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Debenture Redemption Reserve

Debenture Redemption Reserve

Debenture Redemption Reserve

Debenture Redemption Reserve (DRR) is a fund maintained by companies that have issued debentures. Its purpose is to minimise the risk of default on repayment of debentures. The DRR ensures availability of funds for meeting obligations towards debenture-holders. The DRR involves two components. The first component is setting aside a portion of the profit. The allocation of profit is done in a process known as ‘earmarking of funds’. It ensures that adequate profits are available for repaying the debentures. The second component involves an investment of funds. It ensures that the company has enough liquidity to make the repayment.

The requirement to create a DRR was compulsory for all companies. On 16th August 2019, the Ministry of Corporate Affairs (MCA) issued a notification regarding DRRs. The notification has introduced a relaxation in the need for companies to maintain a DRR. With effect from 16th August 2019, companies listed with the Bombay Stock Exchange (BSE), National Stock Exchange (NSE) or Calcutta Stock Exchange (CSE) need not maintain a DRR.

Purpose and Uniqueness

Companies which have borrowed money through debentures may not have the funds to make a repayment. To minimise the chances of default, the Government introduced the concept of a DRR in the year 2000. The primary reasons for default are a lack of profitability and a lack of liquidity. To address both these concerns, the concept of a DRR provides for two requirements:

  • Every year, a portion of the profit is ‘earmarked’ for transfer to the DRR. The earmarked amount cannot be used until repayment of the debentures is made. The effect of this strategy is that the dividend available to shareholders is reduced. When dividends are lowered, enough funds are retained in the company to enable a future settlement to debenture-holders. Thus the chance that the company may make a default due to profitability related issues is minimised.
  • Every year, investments are purchased for an amount equal to the transfer made to the DRR. Only securities approved by the government can be purchased for investments. The investments cannot be sold for any purpose other than meeting the liability toward the debenture holders. The effect of this strategy is that a part of the company’s assets is reserved for repaying the debenture liability. Thus the chance that the company may make a default due to profitability related issues is minimised.

Applicability

All companies should maintain a DRR except the following:

  • Public Financial Institutions (PFIs) (PFIs are companies whose paid-up share capital is held by the Central Government to the extent of more than 51 per cent. Examples are Life Insurance Corporation of India, Infrastructure Development Finance Company Limited, Industrial Credit and Investment Corporation of India Limited, Industrial Finance Corporation of India, and Industrial Development Bank of India.)
  • All India Financial Institutions (AIFI) (AIFIs are companies whose business is carried on under the supervision of the Reserve Bank of India (RBI). Examples are the Export-Import Bank of India, National Bank for Agriculture and Rural Development, Small Industries Development Bank of India, and National Housing Bank.)
  • Housing Finance Companies (HFCs) (The requirement to maintain a DRR will be waived if the company is registered with the National Housing Bank)
  • Non-banking Finance Companies (NBFCs) (The requirement to maintain a DRR will be waived if the company is registered under section 45-IA of the Reserve Bank of India Act, 1934) (For unlisted NBFCs and HFCs, the DRR should be created in cases of public issue of debentures.)
  • All scheduled banks (scheduled banks are banks mentioned in the second schedule of the Reserve Bank of India Act, 1934).
  • Listed companies

These relaxations were introduced by the MCA to reduce the cost of borrowings incurred by companies.

Earmarking of Funds

  • A portion of the company’s profit should be transferred to the DRR. Only profits available for distribution as dividend should be used. The transfer should be made for the debentures repayable during the next financial year (FY).
  • The amount of transfer should be calculated as follows: ten per cent of the outstanding debentures (till 15.08.2019 it was 25%) less the amount available in the DRR. For HFCs and NBFCs, the rate used will be15% instead of 10%. The transfer should be made before 30th April.
  • The Financial Executives of the company should ensure that the amount in the DRR remains unchanged. This amount should be used only to repay debentures. In the case of partly convertible debentures, the DRR should be created for the non-convertible portion only (partly convertible debentures carry the option to convert part of the debt into equity).

Investment of Funds

The amount transferred to the DRR should also be invested in the approved securities. The approved securities are the following:

  • Deposits with scheduled banks
  • Government treasury bills and commercial papers
  • Long-term bonds issued by the Government

The investment should be made before 30th April. The amount invested should be the same as the amount of the transfer made to the DRR. The ledger balance of the DRR and the ledger balance of the investment should be the same.

The market value of the securities invested may become lesser than the book value (Book value is the amount shown in the ledger for the investment). In such cases, a suitable adjustment should be made in the book value. The adjustment is made so that the book value accurately reflects the market value of the investment. Once the adjustment is made, the balance in the DRR will be more than the value of the investment. So, the purchase of additional investments becomes necessary. Book value of the investments should be adjusted if there is evidence that the market value is not likely to improve.

Utilisation of Funds

When debentures become due for repayment, the investments should be sold, and the liability is settled. The sale proceeds should not be used for any purpose other than meeting the obligation towards the debenture-holders. The profit or loss on the sale of the investments should not be adjusted against the DRR. After the entire debt for the debentures is settled, the balance in the DRR may be transferred to the general reserve.

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