IFRS 9 Explained – Issued Financial Guarantees

IFRS 9 Financial Instruments became effective on 1 January 2018. In this article, we take a look at how the accounting for certain issued financial guarantee contracts (FGCs) will be affected.

Identifying FGCs

IFRS 9 retains the same financial guarantee definition as IAS 39, ie a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payments when due in accordance with the terms of a debt instrument. Some common examples of contracts that meet, and do not meet, this definition are set out in the following table:

Contract Type	Meets FGC definition?
Parent company guarantee over a subsidiary’s bank loan which reimburses the bank for losses incurred if the subsidiary fails to pay.	Yes; relates to specific a debtor and debt instrument and only reimburses for losses incurred as a result of a failure to pay.
Parent company guarantee over the general obligations of a subsidiary.	No; not specific in nature and may include obligations other than debt instruments.
Credit Default Swap (CDS) that pays out in the event of a credit downgrade (which does not necessarily equate to an incurred loss).	No; reimburses the holder for losses that it may not incur. A CDS is a derivative and must be measured at Fair Value Through Profit or Loss .

Are all issued FGCs accounted for under IFRS 9?

No. Similar to IAS 39, an entity that has previously asserted explicitly that it considers and accounts for FGCs as insurance contracts can elect to apply IFRS 4 Insurance Contracts instead of IFRS 9. Going forward under IFRS 17 Insurance Contracts, a similar option will be permitted. However, entities will need to consider the changes to the accounting for insurance contracts that IFRS 17 will introduce.

How has the accounting changed under IFRS 9?

IFRS 9 retains the same initial recognition requirements as IAS 39 for issued FGCs but introduces different subsequent measurement requirements.

Initial Recognition

An issued FGC is a financial liability and is initially recognised at fair value. If the FGC is issued to an unrelated party at arms-length, the initial fair value is likely to equal the premium received. If no premium is received (often the case in intragroup situations), the fair value must be determined using a different method that quantifies the economic benefit of the FGC to the holder. For example, if an interest rate of 7% is charged with the benefit of a guarantee and a rate of 10% would be charged without it, the interest rate differential of 3% could be considered to represent the economic benefit of the FGC to the holder. The present value of this differential over the term of the loan would therefore be the initial fair value.

Subsequent Measurement

Subsequently, the FGC is measured at the ‘higher of’:

The IFRS 9 Expected Credit Loss (ECL) allowance, and
The amount initially recognised (ie fair value) less any cumulative amount of income/ amortisation recognised.

Alternatively, it is possible to designate the FGC at fair value through profit or loss - but only in cases of an accounting mismatch or if the FGC is part of a portfolio that is managed and its performance evaluated on a fair value basis.

The change that IFRS 9 introduces relates to part (i) of the ‘higher of’ test. IAS 39 referred to the amount of any provision required under IAS 37 Provisions, Contingent Liabilities and Contingent Assets whereas IFRS 9 refers to the amount of ECL allowance as required under the ‘general approach’ (see the September 2017 edition of Business Edge).

Implications of applying the ECL model to FGCs

The ECL allowance under IFRS 9 will be different to the IAS 37 provision amount. Under IAS 37, a provision is not recognised until an outflow of resources is probable and the amount is reliably measurable. However, under IFRS 9, there is no ‘probable’ threshold; instead, a minimum of 12 month ECL is required to be recognised at all times. In addition, under IAS 37, the provision amount is based on a best estimate, whereas the IFRS 9 ECL allowance is a forward-looking probability weighted measure that must reflect the possibility of a loss occurring (even if very unlikely). These differences are summarised in the table below:

	IAS 37 Provision	IFRS 9 ECL Allowance
Recognition threshold	Yes – probable	No – 12 month ECL minimum
Measurement approach	Best estimate	Forward looking and probability weighted

For example, even if there was only a 5% chance that a loss might occur, this possibility must be factored into the ECL calculation, whereas under IAS 37, no provision would be recognised as the loss was not probable. This means that when applying the ‘higher of’ test, the ECL allowance is likely to be larger and recognised earlier than the IAS 37 provision. However, in cases where underlying borrower is in a strong financial position or where the existence of collateral or other credit enhancements could either prevent default or reduce the amount of loss incurred, the ECL allowance may not be very significant.

Nevertheless, entities are required to apply these new requirements which may present implementation challenges, including:

The measurement of ECL which must take into account the possibility of a credit loss occurring and incorporate forward looking information
Assessing and tracking the underlying borrower’s risk of default to identify a significant increase in credit risk.

This could be particularly challenging for corporate entities with cross company guarantee structures that may not previously have attracted an IAS 37 provision and where there may be a lack of relevant credit risk information.

For help and advice on IFRS 9 please get in touch with your usual BDO contact or Dan Taylor.