How Will You Treat Payment of Interest on Debentures in Cash Flow Statement?

Companies prepare financial statements to report their activities to the stakeholders. These include four reports. Out of these, three use the accrual concept in accounting to present activities. While it is a mandatory accounting concept, it can also be confusing. Furthermore, they do not show how a company uses its cash resources or report cash movements.

However, the fourth financial statement tackles that issue. The cash flow statement presents movements in cash during a period. These movements are critical in allowing users to analyze how a company uses its cash resources. The cash flow statement includes all cash payments and receipts during a specific period. In the end, it also reconciles the opening and closing cash and cash equivalent balances.

The cash flow statement reports cash inflows and outflows under three categories. These consist of cash flows from operating, investing and financing activities. Usually, accounting standards guide on which items these sections must include. Calculating the amounts and reporting them under these sections is straightforward for most items. For some, however, they can be more challenging, for example, interest in debentures.

What is Interest in Debentures?

A debenture refers to marketable security issued by companies to raise finance. Usually, this finance is to help fund long-term operations and expansion goals. Debentures constitute debt capital for the issuer. When a company issues these securities, they receive funds from multiple sources. Debentures are unsecured, unlike bonds that can be secured. These securities also come with various characteristics, one of which includes interest.

When companies receive loans, they enter into a contract with a single institutional lender. However, debentures are different as these involve securities issued by the company. These securities are similar to bonds, although they are unsecured. Similarly, these securities come as a legal certificate specifying the amount owed by the issuer. This amount is the principal amount. On top of that, they mention the interest rate and schedule of payments.

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Interest on debentures represents a percentage paid to the lender for their finance. Usually, it is a fixed rate set when the contract between two parties begins. The borrower receives funds from a lender in exchange for future reimbursement. For these funds, the lender also charges interest. Usually, this interest is the only income source for the lender for the underlying transaction.

Interest on debentures is common for all loan and lending transactions. For the borrower, this interest falls under expenses related to financing. In contrast, it constitutes income for the lender. Therefore, the accounting treatment of these items will differ based on the party recording them. Consequently, the placement on the statement will also vary depending on the underlying treatment.

Interest on debentures follows a specific pattern or schedule. As mentioned above, this schedule is usually a part of the debenture certificate issued by companies. In accounting, this interest primarily relates to the income statement. There, it falls under financing expenses. However, companies may not pay the amount promptly. Under the accrual concept, unpaid interest on debentures will still become a part of the income statement.

How will you treat payment of Interest on Debentures in the Cash Flow Statement?

The payment of interest on debentures may sound like a straightforward treatment on the cash flow statement. However, it is more complex due to the accrual concept in accounting. As mentioned above, companies charge any accrued interest on debentures to the income statement. However, the cash flow statement does not follow the accrual concept. Therefore, it creates a complex treatment due to the format used by this statement.

Usually, companies report their cash flows in the cash flow statement under the indirect method. This format requires companies to start with their net profits as a base. These net profits come from the income statement after reducing all expenses. As mentioned above, one of these expenses includes interest on debentures which fall under financing expenses. Some may think the inclusion of this interest in the net profit will constitute its treatment in the cash flow statement.

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However, the interest charged in the income statement uses the accrual concept of accounting. This treatment creates an issue when reporting cash flows in the cash flow statement. Rarely, the interest reported in the income statement may also represent paid amounts. In those cases, the treatment in the cash flow statement is also complex. The primary reason for this involves the different sections in the cash flow statement.

Net profits fall under cash flows from operating activities. However, companies must include interest on debentures as a cash flow from financing activities. This treatment requires companies to add that interest back to the net profits and move them to the latter section. Therefore, companies treat the interest payment on debentures in the cash flow statement as a financing activity.

Overall, companies treat the payment of interest on debentures as a cash outflow from financing activities. Since this amount relates to debt finance, this treatment is appropriate. However, companies must first calculate the actual cash payments made on those securities. Due to the accrual concept in accounting, the actual paid value may differ from the expense charge. Therefore, establishing the cash outflow is crucial.

Example of Interest on Debentures in Cash Flow Statement

As mentioned above, the indirect method of preparing the cash flow statement starts with net profits. These profits already include the expense charged on the interest. However, it may be accrued expense and not represent the actual cash outflows from the business. In this case, the company must establish the monetary value of the actual payment. They may calculate this figure or pick it from their general ledgers.

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If the expense charged in the income statement constitutes the cash-paid amount, the treatment won’t end there. Companies must still remove the interest expense from operating activities and move it to financing activities. Either way, this reclassification is crucial under both methods. An example of how companies remove interest expense from the cash flow statement is below.

Cash flows from operating activities
Net profits / (losses)XXXX / (XXXX)
Add: Interest expenseXXXX
Add: Other non-cash expensesXXXX
Additions / subtractions from cashXXXX / (XXXX)
Net cash flows from operating activitiesXXXX / (XXXX)

As mentioned above, the above treatment will apply to both cases. Companies must add the interest expense back to the net profits to remove its impact on net profits. Once they do so, they can calculate the net cash flows from operating activities. From there, they must take those interest payments to the cash flows from financing activities.

Before taking the amount there, companies must ensure it represents actual cash payments. If they do not, companies must recalculate the actual cash paid to the debenture holders. Usually, the figure is available through the general ledgers. However, companies can also calculate it through T-accounts or straightforward calculations. Once they have the amount, companies can report it under financing activities.

An example of how companies treat interest on debentures under financing activities is below.

Cash flows from financing activities
Interest on debentures(XXXX)
Other financing activitiesXXXX / (XXXX)
Net cash flows from financing activitiesXXXX / (XXXX)

Conclusion

Debentures are debt securities used by companies to generate finance. They are similar to bonds, though they are unsecured. Usually, companies pay a fixed interest rate on these securities. This interest involves cash payments to the debenture holders. Companies must report these payments in the cash flow statement. This process entails removing it from operating activities and including it under financing activities.