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.

Example

Sample Company’s balance sheet shows the following items:

Sample Company Balance Sheet Excerpt

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.

Frequently Asked Questions

What is a collateral agreement?

A collateral agreement is an agreement between two or more parties in which each party pledges assets as security for the performance of the other party.

What are the benefits of a collateral agreement?

The benefits of a collateral agreement include increased security and certainty for both parties.

What are the risks of a collateral agreement?

The risks of a collateral agreement include the possibility that one or more of the parties will not perform as promised and the potential for loss of the pledged assets.

How can I get out of a collateral agreement?

If you want to get out of a collateral agreement, you can try to negotiate an early termination with the other party or you can seek legal recourse.

What are the consequences of breaching a collateral agreement?

The consequences of breaching a collateral agreement can be significant, and may include financial penalties, loss of the pledged assets, or even legal action.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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