Last update 16/11/2019
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.
Further explanation
These contracts meet the definition of an insurance 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.
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.
Accounting treatment:
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:
- The net contractual cash flows required under a debt instrument, and
- The net contractual cash flows that would have been required without the guarantee.
The present value is calculated using a risk-free rate of interest.
Accounting examples:
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Initial recognition and measurement – Financial guarantee contract |
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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: Year 1: $100m x 10% = $10m 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 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:
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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.
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Subsequent measurement – Financial guarantee contract |
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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:
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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.
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Credit risk increased significantly – Financial guarantee contract |
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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):
The carrying amount of the liability is adjusted as follows (income continued to be recognised):
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. |
See also: The IFRS Foundation
