Financial guarantees

Last update 16/11/2019

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.

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

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).

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.

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.

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 losses – Loan commitments and financial guarantees [IFRS 9 Appendix A: Loss allowance]

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.

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.

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