To reduce the creditor’s risk and thereby obtain financing more easily and cost-effectively, a borrower may enter into a collateral agreement in connection with a loan contract.
Under this arrangement, the borrower agrees that a particular asset (or group of assets) will be sold and the proceeds applied to the loan balance in the event that the amount due cannot be paid.
In practice, collateral agreements are disclosed by identifying not only which liabilities are secured but also which assets are pledged as security.
This treatment allows an actual or potential unsecured creditor to assess what other lenders may have concluded about the borrower’s creditworthiness.
It also provides information regarding the likelihood of collecting the debt in the event that the borrower becomes insolvent.
Sample Company’s balance sheet shows the following items:
In other cases, the borrower may agree to restrictions on some of its activities in order to provide a higher degree of assurance to the lender that its financial position will be kept sound.
The agreement may cover aspects such as the maintenance of a minimum amount of working capital and limitations on dividends, borrowings, and the reacquisition of the company’s stock from its shareholders.
Since the terms of these agreements can affect the prospects for future cash flows to investors and creditors, full disclosure should be provided.
This is especially important when it appears to be probable that the limitations will prevent management from acting as it has done in the past.