Debentures, Features, Types, Accounting Treatment

Debenture is a long-term debt instrument issued by a company to raise capital from the public. It represents a loan taken by the company, making the holder a creditor, not an owner. Debentures are governed by the Companies Act, 2013 and often secured by a charge on the company’s assets. Key features include a fixed interest rate (coupon rate), a redemption date, and a trust deed executed with a debenture trustee to protect investors’ interests. They are a vital source of borrowed funds for corporate financing, ranking above equity in repayment during liquidation. Unlike shares, they do not carry voting rights.

Features of Debentures:

1. Long-Term Borrowed Capital

Debentures represent long-term borrowed capital raised by a company from the public. They are not ownership capital but a form of debt. The company promises to repay the principal amount on maturity. Debenture holders are creditors, not owners of the company. The funds raised are used for expansion, modernisation, and long-term projects. Debentures provide stable long-term finance without diluting ownership. They are generally issued for a fixed period of 5 to 10 years or more. This feature makes debentures suitable for companies needing large funds for capital expenditure. It also helps in maintaining a balanced capital structure with debt and equity.

2. Fixed Rate of Interest

Debenture holders receive interest at a fixed rate irrespective of profits. Interest must be paid even if the company suffers losses. This provides regular and certain income to investors. The rate is decided at the time of issue and mentioned in the debenture certificate. Interest is a charge against profits, not an appropriation. It is payable before dividend. This fixed nature makes debentures attractive to conservative investors seeking stable returns. However, it creates a fixed burden on the company. During low-profit periods, payment of interest may strain financial resources and reduce profits available to shareholders.

3. Secured by Charge on Assets

Debentures are generally secured by a charge on assets of the company. Secured debentures create a fixed or floating charge on property, plant, or stock. This gives debenture holders priority in repayment from sale of charged assets. In case of default or liquidation, they can recover their money from secured assets. This security reduces risk for investors. It increases confidence and helps the company raise funds at lower interest. However, the company cannot freely sell charged assets. Unsecured debentures do not have this protection. Thus, security makes debentures a safer investment compared to unsecured loans and preference shares.

4. No Voting Rights

Debenture holders generally have no voting rights in the management of the company. They cannot vote for directors or participate in routine business decisions. They are only lenders and not owners. Their rights are limited to receiving interest and repayment of principal. This allows promoters to raise funds without diluting control. Debenture holders may get voting rights only in matters directly affecting their interests. This feature is beneficial for the company. For investors, lack of control is a limitation. They must rely on the company’s management for safety. Thus, debentures suit investors seeking fixed income rather than participation in management.

5. Redeemable and Transferable

Debentures are redeemable after a fixed period as per terms of issue. The company repays the principal amount on maturity or in instalments. Redemption may be at par, premium, or discount. Debentures are also freely transferable like shares. Holders can sell them in the market through stock exchange. Transferability provides liquidity to investors. It allows them to exit before maturity if needed. The company must maintain a Debenture Redemption Reserve for redemption. This feature makes debentures flexible and attractive. It combines long-term finance for the company with liquidity and planned repayment for investors.

6. Priority in Repayment

Debenture holders enjoy priority in repayment over preference and equity shareholders. In case of liquidation, after payment to secured creditors, debenture holders are paid before shareholders. Their claims rank higher than all owners. This gives greater safety to their capital. Even if the company fails, they have a better chance of recovering money. This priority reduces investment risk and makes debentures attractive. It also reflects their status as creditors. The company must honour this priority to maintain credibility. Thus, priority in repayment is an important feature that distinguishes debentures from preference shares and equity shares in capital structure.

7. Tax Benefit to Company

Interest on debentures is a tax-deductible expense for the company. It is treated as a charge against profits and reduces taxable income. This lowers the effective cost of debentures compared to preference shares. The company saves tax while paying interest. This benefit encourages companies to raise funds through debentures. It improves profitability after tax. For investors, interest is taxable in their hands. The tax advantage makes debentures a cheaper source of finance. It helps the company in financial planning and capital structure decisions. Thus, debentures are a cost-effective long-term source of funds for growing businesses.

Types of Debentures:

1. Secured vs. Unsecured Debentures

Secured Debentures are backed by a charge (mortgage or hypothecation) on the company’s specific or general assets. If the company defaults, debenture holders can recover their dues by selling these assets. This security makes them less risky. Unsecured Debentures (or “Naked Debentures”) have no such charge. Holders are general creditors with no preferential claim on assets, making them riskier and typically offering higher interest. In India, public issues of debentures are almost always secured to protect investors, with a mandatory debenture trustee.

2. Convertible vs. Non-Convertible Debentures

Convertible Debentures grant holders the right to convert their debt into equity shares of the company after a specified period, at a predetermined ratio. This offers the potential for capital appreciation. Non-Convertible Debentures (NCDs) lack this conversion feature and are redeemed at maturity. NCDs are more common in the Indian market. Convertible debentures are further classified into Fully Convertible (FCDs) and Partly Convertible (PCDs), where only a portion of the value is converted.

3. Redeemable vs. Irredeemable Debentures

Redeemable Debentures are issued with a specific maturity date, on which the company repays the principal amount to holders. Redemption can happen at par, premium, or discount. Most debentures are redeemable. Irredeemable Debentures (or Perpetual Debentures) have no fixed repayment date. They are repayable only upon the company’s liquidation or as per the terms of issue (e.g., after a long notice period). Under the Companies Act, 2013, all debentures issued in India must have a redemption date, effectively eliminating true irredeemable debentures.

4. Registered vs. Bearer Debentures

Registered Debentures are recorded in the company’s register of debenture holders. Transfer requires a proper instrument of transfer and registration with the company. Interest is paid via cheque/directly to the registered holder. Bearer Debentures are negotiable instruments, transferable by mere delivery. Whoever physically holds (bears) the debenture is its owner. Interest is claimed by submitting attached coupons. Due to anonymity and potential misuse, bearer debentures are now largely obsolete and prohibited in India under regulatory norms to prevent money laundering.

5. Specific vs. Floating Charge Debentures

This relates to the nature of security. Specific Charge Debentures are secured by a mortgage on identifiable, fixed assets like land or machinery. These assets cannot be sold without the debenture holder’s consent. Floating Charge Debentures are secured by a charge on the company’s general, fluctuating assets like stock-in-trade or receivables. The company can freely deal with these assets until “crystallization” (e.g., default or winding-up), when the charge becomes fixed. Often, debentures are secured by both a specific and a floating charge.

Steps Treatment of Accounting for Debentures:

1. Issue of Debentures

When debentures are issued for cash or consideration

2. Debenture Allotment Due

When amount becomes payable on allotment

3. Receipt of Debenture Allotment Money

4. Interest on Debentures Due

Interest payable on debentures

5. Payment of Interest on Debentures

6. Redemption of Debentures

At the time of repayment