Guarantees are commonly encountered in the commercial world; these can range from guarantees of bank loans made as accommodations to business associates to negotiated arrangements made to facilitate sales of the entity’s goods or services. Guarantees had not been comprehensively addressed by IFRS prior to a recent (mid-2005) amendment to IAS 39 and IFRS 4 to explicitly deal with certain financial guarantee contracts.
In contrast, under US GAAP (FAS 5, in particular) there had long been a tradition of, at minimum, disclosure of guarantees, and in many circumstances the accrual of the anticipated loss to be suffered by the guarantor. Most recently, US GAAP saw the promulgation of a detailed standard, FIN 45, which established a new regime for measuring, recording, and reporting all guarantees.
IFRS has been revised to provide guidance on the accounting for all financial guarantees—those which are in effect insurance, the accounting for which is therefore to be guided by the provisions of IFRS 4, and those which are not akin to insurance, and which are to be accounted for consistent with IAS 39, which has been amended appropriately.
For purposes of applying the new guidance, a financial guarantee contract is defined as a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due. These are generally to be accounted for under provisions of amended IAS 39, as follows:
- Financial guarantee contracts are initially recognized at fair value. For those financial guarantee contracts issued in stand-alone arm’s-length transactions to unrelated parties, fair value at inception will be equal to the consideration received, unless there is evidence to the contrary.
- In subsequent periods, the guarantee is to be reported at the higher of: (1) the amount determined in accordance with IAS 37, or (2) the amount initially recognized less, if appropriate, the cumulative amortization (to income) that was recognized in accordance with IAS 18.
If certain criteria are met, the issuer (guarantor) may elect to use the fair value option set forth in IAS 39. That is, the guarantee may be designated as simply being carried at fair value, with all changes being reported currently in profit or loss.
The original proposal, released in 2004, was to have dealt with a class of arrangement that required the guarantor to make payments in response to adverse changes in the debtor’s credit rating, even if no event of default occurred. However, in the amendments to IAS 39 and IFRS 4 that were adopted, these are excluded from the definition of financial guarantees. Rather, these credit derivatives (as they are often known) are to be accounted for at fair value under IAS 39. These are derivative financial instruments, not insurance. The accounting for such derivatives is not affected by the amendments.
The amended language of IAS 39 observes that financial guarantee contracts can have various legal forms (e.g., a guarantee, some types of letter of credit, a credit default contract, or an insurance contract), but that the proper accounting treatment does not depend on legal form.
The basic requirement of these amendments is that financial guarantee contracts, as defined, are to be accounted for under IAS 39, not under IFRS 4. However, there is an important exception: if the guarantor/issuer had previously asserted explicitly that it regarded those as insurance contracts, and had accounted for them consistent with such a declaration, then it is permitted to make a onetime election (on a contract-by-contract basis) as to whether the contracts will be accounted for as insurance or as financial instruments. This is an irrevocable election.
Apart from this special optional treatment, all financial guarantees are to be accounted for as set forth above. Free-standing guarantees (e.g., when a party other than the merchandise vendor guarantees the customer’s borrowings made to effect the transaction), if arm’s length, will typically be priced at fair value.
If a $10,000 loan is drawn down so that the borrower can acquire machinery from a dealer, and a third party agrees to guarantee this debt to the bank for a onetime premium of $250, for a loan term of four years, that amount probably represents the fair value of the loan guarantee, which should be recorded accordingly. If it qualifies under IAS 18 for recognition as revenue on a straight-line basis, it would be amortized to income at the rate of $62.50 per year.
Assume that, subsequently, the machinery purchaser’s creditworthiness is impaired by a severe downturn in its industry segment performance, so that, by the end of the second year, the fair value of this guarantee (which has two more years to run) is $200. That could be measured, among other ways, by the onetime premium that would be charged to transfer this risk to another arm’s-length guarantor.
Since the carrying value of the liability is $125 after two years’ amortization has occurred, the higher of the amount determined under IAS 37 or the carrying value, $200 must be reported in the statement of financial position as the guarantee obligation. An expense of ($200 – $125 =) $75 must be recognized in the current (second) year as the cost of the additional risk borne by the reporting entity (but note that $62.50 in fee income is also being recognized in that year). The new book value, $200, will be amortized over the remaining two years ratably, assuming that no default occurs.
Note that IAS 37 stipulates that the “best estimate” of the amount to be reported as a provision is the amount that would rationally be offered to eliminate the obligation. In general, this should comport with the notion of “fair value.” Both imply a probability-weighted assessment, which may be made explicitly or implicitly depending upon the circumstances. Both also imply a present value equivalent of future resource outflows, assuming that the timing of such outflows could be estimated.
When the guarantor is not “arm’s-length,” determining the fair value of the guarantee at inception may be more difficult, since there is no “onetime premium” being paid to secure this arrangement.
Typically, the guarantee is a sales inducement (e.g., when the machinery dealer finds it must guarantee the buyer’s bank loan in order to consummate the sale), and thus is effectively a discount on the price otherwise obtainable for the merchandise (or services).
The full expense would be recognized at the date of the transaction since this expense was incurred in order to generate the sale; thus it is best “matched” against revenue recognized in the current reporting period. The guarantee liability is accounted for as set forth above (adjusted to the higher of fair value or amortized original value, if amortization is proper under IAS 18).
Example of Estimating The Fair Value of a Guarantee
Lie Dharma Company guarantees a $1,000,000 debt of Putra Company for the next three years in conjunction with selling equipment to Putra. Lie Dharma evaluates its risk of payment as follows:
There is no possibility that Lie Dharma will pay to honor the guarantee during year 1 (or, equivalently, there is zero risk of default by Putra in year 1).
There is a 15% chance that Lie Dharma will pay during year 2 (i.e., that there will be a partial or complete default by Putra that year). If it has to pay, there is a 30% chance that it will have to pay $500,000 and a 70% chance that it will have to pay only $250,000.
There is a 20% chance that Lie Dharma will pay during year 3. If it has to pay, there is a 25% chance that it will have to pay $600,000 and a 75% chance that it will have to pay $300,000.
The expected cash outflows from the guarantor are computed as follows:
- Year-1: 100% chance of paying $0 = $0
- Year-2: 85% chance of paying $0 and a 15% chance of paying (0.30 x $500,000 + 0.70 x $250,000) = ($325,000 x 15%) = $48,750
- Year-3: 80% chance of paying $0 and a 20% chance of paying (0.25 x $600,000 + 0.75 x $300,000) = ($375,000 x 20%) = $75,000
The present value of the expected cash flows is computed as the sum of the years’ probability-weighted cash flows, here assuming an appropriate discount rate of 8%.
- Year-1: $ 0 x 1/1.08 = $ 0
- Year-2: $48.750 x 1/(1.08)2 = 41,795
- Year-3: $75,000 x 1/(1.08)3 = 59,537
So, fair value of the guarantee is $101,332
Based on the foregoing, a liability of $101,332 should be recognized at inception. This would effectively reduce the net selling price of the equipment sold to Putra by a like amount, thereby reducing the profit to be reported on the sale transaction.
Assume that the equipment cost was $650,000, then the entry recording the sale (assume specific identification is used for inventory costing) and the guarantee is as follows:
[Debit]. Cash = 1,000,000
[Debit]. Cost of goods sold = 650,000
[Debit]. Sales expense—guarantee of customer debt = 101,332
[Credit]. Revenue = 1,000,000
[Credit]. Inventory = 650,000
[Credit]. Guarantee liability = 101,332
The profit reported in the current period would be $1,000,000 – $650,000 – $101,332 = $248,668. The guarantee liability would be amortized to income over the term of the three-year loan; if no default occurs, the dealer recovers the full sales expense it incurred by offering the discount.