Before going into 'Financial Guarantee' and further deep into 'Corporate Guarantee', it is better to dive into what is the difference between 'a warranty and guarantee for a product sale' for better understanding.
Under IGAAP, issuer needs to just disclose the fact by way of notes to the accounts. But, after the advent of Ind.AS based on IFRS for Indian companies altogether different accounting norms are required to be complied with, in line with new accounting standards.
Guarantee Vis Warranty:
A guarantee is a promise that, if a thing is not of a certain standard or does not fulfil some condition, the original price or consideration paid for the contract or bargain will be returned.
A warranty is usually a written guarantee for a product, and it holds the maker of the product responsible to repair or replace a defective product or its parts. It is only used as a noun.
A glance through of the above definitions brings out in clear terms the difference between 'guarantee and warrantee for products' is more of legal than of language. Both the terms are highly relevant in the context of a contract or bargain. In other words, a guarantee is a promise that, if a thing is not of a certain standard or does not fulfil some condition, the original price or consideration paid for the contract or bargain will be returned. On the other hand, a warranty is a term of a contract, breach of which gives rise to a claim for damages, but not the repudiation of the whole contract.
To sum up, a guarantee is shouldering/ assuming the responsibility for payment of a debt or performance of an obligation if the liable party fails to perform to expectations. Below is an illustration of a guarantee that supports a loan.
Then, what is a Financial Guarantee?
A guarantee is the assumption of responsibility for payment of a debt or performance of an obligation if the liable party fails to perform to expectations.
As spelt out earlier, under IGAAP, issuer needs to just disclose the fact by way of notes to the accounts. But, after the advent of Ind.AS based on IFRS for Indian companies altogether different accounting norms are required to be complied with, in line with new accounting standards.
As per Ind.AS 109, Financial Guarantee contract means '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'.
On the top of this, all financial Instruments should be valued at its fair value on initial recognition (which normally be its transaction price)' and since financial guarantee falls under financial instrument definition (as per Ind. AS-32), it will also be valued at its fair value on Initial recognition. However, if financial Instruments meet the definition of Insurance Contracts then those will be covered under Ind.AS 104 'Insurance Contracts'.
Parties involved in a Financial Guarantee:
Before we dwell on fair valuation under Ind AS regime, let us understand the parties involved in a financial guarantee.
There are in spirit three parties involved in any guarantee:
Guaranteed Party - normally a banker
Answerable/Liable party - a borrower
Guarantor: responsible party in case of default.
Specific Guarantee Vis a Vis General Guarantee:
When a contract 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, this have to be accounted.
But, on the other hand, if the guarantee is of general in nature to support a subsidiary, it is not meriting specific payments to make and this type of guarantee may not come under the mischief of financial-guarantee.
Fair valuation Models:
• More often than not, guarantees issued in favour of intragroup companies are at no fee. In this case, how is to fair value?
One practical way could be the difference between the rate of interest with the guarantee and the market interest rate on unguaranteed loans then that could be the fair platform for computing the fair value of the guarantee -- the present value of the difference in interests charged on guaranteed and unguaranteed loans.
Since a parent has given such guarantee to its subsidiary, the fair value will be done and the calculated difference will be treated as 'Capital Contribution' (in separate financial statements of Parent Company) as the parent is acting as shareholder and accordingly the Investment in subsidiary will be changed by this amount.
Consequently, the other part will flow to the profit and loss of issuer on straight line basis over the period of the guarantee while treating it as finance/ other income.
There would a disclosure for the same in the financial statements movement will be shown accordingly.
• If the market values of these instruments are known and the value of the guarantee is simply the difference in the value of the risky and risk-free instruments. This could be applied to a guarantee on an entity that has both typical debt and guaranteed debt.
• The credit spread method is based on (i.e., Value of Guarantee = Value of Risk-Free Transaction - Value of Risky Transaction). The value of the guarantee calculated this way is valid only when the guarantor's probability of default is zero. Nevertheless, we could approximate a guarantee's value when the guarantor is not default-free.
• On the other hand, when a financial guarantee is given to a third party, then it is an accepted norm, to claim some premium / some fee for issuing that guarantee – and in this case, that would be the fair value of it. In the first case, the comparable risk-free (i.e., guaranteed) and risky (non-guaranteed) instruments exist with the liable party, the market values of these instruments are known and the value of the guarantee is simply the difference in the value of the risky and risk-free instruments. This could be applied to a guarantee on an entity that has both typical debt and guaranteed debt (e.g., backed by the federal government).
• Contingent Claims Valuation Methods Guarantee contracts represent contingent claims into the future. But, given the inherent complexity of this methodology, it should only be used when the other methods are either not possible or not available.
What are the likely journal entries?
• At Initial recognition of financial guarantees:
For example, if a premium of Rs.1, 00,000 is received for issuing a financial guarantee for 5-year loan.The journal entry is:
Debit Cash: Rs 1 00,000;
Credit Liabilities from financial guarantees:---Rs.1 00,000.
If no premium is charged, then:
Debit Profit or loss: The fair value of the guarantee;
Credit Liabilities from financial guarantees: The fair value of your guarantee
• At subsequent measurement of financial guarantees:
Let's get back to our financial guarantee of Rs.1, 00,000 on 5-year loan.
Obviously, that will be amortized on straight-line over 5 years and consequent entry would flow as
Debit Liabilities from financial guarantees: Rs.20, 000 (1, 00,000/5);
Credit Profit or loss – Income from financial guarantees: RS. 20,000.
Then, the next logical step is to determine the expected credit loss on the loan.
In case the loan is OK, then, there is no significant increase in credit risk. If the carrying amount is Rs.80,000, the ECL is 50,000, then, it is obvious to keep measuring the financial guarantee at Rs.80, 000 as this amount is higher.
On the other hand, if theECL on the loan is, say, for example,Rs.90, 000, then there is need to book the difference of Rs.10,000 (= ECL of Rs.90,000 - carrying amount of Rs.80,000) in profit or loss.
Accounting for financial guarantees is a new concept in India unleashed thanks to the adoption of Ind. AS regime as prescribed and adopted and that too without much practical experience. To be frank, in the absence of practical direction, it is high time the ICAI should come forward with necessary Guidance Note so that Accounting and Auditing community is not in wilderness with a clear road map for computing fair value in respect of fair value guarantee to eventually to report on true and fair value of accounts .
If anybody in more in conversant, knowledgeable and familiar with practical tinge, he is requested to share their experience with feedbacks