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Repossessed, Revalued, Regulated: RBI’s framework for treatment of repossessed property

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-Anita Baid & Dayita Kanodia | finserv@vinodkothari.com

RBI, on May 5, 2026, came out with the draft directions on Specified Non-financial Assets (SNFA). These directions have been introduced with the intent of specifying the treatment of non-financial and non-banking assets, particularly immovable property, acquired by the lender in satisfaction of their claims on the borrower. 

It is relevant to note that a common framework has been introduced for banks and NBFC, which is in contradiction to the recent consolidation approach adopted by the Department of Regulations. This could possibly also create confusion as to the treatment of non-banking assets relevant for banks, being referred to under the common framework, to be also made applicable on NBFC. In case of banks, the Banking Regulations Act prohibits banks from holding such non-banking assets (NBAs) beyond a period of 7 years, except for property acquired for own use.

Key Highlights of the Proposal:

Our comments on the key proposals have been provided below:

  1. SNFA would include those immovable assets which are acquired by a RE in satisfaction or part satisfaction of its claims on the borrower along with the non-banking assets as per Section 9 of the BR Act. 

VKC comment: This would mean that movable property, like vehicles, equipment, is not being covered under the purview of these regulations. Further, the restriction on banks as provided under the BR Act to acquire any immovable assets other than assets put to its own use should not apply to NBFCs. 

  1. The SNFA can only be acquired by the RE concerned when
    1. The RE’s exposure to a borrower is classified as non-performing, and 
    2. Where other means of recovery have been explored and deemed unviable.

VKC comment: This could be practically challenging since in certain adverse situations (like fraud classification) the RE may not want to wait for the asset to turn into an NPA before repossession is done. However, practically, evaluation and classification as fraud would easily take 90 days.

Further, the fact that all other means of recovery has been explored and deemed unviable would be very subjective to establish. 

  1. Acquisition will result in proportionate extinguishment of the exposure in lieu of which the SNFA is being acquired. Any part extinguishment of claims by the RE concerned would be deemed as restructuring

VKC comment: It is understood that any compromise settlement of the dues would be done as per the extant regulations for banks and NBFCs (as the case may be) and the amount outstanding post such settlement shall be considered to determine the remaining claims, if any.

  1. Upon acquisition, the SNFA shall be recorded in the balance sheet at the lower of-
    1. The NBV of the extinguished exposure or 
    2. The distress sale value of the SNFA arrived at by at least two independent external valuers.

At each subsequent reporting date, the SNFA shall be carried on the balance sheet at the lower of the last available distress sale value, or the revised NBV (value of extinguished exposure, net of the notional provisions applicable had the exposure continued on the books of the RE).

VKC Comment: The accounting treatment of the SNFA should have been governed as per the provisions of the accounting standards (para 3.2.23 of Ind AS 109). There could be a possible conflict since the accounting standards require the asset to be recognised on fair value. 

  1. Post-acquisition, the SNFA will be revalued at least once every two years on a distress sale basis. The reasons for failure to dispose of the asset earlier shall also be recorded. Valuation gains should be ignored and any diminution in value should be recognised in profit and loss statement immediately.
  1. Any accrued interest or charges with respect to the exposure shall not be recognised till the SNFA is actually disposed off and such interest or charges are received by the RE.

VKC Comment: This is consistent with the IRAC provisions which requires the RE to shift from accrual accounting to cash basis accounting upon the asset turning into an NPA. 

  1. Any expense/income incurred for the SNFA should be recognised in the P/L account for the year in which the same is incurred/earned.
  1. Disposal of such SNFA shall be by way of a public auction following the SARFAESI procedures

VKC Comment: SARFAESI is applicable to NBFCs having an asset size of more than 100 crore and where the outstanding amount is a minimum of ₹20 L. Accordingly, in some cases, SARFAESI may not be applicable at all. In such cases, following SARFAESI procedures should ideally not be made mandatory. 

  1. SNFA cannot be sold back to the borrower or its RPs (as defined under the IBC, 2016)

VKC Comments: Even under IBC, 29A bars the borrower and its connected persons from bidding on the repossessed assets (except for certain exemptions in case of MSME borrowers). 

  1. In case of failure to dispose the SNFA within earlier of:
    1. 7 years from the date of acquisition or 
    2. The carrying value becoming zero

the asset shall be deemed to have been employed for its own use by the RE and will be recorded as a fixed asset.

VKC Comments: It seems unclear if the RE concerned can put the assets to its own use immediately on the acquisition of such assets. 

  1. Specific disclosure to be made as a part of the financial statements as per the format prescribed by RBI. 

Also, read our article,

Factoring DLG into ECL: Relief, But Not A Free Pass

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Vinod Kothari & Chirag Agarwal | finserv@vinodkothari.com

RBI had earlier directed NBFCs to compute expected credit loss (ECL) without considering the impact of any default loss guarantees (DLGs) obtained from its lending service provider (LSP). We had published a short note explaining why this position was debatable (See our article on the topic here) and had also made a formal representation to RBI on the issue. 

Back to the present, RBI has issued an amendment to the IRACP Directions, 2025 (dated February 13, 2026), permitting lenders to factor in DLG while determining provisions under the ECL framework across all stages.

Further, RBI has also specified that upon every event of invocation of DLG, the DLG cover reduces to the extent of invocation. Accordingly, REs shall recompute their ECL provisioning requirements across stages, after duly adjusting for the reduced DLG cover.

With these clarifications now in place, the next question that arises is: How should Regulated Entities (REs) appropriately factor DLG into their ECL computations? The article below discusses the above question at length.

How to factor in DLG in ECL computation?

Let us understand this in simple terms. Suppose a lender estimates that the expected loss on a loan pool is 3.8%. If the lender has received a guarantee of 5%, backed by fixed deposits that are lien-marked in its favour. The  guarantee is sufficient to cover the expected loss. In such a case, effectively, the lender does not expect to bear any loss. On the other hand, if the expected loss is 6.8% and the guarantee covers only 5%, then the lender’s net expected loss would be the balance 1.8%.

However, this adjustment assumes that the guarantee will actually be honoured when required. A guarantee does not, however, eliminate risk completely; it merely shifts the risk of default or loss from the borrower to the guarantor, up to the guaranteed amount.  

DLG & bankruptcy remoteness

The DLG guidelines specify the forms in which a DLG can be obtained. DLG can be accepted in any one of the following forms:

  • Cash deposited with the RE; 
  • Fixed Deposit maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE; 
  • Bank Guarantee in favour of the RE

Accordingly, DLG can only be obtained in fully funded forms, thus eliminating any question of incurring credit loss on such a guarantee. Does that mean that even in case of insolvency of the DLG provider the lender will have the right to invoke the guarantee? The answer to this is negative. Because unlike in the case of bankruptcy-remote SPV, the guarantor is an operating entity, and is prone to the risk of insolvency.

In case of initiation of insolvency proceedings, all the assets of an insolvent entity form part of the insolvency administration/liquidation estate and are beyond the reach of the creditors. The proceeds from the realisation of assets are paid to the creditors in accordance with the waterfall mechanism as specified under section 53 of the IBC, 2016 . 

Accordingly, it becomes important to determine how each permitted form of DLG would be treated in the event of insolvency of the DLG provider.

  • Cash deposited with RE: The cash deposited with the lender is actually a liability held in the books till the same is invoked. As per Section 36 of IBC 2016, assets that may or may not be in possession of the corporate debtor including but not limited to encumbered assets form part of the liquidation estate. Accordingly, cash deposited by the DLG provider with RE would form part of the liquidation estate of the guarantor.
  • Lien marked FD: Similar to cash deposited with RE, the lien marked FD will also form part of the liquidation estate.
  • Bank Guarantee: In the case of a bank guarantee, the credit exposure effectively shifts from the original guarantor to the issuing bank. Given that scheduled commercial banks are subject to stringent regulation and supervision, the risk of insolvency in banks is generally remote. Accordingly, the probability of default in such a structure is unlikely to be impacted.

So, even if the DLG is structured as a funded guarantee, the actual invocation can become complicated if the DLG provider goes into insolvency before such invocation. In such a situation, the lender may not be able to simply invoke the guarantee and take the money. Instead, it may have to submit its claim and wait for distribution under the insolvency process, where payments are made in the statutory priority order. 

Under the waterfall mechanism, secured creditors rank alongside workmen’s dues. Now, in most DLG structures, the guarantor is a fintech entity or a co-lender. These entities typically do not have significant workmen-related liabilities. This may mean that the lender’s priority position is relatively stronger. 

Further, the actual invocation process of the DLG should also be considered. For instance, cash held with the lender can be easily invoked and adjusted as compared to a lien-marked FD or bank guarantee, where there could be procedural delays. 

Illustration: Consider a loan pool of ₹100 crore where the gross ECL rate is estimated at 6.8% (for the static pool covered by the guarantee), resulting in a gross ECL of ₹6.8 crore. The lender has a DLG cover of 5% of the pool (₹5 crore), structured as a lien-marked fixed deposit provided by a fintech sourcing partner. While the DLG is funded, there remains a risk that the guarantor may become insolvent. The first relevant question here is whether we will take a probability of default (PD) as per Stage 1 (12 months PD), or Stage 2/3 (lifelong PD). While the guarantor in question is not in default at all, however, given that the 6.8% ECL is a combination of Stage 1 as well as Stage 2/3 loans, in our view, the PD for the guarantor, to remain conservative, should be the lifelong PD over the tenure of the loans. Let us assume a 20% Probability of Default (PD) for the guarantor. Next question is assessment of Loss Given Default (LGD). As discussed above, the lender has the benefit of full security in form of lien on the fixed deposit, however, there may be depletion of the same on account of first priority in the waterfall, that is, costs of insolvency and bankruptcy process. On a conservative basis, we may, therefore, assume a 10% LGD. Thus, the expected loss on the DLG cover would therefore be 20% × 10% = 2%. 

As a result, the ECL computation may now be:

= 5%*2% + 1.8% = 1.9%

Based on the aforesaid discussion, in our view, while the guarantee is funded the lender may have to adjust the probability of default to factor in the risk of insolvency, particularly where the guarantee is funded in the form of a cash deposit or a lien marked FD. 

Which funded form of DLG is most suited?

As per the analysis, the various options of funded DLG can be ranked basis the maximum consideration allowable for ECL computation:

  1. Bank guarantee:  Being bankruptcy remote and easiest to invoke
  2. Cash deposit: May have to consider the risk of guarantor’s bankruptcy but the invocation would be easier
  3. Lien marked Fixed Deposit: May have to consider the risk of guarantor’s bankruptcy and invocation may involve procedural delays

However, given that there will not be a sizable or material difference in the quantum of counter guarantee risk, the selection of the options for ECL computation may not be significant. 

Can we help this situation?

One of the ways to mitigate the risk of insolvency is by structuring the guarantee in such a way that the guarantee may be invoked upon the occurrence of an adverse material change in the financial condition of the guarantor. In other words, other than the occurrence of losses in the pool, if there are events of default such as adverse material change, insolvency of the guarantor etc., the lender may invoke the guarantee.

Early invocation upon identifiable stress on the part of the guarantor could help the lender realise the guarantee amount before the commencement of insolvency proceedings.

However, such clauses must be appropriately incorporated and drafted in the DLG agreement to ensure the following:

  • A clear definition of “adverse material change”
  • Identifiable trigger events
  • Clarity on invocation mechanism

Impact of DLG invocation on ECL computation 

RBI has also provided a clarification that upon every event of invocation of DLG, the DLG cover reduces to the extent of invocation. Accordingly, REs would be required to recompute their ECL provisioning requirements across stages, after duly adjusting for the reduced DLG cover.

Pool-based guarantees presuppose that the pool is static. This is purely intuitive because if the pool is dynamic, new loans will continue to enter the pool, and therefore, the guarantor’s exposure will keep spreading over a continuing flow of new loans. 

Where the pool is static, the loans gradually get repaid (amortised) over time. As borrowers repay their instalments, the outstanding amount of the loan pool keeps reducing. Since the exposure is shrinking, the ECL on that pool will also typically reduce over time, assuming normal performance. Therefore, whether the utilisation of the DLG on account of pool defaults may cause the ECL computation to increase? This may be so for 2 reasons: one, usual terms of DLG invocation will be the full amount of the defaulted loan will be recovered (due to escalation of the entire principal outstanding). Thus, while the performing loans amortise over time, the non-performing loans are fully recovered once they reach “default”, causing the utilisation of the DLG to run faster than the amortization of the performing loans. Second reason is that once the pool actually starts defaulting, there may be a reason to provide higher estimates of probability of default as well.

Integral part of the contractual terms: Is DLG required to form part of the loan agreement? 

Para 36A of the IRAC Directions read with the principles under Ind AS 109 provides that credit enhancements may be considered while computing ECL only where such enhancements are “integral to the contractual terms.”  The expression “integral to the contractual terms” is taken from the definition of “credit loss” in Ind AS 109. Credit losses are measured after considering the expected cashflows from an asset. Those cashflows will factor in the recovery of any collateral, or credit enhancements, as long as the said credit enhancement is integral to the contractual terms.

What exactly is the meaning of “integral to the contractual terms”? Are we expecting the guarantee (DLG in the present case) to be a part of the terms of the loan contract? That would never be the case, as the so-called guarantee (which may legally be regarded as an indemnity contract) is a bilateral contract between the lender and the DLG provider. Neither is the borrower aware of the guarantee, nor is it desirable to have the borrower know of the guarantee, for obvious reasons. 

IFRS 9 uses the same language. US ASC has more elaborate discussion on this. Para 326-20-30-12 says:

The estimate of expected credit losses shall reflect how credit enhancements (other than those that are freestanding contracts) mitigate expected credit losses on financial assets, including consideration of the financial condition of the guarantor, the willingness of the guarantor to pay, and/or whether any subordinated interests are expected to be capable of absorbing credit losses on any underlying financial assets. However, when estimating expected credit losses, an entity shall not combine a financial asset with a separate freestanding contract that serves to mitigate credit loss. As a result, the estimate of expected credit losses on a financial asset (or group of financial assets) shall not be offset by a freestanding contract (for example, a purchased credit-default swap) that may mitigate expected credit losses on the financial asset (or group of financial assets)

There has been a significant discussion on whether the benefit of a guarantee or credit enhancement which is not a part of the contractual terms of the loan can be factored in ECL computation. From discussions before the IASB, as back as in 2018, two conditions for recognising the benefit of credit enhancements were discussed:

  1. part of the contractual terms; and
  2. not recognised separately by the entity.

The second condition is easy to understand. For example, if the risk of default is hedged by a credit default swap, the value of the same, amounting to a derivative, is separately recognised. Hence, the question of factoring the same while computing ECL does not arise. However, the first condition, relating to contractual terms of the asset, still remains vague.

One may try to get some clues in the US FASB discussions, where para 326-20-30-12 has been interpreted in technical interpretations. In addition, there is a definition of “freestanding contracts” under the Glossary of ASC 326:

A freestanding contract is entered into either:

a. Separate and apart from any of the entity’s other financial instruments or equity transactions

b. In conjunction with some other transaction and is legally detachable and separately exercisable.

The “forming integral part of the contractual terms” does not warrant the principal contract to provide for the guarantee or the credit enhancements. Insisting on the same will be counter-intuitive, except in case of trilateral contracts. However, the conditions indicate that the guarantee or credit enhancement integrates and becomes an inseparable part of the underlying loan or group of loans. For example, if the group of loans was to be transferred, is it such that the benefit of the guarantee may stay iwth the originator and loans may be transferred, or the guarantee travels along with the loans? If the latter is the case, there is no doubt that in reality, the guarantee has become an embedded part of the loan transaction.

Another factor may be the contractual association between the loan cashflows and the payout from the credit enhancements. Some relevant considerations:

  • Is the guarantee specific to the contractual cashflows from the loans?
  • Does the guarantor pay what the original loan asset would have paid, or pays independent of the contractual cashflows?
  • If the lender subsequently recovers the cashflows from the asset, is the payout from the guarantee restored back to the guarantor?

The presence of these factors will suggest the integration or embedding of the guarantee into the contractual cashflows from the loans.

Conclusion

While the recent amendment by the RBI brings welcome clarity by allowing DLG to be factored into ECL computation, lenders must approach this carefully and realistically. A DLG can reduce the expected loss, but it does not make the risk disappear, as the DLG provider itself faces the risk of insolvency. The form of the guarantee, its enforceability, and the possibility of invocation- all of these matter in assessing the true level of protection. REs should not treat DLG as a mechanical deduction from ECL, but as a risk mitigant that requires thoughtful evaluation, continuous monitoring, and recalibration as the pool amortises and the cover reduces.

See our other resources:

  1. Expected credit losses on loans: Guide for NBFCs;
  2. Expected to bleed: ECL framework to cause ₹60,000 Cr. hole to Bank Profits;
  3. Impact of restructuring on ECL computation.

When “Profit” Isn’t Always Distributable

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– Understanding Reportable vs Distributable Profits under Ind AS and the Companies Act, 2013

– Sourish Kundu | corplaw@vinodkothari.com

In the sphere of corporate law intertwined with accounting principles, there arises a question on profits that are reported in the financials of a company and the amount that can actually be distributed, that is to say, a company’s reported profits may be impacted by several accounting standards, yet that does not mean it can distribute all of that profit as dividends. Under Indian law and accounting rules, there is a clear distinction between reportable profits (what appears in the financial statements) and distributable profits (what a company is legally permitted to pay out to shareholders). In this article, we decode the difference between reportable profits and distributable profits and the implications of this difference, whether companies are expected to prepare two statements of profit or loss, how investors are expected to read the financials to ascertain what can be expected as dividend. 

What are Reportable Profits?

“Reportable profits” refers to the profits (or loss) shown in the Statement of Profit & Loss prepared under Indian Accounting Standards (Ind AS). It includes all recognised items of income, expenses, gains and losses, whether realised or unrealised, so long as they meet the recognition and measurement rules in terms of the relevant accounting standards. For example, under Ind AS 109 (Financial Instruments), paragraph 5.7.1 states that changes in fair value of financial assets or liabilities measured at fair value through profit or loss (FVTPL) must be recognised in the PnL. Similarly, fair-value measurement principles under Ind AS 113 (Fair Value Measurement) apply where other Ind ASs require or permit fair value. 

Because reportable profits include unrealised fair value gains, remeasurements, or other accounting adjustments, there is always a possibility of an inflated or deflated picture being painted wherein there is a difference between a company’s “profit” number from the perspective of distribution.

What are Distributable Profits?

“Distributable profits” are that portion of profits (or reserves) out of which a company can legally declare and pay dividends to its shareholders under the Companies Act, 2013. Section 123(1) of the Act states that a company shall not declare or pay any dividend for a financial year except:

  • out of the profits of the company for that year, after providing for depreciation, and
  • out of the profits of any previous financial years, after providing for depreciation and remaining undistributed.

The first proviso to section 123(1) further clarifies that unrealised gains, notional gains or revaluation surplus arising from measurement at fair value shall not be treated as realised profits for the purpose of dividend declaration. 

“Provided that in computing profits any amount representing unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value shall be excluded”

Thus, even though accounting standards allow recognition of such gains/losses in the PnL statement, the law restricts their distribution and ensures distribution can be made of only actual realised profits.

As per the section, following adjustments are required to be made to reportable profits to compute distributable profits

Reportable ProfitsXXX
Less:
(b) unrealised gains(XXX)
(c) notional gains(XXX)
(d) revaluation of assets (positive)(XXX)
(e) any change in carrying amount of assets (positive) on measurement at FV(XXX)
(f) any change in carrying amount of liability (reduction) on measurement at FV
Add:
(a) revaluation of assets (negative)XXX
(b) any change in carrying amount of assets (reduction) on measurement at FVXXX
(c) any change in carrying amount of liability (increment) on measurement at FVXXX
Distributable ProfitsXXX

So effectively, it is not the case that companies need to maintain or prepare parallel PnL, one for the accounting purpose and one for the purpose of ascertaining distributable profits, the adjustments as illustrated above needs to be carried out. This is similar to adjustments carried out for the purpose of ascertaining profits in terms of Section 198 of the Companies Act, 2013, which is broadly used for determining CSR expenditure and the limits of managerial remuneration. Interestingly, the treatment of fair value changes in assets and liabilities is akin to how it is treated here, that is, fair value gains are not given credit and hence reversed, and on the other hand, fair value losses are not deducted and hence added back to arrive at the figure out of which managerial remuneration is to be paid, or CSR expenditure is required to be made. 

Some examples of such fair value changes and their impact on the reportable and distributable profit figures are given below: 

Examples: 

Consider the following scenarios for company following Ind AS principles of accounting: 

  1. Treatment of FVTPL
DateParticularsValue Reportable Profits Distributable Profits 
July, 2024Acquisition of investment Rs. 100––
31st March, 2025Value of investments Rs. 15050 (represents fair value gains routed through PnL)–
January, 2026Sale of investments Rs. 200–100 (realised gain)
  1. Deferred Tax Asset
DateParticularsValue Reportable Profits Distributable Profits 
July, 2024Acquisition of investment Rs. 100––
31st March, 2025Value of investments Rs. 70-30 (represents fair value loss routed through PnL)–
Deferred tax assetRs. 9 (30% tax on Rs. 30)9 –
January, 2026Sale of investments Rs. 90–-10

Why the Difference Exists

The divergence arises because accounting standards and company-law provisions serve different purposes:

  • The Ind AS framework aims to present true and fair information about an entity’s financial performance and position, which includes remeasurements and accounting for fair value changes.
  • The company law legislation aims to protect the company’s capital base and ensure dividends are paid out of “real” profits, thereby protecting creditor interests and preventing erosion of capital.

Thus, distributing unrealised or notional gains could expose the company (and its creditors) to risk if those gains reversed. The legal restriction is a form of capital maintenance concept.

Conclusion

In sum: reportable profits (what Ind AS shows) is not always the same as distributable profits (what a company can legally pay out). The presence of items such as unrealised fair-value gains, which are recognised in profit but not “realised” and hence, not available for distribution under company law, creates this difference. Understanding this distinction is essential because in the end, the dividend cheque flows only from the legally distributable pool and not simply from what the profit and loss account might suggest.

Read more:

Should you expect adjustment in profits for “Expected Credit Loss”?

Cash in Hand, But Still a Loss? 

Workshop on Intricacies of Ind AS 109 for regulated lenders

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OCI and its treatment in law

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OCI-and-its-treatment-in-law

Other ‘I am the best’ presentations can be viewed here

Our other resources on related topics –

  1. https://vinodkothari.com/2018/11/comprehending-other-comprehensive-income-oci-from-nbfcs-perspective/

A Guide to Accounting of Collateral and Repossessed Assets

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-Financial Services Team ( finserv@vinodkothari.com )

The purpose of reporting in accordance with International Financial Reporting Standards (IFRS) is to provide financial information about the reporting entity that is useful to various stakeholders in making decisions about providing resources to the entity.

To satisfy the objective of IFRS/Ind AS reporting, to a large extent, based on estimates, judgements and models rather than exact depictions. In other words, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

Understanding Collateral

Collateral is one or more assets that a borrower offers to a lender as security for a loan, with the intent that if the borrower defaults in making the promised loan payments, the lender has the right to seize the collateral, sell the same and realise the amounts due. Since collateral offers   a security to the lender should the borrower default, loans that are secured by collateral typically carry lower interest rates than unsecured loans.

Needless to say, secured lending forms a very important segment of the world of finance.

Although the legal rights that flow from collateral are typically specified in the loan agreement, law in some jurisdictions might specify particular overriding rights, obligations, restrictions, etc. In some cases, at the commencement of the loan, collateral is physically transferred from the borrower to the lender. These security interests are called possessory security interests – a pledge is an example of a possessory security interest. There are other types of security interests which are non-possessory, which are known as hypothecation, lien or charge in different jurisdictions. A mortgage in English and Indian law has a different connotation – it creates a property right in favour of the lender to secure the loan; hence, it results into transfer of specific title[1].

Irrespective of the form of collateral, it is clear that collateral is merely security interest, and not property interest. While covenants of security documentation may differ, the most common security document allows the lender to sell or cause the sale of the collateral upon default of the borrower.

Accounting of Collateral

Secured Loans:

When a financial institution (FI) extends a secured facility, it recognises  loan as its asset, as the benefits accruing to the entity would be on account of loan provided. The security would only act as backstop measure in case the performance of the loan deteriorates.  Further, the entity’s interest lies in the loan not in the charged asset.

However, this does not imply that security on a loan would go unnoticed while accounting for the loan asset. Collateral and other credit risk mitigants are important factors in an entity’s estimate of Expected credit losses (ECL).

Consequently, IFRS 7 Financial Instruments: Disclosures specifies that an entity must disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period and how those risks have been managed by the entity (paragraphs 31 and 32). When relevant, an entity’s risk management disclosure would include its policies and procedures for taking collateral and for monitoring the continuing effectiveness of collateral in mitigating counterparty credit risk. Paragraph 35K of IFRS 7 requires information that will enable users of financial statements to understand the effect of collateral and other credit enhancements on the amount of expected credit losses.

The Division III of Schedule III to the Companies Act, 2013 prescribes a separate disclosure for secured and unsecured advances. Further the impairment loss allowance for both asset categories is also presented along with the specific asset  .

In short, disclosure of the collateral and credit enhancements is an important disclosure. The existence of the collateral itself may not change the carrying value of the loan, but it may have repercussions on the value of the ECL, as also, in case of fair-valued loans, on the risk-adjusted value by impacting the credit spread that is deployed as a part of the discounting rate.

Collateral and SPPI test

Simply payment of principal and interest (SPPI) test is one of the two tests that are required to be passed for a financial asset to be classified either as subsequently measured at Amortised Cost or at FVOCI. The test says that the contractual cash flows from the asset, on specified dates, should comprise only of principal payments and interest payments on the principal amount outstanding.

Paragraph BC4.206(b) of the Basis for Conclusions on IFRS 9 explains the IASB’s view that financial assets can still      meeting the SPPI test, i.e., the contractual cash flows may consist solely payments of principal and interest, even though they are collateralised by assets.     . Consequently, in performing the SPPI test an entity disregards the possibility that the collateral might be foreclosed in the future unless the entity acquired the instrument with the intention of controlling the collateral.

Accounting of Repossessed Assets

Assume the following facts: FI had a loan of Rs 1000 outstanding, which was in default. FI forecloses and repossesses the collateral, say a machinery, which is valued Rs 700 on the date of repossession. FI keeps the machinery pending disposal, and on the reporting date, the machinery is still in stock. Eventually, in the next reporting period, the machinery is sold, say for a net realisation of Rs 600.

Several questions arise – on the date of repossession, can FI remove loan to the extent of Rs 700 and debit it to machinery held for sale? What happens to the loss of Rs 100 on the sale – is it loss related to the loan, or loss related to disposal of machinery?

Questions like this are faced by financial institutions all the time.

Though accounting standards provide ample guidance on taking cognizance of collateral, specifically for credit risk assessment and asset recognition, the clarity is lost at the issue of accounting for repossessed assets. Accounting standards do not provide a clear view on how an asset should be treated when the entity enforces its right to foreclose and repossess the asset, and the asset is pending disposal. If the disposal of the asset has already been done, then the question of any accounting for collateral does not arise, as the collateral has already      been disposed off. However, the accounting for the collateral itself, as discussed below, will affect the accounting for the disposal as well.

As regards accounting for the repossession of the collateral, some guidance comes from the Para B5.5.55 of IFRS 9/Ind AS 109 :

“…….Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.”

The extract clarifies that mere fact that the asset is repossessed would not make it eligible for being recognised as an asset on the books, as the entity’s interest still lies in recovery loan, the entity would have no interest in the asset if not for dues under the loan.

Further, Para 7 of IAS 16 / Ind AS 16 states that

“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably”

Hence, the FI can capitalise and record only such assets whose future economic benefits would accrure to the financial institution in question, that is, the lender. PPE classification is possible  It may also be possible for an entity to hold the asset as an investment property, for disposal. There may be cases where the collateral may consist of shares, securities or other financial assets, or may consist of stock in trade or receivables.

Irrespective of the type of asset, the key question would be – has the lender acquired a property interest in the collateral, so as to have risks and rewards in the same, or the lender has simply acquired possession over the collateral for causing disposal?

Legal rights in case of collateral

The accounting here is impacted by the legal rights in case of collateral. To  reiterate, we are stating here generic legal position, and it is possible that collateral documents bring rights of the lender which are differential. Further, the legal rights may vary depending upon the kind of security interest being created on the assets, e.g. a pledge would differ from a mortgage.

In the case of Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd[2] the Supreme Court, while also indicating the very distinction between a pawn and a mortgage, observed that even after a pledge is enforced, the  legal title to the goods pledged  would not  vest in the pawnee. the pawnee has only a special  property. A pawnee has no right of foreclosure since he never had absolute ownership at law and his equitable title cannot exceed what  is specifically granted by  law. The right  to property vests in the pledged only so far as is necessary  to secure the debt.[3]

Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed[4] However, as noted in     , Narandas Karsondas vs. S.A Kamtam and Anr[5] it is important to note that the mortgagor does not lose the right of redemption until the sale is complete by registration. In selling the property, the mortgagee is not acting as the agent of the mortgagor but under a different (read: superior) claim. No equity or right in property is created in favour of the purchaser by the contract between the mortgagee and the proposed purchaser.

We have mentioned above that the legal rights of a lender differ (a) based on the law of the jurisdiction, as also consistent practices; (b) legal documentation. For instance, in case of mortgage, the common law provides two different rights of a mortgagee – the decree of sale and the decree of foreclosure [Section 67 of Transfer of Property Act, 1882]      Decree of sale implies that the mortgagee may simply cause the sale of the mortgaged property. Decree of foreclosure is foreclosure of the mortgagor’s      right of redemption, and the mortgagee, therefore, becoming absolute owner of the property. There are exceptional circumstances when this is possible, for example, in case of a mortgage by conditional sale.

In case of pledges too, while the general rule as set out in Lallan Prasad vs Rahmat Ali[6]  and GTL Textiles vs IFCI Ltd.[7] is that the pledgee only has the right to cause sale.

In case of US practices, it is quite a common practice of mortgage lenders to hold the foreclosed property as Real Estate Owned.

Thus, there can be two situations:

  • Case 1 – Lender acquires the asset as means of recovery and does not acquire  any risk and reward in the property;
  • Case 2 – Lender acquirers the property in the full and final settlement of the loan.

Our analysis of broad principles is as follows:

Acquisition as means of recovery

The lender could repossess the property as a result of the borrower’s default with the intention securing the possession of the collateral. The seeking of possession of the collateral is simply seeking the custody of the collateral. This is preventive – to ensure that the asset or its value is not  prejudiced. This is intent when a court, receiver, arbitrator or similar agency seeks control over the collateral. The intent is custodial and not proprietary. The actual sale proceeds of the asset, as and when disposed of by the lender, will go to the credit of the borrower; any amounts received in excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the obligation of the borrower.

The FI may continue to charge interest on the outstanding balance. The lender remains exposed to interest rate risk on the  collateral but is not exposed directly to property price risk.

In such cases, there is no question of the loan being set off against the value of the collateral, until the collateral is actually disposed off. While giving the particulars  of the collateral, the lender may separately classify collateral in possession of the lender, as distinct from collateral which is in possession of the borrower or third parties. However, the classification of the loan remains unchanged.

Acquisition of proprietary interest in the collateral:

The lender could repossess the property, which in terms of the law or contract, gives the lender absolute rights in the property. The lender may have the right to collect the unrealised amount from the borrower, or the obligation to refund the excess, if any,  realised, but the issue is, does the lender acquire proprietary interest in the collateral, and whether the lender now is exposed to the risks and rewards, or the variability in the value of the collateral?

However, FASB has prescribed following guidelines to determine whether the charged asset would replace the loan asset. The FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure[8]  provides that “a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either upon

(1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or

(2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. “

In line with above, where the entity has acquired complete right over the asset there is no doubt that the loan account is closed, and the entity now hold interest entirely in the repossessed asset. Hence the company shall derecognise the loan asset and recognise the charged asset in their books. Whether the asset will be a real asset, financial asset, stock in trade, receivables, PPE or other investment property, will depend on the asset and the intent of the entity in holding it till disposal.

Accounting for repossession of the collateral:

In the above case, the entity should fair value the collateral on the date of seeking repossession, and to the extent of the fair value, the asset should be debited, crediting the loan. Whether the asset will continue to be subjected to fair valuation, or historical cost valuation, will depend on the applicable accounting standard for the type of asset in question.

any subsequent movement in the value of the collateral will affect the entity, and not the borrower.

Conclusion

Given the current stress in the economy, the rates of default on loans collateralized by all kinds of properties – residential real estate, commercial real estate, vehicles, consumer durables, etc., have zoomed up. There will be substantial collateral calls in time to come, and therefore, the need to have clarity on accounting for collateral is more today than ever before.

This article has tried to fill an apparent gap in literature on accounting for collateral. We will want to develop this article further, with numerical examples, by way of further updates.

[1] Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication

[2] Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd

[3] Gtl Limited vs Ifci Ltd

[4] Lallan Prasad vs Rahmat Ali

[5] Narandas Karsondas vs. S.A Kamtam and Anr

[6] Lallan Prasad vs Rahmat Ali

[7] GTL Textiles vs IFCI Ltd

[8] FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure