-Financial Services Team ( firstname.lastname@example.org )
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.
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.
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
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 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.
Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed However, as noted in , Narandas Karsondas vs. S.A Kamtam and Anr 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 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 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.
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.
 Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication