Collateral in measurement of expected credit losses

In IFRS 9 collateral is a relevant factor in the measurement of expected credit losses.

In IFRS 9 the estimate of expected cash shortfalls is reflected by the cash flows expected from collateral and other credit enhancements that are integral to the instrument’s contractual terms. The estimate of expected cash shortfalls on a collateralized financial instrument reflects:

  • the amount and timing of cash flows that are expected from foreclosure on the collateral or other ways of recoverability of the collateral,
  • less the costs of obtaining and selling the collateral.

This is irrespective of whether or not foreclosure is probable. In other words, the estimate of expected cash flows considers both the probability of a foreclosure and the cash flows that would result from it.

A consequence of this is that any cash flows that are expected from the realization of the collateral beyond the contractual maturity of the contract are included in the analysis. This is not to say that the entity is required to assume that recovery will be through foreclosure only however. Instead the entity should calculate the cash flows arising from the various ways in which the asset might be recovered and assign probability-weightings to those outcomes.

5 Common Types of Collateral for Business Loans are:

  1. Real property, like a home or business property,
  2. Manufacturing equipment,
  3. Inventory,
  4. Cash,
  5. Trade accounts receivable,
  6. Blanket lien.

Pledging collateral is critically important when attempting to secure financing for a business. But why is that? And, further, what is collateral in business?

On that first point, collateral is just one form of security for lenders. Obviously, lenders are putting a lot at stake when they offer up capital to a small business. And as well-intentioned as a business owner is when they accept a loan, there’s always the risk that things can go south and they’ll be unable to repay what they owe.

That’s the function collateral—if a borrower defaults on their loan, the lender has the right to seize whatever assets the borrower pledged to make up for the lost capital.

Other than collateral’s very real function, on a symbolic level lenders like to see that a borrower has skin in the game—and that they, too, have a lot to lose if they fall through on their loan payments.

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