What is a Debenture Redemption Reserve?
A Debenture Redemption Reserve (DRR) is a form of capital reserve into which organizations transfer specific amounts from the profit and loss account to ensure funds are reserved for the redemption of debentures that are redeemable at a future date. This practice limits the profits available for dividend distribution, ensuring that debenture holders are paid. However, the DRR itself does not constitute actual funds set aside for debenture redemption. To create the actual funds required, companies must make periodic payments into a debenture redemption reserve fund, which are matched with investments earmarked for this purpose.
Key Points:
- Purpose: To secure funds for redeeming debentures.
- Effect: Limits profits available for distribution as dividends.
- Requirements: Periodic sinking-fund payments into a separate fund.
- Investments: Matching investments are earmarked for redemption purposes.
Examples
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Example 1: XYZ Corporation issues $5 million in debentures due in 10 years. To ensure that they can redeem these debentures at maturity, XYZ allocates a portion of their profits each year to a DRR. In addition, they make periodic payments into a separate sinking fund, investing the funds in secure instruments. At the end of 10 years, XYZ has accumulated the necessary funds through investments to redeem the debentures.
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Example 2: ABC Limited issues $2 million in debentures and transfers $200,000 from its profits each year to the DRR over five years. ABC also deposits into a redemption reserve fund, growing through bonds and fixed deposits. When the debentures mature, the funds in the sinking fund, supplemented by interest earned from investments, are used for redemption.
Frequently Asked Questions (FAQs)
What is the main purpose of a Debenture Redemption Reserve?
The primary purpose of a Debenture Redemption Reserve is to ensure that funds are available for the redemption of debentures when they mature, thereby protecting debenture holders and ensuring the company’s obligations are met.
How does a Debenture Redemption Reserve affect dividends?
Because funds are allocated from the profit and loss account to the DRR, profits available for distribution as dividends are limited, thereby reducing the amount shareholders might receive as dividends.
Is the Debenture Redemption Reserve itself used to redeem debentures?
No, the reserve itself does not provide the actual funds. Instead, the company makes periodic sinking fund payments to an earmarked debenture redemption reserve fund, accompanied by investments allocated for the redemption.
What type of investments are made for the sinking fund?
Common investments for the sinking fund include secure and low-risk instruments like government bonds, fixed deposits, and other similar instruments that ensure safety and assured returns.
When must companies create a Debenture Redemption Reserve?
The creation of a DRR is typically required at the time of debenture issuance or when a company first recognizes its debenture obligation.
Related Terms
- Debenture: A type of debt instrument that is not backed by physical assets or collateral but based on the issuer’s creditworthiness and reputation.
- Profit and Loss Account: A financial statement that summarizes the revenues, costs, and expenses incurred during a specific period—typically quarterly or annually.
- Sinking Fund: A fund established by a company by setting aside revenue over time to repay a debt or a specific expense.
Online Resources
- Investopedia: What is a Debenture?
- Corporate Finance Institute: Debenture
- AccountingTools: Profit and Loss Statement
- Investopedia: Sinking Fund Definition
Suggested Books for Further Studies
- Financial Accounting: An Introduction by Pauline Weetman
- Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen
- Accounting for Dummies by John A. Tracy
- Fundamentals of Financial Accounting by Fred Phillips, Robert Libby, Patricia Libby
Accounting Basics: Debenture Redemption Reserve Fundamentals Quiz
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