Parental guarantee on outstanding debt

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DJP
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Parental guarantee on outstanding debt

Post by DJP »

Hello everyone,

A guarantee provided from a Parent to a Sub, where the Parent commits to provide the necessary funds to the Sub to repay its debts, is not a financial guarantee because the lender is not a part to the contract.

How would you account for this guarantee in case it is highly expected that the Sub will default on its existing debt? Would you see this as a loan commitment and measured according to IFRS 9's impairment rules (even though the parent will make the funds available but will not demand repayment from the sub, i.e. not a loan)? Or as a provision for a contingent liability that is highly probable to occur?

Thanks in advance!
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Marek Muc
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Re: Parental guarantee on outstanding debt

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to me it sounds like a commitment to capital contribution in the future. I would not recognise anything with respect to this commitment. Instead, I would focus on testing the investment in subsidiary for impairment. Does this investment have positive carrying value?
pub_acco
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Re: Parental guarantee on outstanding debt

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I agree that the arrangement sounds like a commitment to make a capital contribution if it is not a "loan" commitment. I also agree that the investment in the sub should first be reduced to zero. But I'm not really sure what you should do if the value of the sub is well below zero. In such a case, the future "capital contribution" will be an expenditure that is not expected to be recovered. In other words, the expenditure will be a capital investment that will be written down as soon as it is made. A promise to make such an expenditure sounds like an onerous contract under IAS 37.

But at the same time, if it is a commitment to make a "capital contribution", the arrangement can also be interpreted as a contract to issue / purchase the sub's equity interest at a price much higher than the fair value. In this way, the arrangement sounds like a financial instrument as well.
DJP
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Re: Parental guarantee on outstanding debt

Post by DJP »

Thanks, guys. This is helpful.

@Marek - the investment is fully impaired
@pub_acco - I'm not sure if this can be seen as a financial instrument because you don't really have a contract. You have a letter (commitment) from the parent to the sub. I believe this should be treated under IAS 37 rather than IFRS 9.

Now, assuming that it becomes highly probable that the parent will have to make funds available. What would you do? Would you then book a provision at that moment against P&L, or against an investment that will immediately be impaired?
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Marek Muc
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Re: Parental guarantee on outstanding debt

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I don't see any basis for recognising a provision, you don't have a present obligation. It's just parent's intention. I would do nothing until actual capital contribution is made, and then test the investment for impairment.
DJP
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Re: Parental guarantee on outstanding debt

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What if the parent knows already that it will have to reimburse the sub because the sub lost a project and cannot repay the loan to the lender?
pub_acco
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Re: Parental guarantee on outstanding debt

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There should be a more rigid legal arrangement if non-controlling interests were involved and in this case the aspect of financial instrument would be more prominent. But I agree in your case IAS 37 sounds more appropriate.

It is actually common under our local gaap (not IFRS) for a parent to recognize a provision for a constructive obligation to pay off a sub's debt in the foreseeable future. The provision is theoretically measured at the amount of expected future payments to the extent that they are deemed attributable to the current and prior years; in practice, it is simply recorded at the amount of negative net worth of the sub. I'm not sure if this logic equally applies to IFRS, but you might be able to make an argument that the amount of net liability on the sub's balance sheet as of a reporting date is the present obligation under the arrangement.
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Marek Muc
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Re: Parental guarantee on outstanding debt

Post by Marek Muc »

there must be a present obligation to recognise a provision, we cannot provide for future expected losses

DJP, why the parent just walk away and liquidate the sub?
DJP
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Re: Parental guarantee on outstanding debt

Post by DJP »

Not an option :)

I guess I am just trying to understand whether this commitment by the Parent creates a constructive obligation, like pub_acco is suggesting.
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Marek Muc
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Re: Parental guarantee on outstanding debt

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My question was aimed at answering this question :)
Why can't the parent just walk away? What are the potential sources of constructive obligation? Any promises made to third parties?
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Re: Parental guarantee on outstanding debt

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all parties are under common control (including the lenders).

so yes, there is an expectation that the parent will provide liquidity for the borrower to make good its loan commitments, and it is highly expected that this will be the case given that the borrower lost a big project.
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Marek Muc
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Re: Parental guarantee on outstanding debt

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but it's still internal expectation only...
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Re: Parental guarantee on outstanding debt

Post by pub_acco »

I think this kind of situation typically occurs when all parties are under common control. Otherwise, the sub cannot raise so much debt without a legal financial guarantee. A typical case I've seen is like: Sub A makes a huge loss and Parent has Sub B lend money to Sub A just as the group's ordinary financial operation. Everything is internal and everything is eliminated in the consolidated statements, but here I see some present obligations to Sub B if the parent prepares a separate financial statement.
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