Bank Guarantee and Contingent Liability?

[kishant50]

Hello Everyone,

Standard Chartered Bank (guarantor) issued a bank guarantee amount in Rs. 5,000,000 to ABC (beneficiary) on behalf of XYZ (applicant). As this guarantee contract is contingent liability for the bank but is it to be disclosed as contingent liability as per IAS 37 in the notes to accounts of XYZ Company?

Thank You.

[JakobLavrod]

Typically, guarantees for financial instruments would fall under IFRS 9 right?

IFRS 9.2.1 e (iii):
this Standard applies to:
an issuer’s rights and obligations under insurance contracts that meet the definition of a financial guarantee contract. However, if an issuer of financial guarantee contracts 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 this Standard or IFRS 17 to such financial guarantee contracts (see paragraphs B2.5⁠–⁠B2.6). The issuer may make that election contract by contract, but the election for each contract is irrevocable

[kishant50]

How to account it if it is the performance guarantee issued by the bank on behalf of the stockiest to the supplier? How does the stockiest disclose this in its financial statements?

[JakobLavrod]

Not sure about how the entity that get the guarantee should disclose it. Unless there is some language that discharge them in case the guarantor picks up the bill (which is quite rare), the only thing the guarantee does is that in case it get utilized, who the entity owes money to changes from supplier to guarantor.

[Marek Muc]

Financial guarantees aren't in the scope of IAS 37 as Jakob noted and thus they aren't contingent liabilities.
Please describe the scenario with more detail.

PS. What's "stockiest"?

[DJP]

Hi everyone and Happy New Year.

This seems to be a performance guarantee, not a financial guarantee. It is also a contingent liability for XYZ Company and falls under the scope of IAS 37. It should be disclosed, unless remote.

[Marek Muc]

I doubt it will be in the scope of IAS 37 for XYZ as it's contractual, but let's wait for more details from kishant50

PS. Happy New Year to you, too

[DJP]

All guarantees are contractual. But I suspect that the guarantee kishant50 is referring to is a performance guarantee, not a financial guarantee. Performance guarantees fall under the scope of IAS 37 (and some potentially under the scope of IFRS 17 for the issuer). Let's indeed wait for kishant50 to come back to us and clarify what type of guarantee this is.

[kishant50]

Thank you everyone for your replies.

I am referring to the performance guarantee issued by the bank on behalf of the applicant (ABC Co.). Specifically the guarantee read as follows:

"Whereas the applicant have entered into a contract with you (beneficiary) for the above purpose (the supply arrangement as wholesaler) and whereas you require from the applicant a performance bond, we the guarantor hereby agree and covenant that in the event of the applicant failing to perform their obligation under the contract for any reason whatsoever, the guarantor shall pay you without demur a sum or sums up to the above amount against your receipt for the sum claimed accompanied by your statement that the applicant failed to comply with the contract terms."

Is this type of performance guarantee issued by the bank to be disclosed as contingent liability in the financial statements of the applicant (ABC Co.)? If yes, to what extent it shall be disclosed?

[DJP]

It is a contingent liability. Contingent liabilities shall be disclosed, unless remote (or immaterial). You may want to disclose the total amount of the bank performance guarantee facilities that are outstanding as at the reporting date.

[Marek Muc]

What is the nature of the contract (if any) between ABC Co. and the Bank in this scenario?

[kishant50]

The bank provided a performance bank guarantee after having some collateral and cash margin for a commission. The non-funded loan deed is entered between bank and the ABC Co.

[DJP]

This is the same as in many other performance guarantees. If ABC Co does not deliver or perform under the contract it has with its customer, the customer may activate the guarantee, in which case the bank will pay a certain amount to the customer (defined in the guarantee contract) and claim that amount from ABC Co.

[Marek Muc]

To me this arrangement should be treated as part of the arrangement with the customer under IFRS 15, with the bank offering additional assurance. As for the exact approach, it hinges on the details, but initially I'd suggest treating any potential performance penalties as variable consideration with relevant disclosures under IFRS 15 https://ifrscommunity.com/knowledge-bas ... sideration

[DJP]

That is an interesting view, but in my opinion performance guarantees should follow "warranty accounting" and be scoped out of IFRS 15 (based on IFRS 15 BC60).

[Marek Muc]

As I understand this, we are discussing assurances of timely and specification-compliant satisfaction of performance obligations, rather than post-service warranties. Thus I don't think IAS 37 applies in this situation.

[Ketan Marwah]

The bank provided a performance bank guarantee after having some collateral and cash margin for a commission.

Hi,

May I ask if the applicant has fully collateralized it's obligations? Generally, a performance guarantee contract contains insurance risk, because the policyholder is compensated for an adverse event. The issuer should assess whether it has accepted insurance risk and the significance of such insurance risk, taking into account the indemnification arrangement and any collateral in place. Applying paragraph B18 of IFRS 17, insurance risk is significant if, and only if, an insured event could cause the issuer to pay additional amounts that are significant in any single scenario, excluding scenarios that have no commercial substance. For example, if the performance guarantee contract requires the applicant to fully collateralize its obligations to indemnify the issuer, the issuer might conclude that it has not accepted significant insurance risk if there are no scenarios with commercial substance that would cause the issuer to pay significant additional amounts to the policyholder.
The issuer might need to exercise significant judgement to determine whether a performance guarantee contract that fully indemnifies the issuer exposes the issuer to insurance risk, applying paragraphs B11–B12 of IFRS 17 (that is, whether the issuer is the insurer), and whether such insurance risk, if accepted by the issuer, is significant, applying paragraphs B18–B23 of IFRS 17. The issuer should apply IFRS 17 to the contract if it concludes that it accepts significant insurance risk from the policyholder.
If the issuer concludes that it has not accepted insurance risk from the policyholder, or that the insurance risk is not considered to be significant, the issuer should account for the performance guarantee as a loan commitment to the applicant applying IFRS 9, since the contract would meet the definition of a loan commitment.

[Ketan Marwah]

Hi.

& now I realize that we were exploring the accounting treatment in the books of the applicant and not the issuer . I would agree with Marek's opinion on it that it can be viewed as variable consideration under IFRS 15. Maybe I try to also illustrate that with an example:

A property developer (Company X) agrees to undertake a development and, in order to do so, establishes two wholly owned subsidiaries:
- Subsidiary A, the ‘Developer’; and
- Subsidiary B, the ‘Guarantor’.
Several agreements have been entered into for the development, including where Subsidiary B will guarantee Subsidiary A’s performance to Company X. Under this agreement, if Subsidiary A defaults (that is, fails to perform under the development contract), Subsidiary B must procure the performance of the relevant obligation through another developer and/or pay financial compensation to the customer.

In Company X’s consolidated financial statements, payments under the performance guarantee can be viewed as penalties and liquidated damages payable to the customer for failure to comply with the terms of the contract. Such amounts are generally accounted for as variable consideration under IFRS 15.

However, in Subsidiary B’s stand-alone financial statements, the performance guarantee meets the definition of an insurance contract and needs to be accounted for under IFRS 17

[Marek Muc]

I think I've seen this example somewhere

Note that this example doesn't address our query regarding the treatment in Subsidiary A (the Developer)'s separate financial statements.

[Ketan Marwah]

I am quite sure you have seen it already in one of our lengthy exchange sometime earlier:-)

IMO, this example can be used for reference purposes because Company X in the consolidated reporting would have the service obligation towards the customer as a developer. It would have to adjust for any implicit variability in its recognized revenue (financial compensation to the customer). Likewise, XYZ company would do the same for the case specified in this thread.

[DJP]

While I fully understand your arguments that a performance guarantee could be seen as some sort of penalty to be considered as variable consideration, I am not sure if this would lead to the best accounting treatment. Even though it is possible that a guarantee can be executed, it would make no sense from a commercial point of view to consider the probability of non-performance at the inception of the contract. One could argue that the probability of the guarantee being executed is very small and thus not affecting the revenue recognised, but in that case, the reader of the financial statements would not be aware of such guarantees being in place as there are no requirements (as far as I am aware) under IFRS 15 to make such disclosures. However, if we consider the guarantee to be a contingent liability, we ought to disclose it.

I do agree though that, in case the guarantee execution becomes probable and some sort of provision/refund liability is recognised, the debit should be recorded in the revenue line (revenue decrease) rather than in any other operating expense line.

What are your thoughts?

[Marek Muc]

I'd disclose the guarantee in the disclosures required by IFRS 15.119 by stating that the contract includes performance penalties, which are a form of variable consideration, and the entity has secured a bank guarantee for these penalties. While it's now a bit of an academic debate about whether this should be disclosed under IFRS 15 or IAS 37, I believe that accountants often jump to IAS 37 too quickly, even when the items they're examining might actually fall under a different IFRS.

[DJP]

End of the day we both agree on the entries, and that's what matters

I still think IAS 37 applies to the performance guarantee because this is an agreement you have with a party other than your customer, and as such you ought to disclose the guarantee as part of your contingent liabilities disclosures -- which should answer the original question to this post.

I've also done a bit of research. Have a look at Nokia's annual report. They disclose performance guarantees in their contingent liabilities note (note 27 of the 2022 Annual Report).

[Marek Muc]

That's quite a broad note, extending beyond the scope of IAS 37, as it even includes leases

https://www.nokia.com/system/files/2023 ... f#page=100