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2.3 Determining whether a contract is a guarantee
Publication date: 31 Dec 2021
us Financing guide 2.3
ASC 460-10-15-4 provides a list of contract types that should be accounted for as a guarantee unless it qualifies for a scope exception. See FG 2.3.1 through FG 2.3.4 for information on each of these types of guarantees. See FG 2.4 for information on the types of guarantees excluded from the scope of ASC 460.
Excerpt from ASC 460-10-15-4
Except as provided in paragraph 460-10-15-7, the provisions of this Topic apply to the following types of guarantee contracts:
- Contracts that contingently require a guarantor to make payments…to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
- Contracts that contingently require a guarantor to make payments…to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees).
- Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
- Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
Guarantees of an underlying related to an asset, liability or equity security of the guaranteed party are accounted for under ASC 460 if the underlying is a separate instrument of the guaranteed party.
The payment required to be made by guarantors is not limited to payments in cash; a guarantee can require payment in cash, financial instruments, other assets, shares of the guarantor’s stock, or by providing services. Some securitizations, as well as other arrangements, may involve the subordination of the rights of some investors to the rights of others. Economically, while the subordinated investors provide credit protection, as a payment is not made, these arrangements are not in the scope of ASC 460.
Question FG 2-1 discusses if commercial letters of credit and loan commitment guarantees are within the scope of ASC 460.
Question FG 2-1
Commercial letters of credit and other loan commitments are often thought of as funding guarantees. Are commercial letters of credit and loan commitments guarantees within the scope of ASC 460?
Commercial letters of credit and other loan commitments are often thought of as funding guarantees. Are commercial letters of credit and loan commitments guarantees within the scope of ASC 460?
PwC response
No. Commercial letters of credit and loan commitments do not guarantee payment of an obligation and they do not provide for payment if the borrower defaults. ASC 460-10-15-4 requires the guarantor to make a payment for the guarantee to be within the scope of ASC 460; many commercial letters of credit and loan commitments include material adverse change clauses that enable the guarantor to avoid making a payment. Additional information on material adverse change clauses can be found in FSP 12.
Question FG 2-2 discusses if a weather derivative is a guarantee within the scope of ASC 460.
Question FG 2-2
Is a weather derivative a guarantee within the scope of ASC 460?
Is a weather derivative a guarantee within the scope of ASC 460?
PwC response
No. To be within the scope of ASC 460-10-15-4(a), the payments made to the guaranteed party must be based on changes in an underlying that is related to an asset, liability, or equity of the guaranteed party. A geological variable is not an asset, a liability or equity of the guaranteed party. A weather derivative also does not meet the criteria in ASC 460-10-15-4(b), ASC 460-10-15-4(c) and ASC 460-10-15-4(d).
2.3.1 Financial guarantees
ASC 460-10-55-2 provides examples of financial guarantee contracts that may be within the scope of ASC 460. Insurance companies that issue financial guarantee contracts must assess whether they are within the scope of ASC 944, Insurance, before considering ASC 460.
The following are examples of contracts of the type described in paragraph 460-10-15-4(a):
a. A financial standby letter of credit
b. A market value guarantee on either a financial asset (such as a security) or a nonfinancial asset owned by the guaranteed party
c. A guarantee of the market price of the common stock of the guaranteed party
d. A guarantee of the collection of the scheduled contractual cash flows from individual financial assets held by a special-purpose entity
e. A guarantee granted to a business or its owner(s) that the revenue of the business (or a specific portion of the business) for a specified period of time will be at least a specified amount.
In each of these contracts, the guarantor is contingently obligated to make payment and is unable to avoid payment.
2.3.1.1 Put options
A put option is a market value guarantee. The holder of a put option has the right to sell a specified amount of an asset to the writer of the put option at a specified price on a specified date or dates. For example, Guarantor G may provide Company X with the right to put its investment in the common stock of a private company to Guarantor G for $10 at a future date. If the value of the common stock is below $10 at that date, Company X would likely exercise its put option.
To determine whether a put option should be accounted for as a guarantee within the scope of ASC 460, the put option writer (i.e., the reporting entity) should first determine whether it meets the requirements to be accounted for as a derivative in ASC 815, Derivatives and Hedging. If so, it is not a guarantee within the scope of ASC 460. See DH 2 for information on determining whether a put option should be accounted for as a derivative, and DH 3 for information on the scope exceptions for certain financial guarantee contracts. In practice, a written put option often is not in the scope of ASC 460.
Next, the put option writer should assess whether the put option holder has an asset or liability relating to the underlying on or about inception of the put option. To meet the definition of a guarantee in ASC 460-10-15-4(a), the put option must be on an underlying related to an asset, liability, or equity security of the guaranteed party (i.e., the put option holder). If the guarantor cannot conclude it is probable that the put option buyer has an asset or liability related to the underlying, then the option is not a guarantee within the scope of ASC 460. A put option also does not meet the scope criteria in ASC 460-10-15-4(b), ASC 460-10-15-4(c) and ASC 460-10-15-4(d). For purposes of measurement, the guarantor should assess whether the put option buyer still holds the asset or liability related to the underlying each period.
A put option that requires the holder to deliver the underlying instrument (i.e., a gross settled option) may be in the scope of ASC 460 if the put option is on an underlying related to an asset, liability, or equity security of the guaranteed party. For instance, if an investor separately (1) buys a non-puttable bond, and (2) enters into a freestanding put option that can only be settled by delivery of the bond, the put option will be a guarantee within the scope of ASC 460 if the bond is held by the guaranteed party (unless one of the scope exceptions identified in ASC 460-10-15-7 applies).
2.3.1.2 Minimum revenue guarantees
In a minimum revenue guarantee, the revenue of a guaranteed party is guaranteed to reach a minimum amount during the guaranteed period. The revenue amount guaranteed may be total revenue, revenue from a specific product line, or some other revenue amount. A minimum revenue guarantee is typically granted to a business or its owners. The guarantor should assess whether the minimum revenue guarantee is within the scope of ASC 460.
Question FG 2-3 discusses if a licensing agreement with a guaranteed minimum royalty payment contains a guarantee within the scope of ASC 460.
Question FG 2-3
Assume sports team X has a licensing agreement with retailer Y, whereby X gives Y the right to sell products with X’s name and logo. If Y’s sales of these products are less than $1 million, X agrees to pay the difference between Y’s actual sales and $1 million. Does the arrangement contain a guarantee in the scope of ASC 460?
Assume sports team X has a licensing agreement with retailer Y, whereby X gives Y the right to sell products with X’s name and logo. If Y’s sales of these products are less than $1 million, X agrees to pay the difference between Y’s actual sales and $1 million. Does the arrangement contain a guarantee in the scope of ASC 460?
PwC response
Yes, X has provided a minimum revenue guarantee to Y within the scope of ASC 460. X has agreed to guarantee that Y’s sales from products that contain X's intellectual property (logos, etc.) will be at least $1 million.
2.3.2 Performance guarantees
There are a number of different types of performance guarantees that may be within the scope of ASC 460. ASC 460-10-55-12 provides the following examples.
The following are examples of contracts of the type described in paragraph 460-10-15-4(b):
a. Performance standby letters of credit
b. Bid bonds
c. Performance bonds
d. Other contracts that are similar to performance standby letters of credit.
A bid bond is a type of a performance guarantee common in the construction industry, which may be within the scope of ASC 460. In a bid bond, a contractor obtains a guarantee from an insurance company or bank that the contractor will complete a project for the amount that it bids. If not, the insurance company or bank would need to pay the difference between the contractor’s bid and the next closest bid. The guarantee provided by the insurance company or bank may be within the scope of ASC 460-10-15-4(b), provided that it is not excluded from that scope by ASC 460-10-15-7(d). See FG 2.4 for information on ASC 460 scope exceptions.
In a performance guarantee, the guarantor agrees to perform the obligations under a contract upon the occurrence of a specified contingent event. Those obligations may be those of the guarantor (e.g., a contractor guarantees its own past performance), or those of a third-party (i.e., a guarantor performs the obligations under a contract if the third-party cannot). See FG 2.4.3 for information on guarantees of a reporting entity's own performance.
In practice, questions often arise regarding whether certain types of performance guarantees and indemnifications are within the scope of ASC 460. A guarantor that guarantees a third-party’s past or future performance is in the scope of ASC 460. A guarantor can guarantee its own past performance under ASC 460, but a guarantor cannot guarantee its own future performance under ASC 460.
2.3.3 Indemnifications
ASC 460-10-55-13 provides three examples of indemnifications that may be a guarantee within the scope of ASC 460.
The following are examples of contracts of the type described in paragraph 460-10-15-4(c):
a. An indemnification agreement (contract) that contingently requires the indemnifying party (guarantor) to make payments to the indemnified party (guaranteed party) based on an adverse judgment in a lawsuit or the imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law.
b. A lessee’s indemnification of the lessor for any adverse tax consequences that may arise from a change in the tax laws, because only a legislative body can change the tax laws, and the lessee therefore has no control over whether payments will be required under that indemnification. In contrast … when a lessee indemnifies a lessor against adverse tax consequences that may arise from acts, omissions, and misrepresentations of the lessee, that indemnification is outside the scope of this Topic because the lessee is, in effect, guaranteeing its own future performance.
c. A seller’s indemnification against additional income taxes due for years before a business combination, because the indemnification relates to the seller-guarantor’s past performance, not its future performance.
Example FG 2-1 illustrates an indemnification of a service provider that is within the scope of ASC 460. Example FG 2-2 illustrates a contract that indemnifies a subsidiary’s past actions.
EXAMPLE FG 2-1
Indemnification of a service provider
Indemnification of a service provider
Consumer Corp enters into a contract to obtain services from Service Inc. The terms of the contract include a provision in which Consumer Corp agrees to indemnify and “hold harmless” Service Inc for all third-party claims relating to the services provided to Consumer Corp, with the exception of any claims resulting from willful misconduct or gross negligence on the part of Service Inc.
Does the contract contain a guarantee within the scope of ASC 460?
Analysis
Yes, the indemnification is a guarantee within the scope of ASC 460 because it contingently requires Consumer Corp to make payments to Service Inc based on the occurrence of a third-party claim, which is related to a liability of Service Inc.
In this example, the indemnification relates to the performance of Service Inc, not Consumer Corp; therefore, it is not eligible for the scope exception in ASC 460-10-15-7(i) related to its own future performance. See FG 2.4 for information on scope exceptions.
EXAMPLE FG 2-2
Indemnification of a subsidiary’s past actions
Indemnification of a subsidiary’s past actions
LCD Corp sells its subsidiary, Subsidiary Inc, to FG Corp. As part of the sales agreement, LCD Corp agrees to indemnify the directors and officers of FG Corp for any third-party claims and matters that may arise related to Subsidiary Inc's past actions.
Does the sales agreement contain a guarantee within the scope of ASC 460?
Analysis
Yes, the indemnification is a guarantee within the scope of ASC 460 because it is not dependent upon Subsidiary's (or LCD's) future performance, but rather on its past performance. LCD is guaranteeing to reimburse the directors and officers of FG Corp for any future claims related to Subsidiary Inc's past performance.
2.3.4 Indirect guarantees of the indebtedness of others
An indirect guarantee of indebtedness requires that the guarantor make a payment to the debtor upon the occurrence of specified events under conditions whereby (1) once the funds are transferred from the guarantor to the debtor, the funds become legally available to creditors as a result of their claims against the debtor, and (2) those creditors can enforce the debtor’s claims against the guarantor under the agreement. An indirect guarantee of indebtedness ensures the borrower will have sufficient funds to repay its creditors. ASC 460-10-20 provides examples of indirect guarantees.
Partial definition from ASC 460-10-20
Examples of indirect guarantees include agreements to advance funds if a debtor’s net income, coverage of fixed charges, or working capital falls below a specified minimum.
A guarantee of the debt of a third-party is generally within the scope of ASC 460.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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