Financial guarantee contracts (FGCs) are a form of financial insurance and are governed by IFRS 9. The entity basically guarantees it will make a payment to another party if a specified debtor does not pay that other party.
FGCs 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 a FGC 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.
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%.
The FGC is initially measured at fair value.
The fair value of the guarantee is $5m, being the present value of the difference between:
- The net contractual cash flows that would have been required without the guarantee
- $100m = ($10/1.11 + $10/1.12 + $110/1.13 )
- The net contractual cash flows required under the loan
- $95m = ($8/1.11 + $8/1.12 + $108/1.13)
The double entry required on 1 January 2017 is:
Dr P/L $5m
Cr Liability $5m
The FGC 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.
Continuing from the previous example, at the end of 2017 the following double entry is required in order to amortize the initial fair value over the life of the guarantee:
Dr Liability $1,67m ($5m *1/3) – ignore discounting
Cr P/L $1,67m
At the end of each subsequent reporting period financial guarantees are measured at the higher of:
- The amount of the loss allowance; and
- The amount initially recognized less cumulative amortization, where appropriate.
The amount of the loss allowance at each subsequent reporting period initially equal to 12-month expected credit losses.
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.
Expected credit losses for a FGC are the cash shortfalls adjusted by the risks that are specific to the cash flows.
Continuing from Example 1 above, 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%
Assume that if DEF Ltd does default, 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%), and the carrying amount of the liability is adjusted as follows:
Dr P/L $60m ($65m – $5m)
Cr Liability $60m