To provide necessary funds for the discharge of debentures, the company may adopt any of the following courses:- 1. By Creation of Debenture Redemption Fund or Sinking Fund 2. Insurance Policy Method.
1. By Creation of Debenture Redemption Fund or Sinking Fund:
The ideal method is to set aside every year a certain sum of money by creating a Sinking Fund or Debenture Redemption Fund. The provision is made out of Profit and Loss Appropriation Account and the fund so appropriation are invested outside the business in earmarked securities.
The Sinking Fund may also be of two types:
(1) CUMULATIVE SINKING FUND where the amount received as interest on securities of Sinking Fund is also reinvested;
(2) NON- CUMULATIVE SINKING FUND where the amount received as interest on securities is not reinvested but treated as revenue profit of the business.
Generally, the Sinking Fund is allowed to accumulate together with interest year by year. In this way, a portion of profits is utilised towards the Debenture Redemption Fund. At the end of a stipulated period, when the time for redemption of debentures comes, securities are realised and the sale proceeds are used to redeem debentures.
The journal entries are as follows:
A Company issued 5,000 debentures of Rs 100 each at par on 1st January 2000 redeemable at par on 31st December 2004. A Sinking Fund was established for the purpose. It was expected that investments would earn 5% net. Sinking Fund tables show that Re. 0.180975 amounts to Re. 1 at the end of 5 years @ 5%. On 31st December 2004, the investments realised Rs 3, 90,000. On that date the Company’s Bank balance stood at Rs 1, 45,600. The debentures were duly redeemed. Give the necessary journal, ledger accounts and assume that the investments were made to the nearest Rs 10.
1. Interest received on Sinking Fund Investments is credited to Sinking Fund Account.
2. The last contribution and the interest are not invested as debentures have to be redeemed.
3. Generally investments are made in multiples of Rs 10 or Rs 100.
4. On sale of the investments in the last year, the profit or loss is transferred to Sinking Fund Account.
5. After the redemption the balance of Sinking Fund is transferred to General Reserve.
When securities are purchased from open market, the nominal value of investments purchased will normally be different from the amount paid. The investments are recorded in the books at the actual amount paid. However, remember that the rate of interest on investments will be calculated with reference to the face value of the investments.
2. Insurance Policy Method:
Instead of making a provision for the redemption of debentures by the purchase of first class securities, the Company may as well decide to acquire an insurance policy for an amount necessary to redeem the debentures. It is another method for the purpose of redemption. The period for the policy is the same as the period for redemption of debentures.
The premium is to be paid by the Company regularly on the definite dates by charging to the Profit and Loss Appropriation Account. The Insurance Policy method differs from the Sinking Fund method only in respect of interest on the amount paid as annual premium. There is no interest received periodically, there is no entry with regard to it. The insurance premium is paid at the beginning of the year.
Illustration 2 (Without Estimated Interest):
M/s Ram Industries Ltd. issued Rs 1, 00,000 7% Debentures of Rs 1,000 each redeemable after 5 years.
To provide for replacement, the Company decided to take out an Insurance Policy paying annual premium of Rs 19,000 from 1.1.2000. You are required to show:
(a) Debenture Redemption Policy Account
(b) Debenture Redemption Fund Account.
Illustration 3 (Insurance Policy with Estimated Interest):
A Company issued 2,000 10% Debentures of Rs 100 each on 1st January 2002. This payment is to be made at the end of the third year. On 1st January 2002 an insurance policy was taken to provide for redemption of these debentures. Annual premium is Rs 60,000 on which return is at 5% p.a. at compound interest.