What is collateral agreement?

In order to reduce the creditor’s risk and thereby obtain financing more easily and cheaply, 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 as well as providing some information as to the likelihood of collecting the debt in the event that the borrower becomes insolvent.

Example

The Sample Company balance sheet might show these items:

collateral agreements example

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 such aspects as maintenance of a┬áminimum amount of working capital and limitations on dividends, borrowings, and the reacquisition of the company’s stock from its shareholders.

Because the terms of these agreements can affect the prospects for future cash flows to investors and creditors, full disclosure of them should be provided, especially when it appears probable that the limitations will prevent management from acting as it has in the past.

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