Debentures in the Trial Balance

We see a question from accounting students: around debentures, in particular, what are they, what are their journal entries, and where are they in the trial balance? So in today’s accounting tutorial, we will dig into debentures a little, our first article covering these financial instruments.

If you are in a bit of a hurry, the quick answer is they are debt instruments with current and non-current components and so coded in the trial balance under the liability section. If you would like a fuller explanation … please read on.

What Are Debentures?

A debenture is just a fancy name (actually from the Latin word debentur) for a debt instrument that is normally not secured, i.e., uncollateralised – other than relying upon the issuer’s creditworthiness. Companies and governments use them as a means to raise debt, generally for capital expenditure programs. Although not required, the instruments are often for periods of ten years or more in funding.

What is the Trial Balance?

To check that the accounting equation is in balance, i.e. all of the debits accounts equal all of the credits accounts, a list of the general ledger accounts is produced called a trial balance. In essence, the list contains the balances of all accounts open at the start of the reporting period (assets, liabilities and equity) and then a summary of all the debits and credits that flowed through all accounts used during the period.

At all times, the debits and credits, either at the opening balances, processed during the period, or closing at the end, must be in balance – this being the nature of double-entry bookkeeping. The purpose of bringing all accounts together is to test that the accounting equation is in balance, i.e. all debit nominated accounts are equal to all credit nominated accounts.

Below is the trial balance for ABC Ltd, taken from our article covering accumulated depreciation, where we worked through how depreciation flowed through the accounts each year.

For completeness, below is the statement of financial performance (profit and loss account) and the statement of financial position (balance sheet) for ABC Ltd year-ending 31 March X2. You can see how the trial balance accounts flow through to the financial statements.

Debentures, Journal Entries and the Trial Balance

The final thing for us to do today is work through some journal entries and see how these appear in the trial balance. And as we have a set of accounts already prepared from earlier, we’ll look at how the journal entries below change the trial balance and accounts.

Debenture Offering

ABC Ltd’s management decides to issue debentures to raise debt to fund some machinery purchases. It will issue 20,000 $10 debentures to local private investors. The instruments carry a 10 per cent coupon rate, accrued annually, with a five-year maturity (saves making a long table). We have also assumed there are no debt issuance costs in this example. If you would like to see how they should be accounted for, please see our article here for a full-worked example.

The table below sets out the interest expense and ending year balance over the five-year life of the debenture issue. Financial years X2 and X7, of course, only include six months of compound interest due to the issue and maturity dates falling halfway through their respective financial years (note the “Financial Year” is that ending March 31 each year).

The first journal entry is to recognise the receipt of the $200,000 in cash in October and raise the liability created at the same time. ABC Ltd now has an obligation to pay a group of debt holders.

The second entry is created at financial year-end when the interest is credited to the debenture holders’ accounts. As discussed above, there are only six months of interest in the first financial year to account for, and this is raised as an expense with a debit entry. At the same time, the credit entry increases the amount owed to the debenture holders by increasing the liability figure.

The Trial Balance

So we now have our journal entries; we can process these through the general journal, which will input them into the trial balance. We have taken the ABC Ltd 31 March X2 accounts you saw above and inserted the new transaction into the financial year X2 so you can see the changes made when the debenture issue is incorporated into the accounts.

In the trial balance below, you can see the new interest line of $10,109 (being for the first six months of the debt being on the issue), the $200,000 increase in bank funds and the new debentures liability of $210,109 (being the principle and interest at year-end).

The Financial Statements

We now move on to the two financial statements (we aren’t worrying about the statement of cash flow nor the statement of changes in equity). The statement of financial performance picks up the interest expense of $10,109. It also means we can insert the extra sub-heading of “operating profit” to highlight the difference between the operation of the business and its funding charges.

The final statement to see is that of ABC’s financial position as of March 31 X2. You can see the increase in bank by $200,000 and a new debentures line of $210,109 ($200,000 + $10,109). And a reduction in retained earnings due to a lower net profit for the year.

Debenture Interest and Repayment

ABC’s accounting team would repeat the journal entries for X2 and each year until maturity. On September 30 X6, the final two journal entries would be made, as we have set out below. The first entry puts through the final interest expense accrued on the debt. While the second entry is the repayment of debt to the debenture holders, including the interest they have accrued over the period.

We also haven’t been concerned with any withholding tax implications. In some jurisdictions, ABC Ltd might be required to deduct withholding tax from the payment to debenture holders. If you would like a fuller explanation of this, please see our article looking at withholding tax.

Conclusion

This was only meant to be a short article, but as we looked more into debentures and their flow through the trial balance into the financial statements, the words and tables kept growing.

We trust this article has helped you better understand debentures and the journal entries involved in their issuing and maturity. As always, we welcome your comments and feedback.