotment.

The accounting entries would be as follows:

When the application money of Rs. 50 and the call money of Rs. 150 are received, the 17.5% non-convertible debentures account would show a credit balance of Rs. 500 crore. This would carry interest at 17.5 per cent and would be debited only on redemption between the fifth and the ninth year.

Between eighteen to twenty-four months, the NCD holders who are entitled to apply for equity shares will have to pay up Rs. 10 per share. Assuming that the holders of 2 crore NCDs of Mangalore Refineries exercise such option, the company would pass the following entry:

Recognition of the Liability under the Equity Warrant Exercisable by the Investor:

The entries given above are under the assumption that the equity liability on the warrants is recognized in the company’s books only when the option for the same is exercised by the debenture holders. However, an International Accounting Standard on ‘Financial Instruments’ has been formulated wherein a different treatment is suggested for the equity options.

The IAS accounting standard requires a company to recognize the financial liability under the warrant option at the time of issuing the compound instrument (i.e., the financial instrument consisting of the debentures, and the equity option) itself.

The liability under the option may be determined by some options valuation model that ate available. It is also required that the liability under the debentures and the equity option have to be segregated and shown separately—the debenture liability along with such similar bond instruments and that under the equity option under share capital.

However, since there is no such legal or accounting standard requirement in India and the equity warrants themselves are new instruments, it is yet to be seen how companies actually account for the same and whether they make any disclosure regarding the equity options in their balance sheets.

It is most desirable, however, that even if companies do not account for the equity options until such options are exercised, specific disclosures as to the number of such warrants issued, the price that is to be paid for converting them into shares and the time within which such options are to be exercised, etc. are given by way of a note to the Balance Sheet in order to facilitate analysis and future projections of the company’s prospects and commitments.