How do companies raise long-term finance through shares and debentures, and how is each accounted for?
Distinguish ordinary shares, preference shares and debentures and account for their issue and the returns paid to holders
A focused answer to the H2 Principles of Accounting outcome on shares and debentures. Ordinary and preference shares, debentures as loan capital, issue at a premium, dividends versus interest, and where each appears in the statements.
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What this dot point is asking
SEAB wants you to distinguish the main types of long-term finance, ordinary shares, preference shares and debentures, and to account for their issue and the returns paid to holders. This dot point links the financing of a company to where the figures land in the statements. The central insight is that shares are ownership (equity) while debentures are borrowing (a liability), and that this single distinction drives everything: the type of return, its place in the statements, and the risk borne by the provider.
The answer
The three instruments compared
| Feature | Ordinary shares | Preference shares | Debentures |
|---|---|---|---|
| Nature | Equity (ownership) | Equity (usually) | Loan capital (liability) |
| Return | Dividend, variable | Dividend, usually fixed % | Interest, fixed % |
| Return obligatory? | No, discretionary | Only if profits and declared | Yes, contractual |
| Voting rights | Usually yes | Usually no | No |
| Ranking on winding up | Last | After creditors, before ordinary | First (as a creditor) |
| Risk and reward | Highest risk, shares in growth | Middle | Lowest risk, capped return |
Ordinary shareholders are the true owners: they bear the most risk and benefit most from growth. Debenture holders are lenders: they have a contractual right to interest and rank ahead of shareholders, but their return is capped.
Accounting for an issue
When shares are issued at a premium (above nominal value), the proceeds are split:
Debentures are recorded as a non-current liability at the amount borrowed; no premium account is involved (they are debt, not equity).
The returns and where they appear
The two returns are treated very differently:
- Dividends (ordinary and preference) are distributions of profit, shown in the statement of changes in equity, never in the income statement.
- Debenture interest is a finance cost, deducted in the income statement to reach profit before tax. Unpaid interest at year end is an accrued current liability.
This difference matters for gearing: debentures add fixed interest obligations and increase financial risk, while ordinary shares do not.
Examples in context
Example 1. Choosing between shares and debentures. A company needs \1$ million. Issuing ordinary shares avoids fixed obligations but dilutes existing owners and their share of profits. Issuing debentures keeps ownership intact and the interest is tax-relievable, but it commits the company to fixed interest regardless of profit and increases gearing. The choice trades dilution against financial risk, which is exactly the tension the two instruments embody.
Example 2. Interest in a downturn. In a poor trading year a company still owes on its \500,000\ of interest that must be paid or the company defaults. It can, however, skip the ordinary dividend to conserve cash. This shows in the statements as a finance cost that persists in the income statement even as the statement of changes in equity shows no dividend, illustrating the contractual-versus-discretionary divide.
Try this
Q1. State where (a) an ordinary dividend and (b) debenture interest appear in the financial statements. [2 marks]
- Cue. (a) The statement of changes in equity (a deduction from retained earnings); (b) the income statement as a finance cost.
Q2. A company issues \1\. Split the proceeds. [3 marks]
- Cue. Cash = 80\,000 \times \1.75 = \; share capital = 80\,000 \times \1 = \; share premium = 80\,000 \times \0.75 = \.
Q3. Explain why debenture holders rank ahead of ordinary shareholders if a company is wound up. [2 marks]
- Cue. Debenture holders are creditors (lenders) with a contractual claim, often secured, so they are repaid before owners; ordinary shareholders hold the residual claim and rank last.
Exam-style practice questions
Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Original7 marksA company issues ordinary shares of \1\, and \200\,0007\%$ debentures at par. (a) Show the effect on the statement of financial position. (b) Calculate the annual debenture interest. (c) State where the debenture interest appears in the financial statements.Show worked answer →
(a) The share issue raises cash by 100\,000 \times \1.30 = \. Of this, share capital rises by the nominal 100\,000 \times \1 = \ and share premium by 100\,000 \times \0.30 = \. The debentures raise cash of \200,000\.
So: bank up 130\,000 + 200\,000 = \330,000\; share premium up \30,000\.
(b) Annual debenture interest = 7\% \times 200\,000 = \14,000$.
(c) The debenture interest is a finance cost in the income statement (deducted to reach profit before tax). Any unpaid interest at year end is an accrued current liability.
Markers reward the split of the share proceeds into capital and premium, the debenture liability, the \14,000$ interest, and its treatment as a finance cost.
Original6 marksExplain three differences between an ordinary share and a debenture, and why debenture interest must be paid even in a loss-making year while an ordinary dividend need not be.Show worked answer →
Three differences:
Nature. An ordinary share is part of the company's equity (ownership); a debenture is loan capital (a liability).
Return. Shareholders receive a dividend, which is discretionary and varies with profits; debenture holders receive interest at a fixed rate, a contractual obligation.
Priority and risk. In a winding up, debenture holders (creditors) are repaid before shareholders; ordinary shareholders rank last and bear the most risk but share in growth.
Debenture interest must be paid even in a loss-making year because it is a contractual obligation to a lender; failure to pay can trigger default. An ordinary dividend is a distribution of profit at the directors' discretion, so it can be reduced or skipped when profits are low. This is the core distinction between servicing debt and rewarding owners.
Markers reward three valid differences (equity vs liability, dividend vs interest, ranking on liquidation) and the contractual-versus-discretionary explanation.
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