Discover what debentures are in accounting, the types and characteristics, and how debenture holders differ from shareholders.
Debentures Explained
Organizations and governments issue debentures to raise money to meet their capital requirements. They are essentially bonds that the public can buy in order to invest in a company.
Unlike bonds and stocks, debentures are not secured against collateral. This means that investors can only rely on the creditworthiness of the issuer. They also only have the reputation of the company to help them make their investment decision.
Not only are debentures a form of debt, but they are also a form of long-term debt. Debenture term times normally exceed a decade. During this term time, the debenture holder receives interest payments from the company that created the debenture (for this reason, debentures are classed as debt instruments).
Fixed interest payments will be verified in the indenture.
How Debenture Holders Are Different From Shareholders
Debenture investors are different because they become creditors to the company when they invest, rather than shareholders in the company. Holders do not have any ownership over the company they invested in. Rather, the company becomes indebted to them via the debenture.
If a company also has shareholders, it has to pay interest to the holders before it pays dividends to the shareholders. Similarly, if the company goes into liquidation, the debenture investors are paid before the shareholders.
On the other hand, debentures are similar to stocks in many other ways. For example, they can be traded on the stock market.
In long-term instances, these debt instruments may become equity shares (if they are convertible). In this case, the investor will gain some level of ownership over the company.
Debentures also have their own special rules.
Different Types of Debentures
Convertible debentures/non-convertible debentures
Debentures can either be convertible or non-convertible. Convertible debentures can be turned into equity shares after a particular date. However, the holder has the option to continue treating the loan as a debenture past the maturity date. This way, the holder will continue to receive interest.
Debentures that are non-convertible, on the other hand, cannot be turned into shares.
Secured/non-secured
Although most debentures are non-secured debts, there are some that come secured against the issuer’s assets.
Fixed charge/floating charge
Many debentures come with a fixed interest rate attached. These are known as “fixed charge” debentures. Other debentures come with a floating charge, which sees the interest rate fluctuate over time.
Perpetual
Perpetual debentures don’t come with a maturity date. This means that the issuer can opt to pay interest for the debenture for an extra-long term.
Characteristics of Debentures
During the trust indenture, all the characteristics of a debenture are defined. These characteristics include the following:
- The fixed rate of interest – If the debenture is fixed charge, the interest rate needs to be defined in the indenture. This is determined by looking at the credit rating of the issuer. Credit rating agencies will define the credit risk of the company, and ultimately the amount of interest that should be charged.
- Date of maturity – This is the date that the debt instrument must be paid back by, or be converted into equity, depending on the type of debenture.
Debentures and Accounting
When debentures are created and bought by investors, they are recorded as long-term liabilities by accountants. In terms of journal entries, debentures can either be issued at par, premium, or discount.
Here’s what each of these entries mean:
- Par debentures – This is the title given to debentures sold at face value.
- Premium debentures – This is the title given to debentures sold above face value. For example, when a debenture is sold for £250 when its face value is £200.
- Discount debentures – This is the title given to debentures sold below face value. For example, when a debenture is valued at £250, but gets sold for £200.
Final Thoughts
Debentures are essentially unsecured bonds that are classed as long-term liabilities by accountants. They can last longer than a decade and some can be converted into company shares.
Hiring an accountant is crucial to ensure proper management and monitoring of the debentures you issue. An experienced accountant can effectively track interest payments, assess credit risks, and provide valuable insights to help optimise your financial decision-making.
Sources:
https://m.economictimes.com/definition/debenture/amp