Financial guarantee

[Lisboa]

Dear all,

The parent company pledges shares of its 100% subsidiary for the bank loan received by its associate.

Assume that market value and the book value of the shares is 1000 USD, and the loan liability is 5000 USD.

No written agreements between the parent and its associated is signed that obliges the associate to pay any fee for the pledge provided.

Should the parent treat the transaction as the agreement of financial guarantee and calculated the fair value of the pledge provided?
Should it be calculated on the basis of market value of pledge provided?

[JRSB]

Very generous to do that for an associate!

[Lisboa]

I understand , I simplified the description, it's a joint venture, so the second partner provides its pledge too.

[Ketan Marwah]

Hi,

The accounting for the collateral (Inv. in sub) by the Parent depends on whether the lender has the right to sell or re-pledge the collateral and on whether the JV has defaulted, so it would be great if you can share some more information related to the pledge.

[Lisboa]

Hi Ketan, thank you for your reply.

Yes, in case of associate's default, the Parent is obliged to sell the stake on the open market and paid off the associate's liability.

[DJP]

"in case of associate's default, the Parent is obliged to sell the stake on the open market and paid off the associate's liability."

Is the parent responsible to pay the whole liability or just to transfer the shares in the sub in case of default?

[Lisboa]

Hi DJP,

The Parent is obliged to sell the shares and transfer the amount received to the bank.

The pledge amount is less than the loan liability. I assume the second parent in associate provides the greater portion of a pledge or any other guarantee to the bank.

[JRSB]

https://ifrscommunity.com/knowledge-bas ... -contracts

[DJP]

The transaction seems to meet the definition of a financial guarantee. When measuring the guarantee, you should take into consideration the probability of default of the associate and the value of the shares (which in this case seems to be your exposure at default).

At initial recognition you recognise a financial guarantee liability in the books of the parent. As for the debit, that is an interesting one. I would take it immediately to P&L since the parent seems to be giving this guarantee for free (and this is not a transaction under common control). The associate itself would not recognise anything in regard to the guarantee. Curious to see if anyone else has a different view.

[Lisboa]

Dear DJP, thanks for your assistance.

Before coming there I've discussed the issue within the team, obtained the similar view, but doubting. So we've got your opinion to support ours. Thanks again and thanks you all for great forum

[Lisboa]

Let me clarify the adjustment amount:

1000usd (the book value of the shares)*market rate for financial guarantee, right?

Or you mean 1000usd*probably of associate's default?

[DJP]

PD (associate's probability of default) x LGD (100% in this case) x shares' maket value

[JakobLavrod]

PD (associate's probability of default) x LGD (100% in this case) x shares' maket value

Maye I have not read all the details here careful enough, but is it given that the LGD = 100 %? Sure, whatever is not possible to recover will fall upon the guarantor to pay, but typically that is first taken from the borrower as much as possible (creating a lower LGD for the guarantor). On a more technical ECL point, the repayment structure could lower the EAD to be lower then the current amount, conditional on if payments are made over time (since earlier payments has a lower risk of shortfall).

Also, in these case where there is not fee being paid for the guarantee right, I remember @Marek bringing up that one is still supposed to fair value estimate the guarantee, rather then using the ECL directly, although in practice that might be a reasonable approximation.

[Ketan Marwah]

While I agree this to be treated as a Financial Guarantee but a financial guarantee contract is initially recognized at fair value irrespective whether premium is received or not. If no premium is received, the fair value must be determined using a method that quantifies the economic benefit of the guarantee to the holder.
The fair value of a financial guarantee contract is calculated as the present value of the difference between the net contractual cash flows required under a debt instrument, and the net contractual cash flows that would have been required without the guarantee. The present value is calculated using a risk free rate of interest. I would agree to take the impact onto the PnL for this being an external transaction.

[Lisboa]

Thanks everyone

I've discussed with the team. We noted that we apply to IFRS 9B2.5 (a)" If the financial guarantee contract was issued to an unrelated party in a stand-alone arm’s length transaction, its fair value at inception is likely to equal the premium received, unless there is evidence to the contrary.'

So in case of related party we apply the rate obtained by the Group when receiving a guarantee from banks.

[Ketan Marwah]

Hi,
The investor (whome you refer to as parent) has issued the guarantee to the bank and not to a related party. Since no premium is received therefore you would have to apply some alternative methods in line with IFRS 13 Fair value measurement. The one I described in my post is the one commonly used to arrive at the FV. To explain with an example: If the debtor pays 5% with the guarantee and the market interest rate on un-guaranteed loans is 6%, then the fair value of the guarantee is the present value of the difference in interests charged on guaranteed and un-guaranteed loans.

[JRSB]

In practice, wouldn't the guarantee be a condition, rather than an optional feature to lower the interest rate? ie making it difficult to identify the incremental points.

[Ketan Marwah]

While that pre-condition/feature has resulted in the credit support as it has enabled an entity to secure access to credit, to borrow at a lower interest rate, improved terms and conditions, etc. it has correspondingly led to a contractual obligation of the guarantor to pay the lender, if the borrower defaults. Such guarantees falls within the scope of IFRS 9. IAS 32.AG8 discusses this quite comprehensively. The approach mentioned in my post is commonly used because an entity is generally aware of it's credit spread. There is a white paper on "how to value guarantees" which I found quite useful for fair value measurement purposes so also linking it here:https://www.garp.org/hubfs/Whitepapers/ ... x7eUAA.pdf

[JakobLavrod]

Great reference Ketan, super thanks!

[kevin.aycardo]

Lisboa - it seems to meet the definition of a financial guarantee contract (agree with the conclusions above). Just 1 point from me in addition to what has been discussed already -
The amount that you would recognise is the HIGHER OF
(1) the ECL on the exposure [this one relates to what was mentioned earlier in which you can check the credit spread of the issuer. If it's a one-off transaction (and the parent does not employ complex model), perhaps you can apply the S&P PD rates and do some approximation; or
(2) the FV of the instrument at initial recognition (plus transaction cost) [you can apply the IFRS 9.B25(a) that you cited i.e. premium amount received is likely the FV]