Accounting for Financial guarantees: a tricky Ind AS accounting issue

This article takes a look at the requirements for accounting for financial guarantees
under Indian Accounting Standards.

What is a financial guarantee contract under Ind AS 109?

Corporate guarantees may have various legal forms, such as a guarantee, some types of
letter of credit, a credit default contract or an insurance contract. The accounting does
not depend on the legal form of the guarantee.

Ind AS 109 defines a financial guarantee contract 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 in accordance with the original or modified
terms of a debt instrument.

Following are two main aspects of the definition:

- Reimbursement for a loss incurred:

Corporate guarantees generally have a similar function as that of some derivative

instruments - the issuer agrees to protect the holder of the contract or instrument.

One of the key distinctions between financial guarantees under Ind AS 109 and
derivatives is that in case of financial guarantees, the contract must provide for
reimbursement of a loss that the holder of the contract actually incurs. Where a loss is
not required for payment to be made, the contract is not a financial guarantee under Ind
AS 109. In other words, if the contract does not, as a precondition for payment, require
that the holder (e.g. a bank) to have incurred a loss on the failure of the debtor (or the
borrower) to make payments on the guaranteed asset when due. If a contract requires
payments in response to changes in a specified credit rating or credit index, these are not
financial guarantees under Ind AS 109. They are most likely a derivative required to be
fair valued through P&L.

- Debt instrument

The definition requires that the holder should be reimbursed for should be as per the
terms of a debt instrument. A debt instrument has not been defined, but it would seem to
be a broader term. For example, if there is a guarantee with respect of default in
payments under operating lease agreement (for example, of a civil aircraft) would qualify
as a financial guarantee.

What are not financial guarantee contracts under Ind AS 109?

Following would not qualify as financial guarantee contracts under Ind AS 109:

(a)   Warranties issued by a manufacturer, dealer, or retailer, since it is not in respect

of debt instrument;
(b)   Residual value guarantees, since there would not be due to loss incurred due to
failure to pay
 (c)   Contingent consideration payable or receivable in a business combination.
It is not clear whether letters of support would meet the definition of financial guarantee
contract. General letters of financial support given by holding company to subsidiary
may not qualify as financial guarantees. One may argue that there is no specified holder
of the instrument. However, certain specific letters of financial support may be financial
guarantees under Ind AS 109.

How are financial guarantees accounted for under Ind AS?

Financial guarantees issued that are accounted for under Ind AS 109 are initially
recognised and measured at fair value.

Subsequently, the measurement is at the higher of the following two amounts:

-   Amount of loss allowance determined as per impairment requirements of Ind AS

109, and
-   Amount initially recognized less, where appropriate, cumulative amortization
recognized under Ind AS 115.
For example, if holding company H gives a financial guarantee to bank A on behalf of its
foreign subsidiary. The fair value of the financial guarantee is 100. The holding company
H will recognize financial asset receivable and financial guarantee obligation both at 100
on day 1.Over the term of the subsidiary's loan, on one hand, H would recognize revenue
through P&L that will unwind the guarantee obligation, on the other hand, the
commission realisations would reduce the financial asset receivable.

Subsequently, if S is expected to default on its payments, H would impair the receivable

on expected credit loss basis. If H is called on to honor the financial guarantee
obligation, H will have to increase the value of the obligation to that amount and book a
P&L charge.

In consolidated financial statements of H group, there would be no impact as it would be

eliminated as an inter company transaction.

How does the subsidiary account for the guarantee?

If the guarantee is an integral part of the loan agreement, which is often the case, the
subsidiary would not separately account for the guarantees provided by the parent on its
behalf.

What about holder's accounting?

Ind AS addresses the treatment of financial guarantee contracts by the issuer. It does not
address their treatment by the holder. Generally the holder would be a bank or a
financial institution, who have not yet applied Ind AS.

Why should such 'notional' accounting income be booked, particularly, if

there is no impact at consolidated level?

US GAAP exempts following type of financial guarantees from being accounted for:
 -   A guarantee issued either between parents and their subsidiaries or between
corporations under common control
-   A parent's guarantee of its subsidiary's debt to a third party (whether the parent
is a corporation or an individual)
-   A subsidiary's guarantee of the debt owed to a third party by either its parent or
another subsidiary of that parent
These exemptions do not exist under IFRS or under Ind AS. In the past, the
International Accounting Standards Board was asked on the merits of such an
accounting in parent's standalone financials. The IASB believed that not accounting for
such guarantee obligations would stand the risk of material liabilities from being
accounted for.

What if a holding is not charging any guarantee commission from the

subsidiary?

Often, in India, parent companies do not charge guarantee commissions from

subsidiaries. In such cases, it would be appropriate to account for the spare debit arising
on initial fair valuation of financial guarantee obligation as additional investment in
subsidiary. The guarantee obligation would unwind over the period through P&L. The
investment in subsidiary arising on initial recognition would be aggregated to the cost of
investment in equity shares of the subsidiary and measured as per Ind AS 27 Separate
Financial Statements.

How do you determine the fair value of financial guarantees?

This has been one of the difficult practical challenges under Ind AS, particularly given
that there is no matured market for such instruments in India.

Fair valuation under Ind AS is generally dealt with by Ind AS 113 Fair Value
Measurement. A fair value measurement under Ind AS 113 requires an entity to consider
the assumptions an independent market participant, acting in their economic best
interest, would use when pricing the asset or a liability. If the financial guarantee
contract was issued to an unrelated party in a stand-alone arm's length transaction, its
fair value at inception is likely to equal the premium received, unless there is evidence to
the contrary. However, giving corporate guarantee to an unrelated party is rarely a
realistic case for a non-banking company in India. Even if a parent charges guarantee
commissions to the subsidiary, the commission charged may not necessarily reflect fair
value since the two are not independent market participants.

The ICAI's Ind AS Interpretations Committee's Bulletin 16 dealt with the valuation
aspects in one of its FAQs. It stated that for determination of the fair value of the
financial guarantee, in the absence of any specific guidance on the issue in Ind AS 109 or
in any other Ind AS and considering the broad principles of Ind AS 113 the following
approaches may be considered:

-   One possible measure of the fair value of the financial guarantee (at initial
recognition) may be the amount that an unrelated, independent third party
would have charged for issuing the financial guarantee.
-   Another possible approach may be to estimate the fair value of the financial
 guarantee as the present value of the amount by which the interest (or other
similar) cash flows in respect of the loan are lower than what they would have
been if the loan were an unguaranteed loan.
-   Yet another possible approach may be to estimate the fair value of the financial
guarantee as the present value of the probability-weighted cash flows that may
arise under the guarantee (i.e. the expected value of the liability).
If applied properly, the results of the three approaches described above are generally
unlikely to differ widely.

What are the factors to be considered for fair valuation?

Factor to be considered would include:

-   Credit/ default risk – this lies at the heart of determining the arm's length
guarantee commission. A weaker credit rating of the borrower would warrant a
higher guarantee commission.
-   Tenure of the guarantee- longer guarantee tenure would mean higher
commission
-   Benching marking with guarantee commission that a bank would charge for a
similar guarantee to the borrower. This would perhaps be the closest surrogate
for independent guarantee commission.
Can financial guarantee be considered to be contingent liability?

In India, often bank require bank guarantees from parent/ group companies of the
borrower as a part of their risk management or documentation requirements. Therefore
the parent's guarantees are integral to the subsidiary's loan agreement. Often loan
covenants prohibit the parent/ promoter group from charging guarantee commission to
the borrower. This is more of an anti-abuse mechanism to check divergence of funds to
promoters by the borrower. Many argue that financial guarantee in Indian context is not
a real liability. One may also argue that Ind AS 104 Insurance Contracts also deals with
financial guarantees and it may be possible under that standard to present financial
guarantees as contingent liabilities, unless there is probability of economic outflow, in
which case there should be a provision recognized.