IFRS 17 Financial guarantee contract

Financial guarantee contract – IFRS 17 Definition: 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 a payment when due in accordance with the original or modified terms of a debt instrument. Financial guarantee contract


Further explanation Financial gu Financial guarantee contract arantee contract

These contracts meet the definition of an insurance contract. Financial guarantee contract

They are, however, outside the scope of IFRS 17, unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used the accounting guidance applicable to insurance contracts. For such contracts, the issuer can choose to apply either IFRS 17 or the guidance in IAS 32, IFRS 7 and IFRS 9. The issuer can make the election on a contract-by-contract basis, but the election for each contract is irrevocable. Financial guarantee contract

Assertions that the issuer regards contracts as insurance contracts can typically be found in business documentation, contracts, accounting policies, financial statements and communications with customers and regulators. Financial guarantee contract


Accounting treatment: Financial guarantee contract

Financial guarantee contracts (FGC)  are recognized as a financial liability at the time the guarantee is issued. The liability is initially measured at fair value.

The fair value of an FGC1 is the present value of the difference between: Financial guarantee contract

  • The net contractual cash flows required under a debt instrument, and Financial guarantee contract
  • The net contractual cash flows that would have been required without the guarantee. Financial guarantee contract

The present value is calculated using a risk-free rate of interest. Financial guarantee contract


Accounting examples: Financial guarantee contract

Initial recognition and measurement – Financial guarantee contract

On 1 January 2017, ABC Ltd guarantees a $100m bullet loan (principal payment at the end of the loan term) of DEF Ltd. The loan is provided to DEF Ltd for 3 years at 8%. Without the guarantee the bank would have charged an interest rate of 10%.

Accounting treatment:

The FGC2 is initially measured at fair value plus 12-month expected credit losses.

Fair value:

The cash flows for a (non-guaranteed) market bullet loan would be: Financial guarantee contract

Year 1: $100m x 10% = $10m
Year 2: $100m x 10% = $10m
Year 3: $100m x 10% = $10m plus the full redemption of $100m = $110m,

The fair value of the market loan would be (don’t be surprised, it is a check-up!):

The net contractual cash flows discounted at 10% or ($10 / 1.11 + $10 / 1.12 + $110 / 1.13) = $9.1 + $8.3 + $82.6 = $100m

The cash flows for a guaranteed bullet loan would be:

Year 1: $100m x 8% = $8m
Year 2: $100m x 8% = $8m
Year 3: $100m x 8% = $8m plus the full redemption of $100m = $108m,

The fair value of the guaranteed loan would be (discount at market rate off course!):

The net contractual cash flows required under the loan = ($8 / 1.11 + $8 / 1.12 + $108 / 1.13) = $7.3 + $6.6 + $81.1 = $95m

The fair value of the guarantee is $5m, being the present value of the difference between the $100m and the $95m calculated above.

12-month expected credit losses:

Based on the recorded credit losses in the past on such loans and the expectations regarding expected future credit losses regarding this specific guarantee, the company recognises a loss allowance, based on the 12-month expected credit losses, on the financial guarantee at initial recognition of:

2% of the $100m guarantee = $2m

The double entry required on 1 January 2017 is:

DT $m

CR $m

Guarantee expenses – PL

7

Long-term provision financial guarantees – fair value at recognition BS

5

Long-term provision financial guarantees – ECL allowance at recognition BS

2

The FGC3 is then amortized as income to profit or loss over the period of the guarantee, representing the revenue earned as the performance obligation (i.e. providing the guarantee) is satisfied, thereby reducing the liability to zero over the period of cover, if no compensation payments are actually made.

Subsequent measurement – Financial guarantee contract

The amortisation is in 3 years, the period for which the guarantee is issued. Annual amortisation is $5 million over 3 years = $1.67m. Discounting is ignored.

As long as there is no significant increase in the credit loss relating to this financial guarantee contract (which has to be challenged and documented each reporting period) the 12-month expected credit losses remains unchanged.

As a result, at the end of 2017 the following double entry is required:

DT $m

CR $m

Long-term provision financial guarantees – BS

1.67

Financial guarantees income – PL

1.67

Let’s assume that on 31 December 2017, there is a significant increase in the risk that DEF Ltd will default on the loan. The probability of default over the remaining life of the loan is 65%.

This result is a situation that the credit risk on the financial guarantee contract is significantly increased and the lifetime expected credit losses have to be provided.

Credit risk increased significantly – Financial guarantee contract

As a result, ABC Ltd does not expect to recover any amount from DEF Ltd. Then in this case, the lifetime expected credit losses (ignoring the effect of discounting) are $65m ($100m x 65%), The fair value of the provision is $7m (see initial recognition), less $1.67m (see subsequent measurement). No financial guarantees income is recognised anymore or only financial guarantees income on the impaired financial guarantee (i.e. provision $5.33 less 65% impairment = $1.9 x 8% = $0.14m.

The carrying amount of the liability is adjusted as follows (no income recognised anymore):

DT $m

CR $m

Impairment of financial guarantees issued – PNL

59.67

Long-term provision financial guarantees – BS

5.33

Short term provision for financial guarantees – BS

65.00

The carrying amount of the liability is adjusted as follows (income continued to be recognised):

Financial guarantee contract Financial guarantee contract Financial guarantee contract Financial guarantee contract

DT $m

CR $m

Impairment of financial guarantees issued – PNL Financial guarantee contract

59.95

Long-term provision financial guarantees – BS Financial guarantee contract

5.05

Short term provision for financial guarantees – BS Financial guarantee contract

65.00

As a result, the long-term provision financial guarantees remains in the balance sheet for an amount of two years financial guarantees income ($0.14 x 2 = $0.28). Check-up: $5.33 -/- $5.05 = $0.28.

Comparision table – Expected credit losses measurement

Financial assets measured at amortised cost or at fair value through other comprehensive income Loan commitments Financial guarantee contracts
Date of initial recognition in applying the
impairment requirements
Trade date Date that an entity becomes a party to the irrevocable commitment Date that an entity becomes a party to the irrevocable commitment
Period over which to estimate ECLs The maximum contractual period (including extension options) over which the entity is exposed to credit risk and not a longer period. The maximum contractual period over which an entity has a present contractual obligation
to extend credit However, for revolving credit
facilities, this period extends beyond the contractual period over which the entity is exposed to credit risk and the ECLs would not be mitigated by credit risk management actions
The maximum contractual period over which an entity has a present contractual obligation to extend credit
Cash shortfalls in measuring ECLs Cash shortfalls between the cash flows that are due to an entity in accordance with the contract and the cash flows that the entity expects to receive. Cash shortfalls between the contractual cash
flows that are due to the entity if the holder of the loan commitment draws down the loan and the cash flows that the entity expects to receive if the loan is drawn down
Cash shortfalls are the expected payments to
reimburse the holder for a credit loss that it incurs less any amounts that the entity (issuer) expects to receive from the holder, the debtor or any other party
EIR used in discounting ECLs The EIR is determined or approximated at initial recognition of the financial instrument The EIR of the resulting asset will be applied and if this is not determinable, then the current rate representing the risk of the cash flows is used The current rate representing the risk of the cash flows is used
Assessment of significant increases in credit risk An entity considers changes in the risk of a default occurring on the financial asset An entity considers changes in the risk of a default occurring on the loan to which a loan commitment relates An entity considers the changes in the risk that the specified debtor will default on the contract

Financial guarantee contract

Financial guarantee contract

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