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Q.‘Interest paid on debentures is a charge against the profits of the company.’ Is this statement correct ? Give reason in support of your answer.

CBSECBSE Class XII Board 2020Subjective· 1mImportance★★★★★
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The statement is correct — interest on debentures is a charge against profits, not an appropriation, because it is a contractual obligation payable regardless of whether the company earns a profit.

Concept First: Charge vs. Appropriation

In Accountancy, the distinction between a charge and an appropriation is fundamental to understanding how items are treated in the Profit and Loss Account.

A charge is an expense that a company is legally or contractually obliged to pay, irrespective of whether it has earned any profit. It is deducted from revenue to arrive at net profit. Examples include rent, salaries, and — crucially — interest on debentures.

An appropriation, on the other hand, is a distribution of profit after it has been earned. It is only made if there is sufficient profit. Examples include dividends to shareholders and transfers to reserves.

Debentures are a form of long-term borrowing. The company enters into a contract with debenture holders, promising to pay a fixed rate of interest at regular intervals. This interest is a financial cost, exactly like interest on a bank loan. It is not a reward for ownership (like a dividend) but a cost of using borrowed funds.

Why Interest on Debentures is a Charge

The statement is correct. Here is the reasoning:

  1. Contractual Obligation: The terms of the debenture trust deed create a legally binding obligation to pay interest. Failure to pay interest can lead to default and legal action by debenture holders.
  2. Paid Before Profit Calculation: Interest on debentures is debited to the Profit and Loss Account as a finance cost. It is deducted from the company's gross profit to arrive at the net profit for the year. It is never taken from the net profit.
  3. Payable Even in Loss: If a company incurs a net loss, it is still legally required to pay interest on its debentures. This would increase the loss. A dividend, being an appropriation, cannot be paid if there is no profit.
Watch out

Common Mistake

Students often confuse debenture interest with dividend on shares. Remember: a debenture holder is a creditor of the company, not an owner. Interest is a cost of borrowing; a dividend is a share of profit. One is a charge, the other is an appropriation.

Tip

Quick Test

Ask yourself: "Would this payment still have to be made if the company made zero profit?" If the answer is yes, it is a charge. For debenture interest, the answer is always yes.

Journal Entry for Interest on Debentures …

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