- 1 What Are Debentures?
- 2 Types of Non-cash Consideration
- 3 Discounts and Premiums
- 4 Debentures Issue – Examples of Non-Cash Consideration With Journal Entries
- 5 Conclusion
The other day we looked at debentures and in particular working through an example and how it flowed through the trial balance and into the financial statements. In working on that article for our accounting tutorial series, I wanted to come back to write about the issue of debentures for consideration (ie payment) other than when cash is used. Although the receipt of cash is common when businesses issue these debt instruments, it is not alway the case. And that is the focus of today’s article.
What Are Debentures?
So a quick summary of what a debenture is and why they are used. A debenture is a debt instrument issued by a business to raise funds normally for capital expenditure (accountants love to call this capex … makes them feel all sophisticated).
Debentures are normally unsecured instruments, meaning, the issuer has not promised any of its assets to the buyers of the debentures in case of default. Other advantages of these instruments include they tend to be cheaper forms of borrowing compared to other debt (issuing and wind-up costs) and interest is often only required to be paid annually or even at the fixed redemption date.
Types of Non-cash Consideration
In addition to being issued for cash, the most common form of debentures issue, these instruments are often issued for non-cash consideration. The types of non-cash payments include:
- the receipt of other assets, for example non-current assets to be used in the business’ operations;
- the cancelling of other debt already held by the debenture holder; or
- the exchange of capital for debt.
Discounts and Premiums
As a quick recap; we have looked at what debentures are, some of their advantages over other forms of debt financing and the types of non cash consideration that can be used in their issue.
Next we move onto discounts and premiums. Like other forms of debt and capital, debentures can be issued at their par value, at a discount or at a premium. These terms are used from the buyers perspective, ie the discount or premium being offered is to the buyer of the debentures, not the issuer. If a discount is being used this means the buyer of the debenture is paying less than par value. While if a premium is in place, the buyer is paying above par value.
Debentures Issued at Par
The simplest of the issues for journal entries is for debentures being sold at par. The journal entry for consideration say being a small warehouse would be:
The debit reflects the increase in non-current assets the entity now has control over, this being the non-cash consideration they received. And the credit increases non-current liabilities with the debentures now on issue.
This type of non-cash consideration would often mean the debentures are issued to a single buyer perhaps using owners financing.
Debentures Issued at a Discount
Now we get into slightly more difficult areas of discounts and premiums. We’ll work through a discount situation in the example section below, looking at the calculations involved. But for the journal entries the basic three entries would be:
|Discount on Debenture Issue||x|
In the discount (also known as an original issue discount (OID)) example the debit and credit of the original entry (issued at par) won’t be in balance because the non-cash consideration value is less than the debt taken on by the issuer. That difference is called a discount and so that is a debit into and account named along the lines of “Discount on Debenture Issue”.
Debentures Issued at a Premium
A premium on issue of a debenture is of course the opposite to that of a discount as we just covered. In the premium case the imbalance of the debits and credits is balanced through a credit to an account named along the lines of “Premium on Debenture Issue”. A sample of the journal entry is set out below.
|Premium on Debenture Issue||x|
Debentures Issue – Examples of Non-Cash Consideration With Journal Entries
The last section we need to cover now is working through some examples with the calculations and debits and credits. This normally helps to gain a better understanding of the theory we have already covered.
Let us turn to ABC Ltd, our trusty fictitious company, for an example of purchasing a building through the issue of debenture debt to the vendor. ABC has the opportunity to purchase some warehouse space and has agreed that the seller will provide the finance for the purchase (also known as owner financing).
The facts of the transaction are:
- the sale will take place on June 15;
- the warehouse is being purchased for $350,000;
- the purchase is being financed by $1,000 (par value) debenture notes;
- the notes are for 10 years, paying 7% pa, compounding daily, paid annually; and
- the debentures are secured by the property and director guarantees.
With this information ABC’s accounting team would prepare the following initial journal entries based on three scenarios we covered above, being; par, discount and premium.
Debentures at Par
In the first scenario the debentures are issued at par, being $1,000. The total number of the debenture issue is:
non-cash consideration / price per debenture issued
$350,000 / $1,000 = 350 debentures to issue
And the formula for working out the debentures liability figure is (all rather straight forward when issued at par):
number of debentures issued x issue price
350 x $1,000 = $350,000
|June 15||Warehouse Building||350,000|
The debit to buildings increases the non-current asset balance for ABC, while the credit to debentures increases it’s non-current liabilities. So at the moment there is no change in the net worth of the company.
Debentures at Discount
In our second scenario, to make the deal more attractive for the seller, ABC agreed to issue the debentures at a 10 per cent discount to par value. The total value of debentures liability to record is set out below.
First thing is to work out what the issue price is per debenture:
$1,000 par value x (1 – 10 per cent discount) = $900
Now we have to work out how many debentures are to be issued:
$350,000 / $900 = 389 debentures to be issued
And the workings for the debentures liability and discount on issuance figures are:
389 x $1,000 = $389,000 debenture liability
$389,000 – $350,000 = $39,000 discount/(premium) on debenture issue
|June 15||Warehouse Building||350,000|
|Discount on Debenture Issue||39,000|
The debit to buildings stays the same, as the agreed consideration has not changed at $350,000. However we now have another debit of $39,000, this being the discount offered to the vendor in the financing agreement. And finally the credit must be increased to reflect discount offered and so ABC now has a larger sum of money to repay.
The discount on issue is classed as a contra account, in that it is married-up to another account with an opposite natural balance. The discount account carries a natural debit balance, while its friend, the debenture liability account, of course has a natural credit balance. The net of these two is then disclosed in the balance sheet (detail is then normally carried in the notes to the accounts). With the discount balance being amortised over the life of the debenture, flowing through the profit and loss statement (statement of financial performance).
If you would like more information of the journal entries involved in the amortisation and the interest expense accounting each year, check out our article here.
Debentures at Premium
The third and final scenario is that involving ABC being able to obtain a premium from the vendor for the debentures being issued. So let’s say in this case the vendor was willing to pay a premium of 10 per cent. Using the formulas we used above, the calculations would be:
$1,000 par value x (1 + 10 per cent premium) = $1,100 price per debenture
$350,000 / $1,100 = 318 debentures to be issued
318 x $1,000 = $318,000 debenture liability
$318,000 – $350,000 = $(32,000) discount/(premium) on debenture issue
|June 15||Warehouse Building||350,000|
|Premium on Debenture Issue||32,000|
Unsurprisingly we are now dealing with the opposite of what we saw with the discount. The buildings debit of $350,000 stays the same, but the credit to the debentures liability is now only $318,000 due to the premium ABC was able to command for its debt issue. The difference of course is now a credit of $32,000 to a premium on debenture issue account.
Premium on debenture issue is classed as an adjunct account, in that it is added to debentures as a natural credit balance in the balance sheet. From there it is amortised over the life of the bond, flowing through the profit and loss statement (statement of financial performance). We have more on how this works in our article covering how bond premiums are calculated and accounted for.
We hope this article has helped your understanding in how the issue of debentures for consideration other than cash should be accounted for. We looked at the journal entries involved in issuing at par, discount and premium. And the calculations required to account for the discount or premium the debentures are being issued at. Remember, the discount or premium is from the customers point of view; ie are they receiving a discount or paying a premium for the debt issue.