Accounting for Subordinated Debt

Accounting for subordinated debt allows financial managers to make difficult choices about liquidity management, liability recording, staff planning and interdepartmental coordination. To accurately post debt-related journal entries, managers must work in tandem with personnel from various departments -- including cash management, accounts payable, investment analysis, lender relationship management and corporate treasury.

A subordinated debt is a sum of money a borrower owes an unsecured creditor -- that is, a lender who has not requested a financial guarantee or has not attached collateral to the loan before advancing funds. In the event of bankruptcy or outright liquidation, a court-appointed trustee would settle the claims of secured creditors before making whole lenders that have submitted subordinated debt claims. Various debt arrangements fit the subordination profile, from credit card balances and student loans to personal loans. Any liability transaction that does not mandate that a borrower post collateral, or security, qualifies as a subordinated loan -- and the lender, at that time, becomes an unsecured creditor.

Various professionals provide strategic guidance and execution support to help unsecured lenders reduce credit risk, maintain healthy profit margins and stay in business in the long term. Personnel such as risk managers, credit analysts and financial administrators help creditors achieve competitive advantage, cope with default tedium effectively, and monitor the operating prognosis of individual and corporate borrowers. Secured creditors may have peace of mind when it comes to credit risk appraisal because of the underlying collateral, but they still have to monitor the value of the collateral to prevent asset depletion and a decline in loan-to-asset ratios.

To record subordinated loan proceeds, a corporate bookkeeper debits the cash account and credits the debt payable account. A junior accountant working for the unsecured lender posts an opposite entry; the accountant debits the loan receivable account and credits the cash account. In accounting terminology, crediting cash -- an asset account -- means decreasing company money. This is distinct from the banking terminology. When a corporate borrower makes periodic interest and principal payments, the journal entry is: credit the cash account, debit the debt payable account and debit the interest expense account.

Financial managers report a subordinated debt in a statement of financial position, also known as a balance sheet or statement of financial condition. They classify the loan as a short-term or long-term item, depending on the maturity. The cut-off time is 12 months, so any debt with a longer repayment window becomes a long-term loan. Interest expense is integral to a statement of profit and loss, which also goes by the names “income statement,” “P&L” and “statement of income.”