Collateral Security
To get a detailed meaning, let us first know about principal security. Loans that are secured by the mortgage of the assets are known as the principal or primary security. The security given in addition to the primary security is called Collateral Security. The term collateral security can be referred to as the assets given that a lender considers as security for the loan. This acts as a protection for the lender.
In any case, if the borrower fails to pay the amount of the money he took from the lender, the lender has all the rights for the collateral property offered to him by the borrower. Therefore, he has the right to seize it, sell it, and get the money to compensate for the unpaid portion of the loan.
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Types of Collateral
The collateral type generally depends on the loan type. Let us take a look at the collateral security examples. Suppose you take a loan for a car, the car is considered as the collateral security for the loan. Similarly, if you take a mortgage, then your home is considered as collateral.
For a business owner to take out the loans successfully, he should know about the types of collateral that are considered while borrowing.
Invoice Collateral:
If a company or a borrower fails to pay the money to the bank /lender, then they can use the Invoice as collateral. This can be done in two different ways one is factoring and the other is discounting.
In the case of the factoring method, the company approaches the lender and sells the unpaid invoice to them. Through this, the lender can be compensated by the amount of money he gets from the payments of the customers.
In the case of the discounting method, the company can get even ninety percent of the invoice worth. Here the repaid amount excludes the fee or interest while the payment is done to the bank or lender.
Inventory Financing:
This is used by the private or small business that doesn't have access to the other options. Inventory financing means the credit that is obtained by the business to pay it beforehand for the products which are not sold.
Cash Secured Loan:
This is very commonly used and it works in a simple way. In a cash-secured loan what happens is, the bank will freeze your savings account or any other assets in share to that. After the payment of the debt, they will be available.
Issue of Debentures as Collateral Security
A debenture is defined as a debt instrument which is generally raised to meet the long-term capital needs. Debentures generally include stocks, bonds, and other security of the company. Generally, debentures are a secured mode of investing in a company because if we invest in shares, then the interest has to be paid. In this, a company can issue a debenture as collateral security for the loan. In legal terms, it is defined as the documents which generate liability. This is just considered as collateral security. It has no impact on your balance sheet. If the repayment is not made by the company, then the bank will take it. This is considered as a debenture issue.
During the period, the company has a fixed interest to the lender/creditor. Generally, the creditors take a part or complete asset possessed by the company in case if it fails to repay the amount taken.
Solved Example
The accounting treatment for the debentures issued as collateral security generally consists of two methods, which are given below.
First Method:
While issuing the debentures as collateral security, the companies won't make any general entry in the account books. Rather than that, it spends the note below the liabilities in the balance sheet. Doing this indicates that the issue of debentures has secured the loan.
Second Method:
In this method, the debentures issued as collateral security is noted in the journal. On the asset side of the balance sheet, the Debenture Suspense account should appear. On the liability side, the Debentures should appear. The entry will get reversed once the company repays the loan to cancel it.
Did You Know?
Debentures are called robust debt instruments of a company as they can create a win-win situation for both borrowers and lenders. The rate of interest paid on the dividend share is more than when compared to the rate of interest paid on the debenture. Due to this advantage, many companies prefer to issue debentures as the fixed rate of interest associated with them irrespective of any changes made in the price levels.
FAQs on Debentures as Collateral Security: Key Insights
1. What does it mean when a company issues debentures as collateral security?
When a company issues debentures as collateral security, it means they are pledging these debentures as an additional or secondary security against a loan taken from a bank or financial institution. These are issued over and above the primary security. The lender can only claim these debentures if the company defaults on the repayment of the principal loan amount or its interest.
2. What are the accounting treatments for the issue of debentures as collateral security as per the CBSE Class 12 syllabus?
There are two methods for accounting for debentures issued as collateral security:
- First Method (No Journal Entry): In this method, no journal entry is made in the books of accounts when the debentures are issued as collateral. A note is simply added below the loan on the liabilities side of the Balance Sheet, stating that the loan is secured by the issue of a specific number and value of debentures as collateral security.
- Second Method (Journal Entry): In this method, a journal entry is passed to record the issue. The entry is: Debenture Suspense A/c Dr. To Debentures A/c. In the Balance Sheet, 'Debentures' are shown under 'Long-term Borrowings', and the 'Debenture Suspense' account is deducted from it, resulting in a nil effect.
3. How are debentures issued as collateral security presented in a company's Balance Sheet?
In the Balance Sheet, the loan against which the debentures are issued as collateral is shown under 'Long-term Borrowings' or 'Short-term Borrowings' on the 'Equity and Liabilities' side. A note to the accounts will specify the details of the loan and clearly mention that it is secured by the issue of a certain number of debentures as collateral security. If the journal entry method is used, the 'Debenture Suspense Account' is shown as a deduction from the Debentures under the same heading.
4. Why would a company issue debentures as collateral instead of simply issuing them for cash?
A company issues debentures as collateral primarily to provide extra assurance to the lender, which can help in securing a loan on more favourable terms or when the primary security is insufficient. It is a conditional liability that only becomes active upon default. This avoids immediate dilution of ownership or creating a fixed interest liability, as interest is not paid on these debentures until the company defaults and the lender activates them.
5. What is the key difference between primary security and collateral security?
The key difference lies in the order of claim. Primary security is the main asset or group of assets against which a loan is given (e.g., land, buildings). The lender has the first right over this security in case of a default. Collateral security, like debentures in this case, is a secondary or additional security. The lender can only make a claim on the collateral security if the amount recovered from selling the primary security is not enough to cover the loan dues.
6. Does the holder of debentures as collateral security (the lender) earn any interest on them?
No, the lender is not entitled to any interest on the debentures held as collateral security. Interest is only payable on the primary loan amount. The lender's rights over the debentures, including the right to receive interest, are only activated if the borrowing company defaults on the loan repayment, at which point the lender may become the debenture holder.
7. What happens to the debentures issued as collateral security once the company repays the loan?
Once the loan is fully repaid, the lender's charge over these debentures is lifted. The company can then get these debentures back. These debentures are considered cancelled, and if a journal entry was passed at the time of issue (Debenture Suspense A/c Dr. to Debentures A/c), a reverse entry is passed to cancel it: Debentures A/c Dr. To Debenture Suspense A/c.
