Accounting for Collateral: With Example Under US GAAP – ASC860

What is Collateral?

The term collateral represents an asset that one party offers as security in exchange for receiving a loan. The party offering collateral is the lender that owns the asset. The counterparty is the lender that accepts collateral. This collateral may come in as fixed assets, such as property, equipment, vehicles, etc. Some companies or businesses may also offer non-fixed assets as collateral.

Collateral acts as security for the lender. It protects the lender against any default on loans by the borrower. However, that does not imply that it eliminates the chances of such defaults occurring. However, when a borrower defaults, the lender receives the right to the collateral asset. In that case, the lender can dispose of the asset and recover the loan amount from it.

Collateral is also beneficial for borrowers. It allows borrowers to receive secured loans, which are usually more lenient in the terms they offer. Borrowers can easily obtain loans when they offer collateral without having to meet complicated requirements. Similarly, borrowers can receive loans for a lower interest rate when they offer collateral compared to non-secured loans.

Under US GAAP – ASC 860, the accounting for collateral applies to all transfers of financial assets which have been pledged as collateral. This includes the repurchase agreements, dollar-roll, and securities lending etc…. In addition, such collaterals are accounted as a secured borrowing.

How Does Collateral Work?

When issuing a loan, a lender will try to minimize the default risk associated with the transaction. For that purpose, they will check the borrower’s creditworthiness. Based on that check, the lender will accept or reject the borrower’s application to receive a loan. However, there are some other factors that may also play a role in the lender’s decision.

One of these factors includes any collateral offered by the borrower. Collateral is an asset that a borrower owns but provides the right to the lender. In case of a default, the borrower loses control of the asset to the lender. This asset offered by the borrower minimizes the risk for the lender. The lender can then dispose of the asset and recover the value of the loan.

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There are many types of collateral that borrowers may offer. Usually, the type of security that a borrower may offer depends on the type of loan they acquire. For example, for home mortgages, the underlying home bought by the owner acts as collateral. For companies and businesses, accounts receivables, inventory, or even cash can be collateral.

What is the accounting for Collateral?

The accounting for collateral depends on the type of collateral that the borrower has offered. If a borrower provides non-cash collateral, the accounting treatment will depend on two factors. Firstly, it will consider whether the lender has the right to sell or repledge the collateral. Similarly, it will also take into account whether the borrower has defaulted. In these cases, both parties will account for collateral.

If the lender has the right to sell or repledge the collateral according to the contract, the borrower will reclassify that asset in the balance sheet. The borrower will have to present the secured asset separate from other assets on the balance sheet. Subsequently, if the borrower repays the loan, the accounting treatment will be reversed. The borrower must also disclose the terms for the collateral in the notes to the financial statements.

If the borrower fails to repay the lender, the borrower will have to derecognize the asset from its financial statements. However, the lender must have the right to sell the asset according to the contract. The lender, on the other hand, must recognize the collateral as an asset initially. The lender will have to measure the asset at fair value.

When the lender sells the asset, they must derecognize the obligation to return the collateral. The lender must also recognize the proceeds from the sale and a liability measured at fair value for its obligation to return the collateral.

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Companies or businesses may also offer cash collateral when obtaining loans or other purposes. Usually, these include assets, such as cash, documents of title, securities, deposit accounts, negotiable instruments or other cash equivalents. In that case, the accounting treatment will be the same as for restricted cash.

Under accounting standards, companies need to hold any cash collateral at separate escrow accounts. With the restricted cash method, companies must transfer these funds from one account to another. They must also present this account separately in the balance sheet and term it as restricted funds. Similar to non-cash collateral, the company must also disclose the terms associated with the collateral.

Regardless of the type of collateral, the accounting treatment is similar. The borrower only needs to reclassify the provided asset and disclose the terms of the collateral. The borrower’s assets on its balance sheet will no change. The only difference caused by accounting for collateral is the reclassification in the borrower’s balance sheet.

Example

ABC Co has signed a loan agreement with a commercial bank for $4,000,000. The company used its submersibles as collateral. The loan has an annual interest of 9% with monthly payment of interest which followed by a balloon payment in five years for the whole amount of principal. The submersibles’ book value is $3,600,000 while the accumulated depreciation is $450,000. The company expects to have a fair value of $3,800,000.

ABC Co has missed the first payment; therefore, the both parties have renegotiated the loan agreement to allow the bank to have the right to sell the submersibles.

From the above, example, how can ABC Co account for the collateral?

Since the submersibles are pledged as collateral and the bank has the right to sell such assets, in the book of ABC Co, the submersibles shall need to reclassify separately from the property, plant and equipment (PPE) in its statement of financial position.

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Below is the extract presentation in the statement of financial position:

Equipment used as collateral with right of sales (at NBV) …………..$3,600,000

Assume that two months later, ABC Co has defaulted on the note and has filed for bankruptcy. Therefore, the commercial bank takes the possession of the submersibles.

Below is the journal entry for the default in ABC Co account:

Account NameDebitCredit
Loan payable$4,000,000 
Accrued interest payable$60,000 
Accumulated depreciation$450,000 
Fixed Assets – Equipment $4,200,000
Gain on loan defaults (Balancing) $310,000

At the same time, the commercial bank needs to account for the foreclosed property since it is certain. From the bank, they need to estimate the cost to sell the submersibles in order to record in their book. They need to account for the commission as well so that they can incorporate in the valuation of the foreclosed property.

The commission is calculated at $76,000 ($3,800,000 × 2%). The value of foreclosed property is $3,724,000 net of commission ($3,800,000 – $76,000). Therefore, below is the accounting for collateral from bank perspective:

Account NameDebitCredit
Repossessed assets (Foreclosed assets)$3,724,000 
Bad debt expense (Balancing)$336,000 
Interest receivable $60,000
Loan receivable $4,000,000

Assume that the bank sells the foreclosed submersibles for $3,700,000 net of commission. Therefore, below is the journal entry to record the sales of foreclosed submersible:

Account NameDebitCredit
Cash$3,700,000 
Loss on assets sale$24,000 
Repossessed assets $3,724,000

Conclusion

Collateral is an asset that a borrower provides to a lender as security in exchange for a loan. If the borrower fails to repay the loan or defaults on payments, the lender can dispose of the asset to recover the loan. The accounting for collateral involves reclassifying the collateral in the borrower’s balance sheet. Similarly, the borrower must disclose the terms of the collateral in its financial statements.

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