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Monday, December 14, 2009
Explanation of Debentures
Company Account: Issue of Debentures
Q.1. What do you mean by the term 'Debenture'? What are the kinds of Debentures?
Answer: When a company desires to borrow a considerable sum of money for its expansion, it invites the general public to subscribe to its debentures. A debenture is a certificate issued by the company acknowledging the debt due by it to its holders and is issued by means of a prospectus in the same manner as shares.
Kinds of Debentures:
The following are the various types of debentures issued by a company:
Security Point of View
Fixed Charge: A fixed charge is created on certain specified assets generally immovable such as land and building, plant and machinery, long term investments and the like. So it is equivalent to mortgage. When the charge is fixed, the company can only deal with the property subject to the charge, that is, a fixed charge allows the company to retain possession of the assets but prevents the company from selling, leasing etc., of the assets without the consent of the charge holders. The property identified remains so identified during the period for which the charge is created.
Floating Charge: A floating charge is generally in respect of movables, that is, properties which are constantly changing. It does not amount to mortgage of property. A charge on the stock-in-trade from time to time of a business is a floating charge. When an item is sold out of the stock, the charge ceases to attach to it and the buyer cannot be asked to pay the debt. When a new item is added to it the charge automatically attaches to it without further new agreement. So the property is certainly identified at the time of creation of charge; its very identification goes on changing and the final identification is at the point of time when the charge crystallizes or becomes fixed after which the company can mortgage or sell that property subject the charge. The charge will continue to attach only so long as the item remains unsold.
Unsecured Debentures: When debentures are issued without any charge or security, they are termed as unsecured or naked debentures. Holders of unsecured debentures are ordinary unsecured creditors and do not enjoy any special rights.
Tenure Point of View
Redeemable Debentures: Such debentures are redeemable at par or premium after the expiry of a particular period or under a system of periodical drawings.
Perpetual Debentures: Debentures may be made irredeemable or in other words perpetual. Such debentures are redeemable either on the happening of a contingency or when the company is wound up or when the company decides to redeem.
Mode of Redemption Point of View
Convertible Debentures: Debentures may be convertible into equity or preference shares of the company on certain dates or during certain periods on the basis of an agreement between company and debenture holders.
Fully Convertible Debentures: When the full amount of debentures is converted into shares of the company at agreed terms and conditions. The conversion is to be made at or after 18 months from the date of allotment but before 36 months.
Partly Convertible Debentures: When only a part of the amount of debentures is convertible into shares at a specified time and remaining part of debenture is redeemable on agreed terms.
Non-Convertible Debentures: Such debentures are not convertible into equity or preference shares.
Coupon Rate Point of View: Usually the debentures are issued with a specified rate of interest, which is called as coupon rate. The specified rate may either be fixed or floating. The floating interest rate is usually tagged with the bank rate and yield on Treasury bond plus a reward for risk. Since the bank rate and yield on treasury securities keep on fluctuating over a period of time any change is compensated in the risk premium. The rate of interest in such a case is quoted as "PLR + 50 basis points". In this case if it is assume a PLR of 9% the rate of interest would 9.5%. The "+ basis points" is determined in relation to risk involved.
A zero coupon bondis one which does not carry a specified rate of interest. In order to compensate the investors such bonds are then issued at a substantial discount. The difference between the face value and issue price is the total amount of interest related to the duration of the bond. In order to calculate the periodic charge of interest, the amount is calculated by using the following formula:
BO = MV/(1+ i)n
BO = Value of zero coupon bond.
MV = Maturity value of zero coupon bond.
n = Life of zero coupon bond.
i = Required rate of return.
In the above formula the value of (1 +i)n is easily computed by dividing issue price in the maturity value of the bond. To find out the interest rate applicable to such bonds, we need to look for present value interest factor tables across the period equal to 'n' and find out the value near the above computed value. The interest rate in that column will be the interest on bonds. Thus, if we know the interest rate, years to maturity and the issue price, then the maturity value can be computed. In the same manner, if interest rate, years to maturity and maturity value are known, then the issue price can be computed. Present value interest factor for i rate of interest and 'n' years is written as PVIF,i.n and are given in present value of Re. 1 table shown in the appendix.
BO = MV x PVIF,i,n
MV= BO/PVIF, i. n
PVIFi.n = BO/ MV
Q.2. Briefly explain the following concepts:
1. Debentures: The word 'Debenture' is used to signify the acknowledgement of a debt, given under the seal of the company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest (usually half yearly) at a fixed rate until the principal sum is repaid and it may or may not give a charge on the assets of the company as security for the loan.
Section 2 (12) of the Companies Act states that "a debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not".
2. Bond: Bond is similar to that of debenture both in terms of contents and texture. Traditionally government issued the bonds, but now these are also issued by semi-government and non-government organizations. The significant difference between bonds and debentures is with respect to the issue condition i.e., bonds can be issued without predetermined rte of interest.
3. Charge: A charge is created on certain specified assets generally immovable such as land and building, plant and machinery, long term investments and the like. So it is equivalent to mortgage. When the charge is fixed, the company can only deal with the property subject to the charge, that is, a fixed charge allows the company to retain possession of the assets but prevents the company from selling, leasing etc., of the assets without the consent of the charge holders. The property identified remains so identified during the period for which the charge is created.
4. Debenture Stock: Debenture stock is a document representing the loan capital of the company consolidated into one single composite debt which may be divided into the transferable in convenient units of fixed amount. This sum may be of any amount and may include fraction of a rupee. Certificates are issued to each debenture stockholder indicating the amount of his contribution or holding. The debenture stock must be fully paid. Debenture is always for a fixed sum and is transferable only in its entirety by a debenture stock may be the consideration of the several debenture amounts and a single certificate issued covering many debenture. Similarly debenture stock may be transferable in parts if articles so permit.
Q.3. Distinguish between Shares and Debentures.
Basis of Difference
A share is a part of equity or preference share capital of a company. The holders of the shares may be described as part owner of the company.
A debenture is a part of loan capital of the company. The holder of a debenture is the creditor of the company.
Return on share is known as dividend. A company declares dividend only when there are profits and its rate may vary from year to year.
Return on a debenture is known as interest and the company compulsorily pays it at a fixed rate whether there are profits or losses.
Dividend is an appropriation of profit and is therefore debited in Profit & Loss Appropriation Account.
Interest on debenture is a charge against profits and is therefore debited in Profit & Loss Account.
4. Charge on Property
Shares do not create any charge on the assets of the company.
Debentures create a charge on the asset of the company.
Normally the share capital is not returned during the lifetime of the company.
The amount of debentures has to be returned after a stipulated period of time as per the conditions of issue.
6. Discount on Issue
Shares can be issued at discount only when the conditions lay down in Section 79 of the Companies Act 1956 are fulfilled.
There are no restrictions on issue of debentures at a discount.
7. Premium on Issue
The premium received on issue of shares can be utilised by the company subject to the conditions given in Section 78 of the Companies Act 1956.
Premium received on issue of debentures can be utilised by company in any manner it likes.
A company cannot purchase its own shares
A company can purchase own debentures from the open market.
Shares cannot be converted into debentures.
Debentures can be converted into shares according to the conditions of issue of debentures.
A shareholder has the right to control the affairs of the company by exercising his right to attend the general meeting of the company and by exercising his voting right.
A debenture holder does not have any right to control the affairs of the company.
11. Winding up
At the time of winding up the shareholders are paid their capital at the end.
Debenture holders have a priority as to return of amount received from them in the event of winding up of the company.
Q.4. Explain the meaning of debentures issued as collateral security by a company. Show its treatment in the Balance Sheet.
Answer: When debentures are issued as security in addition to any other security against a loan or bank overdraft such an issue of debentures is known as issue of debentures as collateral security. The idea of such an issue is that if the company does not repay the loan and the interest and the main security is not sufficient, the bank will be entitled to sell the debentures in the market or the bank may keep the debentures with it. If the company repays the loan, the bank will return the debentures issued as collateral security to the company.
No entry needs to be passed in the books of the company because debentures are issued only as a collateral security. Debentures become alive only when loan is not repaid. The fact of such an issue of debentures must be clearly stated in the Balance Sheet by way of a note under the loan and debentures as shown below:
Balance Sheet of --- Co. Ltd.
(secured by issuing 6,000 12% Debentures of Rs. 100 each)
Alternatively, the following entry may be passed in books of the company:
Bank A/c Dr.
To Bank Loan A/c
(For loan borrowed from bank)
Debentures Suspense A/c Dr.
To 12% Debentures A/c
(For 6,000 Debentures of Rs. 100 each issued as collateral security)
Balance Sheet of --- Co. Ltd.
Debentures Suspense A/c
(6,000 12% Debentures of Rs. 100 each issued as collateral security)
Q.5. Briefly explain the meaning of Trust Deed. Who can be a Trustee? What the duties of a Trustee?
Answer: When a series of debentures are issued to numerous debenture holders, it is not a practical proposition to create a number of separate charges on the properties of the company in favour of individual debenture holders. And it is practically impossible for the debenture holders also to keep a watch on the assets of the company in order to safeguard their own interests. It is thus becomes necessary to execute trust deed by which properties of the company are charged by way of mortgage to the trustees. A trust deed is therefore a contract between the company and the trustees for the debenture holders. Generally trust deed has to be executed before the debentures are offered for public subscriptions so that the prospective investors may satisfy themselves as to the contents of the trust deed and credibility of the trustees selected by the company to look after their interest. A trust deed is also a mortgage deed between the company and the trustees for debenture holders. The debenture holders are merely beneficiaries under the trust deed. Section 118 of the Companies Act gives the right to obtain the copies and inspect trust deed by any member of the company. The advantages of creating a trust deed are:
The trustees can act expeditiously and effectively in safeguard interests of the debenture holders and enforcing the security on their behalf.
They will act as watchdogs in seeing and insisting that company's obligations under the trust deed are carried out properly.
They are generally empowered to settle and adjust matters of dispute with the company.
In cases of doubt or difficulty they can convene meetings and enable the debenture holders to meet and discuss and authorize the trustees to pursue any course of action to be beneficial to the debenture holders as a whole.
Who can be Trustees?
Only the following are eligible to be debenture trustee:
A scheduled bank carrying on commercial activity.
A public financial institution within the meaning of sections 4A (1) of the Companies Act 1956.
Who can not be a Trustee?
No person can be appointed as a trustee if he:
Beneficially holds share in the company.
Beneficially entitle to receive money, which are to be paid to/the by the company to the debenture trustee.
Has entered into any guarantee in respect of principal debts, secured by debenture or interest thereon.
Duties of Trustees
Call for periodic reports from the body corporate
Take possession of trust property in accordance with the provisions of the trust deed
Enforce security in the interest of debenture holders
The charge created against the assets under debenture trust deed should be completed within 30 days of the issue of allotment letter and dispatch of debenture certificate.
A debenture trustee who fails to comply with any conditions, contravenes any of the provisions of the Act, rules or regulations, the Companies Act or rules made thereunder, may disqualify him to act as trustee.