The ASC 460 guides an entity to recognize and record a liability arising from a guarantee. Guarantees can be issued for several purposes, including performance, financial, and revenue guarantees.
ASC 460 guidelines provide useful information on whether a contract should be accounted for as a guarantee. Let us discuss the accounting treatment of a guarantee under ASC 460.
Guarantee – Definition
A guarantee is a promise that an entity undertakes for the obligation of another party if it fails to fulfill the obligation primarily.
A guarantee can be for the repayment of a loan, fulfillment of a project, or other forms of contractual obligation. Commonly, relevant parties offer guarantees on behalf of their relevant parties when they have joint interests. For example, a parent company offering a guarantee for its subsidiary in a loan agreement with a commercial bank.
In many cases, the issuance of a guarantee may become a liability. The issuance party may need to record the obligation properly.
Accounting for Guarantee Under ASC 460
A guarantee can be financial or operational in nature. It often comes with performance contracts, loan agreements, sale or purchase contracts, and joint venture projects.
ASC 460 provides accounting guidance for financial and non-financial guarantees. This guidance applies to certain types and the guarantor should account for the liability accordingly.
The liability will be generally recorded at its fair value. It may require an initial recognition as well as certain disclosures by the guarantor.
A Contract as a Guarantee
One of the most common uses of guarantees comes in the form of contracts. ASC 460 offers guidance on several types of contracts that should be accounted for as a guarantee.
ASC 460-10-15-4 guides on the recognition of a contract as a guarantee as below. An entity must account for a contract unless it meets the exception criteria.
- Contracts that contingently require a guarantor to pay the guaranteed party on the basis of any changes in the underlying asset, liability, or equity instrument of the guaranteed party.
- Contracts that contingently require a guarantor to pay the guaranteed party based on another party’s failure to perform certain duties under contractual agreements.
- Any changes in underlying that relate to assets, liabilities, or equity of an indemnified party that obligate the guarantor to make a payment to the indemnified party contingently.
- Even if the changes to underlying that relate to an asset, liability, or equity of the guaranteed party, the guarantor may need to make a payment for the indirect indebtedness of the guaranteed party.
The obligation or payment can be made in the form of cash or other instruments. Other instruments include stocks, assets, or financial assets.
Financial Guarantee
Many companies use financial guarantees for several purposes. Some common uses include letters of credit, bank loan guarantees, and price guarantees.
ASC 460-10-55-2 provides guidance on the recognition of a financial guarantee with the following types of financial contracts.
- A market value guarantee on a financial or a non-financial asset for the guaranteed party.
- A standby letter of credit presented as a guarantee.
- A guarantee issued for the certain stock price of a guaranteed party.
- A guarantee that a business will generate a certain level of revenue for a specified period. It can be for a business or a part such as a department or a franchise.
- A guarantee of the collection of contractual scheduled cash flows from financial assets.
The guarantor is contingently obliged to make payment in all of these financial contracts.
Minimum Revenue Guarantee
Minimum revenue guarantees are offered to a business or business owners by guarantors. These are issued to assure the business owners that the business will generate a minimum revenue.
The obligation should be carefully evaluated to determine if it falls within the scope of ASC 460. The reporting entity must evaluate the complete circumstances to make the final decision.
The royalty payment is a common example of the minimum revenue guarantee. For example, a business may take over a department of another entity. It provides a guarantee to the business owners to generate specific revenue for a specified period. The guaranteed entity would receive a minimum royalty payment for that period.
Importantly, once the guarantor offers a minimum revenue guarantee, it becomes contingently liable for the payment. The liability wouldn’t be affected by other considerations such as the performance of the business.
Performance Guarantee
A guarantor provides assurance of performing certain obligations if the guaranteed party fails to provide them. These obligations can be for the guarantor itself as well.
Bid bonds in the constructions are prime examples of performance guarantees. Bidders obtain them from an insurance company or a bank to present them along with the bidding tender. The guarantors assure against the loss in case of the contingent occurrence.
Bid bonds contractually bind the bidder to perform a project for the specified amount. If the bidder fails, the bank or the insurance company pays for the loss or the difference between the bidding price of the failed bidder and the next highest bidder.
Some common examples of performance guarantees that are covered under ASC 460-10-55-12 include:
- Performance bonds
- Bid bonds
- Performance standby letters of credit
Important: A guarantor can guarantee its own past performance as well, but it cannot offer the same for its future performance. However, it can offer a guarantee for a third party for its past or future performance under the scope of ASC 460.
Indemnification
Performance and indemnification instances are closely related within the scope of ASC 460. The indemnification clauses can be guaranteed by a guarantor for the past or future performance of a third party.
ASC 460-10-55-13 provides indemnification guidance for the following cases.
- An indemnification contract that contingently require the guarantor to pay the guaranteed party (indemnified party) for an adverse judgment in a lawsuit. Or for the imposition of additional taxes due to tax law changes or adverse interpretation of the existing tax laws.
- A lessee’s indemnification of a lessor for any adverse tax obligations that may arise due to changes in tax laws. The legislative power rests with the legislative bodies, therefore, the lessee cannot control the decision whether to make the payment for the indemnification or not.
- A seller’s indemnification against taxes due for the previous years before a business combination. The indemnification is for the past performance of the seller.
Exemption from the Scope of ASC 460
Certain types of contracts and obligations can be exempted from the scope of ASC 460. However, in most cases, the entity would still require disclosures about these exempted arrangements.
The following types of arrangements are exempted according to ASC 460-10-25-1.
- A guarantee that can be accounted for as a derivative at fair value.
- A guarantee issued in a business combination or an acquisition by a not-for-profit entity that is contingent.
- A product warranty for which the underlying is relates to the performance of a non-financial asset that is owned by the guaranteed party.
- A guarantee for which the guarantor’s obligation would be recorded as an equity item rather than a liability.
- A guarantee issued between business combinations or corporations with common control.
- A parent company’s guarantee for its subsidiary’s debt obligation to a third party.
- A subsidiary’s guarantee for the debt owed to a third party by its parent company or another subsidiary of the same parent.
Recognition and Measurement
An entity must report the noncontingent component of a guarantee. However, it may need to report the contingent part as well.
The noncontingent component requires a guarantor to remain steady should certain events happen to perform the obligation. This component of the guarantee is recorded under ASC 460 guidance at its fair value.
The contingent part means to perform certain obligations should certain future events or triggers occur. This component is accounted for under ASC 450 or ASC 326.
If a guarantee is issued as a standalone at arm’s length transaction, it is initially recognized at an amount equal to the guarantee in a practical event. If the guarantee is issued for multiple transactions, the guarantor should measure the fair value of the guarantee as if it is issued for a single at arm’s length transaction.
ASC 460-10-30-3 guides for the contingent component of the guarantee. The guarantor shall record the liability for the higher of the following two values:
- The amount that satisfies the fair value objectives or
- The contingent liability amount to be recognized at the inception of a guarantee.
ASC 460-10-55-23 guides on the recognition of a guarantee for the liability and its offsetting entry with the following guidelines.
- If the guarantee was issued as a standalone transaction, the offsetting entry will be the consideration received in the form of cash or noncash asset.
- If the liability arises in conjunction with multiple transactions such as the sale of a product, business, or an asset, the total proceeds will be allocated between the consideration to the guarantor and the proceeds from the sale.
- If a guarantee is issued to an unrelated party for no consideration on a standalone basis, the offsetting entry will be an expense.
