Issue of Debentures as a Collateral Security

What Is Collateral Security?

When a company borrows money from a bank or financial institution, it usually pledges some assets as the primary security — the main guarantee that the loan will be repaid. But sometimes the lender demands an extra layer of protection: a secondary or additional security over and above the primary one. This extra security is called collateral security.

If the company defaults on the loan, the lender can first sell the primary security to recover the amount. If the sale proceeds fall short of the outstanding loan, the lender can then fall back on the collateral security to recover the balance. In such a situation, the company may issue its own debentures to the lender as that collateral security. This is known as “Issue of Debentures as Collateral Security.”

The lender does not become a debenture holder in the usual sense — they cannot claim interest or redemption unless the company defaults. Only if the company fails to repay the loan (with interest) does the lender get the right to either present those debentures for redemption or sell them in the open market to recover the shortfall.

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Two Methods of Accounting Treatment

The book presents two distinct ways to record this in the company’s books. Both are acceptable, but they lead to different presentations in the balance sheet.

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First Method: No Journal Entry

Under this method, no entry is made in the journal because the company has not created any new liability — the debentures are merely a contingent security. The loan itself is the only liability recorded.

However, the balance sheet must disclose the fact that the loan is secured by the issue of debentures as collateral. This is done by adding a note below the loan item on the liabilities side.

Example from the textbook:

X Company takes a loan of ₹10,00,000 from a bank and issues 10,000, 9% debentures of ₹100 each as collateral security.

Balance Sheet (Extract)

Notes to Accounts

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Second Method: Journal Entry Recorded

Here, the issue of debentures as collateral security is formally recorded through a journal entry. A special account called Debenture Suspense Account is used.

Journal Entry (at the time of issue):

Why this entry?

• Debenture Suspense A/c is debited because the debentures are not a genuine liability — they are held in suspense, to be cancelled when the loan is repaid.
• 9% Debentures A/c is credited because the company has, on paper, issued these debentures. This account will later be reversed.

Balance Sheet Presentation (Second Method):

Notes to Accounts

Notice that the debentures and the suspense account cancel each other out, showing a net figure equal to the loan amount. The debentures are shown as a deduction — they are not a real liability.

When the loan is repaid, the above entry is reversed:

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Key Points to Remember …