Interest on Debentures: Explained

Business owners often resort to public borrowing to meet capital deficit or for expansion purposes. Now, there are several means through which company owners can generate funds. Notably, the issue of debenture is arguably one of the best ways of generating some money for the company. 

Both debenture holders and company owners tend to benefit through the issue of debentures. To elaborate, the company owners can raise the required amount of capital, while debenture holders generate income in the form of debenture interest.

Before we dive straight into the meaning of debenture interest, we should become familiar with the fundamental concept of debentures first. It would help us to gain a more precise idea of the concept and all its aspects.

What is Debenture?

A debenture is an unsecured debt instrument. Typically, it is a certificate which is issued by a company as an acknowledgement that it owes money to its holder. It is issued to the public through a prospectus which is quite to the issue of shares.

The fact that there is no collateral involved with debentures, their holders are heavily dependent on the reputation and creditworthiness of the issuer.  Like mentioned earlier, the primary purpose of issuing debenture is to raise the required funding or capital for business-oriented reasons. For investors, debentures are deemed to be low-risk investment options that help to generate substantial returns. Debenture can be defined as an unsecured debt unit. It is a certificate that is issued by a company where it states that it owes money to the owner of the debenture. This is issued to the public by a prospectus. There is no collateral included in the debentures and the holders of the debentures are dependent on the reputation of the company that issues the debenture. Debentures are mainly issued so that fundings can be raised or the capital required is obtained for business-related reasons. The investors see debentures as a low-risk investment that can help them to get substantial returns too.  

Debenture interest can be defined as the money the owner of the debenture is supposed to earn after they invest money in the debenture of the company. If the company wants collateral security then the owners would not get any interest on the amount they have invested. It is paid at a rate that is fixed on the face value. Interest is a charge on the company that issues a debenture and the interest must be paid irrespective of the status of revenue. According to the Income Tax Act of 1961, the companies that issue debentures have to deduct TDS on interest at a rate of interest specified. In simple terms, interest can be defined as an award where all the holders of the debentures receive the interest for investing in the company’s debentures. The company is the one that pays the interest at a regular period which is previously set by the interest rate in the face value.

Test Your Knowledge: Who are debenture holders?

1. Company Owner

2. Creditor

3. Debtor

4. Promoter

Types of Debenture

As per the Companies Act, 2013, a company cannot issue debentures that accompany voting rights. Other than that, companies can issue the following debentures –

1. On the Basis of Security

i. Secured debentures

ii. Unsecured debentures

2. On the Basis of Convertibility

i. Convertible debentures

ii. Non-convertible debentures

3. On the Basis of Priority 

i. First mortgage debentures

ii. Second mortgage debentures

4. On the Basis of Negotiability

i. Bearer debentures

ii. Registered debentures

5. On the Basis of Permanence 

i. Redeemable debentures

ii. Irredeemable or perpetual debentures

Test Your Knowledge: A debenture whose principal amount is not paid by the issuing company only at the time of liquidation is known as:

1. Redeemable Debentures

2. Non-convertible Debentures

3. Bearer Debentures

4. Irredeemable Debentures

What is Interest in Reserved Debenture?

Debenture interest can be explained as the capital which debenture holders are entitled to earn for investing their money in the said company’s debenture. However, if a company tends to issue debenture as collateral security, the holders would not receive any interest on their investment.

Typically, interest on debentures is paid at a fixed rate on their face value systematically. It must be noted that such an interest is a charge on debenture issuing company’s profit and must be paid to the holders, irrespective of the revenue status.

As per Income Tax Act, 1961, debenture issuing companies are required to deduct TDS on interest on debentures at a specified rate of interest. However, such a tax is imposed only if the payable interest amount exceeds the mentioned limit. The tax thus collected is deposited to the income tax authorities by the denture issuing company.

Test Your Knowledge: Interest paid on debenture is:

1. Appropriation of Profits

2. Charge Against Profit

3. Transferred to General Reserve

4. Transferred to the Account of Sinking Fund

On that note, let’s check out how debenture interest is treated in the books of accounts.

Accounting Treatment of Interest on Debenture

This is how debenture interest is treated in accounting in a different situation.

A. In Case Interest is Due and the Tax on It is ignored – Interest Paid Journal Entry 

B. In Case Interest on Debenture is Due and TDS is levied – TDS Payable Journal Entry

C. In Case of Payment of Interest on Debenture – Interest Payable Journal Entry

D. In Case of Deposition of TDS – TDS Payable Journal Entry

E. Transferring Interest to the Statement of Profit and Loss at Year-End

Test Your Knowledge: What is the nature of a debenture application account?

1. Personal account

2. Real account

3. Nominal account

4. None of these

Task For You: Pass a journal entry for TDS deducted.

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