Explain the different types of debentures?

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Q. Explain the different types of debentures?

Puducherry CbseNCERTSubjective· 3mImportance★★★★★

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Concept understanding — Debenture Definition

Debentures: The Company's Way of Borrowing Money

Think of a debenture like this: you need ₹5,00,000 to expand your business. Instead of asking a bank for a loan, you go to the public and say, "Lend me money, and I'll pay you interest every year. After 5 years, I'll return your full amount." Each person who lends you money gets a certificate — that certificate is a debenture.

The Precise Meaning

A debenture is a written instrument issued by a company under its common seal, acknowledging a debt. It contains a promise to repay the borrowed amount at a specified date (maturity) and to pay interest at a fixed rate at regular intervals (usually half-yearly or yearly).

Note

A debenture holder is a creditor of the company, not an owner. They have no voting rights and no share in profits — only a fixed interest payment.

Why Debentures Matter

Companies issue debentures because:

They raise large funds without diluting ownership (unlike shares)
Interest paid on debentures is a tax-deductible expense (reduces taxable profit)
Debentures are safer for investors than shares (fixed return, priority in repayment)

For investors, debentures offer:

Fixed, predictable income
Higher safety than equity shares
Priority over shareholders if the company is liquidated

Accounting Treatment

When a company issues debentures, the journal entry is:

Particulars	Debit (₹)	Credit (₹)
Bank A/c Dr.	[Amount received]
To Debentures A/c		[Face value]
To Securities Premium Reserve A/c (if issued at premium)		[Premium amount]
(Being debentures issued at premium)

Key points:

Debit Bank A/c with the actual amount received
Credit Debentures A/c with the face value (nominal value)
If issued at a premium (e.g., ₹100 debenture issued for ₹110), credit the extra ₹10 to Securities Premium Reserve A/c
If issued at a discount (e.g., ₹100 debenture issued for ₹95), debit the discount to Discount on Issue of Debentures A/c (a fictitious asset written off over the debenture's life)

Watch out

Never confuse debentures with shares. Debentures are liabilities (shown under "Non-Current Liabilities" in the Balance Sheet), while shares are equity (shown under "Shareholders' Funds").

Interest on Debentures

Interest is calculated as:

Interest = Face Value of Debentures × Rate of Interest × Time Period

For example, if a company issues ₹10,00,000 worth of 9% debentures, the annual interest is:

₹10,00,000 × 9% = ₹90,000 per year

The journal entry for interest payment:

Particulars	Debit (₹)	Credit (₹)
Debenture Interest A/c Dr.	[Gross interest]
To Bank A/c		[Net interest paid]
To TDS Payable A/c		[Tax deducted at source]
(Being interest paid on debentures after deducting TDS)

At the end of the year, Debenture Interest A/c is closed by transferring to the Statement of Profit and Loss (as a finance cost).

Format in the Balance Sheet

As per NCERT Class 12 Accountancy, debentures appear under:

EQUITY AND LIABILITIES

Shareholders' Funds
Non-Current Liabilities
- Long-term borrowings
  - Debentures
Current Liabilities

Important

Debentures are always shown at their face value in the Balance Sheet, regardless of whether they were issued at a premium or discount. The premium or discount is shown separately.

The Big Picture

Debentures are the company's IOU — a formal promise to repay borrowed money with interest. They give the company funds without giving away control, and they give investors a safe, fixed-income investment. In accounting, they are treated as long-term liabilities, with interest treated as an expense in the Profit and Loss statement.

A debenture is a written instrument acknowledging a debt under the common seal of the company. It is a certificate issued by a company under its seal, promising to pay a specified sum with interest at a fixed rate. The different types of debentures are classified based on four criteria: security, tenure, convertibility, and registration.

Types of Debentures

Basis of Classification	Type	Description
Security	Secured / Mortgage Debentures	A charge is created on the company's assets (fixed or floating) as a guarantee. If the company defaults, debenture holders can sell those assets.
	Unsecured / Naked Debentures	No charge is created on any asset. The holder relies solely on the company's general creditworthiness.
Tenure	Redeemable Debentures	Issued for a fixed period. The company repays the principal amount on a specified date.
	Irredeemable / Perpetual Debentures	No fixed date of repayment. The company repays only when it goes into liquidation or after a very long period. (Note: Under the Companies Act, 2013, all debentures must be redeemable; perpetual debentures are now rare in practice.)
Convertibility	Convertible Debentures	The holder has the option to convert the debentures into equity shares (or other securities) at a specified time and ratio.
	Non-Convertible Debentures (NCDs)	Cannot be converted into equity shares. They remain debt instruments until redemption.
Registration	Registered Debentures	The company maintains a register of debenture holders. Transfer requires a proper instrument of transfer. Interest and principal are paid directly to the registered holder.
	Bearer Debentures	Transferable by mere delivery (like a negotiable instrument). Interest is paid to the person who presents the coupon attached to the debenture. The company does not maintain a register of holders.

✓Final answer

Debentures are classified into secured/unsecured, redeemable/irredeemable, convertible/non-convertible, and registered/bearer types based on security, tenure, convertibility, and registration.

Debentures are long-term debt instruments issued by companies to raise borrowed capital. They are classified based on security, tenure, convertibility, redemption, registration, coupon rate, and priority — each type affecting the rights and risks of the debenture holder.

Concept First: What is a Debenture?

A debenture is a written instrument acknowledging a debt owed by a company. When a company needs large funds for expansion or working capital but doesn't want to dilute ownership (by issuing shares), it borrows from the public by issuing debentures. The debenture holder is a creditor of the company, not an owner — they receive fixed interest (called coupon) regardless of company profits, and the principal is repaid at maturity.

The accounting treatment follows the Nominal Account rule: "Debenture" is a liability account — credited when issued, debited when redeemed. Interest on debentures is a charge against profit (not an appropriation), meaning it must be paid even if the company makes a loss. This is a critical distinction from dividends on shares.

Types of Debentures — Explained with Accounting Implications

1. From Security Point of View

Secured (or Mortgage) Debentures: These are backed by a charge on the company's assets. If the company defaults, debenture holders can sell the assets to recover their money. In accounting, the company records a "Debenture Trust Deed" and may create a Debenture Redemption Reserve (DRR) as per legal requirements.

Unsecured (or Naked) Debentures: No asset backing. Holders rely solely on the company's general creditworthiness. These carry higher risk, so interest rates are usually higher. No specific asset is mortgaged in the books.

Watch out

A common mistake: thinking all debentures are secured. Unsecured debentures exist and are legally valid — they rank equally with other unsecured creditors in case of liquidation.

2. From Tenure Point of View

Perpetual (or Irredeemable) Debentures: No fixed maturity date — the company never repays the principal unless it chooses to. These are rare today because company law now requires a redemption period. In accounting, they appear as a permanent liability.

Redeemable Debentures: Issued for a fixed period (e.g., 5, 10, 20 years). The company must repay the principal on the due date. The redemption is recorded by debiting "Debentures Account" and crediting "Bank Account" (or by creating a sinking fund).

3. From Convertibility Point of View

Convertible Debentures: The holder has the option to convert debentures into equity shares after a specified period. This is attractive because it combines fixed income with potential equity upside. In accounting, upon conversion, the debenture liability is transferred to "Share Capital Account" — the entry is:

Particulars	Debit (₹)	Credit (₹)
10% Debentures A/c Dr.	1,00,000
To Equity Share Capital A/c		1,00,000
(Being debentures converted into equity shares)

Non-Convertible Debentures (NCDs): Cannot be converted into shares. They remain debt until redemption. These are simpler to account for — just interest payments and eventual redemption.

Tip

For convertible debentures, remember: the conversion ratio is fixed at issue. If the market price of shares rises, the debenture holder benefits. The company's accounting does not revalue the debentures — the conversion is at the agreed ratio.

4. From Redemption Point of View

Redeemable at Par: The company repays the face value (e.g., ₹100 debenture repaid at ₹100). No premium or discount.

Redeemable at Premium: The company pays more than face value (e.g., ₹100 debenture repaid at ₹110). The extra ₹10 is a loss for the company — debited to "Premium on Redemption of Debentures A/c" (which is shown as a loss in the financial statements).

Redeemable at Discount: Rare, but possible — the company repays less than face value (e.g., ₹100 debenture repaid at ₹95). The discount is a gain for the company, credited to "Capital Reserve".

5. From Registration Point of View

Registered Debentures: The company maintains a register of debenture holders. Transfer requires a proper deed. Interest is paid to the registered holder. This is the standard type.

Bearer Debentures: Transferable by mere delivery — like currency notes. The company pays interest to whoever holds the certificate. These are less common now due to regulatory concerns. No register is maintained.

6. From Coupon Rate Point of View

Fixed Rate Debentures: Interest rate is fixed at issue (e.g., 10% p.a.). The accounting is straightforward — interest is calculated on face value and paid periodically.

Floating Rate Debentures: Interest rate changes with a benchmark (e.g., bank rate + 2%). The rate is recalculated each period. In accounting, the interest expense varies — you must compute it each time based on the current rate.

Zero Coupon Debentures: No periodic interest. Instead, they are issued at a deep discount (e.g., issued at ₹60 for face value ₹100). The difference (₹40) is the interest, amortised over the life of the debenture. The accounting entry at issue:

Particulars	Debit (₹)	Credit (₹)
Bank A/c Dr.	60,000
Discount on Issue of Debentures A/c Dr.	40,000
To 10% Debentures A/c		1,00,000
(Being zero coupon debentures issued at discount)

The discount is written off each year to the Profit & Loss Account.

7. From Priority Point of View

First Mortgage Debentures: Have the first claim on the company's assets in case of liquidation. They are the safest.

Second Mortgage Debentures: Have a claim only after first mortgage holders are paid in full. Higher risk, higher interest.

Important

In liquidation, the order of payment is: secured creditors (first mortgage, then second mortgage), then preferential creditors (government dues, employee wages), then unsecured creditors (including unsecured debenture holders), and finally shareholders.

Summary Table

Basis of Classification	Types
Security	Secured, Unsecured
Tenure	Perpetual, Redeemable
Convertibility	Convertible, Non-Convertible
Redemption	At Par, At Premium, At Discount
Registration	Registered, Bearer
Coupon Rate	Fixed, Floating, Zero Coupon
Priority	First Mortgage, Second Mortgage