Ind AS 109:Accounting treatment of Financial Guarantee Contract (on debt instrument) and Expected Credit Loss on financial guarantee contract

Financial Guarantee Contract: 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. Financial guarantee contracts may have various legal forms, such as a guarantee, some types of letter of credit, a credit default contract or an insurance contract. Their accounting treatment does not depend on their legal form.

It is worthwhile to note the below key criterion to be classified under the financial guarantee contract:

1. It must be a debt obligation

2. It must be to reimburse the holder for a loss only and holder should not be compensated for more than the actual loss incurred

In other words, for a financial guarantee contract, the entity is required to make payments only in the event of a default by the debtor in accordance with the terms of the instrument that is guaranteed. Accordingly, cash shortfalls are the expected payments to reimburse the holder for a credit loss that it incurs less any amounts that the entity expects to receive from the holder, the debtor or any other party.

Although a financial guarantee contract meets the definition of an insurance contract in Ind AS104 if the risk transferred is significant, the issuer applies this Standard. Nevertheless, if the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting that is applicable to insurance contracts, the issuer may elect to apply either Ind AS 109 or Ind AS104 to such financial guarantee contracts.If a financial guarantee contract was issued in connection with the sale of goods, the issuer applies Ind AS 115 in determining when it recognises the revenue from the guarantee and from the sale of goods.

Accounting treatment of financial guarantee:

1. Initial recognition – At fair value

2. Subsequent measurement – Higher of an amount determined based on the expected loss method (as per guidance in Ind AS 109) or the amount originally recognised less, the cumulative amount recognised as income in accordance with Ind AS 115, Revenue from Contracts with Customers

The fair value of a financial guarantee at initial recognition is normally the transaction price (i.e. the consideration received). However, if there is no consideration received or consideration received is not reflecting the fair value (i.e. the price would be received to assume the liability in an orderly transaction between market participants at the measurement date) than the fair value will be determined using appropriate valuation method. Determination of fair value of financial guarantee is difficult as the financial guarantee contracts are non-standardised and there is no active market available in India to determine the price for similar transaction between the unrelated parties. One of the approach to find out the fair value of financial guarantee is consideration exchange for a similar financial guarantee contract (similar as to currency, term, credit rating of borrower and guarantor and other factors) or difference between the NPV of cash outflow of debt obligation with and without financial guarantee.

Income recognition as per Ind AS 115 will be done over the tenure of the financial guarantee contract as the performance obligation of issuer is satisfied over time. Generally, the financial guarantee tenure is more than one year, and consideration is received upfront (i.e. advance from customer and it is financing the issuer) which indicate thatit contain a significant financing component in the contract and hence as per the requirement of Ind AS 115, an entity shall present the effects of financing (i.e. interest expense) separately from revenue from contracts with customers in the statement of profit and loss. (para 60-65 of Ind AS 115). If the consideration is not receivable upfront but on different time intervals than entity has to discount the cashflow receivables to determine the NPV which will be the fair value on initial recognition and financing component (i.e. time value of money) will be present separately from revenue from contracts with customers in the statement of profit and loss.

Expected credit loss

As per Ind AS 109, the expected credit loss on the financial guarantee contract will be determined using ‘General approach’, as per the approach the financial guarantee contract must be classified into stage 1 on initial recognition. If there is a significant increase in credit risk on reporting date than it will be classified into stage 2, further if it is credit impaired than it is classified into stage 3. Based on the classification into stages the ECL will be calculated and recognised as stated below.

Stage 1

(Initial recognition)

Stage 2

(Significant increase in credit risk)

Stage 3

(Credit Impaired)

12 Month ECL Lifetime ECL

ECL = Exposure at Default (EAD) * Loss given default (LGD)# * Probability of Default (PD)##

#LGD (loss given default) denotes the share of losses, i.e. the actual receivables loss in the event of customer default, or what is expected to be irrecoverable from among the assets in insolvency proceedings.

## for stage 1 PD is probability of default in next 12 month, for stage 2 PD is probability of default in entire lifetime of asset and for stage 3 PD is 100% since credit impaired financial instrument.

 Illustration of financial guarantee contract:

 Company A (100% wholly owned subsidiary of Company B) has availed term loan on 1 April 20X7 from bank C of INR 700,000,000 at 12 % p.a. Instalment (principal & interest) are payable annually. Holding Company B has provided guarantee to bank C to pay in case of default / non-payment by Company A. Any subsequent recoveries from Company A in case of default shall be reimbursed to Company B against the amount paid under guarantee. Company B recovers nil fees / income against this guarantee from Company A. Loan is repayable in 5 years.Fees / income for a similar transaction would be 4% p.a. of the total debt availed for the said contract to be payable upfront

Determine whether the contract meets criterion of financial guarantee contract:

a. The guarantee provided by Company B is against the term loanavailed by Company A & hence, guarantees a debt obligation

b. Company B shall discharge payment only if bank C incurs loss i.e. Company A defaults to discharge the instalment due

c. Company B shall only pay to the extent of loss incurred by bank C & any subsequent recoveries from Company A shall be repaid to Company B

Since, all the conditions have been fulfilled, the contract qualifies as financial guarantee under Ind AS 109.

Initial recognition on 1 April 20X7:

Since the transaction between the holding and subsidiary without any consideration the principle of attribution acquires significance and the financial guarantee should be recognise in its financial statements. the fair value of financial guarantee contract at initial recognition will be the fees charged for a similar transaction between unrelated parties i.e. 4% p.a. of total debt availed to be payable upfront.

Fair value of financial guarantee = Total debt availedx Tenure of loan x percentage of commission

= INR 700,000,000 x 5 Years x 4%

= INR 140,000,000

Accounting entries in the books of guarantor being Company B:

At fair value:

Investment in A                                                 140,000,000

To financial guarantee liability                       140,000,000

(As no payments are being made by Company A to B, this has been considered as equity infusion by A in B)

Ind AS 109 does not provide any guidance for financial guarantee accounting in the books of beneficiary. However, Company A in an arrangement with external party (being non-related party) would have recognised this as an expense and hence, to eliminate gaps at consolidation as well as treat it at arm’s length, mirror accounting has been adopted in the books of A.

For Company A the commission expense of financial guarantee will be considered as transaction cost for obtaining the loan, being an incremental cost incurred by the entity for the loan without which the loan would have not been disbursed by bank C. Hence same will be reduced from the initial recognition of loan at fair value

The following entries shall be effected (mirror accounting of B) in the books of A:

Accounting entries in the books of borrower being Company A:

Loan from bank C                                             140,000,000

To equity share capital                                     140,000,000

Bank                                                                     700,000,000

To Loan from bank C                                        700,000,000

Subsequent measurement – 31 March 20X8:

Computation of income recognition and interest expense as per Ind AS 115

Year Opening balance Interest expense @ 12% (EIR) Commission income Closing balance
1     140,000,000     16,800,000       (38,837,362)     117,962,638
2     117,962,638     14,155,517       (38,837,362)        93,280,792
3        93,280,792     11,193,695       (38,837,362)        65,637,124
4        65,637,124        7,876,455       (38,837,362)        34,676,216
5        34,676,216        4,161,146       (38,837,362)

Further Company A has discharged its financial obligation to bank C on due date and has been rated as AAA and hence there is no significant increase in risk due to which for calculation of ECL the contract will be classified in stage 1 and 12 month ECL will be calculated. (Input for 12-month ECL PD: 3% and LGD: 65%)

12 Month ECL = Exposure at Default (EAD) * Loss given default (LGD) * Probability of Default (PD)

= INR 560,000,000 * 65% * 3%

=INR 10,920,000

Guarantee to be recognised at higher of:

a. Amount based on ECL method – INR 10,920,000

b. Amount originally recognised (140,000,000) less, the cumulative amount recognised as income in accordance with Ind AS 115,(23,037,362) – INR117,962,638

(No additional entry is required since amount based on ECL in a above is lower than the carrying value of financial guarantee)

Accounting entries in books of guarantor being Company B:

Interest on financial liabilities                              16,800,000

To financial guarantee liability                             16,800,000

Financial guarantee liability                                38,837,362

To guarantee / commission income                    38,837,362

Accounting entries in the books of borrower being Company A:

Loan from bank C                                             16,800,000

To interest on loan (EIR)                                 16,800,000

Interest on loan (EIR)                                      38,837,362

To loan from bank C                                         38,837,362

Subsequent measurement – 31 March 20X9:

Post 31 March 20X8 and before 31 March 20X9, there has been significant decline in market size of goods produced by Company A due to technological advancement in the market leading to substantial losses and affecting the liquidity position of Company A. As at reporting date being 31 March 20X9, Company A has not discharged its financial obligation which has been past due for more than 30 days.Hence there has beensignificant increase in credit risk of financial guarantee contract due to which it will now be classified into stage 2 and lifetime ECL has to be calculated. (Input for Lifetime ECL PD: 40% and LGD: 75%)

Lifetime ECL = Exposure at Default (EAD) * Loss given default (LGD) * Probability of Default (PD)

= INR 420,000,000 * 75% * 40%

= INR 126,000,000

Guarantee to be recognised at higher of:

a. Amount based on ECL method – INR 126,000,000

b. Amount originally recognised (140,000,000) less, the cumulative amount recognised as income in accordance with Ind AS 115, (46,719,208) – INR 93,280,792

Accounting entries in books of guarantor being Company B:

Interest on financial liabilities                              14,155,517

To financial guarantee liability                             14,155,517

Financial guarantee liability                                 38,837,362

To guarantee / commission income                    38,837,362

Expected credit loss*                                              32,719,208

To Financial guarantee liability                            32,719,208

* Expected credit loss (INR 126,000,000) less Carrying value of financial guarantee contract (INR 93,280,792) equals to INR 32,719,208

Accounting entries in the books of borrower being Company A:

Loan from bank C                                          14,155,517

To interest on loan (EIR)                             14,155,517

Interest on loan (EIR)                                  38,837,362

To loan from bank C                                      38,837,362

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