Debentures are a type of debt instrument or bond that does not have any underlying collateral assets. Due to unsecured loans, debt through debentures may be more difficult to obtain.
This is mainly because the risks associated with debentures are very high for debenture holders. To tackle this problem, debenture holders may require businesses to obtain debt to qualify for the loan.
This may come in the form of creditworthiness checks. Similarly, another characteristic of debentures is the high-interest rates charged on them.
Interest on debentures
Interest on debentures is an amount that debenture holders are entitled to. These debenture holders provide debt to a business. In return, the business pays them their principal amount along with interest.
Interest is a type of reward for debenture holders for the risk they have taken and the debt they have provided to the business.
Interest on debentures is usually a fixed rate. This rate is specified on the face of the debenture instrument. Similarly, a business must pay interest on these instruments after predetermined regular intervals of time.
This interest must be paid by a business regardless of whether a business makes any profits or not. Debenture holders also come with predetermined maturity dates.
Any interest paid on debentures is considered a finance expense for a business. Therefore, the business can reduce the interest from its revenues to reach its profit.
Similarly, due to debentures being an expense for the business, they are also tax-deductible under the tax laws of many countries.
This means that when a business pays interest on debentures, the interest can help it to reduce its tax expenses during the year.
Accounting Treatment
The accounting treatment of interest on debentures depends on the type of debenture interest. First of all, when the interest on debentures is due, it must be recorded in the accounting system of a business.
This is because interest expenses are accrued first and then ultimately paid. Therefore, the business must make the following double entries in its accounts when interest is due:
Dr Interest on debentures
Cr Interest on debenture payable (Debenture holders’ account)
Eventually, when the business pays its debenture holders for the interest due, the business uses the following accounting treatment:
Dr Interest on debenture payable (Debenture holders’ account)
Cr Bank
At the end of the accounting period, the business will transfer the interest to its profit or loss account. For this purpose, the business must use the following double entries:
Dr Profit or Loss account
Cr Interest on debentures
Tax deducted at the source
Under some tax laws, the business paying interest may also need to deduct income tax for the interest paid.
The business deducts the income tax on the debenture holder’s behalf and pays it to the government at a later point in time. This concept is known as tax deducted at source.
When required to do so, the business must also account for any taxes deducted at source. The accounting entries for the tax deducted at source will be:
Dr Interest on debentures
Cr Interest on debenture payable (Debenture holders’ account)
Cr Tax payable (Tax deducted at source)
Subsequently, when the business pays the tax to the government, it must use the following double entries to record the transaction in its accounts:
Dr Taxes payable (Tax deducted at source)
Cr Bank
Example
A company ABC Co. issues debentures of $10,000 at a 5% interest rate per annum. The government requires companies to deduct a 10% interest at source when accounting for interest expenses.
The company also has a set maturity date for the debenture, but it can be ignored in this example.
After one year, ABC Co. incurred interest expenses of $500 ($10,000 x 5%). Since the government requires the company to deduct tax at source, it also deducts the tax for the interest paid.
The tax amounted to $50 ($500 x 10%). The accounting entries that the company must pass are as follows:
Dr Interest on debentures $500
Cr Interest on debenture payable ($500 – $50) $450
Cr Tax payable $50
Subsequently, when ABC Co. pays the interest to its debenture holders, the company will use the following accounting treatment:
Dr Interest on debenture payable $450
Cr Bank $450
Similarly, when ABC CO. pays the tax deducted at source to the government, the company will use the following accounting treatment:
Dr Taxes payable $50
Cr Bank $50
Finally, when the business makes its income statement at the end of the period, the interest expense must be transferred to the profit or loss account.
The preparation of an income statement may come before the payments of the above amounts. For transferring the expense, the business will use the following accounting treatment:
Dr Profit or Loss account $500
Cr Interest on debentures $500
Conclusion
A debenture is a type of bond or debt instrument that businesses use to obtain debt finance. Businesses don’t need to provide an asset as security for debentures.
Therefore, they may come with some checks. Debenture also comes with interest payments to debenture holders.
The interest payment rate and time are predetermined. Interest payments on debentures are recorded in the business’s accounting system when accrued.
Some governments may also require businesses to deduct tax at source on these interests accrued.
