CA Foundation Accounting: Redemption of Debentures Explained with Examples

Redemption of Debentures is one of the most important topics in CA Foundation Accounting and frequently appears in exams. It refers to the repayment of borrowed funds to debenture holders according to pre-decided terms.

Just like a bank loan must be repaid, debentures, being a long-term liability, must also be redeemed by the company. Understanding the modes of redemption, journal entries, Debenture Redemption Reserve (DRR), and Debenture Redemption Reserve Investment (DRRI) is essential for solving practical questions accurately in exams.

Here, you will learn the complete concept of redemption of debentures with examples and accounting entries.

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What is Redemption of Debentures?

Redemption of Debentures signifies the repayment of funds to debenture holders. Debentures represent a form of debt, and just as a bank loan must be repaid, the amount borrowed from debenture holders in the form of debentures must also be returned.

The terms of repayment, including the amount, date, and value of redemption, are predetermined and agreed upon at the time of issue of debentures.

Modes of Redemption of Debentures

Companies can repay their debentures using several methods:

1. Redemption in Installments: The company repays debenture holders over time through multiple payments. For example, repaying 1/3 each year for three years, or 25% each year for four years.

2. Redemption by way of Lump-sum Repayment: The entire borrowed amount is repaid at once on a specific maturity date.

3. Redemption by way of Conversion: The company offers debenture holders the option to exchange their debentures for the company's shares (either equity or preference shares). This involves taking back the debentures and issuing shares in return.

4. Open Market Purchase and Cancellation of Own Debentures: Companies can buy back their own debentures from the open market (stock exchange) and then cancel them through a book entry, reducing their debenture liability.

Regulatory Compliance for Redemption of Debentures (Section 71)

When redemption involves cash payment (not conversion), companies must adhere to specific provisions outlined in Section 71 of the Companies Act.

Cash Redemption vs. Conversion

A. Creation of Debenture Redemption Reserve (DRR)

Section 71 mandates that when debentures are redeemed in cash, a Debenture Redemption Reserve (DRR) must be created.

• Purpose: The DRR is a reserve created by transferring funds from the company's profits. It aims to set aside a portion of profits specifically for debenture redemption, ensuring that funds are available for repayment.

• Creation Entry:

• Profit & Loss Account Dr.

• To Debenture Redemption Reserve (DRR)

• Applicability (Who must create DRR?):

• DRR is NOT mandatory for all companies.

• It is specifically required for "Unlisted Other Companies."

• "Unlisted": The company must not be listed on a stock exchange.

• "Other Companies": This excludes All India Financial Institutions (AIFIs), Banking Companies, Housing Finance Companies, and Non-Banking Financial Companies (NBFCs).

• Amount of DRR: 10% of the nominal value of the total debentures outstanding.

• Timing of Creation: The DRR must be created before the commencement of redemption. It can be created progressively over years or as a lump sum before the redemption year.

B. Conditions for DRR Creation (Special Cases)

• Full Conversion: If debentures are 100% convertible into shares, no DRR is required because there is no cash outflow.

• Partial Conversion: If debentures are partially convertible (e.g., a portion is converted into shares, and the rest is redeemed in cash), DRR is required only for the non-convertible part (the portion to be redeemed in cash).

C. Utilisation of DRR Post-Redemption

Once the redemption of debentures is complete, the amount in the DRR becomes available for other purposes. The balance in the DRR should be transferred to General Reserve. A General Reserve is a free reserve and can be used for any purpose, such as dividend distribution or writing off losses.

D. Investment in Debenture Redemption Reserve (DRRI)

In addition to creating a DRR, companies must make an investment called Investment in Debenture Redemption Reserve (DRRI).

• Purpose: This investment ensures that liquid funds are available to meet the redemption obligation on the maturity date. It prevents the company from facing a cash shortage even if it has sufficient assets. 

• Applicability: Almost all companies are required to make this investment, unlike DRR, which has more exemptions.

• Type of Investment: The investment must be made in specified securities, such as Fixed Deposits with scheduled banks or government bonds.

• Timing of Investment (Rule 18(7) of Companies (Share Capital & Debentures) Rules, 2014): The investment must be made on or before April 30th of the financial year in which redemption is scheduled to occur.

• Amount of Investment: 15% of the nominal value of the debentures maturing during the year.

• Comparison: DRR vs. DRRI Calculation

• DRR: 10% of total debentures outstanding.

• DRRI: 15% of debentures maturing during the year.

Steps for Debenture Redemption (with Entries)

This sequence outlines the typical steps and journal entries for debenture redemption:

1. Creation of DRR:

• Create DRR (10% of total debentures outstanding) from profits.

• Profit & Loss Account Dr.

• To Debenture Redemption Reserve (DRR)

• Timing: Before redemption begins (can be any time before the year of redemption).

2. Investment in DRRI:

• Invest 15% of the nominal value of debentures maturing during the year.

• DRR Investment Account Dr.

• To Bank

• Timing: On or before April 30th of the year of redemption.

3. Interest on DRRI & Sale of Investment:

• Receive interest on the DRRI and then sell the investment.

• Bank Account Dr.

• To Interest on DRR Investment (for interest received)

• Bank Account Dr.

• To DRR Investment Account (for sale of investment)

• Timing: At the end of the financial year / prior to redemption payment.

4. Debentures Due for Redemption:

• Transfer the liability from debentures to debenture holders.

• Debentures Account Dr. (Nominal value)

• Premium on Redemption of Debentures Account Dr. (If applicable)

• To Debenture Holders Account

• Timing: On the redemption date.

5. Payment of Interest to Debenture Holders:

• Pay any outstanding interest to debenture holders up to the date of redemption.

• Interest on Debentures Account Dr.

• To Bank

• Timing: On the redemption date.

6. Payment to Debenture Holders:

• Pay the debenture holders.

• Debenture Holders Account Dr.

• To Bank

• Timing: On the redemption date.

7. Transfer DRR to General Reserve:

• Once redemption is complete, transfer the DRR balance to General Reserve.

• Debenture Redemption Reserve (DRR) Account Dr.

• To General Reserve

• Timing: After all debentures are redeemed.

Short-Term Debentures

Debentures that are redeemable within 18 months from the date of issue are considered Short-Term Debentures. No DRR requirement applies to short-term debentures; the general rule for DRR does not cover them.

Redemption by Conversion

Conversion allows debenture holders to exchange their debentures for shares. 

• No Cash Transaction: Since no cash outflow occurs, there is no requirement for DRR or DRRI in the case of conversion.

• Process:

1. Pay outstanding interest to debenture holders up to the date of conversion.

2. Make the debentures due for conversion (transfer from Debentures to Debenture Holders).

3. Issue shares to debenture holders.

Example: Conversion Entries (Partial Conversion Scenario)

Scenario: 5,000 debentures of ₹100 each (redeemable at ₹105) are to be converted into equity shares of ₹10 nominal value at a premium of ₹10 (i.e., issue price of ₹20).

• Step 1: Debentures Due for Conversion:

• 12% Debentures Account Dr. (5,000 debentures x ₹100) = ₹5,00,000

• Premium on Redemption of Debentures Account Dr. (5,000 debentures x ₹5) = ₹25,000

• To Debenture Holders Account = ₹5,25,000

• Step 2: Issue Shares to Debenture Holders:

• Total value to be converted = ₹5,25,000

• Issue price per share = ₹20 (₹10 nominal + ₹10 premium)

• Number of shares to be issued = ₹5,25,000 / ₹20 = 26,250 shares

• Debenture Holders Account Dr. = ₹5,25,000

• To Equity Share Capital Account (26,250 shares x ₹10) = ₹2,62,500

• To Securities Premium Account (26,250 shares x ₹10) = ₹2,62,500

• DRR and DRRI implication for Partial Conversion:

• For the portion of debentures converted into shares, neither DRR nor DRRI is required.

• For the portion of debentures redeemed in cash, DRR and DRRI compliance (as per the rules) would be necessary.