When a company is formed, one of its initial challenges is generating funds. The company can raise funds by either taking a loan, with the help of investors or by issuing debentures and shares.
Issue of debentures meaning: Debentures are an instrument used to raise long term debt capital for the company. The debenture that a company issues is seen as an acknowledgement that the company has borrowed an amount, which it will have to repay at some time in the future. Because of this, a debenture holder will be referred to as the company’s creditors.
Issuing of debentures
Debentures are issued at face value. Even though that is the case, the market price of debentures usually fluctuates. In case the face value is higher than the market value, the company will discontinue the debentures. However, if the face value is lower than the market value, the debentures are premium issued.
Types of Debentures
There are two types of debentures – redeemable and non-redeemable debentures.
- Redeemable debentures: Redeemable debentures are those that are issued for a fixed specified period of time. The company has to repay the creditor the full amount with interest on the predetermined date. This type of debenture ensures that the company fulfils its obligation to the holder.
- Non-redeemable debentures: As the name suggests, non-redeemable debentures can not be redeemed during the company’s lifetime. These debentures are repaid during the liquidation of the company.
- Mortgage debentures: These debentures are issued by mortgaging an asset of the company. On repayment failure from the company, the debenture holder can sell the asset and recover the dues.
- Non-convertible debentures: A non-convertible debenture can not be converted into an equity share at any given point. The debenture holders remain as creditors till their debentures are matured.
- Partially convertible debentures: A partially convertible debenture holder is given the option to convert a part of their debentures into equity shares. If they choose to convert that part, they will enjoy the benefits of both debentures as well as shares.
- Fully convertible debentures: These can be fully converted into a specified number of shares after their maturity.
Features of Debentures
- Since debentures are a form of loan, debenture holders are seen as creditors of the company.
- Debentures can be of different types, but the most common ones are redeemable and non-redeemable.
- Debenture holders can either secure their debentures that are put up assets as security or leave them unsecured with no collateral backing their debentures.
- The interest on the debentures is a tax-deductible expense since they are a charge against the company’s profit.
- Unlike shareholders, who enjoy the benefit of voting during the decision making of the company, debenture holders do not enjoy this benefit.
- Even if the company faces losses, they are obliged to pay the interest on debentures.
Advantages/Merits
The advantages of raising funds through the instrument of issuing debentures are:
- Investors/people prefer debentures over shares because it ensures a fixed income but is less risky than a share. A company is obliged to pay the interest on the debentures even if they are facing losses.
- Debentures have no role in the company’s profits; they are fixed charge funds.
- In cases where the sales and profits are stable, debentures are preferred over shares.
- Since debenture holders do not get access to the company’s voting rights, raising funds through debentures does not affect the control of shareholders on the management.
- Debentures are tax-deductible; it deducts the company’s liability by lowering its taxable income, so issuing debentures is less costly.
Limitations
Despite the many benefits of issuing debentures to raise funds, debentures have certain limitations:
- A company has to pay a fixed charge on each debenture issued, despite the company’s losses
- Because of this, it puts permanent stress over the income of the company. This can be seen as a risk for the company if its earnings fluctuate
- In the case of redeemable debentures, the company has to make a provision for its repayment even during the times when the company is facing losses
- The capacity of a company to borrow funds reduces when they issue debentures since each company has a specific borrowing capacity
Liquidation of assets
When it comes to ranking shares, debentures and bonds during liquidation of the company, debentures and bonds will always get the first preference in terms of receiving debt. Suppose company XYZ goes bankrupt. Debentures will come first in the order during its liquidation while repaying debt. However, there are two types of debentures here: first and second. First debentures get to recover their investment first. Second debentures imply that the holder will get their debt repaid after other debts are paid off.
Debenture Redemption Reserve
The Debenture Redemption reserve is a failsafe account created by the companies in India that issue Debentures. This is made so that in case of any catastrophe, the company is able to pay off the investors who bought Debentures without selling off their assets or mortgaging their property.
Journal Entries on Issue of Debentures
The basic journal entries for the issue of debentures and receiving the payment is as follows.
DATE | PARTICULARS | LF | Debit Amount | Credit Amount |
Bank A/c to Debentures Application A/c (receiving the application money) | — | — | ||
Debentures Application A/c to Debentures A/c (transfer of application money) | — | — | ||
Debentures Allotment A/c to Debentures A/c (allotment money is due) | — | — | ||
Bank A/c to Debentures Allotment A/c (receiving the allotment money) | — | — |
Conclusion
A debenture is a debt instrument used by the company to raise capital. A debenture is thus an acknowledgement or a certification of loan that the company has an obligation to repay a specific amount to the creditors with interest. Debentures can be of many types: redeemable and non-redeemable, secure and unsecured, partly convertible, fully convertible and non-convertible. Debenture holders enjoy many benefits like a less risky investment, fixed income, first preference to repay debts if the company goes bankrupt, etc. Debentures can be issued at par, premium, discount, oversubscription, as collateral security and for consideration other than cash.
