A Comprehensive Overview of Financial Guarantee Contracts

Corporate guarantee contracts are recently in the news due to the taxability aspects of such issuance, part of which are financial guarantee contracts which are issued to the lenders for assurance so that the lender would feel comfortable since the guarantor assures that money gets repaid to the lender in case of default by the borrower.

In Accounting parlance, guarantee contracts have always been a grey area. This article attempts to comprehensively cover an overview of the financial reporting implications of Financial Guarantee Contracts ("FGC") and touch upon certain ancillary legal considerations, including analyzing industry practices.

Under the current credit framework, demand for corporate guarantees by lenders is considered a default and non-negotiable part of the funding agreement, especially in the case of extended maturity projects that are executed by a particular special purpose vehicle structure, for which lenders would demand financial guarantees from promoters (i.e., the parent company).

In certain cases (like a low credit rating of the borrower), the borrower would even become eligible for a loan that he would not have otherwise been qualified for only due to the guaranteed element.

Apart from that, having a guarantee provision in lending arrangements may also lower your cost of borrowing; however, it is to be noted that as per RBI¹ IRAC norms, guarantees are not considered security, so only guarantee-backed loans cannot be considered as secured.

Attending Basics

Generally, there are two types of guarantees prevailing in the corporate spectrum: performance guarantees and financial guarantees. In this article, we will stick to financial guarantees only.

In a literary sense, a guarantee is a promise to pay another person’s debt if that other person fails to perform his or her obligation; thus, Financial Guaranty Contract FGC refers to 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.

The contract of guarantee is governed mainly by the provisions of the Indian Contract Act, 1872 (Section 126).

The parties to the contract are:

• Guarantor: one who has to perform the legal obligation by taking over the payments of the loan if the debtor is unable to perform their obligation.
• Lendor: one who gives a loan to a borrower and to whom the guarantee is given.
• Borrower: one to whom the loan is given.

The contract of guarantee is considered a secondary contract to the principal contract of debt, and the extent of liability has to be explicitly provided for and can always be limited (a “limited guarantee”) or extended.

Financial Reporting Implications

A financial guarantee contract is defined under appendix A of Ind AS 109 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 payment when due in accordance with the original or modified terms of a debt instrument”.

Corporate guarantees, default support agreements, letters of credit, credit default contracts, and other structured documents may be considered as FGC. Their legal form has no bearing on how they are accounted for. Therefore, a letter of comfort² or support can also be regarded as an FGC if the issuer is contractually obligated to make certain payments in the event that the credit holder defaults.

The significant features of FGC are as follows:

• The holder is compensated only for the actual loss that it incurs (not compensated for more than the actual loss incurred).
• The reference obligation is a debt instrument.
• Guarantor agrees to assume financial responsibility if the debtor defaults.
• Other guarantees involve deposits or collateral that can be liquidated if the debtor defaults in its obligation.

I. Initial Recognition of Financial Guarantee Contracts

Firstly, ICAI’s Expert Advisory Committee(EAC) EAC opinion³ published in October, 21 clarified that no default on part of the borrower could not be the argument for non-recognition of FGC, meaning that the extent of credit risk shall not affect the initial recognition of financial guarantee liability; however, this may be one of the factors that the company may consider for the purpose of fair valuation at the time of initial measurement.

Ind AS 109 requires the guarantor to recognise the financial guarantee contract as a financial liability initially at its fair value; the fair value at initial recognition is normally the transaction price (i.e., the consideration received). However, if there is no consideration received or if the consideration received does not reflect the fair value, the fair value will be determined using the appropriate valuation method.

As regards the 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, Fair Value Measurement, the following approaches may be considered:⁴

• 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 is, it may be calculated as 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.
• 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).

Financial reporting treatment of initial recognition is tabulated as below.

II. Subsequent Measurement of Financial Guarantee Contracts

Ind AS 109 requires FGC to be subsequently measured at higher of:

• Loss allowance as per Expected Credit Loss Impairment model
• The amount initially recognized (i.e., fair value), less than any cumulative amount amortisation recognized in accordance with Ind AS 115

The amount of unearned financial guarantee commission would be first reported as a liability and amortised throughout the guarantee’s duration if Ind AS 115 were to be applied.

For the purposes of applying the impairment requirements, the date the entity becomes a party to the irrevocable commitment shall be deemed the date of initial recognition.

In cases where the amount computed under expected credit loss(ECL) is higher than the closing balance derived as per amortisation, the liability (i.e. financial guarantee obligation) is adjusted to ECL amount by charge to profit and loss.

Financial reporting treatment of Subsequent recognition is tabulated as below.

Key points to adhere to for subsequent measurement

• In addition to amortising the unearned financial guarantee commission to income, at each reporting date the beneficiary is required to compare the unamortized amount of the deferred income with the amount of loss allowance determined in respect of the guarantee as at that date. In accordance with the requirements of Ind AS 109, the recognition of guarantee commission on an amortisation basis should be EIR-based and not straight-line.
• The discount rate for FGC would be the current risk-free rate adjusted for risks specific to the cash flows.
• The amount of the loss allowance at each subsequent reporting period equals the 12-month expected credit losses (Stage -1). However, where there has been a significant increase in the risk that the specified debtor will default on the contract, the calculation is for lifetime expected credit losses (Stage -2).
• As an alternative, the FGC may be designated at fair value through profit or loss, but only in situations where there is an accounting discrepancy or if the FGC is a component of a managed portfolio whose performance is assessed on a fair value basis.

III. Derecognition of Financial Guarantee Contracts

There may be a case where the FGC were originally recognised based on the estimated term of the debt instrument, but the beneficiary prepays the entire debt, resulting in a change in the expected tenure in terms of contractual life. This would amount to changes in the accounting estimates (Ind AS 8), since no obligation exists for the guarantor after prepayment; the guarantor would reverse the amount of the outstanding obligation. The amount debited to investment upon providing a guarantee is, in substance, the consideration that the parent would have collected for providing a similar guarantee to an unrelated third party. In the case of a prepayment of a loan by an unrelated third party, the parent would generally not have refunded the consideration and would have recognised the entire unrecognised commission in profit and loss. A similar approach should be followed.

Subsequent to recent amendment of Ind AS 8⁶, whereby Ind AS 8 now defines accounting estimates, which would broadly cover curtailment in expected tenure of debt schedule, requiring prospective recognition of the effect.

IV. Disclosures for Financial Guarantee Contracts

• Credit Risk Disclosure: In credit risk disclosure, the entity should disclose the extent of contractual liability. Inferring from Ind AS 107, the disclosure requirement is for the maximum exposure of FGC to credit risk, which is the maximum amount the entity would have to pay if the guarantee is called on, which may be significantly greater than the amount recognized as a liability.
• Liquidity Risk Disclosure: In liquidity risk disclosure, an entity shall disclose a maturity analysis for non-derivative financial liabilities (including FGC) that shows the remaining contractual maturities, based on the maximum amount that can be called for under FGC. Such disclosure needs to be based on contractual undiscounted cash flow, which would differ from the amount included in the balance sheet. Further, the entity needs to describe how it manages the liquidity risk.
• Non-Applicability of Ind AS 37: Ind AS 37 does not apply to financial instruments (including guarantees) that are within the scope of Ind AS 109. Therefore, financial guarantees, in the extant case, being governed by Ind AS 109, are not within the scope of Ind AS 37 and therefore cannot be classified as contingent liabilities.
• Related Party Disclosure: The gross amount of any guarantee given or received on behalf of a related party will be disclosed in the related party disclosure in accordance with the requirement of Ind AS 24.

Other Financial Reporting implications for Financial Guarantee Contracts

On subsequent measurement, the beneficiary would amortize the cost under finance cost, such finance cost being an integral part of the determination of interest expense calculated using EIR, thus forming part of the borrowing costs, as defined under Ind AS 23 and can be capitalised to qualifying asset in accordance with Ind AS 23.

V. IBC Case law on Financial Guarantee Contracts

With bank guarantees being out of moratorium shelter under IBC, and that being a settled legal position, we will analyze corporate guarantees from IBC spectrum and have a glance over certain case laws. As clarified earlier, corporate guarantee functions between 3 parties i.e., guarantor (let’s say holding company), borrower (let’s say subsidiary company) and lender (let’s say banker). Thus, banker would have provided funds to subsidiary, due repayment of which is guaranteed by the holding company. Now, in IBC terms the terminology would be corporate guarantor (holdco.), principal borrower (subsidiary) and financial creditor (bank).

The Bankruptcy Legislative Reforms Commission report of 2015 did not touch upon the concept of secondary contract of corporate guarantee. It is imperative to note that the treatment of the guarantor of a corporate debtor facing insolvency proceedings has also been constantly changing ever since the enactment of the IBC. The central consideration would be that the guarantor’s responsibility would be co-extensive with that of the principal debtor, and thus the whole purpose of guarantee would be defeated if the creditor is compelled to delay the use of remedies against the corporate guarantor.

Hon’ble Supreme Court in the matter of Laxmi Pat Surana -Vs- Union Bank of India & Anr. in Civil Appeal No. 2734 of 2020 held that the liability of the ‘Corporate Guarantor’ is ‘coextensive’ with that of the ‘Principal Borrower’ and that acknowledgment given by the ‘Principal Borrower’ also binds the ‘Corporate Guarantor’.

Post above judgement, Insolvency Law Committee was set up to perform a thorough analysis of the IBC in light of issues related to guarantors, wherein it provided below pointers in its report:⁶

• The creditor is at liberty to proceed against either the debtor alone, or the surety alone, or jointly against both the debtor and the surety.
• That creditor should necessarily carry out adequate due diligence regarding the debtor’s financial position, and should not extend a loan solely by relying on a contract of guarantee without assessing the financial and technical feasibility of the respective project.

VI. Industry wide Practices for FGC

Here, we have only analyzed the financial statements of certain companies and this is just for the purpose of comparing practices followed by companies, and not to comment on the suitability of one over another.

List of References

1. https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=12281&Mode=0
2. Microsoft Word - 18 . Final ITFG 12_CC (icai.org) (ITFG Clarification Bulletin 12, Issue 3)
3. https://resource.cdn.icai.org/71027eac57077-p1.pdf (Query – 15, Pg188)
4. 51647indas41303.pdf (icai.org) (ITFG Clarification Bulletin 16, Issue 1)
5. https://ibbi.gov.in/webadmin/pdf/order/2019/Jan/8th%20Jan%202019%20in%20the%20matter%20of%20Ferro%20Alloys%20Corporation%20Ltd.%20&%20Ors.%20Vs.%20Rural%20Electrication%20Corporation%20Ltd.%20CA%20(AT)%20(Insolvency)%20No.%2092,93%20&%20148-2017_2019-01-10%2012:10:07.pdf
6. https://ibbi.gov.in/uploads/resources/c6cb71c9f69f66858830630da08e45b4.pdf