Redemption of Debentures

Redemption of debentures

A debenture is an acknowledgement of a loan to a company. It is usually issued under the company's seal (i.e. is an official document issued by the company, similar to a share certificate) and bears a fixed rate of interest. However, unlike shares, which normally depend on profits out of which to issue dividends, debenture interest does not depend on profit, instead it should be paid whether profits are made or not. A debenture may be redeemable, that is, repayable at or by a specified date. Conversely, debentures may be irredeemable, that is, debenture holders will be repaid their capital when the company is eventually liquidated.

People lending money to companies in the form of debentures will obviously be interested in how safe their investment will be. In the case of some debentures, the debenture holders are given the legal right that on certain happenings they will be able to take control of specific assets, or of the whole of the company's assets. They can sell the assets and recoup the amount due under their debentures, or deal with the assets in ways specified in the deed under which the debentures were issued. These debentures are known as being secured against the asset, and the term mortgage debenture is often used to describe them. Other debentures carry no prior right to control the assets under any circumstances. These are known as simple or naked debentures.

Redemption of debentures involves the repayment of these debentures by the company to the debenture holders. In the process of redemption, the companies discharge its liability to debenture holders and remove it from the statement of financial position. The method of redemption of each category of debentures will be expressly stated in a debenture trust deed. There are five (5) common methods in which redemption of debentures can take place. These methods have different accounting treatments as well. The methods are:

1. Payment in lump sum
2. Payment in instalments
3. Purchase in open market
4. Redemption by sinking fund; and
5. Conversion into shares or new debentures

Payment in lump sum

This method, as the name suggests is a one-time payment method. Here the company will repay the whole amount in one lump sum payment to the debenture holders. The amount and the date of the payment will be according to the terms of issue. Since the company knows the date of the repayment in advance they can plan their finances accordingly. So they make provisions and necessary arrangements to pay the debenture holders when due. Thus, the company sets up a special account known as the Debenture Redemption Reserve (DRR). This debenture redemption reserve is a capital reserve account. It is funded by the divisible profits of each year, that is, a portion of the profits are set aside every year for this purpose. This account can only be utilized for the purpose of redemption of debentures and not for any other purpose.

Journal Entries for Debenture Redemption Reserve (DRR)

S/N	Journal Entries	Dr. (Debit)	Cr. (Credit)
1	Appropriation of Profit to DRR Account	Profit or loss appropriation account xx	Debenture redemption reserve account xx
2	Investment in Securities	DRR investment account xx	Bank account xx
3	Interest Received on DRR Investment	Bank account xx	Interest on DRR investment account xx
4	Interest Credited to DRR Account	Interest on DRR investment account xx	DRR account xx
5	Appropriation of Profit to DRR Account	Profit or loss appropriation account xx	DRR account xx
6	Investment in Securities (Subsequent Year)	DRR investment account xx	Bank account xx
7	Investment Sold in the Final Year	Bank account xx	DRR account xx
8	Transfer of Profit to DRR Account (Final Year)	Profit or loss appropriation account xx	DRR account xx
9	Profit on Sale of Investment Transferred to General Reserve	DRR account xx	General reserve account xx

Payment in instalments

This method is also known as the drawing of lots method. Under this method, usually redemption of debentures is paid in instalments on the particular date during the life time of debentures. The total amount of debenture liability is being divided by the total number of years. It must be noted that the debentures to be redeemed are recognized by drawing the required number of lots out of the debentures outstanding for the payment. Here the company will start redeeming debentures in lots or instalments from one particular year as agreed by the terms of issue.

The accounting treatments for this method are provided bellow:

Journal Entries for Payment in Instalments

S/N	Journal Entries	Dr. (Debit)	Cr. (Credit)
1	If the Debentures are Redeemed from Profits	Profit and loss appropriation account xx	DRR account xx
2	Redemption of Debentures	Debentures account xx	Debenture holders account xx
3	Payment to Debenture Holders	Debenture holders account xx	Bank account xx

Purchase in open market

When an enterprise buys its own debentures in the market for the aim of cancellation, such an act of buying and cancelling the debentures comprises redemption of debentures by purchase in the open market. In this method, the company will buy its debentures from the open market and then immediately cancel them. Companies can buy the debentures at a discount that can make additional benefits/profits, or even at a premium. In this way the company can defer the redemption till the purchase price is favorable to them. A sum, equal to the cash paid on redemption is transferred from the profit and loss appropriation account to the credit of the debenture redemption reserve account. The sum paid will be credited to the bank account and debited to the debentures account. Any discount (or profit) on purchase will be transferred to a reserve account. Any premium (or loss) on purchase will be deemed to come from a reserve account, or if such account does not exist, or if it is insufficient, then it will be deemed to come out of the share premium account. In absence of reserve account or share premium account, any loss will be transferred to the profit and loss appropriation account. Purchase in open market would not be favourable if the debentures had to be redeemed at premium. Although, the purchase can be made it would still be favourable if the premium paid was not as high as the premium to be paid on the redemption date.

The accounting treatment

Journal Entries for Debentures Purchased at Premium or Discount

S/N	Journal Entries	Dr. (Debit)	Cr. (Credit)
1	When Debentures are Purchased at a Premium	Debentures account xx	Bank account xx
		Loss on redemption account xx
2	Transfer of Loss to Retained Earnings	Retained earnings account xx	Loss on redemption account xx
3	When Debentures are Purchased at a Discount	Debentures account xx	Bank account xx
			Profit on redemption account xx
4	Transfer of Profit to Capital Reserve	Profit on redemption account xx	Capital reserve account xx

When debentures are redeemed at a premium

The funds with which the premium is paid should be taken from the share premium account. If this does not exist, or when the premium on redemption paid is more than the balance on the share premium account, then any part not covered by a share premium account is deemed to come from profit and loss appropriation account. The balance on the debenture redemption reserve account is increased by the nominal value of the debentures redeemed each year. Any element of the redemption sourced by the share premium account is entered as a debit to that account and is not included in the debenture redemption reserve. When the whole issued of debentures has been redeemed, the balance on the debenture redemption reserve account is transferred to the credit of a general reserve account. Hence, this will be accumulation of undistributed profits.

Example

The following is a statement of financial position of SIGMA Ltd. for the year ended 31st December, 2020.

Sigma Ltd. Statement of Financial Position as at 31st December, 2020

Details	TZS
Non-current assets	12,900,000
Current assets	3,400,000
Bank	16,300,000
Total assets	16,300,000
Equity and liabilities
Equity share capital	10,000,000
Debenture redemption reserve	-
10% Debentures	2,000,000
Retained earnings	4,300,000
Total equity and liabilities	16,300,000

Required: Prepare ledger accounts to record redemption of debenture by drawing out of profits method, assuming that TZS 400,000 nominal value debentures were redeemed on 31st December, 2021, at a premium of 20%

Non-current Assets Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
1st Jan., 2021	Balance b/d	12,900	1st Jan., 2022	Balance b/d	12,900
31st Dec., 2021	Balance c/d	12,900

Bank Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
1st Jan., 2021	Balance b/d	3,400	31st Dec., 2021	Debenture Holders	480
31st Dec., 2021	Balance c/d	2,920

Share Capital Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	Balance c/d	10,000	1st Jan., 2021	Balance b/d	10,000

Debenture Redemption Reserve Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	Balance c/d	400	31st Dec., 2021	Retained Earnings	400

10% Debentures Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	10% Debenture Holders	400	1st Jan., 2021	Balance b/d	2,000
31st Dec., 2021	Balance c/d	1,600

Premium on Redemption Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	Debenture Redemption Reserve	80	1st Jan., 2021	Retained Earnings	80

Profit or Loss Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	Debenture Redemption Reserve	400	31st Dec., 2021	Balance c/d	3,820
31st Dec., 2021	Premium on Redemption	80
1st Jan., 2021	Balance b/d	4,300

10% Debenture Holders Account

Date	Details	Amount (TZS '000)	Date	Details	Amount (TZS '000)
31st Dec., 2021	Bank	480	31st Dec., 2021	Debentures	400
31st Dec., 2021	Premium on Redemption	80

SIGMA Ltd. Statement of Financial Position as at 31st December 2021

Details	Amount (TZS)
Assets
Non-current assets	12,900,000
Current assets
Bank	2,920,000
Total assets	15,820,000
Equity and Liabilities
Share capital	10,000,000
Debenture Redemption Reserve	400,000
10% Debentures	1,600,000
Profit or Loss	3,820,000
Total equity and liabilities	15,820,000

Conversion of debentures into shares or new debentures

An enterprise can recover its debentures by transforming them into a new class of debentures or shares. If debenture holders find that the offer is useful to them, they can exercise their right of transforming their debentures into new class of debentures or shares. It should be noted that this method is applicable only for convertible debentures. A company may opt not to pay the debenture holders at the time of redemption, instead, it can convert the debentures into a new class of debentures or even equity shares. Such debentures are known as convertible debentures. The new debentures or shares can be issued at par, premium or even discount. The accounting treatment for these scenarios are provided as follows

Journal Entries for Conversion of Debentures

S/N	Journal Entries	Dr. (Debit)	Cr. (Credit)
1	Debentures Converted to a New Class of Debentures	8% Debentures account (old) xx	9% Debentures account (New) xx
2	Debentures Converted to Equity Shares	8% Debentures account (old) xx	Equity share capital xx

Redemption by sinking fund method

Under this method fund will be created by annual appropriation from annual profit and the same will be invested to selected type of investments which will be managed by the trustee. The return from these investments will be reinvested until sufficient amount to redeem those debentures is built up. The fund will result from annual appropriation of profits and later invested on the trustee managed investments. Three special accounts have to be opened to cater for: fund creation; investment; and redemption. These accounts are:

1. Sinking fund account to cater for the build-up of the fund
2. Sinking fund investment account to cater for amount of funds which have been invested; and
3. Debenture redemption account for the ascertainment of a gain or loss on each redemption

Accounting Entries for Redemption of Debentures Using Sinking Fund Method

S/N	Details	Accounting Treatment	Dr. (Debit)	Cr. (Credit)
1	When making annual appropriation of profit	With the amount set aside from profit and loss account	Profit or loss appropriation account xx	Sinking fund account xx
2	When investing funds which were set aside	With money invested pertaining to the sinking fund	Sinking fund investments account xx	Bank/Cash account xx
3	When income (return) is received on the investment made	With the amount of income received	Bank account xx	Sinking fund account xx
4	When the received income is reinvested	With the amount of income received and reinvested	Sinking fund investment account xx	Bank account xx
5	When redeeming the debentures when they mature	With the nominal value of debenture being cancelled	Debentures account xx	Debenture redemption account xx
6	When making settlement to debenture holders	With amount due to debenture holders being redeemed	Debenture redemption account xx	Bank account xx
7	If debentures have been redeemed at more than the nominal value (premium)	With premium on redemption	Sinking fund account xx	Debenture redemption account xx
8	If redeemed at less than nominal value (discount or profit)	With the amount of discount on redemption	Debenture redemption account xx	Sinking fund account xx
9	To provide for the funds to be used to redeem the debentures, some investments need to be sold
10	Upon sale of the investments	With sales proceeds from investment sold	Bank account xx	Sinking fund investment account xx
11	If there is profit on sale	With the differences between cost and realizable value when sale proceeds are more than costs	Sinking fund investment account xx	Sinking fund account xx
12	If there is loss on sale	With the differences between cost and realizable value when sale proceeds are less than costs	Sinking funds account xx	Sinking fund investment account xx