Accounting implications of intragroup guarantees

Companies often provide guarantees to third parties, ensuring the payment of liabilities or the fulfillment of contractual obligations of a fellow group company. Although it is a common way for groups to secure businesses or funding from banks, the accounting implications of such an arrangement can be complex.

This article focuses on the accounting implications for the issuer (the provider of the guarantee) and its group. Companies need to consider the 3 questions below to identify and understand the key terms that define the scope for accurate accounting.

3 questions for defining the scope of guarantee contracts

Question 1: What is a guarantee contract?

The issuer of a guarantee contract usually compensates the holder of the contract if the obligor fails to make specified payments or fulfill contractual obligations. This compensation may take the form of cash or direct completion of the contractual obligations.

Question 2: What do the guarantees compensate?

The contract fulfils the definition of a financial guarantee contract if it compensates the holder for failed payments of debts, whereas it is a performance guarantee contract if it compensates the holder for non-fulfilment of contractual obligations.

Question 3: Is the issuer indemnified against any compensation?

The accounting treatment of guarantee contracts varies depending on whether the contract qualifies as an insurance contract. A key feature of an insurance contract is the issuer’s acceptance of significant insurance risk from the holder. In the context of an intragroup guarantee, while it is not the only factor, the indemnity of issuer against any compensation paid is a common term to consider. If the issuer is indemnified against any compensation by either the obligor or a third party (eg, insurance company), it may not have accepted significant insurance risk and, therefore, it is not an insurance contract.

Accounting treatment

IFRS 17 applies to financial guarantee or performance guarantee contracts that meet the definition of an insurance contract.

Accounting treatment of financial guarantee contract

Although a financial guarantee contract generally meets the definition of an insurance contract, IFRS 17 scope exclusion applies.

Financial guarantee contracts must be accounted for under IFRS 9 unless the issuer has previously (before IFRS 17 came into effect) made an explicit assertion that it regards financial guarantee contracts as insurance contracts and used insurance contract accounting (ie, IFRS 4) for them. Then, on transition to IFRS 17, the issuer has an irrevocable choice on a contract-by-contract basis to account for them either under IFRS 17 or IFRS 9.

The issuer recongises a liability for the guarantee contract at its initial fair value under IFRS 9. Subsequently, the contract is measured at the higher of the expected credit loss and the amount initially recognised (ie, fair value) less any cumulative amount of income/amortisation recognised.

If the issuer elects to account for a financial guarantee contract under IFRS 17, the accounting treatment is the same as a performance guarantee contract, which is discussed below.

Accounting treatment of performance guarantee contract

The issuer must apply IFRS 17 for a guarantee contract that qualifies as an insurance contract which is not a financial guarantee contract. Under IFRS 17, the insurance contract liability is measured using the general measurement model (the ‘GMM’) or the premium allocation approach (the ‘PAA’) if it fulfils the eligibility criteria. Under both approaches, issuers need to apply actuarial techniques to determine the present value of probability-weighted cash flows considering possible scenarios. This process can be judgmental and a source of estimation uncertainty.

Accounting treatment of guarantee which is not an insurance contract

If the guarantee contract does not meet the definition of an insurance contract, it is not within the scope of IFRS 17. The contract may meet the definition of a loan commitment under IFRS 9 or a provision under IAS 37, depending on the exact terms and conditions.

Intragroup guarantees issued at little or nil premium

Many of these guarantee contracts are provided by entities to another entity within the group for little or no compensation. Such compensation, when paid, is commonly referred to as an insurance premium. There are additional considerations for this type of intragroup guarantee.

Measurement

When a guarantee is provided by an unrelated third party, the amount of the premium received by the issuer is usually considered to represent the fair value of the liability under IFRS 9 or is used in IFRS 17 measurement models in the initial measurement of the contracts.

One of the valuation techniques below can be applied to determine the initial fair value when the guarantee contract is issued at nil or an artificially low premium:

a) Market prices for similar contracts

b) Difference in interest between a guaranteed loan and an unguaranteed loan

c) Probability-weighted discounted cash flow of the contract

When applying either the GMM or PAA model for determining the initial value, the issuer can either calculate and allocate a “deemed premium” (ie, the premium that would have been charged in an arm’s length transaction) or use nil premium consideration.

Difference in accounting treatment between separate and consolidated financial statements

Separate financial statements of the issuer

When a parent recognises a liability for a guarantee contract it has provided on behalf of one of its subsidiaries with no premium, the corresponding debit entry forms an additional investment in that subsidiary. When a guarantee is issued by a subsidiary on behalf of its parent or a fellow subsidiary with no premium, the corresponding debit entry represents a deemed distribution.

Separate financial statements of the obligor

The obligor benefiting from a financial guarantee contract will recognise a loan from a third party. The obligor can either measure the initial fair value of the liability based on i) the face value of the proceeds received or ii) a calculated fair value based on the interest rate it would have been charged for a similar but unguaranteed loan. The difference between the proceeds received and the fair value calculated using the second approach is treated as either a capital contribution or receipt of a dividend, depending on whether the obligor is a parent, subsidiary or fellow subsidiary of the issuer. In practice, most entities account for guaranteed loan using the first approach.

Consolidated financial statements of the group

From a group perspective, the guarantee contract is considered as part of the loan or contractual obligations to the third party. It is not accounted for separately and needs to be included in the initial fair value of the liability from the third party.

If you want to discuss the accounting implications of any guarantee contracts, please contact Bernd Kremp.