Financial guarantees

Financial guarantees IFRS 9 Definition: In general, a financial guarantee is a promise to take responsibility for another company’s financial obligation if that company cannot meet its obligation. The entity assuming this responsibility is called the guarantor. Financial guarantees

Such a guarantee can be limited or unlimited, making the guarantor liable for only a portion or all of the debt. FiContingenciesnancial guarantees

A contract with a customer may partially be in scope of IFRS 15 and partially within the scope of other standards, e.g. a contract for the lease of an asset and maintenance of the leased equipment.In such instances, an entity must first apply the other standards if those standards specify how to separate and/or initially measure one or more parts of the contract. The entity will then apply IFRS 15 to the remaining components of the contract (IFRS 15 7). Financial guarantees

For example – If a contract includes a financial instrument (e.g. financial guarantee) and a revenue component, the fair value of the financial instrument is first measured under IFRS 9 Financial Instruments and the balance contract consideration is allocated in accordance with IFRS 15. Financial guarantees

Transactions that fall within the scope of multiple standards should be separated into components, so that each component can be accounted for under the relevant standards.

IFRS 9 retains the same financial guarantee definition as IAS 39 i.e. 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 payments when due in accordance with the terms of a debt instrument. Some common examples of contracts that meet, and do not meet, this definition are set out in the following table:

Contract Type Financial guarantees Meeting Financial guarantee definition? Financial guarantees
Parent company guarantee over a subsidiary’s bank loan which reimburses the bank for losses incurred if the subsidiary fails to pay. Yes; relates to specific a debtor and debt instrument and only reimburses for losses incurred as a result of a failure to pay.
Parent company guarantee over the general obligations of a subsidiary. No; not specific in nature and may include obligations other than debt instruments.
Credit Default Swap (CDS) that pays out in the event of a credit downgrade (which does not necessarily equate to an incurred loss). No; reimburses the holder for losses that it may not incur.
A CDS is a derivative and must be measured at Fair Value through Profit or Loss (FVPL).
Something else -   Contractually linked instruments

Similar to IAS 39, if an entity that has previously asserted explicitly that it considers and accounts for Financial guarantees as insurance contracts can elect to apply IFRS 4 Insurance Contracts instead of IFRS 9. Going forward under IFRS 17 Insurance Contracts, a similar option will be permitted. However, entities will need to consider the changes to the accounting for insurance  contracts that IFRS 17 will introduce.

Accounting for Financial guarantees under IFRS 9
IFRS 9 retains the same initial recognition requirements as IAS 39 for issued Financial guarantees but introduces different subsequent measurement requirements. An issued Financial guarantee is a financial liability and is initially recognised at fair value.

If the Financial guarantee is issued to an unrelated party at arm’s length, the initial fair value is likely to equal the premium received. If no premium is received (often the case in intra group situations), the fair value must be determined using a different method that quantifies the economic benefit of the Financial guarantee to the holder.

For example, if an interest rate of 7% is charged with the benefit of a guarantee and a rate of 10% would be charged without it, the interest rate differential of 3% could be considered to represent the economic benefit of the Financial guarantee to the holder. The present value of this differential over the term of the loan would therefore be the initial fair value.

Subsequently, the Financial guarantee is measured at the ‘higher of’:Financial guarantees

  1. The IFRS 9 Expected Credit Loss (ECL) allowance; and
  2. The amount initially recognised (i.e. fair value) less any cumulative amount of income/amortisation recognised.

Alternatively, it is possible to designate the Financial guarantee at FVPL but only in cases of an accounting mismatch or if the Financial guarantee is part of a portfolio that is managed and its performance evaluated on a fair value basis.

Something else -   Events after the reporting date

The change that IFRS 9 introduces relates to part (i) of the ‘higher of’ test. IAS 39 referred to the amount of any provision required under IAS 37 Provisions, Contingent Liabilities and Contingent Assets whereas IFRS 9 refers to the amount of ECL allowance as required under the General Approach.

A case:

Let’s assume XYZ Company has a subsidiary named ABC Company. ABC Company would like to build a new plant and thus would like to borrow €10 million from a bank. The bank will probably require XYZ Company to provide a financial guarantee of the loan. By doing so, XYZ Company agrees to repay the loan using cash flows from other parts of its business if ABC Company is unable to generate enough cash on its own to repay the debt.

Often a parent company will offer a financial guarantee of bonds issued by one of the parent’s subsidiaries, but there are plenty of other situations that might involve guarantees.

For example, vendors sometimes require financial guarantees from their customers if the vendor is uncertain about the customer’s ability to pay (this most often happens in transactions involving expensive equipment or other physical property). In these situations, a customer’s bank might financially guarantee the customer’s payment, meaning that the bank will pay the vendor if the customer does not (and the customer pays the bank a fee for this!).

Financial guarantors don’t always guarantee the entire amount of a liability. In bond issues, for example, the financial guarantor might only guarantee the repayment of interest or principal, but not both. Sometimes more than one company might financially guarantee a security. In these cases, each guarantor is usually responsible for only a pro-rata portion of the issue, but in other cases, each guarantor may be responsible for the other guarantors’ portions if they also default on their responsibilities.

US railroad companies are well-known for their guaranteed bonds because in order for a railroad company to lease another company’s railroad, the lessee must often guarantee the debt of the lessor.

Expected credit lossesLoan commitments and financial guarantees [IFRS 9 Appendix A: Loss allowance]Financial guarantees

  • The three-stage expected credit loss model also applies to these off-balance sheet financial commitments
  • An entity considers the expected portion of a loan commitment that will be drawn down within the next 12 months when estimating 12 month expected credit losses (stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life the loan commitment (stage 2)
  • For loan commitments that are managed on a collective basis, an entity estimates expected credit losses over the period until the entity has the practical ability to withdraw the loan commitment.
Something else -   DCF Calculation Value of the business

Disclosures of financial guarantees

Historically, financial guarantors disclosed the nature and size of their guarantees in the notes to their financial statements. It is important to note that guarantees issued between parents and their subsidiaries do not have to be booked as balance sheet liabilities. Examples of this include a parent’s guarantee of a subsidiary’s debt to a third party or a subsidiary’s guarantee of the parent’s debt to a third party or another subsidiary.

All financial guarantees must, however, be disclosed. The guarantor must disclose the nature of the guarantee (terms, history, and events that would put the guarantor on the hook), the maximum potential liability under the guarantee and any provisions that might enable the guarantor to recover any money paid out under the guarantee.

Financial guarantees

Financial guarantees

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