Redemption of Debentures | ISC Class 12 Accounts Notes

This note covers the redemption of debentures: the meaning of redemption, the methods of redemption, the creation of the Debenture Redemption Reserve (wherever applicable), redemption out of profits, redemption out of capital, redemption in a lump sum, and redemption in annual instalments by draw of lots.

What does "redemption of debentures" mean?

Redemption of debentures refers to extinguishing or discharging the liability on account of debentures in accordance with the terms of issue. In other words, redemption means repayment of the amount of debentures by the company to the debentureholders.

A company may redeem its debentures on the due date, or, if its articles provide for it, before the maturity date.

Definition: Redemption of debentures. Discharge of the liability on account of debentures by repayment made to the debentureholders, as per the terms on which the debentures were originally issued.

Two factors are considered by a company before redeeming debentures: the time of redemption (generally on the due date, though earlier redemption is possible if the articles allow it) and the source of redemption, that is, whether the company redeems the debentures out of capital or out of profits.

What are the methods of redeeming debentures?

There are four ways by which debentures can be redeemed: payment in lump sum, payment in instalments, purchase in open market, and conversion into shares or new debentures.

The sections below deal with redemption in lump sum and redemption in annual instalments by draw of lots, together with the creation of the Debenture Redemption Reserve and redemption out of profits or out of capital.

What is the Debenture Redemption Reserve (DRR) and when must it be created?

A company may source the redemption of its debentures either out of capital or out of profits.

Where a company redeems debentures out of profits, an amount is set aside each year as a Debenture Redemption Reserve, which is a reserve created out of profits so that the full resources are not distributed as dividend and remain available to meet the redemption liability.

Definition: Debenture Redemption Reserve (DRR). A reserve created, wherever applicable, by transferring an amount out of profits (Statement of Profit and Loss) so that a fund is built up before debentures fall due for redemption.

Under the Companies Act, 2013, all India financial institutions regulated by the Reserve Bank of India, banking companies, Non-Banking Finance Companies (NBFCs) registered with the Reserve Bank of India, Housing Finance Companies registered with the National Housing Bank, and companies listed on a stock exchange, along with other unlisted companies that are exempted, are not required to create a Debenture Redemption Reserve and may redeem debentures out of capital.

For an other unlisted company (one not falling in the exempted categories), the Debenture Redemption Reserve must be adequate, and the amount is ten percent of the value of the outstanding debentures. This requirement is meant to protect debentureholders where the company is not otherwise closely regulated by the Reserve Bank of India or by stock-exchange listing norms.

The entry to create the reserve debits the Surplus account, that is the balance in the Statement of Profit and Loss, and credits the Debenture Redemption Reserve account.

Once the related debentures are redeemed, the reserve is no longer needed for that purpose and is transferred to General Reserve, usually in instalments corresponding to the instalments of debentures redeemed.

How are debentures redeemed out of profits?

When debentures are redeemed out of profits, the company first creates a Debenture Redemption Reserve (where applicable) by appropriating an amount from the Statement of Profit and Loss, so that distributable profits are reduced and resources are retained in the business.

This is the method required of other unlisted companies, which must maintain a DRR equal to 10% of the outstanding debentures before redemption.

Once the debentures are actually repaid, the DRR that was created for them is no longer required and is transferred to General Reserve. The proceeds available with the company are then used to pay the debentureholders account.

Worked example 1. Y Ltd., an other unlisted company, has 4,000, 10% debentures of ₹100 each outstanding, to be redeemed out of profits. Show the entry to create the Debenture Redemption Reserve and the entry to transfer it to General Reserve after redemption.

Answer: DRR required = 10% of ₹4,00,000 (4,000 × ₹100) = ₹40,000. Surplus, i.e., Balance in Statement of Profit and Loss A/c Dr ₹40,000; To Debenture Redemption Reserve A/c ₹40,000. After the debentures are redeemed: Debenture Redemption Reserve A/c Dr ₹40,000; To General Reserve A/c ₹40,000.

How are debentures redeemed out of capital?

When debentures are redeemed out of capital, no Debenture Redemption Reserve needs to be created, because the company is one of the categories exempted under the Companies Act, 2013: all India financial institutions regulated by the Reserve Bank of India, banking companies, NBFCs registered with the Reserve Bank of India, Housing Finance Companies registered with the National Housing Bank, and companies (listed or unlisted) that fall within the exempted categories.

Such companies may redeem their debentures directly out of the funds available, without first setting aside profits into a reserve.

Because no reserve has been built up, the company must plan its cash position carefully so that the full amount due to debentureholders is available on the redemption date.

How are debentures redeemed in a lump sum?

Redemption by payment in lump sum means the company pays the whole amount due on the debentures in one instalment to the debentureholders at maturity, as per the terms of issue. The accounting depends on whether the debentures are redeemable at par or at a premium.

1. If debentures are redeemable at par: debit the Debentures account and credit Debentureholders account with the nominal (face) value due.
2. If debentures are redeemable at a premium: debit the Debentures account with the nominal value and debit the Premium on Redemption of Debentures account with the premium amount, crediting Debentureholders account with the total.
3. Where a Debenture Redemption Investment exists, it is first realised (debit Bank account, credit Debenture Redemption Investment) so that cash is available.
4. Finally, the amount due is paid: debit Debentureholders account and credit Bank account.

Worked example 2. X Ltd. issued 5,000, 9% debentures of ₹100 each at par, redeemable at par at the end of 5 years out of capital. Pass the journal entries at the time of redemption.

Answer: 9% Debentures A/c Dr ₹5,00,000; To Debentureholders A/c ₹5,00,000 (amount due on redemption). Then Debentureholders A/c Dr ₹5,00,000; To Bank A/c ₹5,00,000 (payment made). As X Ltd. redeems out of capital, no Debenture Redemption Reserve entry is needed.

Worked example 3. X Ltd. issued ₹1,00,000, 12% debentures at a discount of 5% but redeemable at a premium of 5% at the end of 5 years. Pass the journal entries at the time of redemption.

Answer: 12% Debentures A/c Dr ₹1,00,000; Premium on Redemption of Debentures A/c Dr ₹5,000; To Debentureholders A/c ₹1,05,000 (amount due on redemption, including premium). Then Debentureholders A/c Dr ₹1,05,000; To Bank A/c ₹1,05,000 (payment made to debentureholders).

Worked example 4. XYZ Ltd., an other unlisted company, issued 200, 15% debentures of ₹100 each on 1 April 2016 at a discount of 10%, redeemable at a premium of 10%, to be redeemed in a lump sum at the end of the fourth year. The face value of the debentures is ₹20,000. Show the DRR and the redemption entries.

Answer: DRR required = 10% of ₹20,000 = ₹2,000. Surplus, that is Statement of Profit and Loss A/c Dr ₹2,000; To Debenture Redemption Reserve A/c ₹2,000. Redemption entry: 15% Debentures A/c Dr ₹20,000; Premium on Redemption of Debentures A/c Dr ₹2,000; To Debentureholders A/c ₹22,000. Payment: Debentureholders A/c Dr ₹22,000; To Bank A/c ₹22,000. Since the reserve is no longer required: Debenture Redemption Reserve A/c Dr ₹2,000; To General Reserve A/c ₹2,000.

How are debentures redeemed in annual instalments by draw of lots?

Under payment in instalments, the debentures are not all repaid on one date; instead, redemption takes place in instalments on specified dates during the tenure of the debentures.

The total amount of debenture liability is divided over the number of years of instalments, and the actual debentures to be redeemed each year are identified by means of draw of lots out of the debentures that remain outstanding for payment, so that no particular holder is favoured and the selection is random among the outstanding holdings.

Conceptually, at the time each instalment falls due, the Debentures account is debited (with the nominal value of the debentures drawn for redemption that year) and the Debentureholders account is credited; where the instalment is redeemable at a premium, the Premium on Redemption of Debentures account is also debited.

The Debentureholders account is then debited and Bank credited on payment. Where applicable, a proportionate part of the Debenture Redemption Reserve corresponding to the debentures redeemed in a given year is transferred to General Reserve.

Interest on the debentures still outstanding continues to be paid on the earlier (larger) amount until that instalment is redeemed; after each instalment, interest is calculated on the reduced balance of debentures remaining outstanding, since interest on debentures is calculated on their nominal value and is payable as long as the debentures remain outstanding.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

How are debentures redeemed by purchase in the open market?

A company may also redeem debentures by purchasing its own debentures in the open market for immediate cancellation.

This is attractive when the company has surplus funds and its debentures are quoted below their nominal value, since the difference is a gain. If the market price is above the nominal value, the difference is a loss.

Where debentures are purchased below nominal value and cancelled, the excess of nominal value over the price paid is credited to a Profit on Redemption of Debentures account, which is later transferred to Capital Reserve, because it represents a capital gain and not a trading profit.

Worked example 7. X Ltd. purchased its own debentures of ₹100 each, of the face value of ₹20,000, from the open market for cancellation at ₹92. Record the necessary journal entries.

Answer: Debentures A/c Dr ₹20,000; To Bank A/c ₹18,400 (20,000 × 92/100); To Profit on Redemption of Debentures A/c ₹1,600 (balancing figure, being the discount gained). Then Profit on Redemption of Debentures A/c Dr ₹1,600; To Capital Reserve A/c ₹1,600, transferring the profit on cancellation of debentures to capital reserve.

How are debentures redeemed by conversion into shares or new debentures?

Besides lump sum and instalment redemption, a company can also redeem debentures by conversion into shares or new debentures, where the terms of issue permit this. Only the actual proceeds originally realised from the debentures, that is, after allowing for any discount on original issue, are taken into account when computing how many new shares are issued in exchange, and this method applies only to convertible debentures.

How are debentures classified by tenure?

Debentures may also be classified from the point of view of tenure as redeemable debentures, which are payable on the expiry of a specific period either in lump sum or in instalments, or as irredeemable debentures, also known as perpetual debentures, for which the company gives no undertaking to repay and which are repayable only on winding up or at the expiry of a long period.

What is a collateral security issue of debentures?

A company may also issue its own debentures as collateral security, that is, as an additional security alongside a primary asset, when obtaining a loan from a bank or financial institution; if the company repays the loan, these debentures are cancelled and never need to be formally redeemed through the usual methods.

What is a Debenture Redemption Investment (DRI) and how is it calculated?

Separately from the DRR, a company is required to invest or deposit a sum, on or before 30 April of a year, which shall not be less than 15% of the amount of debentures maturing during the year ending 31 March of the next year.

This investment, called the Debenture Redemption Investment, may be made in one or more of: deposit with any scheduled bank free of any charge or lien, securities of the Central Government or any State Government, securities mentioned in the Indian Trusts Act, 1882, or bonds of a company notified under that Act.

The amount invested or deposited cannot be used for any purpose other than redemption of the debentures maturing during that year. Where debentures are redeemed in a single lump sum, the investment of 15% is realised fully at redemption.

Where debentures are redeemed in instalments, the investment is not realised in full each time; instead, it is carried forward and topped up or partly realised so that it remains at least 15% of the value of debentures due for redemption in the following year.

Definition: Debenture Redemption Investment (DRI). An investment or deposit, equal to at least 15% of debentures maturing in the year, made by a company on or before 30 April so that cash is available for redemption.

DRI = 15% × debentures maturing in the year, invested or deposited on or before 30 April preceding the year of redemption, and realised at the time the debentures actually fall due.

Worked example 6. XYZ Ltd., an other unlisted company, issued 200, 15% debentures of ₹100 each, redeemable in a lump sum at the end of the fourth year. Show the Debenture Redemption Investment entries.

Answer: DRI required = 15% of ₹20,000 = ₹3,000, invested on or before 30 April before the year of redemption: Debenture Redemption Investment A/c Dr ₹3,000; To Bank A/c ₹3,000. At redemption, the investment is realised: Bank A/c Dr ₹3,000; To Debenture Redemption Investment A/c ₹3,000.

What are the advantages and limitations of the different redemption methods?

Advantages

• Redemption in lump sum is simple to administer, as all debentureholders are repaid on a single date according to the terms of issue.
• Redemption in instalments by draw of lots spreads the cash outflow of the company over several years rather than requiring one large payment.
• Redemption out of profits, through a Debenture Redemption Reserve, builds up resources gradually and protects debentureholders, since profits are not all distributed as dividend.
• Redemption out of capital is quicker for exempted companies, as no part of the profits has to be locked up in a reserve before repayment.

Limitations

• Redemption in lump sum requires the company to arrange a large sum of cash on a single date, which can strain liquidity if not planned for through a reserve well in advance.
• Redemption by draw of lots means an individual debentureholder cannot be certain when their own holding will be selected for repayment.
• Where a Debenture Redemption Reserve is required (for other unlisted companies), profits that might otherwise be available for dividend are locked into the reserve until the debentures are redeemed.
• Companies exempted from creating a DRR and redeeming out of capital must still find the resources for repayment without the cushion of an accumulated reserve of profits.

How would an instalment redemption look in figures?

The draw-of-lots method is studied as a concept, but a short illustration shows how the entries follow.

Worked example 5. P Ltd., an other unlisted company, has 8,000, 12% debentures of ₹100 each, to be redeemed in four equal annual instalments of 2,000 debentures each by draw of lots. Show the redemption entry for the first instalment and the DRR transfer for that year, given that a DRR of ₹80,000 was created.

Answer: Debentures drawn in the first instalment = 2,000 × ₹100 = ₹2,00,000. 12% Debentures A/c Dr ₹2,00,000; To Debentureholders A/c ₹2,00,000. Payment: Debentureholders A/c Dr ₹2,00,000; To Bank A/c ₹2,00,000. One fourth of the DRR is transferred: Debenture Redemption Reserve A/c Dr ₹20,000; To General Reserve A/c ₹20,000.

Glossary

• Debenture: a written instrument, under the common seal of the company, acknowledging a debt and providing for repayment of principal and periodic interest at a fixed rate.
• Redemption of debentures: discharge of the liability on account of debentures by repayment made to the debentureholders, as per the terms of issue.
• Debenture Redemption Reserve (DRR): a reserve created out of profits, wherever applicable, so that resources are retained to meet the redemption liability on debentures.
• Payment in lump sum: redemption of the whole amount of debentures in one instalment to the debentureholders at maturity.
• Payment in instalments: redemption of debentures over several specified dates during their tenure, the actual debentures being chosen by draw of lots.
• Draw of lots: a method of randomly selecting, out of the outstanding debentures, which particular holdings will be redeemed in a given instalment.
• Premium on Redemption of Debentures: the account debited for the extra amount, over nominal value, payable to debentureholders when debentures are redeemable at a premium.
• General Reserve: a free reserve to which the Debenture Redemption Reserve is transferred once the related debentures have been redeemed and the reserve is no longer required.
• Other unlisted company: a company not falling within the categories exempted by the Companies Act, 2013 from creating a Debenture Redemption Reserve, and therefore required to maintain a DRR of 10%.
• Listed company: a company whose securities are listed on a stock exchange; exempted, under the Companies Act, 2013, from the requirement to create a DRR.
• Debenture Redemption Investment (DRI): an investment or deposit of at least 15% of debentures maturing in a year, made on or before 30 April before that year.
• Purchase in open market: a company buying back its own debentures from the market for the purpose of immediate cancellation.
• Profit on Redemption of Debentures: the gain arising when a company cancels its own debentures bought from the market at a price below nominal value; transferred to Capital Reserve.
• Capital Reserve: a reserve of a capital nature, not normally available for dividend, to which a profit on redemption of debentures is transferred.

Common errors and misconceptions

• Misconception: Every company must create a Debenture Redemption Reserve. Correct: Listed companies, banking companies, NBFCs and certain other categories are exempted; only other unlisted companies must create a DRR of 10%.
• Misconception: Premium on Redemption of Debentures is credited at the time of redemption. Correct: It is debited at redemption, being an amount payable to debentureholders over and above the nominal value.
• Misconception: Redemption by draw of lots lets a company choose which debentureholders to repay first. Correct: The debentures to be redeemed are selected at random by draw of lots among those outstanding.
• Misconception: Redemption out of capital also requires a Debenture Redemption Reserve. Correct: Redemption out of capital is available to exempted companies and needs no DRR, though the cash for repayment must still be arranged.
• Misconception: The Debenture Redemption Reserve stays in the books forever after it is created. Correct: Once the related debentures are redeemed, the reserve is transferred to General Reserve, usually in instalments matching the redemption.
• Misconception: In instalment redemption, interest continues on the original amount throughout. Correct: After each instalment, interest is calculated only on the debentures still outstanding, since interest is charged on nominal value.
• Misconception: A company can redeem debentures before the due date whenever it likes. Correct: Early redemption is possible only if the articles of the company provide for it.

Exam-style questions with model answers

Q1. Enumerate two methods of redemption of debentures. [1 mark]

1. Payment in lump sum, and payment in instalments by draw of lots.

Q2. Define Debenture Redemption Reserve. [2 marks]

1. It is a reserve created out of profits, wherever applicable, by transferring an amount from the Statement of Profit and Loss, so that resources are retained within the business to meet the liability of repaying debentureholders.
2. It is required only of other unlisted companies, at 10% of the value of outstanding debentures; listed companies and certain financial institutions are exempted.

Q3. Distinguish between redemption of debentures out of profits and redemption out of capital. [3 marks]

1. Redemption out of profits requires the company to create a Debenture Redemption Reserve by appropriating an amount from the Statement of Profit and Loss before the debentures are repaid.
2. Redemption out of capital is available to companies exempted under the Companies Act, 2013, such as listed companies, banking companies and certain financial institutions, which may redeem debentures without first creating a DRR.
3. In both cases the debentures are finally discharged by debiting the Debentures account and crediting the Debentureholders account, and then paying them by debiting Debentureholders and crediting Bank.

Q4. RK Ltd., an other unlisted company, has 6,000, 10% debentures of ₹100 each to be redeemed in a lump sum. Calculate the amount of Debenture Redemption Reserve required. [2 marks]

1. Face value of debentures = 6,000 × ₹100 = ₹6,00,000.
2. Debenture Redemption Reserve required = 10% of ₹6,00,000 = ₹60,000, since RK Ltd. is an other unlisted company and is not exempted.

Q5. Explain how the liability of a company differs between redemption at par and redemption at a premium, in a lump sum redemption. [3 marks]

1. When debentures are redeemable at par, only the nominal (face) value is credited to the Debentureholders account on redemption.
2. When debentures are redeemable at a premium, the nominal value is credited along with an additional amount, debited to the Premium on Redemption of Debentures account, representing the extra sum payable over face value.
3. In both cases, the amount due is finally paid by debiting the Debentureholders account and crediting Bank.

Q6. A Ltd. issued ₹2,00,000, 10% debentures at par, redeemable at a premium of 5% at the end of 5 years. Pass the journal entries at the time of redemption. [3 marks]

1. 10% Debentures A/c Dr ₹2,00,000.
2. Premium on Redemption of Debentures A/c Dr ₹10,000 (5% of ₹2,00,000).
3. To Debentureholders A/c ₹2,10,000 (amount due on redemption).
4. Debentureholders A/c Dr ₹2,10,000; To Bank A/c ₹2,10,000, on payment to debentureholders.

Q7. Explain the concept of redemption of debentures in annual instalments by draw of lots. [5 marks]

1. Under this method, the debentures are not repaid all at once; instead, redemption is spread over several years as per the terms of issue, with a fixed number or proportion of debentures repaid in specified years.
2. At each instalment date, the particular debentures to be redeemed are identified by drawing lots at random among the debentures still outstanding, so that no holder is deliberately favoured.
3. The Debentures account is debited and Debentureholders account credited with the nominal value of the debentures drawn for that instalment; where redeemable at a premium, Premium on Redemption of Debentures is also debited.
4. Debentureholders account is then debited and Bank credited when payment is actually made to them.
5. Where a DRR was created, a proportionate part of it is transferred to General Reserve each year, and interest for subsequent years is calculated only on the debentures still remaining outstanding after each instalment is redeemed.

Q8. Why does the Companies Act, 2013 exempt certain companies from creating a Debenture Redemption Reserve? Name two categories of exempted companies. [4 marks]

1. Companies such as all India financial institutions regulated by the Reserve Bank of India and banking companies are listed in the Companies Act, 2013 among the categories exempted from creating a Debenture Redemption Reserve.
2. Listed companies, whose securities trade on a stock exchange and are subject to continuing disclosure requirements, are also exempted and may redeem debentures out of capital.
3. Two examples of exempted categories are: banking companies, and companies listed on a stock exchange.
4. Companies not in any exempted category, called other unlisted companies, are required to maintain a DRR of 10% of outstanding debentures to protect debentureholders, since such companies are less closely regulated.

Q9. P Ltd., an other unlisted company, has 8,000, 12% debentures of ₹100 each to be redeemed in four equal annual instalments by draw of lots. A DRR of ₹80,000 has been created. Show the redemption entry for the first instalment and the transfer from the DRR. [3 marks]

1. Debentures drawn in the first instalment = 2,000 × ₹100 = ₹2,00,000.
2. 12% Debentures A/c Dr ₹2,00,000; To Debentureholders A/c ₹2,00,000; then Debentureholders A/c Dr ₹2,00,000; To Bank A/c ₹2,00,000.
3. One fourth of the DRR is transferred: Debenture Redemption Reserve A/c Dr ₹20,000; To General Reserve A/c ₹20,000.

Key takeaways

• Redemption of debentures means discharging the liability on debentures by repaying debentureholders as per the terms of issue.
• Debentures can be redeemed by lump sum payment, payment in instalments by draw of lots, purchase in the open market, or conversion into shares or new debentures.
• A Debenture Redemption Reserve is required only of other unlisted companies at 10% of outstanding debentures; several categories, including listed companies, are exempted under the Companies Act, 2013.
• Redemption out of profits requires creating a DRR before repayment; redemption out of capital does not.
• Lump sum redemption pays the whole liability on one date; redemption by draw of lots spreads repayment over several years with debentures chosen at random each time.
• When debentures are redeemable at a premium, Premium on Redemption of Debentures is debited along with the Debentures account at the time of redemption.
• Once debentures are redeemed, any Debenture Redemption Reserve created for them is transferred to General Reserve.
• Interest on debentures is calculated on nominal value, so it falls after each instalment as the outstanding debentures are reduced.

Test yourself

What is meant by redemption of debentures?

Discharging the liability on account of debentures by repaying debentureholders as per the terms of issue, through one of the recognised methods of redemption.

Which companies are exempted from creating a Debenture Redemption Reserve?

All India financial institutions regulated by the Reserve Bank of India, banking companies, NBFCs registered with the Reserve Bank of India, Housing Finance Companies registered with the National Housing Bank, and listed companies.

What rate of DRR must other unlisted companies maintain?

The Debenture Redemption Reserve required of other unlisted companies is 10% of the value of their outstanding debentures.

How are debentures selected for redemption under the instalment method?

By draw of lots, at random, out of the debentures still outstanding at the time of each instalment.

What account is debited, in addition to the Debentures account, when debentures are redeemed at a premium?

The Premium on Redemption of Debentures account, since debentureholders are entitled to the extra amount over nominal value as well.

Once debentures are repaid, what happens to the Debenture Redemption Reserve created for them?

It is no longer required for that purpose and is transferred to General Reserve.

Can a company redeem its debentures before the due date?

Generally debentures are redeemed on the due date, but a company may redeem them before maturity if its articles provide for such early redemption.

On what amount is interest on debentures calculated?

Interest is calculated on the nominal value of the debentures still outstanding, so it falls after each instalment is redeemed.