Q.1. Explain briefly the various methods of redemption of debentures.
Answer: Repayment or discharge of liability on account of debentures is called redemption of debentures. The method of debenture redemption adopted determines to a very large extent, the actual accounting for redemption as well as the marshalling of resources for the same.
There are broadly four methods for the redemption of debentures which are as follows:
- Lump-sum payment method: In this method, redemption of debentures is done by repayment in one lump sum after the expiry of a stipulated period. The total amount payable to debenture holders is decided at the time of issue of debentures (i.e. debentures will be redeemed at par or at premium). Usually a company creates sinking fund or an insurance policy fund for the redemption of debentures.
- Drawings of Lots method: In order to reduce the liability of debentures, company may repay the debentures in some instalments. A certain amount of debentures is redeemed at regular interval of time during the lifetime of the debentures by drawings of lots.
- Purchase in the Open Market: The company from the open market can purchase its own Debentures. Debentures so purchased may be cancelled immediately or may be kept as an investment, which will be cancelled later. It may beneficial for the company if it purchases its own debentures at a discount from the open market.
- Conversion Method: Usually debentures are redeemed in cash but sometimes debenture holder are given an option to get their debentures converted either in shares or for new debentures of the company. The redemption of debentures by means of shares or new debentures is known as redemption by conversion. Debentures, which carry such right, are called ‘Convertible Debentures’.
Answer:
Redemption out of Capital:
When debentures are redeemed out of capital, no transfer is made to general reserve or debenture redemption reserve account. In this method it is assumed that the company has sufficient funds to redeem the debentures. So the profits are not utilised to replace the debentures. It affects adversely to the Working Capital of the company. The following entries are passed when debentures are redeemed out of capital: -
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1. |
For amount of debentures due to Debenture holders: |
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(a) when debentures are redeemable at par: |
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% Debentures A/c Dr. |
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To Debenture holders A/c |
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(b) when debentures are redeemable at premium: |
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% Debentures A/c Dr. |
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Premium on Redemption of Debentures A/c Dr. |
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To Debenture holders A/c |
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2. |
For payment to Debenture holders: |
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Debenture holders A/c Dr. |
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To Bank A/c |
When it is intended to redeem the debentures out of profits, a part of profits available for distribution of dividends is withheld by the company every year to be used for redemption purposes as and when the need arises for the same. There are two alternatives available to the company in this regard namely: (a) the amount of divisible profits withheld by the company may be retained in the business itself as a source of internal financing. (b) The amount of divisible profits withheld from distribution as dividend may be invested either (i) in readily marketable securities or (ii) in taking out insurance policy to provide funds when required. The following entries are passed when debentures are redeemed out of profit:
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1. |
For amount of debentures due to Debenture holders: |
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(a) when debentures are redeemable at par: |
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% Debentures A/c Dr. |
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To Debenture holders A/c |
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(b) when debentures are redeemable at premium: |
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% Debentures A/c Dr. |
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Premium on Redemption of Debentures A/c Dr. |
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To Debenture holders A/c |
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2. |
For payment to Debenture holders: |
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Debenture holders A/c Dr. |
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To Bank A/c |
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3. |
For profit transferred to General Reserve |
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Profit & Loss Appropriation A/c Dr. |
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To General Reserve A/c |
(A.I.S.S.C.E. 1987)
Answer: A sinking fund may be defined as a fund created by a charge against or appropriation of profits and represented by specific investments. The accounting entries for creating a Sinking Fund would be as under:
| I. | First Year: |
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On the date of issue of Debentures: |
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1. For issue of Debentures |
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Bank A/c Dr. |
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To % Debentures A/c |
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At the end of first year: |
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2. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c |
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Profit & Loss Appropriation A/c Dr. |
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To Sinking Fund A/c |
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3. For Investments made for the amount of sinking fund |
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Sinking Fund Investment A/c Dr. (with the amount of sinking fund) |
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To Bank A/c |
| II. | At the end of second and subsequent years during the life of the debentures excepting last year: |
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1. For receipt of interest on investment |
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Bank A/c Dr. |
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To Interest on Sinking Fund Investment A/c |
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2. For interest on investment t/f to sinking fund |
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Interest on Sinking Fund Investment A/c Dr. |
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To Sinking Fund A/c |
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3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c |
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Profit & Loss Appropriation A/c Dr. |
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To Sinking Fund A/c |
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4. For Investments made for the amount of sinking fund |
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Sinking Fund Investment A/c Dr. (with the total amount of annual sinking fund + interest) |
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To Bank A/c |
| III. | Last year: |
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1. For receipt of interest on investment |
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Bank A/c Dr. |
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To Interest on Sinking Fund Investment A/c |
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2. For interest on investment t/f to sinking fund |
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Interest on Sinking Fund Investment A/c Dr. |
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To Sinking Fund A/c |
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3. For amount of Sinking Fund Charged to Profit & Loss Appropriation A/c |
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Profit & Loss Appropriation A/c Dr. |
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To Sinking Fund A/c |
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4. For sale of investment |
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Bank A/c Dr. |
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To Sinking Fund Investment A/c |
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5. For gain on sale of investment |
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Sinking Fund Investment A/c Dr. |
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To Sinking Fund A/c |
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Or |
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For loss on sale of investment |
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Sinking Fund A/c Dr. |
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To Sinking Fund Investment A/c |
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6. For amount of debentures due to Debenture holders: |
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(a) when debentures are redeemable at par: |
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% Debentures A/c Dr. |
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To Debenture holders A/c |
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(b) when debentures are redeemable at premium: |
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% Debentures A/c Dr. |
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Premium on Redemption of Debentures A/c Dr. |
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To Debenture holders A/c |
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7. For payment to Debenture holders: |
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Debenture holders A/c Dr. |
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To Bank A/c |
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8. For transfer of Sinking Fund to General reserve |
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Sinking Fund A/c Dr. |
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To General Reserve A/c |
Answer: The amount required for the redemption of debentures is usually very large. It creates a great difficulty for the company to arrange this large amount to pay off its debentures. In case this large amount is paid out of company’s working capital, it may affect the routine working of the company and that will affect the profitability of the company also. So in order to avoid this difficulty a company needs funds to repay its debentures.
According to a notification of Government of India issued by Controller of Capital Issue as on 1-1-1987, it is compulsory for all companies to create a Debenture Redemption Reserve up to at least 50% of the amount of debentures issued before the commencement of redemption of debentures. The effect of such a notification is that a Company cannot redeem its debentures purely out of capital or purely out of current profits.