In the context of notes payable, why do some lenders require borrowers to secure a note with collateral?

• A. To ensure the note payable is classified as equity rather than a liability on the borrower’s balance sheet
• B. To reduce the lender’s credit risk by giving the lender a legal claim on specific assets if the borrower defaults
• C. To eliminate the need for the borrower to pay interest on the note
• D. To guarantee the borrower will record the note payable at face value instead of present value

Answer: (B)

Verified step by step guidance

1. Understand the concept of notes payable: Notes payable are written promises to pay a certain amount of money at a future date, often with interest, and are classified as liabilities on the borrower's balance sheet.
2. Recognize the role of collateral: Collateral is an asset pledged by the borrower to secure the note payable, providing the lender with a legal claim to that asset if the borrower fails to meet the payment obligations.
3. Analyze why lenders require collateral: Lenders require collateral primarily to reduce their credit risk, meaning they want to ensure they have a way to recover their funds if the borrower defaults on the note.
4. Evaluate the incorrect options: Securing a note with collateral does not change its classification from liability to equity, does not eliminate interest payments, and does not affect whether the note is recorded at face value or present value.
5. Conclude that the main reason for requiring collateral is to protect the lender by giving them a legal claim on specific assets, thereby reducing the risk of loss in case of default.