Question

How do debt and equity securities differ? Describe how the various levels of ownership impact how companies account for investments.

Answer 1

Debt and Equity are the most common means of financing used by companies, and they are the external sources of finance for a business. Equity securities are those that are raised by selling interests in the company. Debt securities on the other hand, are those that are borrowed from the general public by not giving the ownership. So, it is also said that the Debt holders are the creditors of the company whereas, the equityholders are the owners of the company. Both these kinds of securities have the potential to deliver significant returns. However, debt carries a significant lower risk as compared to equity. Debt can be issued in the form of bonds, term loans, debentures etc. Equity can be in the form of stocks or shares.

Few ways in which these two kinds of securities differ are-

• Debt is issued at a fixed rate of interest, thus the cost of capital is pre-determined. The cost of capital for Equity is not fixed.
• Debenture holders do not have voting rights, whereas equity holders do.
• Debt holders create leverage, whereas equity holders don't.
• Debt holders are not much involved in the affairs of the company, since there's no ownership sharing. However, equity holders are very much involved since equity financing is all about sharing ownership.
• Debentureholders do not enjoy voting rights, but equity holders do.
• Debentureholders do not have the right to receive dividens, which is not so in the case of equity holders, and thus, it can also be said that equity holders have a share in the profits of the company and they receive it through dividends.
• At the time of liquidation, the debentureholders are paid first. However, the equity holders are paid at last, if at all any balance is left after paying off the preferential creditors and all other outside parties.

The accounting for investments in case of Debt and Equity is quite different-

When companies, raise funds through debt, debt capital is credited with a corresponding debit to cash. When annual interest payments are made, interest expense is debited with a corresponding credit in cash.

When companies, raise funds through equity financing, cash account is debited with a corresponding credit to the Share Capital Account. In case, the shares are issued at premium, the Share Premium Account is alsp credited in addition to the above, for the extra portion of share premium, which is gradually transferred to the Reserves.

This is how companies account for debt and equity.