dealt with at 3.4.2 below.
3.4.1
Definition of a financial guarantee contract
A financial guarantee contract is defined as 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. [IFRS 4 Appendix A, IFRS 9 Appendix A].
3.4.1.A
Reimbursement for loss incurred
Some credit-related guarantees (or letters of credit, credit derivative default contracts
or credit insurance contracts) do not, as a precondition for payment, require that the
holder is exposed to, and has incurred a loss on, the failure of the debtor to make
payments on the guaranteed asset when due. An example of such a guarantee is one
that requires payments in response to changes in a specified credit rating or credit
index. Such guarantees are not financial guarantee contracts, as defined in IFRS 9, nor
are they insurance contracts, as defined in IFRS 4, or contracts within the scope of
IFRS 17. Rather, they are derivatives and accordingly fall within the scope of IFRS 9.
[IFRS 9.B2.5(b), IFRS 4.B19(f), IFRS 17.B27(f), B30].
When a debtor defaults on a guaranteed loan a significant time period may elapse prior
to full and final legal settlement of the loss. Because of this, certain credit protection
contracts provide for the guarantor to make a payment at a fixed point after the default
event using the best estimate of loss at the time. Such payments typically terminate the
credit protection contract with no party having any further claim under it whilst
3424 Chapter 41
ownership of the loan remains with the guaranteed party. In situations like this, if the
final loss on the debtor exceeds the amount estimated on payment of the guarantee, the
guaranteed party will suffer an overall financial loss; conversely, the guaranteed party
may receive a payment under the guarantee but eventually suffer a smaller loss on the
loan. Therefore such a contract will often not meet the essence of the definition of a
financial guarantee. However, if the payment is designed to be a reasonable estimate of
the loss actually incurred, such a feature (which is common in many conventional
insurance contracts) will sometimes allow the contract to be classified as a financial
guarantee contract. This will particularly be the case if such payments are agreed by
both parties in order to settle the financial guarantee, as opposed to being specified as
part of the original contract.
Also, such a contract should meet the definition of a guarantee if it was structured in
either of the following ways:
• the contract requires the guarantor to purchase the defaulted loan for its nominal
amount; or
• on settlement of the final loss, the contract provides for a further payment between
the guarantor and guaranteed party for any difference between that amount and
the initial loss estimate that was paid.
3.4.1.B Debt
instrument
Although the term ‘debt instrument’ is used extensively as a fundamental part of the
definition of a ‘financial guarantee contract’, it is not defined within the financial instruments
or insurance standards. The term will typically be considered to include trade debts,
overdrafts and other borrowings including mortgage loans and certain debt securities.
However, entities often provide guarantees of other items and analysing these in
the context of IFRS 9, IFRS 4 and IFRS 17 is not always straightforward. Consider,
for example, a guarantee of a lessor’s receipts under a lease. In substance, a finance
lease gives rise to a loan agreement (see 2.2.4 above) and it therefore seems clear
that a guarantee of payments on such a lease should be considered a financial
guarantee contract.
From the perspective of the guarantor, a guarantee of a non-cancellable operating lease will
give rise to a substantially similar exposure, i.e. credit risk of the lessee. Moreover, individual
payments currently due and payable are recognised as financial (debt) instruments.
Therefore, such guarantees would seem to meet the definition of a financial guarantee at
least insofar as they relate to payments currently due and payable. It may be argued that the
remainder of the contract (normally the majority) fails to meet the definition because it
provides a guarantee of future debt instruments. However, the standard does not explicitly
require the debt instrument to be accounted for as a financial instrument that is currently
due and we believe a guarantee of a lessor’s receipts under an operating lease could also be
argued to meet the definition of a financial guarantee contract.
Financial instruments: Definitions and scope 3425
Where it is accepted that such a guarantee is not a financial guarantee contract, one
must still examine how the related obligations should be accounted for – the contract
is, after all, a financial instrument. The possibilities are a derivative financial
instrument (accounted for at fair value through profit or loss under IFRS 9) or an
insurance contract (accounted for under IFRS 4 or IFRS 17 – commonly resulting only
in disclosure of a contingent liability, assuming payment is not considered probable).
The analysis depends on whether the risk transferred by the guarantee is considered
financial risk or insurance risk (see 3.3 above). Credit risk sits on the cusp of the
relevant definitions making the judgement a marginal one, although we believe that
in many situations the arguments for treatment as an insurance contract will be
credible. Of course for this to be the case the guarantee must only compensate the
holder for loss in the event of default.
Other types of guarantee can add further complications – for example guarantees of
pension plan contributions to funded defined benefit schemes. Where such a guarantee
is in respect of discrete identifiable payments, the analysis above for operating leases
seems equally applicable. However, the terms of such a guarantee might have the effect
that the guaranteed amount depends on the performance of the assets within the
scheme. In these cases, the guarantee seems to give rise to a transfer of financial risk
(i.e. the value of the asset) in addition to credit risk, which might lend support for its
treatment as a derivative.
3.4.1.C
Form and existence of contract
The application guidance to IFRS 9 emphasises that, whilst financial guarantee
contracts may have various legal forms (such as guarantees, some types of letters of
credit, credit default contracts or insurance contracts), their accounting treatment does
not depend on their legal form. [IFRS 9.B2.5].
In some cases guarantees arise, directly or indirectly, as a result of the operation of
statute or regulation. In such situations, it is necessary to examine whether the
arrangement gives rise to a contract as that term is used in IAS 32. For example, in
some jurisdictions, a subsidiary may avoid filing its financial statements or having
them audited if its parent and fellow subsidiaries guarantee its liabilities by entering
into a deed of cross guarantee. In other jurisdictions sim
ilar relief is granted if group
companies elect to make a statutory declaration of guarantee. In the first situation it
would seem appropriate for the issuer to regard the deed as a contract and hence
any guarantee made under it would be within the scope of IFRS 9. The statutory
nature of the declaration in the second situation makes the analysis more difficult.
Although the substance of the arrangement is little different from the first situation,
statutory obligations are not financial liabilities and are therefore outside the scope
of IFRS 9.
3426 Chapter 41
3.4.2
Issuers of financial guarantee contracts
In general, issuers of financial guarantees contracts should apply IAS 32, IFRS 9 and
IFRS 7 to those contracts even though they meet the definition of an insurance contract
in IFRS 4 (or IFRS 17) if the risk transferred is significant. [IFRS 9.B2.5(a)]. However, if an
entity has previously asserted explicitly that it regards such contracts as insurance
contracts and has used accounting applicable to insurance contracts, the issuer may
elect to apply either IFRS 9 or IFRS 4 (or IFRS 17 when applicable) (see Chapter 51
at 2.2.3.E). That election may be made contract by contract, but the election for each
contract is irrevocable. [IAS 32.4(d), IFRS 4.4(d), IFRS 7.3(d), IFRS 9.2.1(e), IFRS 17 7(e)]. This
concession does not extend to contracts that are similar to financial guarantee contracts
but are actually derivative financial instruments (see 3.4.1.A above).
The IASB was concerned that entities other than credit insurers could elect to apply
IFRS 4 to financial guarantee contracts and consequently (if their accounting policies
permitted) recognise no liability on inception. Consequently, it imposed the restrictions
outlined in the previous paragraph. [IFRS 9.BCZ2.12]. The application guidance contains
further information on these restrictions where it is explained that assertions that an
issuer regards contracts as insurance contracts are typically found throughout the issuer’s
communications with customers and regulators, contracts, business documentation as
well as in their financial statements. Furthermore, insurance contracts are often subject
to accounting requirements that are distinct from the requirements for other types of
transaction, such as contracts issued by banks or commercial companies. In such cases,
an issuer’s financial statements would typically include a statement that the issuer had
used those accounting requirements, i.e. ones normally applied to insurance contracts.
[IFRS 9.B2.6]. Nevertheless, other companies do consider it appropriate to apply IFRS 4
rather than IFRS 9 (or its predecessor IAS 39) to these contracts. Rolls Royce disclosed
the following accounting policy in respect of guarantees that it provides.
Extract 41.1: Rolls-Royce Holdings plc (2017)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS [extract]
1. Accounting
policies [extract]
Customer
financing
support [extract]
In connection with the sale of its products, the Group will, on occasion, provide financing support for its customers.
These arrangements fall into two categories: credit-based guarantees and asset-value guarantees. In accordance with
the requirements of IAS 39 and IFRS 4 Insurance Contracts, credit-based guarantees are treated as insurance
contracts. The Group considers asset-value guarantees to be non-financial liabilities and accordingly these are also
treated as insurance contracts.
Accounting for the revenue associated with financial guarantee contracts issued in
connection with the sale of goods is dealt with under IFRS 15 – Revenue from Contracts
with Customers (see Chapter 28). [IFRS 9.B2.5(c)].
3.4.3
Holders of financial guarantee contracts
As discussed in Chapter 47 at 5.8.1, certain financial guarantee contracts held will be
accounted for as an integral component of the guaranteed debt instrument. Financial
guarantee contracts held that are accounted for separately are not within the scope
Financial instruments: Definitions and scope 3427
of IFRS 9 because they are insurance contracts (see 3.3 above). [IFRS 9.2.1(e)]. However,
IFRS 4 does not apply to insurance contracts that an entity holds (other than
reinsurance contracts) either. [IFRS 4.4(f)]. Accordingly, as explained in the guidance on
implementing IFRS 4, the holder of a financial guarantee contract will need to
develop its accounting policy in accordance with the ‘hierarchy’ in IAS 8 –
Accounting Policies, Changes in Accounting Estimates and Errors. The IAS 8
hierarchy specifies criteria to use if no IFRS applies specifically (see Chapter 3 at 4).
[IFRS 4.IG2 Example 1.11, IFRS 17.BC66].
In selecting their policy, entities may initially look to the requirements of IAS 37
dealing with contingent assets (see Chapter 27 at 3.2.2) or reimbursement assets
(see Chapter 47 at 5.8.1.B), at least as far as recoveries under the contract are
concerned. In certain situations it may also be possible for the holder of a financial
guarantee contract to account for it as an asset at fair value through profit or loss.
This might be considered appropriate if it was acquired subsequent to the initial
recognition of a guaranteed asset that had itself been classified as at fair value
through profit or loss.
It should, however, be noted that IFRS 9 has been amended by IFRS 17. The scope
exclusion for financial guarantee contracts will change from those contracts that meet
the definition of insurance contracts to those that are in the scope of IFRS 17. As the
accounting by the holder of the guarantee is not in the scope of IFRS 17, it will, by
default, be in the scope of IFRS 9. This is discussed in more detail in Chapter 47
at 5.8.1.B.
3.4.4
Financial guarantee contracts between entities under common
control
There is no exemption from the measurement requirements of IFRS 9 for guarantees
issued between parents and their subsidiaries, between entities under common control
nor by a parent or subsidiary on behalf of a subsidiary or a parent (unlike an exemption
under US GAAP). [IFRS 9.BCZ2.14].
Therefore, for example, where a parent guarantees the borrowings of a subsidiary, the
guarantee should be accounted for as a standalone instrument in the parent’s separate
financial statements. However, for the purposes of the parent’s consolidated financial
statements, such guarantees are normally considered an integral part of the terms of the
borrowing (see Chapter 43 at 4.8) and therefore should not be accounted for
independently of the borrowing.
3.5 Loan
commitments
Loan commitments are firm commitments to provide credit under pre-specified terms
and conditions. [IFRS 9.BCZ2.2]. The term can include arrangements such as offers to
individuals in respect of residential mortgage loans as well as committed borrowing
facilities granted to a corporate entity.
Although they meet the definition of a derivative financial instrument (see 2.2.8 above
and Chapter 42 at 2), a pragmatic decision has been taken by the IASB to simplify the
accounting for holders and issuers of many loan commitments. [IFRS 9.BCZ2.3].
Accordingly, loan commitments that cannot be settled net – in practice, most loan
3428 Chapter 41
commitments – may be excluded from the scope of IFRS 9, with the exception of the
impairment requirements and derecognition provisions (see Chapters 47 and 48), but
are included within the scope of IFRS 7. [IFRS 9.2.1(g), IFRS 7.4]. Some loan commitments,
however, are within the scope of IFRS 9, namely: [IFRS 9.2.1(g)]
• those that are designated as financial liabilities at fair value through profit or loss
(this may be appropriate if the associated risk exposures are managed on a fair
value basis or because designation eliminates an accounting mismatch; [IFRS 9.2.3(a)]
• commitments that can be settled net in cash or by delivering or issuing another
financial instrument; [IFRS 9.2.3(b)] and
• all those within the same class where the entity has a past practice of selling the
assets resulting from its loan commitments shortly after origination. The IASB sees
this as achieving net settlement. [IFRS 9.2.3(a)].
In addition, commitments to provide a loan at a below-market interest rate are also
within the scope of IFRS 9. [IFRS 9.2.3(c)]. For these loan commitments, IFRS 9 contains
specific measurement requirements which are different from those applying to other
financial liabilities. IFRS 9 requires the commitments to be measured at fair value on
initial recognition and subsequently amortised to profit or loss using the principles of
IFRS 15 (see Chapter 28) but requires the expected credit loss allowance to be used, if
higher. [IFRS 9.4.2.1(d)]. The reason for this accounting treatment is that the IASB was
concerned that liabilities resulting from such commitments might not be recognised in
the statement of financial position because, often, no cash consideration is received.
[IFRS 9.BCZ2.7].
In respect of commitments that can be settled net in cash IFRS 9 contains only limited
guidance on what ‘net settlement’ means. Clearly a fixed interest rate loan commitment
that gives the lender and/or the borrower an explicit right to settle the value of the
contract (taking into account changes in interest rates etc.) in cash or by delivery or
issuing another financial instrument would be considered a form of net settlement and
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 677
