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2.6 Initial measurement and recognition of a guarantee
Publication date: 31 Dec 2021
us Financing guide 2.6
A reporting entity that provides a guarantee is required to recognize the noncontingent component of the guarantee. They may also be required to recognize a contingent component.
The noncontingent component of a guarantee represents the obligation to stand ready to perform in the event that a specified triggering event or condition occurs. This component should be recorded as a guarantee liability at its fair value based on the guidance in ASC 460. See FG 2.6.1 for additional information.
The contingent component of a guarantee represents the obligation to make future payments if a triggering event or condition occurs. The contingent component is accounted for using the guidance in ASC 450, Contingencies, or in some situations, ASC 326, Credit Losses, as discussed in FG 2.6.2. Unlike the noncontingent component, the contingent component is only recorded if payment of the guarantee is probable, which is typically not the case at inception of the guarantee.
2.6.1 Initial measurement—noncontingent component of a guarantee
A guarantee recognized as a liability under the guidance in ASC 460 should be initially recognized at fair value at issuance. This is the noncontingent component of the guarantee.
When a guarantee is independently issued in a standalone arm’s-length transaction with an unrelated party, it is generally recognized at an amount equal to the amount paid for the guarantee as a practical expedient.
When a guarantee is issued as part of a transaction with multiple elements (such as in conjunction with selling an asset or entering into an operating lease), the guarantor should measure the fair value by determining the amount that would have been charged to issue the same guarantee in a standalone arm’s-length transaction. A reporting entity should evaluate all facts, circumstances, and business practices to develop a process to identify guarantees included in other contracts that should be accounted for under ASC 460.
When there is no observable data for identical or similar guarantee transactions, as is often the case, the measurement of a guarantee will require the use of estimates. A reporting entity should develop valuation models which consider all relevant facts and circumstances, to determine the fair value of its guarantees. Reporting entities often use a discounted cash flow model to determine the fair value, but other models may also be appropriate.
2.6.2 Initial measurement—contingent component of a guarantee
At inception of a guarantee, the guarantor should also assess the need to recognize a liability for the contingent component of the guarantee (the obligation to make future payments under the guarantee) using the guidance in ASC 450-20-25.
In the event that, at the inception of the guarantee, the guarantor is required to recognize a liability under Section 450-20-25 for the related contingent loss, the liability to be initially recognized for that guarantee shall be the greater of the following:
a. The amount that satisfies the fair value objective as discussed in the preceding paragraph
b. The contingent liability amount required to be recognized at inception of the guarantee by Section 450-20-30.
Estimated liabilities recognized using the guidance in ASC 450 are typically not discounted. That said, payments are only measured once they are considered probable. As discussed in ASC 460-10-30-4, it is unusual for the contingent liability recognized in accordance with ASC 460-10-30-3(b) to exceed the fair value amount to be recognized at inception under the guidance in ASC 460-10-30-3(a). ASC 460-10-30-4 discusses two scenarios when that may occur:
- At inception, it is probable that the guarantor will be required to pay the maximum potential settlement at the end of the term, and there is some likelihood that the guarantor will not be required to make any payment at the end of the term. Measuring the guarantee liability at fair value would require the consideration of the likelihood that no payment will be required. However, the accrual of the contingent loss under ASC 450-20-30 would be based solely on the best estimate of the probable settlement amount (the maximum potential settlement amount in this example).
- A contingent liability that is probable to occur well in the future. Under ASC 450-20-S99-1, the contingent liability is often undiscounted, which will likely exceed a guarantee liability recorded at fair value, which takes into account the time value of money.
2.6.2.1 Contingent component of a guarantee under ASC 326
The guidance in ASC 326, Financial Instruments – Credit Losses, was effective beginning in 2020. The guidance on the measurement of the contingent component of a guarantee not accounted for as insurance was amended when the guidance in ASC 326 became effective, as discussed in ASC 460-10-25-2 and ASC 460-10-30-5.
Excerpt from ASC 460-10-25-2 (as amended)
For guarantees that are within the scope of Subtopic 326-20, the expected credit losses (the contingent aspect) shall be measured and accounted for in addition to and separately from the fair value of the guarantee (the noncontingent aspect) in accordance with paragraph 460-10-30-5.
At the inception of a guarantee within the scope of Subtopic 326-20 on financial instruments measured at amortized cost, the guarantor is required to recognize both of the following as liabilities:
a. The amount that satisfies the fair value objective in accordance with paragraph 460-10-30-2
b. The contingent liability related to the expected credit loss for the guarantee measured under Subtopic 326-20.
2.6.3 Recognition of a guarantee
When a reporting entity records a guarantee liability, the offsetting entry will depend on the specific facts and circumstances that gave rise to the guarantee. ASC 460 does not prescribe a specific account for the offsetting entry; however, ASC 460-10-55-23 provides illustrative examples for various types of guarantees.
ASC 460-10-55-23 [edits applicable upon adoption of ASC 842]
Although paragraph 460-10-25-4 does not prescribe a specific account, the following illustrate a guarantor’s offsetting entries when it recognizes the liability at the inception of the guarantee:
a. If the guarantee were issued in a standalone transaction for a premium, the offsetting entry would be consideration received (such as cash or a receivable).
b. If the guarantee were issued in conjunction with the sale of assets, a product, or a business, the overall proceeds (such as the cash received or receivable) would be allocated between the consideration being remitted to the guarantor for issuing the guarantee and the proceeds from the sale. That allocation would affect the calculation of the gain or loss on the sale transaction.
c. If the guarantee were issued in conjunction with the formation of a partially owned business or a venture accounted for under the equity method, the recognition of the liability for the guarantee would result in an increase to the carrying amount of the investment.
d. If a residual value guarantee were provided by a lessee-guarantor when entering into an operating lease, the offsetting entry (representing a payment in kind made by the lessee when entering into the operating lease) would be reflected as prepaid rent, which would be accounted for under Section 840-20-25. [Subparagraph superseded by ASC 842 (i.e., only applies to reporting entities that have not yet adopted ASC 842)]
e. If a guarantee were issued to an unrelated party for no consideration on a standalone basis (that is, not in conjunction with any other transaction or ownership relationship), the offsetting entry would be to expense.
A reporting entity may also provide a guarantee on behalf of an equity method investee. When a reporting entity provides such a guarantee, it should evaluate whether the guarantee affects its accounting for the equity method investee. Example FG 2-5 illustrates the accounting for a guarantee made on behalf of an equity method investee.
EXAMPLE FG 2-5
Guarantee of a loan made to an equity method investee
Guarantee of a loan made to an equity method investee
FG Corp has an equity method investment in Investee Co.
Investee Co borrowed money from Bank Corp, a third-party lender. In connection with the borrowing, FG Corp issues a guarantee of Investee Co's repayment of its loan. FG Corp is the only investor in Investee Co that issues a guarantee. FG Corp does not receive any consideration for the guarantee. Although Bank Corp would have made the loan to Investee Co without the guarantee, the cost of borrowing is reduced as a result of it. FG Corp and the other investors in Investee Co benefited from the reduced borrowing cost.
How should FG Corp account for its guarantee of Investee Co's borrowing?
Analysis
FG Corp first determines the amount of the guarantee related to its ownership interest in Investee Co by performing a pro rata calculation using the fair value of the guarantee. Based on the pro rata calculation, a portion of the guarantee will be an increase to the equity method investment, and a portion of the guarantee will be expensed. FG Corp concludes that a portion of the guarantee should be an increase to the equity method investment by analogizing to ASC 460-10-55-23(c). FG Corp concludes that the remaining portion of the guarantee should be expensed by analogizing to ASC 323, Equity Method and Joint Ventures. ASC 323-10-25-3 discusses the accounting when one investor grants stock-based payment awards to the employees or nonemployees of an equity method investee. The contributing investor must expense the portion of the costs of the grant that exceeds its proportionate ownership percentage.
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