Chapter 5 — Guarantees
Chapter 5 — Guarantees
5.1 Overview
ASC 460 addresses the
accounting and disclosure requirements for
guarantors. The objective of the guidance in ASC
460 is to achieve transparency in a guarantor’s
financial reporting about the obligations and
risks related to issuing guarantees. This
objective is achieved by providing informative
disclosures about the nature and amount of
guarantees in the guarantor’s financial statements
as well as by helping ensure comparability between
guarantees issued with a separately identified
premium (i.e., guarantees for which the guarantor
receives consideration in exchange for the
issuance of the guarantee) and guarantees issued
without a separately identified premium. ASC 460
applies to all entities.
5.2 Scope
The guidance in ASC 460 is organized into two subsections: (1)
general and (2) product warranties. The guidance on product warranties is discussed
in Section 5.6;
accordingly, the remainder of this section addresses the scope of all guarantees
other than product warranties.
It may prove challenging to assess
the scope of ASC 460 because there are several exceptions related to applying the
recognition, measurement, or disclosure guidance therein. In some instances, the
guidance in ASC 460 results in the recognition and disclosure of a liability for a
guarantee obligation. However, other types of guarantees are outside the scope of
ASC 460’s recognition and measurement guidance (e.g., derivatives accounted for in
accordance with ASC 815) but are still subject to its disclosure requirements. The
figure below presents a framework for evaluating whether a guarantee is within the
scope of ASC 460 and indicates that there are three possible conclusions for
guarantees within the scope of ASC 460-10-15-4.
The figure below illustrates the
decisions made to determine whether a guarantee is within the scope of any portion
of ASC 460.
5.2.1 Transactions Within the Scope of ASC 460-10-15-4
ASC 460-10-15-4 is the starting point for determining whether a
transaction is a guarantee that may be within the scope of the recognition,
measurement, and disclosure requirements of ASC 460. ASC 460-10-15-4 lists
contract types that should be accounted for as guarantees under ASC 460 in the
absence of a specific scope exception in ASC 460-10-15-7 (as discussed in
Section 5.2.2).
The flowchart below illustrates
common types of guarantee contracts that are within the scope of ASC
460-10-15-4.
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 (as described in the following paragraph) 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. For related implementation guidance, see paragraph 460-10-55-2.
- Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). For related implementation guidance, see paragraph 460-10-55-12.
- 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.
It is possible that a guarantee could result from a contractual
arrangement that represents one or more of the four types of contracts described
in ASC 460-10-15-4. In the absence of a scope exception in ASC 460-10-15-7, a
contractual arrangement only needs to be one of these four contract types to be
a guarantee within the scope of ASC 460. Accordingly, once an entity has
concluded that its guarantee is one of these four types of contracts, it does
not need to further consider whether it also represents one or more of the
remaining three types.
According to the above guidance, contracts or indemnification
agreements that could require a guarantor to make payments that are based on an
underlying (as defined below) related to an asset, liability, or equity security
of the guaranteed party are within the scope of ASC 460-10-15-4.
ASC 460-10 — Glossary
Underlying
A specified interest rate, security
price, commodity price, foreign exchange rate, index of
prices or rates, or other variable (including the
occurrence or nonoccurrence of a specified event such as
a scheduled payment under a contract). An underlying may
be a price or rate of an asset or liability but is not
the asset or liability itself. An underlying is a
variable that, along with either a notional amount or a
payment provision, determines the settlement of a
derivative instrument.
ASC 460-10-20 describes an underlying as “a variable that . . .
determines the settlement of a derivative instrument.” In the context of a
guarantee contract, the underlying will govern whether the guarantor is required
to make a payment. For example, in a guarantee of the principal balance of a
loan, the underlying is the occurrence or nonoccurrence of the debtor’s
repayment of the loan. If the debtor repays the loan on its contractual
repayment date, the guarantor will not be required to make a payment. If the
debtor fails to repay the loan on the specified date, the guarantor is obligated
to make the payment.
An important provision of ASC 460-10-15-4(a) is that the
underlying must be related to an asset, liability, or equity security of the
guaranteed party. Regarding guarantees of debt, ASC 460-10-15-6 states, in
part:
[I]t does not matter whether the guaranteed party
is the creditor or the debtor, that is, whether the guarantor is required to
pay the creditor or the debtor (who would then have the funds to pay its
debt to the creditor). The underlying (that is, the debtor’s failure to make
scheduled payments or the occurrence of other events of default) could be
related to either the creditor’s receivable or the debtor’s liability.
ASC 460-10-15-5 notes that the payment the guarantor must make,
as described in ASC 460-10-15-4, is not limited to a payment in cash; rather,
payment can take the form of cash, financial assets, nonfinancial assets, shares
of the guarantor’s stock, or the provision of services.
Connecting the Dots
While the payment a guarantor may be required to make
can take the form of the provision of a service, a contract that
requires an entity to perform a service regardless of changes in an
underlying would not represent a guarantee and therefore would be
subject to other guidance (e.g., ASC 606-10). For example, if an entity
is required to perform health care claim services for another party,
that contract would not represent a guarantee within the scope of ASC
460-10. Rather, it would constitute a contract to perform services. If,
however, an entity agrees to provide a service to a guaranteed party on
the basis of another entity’s failure to properly perform this service,
such an arrangement may be subject to the recognition, measurement, and
disclosure provisions of ASC 460-10.
5.2.1.1 Financial Guarantees
ASC 460-10-15-4(a) describes financial guarantee contracts,
and ASC 460-10-55-2 indicates that common examples of such contracts
include, but are not limited to, the following:
- A financial standby letter of credit
- A market value guarantee on either a financial asset (such as a security) or a nonfinancial asset owned by the guaranteed party [e.g., real estate or a commodity]
- A guarantee of the market price of the common stock of the guaranteed party
- A guarantee of the collection of the scheduled contractual cash flows from individual financial assets held by a special-purpose entity
- 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.
For each of these contracts, the guarantor could be required
to make payments to the guaranteed party for a specified financial
obligation. The requirement to make payments is an important consideration
in the evaluation of whether an arrangement is within the scope of ASC 460.
If the guarantor is able to avoid payment, such as through specific clauses
limiting the requirement to make a payment (e.g., a material adverse change
clause, as further described in Section 5.2.1.1.1), the arrangement
would not be within the scope of ASC 460.
5.2.1.1.1 Financial Guarantees — Financial Standby Letters of Credit
ASC 460-10-20 defines a
financial standby letter of credit and a commercial letter of credit as
follows:
ASC 460-10 — Glossary
Financial
Standby Letter of Credit
An irrevocable undertaking
(typically by a financial institution) to
guarantee payment of a specified financial
obligation.
Commercial
Letter of Credit
A document issued typically by a
financial institution on behalf of its customer
(the account party) authorizing a third party (the
beneficiary), or in special cases the account
party, to draw drafts on the institution up to a
stipulated amount and with specified terms and
conditions; it is a conditional commitment (except
if prepaid by the account party) on the part of
the institution to provide payment on drafts drawn
in accordance with the terms of the document.
ASC 460-10-55-16(a) states that “[c]ommercial letters of credit and other
loan commitments, which are commonly thought of as guarantees of
funding, are not included in the scope of [ASC 460-10] because those
instruments do not guarantee payment of a money obligation and do not
provide for payment in the event of default by the account party.”
Therefore, entities must distinguish between financial standby letters
of credit, which are subject to ASC 460-10, and commercial letters of
credit, which are not subject to ASC 460-10.
A financial standby letter of credit is an irrevocable undertaking by an entity (e.g., a
bank) guaranteeing to the guaranteed party (e.g., a third-party seller
of goods) the payment of a specified financial obligation of a third
entity (e.g., a customer or account party). For example, if a customer
is unable to make a payment on an obligation to a seller of goods, the
bank (i.e., the guarantor) will make that payment. Because the issuer of
a financial standby letter of credit cannot avoid making a payment upon
a default of a third party, such letters of credit are within the scope
of ASC 460.
Footnote 5 of the Basis for Conclusions of Interpretation 45 states that a commercial letter of credit “is a
document issued typically by a financial institution on behalf of its
customer (the account party) authorizing a third party (the
beneficiary), or in special cases the account party, to draw drafts on
the institution up to a stipulated amount and with specified terms and
conditions; it is a conditional commitment (except when prepaid by the
account party) on the part of the institution to provide payment on
drafts drawn in accordance with the terms of the document.” A commercial
letter of credit is similar to a loan commitment. Neither of those
instruments possesses the characteristics in ASC 460-10-15-4(a) because
they do not guarantee payment of a money obligation and do not provide
for payment in the event of default by the account party. Like loan
commitments, commercial letters of credit customarily contain material
adverse change clauses or similar provisions that allow the issuing
institution (i.e., the bank) to avoid making a loan (or other payment)
if the borrower encounters financial difficulties after the instrument
is issued.
Example 5-1
Financial
Standby Letter of Credit
Company J is a purveyor of fine
meats and cheeses and is based in the United
States. Company J wishes to purchase $1 million of
goods from Company W, which is based in Italy, for
J to resell in the United States. While J is an
established company with a history of reselling
meats and cheeses, W has had no prior business
dealings with J and requests additional assurance
that it will ultimately collect amounts owed for
selling its products to J.
Accordingly, J obtains a
financial standby letter of credit from Company L
(i.e., the guarantor) for up to $1 million, which
guarantees payment to W (i.e., the guaranteed
party) in the event that J is unable to meet its
contractual financial obligation. The guarantee is
effective for up to one year from the issuance
date. In exchange for issuing the financial
standby letter of credit, L charges J a fee
commensurate with J’s credit evaluation and
collateral provided.
Upon receipt of evidence of the
financial standby letter of credit, W provides the
goods to J on June 1, 20X1, with payment due on
July 1, 20X1. As of July 1, 20X1, J is only able
to make a payment on $600,000 of its contractual
financial obligation. Therefore, L must provide
$400,000 to W.
Example 5-2
Commercial
Letter of Credit
Assume the same facts as in the
example above except that J is a newly
incorporated entity as of January 1, 20X1. Because
J does not have an established operating history,
to provide goods to J, W demands payment for the
goods upon delivery.
To ensure payment to W upon
delivery, J obtains from Bank T a commercial
letter of credit that allows W to draw down from
the bank up to $1 million upon J’s receipt of the
goods. Bank T charges J a fee commensurate with
J’s credit evaluation and collateral provided for
issuing the commercial letter of credit.
On June 1, 20X1, J receives the
goods from W. Accordingly, T makes a direct
payment to W for $1 million. As a result, J now
owes T $1 million. This arrangement is similar to
a loan commitment.
Example 5-3
Ability of a
Guarantor to Avoid Payment
Company J and Company V form a
joint venture (JV), and V issues a financial
standby letter of credit to the JV. If the JV does
not perform (i.e., defaults), V is obligated to
make payments to the financial institution that
issued a line of credit to the JV. Company V’s
investment in the JV is appropriately accounted
for under the equity method. The JV does not need
V’s approval to draw down on the line of
credit.
Company V’s guarantee of the
line of credit is within the scope of ASC
460-10-15-4(a) because V is required to make a
payment to the institution that issued the line of
credit if the JV defaults. Company V is unable to
avoid payment. The guarantee does not qualify for
the scope exception in ASC 460-10-25-1(g) for
guarantees made by a parent on a subsidiary’s debt
to a third party since V is not the JV’s parent
(i.e., it applies the equity method to account for
its investment in the JV).
Further, at the inception of the
guarantee, V does not factor the outstanding
balance of the line of credit into its conclusion
regarding whether the guarantee is within the
scope of ASC 460. As noted in ASC 460-10-25-2 and
discussed in Section 5.3.2, a
guarantee obligation consists of two components:
(1) a noncontingent portion arising from the
guarantor’s undertaking of “an obligation to stand
ready to perform over the term of the guarantee in
the event that the specified triggering events or
conditions occur” and (2) a contingent portion
representing the guarantor’s “obligation to make
future payments if those triggering events or
conditions occur.” At a minimum, when a guarantor
enters into the guarantee arrangement, it must
record a liability for the fair value of its
noncontingent obligation to stand ready to
perform. The amount of any subsequent balance
drawn down by the JV on its line of credit would
factor into the determination of the contingent
portion of the guarantee obligation; the amounts
JV expects to draw on the line of credit could
affect the fair value ascribed to the
noncontingent portion that is recognized at
inception of the guarantee liability.
Additional Scenario
If the scenario described above
was changed to specify that the JV needs V’s
approval before drawing down on the line of
credit, V’s guarantee of the line of credit would
not be within the scope of ASC 460. If the JV
needs V’s approval before drawing down on the line
of credit, V can avoid payment under the guarantee
by not providing approval to the JV. The guidance
in ASC 460 is applicable as soon as V gives
approval since, at that point, V cannot avoid its
contingent obligation to pay.
5.2.1.1.2 Financial Guarantees — Market Value Guarantees
A market value guarantee is a type of financial
guarantee that includes a guarantee of the price of a financial asset
(such as a security), a nonfinancial asset, or the common stock of a
guaranteed party. Payments are based on changes in the underlying that
is related to an asset, liability, or equity security of the guaranteed
party. This consideration is important because payments must be based on
such changes to be within the scope of ASC 460-10-15-4(a).
Option-based contracts in which any net potential
contingent payment flows only from the guarantor to the guaranteed party
are the most common type of market value guarantees. Option-based
contracts can take the form of a put option or call option. A put option
gives the holder the right, but not the obligation, to sell a specified
amount of an underlying at a certain price and time. A call option gives
the holder the right, but not the obligation, to buy a specified amount
of an underlying at a certain price and time. For these types of
contracts, only the issuer (writer) of the option could potentially
represent the guarantor. As further described below, these contracts may
be within the scope of ASC 460.
5.2.1.1.2.1 Market Value Guarantees — Put Options
There are two main considerations that entities
should evaluate to determine whether a written put option is within
the scope of ASC 460:
- Whether the written put option is a derivative in accordance with ASC 815.
- Whether the put option represents a freestanding instrument.
5.2.1.1.2.1.1 Evaluating Whether the Written Put Option Represents a Derivative in Accordance With ASC 815
In evaluating whether a written put option is
within the recognition and measurement provisions of ASC 460, an
entity should first assess whether the option is within the
scope of ASC 815. Written put options accounted for as
derivatives in accordance with ASC 815 are not subject to the
recognition and measurement provisions of ASC 460, as noted in
Section
5.3.1. However, the disclosure requirements of
ASC 460 apply to written put options that possess the
characteristics in ASC 460-10-15-4(a) even if those options are
accounted for as derivatives under ASC 815.
ASC 815-10
15-83 A
derivative instrument is a financial instrument or
other contract with all of the following
characteristics:
- Underlying, notional amount,
payment provision. The contract has both of the
following terms, which determine the amount of the
settlement or settlements, and, in some cases,
whether or not a settlement is required:
- One or more underlyings
- One or more notional amounts or payment provisions or both.
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract
can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
An entity’s evaluation of whether a written put
option is within the scope of ASC 460 may depend on the
settlement terms in the contract.
5.2.1.1.2.1.2 Gross-Settled Written Put Options
A written put option that must be gross-settled
is within the scope of ASC 460 since the issuer (the guarantor)
is contingently required to make payments to the option holder
on the basis of changes in an underlying asset, liability, or
equity security of the option holder (the guaranteed party). As
discussed in ASC 460-10-55-5, a written put option that must be
gross-settled by delivery of an asset related to the underlying
of the option possesses the characteristics described in ASC
460-10-15-4(a) irrespective of whether the entity knows whether
the option holder owns an asset or owes a liability related to
the underlying.
Written put options that must be gross-settled
will be accounted for as derivatives if the net settlement
characteristic in ASC 815-10-15-83(c) is present (e.g., if the
underlying asset is readily convertible to cash).
Connecting the Dots
For a contract to be considered a
derivative and accounted for under ASC 815, it must be
required or permitted to be net-settled, it “can readily
be settled net by a means outside the contract” (i.e., a
market mechanism), or it “puts the recipient in a
position not substantially different from net
settlement” (i.e., the underlying asset is readily
convertible to cash or is itself a derivative).
Therefore, an entity must carefully consider the
settlement provisions of written put options.
Written put options accounted for as derivatives
are not subject to the recognition and measurement provisions of
ASC 460 (see ASC 460-10-25-1(a)). However, as specified in ASC
460-10-50-1, the disclosure requirements of ASC 460 apply to
written put options that possess the characteristics in ASC
460-10-15-4(a) even if those options are accounted for as
derivatives under ASC 815. Accordingly, gross-settleable written
put options accounted for as derivatives (i.e., that meet the
net settlement characteristic as described above) are subject to
the disclosure requirements of ASC 460.
5.2.1.1.2.1.3 Net-Settled Written Put Options
As discussed in ASC 460-10-55-7, if a put option
is permitted or required to be net-settled, the issuer (the
guarantor) must assess whether it is probable that the option
holder (the guaranteed party), on or around the date of the put
option’s issuance, owns an asset or owes a liability related to
the underlying of the option. If it is probable that the holder
has such an asset or liability, the put option possesses the
characteristics described in ASC 460-10-15-4(a) and therefore is
within the scope of ASC 460 because the put option contractually
requires the writer of the option to purchase the asset or
liability related to the option’s underlying if the option is
exercised. In performing this assessment, the issuer must
consider its business relationship with the option holder and
other circumstances related to the issuance of the put option.
If the issuer has no basis for concluding that it is probable
that the option holder owns an asset or owes a liability related
to the underlying, the option is not a guarantee under ASC
460-10-15-4(a).
The assessment of whether the guaranteed party
owns an asset or owes a liability associated with the underlying
of the put option is performed only at inception of the option.
There is no reassessment of whether the guaranteed party owns
the underlying asset or owes the underlying liability during the
term of the option.
Generally, net-settled written put options are
(1) within the scope of ASC 815 and (2) accounted for as
derivatives. Written put options accounted for as derivatives
are not subject to the recognition and measurement provisions of
ASC 460 (see ASC 460-10-25-1(a)). However, as specified in ASC
460-10-50-1, the disclosure requirements of ASC 460 apply to
written put options that have the characteristics in ASC
460-10-15-4(a) even if those options are accounted for as
derivatives under ASC 815. Accordingly, net-settleable written
put options accounted for as derivatives are subject to the
disclosure requirements of ASC 460, provided that, as discussed
above, it is probable that the option holder owns an asset or
owes a liability related to the underlying on or around the date
of the issuance of the put option.
Example 5-4
Market
Value Guarantee — Interaction With Derivative
Accounting
Farmer enters into a put
option traded on the Chicago Mercantile Exchange
(CME) with Farmers Market. The put option gives
Farmer the right to sell 5,000 bundles of corn at
$10 per bundle to Farmers Market. Physical
settlement is contractually required for the put
option.
The written put option is not
subject to the recognition and measurement
provisions of ASC 460 because it is accounted for
as a derivative instrument in accordance with ASC
815. Although physical settlement is contractually
required for the put option, there is a market
mechanism to facilitate net settlement (i.e., the
put option is traded on the CME); therefore, the
option meets the net settlement criterion for a
derivative.
In contrast, assume that
Supplier enters into a put option with Clothing
Market under which Supplier has the right to sell
5,000 bundles of yarn at $10 per bundle to
Clothing Market. The put option is not traded on
an exchange, the yarn is not readily convertible
to cash, and physical settlement is contractually
required for the put option. In that case, the
written put option is subject to the recognition
and measurement provisions of ASC 460 since it is
not accounted for in accordance with ASC 815
because physical settlement is contractually
required for the put option and the option does
not allow for implicit net settlement.
Example 5-5
Determining Whether an Underlying Is Related to
an Asset or Liability of the Guaranteed Party
Company W sells a
weather-based derivative contract to Company X.
Contract payouts depend on whether rainfall
exceeds 5 inches in Seattle during January 20X1.
The contract is not within the scope of ASC 460.
Weather derivatives are typically option-based
contracts that involve a payment to the guaranteed
party on the basis of a climatic or geological
variable (e.g., whether a specified amount of
rainfall occurs). The characteristic in ASC
460-10-15-4(a) involves payments based on changes
in an underlying that is related only to an asset,
liability, or equity security of the guaranteed
party. Since the climatic variable is not an
asset, liability, or equity security of the
guaranteed party, the weather derivative is not
within the scope of ASC 460.
5.2.1.1.2.1.4 Evaluating Whether the Put Option Represents a Freestanding Instrument
ASC 815-40-20 defines a freestanding contract as
one entered into either “[s]eparate and apart from any of the
entity’s other financial instruments or equity transactions” or
“[i]n conjunction with some other transaction and is legally
detachable and separately exercisable.” Section
3.2.1 of Deloitte’s Roadmap Contracts on an
Entity’s Own Equity describes the
different considerations related to identifying freestanding
contracts that should be viewed as separate units of
account.
A written put option that is embedded (i.e., not
a freestanding instrument) in its underlying asset, liability,
or equity security does not possess the characteristics in ASC 460-10-15-4(a) because the guaranteed party’s asset is an investment in the entire contract (the puttable security) and not an investment in a nonputtable security. Therefore, a written put option embedded in its underlying security typically would be outside the scope of ASC 460. This concept is explained in paragraph A10 of the Basis for Conclusions of FASB Interpretation 45, which states, in part:
For example, the put option that is embedded in a puttable
bond (but is not accounted for separately as a derivative)
could be viewed by the investor (the guaranteed party) as a
guarantee against the market value of the remaining
instrument (a bond absent the put option) declining below
the put price; however, the embedded put option does not
meet characteristic (a) because the guaranteed party’s asset
is an investment in the entire contract, a puttable bond,
and not an investment in a nonputtable bond.
Example 5-6
Put Option
— Freestanding Contract
Entity X issues a structured
note that contains a written put option allowing
the holder, at maturity or upon a triggering
event, to put bonds issued by Entity Y to X in
exchange for the principal amount of the notes
issued by X plus the principal amount of the bonds
issued by Y.
In this example, the written
put option is not embedded in the structured note
but the underlying of the put option is a separate
bond issued by Y. Since the guarantee is not
considered embedded, it would be within the scope
of ASC 460, provided that it possesses the
characteristics in ASC 460-10-15-4(a).
5.2.1.1.2.2 Market Value Guarantees — Call Options
ASC Master Glossary
Call
Option
A contract that allows the
holder to buy a specified quantity of stock from
the writer of the contract at a fixed price for a
given period. See Option and Purchased Call
Option.
ASC 460 does not provide specific guidance on
written call options. Therefore, the writer of the option should
consider its business relationship with the holder and the other
circumstances related to the issuance of the option. If the writer
of the option has knowledge that the holder is purchasing the option
to cover a short position in the same asset as the underlying in the
option, the written call option is within the scope of ASC
460-10-15-4(a), since the writer of the call option is required to
transfer an asset to the option holder on the basis of the changes
in a liability of the option holder (i.e., the underlying short
position).
If the writer of the call option has no factual
basis to conclude that the holder of the call option is purchasing
the option to cover a short position in the asset, the written call
option is not within the scope of ASC 460, since the writer of the
call option does not have the information necessary to conclude that
the option holder has an underlying short position. In practice,
written call options are generally not accounted for as guarantees
because the writers of such options are typically unaware of whether
the purchaser has a short position in the same underlying asset.
Example 5-7
Evaluating
Whether a Call Option Is Within the Scope of ASC
460
A short position is created
when an entity sells a security or other asset
that it does not own. Such transactions occur
because the seller expects the price of the
security or other asset to decline. To settle the
short position, the entity must purchase the
security or other asset before the maturity of the
sale transaction so that the sale is “covered.”
For example, assume that on
April 1, 20X0, Trader A sells gold for $2,000 an
ounce to Entity B and that the settlement date is
December 15, 20X0. On July 1, 20X0, the price of
gold has declined to $1,800 an ounce. Trader A
expects that the price of gold will continue to
decline and will be lower as of the settlement
date of the short sale. However, A wants to “lock
in” a profit on the short sale. To do so, A
purchases an option to buy gold at $1,900 an ounce
from Entity C, a third party; the settlement date
is December 15, 20X0. (Note that the option
premium payable to purchase gold at $1,800 an
ounce [December 15, 20X0, settlement date] was too
expensive.)
Entity C would consider the
presence of the short position, to the extent
known, in determining whether the call option is
within the scope of ASC 460. If C is aware of A’s
short position, the call option written by C would
be within the scope of ASC 460. However, if C is
not aware of the short position and has no basis
for concluding that A is purchasing the option to
cover a short position in the asset, C’s written
call option would not be within the scope of ASC
460.
5.2.1.1.3 Financial Guarantees — Contractual Cash Flows of a Special-Purpose Entity
A guarantee of the contractual cash flows of the
financial assets or financial liabilities of a special-purpose entity
(SPE) is a type of financial guarantee. SPEs are distinct legal entities
whose permitted activities are significantly limited, as defined in the
legal documents that established the SPE, and that typically only hold
financial assets. Companies may use SPEs to sell financial assets, such
as receivables, to isolate financial risks (e.g., interest rate risk and
credit risk).
Example 5-8
Guarantee of
an SPE’s Receivables
Company X, a financial services
company, transfers certain mortgage receivables
that arose from its commercial property business
to a nonconsolidated SPE in exchange for cash
consideration. Company X guarantees the status of
the receivables transferred at the time of the
transfer to the SPE. For example, X guarantees
that the receivables transferred will not become
overdue by more than 180 days. If the transferred
mortgage receivables become overdue by more than
180 days, X will be obligated to make a cash
payment to the SPE.
This contract meets the
definition of a guarantee in accordance with ASC
460-10-15-4(a) as follows:
- It requires the guarantor (X) to make contingent payments to a guaranteed party (SPE) — Company X is required to make cash payments to the SPE in the event that the transferred receivables fail to perform in a manner as guaranteed at the time of transfer.
- It is related to an underlying — The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract) is a variable that is considered an underlying. In X’s case, a specified event, such as an event that brings to light the fact that a receivable becomes overdue would be considered a change related to an underlying.
- It is related to an asset, liability, or equity security of the guaranteed party — The underlying is related to the transferred mortgage receivables, which are assets of the SPE.
5.2.1.1.4 Financial Guarantees — Minimum Revenue Guarantees
Minimum revenue guarantees are a type of financial
guarantee. The ASC master glossary defines a minimum revenue guarantee
as a “guarantee granted to a business or its owners 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 minimum amount.” As noted
above, ASC 460-10-15-4(a) includes “[c]ontracts that contingently
require a guarantor to make payments (as described in the following
paragraph) 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.”
Connecting the Dots
A minimum revenue guarantee is within the scope of ASC 460-10
because the guarantee’s underlying (the business’s gross
revenue) is considered related to an asset or equity security of
the guaranteed party. For example, if the guaranteed party is
the owner of the business, the business’s gross revenues are
considered related to changes in the owner’s investment in the
business (i.e., an equity security of the guaranteed party). If,
however, the guaranteed party is the business itself, the
business’s gross revenues are considered related to changes in
the net assets of the business because of transactions with
customers.
ASC 460-10-55-10 gives an example of a minimum revenue
guarantee.
ASC 460-10
55-10
An example of the type of guarantee described in
paragraph 460-10-55-2(e) is a minimum revenue
guarantee granted to a new day-care center by a
corporation as an incentive for the center to
locate near the corporation’s main plant. The
corporation, as the guarantor, has agreed to make
monthly payments to the day-care center (the
guaranteed party) over a specified term for any
shortfall from the guaranteed minimum amount of
revenue for each month.
The example below
further illustrates a minimum revenue guarantee contract.
Example 5-9
Minimum Revenue Guarantee
A regional hospital recruits nonemployee
physicians to establish independent practices in
nearby communities. As part of an incentive
package, the regional hospital guarantees a
physician’s practice a minimum level of revenue
over a predetermined period (e.g., one year).
Thus, during this period, the physician will be
able to bill (or collect) a minimum amount of
monthly revenue from the private practice. If
actual monthly billings are below this minimum
amount, the regional hospital will pay the
physician for the difference. In exchange for this
guarantee, the physician agrees to offer services
for a specified period (e.g., three years). The
physician also agrees to provide on-call coverage
at the regional hospital in her area of
specialization.
According to the guarantee agreement, if the
physician fails to provide services for the
agreed-upon service period, the physician is
required to pay the regional hospital back for any
payments made under the guarantee (the clawback
feature). The terms of the agreement reduce the
amount due under the clawback feature on a pro
rata basis over the required service period. That
is, for each month the physician works, a portion
of the regional hospital’s clawback potential is
reduced.
This minimum revenue guarantee is within the
scope of ASC 460. Specifically, the scope of ASC
460-10-55-2(e) includes 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.”
Further, ASC 460-10-55-11 gives an example of a
guarantee that is within the scope of ASC
460-10-55-2(e) and states the following:
Another example is a guarantee granted to a
nonemployee physician by a not-for-profit health
care facility that has recruited the physician to
move to the facility’s geographical area to
establish a practice. The health care facility, as
the guarantor, has agreed to make payments to the
newly arrived physician (the guaranteed party) at
the end of specific periods of time if the gross
revenues (gross receipts) generated by the
physician’s new practice during that period of
time do not equal or exceed a specific dollar
amount. This Topic applies to minimum revenue
guarantees granted to physicians regardless of
whether the physician’s practice qualifies as a
business.
The regional hospital concludes that its
guarantee to the nonemployee physician meets the
criterion in ASC 460-10-15-4(a) and that it does
not qualify for one of the scope exceptions in ASC
460-10-15-7, as discussed in Section 5.2.2.
Initial Measurement
Section 5.3.2
discusses the recognition and measurement of a
guarantee liability. The regional hospital should
apply the guidance in ASC 460-10-30-2(b) and ASC
460-10-30-3 and 30-4, which require, at the
inception of the guarantee, recognition of a
liability that is equal to the greater of (1) the
estimated contingent loss (if probable) under ASC
450-20-25-2 or (2) the amount that satisfies the
fair value objective discussed in ASC
460-10-30-2(b). In estimating the liability, the
regional hospital should not rely solely on simple
averages of historical payouts under similar
arrangements. Rather, the estimate should be
refined on a contract-by-contract basis. For
example, if past patterns of revenue guarantees
varied because of discernible factors such as
geographic location, type of physician practice,
experience level of the physician, or amount of
the revenue guarantee or other commitments, the
regional hospital should consider such factors in
estimating the fair value of the stand-ready
obligation or the ASC 450 contingent minimum
revenue guarantee obligation.
Offsetting
Entry
Section 5.3.2.4
discusses the offsetting entry upon the initial
recognition of a guarantee liability. ASC
460-10-55-23 describes four situations involving
offsetting entries, none of which accurately
reflect the regional hospital’s circumstances.
However, ASC 460-10-55-23(a) indicates that “[i]f
the guarantee were issued in a standalone
transaction for a premium, the offsetting entry
would be consideration received (such as cash or a
receivable).”
Although the regional hospital
did not issue a guarantee for a premium, the
regional hospital concludes that ASC
460-10-55-23(a) would apply by analogy. The
regional hospital has received a commitment from
the physician to locate her practice to the region
for a specified number of years. If the physician
leaves before fulfilling her obligation, she must
repay the regional hospital a pro rata portion of
the payments received under the guarantee. These
commitments are a form of consideration. The
physician’s presence in the community has a
positive impact on the hospital’s financial
performance, since patients are more likely to
stay in the community to receive treatment and,
therefore, to use the hospital’s facilities. The
regional hospital is not providing a guarantee for
no consideration on a stand-alone basis, as
described in ASC 460-10-55-23(e) (i.e., the
guarantee is not within the scope of the guidance
on contributions in ASC 720-25).
The regional hospital can
conclude that its guarantee meets the definition of an asset in FASB Concepts Statement 8, Chapter
4. The physician’s obligation to operate a
practice in the regional hospital’s area (or pay
back certain amounts if the obligation is not
fulfilled) represents a probable future economic
benefit that the regional hospital has obtained as
a result of the contractual relationship with the
physician. Accordingly, the offsetting entry
should be an asset.
Subsequent
Accounting
Section 5.4
discusses the (1) subsequent accounting for a
guarantee liability and (2) offsetting entry, if
applicable. In determining the appropriate
subsequent accounting for the minimum revenue
guarantee liability and offsetting entry (i.e.,
the asset), the regional hospital considers that
the overriding principle of ASC 460 is the
recognition of a liability at the inception of a
guarantee and the derecognition of the remaining
carrying amount of that guarantee liability at the
end of the guarantee period.
In accordance with ASC
460-10-35-1 and 35-2, amortization should occur in
a systematic and rational manner over the period
of the guarantee (three years in the example
presented). At the end of the minimum revenue
guarantee period, no stand-ready obligation should
remain. That is, the only remaining liability
should be any unpaid guarantee benefits.
The offsetting entry (i.e., the
asset) should be amortized over the useful life of
the asset — generally the period the physician is
contractually required to stay in the community
(three years in the example). The regional
hospital should periodically assess the asset for
impairment.
ASC 460 does not permit
subsequent adjustments to the guarantee liability
or to the related asset on the basis of actual
cash payments under the guarantee. The stand-ready
obligation is separate from the ASC 450 contingent
liability for probable cash payments under the
guarantee. During the guarantee period, the
regional hospital will need to continually monitor
whether it should remeasure its contingent
liability in accordance with ASC 450.
As discussed above,
revenues are changes in a business’s net assets because of transactions
with customers. Expenses and net income also represent changes in a
business’s net assets. In addition, the form of an arrangement should
not override its substance in the determination of whether the
arrangement is a guarantee under ASC 460-10-55-2. Accordingly, certain
net income reimbursement arrangements and expense reimbursement
arrangements are within the scope of ASC 460-10-15-4(a), as illustrated
in the example below.
Example 5-10
Minimum
Revenue Guarantee — Expense Reimbursement
Assume the same facts as in
Example 5-9,
except that the hospital agrees to reimburse the
physician for allowable expenses that exceed a
stated amount up to a maximum reimbursable amount
(e.g., a reimbursement of expenses in excess of
$400,000 up to a maximum amount of $1 million).
Examples of allowable expenses include office
rent, equipment rental, and other similar expenses
associated with establishing and maintaining a
medical practice.
Although the guarantee is not
based on the level of the physician’s revenue, it
is within the scope of ASC 460-10-55-2(e). The
medical practice assistance agreement is similar
in substance to a minimum revenue guarantee. That
is, the substance of the medical practice
assistance is a guarantee of the performance (net
assets) of the physician’s practice.
Like a traditional minimum
revenue guarantee, a medical practice assistance
arrangement creates an obligation for the hospital
providing the protection. The substance of an
agreement to reimburse expenses of a physician’s
practice is a guarantee of the performance of the
physician’s practice. Accordingly, the medical
practice assistance is within the scope of the
recognition, measurement, and disclosure
provisions of ASC 460.
5.2.1.2 Performance Guarantees
ASC 460-10-15-4(b) defines a performance guarantee as a
contractual arrangement that “contingently require[s] a guarantor to make
payments . . . to a guaranteed party based on another entity’s failure to
perform under an obligating agreement.” An important item to note, as
highlighted in ASC 460-10-15-7(i), is that an entity’s guarantee of its own
performance is only within the scope of ASC 460 if it is related to the
entity’s past performance. Conversely, a guarantee of a third party’s
performance is subject to ASC 460 regardless of whether it is related to
future or past performance. This concept is illustrated in the example
below.
Example 5-11
Performance
Guarantees on an Entity’s Future
Performance
Company A engages Contractor C to
construct a building in accordance with certain
specifications outlined in the contract. In exchange
for a premium from C, Company B issues a guarantee
to A such that A is guaranteed compensation from B
if C fails to follow the contractual specifications
for the building.
The guarantee provided by B is
within the scope of ASC 460. Company B is providing
a guarantee to A for a third party’s future
performance in constructing the building.
ASC 460-10-55-12 lists common examples of performance
guarantees such as performance standby letters of credit, bid bonds, and
performance bonds. The ASC master glossary defines a performance standby
letter of credit as “[a]n irrevocable undertaking by a guarantor to make
payments in the event a specified third party fails to perform under a
nonfinancial contractual obligation.” This guarantee is within the scope of
ASC 460 because it contingently requires the guarantor to make payments to
the guaranteed party on the basis of another entity’s failure to perform
under an agreement.
Connecting the Dots
A financial standby letter of credit is a guarantee
within the scope of ASC 460-10-15-4(a), while a performance standby
letter of credit is within the scope of ASC 460-10-15-4(b). A
financial standby letter of credit requires the guarantor to make a
payment in the event of a third party’s default (i.e., failure to
pay a financial obligation), while a performance standby letter of
credit requires the guarantor to make a payment in the event that a
third party fails to perform a nonfinancial obligation.
5.2.1.3 Indemnifications
ASC 460-10-15-4(c) describes
indemnification agreements. Further, ASC 460-10-55-13 gives examples of
common types of indemnification arrangements that are within the scope of
ASC 460.
ASC 460-10
55-13 The following are
examples of contracts of the type described in
paragraph 460-10-15-4(c):
- 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.
- 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, as discussed in paragraph 460-10-55-18(a), 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.
- 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.
Indemnification agreements require the issuer (i.e., the
guarantor) to compensate the guaranteed party upon the occurrence of certain
conditional events. The examples in ASC 460-10-55-13 illustrate that for an
indemnification agreement to be within the scope of ASC 460, it can be
related to either (1) the future or past performance of another entity or
(2) the past performance of the issuing entity. In a manner similar to that
discussed in Section
5.2.1.2, when an entity issues an indemnification related to
its own performance, the indemnification is only within the scope of ASC 460
if it is related to the entity’s past performance.
The examples below
illustrate scenarios in which an entity indemnifies a third party.
Example 5-12
Indemnifications
for Losses by a Contracting Party
Company A engages Company B to
perform certain duties on behalf of A. Company A
indemnifies B for third-party damage claims and
lawsuits that could be filed against B in performing
the contracted services.
The indemnification provided by A is
within the scope of ASC 460. The indemnification
contingently requires A to make a payment to B on
the basis of changes in B’s contingent liability.
This indemnification possesses the characteristics
defined in ASC 460-10-15-4(c) and is within the
scope of ASC 460.
Example 5-13
Indemnification of Taxes in a Business Combination
Company C enters into an agreement to sell 100
percent of the outstanding stock in its wholly owned
subsidiary, Company Y, to Company D. Before the
sale, Y files a separate tax return in which a tax
position is taken that requires the recognition of a
liability for an unrecognized tax benefit. Because Y
filed a separate tax return, C is not directly
liable for any of Y’s tax obligations after the
sale. As part of the purchase agreement, C
indemnifies D for any future settlement with the tax
authority in connection with the uncertain tax
position taken by Y in its prior tax return.
Company C would not account for the tax
indemnification related to Y’s previously taken tax
position after the sale under ASC 740. Rather, by
indemnifying D for any loss related to Y’s prior tax
position, C has entered into a guarantee contract
that is within the scope of ASC 460-10-15-4(c) and
ASC 460-10-55-13(c). Therefore, C would recognize a
guarantee liability on the sale date and on each
reporting date thereafter in accordance with the
recognition and measurement provisions of ASC
460-10.
Company C makes the following
assumptions in recording journal entries as of the
date on which Y is sold:
-
The amount of Y’s uncertain tax benefit is $100 (i.e., Y recognizes this amount as a liability under ASC 740-10 before and after the sale).
-
Settlement of the indemnification liability would result in a tax deduction for C.
-
The initial guarantee liability determined under ASC 460-10 is $40.
-
Company C has an effective tax rate of 25 percent.
The journal entries recorded would be as follows:
The deferred tax entry is recognized because there is
a deductible temporary difference related to the
difference between the reported amount and the tax
basis of the indemnification liability (i.e., 25
percent of $40).
It is common for a party to issue indemnification agreements
(i.e., the guarantor) to a third party (i.e., the guaranteed party) in
connection with a contingent liability of the third party. The underlying’s
relationship to an unrecognized liability is irrelevant to the assessment of
whether the indemnification is within the scope of ASC 460. Therefore, such
an indemnification would be within the scope of ASC 460 even if the
guaranteed party has not recognized a liability. This conclusion is
consistent with the example in ASC 460-10-55-13(c) (see above).
The examples below
illustrate the analysis an entity must perform for such
indemnifications.
Example 5-14
Indemnifications
— Underlying Analysis
Company Z enters into an alliance
agreement with Company Y, an unrelated party, under
which Z and Y plan to jointly launch a generic
version of Product A. Product A is currently
patent-protected; thus, any launch of a generic
version would be an at-risk launch (i.e., at risk
for litigation). The following outcomes are possible
according to the terms of the alliance agreement:
- Scenario 1 — Companies Z and Y mutually agree to jointly launch a generic version of Product A. All profits and costs will be shared equally, and each company has agreed to indemnify the other for litigation costs in such a way that any costs incurred by either party will be shared equally.
- Scenario 2 — Either Z or Y can compel the other party to go forward with an at-risk launch of the generic version of Product A. The compelling party would receive 90 percent of the profits and cover 90 percent of the costs from the sale of the generic product. In addition, the compelling party agrees to indemnify the other party for 100 percent of any litigation costs that may be incurred.
- Scenario 3 — Companies Z and Y agree not to launch a generic version of Product A and effectively terminate the alliance agreement. Upon termination, Z and Y will share in any inventory losses equally.
In Scenarios 1 and 2, both Z and Y
can avoid placing themselves in a guarantor
capacity, since both parties have control over
whether they proceed with a particular scenario. The
analysis of these scenarios is discussed below.
Scenario 3 does not address an indemnification
arrangement.
Underlying
Analysis
The litigation indemnification in
the alliance agreement is within the scope of ASC
460. Indemnification agreements that contingently
require payments to be made on the basis of changes
in an underlying related to an asset, liability, or
equity security of the indemnified party are within
the scope of ASC 460, as stated in ASC
460-10-15-4(c). Scenarios 1 and 2 both include this
type of indemnification. From Z’s perspective, if
the terms of the litigation indemnification included
in the alliance agreement become effective, these
terms will contingently require Z to make payments
to Y on the basis of changes in Y’s contingent
liability associated with potential litigation — the
underlying. Although the underlying is not related
to a recognized asset, liability, or equity security
of the indemnified party, the change in an
underlying related to an unrecognized contingent
liability is within the scope of ASC 460. Since the
indemnification possesses the characteristics
defined in ASC 460-10-15-4(c), it is within the
scope of ASC 460.
Recognition
of a Stand-Ready Obligation
Company Z should not recognize a
stand-ready obligation under ASC 460 until it places
itself in a guarantor capacity. At the inception of
the alliance agreement, Z had not yet obligated
itself to contingently make payments to Y. The
decision that would place Z in a stand-ready
capacity to indemnify future litigation costs to Y
is currently within Z’s control; that event had not
yet occurred as of inception and may never occur.
Under Scenario 1, Z would control the decision to
mutually agree to go forward with an at-risk launch
because mutual agreement requires the consent of
both parties and would obligate Z to stand ready to
perform under the indemnification. Under Scenario 2,
Z would control the decision about whether to compel
Y to go forward with an at-risk launch. Upon
compelling Y in this scenario, Z would become
obligated to stand ready to perform under the
indemnification. Company Z should record a
stand-ready obligation under ASC 460 when the
litigation indemnifications under either Scenario 1
or Scenario 2 become effective.
Example 5-15
Indemnifications
— Underlying Analysis for Contingent
Liabilities
Company A has in the past issued
certain indemnifications to underwriters and is
likely to issue similar indemnifications in the
future. The terms of these indemnifications are as
follows:
The Company agrees
to indemnify and hold harmless each underwriter,
the directors, officers, employees, and agents of
each underwriter and each person who controls any
underwriter, within the meaning of either the Act
or the Exchange Act, against any and all losses,
claims, damages, or liabilities, joint or several,
to which they or any of them may become subject
under the Act, the Exchange Act, or other federal
or state statutory law or regulation, at common
law or otherwise, insofar as such losses, claims,
damages, or liabilities (or actions in respect
thereof) (1) arise out of or are based on any
untrue statement or alleged untrue statement of a
material fact contained in the registration
statement as originally filed or in any amendment
thereof, or in the basic prospectus, any
preliminary final prospectus or the final
prospectus, or in any amendment thereof or
supplement thereto, or (2) arise out of or are
based on the omission or alleged omission to state
therein a material fact required to be stated
therein or necessary to make the statements
therein not misleading.
The above indemnification is subject
to the recognition and measurement provisions of ASC
460. Under ASC 460-10-15-4(c), an indemnification is
within the scope of ASC 460 if contingent payments
are “based on changes in an underlying that is
related to an asset, a liability, or an equity
security of the indemnified party.” Since A would be
required to make payments to the underwriter in the
event that the underwriter is held liable for
losses, damages, or claims resulting from any untrue
statement contained in a registration statement, A
has satisfied the contingent payment condition.
A specified event, such as a
requirement by a court of law requiring an
underwriter to make a payment to a third party
because of an untrue statement in a registration
statement, would be considered an underlying. Thus,
A has also satisfied the “underlying” condition in
ASC 460-10-15-4(c).
ASC 460-10-15-4(c) also requires
entities to assess whether the underlying is related
to an asset, liability, or equity security of the
underwriter. In A’s case, the underlying is related
to a contingent liability of the underwriter that
may arise if the future specified event occurs. As
noted above in this section, an indemnification in
which the underlying is an unrecognized contingent
liability of the indemnified party is within the
scope of ASC 460.
Example 5-16
Indemnification
— Environmental Liability
Company A sells a building to
Company B. As part of the sale, A indemnifies B from
future claims resulting from environmental
liabilities existing on or before the date of sale.
Assume that on the date of purchase, B is not
required to recognize an environmental liability
under GAAP.
The indemnification provided by A to
B is within the scope of ASC 460. The
indemnification applies to environmental
contamination that occurred before the date of sale
and may result in a liability to B because of
changes in environmental laws or subsequent
discovery of contamination. ASC 460-10-15-4(c)
states that “[i]ndemnification 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” are within the scope of ASC
460.
Company A’s indemnification of B
from changes in B’s contingent liability related to
the discovery of contamination that occurred on or
before the date of sale is within the scope of ASC
460 because it meets the definition of a guarantee
(A is assuming the risk of the environmental
liabilities resulting from the condition of the
building at the time of sale). It does not matter
that the liability has not been recognized in the
financial statements of the guaranteed party.
5.2.1.4 Indirect Guarantees of the Indebtedness of Others
ASC 460-10-15-4(d) describes indirect guarantees of the indebtedness of others. Indirect guarantees were originally within the scope of FASB Interpretation 34, which was later incorporated into FASB Interpretation 45 (codified in ASC 460). Paragraph 9 of FASB Interpretation
34 clarifies the difference between a direct guarantee and an indirect
guarantee and states:
Some respondents requested
clarification of the definition of an indirect guarantee and the
difference between direct and indirect guarantees of indebtedness of
others. Both direct and indirect guarantees of indebtedness involve
three parties: a debtor, a creditor, and a guarantor. In a direct
guarantee, the guarantor states that if the debtor fails to make payment
to the creditor when due, the guarantor will pay the creditor. If the
debtor defaults, the creditor has a direct claim on the guarantor. Under
an indirect guarantee, there is an agreement between the debtor and the
guarantor requiring the guarantor to transfer funds to the debtor upon
the occurrence of specified events. The creditor has only an indirect
claim on the guarantor by enforcing the debtor’s claim against the
guarantor. After funds are transferred from the guarantor to the debtor,
the funds become available to the creditor through its claim against the
debtor.
The ASC master glossary
defines both direct and indirect guarantees of indebtedness.
ASC Master Glossary
Direct Guarantee
of Indebtedness
An agreement in which a guarantor
states that if the debtor fails to make payment to
the creditor when due, the guarantor will pay the
creditor. If the debtor defaults, the creditor has a
direct claim on the guarantor.
Indirect
Guarantee of Indebtedness
An agreement that obligates the
guarantor to transfer funds to a debtor upon the
occurrence of specified events, under conditions
whereby:
- After funds are transferred from the guarantor to the debtor, the funds become legally available to creditors through their claims against the debtor
- Those creditors may enforce the debtor’s claims against the guarantor under the agreement.
In contrast, with a direct guarantee
of indebtedness, if the debtor defaults, the
creditor has a direct claim on the guarantor.
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.
As demonstrated in the
graphic below, a creditor has a direct claim on a guarantor in a direct
guarantee of indebtedness. Conversely, a creditor may enforce the debtor’s
claim against a guarantor in an indirect guarantee of indebtedness rather
than making a claim against the guarantor itself.
The example in ASC
460-10-55-15 illustrates an indirect guarantee of the indebtedness of
others, as that term is addressed in ASC 460-10-15-4(d).
ASC 460-10
55-15 A community foundation
has a loan guarantee program to assist
not-for-profit entities (NFPs) in obtaining bank
financing at a reasonable cost. Under that program,
the community foundation issues a guarantee of an
NFP’s bank debt. That guarantee is within the scope
of this Topic, and on the issuance of the guarantee,
the community foundation would recognize a liability
for the fair value of that guarantee. The issuance
of that guarantee would not be considered merely a
conditional promise to give under paragraphs
958-605-25-11 through 25-13 because, upon the
issuance of the guarantee, the NFP will have
received the gift of the community foundation’s
credit support. That credit support enables the NFP
to obtain a lower interest rate on its
borrowing.
The example below further
illustrates an indirect guarantee of the indebtedness of others.
Example 5-17
Indirect
Guarantee of the Indebtedness of Others
Company A is a distributor of mobile
devices. Company B provides wireless communication
services to consumers and often leases mobile
devices to its customers. Company B leases its
mobile devices from Company L (the “head lease”),
which B then uses to lease to its customers (the
“sublease”). Assume that B has not applied ASC 842
and therefore has not recognized any assets or
liabilities related to these leases (i.e., they are
operating leases).
Companies A and B enter into a
program (the “Program”) under which B will offer its
customers the right to upgrade or replace their
mobile devices at any time. The customer will pay B
$5 a month for this right in addition to an
incremental fee upon upgrade. This incremental fee
is determined on the basis of the quality of the
device as well as the date on which the upgrade
occurs throughout its sublease term.
Under the Program, A assumes B’s
obligations in exchange for a portion of the monthly
fee from the customer and the incremental upgrade
fee. Upon an upgrade, A will pay B an amount that
represents the purchase price of the device, less an
amount that reflects the lease payments previously
received by B from its customer. Company B will then
use these proceeds to repay its head lease payment
to L. Company A cannot cancel this agreement with B
and is obligated to perform under the Program.
Company A concludes that the Program
represents an obligation to B rather than to L.
Company L and its creditors must look solely to B
for consideration related to early termination of
the head lease. Company B has a direct claim for
payment from A regardless of whether B satisfies its
obligation to L. If B did not make the payment to L
for an early termination of the head lease, L could
pursue a claim against A to make its payment under
the Program to B, which L could then recover. The
Program represents an obligation of A that is based
on changes in an underlying related to an
unrecognized asset and unrecognized liability of
B.
5.2.2 Transactions Outside the Scope of ASC 460
Guarantee arrangements that qualify as one of the four types of
arrangements discussed in ASC 460-10-15-4, but that are subject to a scope
exception in ASC 460-10-15-7, are outside the scope of ASC 460. Such
arrangements should be accounted for under other applicable authoritative
literature such as that on revenue recognition, derivative accounting, leasing,
or industry-specific topics. The scope exceptions in ASC 460-10-15-7 are
included because other Codification topics already address the relevant
accounting considerations.
ASC 460-10
15-7 The guidance in this
Topic does not apply to the following types of guarantee
contracts:
- A guarantee or an indemnification that is excluded from the scope of Topic 450 (see paragraph 450-20-15-2 — primarily employment-related guarantees)
- A lessee’s guarantee of the residual value of the underlying asset at the expiration of the lease term under Topic 842
- A contract that meets the characteristics in paragraph 460-10-15-4(a) but is accounted for as variable lease payments under Topic 842
- A guarantee (or an indemnification) that is issued by either an insurance entity or a reinsurance entity and accounted for under Topic 944 (including guarantees embedded in either insurance contracts or investment contracts)
- A contract that meets the characteristics in paragraph 460-10-15-4(a) but provides for payments that constitute a vendor rebate (by the guarantor) based on either the sales revenues of, or the number of units sold by, the guaranteed party
- A contract that provides for payments that constitute a vendor rebate (by the guarantor) based on the volume of purchases by the buyer (because the underlying relates to an asset of the seller, not the buyer who receives the rebates)
- A guarantee or an indemnification whose existence prevents the guarantor from being able to either account for a transaction as the sale of an asset that is related to the guarantee’s underlying or recognize in earnings the profit from that sale transaction
- A registration payment arrangement within the scope of Subtopic 825-20 (see Section 825-20-15)
- A guarantee or an indemnification of an entity’s own future performance (for example, a guarantee that the guarantor will not take a certain future action)
- A guarantee that is accounted for as a credit derivative at fair value under Topic 815.
- A sales incentive program in which a manufacturer contractually guarantees to reacquire the equipment at a guaranteed price or guaranteed prices at a specified time, or at specified time periods (for example, the entity is obligated to reacquire the equipment or the entity is obligated at the customer’s request to reacquire the equipment). That program shall be evaluated in accordance with Topic 606 on revenue from contracts with customers, specifically the implementation guidance on repurchase agreements in paragraphs 606-10-55-66 through 55-78.
For related implementation guidance, see
Section 460-10-55.
5.2.2.1 Scope Exceptions That Are Outside the Scope of ASC 450
Section
2.2 discusses the scope exceptions in ASC 450-20-15-2, which
include (1) stock issued to employees (addressed in ASC 718), (2) certain
employment-related costs (addressed in ASC 710, ASC 712, and ASC 715),1 (3) uncertainty in income taxes (addressed in ASC 740-10-25), and (4) accounting and reporting by insurance entities (addressed in ASC 944). Because FASB Interpretation 45 (codified in ASC 460) was originally issued as an interpretation of FASB Statement 5 (ASC 450), the scope of ASC 460
does not include contingencies and uncertainties that are outside the scope
of ASC 450.
Connecting the Dots
A company’s indemnification of its employees against
litigation that arises in connection with their employment is
outside the scope of ASC 460 because it is considered an
employment-related cost that is outside the scope of ASC 450.
Similarly, a company’s indemnification of its nonemployee directors,
such as board members, is also outside the scope of ASC 460 since
nonemployee directors are considered employees as defined by ASC
718-10-20.
5.2.2.2 Guarantee or Indemnification of an Entity’s Own Future Performance
As discussed in Section 5.2.1.3, to
be within the scope of ASC 460, an indemnification can be related to either
(1) the future or past performance of another entity or (2) the past
performance of the issuing entity. That is, the scope exception in ASC
460-10-15-7(i) specifically excludes guarantees or indemnifications of an
entity’s own future performance, which is illustrated in the example
below.
Example 5-18
Guarantees of an
Entity’s Own Performance — Employment-Related
Arrangements
Company A has many employees who are
paid in accordance with a union contract. The
contract stipulates that, in the event that a
facility is idled, employees will continue to
receive payments throughout the contract period in
amounts equaling approximately 95 percent of their
base pay.
This provision of the union contract
is not a guarantee within the scope of ASC 460 both
in circumstances in which the idling of the facility
is within A’s control and in circumstances outside
A’s control. ASC 460-10-15-7(i) excludes guarantees
of an entity’s own future performance from the scope
of ASC 460 (see further discussion below).
However, although the guarantee is
not within the scope of ASC 460, A is still required
to apply the recognition and disclosure requirements
of ASC 450 and ASC 712 for its postemployment
obligations under the union contract, as described
in Section 2.2.2.
ASC 712 establishes the accounting
for benefits provided to former or inactive
employees, their beneficiaries, and covered
dependents. ASC 712-10-20 defines inactive employees
as “[e]mployees who are not currently rendering
service to the employer and who have not been
terminated. They include those who have been laid
off and those on disability leave, regardless of
whether they are expected to return to active
status.”
In addition, ASC 712-10-05-5 gives
the following examples of other postemployment
benefits:
“Other
postemployment benefits include, but are not
limited to, the following:
- Salary continuation
- Supplemental unemployment benefits
- Severance benefits
- Disability-related benefits (including workers’ compensation)
- Job training and counseling
- Continuation of benefits such as health care benefits and life insurance coverage.”
As described in Section
2.2.2, an entity accounts for certain
postemployment contracts in accordance with ASC 450
by applying ASC 712; therefore, such contracts could
be within the scope of ASC 460 (i.e., the scope
exception in ASC 460-10-15-7(a) does not apply).
Accordingly, A must determine whether the scope
provisions of ASC 460-10-15-4 apply to the
guarantee. The table below summarizes whether the
guarantee is within the scope of ASC 460.
Scope
|
Within Scope?
|
---|---|
ASC 460-10-15-4(a) —
“Contracts that contingently require a guarantor
to make payments (as described in [ASC
460-10-15-5]) 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.”
|
No — The guaranteed party
would not record a related asset, liability, or
equity security in connection with the
contract.
|
ASC 460-10-15-4(b) —
“Contracts that contingently require a guarantor
to make payments (as described in [ASC
460-10-15-5]) to a guaranteed party based on
another entity’s failure to perform under an
obligating agreement (performance
guarantees).”
|
No — There is no third-party
performance guarantee.
|
ASC 460-10-15-4(c) —
“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.”
|
No — There is no
indemnification agreement. Furthermore, the entity
is guaranteeing its own future performance.
|
ASC 460-10-15-4(d) —
“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.”
|
No — There is no indirect
guarantee of the indebtedness of others.
|
As outlined in the table, the
guarantee does not meet the scope requirements in
ASC 460-10-15-4 and is therefore outside the scope
of ASC 460. This conclusion is appropriate because
the guarantee is considered related to the entity’s
own future performance.
5.2.2.3 Transactions Accounted for Under Other Applicable GAAP
ASC 460-10-15-7 lists scope exceptions (in addition to those
described in Sections
5.2.2.1 and 5.2.2.2) under which an entity would not apply ASC 460 to
certain transactions that are addressed in other Codification topics.
5.2.2.3.1 Lease Accounting
Under ASC 460-10-15-7(c), the scope of ASC 460 excludes
a contract that has the characteristics in ASC 460-10-15-4(a) but is
accounted for as variable lease payment under ASC 842.
5.2.2.3.2 Insurance Accounting
ASC 460-10-15-7(d) excludes from the scope of ASC 460 a
“guarantee (or an indemnification) that is issued by either an insurance
entity or a reinsurance entity and accounted for under Topic 944
(including guarantees embedded in either insurance contracts or
investment contracts).”
5.2.2.3.3 Revenue Recognition
ASC 460-10-15-7(e), (f), and (k) contain certain scope
exceptions from ASC 460 for items within the scope of ASC 606 related to
revenue from contracts with customers. As noted in ASC 460-10-15-7(e)
and (f), “payments that constitute a vendor rebate” are generally
outside the scope of ASC 460 since the accounting for such payments is
addressed by ASC 606, specifically with respect to consideration payable
to a customer as described in Chapter 6 of Deloitte’s Roadmap
Revenue
Recognition. Furthermore, as described in ASC
460-10-15-7(k), sales incentive programs in which a manufacturer
contractually guarantees to reacquire the equipment at a guaranteed
price are outside the scope of ASC 460 and are accounted for under ASC
606, as described in Section 8.7 of Deloitte’s Roadmap Revenue
Recognition.
5.2.2.3.4 Guarantees That Prevent a Sale or Recognition of Profits From That Sale
ASC 460-10-15-7(g) excludes from the scope of ASC 460
guarantee arrangements whose existence prevents the guarantor from being
able to either account for a transaction as the sale of an asset that is
related to the guarantee’s underlying or recognize in earnings the
profit from that sale transaction. The FASB’s rationale for including
this scope exception was that if the guarantee serves as an impediment
to sale accounting (under ASC 860) or to recognizing the profit from a
sale, the guarantor and guaranteed party will both have the asset on
their books. The FASB considered that other GAAP adequately addressed
the accounting for such situations and therefore did not want to include
guidance in ASC 460.
5.2.2.3.5 Registration Payment Arrangements
ASC 460-10-15-7(h) excludes from the scope of ASC 460 a
registration payment arrangement within the scope of ASC 825-20 (see ASC
825-20-15).
5.2.2.3.6 Credit Derivatives
ASC 460-10-15-7(j) excludes from the scope of ASC 460
credit derivatives accounted for in accordance with ASC 815. Although
credit derivatives that are within the scope of ASC 815 would
nevertheless be outside the scope of ASC 460’s recognition and
measurement provisions under ASC 460-10-25-1(a), this exception
clarifies that the disclosure provisions of ASC 460 do not apply to
credit derivatives. Rather, the disclosures that apply to these
instruments are addressed in ASC 815-10-50-4H and ASC 815-10-50-4J
through 50-4L.
The ASC master glossary
defines a credit derivative as follows:
ASC Master Glossary
Credit
Derivative
A derivative instrument that has
both of the following characteristics:
- One or more of its
underlyings are related to any of the following:
- The credit risk of a specified entity (or a group of entities)
- An index based on the credit risk of a group of entities.
- It exposes the seller to potential loss from credit-risk-related events specified in the contract.
Examples of credit derivatives
include, but are not limited to, credit default
swaps, credit spread options, and credit index
products.
The example below
illustrates a credit derivative that is not subject to the provisions of
ASC 460.
Example 5-19
Credit
Derivatives
Bank A makes a loan to Customer
B. To hedge its credit risk related to the loan, A
enters into a credit derivative with Bank C. Under
the credit derivative, C agrees to pay A if B’s
credit rating declines below investment-grade, B
defaults on the loan, or B defaults on any other
debt obligation.
For C, the credit derivative is
accounted for under ASC 815. Therefore, it
qualifies for the scope exception from ASC 460
under ASC 460-10-15-7(j). Moreover, all
derivatives accounted for under ASC 815 qualify
for the scope exception applicable to recognition
and measurement under ASC 460-10-25-1(a) and ASC
460-10-30-1.
For C, the credit derivative is
also not subject to the disclosure provisions of
ASC 460. Rather, the disclosure requirements in
ASC 815-10-50 apply.
Footnotes
1
As discussed in Section 2.2.2, certain
postemployment benefits are within the scope of ASC 450.
5.3 Initial Recognition and Measurement Provisions of ASC 460
5.3.1 Guarantees Not Subject to Recognition and Measurement Provisions of ASC 460
For certain types of guarantees, the guarantor
is exempt from the recognition of such a liability but is still subject to the
financial statement disclosure requirements in ASC 460-10-50 (see Section 5.5).
ASC 460-10
25-1 The following types of
guarantees are not subject to the recognition provisions
of this Subsection:
- A guarantee that is accounted for as a derivative instrument at fair value under Topic 815.
- A product warranty or other guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party (see paragraph 460-10-15-9 for related guidance).
- A guarantee issued in a business combination or an acquisition by a not-for-profit entity that represents contingent consideration (as addressed in Subtopics 805-30 and 958-805).
- A guarantee for which the guarantor’s obligation would be reported as an equity item rather than a liability under generally accepted accounting principles (GAAP) (see Topics 480 and 505).
- A guarantee by an original lessee that has become secondarily liable under a new lease that relieved the original lessee from being the primary obligor (that is, principal debtor) under the original lease, as discussed in paragraph 842-20-40-3. This exception shall not be applied by analogy to other secondary obligations.
- A guarantee issued either between parents and their subsidiaries or between corporations under common control.
- A parent’s guarantee of its subsidiary’s debt to a third party (whether the parent is a corporation or an individual).
- A subsidiary’s guarantee of the debt owed to a third party by either its parent or another subsidiary of that parent.
30-1 The
types of guarantees identified in paragraph 460-10-25-1
are not subject to the initial measurement provisions of
this Subsection.
5.3.1.1 Transactions Accounted for Under Other Applicable GAAP
Certain arrangements, such as those described in ASC
460-10-25-1(a) and ASC 460-10-25-1(c)–(e), are outside the scope of the
recognition and measurement provisions of ASC 460 because the accounting
treatment is prescribed by other U.S. GAAP. Product warranties and other
guarantee contracts for which the underlying is related to the functional
performance of nonfinancial assets that are owned by the guaranteed party
are addressed separately in ASC 460. See Section 5.6 for more information.
5.3.1.2 Guarantees Between Commonly Controlled Entities
Guarantees that are issued between a parent and its
subsidiary or among entities under common control are subject to an
exception from the recognition and measurement guidance in ASC 460 (see ASC
460-10-25-1(f)–(h)). These exceptions are written in the context of the
entity’s preparation of financial statements (i.e., consolidated financial
statements or stand-alone financial statements of either the parent or the
subsidiary).
With respect to the consolidated financial statements, the following
guarantees are not subject to ASC 460’s recognition and measurement
guidance:
- Any guarantee issued by any entity in the consolidated group to another entity in the consolidated group (i.e., both the guarantor and the guaranteed party are included in the consolidated financial statements).
- Any guarantee of debt recognized in the consolidated financial statements, regardless of the entity within the consolidated group that (1) is the obligor of the debt and (2) issues the guarantee.
Guarantees that are issued by an investor directly or indirectly to an equity
method investee (e.g., guarantees of the investee’s debt) are not subject to
the scope exception discussed above. Furthermore, while the investor that
issues such a guarantee must perform in the event that the underlying event
for which payment is required occurs, it is not appropriate for the investor
to conclude that such a guarantee represents a guarantee of its future
performance.
Connecting the Dots
ASC 460-10-25-1(f)–(h) and ASC 460-10-50-1 imply that guarantees between entities under common control are subject to the disclosure provisions in ASC 460 but are outside the scope of ASC 460’s recognition and measurement guidance. However, paragraph A23 of the Basis for Conclusions of FASB Interpretation 45 indicates
that in consolidated financial statements, the parent’s
guarantee of a subsidiary’s debt to a third party is not “subject to
the recognition, measurement, and disclosure provisions of the
Interpretation.”
In the consolidated financial statements that
include both the guarantor (e.g., parent) and the obligor (e.g.,
subsidiary) of debt that is recognized in the consolidated financial
statements, the guarantee is outside the scope of ASC 460’s
disclosure provisions because the debt obligation is included and
fully disclosed in the consolidated financial statements. The
guarantee is akin to a guarantee of the consolidated entity’s own
future performance, as described in ASC 460-10-15-7(i).
SEC Considerations
While certain guarantees involving entities within a
consolidated group are outside the scope of the recognition,
measurement, and disclosure provisions of ASC 460, SEC regulations
include specific disclosure requirements for registered guaranteed
securities. Debt or preferred stock registered under the Securities
Act may be guaranteed by one or more affiliates of the issuer.
Guarantees of registered securities are considered securities
themselves under the Securities Act. As a result, registration of
guaranteed securities under the Securities Act can result in a
requirement for both the issuer of the guaranteed security and the
guarantor(s) of the security to file Exchange Act periodic reports
(i.e., Form 10-K and Form 10-Q). However, in most circumstances, the
SEC has provided relief from this requirement for each issuer and
guarantor. Under Regulation S-X, Rules 3-10 and 13-01, entities can
provide alternative financial disclosures or qualitative disclosures
in lieu of such separate financial statements when certain criteria
have been met. For more information, see Deloitte’s Roadmap
SEC
Reporting Considerations for Guarantees and
Collateralizations.
Example 5-20
Consolidated Financial Statements — Guarantees
Outside the Scope of ASC 460
In accordance with ASC 810, Parent A is preparing
consolidated financial statements that include both
Subsidiary B and Subsidiary C. Parent A concludes
that each of the guarantees discussed below are
outside the scope of ASC 460’s recognition,
measurement, and disclosure provisions.
Parent’s
Direct Guarantee of Subsidiary’s Indebtedness
Bank D, a third party, issues $100
million of debt to B. In conjunction with this
issuance, A issues a guarantee directly to D, on
behalf of B, stating that in the event of B’s
default on the debt, A will make all remaining
scheduled payments to D.
Parent A presents the $100 million
debt obligation in its consolidated financial
statements and concludes that this guarantee
represents a direct guarantee of indebtedness.
Because A presents the underlying obligation (i.e.,
the $100 million debt) in its consolidated financial
statements, this guarantee represents a guarantee of
A’s own performance; accordingly, A would not
account for the guarantee in accordance with the
recognition and measurement provisions of ASC 460,
nor would it provide the disclosures required by ASC
460.
Parent A further observes that, with
respect to its consolidated financial statements,
disclosures related to this guarantee would not
provide any incremental information relevant to
users of its financial statements, since A has
properly disclosed all relevant information about
the debt obligation. Further, A observes that if it
had recognized a guarantee obligation related to B’s
debt, this obligation would need to be eliminated in
consolidation.
Parent A’s conclusion would be
similar if this debt arrangement was reversed. If D
had issued $100 million in debt proceeds to A, and B
had guaranteed payment to D upon A’s default, the
analysis described above would be equally
applicable.
Parent’s
Indirect Guarantee of Subsidiary’s
Indebtedness
In a separate transaction, B borrows
$50 million from Bank E, a third party. As part of
B’s agreement with E, A agrees to guarantee B’s
obligation to Bank E. If B defaults, A will transfer
funds to B so that B can pay E. Parent A presents
the $50 million obligation in its consolidated
financial statements and concludes that this
represents an indirect guarantee of the indebtedness
of others. For the same reasons described above
related to the direct guarantee of the indebtedness
of others, A concludes that this guarantee is
outside the scope of the recognition, measurement,
and disclosure provisions of ASC 460.
Subsidiary’s
Direct Guarantee of Another Subsidiary’s
Indebtedness
Subsidiary C borrows $20 million
from Bank F, a third party. Subsidiary B provides a
direct guarantee to F that it will make all
remaining scheduled payments to F in the event of
C’s default. Parent A presents this $20 million
obligation in its consolidated financial statements.
With respect to its consolidated financial
statements, A concludes that this guarantee between
entities under common control is outside the scope
of ASC 460’s recognition, measurement, and
disclosure provisions because A already presents
this obligation in its consolidated financial
statements; therefore, this guarantee is a guarantee
of A’s own performance.
In the stand-alone financial statements of a guarantor that does not
consolidate the financial statements of a commonly controlled entity that is
the obligor of debt, the guarantor is subject to ASC 460’s disclosure
provisions even though the recognition and measurement guidance in ASC 460
does not apply. For example, if Subsidiary A guarantees the debt of its
sister company, Subsidiary B, to a third party, A must disclose this fact in
its stand-alone financial statements since the affiliate’s debt is not
included in the guarantor’s stand-alone financial statements. However, in
that case, the guarantee would be outside the scope of the recognition and
measurement provisions in accordance with ASC 460-10-25-1(h).
Upon the deconsolidation of
a subsidiary, the parent entity and subsidiary should account for such
guarantee arrangements in accordance with ASC 460 since they no longer would
qualify for the recognition and measurement scope exception in ASC
460-10-25-1(f)–(h). This conclusion is illustrated in the examples
below.
Example 5-21
Impact of Deconsolidation of a Subsidiary
Company A, a calendar-year-end entity, owns 100
percent of Company B, another calendar-year-end
entity, and includes B in its consolidated financial
statements. Company A guarantees B’s debt to a
third-party bank. Both the debt agreement and the
guarantee were entered into on July 1, 20X2; no
provisions of the debt agreement or the guarantee
have since been modified. With respect to its
consolidated financial statements for the year ended
December 31, 20X2, A concludes that the guarantee is
outside the scope of ASC 460 because of the scope
exception in ASC 460-10-25-1(g).
Subsequently, on December 15, 20X3, A reduces its
ownership interest in B to 49 percent. Because B is
not a variable interest entity under ASC 810, A
deconsolidates B in accordance with ASC 810. Upon
its deconsolidation of B, A should recognize its
guarantee of B’s debt to the third-party bank at its
then fair value.
Although the terms of the guarantee have not changed,
the relationship between the guarantor, A, and the
subject of the guarantee, B, has been modified upon
the reduction in ownership, which occurred after
December 31, 20X2. Company A’s reduced ownership
interest in B and deconsolidation of B eliminates
the relationship between the parent and subsidiary.
Accordingly, A may no longer apply the scope
exception in ASC 460-10-25-1(g).
The example above
specifically applies to the deconsolidation of a subsidiary; however, the
same logic applies to a spin-off transaction, as highlighted in the example
below.
Example 5-22
Impact of a Spin-Off
Assume that Entity A is spinning off one of its
subsidiaries (Entity B) as an independent, publicly
traded company by distributing its equity interests
in B to A’s shareholders on a pro rata basis (i.e.,
B will no longer be a subsidiary of A). The
separation is accounted for as a spin-off
transaction at historically recorded amounts in
accordance with ASC 845-10-05-4 and ASC
845-10-30-10.
Further assume that before the
spin-off, various guarantee obligations are
established between the two entities. One example is
a guarantee to a landlord by A on behalf of B in
connection with a lease. Another example is a lease
obligation that cannot be legally assigned from A to
B but for which B will be responsible. For such
guarantees, B agrees to indemnify A for payments
made by A in accordance with such obligations.
Before the spin-off, the guarantees qualify for the
scope exception in ASC 460-10-25-1(g) and (h). (Note
that such guarantees would also represent guarantees
of an entity’s own future performance, since A
consolidated B.)
Both A and B would be required to
recognize their respective guarantee obligations
upon spin-off at fair value in accordance with the
recognition and measurement provisions of ASC 460.
Once the spin-off occurs, those guarantee
obligations no longer qualify for the scope
exceptions in ASC 460-10-25-1(g) or (h). Although
the terms of the guarantees have not changed, the
relationships between the guarantors and the
guaranteed parties have changed. That is, once the
spin-off occurs, the former parent entity, A, no
longer controls the resources of the spinnee, B, and
the entities operate as independent entities.
Although spin-off transactions are recorded at
historically recorded amounts, guarantee obligations
between the formerly related entities should be
recognized at fair value upon the spin-off in
accordance with ASC 460 given that the guarantee is
essentially created contemporaneously with the
spin-off and that the fair value can be reliably
determined.
These views are consistent with
those expressed in a speech by Eric West, associate chief accountant in the SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC and PCAOB Developments. Specifically, Mr. West stated that the SEC staff believes that “the FIN 45
[codified as ASC 460] parent-subsidiary scope
exception applies only during the parent-subsidiary
relationship since the guarantee is not relevant to
the consolidated financial statements.”
Offsetting
Entry
Section 5.3.2.4
discusses the accounting for the offsetting entry
upon initial recognition of a guarantee liability.
Both guarantors conclude that the offsetting entry
(i.e., the debit) should be in equity.
ASC 460-10-25-4 specifies that the
“offsetting entry depends on the circumstances in
which the guarantee was issued.” As discussed in ASC
845-10-05-4, spin-off transactions are recorded as
nonreciprocal transfers between an enterprise and
its owners (i.e., as equity transactions). Both
guarantors consider that, given the facts and
circumstances of a spin-off accounted for at
historical cost (i.e., as an equity transaction),
the offsetting entry should be within equity.
Economically, the guarantees are
similar to other adjustments to the net assets
(either via adjustments to current assets or the
debt levels) included in the spin-off of B.
Therefore, recording the debit side of the entry for
the guarantee in equity is consistent with recording
what the entry would have been if the net assets
included in the spin-off were adjusted.
Subsequent
Accounting
Section 5.4
discusses the subsequent accounting for guarantee
liabilities. In this example, both guarantors
conclude that it would not be appropriate to release
the guarantee liability related to the noncontingent
liability to equity (i.e., where the offsetting
entry was recognized). ASC 460-10-35-1 specifies
that the liability that the guarantor initially
recognized would typically be reduced (by a credit
to earnings) since the guarantor is released from
risk under the guarantee. For example, both
guarantors might derecognize the liability ratably
over the remaining life of the lease, with a credit
to earnings. ASC 450-20 addresses the recognition
and subsequent accounting for any liability related
to the contingent loss for the guarantee.
As noted above (and further
described in Section
5.3.2), a parent company is required to consider the guidance
in ASC 450-20 in determining whether it needs to record in its stand-alone,
parent-only financial statements an estimated loss from a loss contingency
for its guarantee of its subsidiary’s debt under ASC 450-20-25. The example
below illustrates application of ASC 450-20-25.
Example 5-23
Determining When to Recognize a Liability for the
Guarantee of a Subsidiary’s Debt
On October 15, 20X4, Entity A purchases a controlling
interest in Investee B and consolidates B in A’s
consolidated financial statements. Entity A also
guarantees B’s third-party debt of $1 million. The
entire $1 million of debt is recognized in A’s
consolidated financial statements owing to A’s
controlling interest in B.
In preparing its stand-alone, parent-only financial
statements, A continually reassesses the guidance in
ASC 450 in each reporting period. On December 31,
20X5, A determines that (1) it is probable that B
will default on its debt in the future and (2) the
amount of the loss can be reasonably estimated. In
accordance with ASC 450-20-25-2, A should recognize
a liability in its stand-alone, parent-only
financial statements for its probable payment of B’s
debt. The amount of the liability is determined by
identifying the best estimate, or minimum amount
within a range, as indicated in ASC 450-20-30-1.
In a scenario in which an investment fund, in accordance with ASC 946-810,
does not consolidate a noninvestment company investee in which it has a
controlling interest, the fund nonetheless would apply the scope exception
in ASC 460-10-25-1(g) related to “[a] parent’s guarantee of its subsidiary’s
debt to a third party” with respect to a guarantee issued by the investment
fund for a debt that the noninvestment company investee owes to a third
party. This is because, even though the investment fund has not consolidated
the noninvestment company investee, the nature of their relationship is that
between a parent and its subsidiary. In this case, the investment fund
should consider the guidance in ASC 450-20-25 when determining whether a
loss contingency should be recorded for the guarantee of its investee’s
debt.
If an investment fund provides a guarantee in conjunction with initially
investing in a noninvestment company investee, it should consider whether
the unit of account represented by the transaction price paid differs from
the unit of account for the investment as subsequently measured at fair
value. Generally, it would be inappropriate to recognize a gain in earnings
as a result of (1) including the impact of the guarantee when the investment
is initially measured and (2) excluding the guarantee’s impact when the
investment is subsequently measured at fair value.
Note that the scope exception in ASC 460-10-25-1(g) applies
only to the recognition and measurement provisions of ASC 460. The
investment fund is still required to adhere to the disclosure requirements
in ASC 460 and the guidance on subsequent recognition and measurement in ASC
450.
5.3.1.3 Guarantees in Which the Obligation Is Not a Liability
ASC 480 requires (1) issuers to classify certain shares and share-settled
contracts as liabilities or, in some circumstances, as assets, and (2) SEC
registrants to classify certain redeemable equity instruments as temporary
equity. Certain contracts that an entity is not required to classify as a
liability (or asset) under ASC 480 are evaluated for classification within
equity in accordance with ASC 815-40. If a guarantee meets the indexation
and classification conditions in ASC 815-40 in such a way that it is
recognized within equity (e.g., a requirement to deliver a fixed number of
equity shares upon the occurrence of a specified event), the transaction is
not subject to the recognition and measurement requirements of ASC 460.
5.3.2 Guarantees Subject to the Recognition and Measurement Provisions of ASC 460
ASC 460-10
25-2 The issuance of a
guarantee obligates the guarantor (the issuer) in two
respects:
- The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur (the noncontingent aspect).
- The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur (the contingent aspect).
For guarantees that are not within the
scope of Subtopic 326-20 on financial instruments
measured at amortized cost, no bifurcation and no
separate accounting for the contingent and noncontingent
aspects of the guarantee are required by this Topic. 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.
25-3 Because the issuance of
a guarantee imposes a noncontingent obligation to stand
ready to perform in the event that the specified
triggering events or conditions occur, the provisions of
Section 450-20-25 regarding a guarantor’s contingent
obligation under a guarantee should not be interpreted
as prohibiting a guarantor from initially recognizing a
liability for a guarantee even though it is not probable
that payments will be required under that guarantee.
Similarly, for guarantees within the scope of Subtopic
326-20, the requirement to measure a guarantor’s
expected credit loss on the guarantee should not be
interpreted as prohibiting a guarantor from initially
recognizing a liability for the noncontingent aspect of
a guarantee.
25-4 At the
inception of a guarantee, a guarantor shall recognize in
its statement of financial position a liability for that
guarantee. This Subsection does not prescribe a specific
account for the guarantor’s offsetting entry when it
recognizes a liability at the inception of a guarantee.
That offsetting entry depends on the circumstances in
which the guarantee was issued. See paragraph
460-10-55-23 for implementation guidance.
30-2 Except as indicated in
paragraphs 460-10-30-3 through 30-5, the objective of
the initial measurement of a guarantee liability is the
fair value of the guarantee at its inception. For
example:
- If a guarantee is issued in a standalone arm’s-length transaction with an unrelated party, the liability recognized at the inception of the guarantee shall be the premium received or receivable by the guarantor as a practical expedient.
- If a guarantee is issued as part of a transaction with multiple elements with an unrelated party (such as in conjunction with selling an asset), the liability recognized at the inception of the guarantee should be an estimate of the guarantee’s fair value. In that circumstance, a guarantor shall consider what premium would be required by the guarantor to issue the same guarantee in a standalone arm’s-length transaction with an unrelated party as a practical expedient.
- If a guarantee is issued as a contribution to an unrelated party, the liability recognized at the inception of the guarantee shall be measured at its fair value, consistent with the requirement to measure the contribution made at fair value, as prescribed in Section 720-25-30. For related implementation guidance, see paragraph 460-10-55-14.
Guarantees Not
Within the Scope of Subtopic 326-20
30-3 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:
- The amount that satisfies the fair value objective as discussed in the preceding paragraph
- The contingent liability amount required to be recognized at inception of the guarantee by Section 450-20-30.
30-4 For many
guarantors, it would be unusual at the inception of the
guarantee for the contingent liability amount under (b)
in the preceding paragraph to exceed the amount that
satisfies the fair value objective under (a) in the
preceding paragraph. An example of that unusual
circumstance is a guarantee for which, at inception,
there is a high (probable) likelihood that the guarantor
will be required to pay the maximum potential settlement
at the end of the six-month term and a low likelihood
that the guarantor will not be required to make any
payment at the end of the six-month term. The amount
that satisfies the fair value objective would include
consideration of the low likelihood that no payment will
be required, but the accrual of the contingent loss
under Section 450-20-30 would be based solely on the
best estimate of the settlement amount whose payment is
probable (the maximum potential settlement amount in
this case). This example is considered to be an unusual
circumstance because of the high likelihood at inception
that the maximum potential settlement amount will be
paid, resulting in a substantial initial fair value for
that guarantee. Another example in which the contingent
liability amount required to be recognized under (b) in
the preceding paragraph exceeds the fair value at
inception under (a) in the preceding paragraph would
involve an undiscounted accrual under Subtopic 450-20
for a guarantee payment that is expected to occur many
years in the future.
Guarantees Within
the Scope of Subtopic 326-20
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:
- The amount that satisfies the fair value objective in accordance with paragraph 460-10-30-2
- The contingent liability related to the expected credit loss for the guarantee measured under Subtopic 326-20.
An entity that issues a guarantee obligates itself to the guaranteed party in two
ways: (1) a noncontingent stand-ready obligation and (2) a contingent
obligation. The noncontingent liability represents the guarantor’s obligation to
stand ready to perform under the guarantee in the event of the occurrence of the
event or condition specified in the terms of the guarantee. The contingent
obligation represents the liability for the future payments if the event or
condition specified in the terms of the guarantee occurs.
ASC 460 explains the distinction between the contingent and noncontingent aspects
of a guarantee obligation to clarify that a guarantor is required to recognize a
liability at the inception of a guarantee within the scope of ASC 460’s
recognition and measurement guidance even if a loss on the contract is not
probable. If a guarantee is not a freestanding transaction with a separate
premium (i.e., it is embedded in a sales contract or other agreement), the
failure to recognize a liability may result in an overstatement of the related
income statement impact of the transaction. ASC 460 addresses this issue by
requiring an entity to record a liability for the stand-ready obligation
component of a guarantee.
5.3.2.1 Noncontingent Liability
For guarantee arrangements that are within the scope of ASC 460’s recognition
and measurement guidance, the guarantor is required to record a liability
for the stand-ready component of the guarantee at the inception of the
guarantee arrangement. The overall principle in ASC 460 is that the
guarantee liability should be initially recognized at fair value.
As noted in Section 5.1, one of the objectives in
ASC 460 is to achieve comparability of financial reporting for guarantees
irrespective of whether they are issued in return for a separately
identified premium. Even if there is no explicit payment or premium
receivable at the inception of a guarantee arrangement, the guarantor is
still required to stand ready to perform over the term of the arrangement
and, therefore, a liability should be recognized. The guarantee liability
recognized at inception generally represents unearned income for standing
ready to perform, which, as discussed in Section 5.4, will be reduced by a
credit to earnings as the guarantor is released from risk under the
guarantee.2
The liability that a guarantor incurs upon issuing a
guarantee should be initially recognized at fair value regardless of the
probability that the guarantor will be required to transfer assets or
provide services to satisfy its guarantee obligation. A stand-ready
obligation is a type of liability even though it may not result in the
eventual transfer of cash or other assets. For example, assume that Entity A
issues a guarantee to pay Entity C upon Entity B’s default on an obligation
that B has to C. Upon issuing the guarantee, A does not believe that B’s
default is probable; thus, it is not probable that the event that would
trigger payment will occur. Regardless of whether A received a separately
identified premium at the inception of the guarantee as consideration for
entering into this obligation, A has a contractual obligation to stand ready
to make payments to C upon B’s default. For A to extinguish its contractual
obligation, it would have to make a payment to another party to step into
its legal obligation to stand ready to perform in the event that B defaults.
Accordingly, upon issuing the guarantee, A has a liability to stand ready to
perform or to make a payment to a third party to exit this obligation. The
fact that A would have to pay another party to exit the obligation serves as
evidence of the liability’s existence.
ASC 460 describes the two aspects of a guarantee to emphasize that the
guidance in ASC 450-20 on loss contingencies does not prohibit the
recognition of a liability arising from the issuance of a guarantee. If
entities considered guarantees as representing only contingent liabilities,
there often would be no recognition at issuance because it would not be
probable that the event or condition that triggers the guarantor’s
performance would occur.
ASC 460 contains additional discussion of the initial recognition of a
guarantee obligation.
ASC 460-10
55-21 In many
cases, the one-time premium received by a guarantor
for issuing a guarantee will be an appropriate
practical expedient for the initial measurement of
the guarantee obligation (see paragraph
460-10-30-2[a]). However, if a one-time premium is
specified for a guarantee that is issued in
conjunction with another transaction (such as the
sale of assets by the guarantor), the specified
premium may not be an appropriate initial
measurement of the guarantor’s liability because the
amount specified as being applicable to the
guarantee may or may not be its fair value (see
paragraph 460-10-30-2[b]).
55-22 In accordance with
paragraph 460-10-30-2, a liability shall be
recognized at the inception of the guarantee even if
the guarantor does not receive a separately
identified premium when it issues the guarantee. For
example, in conjunction with the cash sale of
equipment to a customer, a manufacturer may issue to
its customer’s bank a guarantee of the customer’s
loan for which the proceeds are used to pay for the
equipment. There is no separately identified premium
for the guarantee, although the sales arrangement
may impound an implicit premium. The manufacturer
may simply view the guarantee as an accommodation to
its customer. The seller-guarantor has incurred an
obligation identical to the obligation it would
incur if it required its customer to pay an explicit
premium for the guarantee. Thus, the
seller-guarantor shall immediately recognize a
liability for its obligations under a newly issued
guarantee, even if a separately identified premium
was not received. If an entity guaranteed a
customer’s bank loan purely as an accommodation to
an important longstanding customer, unrelated to a
specific transaction, the liability for the entity’s
obligations under the guarantee should be
recognized.
The general principle in ASC 460 is that a guarantee obligation should be
initially recognized at fair value. ASC 820 defines fair value as “[t]he
price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.” Under ASC 820, fair value represents a measurement based
on an exit price — that is, the price that would be received to sell an
asset or paid to transfer a liability. Initially measuring a guarantee at
fair value in accordance with ASC 820’s exit price notion is consistent with
the objective in ASC 460 to determine the amount of consideration a
guarantor would have to pay another party to step into the guarantor’s
stand-ready obligation to perform under the terms of a guarantee.
Connecting the Dots
The fair value of a guarantee obligation will be affected by the
nonperformance risk (e.g., credit risk) of the guarantor. However,
this does not mean that the guarantor qualifies for the recognition
exception that applies to guarantees of an entity’s own
performance.
Although the initial measurement objective for guarantees
recognized under ASC 460 is fair value, ASC 460-10-30-2(a) contains a
practical expedient that allows a guarantor to use the premium received or
receivable as its initial measurement for a guarantee issued in a
stand-alone, arm’s-length transaction. Such measurement represents an entry
price rather than an exit price. As discussed in Section 9.1 of Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option), an entry price (i.e., the transaction price) and
an exit price are not always the same. Nevertheless, ASC 460 contains a
practical expedient that allows for initial measurement on the basis of an
entry price.
A guarantee issued as part of a multiple-element arrangement
may be more difficult to measure than one in which a separate premium is
received, but the guidance in ASC 460-10-30-2(b) indicates that a guarantor
should consider the premium that would have been received for the same
guarantee if it were issued in a stand-alone transaction. While the
measurement examples in both ASC 460-10-30-2(a) and (b) represent an entry
price rather than an exit price (which is required for fair value
measurements), the guidance indicates that an entry price may be used as a
practical expedient to achieve the fair value measurement objective. For
further discussion of the interaction of this practical expedient and fair
value under ASC 820, see Section 2.3.4 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option).
5.3.2.2 Contingent Liability — Guarantees Within the Scope of ASC 326-20
Some financial guarantees are also within the scope of ASC
326-20.3 For a guarantee that is within the scope of ASC 326-20, the guarantor
must recognize the amount that meets the fair value objective of the
guarantee (as described in Section 5.3.2.1) as well as a liability related to the
expected credit losses on the guarantee.
Example 5-24
Guarantee Within the Scope of ASC 326-20
Company A sells medical equipment to Hospital H for
$100 million. Hospital H pays for the medical
equipment by taking out a loan with Bank B. As part
of the sale transaction, A provides a guarantee of
the repayment of H’s loan to B. Company A determines
that the initial fair value of the guarantee is $5
million. Company A should record the following entry
related to the sale and the stand-ready obligation
associated with the guarantee:
In addition, A must separately record a liability for
the expected credit losses on the guarantee. Company
A determines that the current expected credit loss
in accordance with ASC 326-20 is $2 million.
Therefore, A will recognize the following additional
entry:
5.3.2.3 Contingent Liability — Guarantees Not Within the Scope of ASC 326-20
A guarantor assumes the risk
that it will need to perform under a guarantee. In an arm’s-length
transaction between unrelated parties, a guarantor would be expected to
charge a premium, either separately or embedded within the purchase price of
a multiple-element contract. That premium is expected to be commensurate
with the amount of risk incurred. It would be unusual for a guarantor to
charge a premium that is less than the amount that is probable to be paid
under the contract as of its inception date. Accordingly, for guarantees
that are not within the scope of ASC 326-20, entities often only recognize
the fair value of the obligation at the inception of a guarantee; they
generally do not recognize an amount for the contingent liability component
as of that date. If, however, an entity does consider that, at the inception
of a guarantee, it is probable (according to ASC 450-20-25-2) that it will
have to perform in accordance with the contingent aspect of the guarantee,
the entity should recognize the larger of (1) the fair value of the
guarantee or (2) the contingent liability.
ASC 460-10-30-4 acknowledges
that it would be unusual at the inception of the guarantee for the
contingent liability measured in accordance with the principles of ASC 450
to be greater than the fair value estimate.
ASC 460-10
30-4 For many
guarantors, it would be unusual at the inception of
the guarantee for the contingent liability amount
under (b) in the preceding paragraph to exceed the
amount that satisfies the fair value objective under
(a) in the preceding paragraph. An example of that
unusual circumstance is a guarantee for which, at
inception, there is a high (probable) likelihood
that the guarantor will be required to pay the
maximum potential settlement at the end of the
six-month term and a low likelihood that the
guarantor will not be required to make any payment
at the end of the six-month term. The amount that
satisfies the fair value objective would include
consideration of the low likelihood that no payment
will be required, but the accrual of the contingent
loss under Section 450-20-30 would be based solely
on the best estimate of the settlement amount whose
payment is probable (the maximum potential
settlement amount in this case). This example is
considered to be an unusual circumstance because of
the high likelihood at inception that the maximum
potential settlement amount will be paid, resulting
in a substantial initial fair value for that
guarantee. Another example in which the contingent
liability amount required to be recognized under (b)
in the preceding paragraph exceeds the fair value at
inception under (a) in the preceding paragraph would
involve an undiscounted accrual under Subtopic
450-20 for a guarantee payment that is expected to
occur many years in the future.
Example 5-25
Contingent Liability Exceeds Fair Value at
Inception
Company A engages Company B to perform certain duties
on behalf of A as part of a 10-year contract.
Company A indemnifies B for third-party damage
claims and lawsuits that could be filed against B in
performing the contracted services over the course
of the long-term contract.
The indemnification contingently requires A to make a
payment to B on the basis of changes in a contingent
liability of B. This indemnification possesses the
characteristics in ASC 460-10-15-4(c) and therefore
is within the scope of ASC 460.
Company A determines that the probable loss is $10
million, which is payable after the end of the
contract. As discussed in Section 2.4.3.1, contingent
liabilities are rarely discounted; thus, the
liability under ASC 450-20 is $10 million. Company A
may calculate the fair value of the guarantee by
using the same projected cash flows, discounted back
to present value. Because the fair value measurement
reflects the time value of money but the contingent
liability does not, the liability calculated in
accordance with ASC 450-20 is greater than the
amount of the guarantee determined by using fair
value.
5.3.2.4 Offsetting Entry
As noted in ASC 460-10-25-4,
ASC 460 does not prescribe a specific offsetting entry upon the initial
recognition of a guarantee obligation; the offsetting entry will depend on
the facts and circumstances. ASC 460-10-55-23 gives examples of a
guarantor’s offsetting entries for different guarantee arrangements:
Transaction Type
|
Offsetting Entry
|
---|---|
Guarantee is issued in a stand-alone transaction for
a premium (i.e., for separate consideration
received) (ASC 460-10-55-23(a))
|
Consideration received (e.g., cash or a
receivable).
|
Guarantee is issued in conjunction with the sale of
assets, a product, or a business (ASC
460-10-55-23(b))
|
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.
|
Guarantee is issued in conjunction with the formation
of a partially owned business or a venture accounted
for under the equity method (ASC
460-10-55-23(c))
|
Recognition of the liability for the guarantee would
result in an increase to the carrying amount of the
investment.
|
Guarantee is issued to an unrelated party for no
consideration on a stand-alone basis (ASC
460-10-55-23(e))
|
Expense.
|
SAB Topic 5.E provides interpretive guidance on the
accounting for divestiture of a subsidiary or other business operation when
a guarantee is issued in conjunction with such a transaction. This guidance
further expands on the ASC 460 implementation guidance related to guarantees
issued in conjunction with the sale of assets, a product, or a business and
would also apply to entities that are not SEC registrants. SAB Topic 5.E
states the following:
Facts: Company X transferred certain operations (including
several subsidiaries) to a group of former employees who had been
responsible for managing those operations. Assets and liabilities
with a net book value of approximately $8 million were transferred
to a newly formed entity — Company Y — wholly owned by the former
employees. The consideration received consisted of $1,000 in cash
and interest bearing promissory notes for $10 million, payable in
equal annual installments of $1 million each, plus interest,
beginning two years from the date of the transaction. The former
employees possessed insufficient assets to pay the notes and Company
X expected the funds for payments to come exclusively from future
operations of the transferred business. Company X remained
contingently liable for performance on existing contracts
transferred and agreed to guarantee, at its discretion, performance
on future contracts entered into by the newly formed entity. Company
X also acted as guarantor under a line of credit established by
Company Y.
The nature of Company Y’s business was such that Company X’s
guarantees were considered a necessary predicate to obtaining future
contracts until such time as Company Y achieved profitable
operations and substantial financial independence from Company X.
Question: If deconsolidation of the
subsidiaries and business operations is appropriate, can Company X
recognize a gain?
Interpretive Response: Before recognizing any gain, Company X
should identify all of the elements of the divesture arrangement and
allocate the consideration exchanged to each of those elements. In
this regard, we believe that Company X would recognize the
guarantees at fair value in accordance with FASB ASC Topic 460,
Guarantees; the contingent liability for performance on existing
contracts in accordance with FASB ASC Topic 450, Contingencies; and
the promissory notes in accordance with FASB ASC Topic 310,
Receivables, and FASB ASC Topic 835, Interest.
ASC 460-10-55-23(b) does not
explicitly distinguish between the sale of services and the sale of assets;
therefore, the concepts are considered the same, as illustrated in the
example below.
Example 5-26
Guarantee Issued in Connection With a Service
Contract
A company provides management services for a group of
hotels to be constructed and owned by an unrelated
master limited partnership (MLP). The management
contract is exclusive for a five-year term and
specifies the company’s annual fixed fee as well as
an annual contingent fee that is based on operating
cash flows at the hotels. In connection with
obtaining the contract, the company agrees to
provide a guarantee of mezzanine debt to be issued
by the MLP for the funding of the hotel
construction. The debt has scheduled principal
repayment on a straight-line basis over five years.
The company has determined that it should recognize a
liability for the guarantee separately and apart
from the management agreement at inception of the
arrangement (see ASC 460-10-30-2(b)). The amount of
the liability recognized is an estimate of the fair
value of the guarantee.
ASC 460-10-55-23 gives examples of various
circumstances and the appropriate offsetting
entries. ASC 460-10-55-23(b) states:
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.
The company should allocate the total expected fees
during the five-year service agreement between
collection of the premium for issuing the guarantee
and the future services to be provided. The offset
to the guarantee liability at inception is a
receivable equal to the fair value of the expected
fees to be received for issuing the guarantee. When
the company receives payments from the MLP in
connection with the contract, the cash flow
allocated to the guarantee premium should be
credited to the asset previously recognized upon
inception of the guarantee. The asset would be
accreted up to the amount of cash to be received,
resulting in recognition of interest income. The
amount of service revenue the company would record
over the course of the agreement would be reduced by
the amount of the proceeds initially allocated to
the premium for the debt guarantee and by the
related accretion of interest.
Additional Fact
At the end of the third year, the debt is retired
early because of better-than-expected cash flows at
the MLP.
Subsequent Accounting at the End of Year 3
At the time of the debt’s extinguishment, the
remaining balance of the guarantee liability should
be recognized immediately in income because the
specific guarantee no longer exists. The accounting
for the receivable should not change because of the
extinguishment of the debt as long as the management
agreement itself is not terminated. The receivable
should not be written off as an offset to the
extinguishment of the guarantee liability since the
receivable is still collectible. The company has
essentially financed its receipt of the premium for
writing the guarantee over a period longer than the
actual life of the guarantee.
Certain guarantee transactions may not be addressed by the
examples in ASC 460-10-55-3. In these situations, the guarantor will need to
use judgment to determine the offsetting entry. Just because a guarantor
does not receive a separately identified payment for entering into a
guarantee does not mean that the guarantee was issued for no consideration.
In some transactions, it may be appropriate to recognize an asset other than
cash or a receivable. Example 5-9 illustrates an entity’s determination that the
offsetting entry upon initial recognition should be an asset. Although not a
specific example in ASC 460-10-55-23, the recognition of the offsetting
entry in equity may be appropriate in certain transactions. See Example 5-22 for an
illustration.
ASC 460-10-55-23(c) provides guidance on the offsetting
entry that a guarantor would record when a guarantee is issued in
conjunction with the formation of a partially owned business or a venture
accounted for under the equity method. See Section 4.2.1 of Deloitte’s Roadmap
Equity Method
Investments and Joint Ventures for additional
discussion and examples. In addition, Section 5.2.1 of that same Roadmap
discusses the offsetting entry that would be recorded when a guarantee is
issued in connection with an entity’s investment in a joint venture but that
guarantee was not contemplated or required by the formation documents.
Footnotes
2
Under ASC 606-10-15-2(d), guarantees (other than
product or service warranties) that are within the scope of ASC 460
are outside the scope of ASC 606.
3
See Chapter 2 of Deloitte’s
Roadmap Current
Expected Credit Losses for additional
discussion of the scope of ASC 326-20.
5.4 Subsequent Measurement
ASC 460 does not provide specific guidance on how to account for the guarantees after
issuance. Rather, if an entity does not elect the fair value option for the
guarantee, the entity would apply an overarching principle in the guidance under
which it would release the initial liability to income (by a credit to earnings) as
the guarantor is released from risk under the guarantee; the remaining contingent
aspect should be accounted for in accordance with ASC 450-20.
ASC 460-10
35-1
This Subsection does not describe in detail how the
guarantor’s liability for its obligations under the
guarantee would be measured after its initial recognition.
The liability that the guarantor initially recognized under
paragraph 460-10-25-4 would typically be reduced (by a
credit to earnings) as the guarantor is released from risk
under the guarantee.
35-2
Depending on the nature of the guarantee, the guarantor’s
release from risk has typically been recognized over the
term of the guarantee using one of the following three
methods:
- Only upon either expiration or settlement of the guarantee
- By a systematic and rational amortization method
- As the fair value of the guarantee changes.
Although those three methods are currently being used in
practice for subsequent accounting, this Subsection does not
provide comprehensive guidance regarding the circumstances
in which each of those methods would be appropriate. A
guarantor is not free to choose any of the three methods in
deciding how the liability for its obligations under the
guarantee is measured subsequent to the initial recognition
of that liability. A guarantor shall not use fair value in
subsequently accounting for the liability for its
obligations under a previously issued guarantee unless the
use of that method can be justified under generally accepted
accounting principles (GAAP). For example, fair value is
used to subsequently measure guarantees accounted for as
derivative instruments under Topic 815.
35-3 Paragraph
superseded by Accounting Standards Update No. 2016-13.
35-4 The discussion in
paragraph 460-10-35-2 about how a guarantor typically
reduces the liability that it initially recognized does not
encompass the recognition and subsequent adjustment of the
contingent liability related to the contingent loss for the
guarantee. The contingent aspect of the guarantee shall be
accounted for in accordance with Subtopic 450-20 unless the
guarantee is accounted for as a derivative instrument under
Topic 815 or the guarantee is within the scope of Subtopic
326-20 on financial instruments measured at amortized cost.
For guarantees within the scope of Subtopic 326-20, the
expected credit losses (the contingent aspect) of the
guarantee shall be accounted for in accordance with that
Subtopic in addition to and separately from the fair value
of the guarantee liability (the noncontingent aspect)
accounted for in accordance with paragraph 460-10-30-5.
5.4.1 Subsequent Accounting for Noncontingent Aspect of Guarantee
An entity cannot freely choose to elect one of the three methods in ASC
460-10-35-2 to subsequently account for the liability recognized upon issuance
of a guarantee. Instead, a guarantor should choose the method that is
appropriate given the particular facts and circumstances related to each
individual guarantee. Irrespective of the method it chooses, the entity should
document and consistently apply the method for similar guarantees throughout the
term of each guarantee. Often, a systematic and rational amortization method is
appropriate. At the 2003 AICPA Conference on Current SEC Developments, the SEC
staff stated the following:
So what do we believe the appropriate “day two” accounting for the
obligation to stand ready would be? . . . It would seem a systematic and
rational amortization method would most likely be the appropriate
accounting.
Examples 5-9, 5-22, and 5-27 illustrate how an entity might account for the guarantee
liability in periods after initial measurement.
For some guarantees, an entity is required or permitted to use fair value as the
subsequent-measurement attribute:
- Subsequent measurement at fair value is required for a guarantee that meets the definition of a derivative and is within the scope of ASC 815-10.
- For a guarantee that meets the definition of a financial instrument or that is otherwise within the scope of the guidance in ASC 825-10 on the fair value option, an entity is permitted to elect fair value as the subsequent-measurement attribute. However, an entity cannot justify fair value as the subsequent-measurement attribute solely on the basis of ASC 460-10-35-2, which indicates that for some guarantees, the release from risk changes as the fair value of the guarantee changes. ASC 460-10-35-2 specifies that a “guarantor shall not use fair value in subsequently accounting for the liability for its obligations under a previously issued guarantee unless the use of that method can be justified under [GAAP].” Therefore, a fair value election is appropriate only if it conforms to the guidance in ASC 825-10. See Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for additional discussion of the eligibility and application of the fair value option.
5.4.2 Subsequent Accounting for the Contingent Aspect of a Guarantee
The discussion in ASC 460-10-35-2 about how a guarantor
typically reduces the liability that it initially recognized does not encompass
the recognition and subsequent adjustment of the liability related to the
contingent loss on the guarantee. The subsequent measurement of the contingent
liability, if any, is measured in accordance with ASC 450-20 unless the
guarantee is subsequently measured at fair value through earnings (or is within
the scope of ASC 326-20). The ASC 450-20 liability is subsequently measured on
the basis of facts and circumstances specific to the contingency, and the
related loss is recognized in earnings.
5.4.2.1 Subsequent Accounting for Guarantees Within the Scope of ASC 326-20
The contingent aspect of a
guarantee that is within the scope of ASC 326-20 is accounted for separately
from the initial recognized liability in accordance with the expected credit
loss model.
Example 5-27
Guarantee Within the Scope of ASC
326-20
Assume the same facts as in
Example 5-24. Further assume that the
guaranteed loan has a term of three years and that
A’s systematic and rational method for subsequent
measurement of the initial obligation is to amortize
the liability over the life of the loan, given that
H makes monthly payments of principal and interest.
Company A’s expected credit losses as of the end
date of each reporting period are as follows:
- End of year 1 — $3 million.
- End of year 2 — $1 million.
- End of year 3 — $0 million.
Company A will record the following
subsequent-accounting entries:
End of year
1
End of year
2
End of year
3
In this example, since no amount was
ultimately paid on the guarantee, the expected loss
reverts to zero as of the end of the term of the
guarantee.
5.4.2.2 Subsequent Accounting for Guarantees Not Within Scope of ASC 326-20
Neither ASC 460-10 nor ASC 450-20 provides explicit guidance
on the interaction between those subtopics after initial recognition.
Accordingly, entities should establish a systematic and rational method that
is supportable for the subsequent accounting. In establishing that method,
entities may look to analogous guidance, such as ASC 605-20-25-6, ASC
606-10, ASC 942-825-50-2, and ASC 944. Irrespective of the method it
chooses, the entity should document and consistently apply the method for
similar guarantees throughout the term of each guarantee. Further, the
entity should consider the nature of its operations and the specific terms
of the guarantee to ensure that the method is appropriate on the basis of
the facts and circumstances of the guarantee. Two possible methods of
determining the amount of an ASC 450-20 liability to record are discussed
below.
5.4.2.2.1 Method 1 — Incremental Recognition of the ASC 450-20 Contingent Liability
After the initial recognition, an entity would record a separate ASC
450-20 liability only when the entire estimated ASC 450-20 amount
exceeds the unamortized ASC 460 liability. The ASC 450-20 liability
equals the excess of the entire estimated probable obligation over (1)
the unamortized ASC 460 liability or (2) the expected unamortized ASC
460 liability at the time of the expected payment. In subsequent
periods, the ASC 450-20 liability may need to be adjusted so that it
continues to equal the excess of the entire estimated probable
obligation over the unamortized ASC 460 liability.
5.4.2.2.2 Method 2 — Gross Recognition of the ASC 450-20 Liability
Under this method, after the initial recognition and measurement of the
guarantee, an entity would record a separate ASC 450-20 liability for
the entire amount of the estimated probable obligation. The entity would
continue to amortize the ASC 460 liability in accordance with its
established policy until it is released from its obligation to stand
ready. This approach is similar to the approach required for guarantees
within the scope of ASC 326-20 although the contingent loss is measured
in accordance with ASC 450-20 rather than under the expected credit loss
model.
Note that this guidance does not apply to guarantees that meet the
definition of a derivative or are otherwise recognized at fair value. If
a guarantee meets the definition of a derivative or is otherwise
subsequently accounted for at fair value, both the stand-ready
obligation and contingent obligation of the guarantee should be treated
as a single unit of account, with subsequent changes in fair value of
the guarantee recorded in earnings for the period in which the changes
occur.
The example below
illustrates the two different methods discussed above.
Example 5-28
Contingent
Liability — Incremental Versus Gross
Recognition
Entity B is seeking to borrow $20 million for a
term of five years from Bank C; however, C will
not issue such proceeds to B without a third-party
guarantee. On January 1, 20X1, B pays Entity A $1
million as a separately identified premium in
exchange for A’s issuance to C of a guarantee
stating that, in the event of B’s default, A will
step in and make all remaining scheduled payments.
Also, on January 1, 20X1, C loans Entity B $20
million. The loan calls for equal monthly payments
of principal and interest during the five-year
term.
Upon initial recognition of the guarantee
obligation, A applies ASC 460-10-30-2(a) and
recognizes the $1 million cash received with a
corresponding guarantee liability.
As of each reporting period through September 30,
20X3, A assesses the probability of B’s default
(i.e., the event that would require A to make some
or all of B’s remaining payments to C) and
concludes that it is not probable that B will
default. However, during the fourth quarter of
20X3, a severe decrease in demand for B’s main
product occurred, as a result of which A concluded
that it is probable that it will be required to
pay C for B’s payments due in 20X4 and 20X5.
Entity B can make the contractually required
payments through December 31, 20X3. Assume that
the total amount of the remaining payments after
December 31, 20X3, is $10 million.
The two examples below illustrate how A’s
accounting would differ depending on which method
is applied to the subsequent accounting for the
contingent aspect of the guarantee.
Subsequent
Entries:
December
31, 20X1
No entry is required for the ASC
450 contingent liability because a loss is not
probable.
December
31, 20X2
No entry is required for the ASC
450 contingent liability because a loss is not
probable.
December
31, 20X3
Incremental
Recognition
Gross Recognition
Note that after these two
entries, there remains $400,000 of the guarantee
liability for the unamortized portion of the
stand-ready obligation. It would be acceptable for
that amount to also be recognized immediately into
income since the full amount of the guarantee has
been recognized as a contingent liability.
5.5 Disclosure Requirements
This section discusses the disclosure
requirements in ASC 460.
The requirements in ASC 460-10-50-2 through 50-4 apply to guarantees,
including guarantees that are outside the scope of ASC 460-10-15-4; however, they do not
apply to the guarantees described in ASC 460-10-15-7.
ASC 460-10
50-1 The requirements in paragraphs
460-10-50-2 through 50-4 apply to guarantees, including
guarantees that are outside the scope of paragraph 460-10-15-4;
however, they do not apply to guarantees described in paragraph
460-10-15-7.
50-2 An entity
shall disclose certain loss contingencies even though the
possibility of loss may be remote. The common characteristic of
those contingencies is a guarantee that provides a right to
proceed against an outside party in the event that the guarantor
is called on to satisfy the guarantee. Examples include the
following:
- Guarantees of indebtedness of others, including indirect guarantees of indebtedness of others
- Obligations of commercial banks under standby letters of credit
- Guarantees to repurchase receivables (or, in some cases, to repurchase the related property) that have been sold or otherwise assigned
- Other agreements that in substance have the same guarantee characteristic.
50-3 The disclosure
shall include the nature and amount of the guarantee.
Consideration should be given to disclosing, if estimable, the
value of any recovery that could be expected to result, such as
from the guarantor’s right to proceed against an outside
party.
50-4 A guarantor shall disclose all
of the following information about each guarantee, or each group
of similar guarantees, even if the likelihood of the guarantor’s
having to make any payments under the guarantee is remote:
- The nature of the guarantee, including
all of the following:
- The approximate term of the guarantee
- How the guarantee arose
- The events or circumstances that would require the guarantor to perform under the guarantee
- The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the guarantee (for example, the current status of the payment/performance risk of a credit-risk-related guarantee could be based on either recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk)
- If the entity uses internal groupings for purposes of item (a)(4), how those groupings are determined and used for managing risk.
- All of the following information about
the maximum potential amount of future payments under
the guarantee:
- The maximum potential amount of future payments (undiscounted) that the guarantor could be required to make under the guarantee, which shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee (which are addressed under (d) and (e))
- If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact
- If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount.
- The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under Section 450-20-30 or Subtopic 326-20 on financial instruments measured at amortized cost), regardless of whether the guarantee is freestanding or embedded in another contract
- The nature of any recourse provisions that would enable the guarantor to recover from third parties any of the amounts paid under the guarantee
- The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee
- If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee.
See the Product Warranties Subsection of Section
460-10-50 for an exception to the requirements of (b).
50-5 The disclosures required by
this Subsection do not eliminate or affect the following
disclosure requirements:
- The requirements in the General Subsection of Section 825-10-50 that certain entities disclose the fair value of their financial guarantees issued
- The requirements in paragraphs 450-20-50-3 through 50-4 that an entity disclose a contingent loss that has a reasonable possibility of occurring
- The requirements in the Disclosure Sections of Topic 815, which apply to guarantees that are accounted for as derivatives
- The requirements in Section 275-10-50 that an entity disclose information about risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term. See Example 1 (paragraph 460-10-55-25) for an illustration of the required disclosure.
- The requirements in Section 326-20-50 that an entity disclose information on the measurement of credit loss.
In addition to the disclosure requirements for contingencies and
uncertainties in ASC 275 that are discussed in Section 2.8, ASC 275-10-50-15(j) contains
incremental guarantee-related disclosure requirements related to estimates that are
particularly sensitive to changes in the near term. These requirements are illustrated
in ASC 460-10-55-25 through 55-27.
ASC 460-10
55-25 This Example
illustrates the disclosure required by paragraph 275-10-50-15(j)
of the potential near-term effect of a change in estimate of a
contingent liability resulting from the guarantee of the debt of
another entity. Entity A’s loss of customers causes the
potential for a near-term material change in that estimate
within the next fiscal year. Although disclosure of Entity A’s
ongoing efforts to replace those customers is not required, this
additional information may be presented.
55-26 Entity
A operates a shipping center in Local City. In 19X0, Entity A
decided to raise money for modernization of facilities through a
debt offering. In order for the offering to take place, Entity
B, a local manufacturer, agreed to guarantee the bonds if Entity
A’s revenues were insufficient to pay debt service. In May 19X4
(four years later when the bonds had an outstanding balance of
$55 million), Entity A lost two of its major shipping customers,
constituting 35 percent of its prior-year revenues, to a
competitor in a neighboring port. At Entity B’s June 30, 19X4,
year end, Entity A was directing substantial efforts toward
finding new customers. It is reasonably possible, however, that
Entity A will not replace the lost revenue in time to pay debt
service installments at December 30, 19X4, and June 30, 19X5,
totaling $6 million.
55-27 Entity B
would make the following disclosure.
In 19X0, Entity B guaranteed the Series AA
debt of Entity A, which operates a shipping center within Local
City. Entity B continues as guarantor of such debt totaling $55
million. In May 19X4, Entity A lost two of its major customers.
Although Entity A is directing substantial efforts toward
obtaining new customers, it is at least reasonably possible that
Entity A will not replace lost revenues sufficient to make its
December 19X4 and June 19X5 debt service payments totaling $6
million. If so, Entity B will become responsible for repayment
of at least a portion of that amount and possibly additional
amounts over the debt term. A liability of $XX has been reported
in Entity B’s financial statements pending the outcome of Entity
A’s efforts during the next fiscal year.
5.5.1 Guarantees Issued by Related Parties
ASC 460 requires disclosures that are incremental to
those in ASC 850.
ASC 460-10
50-6 Some
guarantees are issued to benefit entities that are related
parties such as joint ventures, equity method investees, and
certain entities for which the controlling financial
interest cannot be assessed by analyzing voting interests.
In those cases, the disclosures required by this Topic are
incremental to the disclosures required by Topic 850.
ASC 850-10
50-1 Financial
statements shall include disclosures of material related
party transactions, other than compensation arrangements,
expense allowances, and other similar items in the ordinary
course of business. However, disclosure of transactions that
are eliminated in the preparation of consolidated or
combined financial statements is not required in those
statements. The disclosures shall include:
- The nature of the relationship(s) involved
- A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements
- The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period
- Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement
- The information required by paragraph 740-10-50-17.
50-6 If the
reporting entity and one or more other entities are under
common ownership or management control and the existence of
that control could result in operating results or financial
position of the reporting entity significantly different
from those that would have been obtained if the entities
were autonomous, the nature of the control relationship
shall be disclosed even though there are no transactions
between the entities.
If a principal shareholder or another related party issues a guarantee that benefits
the reporting entity, the guarantee should be disclosed in the entity’s financial
statements.
5.5.2 Guarantees Obtained by a Reporting Entity Related to Its Own Assets, Liabilities, or Equity Securities
In addition to providing the disclosures required by ASC 460 for
entities that issue guarantees, an entity should disclose instances in which it
purchases or otherwise receives guarantees related to its own assets, liabilities,
or equity securities. Financial statement users may find that information useful in
assessing the entity’s access to liquidity or its ability to obtain financing.
5.5.3 Subsequent Events
ASC 855-10
25-3 An entity
shall not recognize subsequent events that provide evidence
about conditions that did not exist at the date of the
balance sheet but arose after the balance sheet date but
before financial statements are issued or are available to
be issued. See paragraph 855-10-55-2 for examples of
nonrecognized subsequent events.
55-2 The following are examples
of nonrecognized subsequent events addressed in paragraph
855-10-25-3:
- Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued
- A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be issued (Topic 805 requires specific disclosures in such cases.)
- Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued
- Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in estimated credit losses on receivables arising after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued
- Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued.
A significant commitment or contingent liability, such as a
guarantee contract, entered into after the balance sheet date but before the
financial statements are issued (or available to be issued) is an example of a
nonrecognized subsequent event. In accordance with ASC 855-10-50-2, an entity should
consider whether such a contract should be disclosed to prevent the financial
statements from being misleading. In that case, the entity should disclose (1) the
nature of the guarantee and (2) an estimate of its financial effect or a statement
that the financial effect cannot be estimated.
5.6 Product Warranties
ASC 460 includes guidance on warranty
obligations incurred in connection with the sale of goods or services (i.e., product
warranties). The ASC master glossary defines a warranty as follows:
ASC Master Glossary
Warranty
A guarantee for which the underlying is related to the
performance (regarding function, not price) of nonfinancial
assets that are owned by the guaranteed party. The obligation
may be incurred in connection with the sale of goods or
services; if so, it may require further performance by the
seller after the sale has taken place.
5.6.1 Scope of Guidance on Product Warranties
Section 5.2 discusses the application of the
scope guidance in ASC 460 that is relevant to all guarantees other than product
warranties. All product warranties are within the scope of the disclosure
requirements of ASC 460; however, certain product warranties may be outside the
scope of ASC 460’s recognition and measurement guidance and may instead be accounted
for in accordance with ASC 606.
ASC 460-10
15-9 The
guidance in the Product Warranties Subsections applies only
to product warranties, which include all of the
following:
- Product warranties issued by the guarantor, regardless of whether the guarantor is required to make payment in services or cash
- Separately priced extended warranty or product maintenance contracts and warranties that provide a customer with a service in addition to the assurance that the product complies with agreed-upon specifications (see paragraphs 606-10-55-30 through 55-35 for guidance on determining whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications)
- Warranty obligations that are incurred in connection with the sale of the product, that is, obligations in which the customer does not have the option to purchase the warranty separately and that do not provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.
Connecting the Dots
Because the general recognition and measurement requirements that apply to
guarantees in ASC 460-10 differ significantly from the recognition and
measurement requirements for product warranties, it is important for
entities to appropriately determine whether an arrangement is subject to the
guidance that applies to product warranties. On the basis of informal
discussions, we understand that the SEC’s Office of the Chief Accountant
recently objected to a transaction in which a registrant accounted for an
arrangement as a product warranty that involved the guarantee of the
functionality of a security service provided to the entity’s customer by
another customer of the entity. While this guarantee was part of a
multiple-element revenue arrangement, the SEC staff objected to the
registrant’s conclusion that this arrangement was a product warranty. We
understand that the SEC staff believed that a guarantee of a service
provided to a customer by another entity cannot be a product warranty
because the guarantor was not the entity that provided the service. The SEC
staff believed that the arrangement should be accounted for in accordance
with the general recognition and measurement guidance that applies to
guarantee obligations.
As noted in ASC 460-10-15-9(b),
certain warranties may be accounted for as separate performance obligations under
ASC 606. Section 5.5 of
Deloitte’s Roadmap Revenue
Recognition discusses the determination of whether a warranty
is an assurance-type warranty (and therefore outside the scope of ASC 606) or a
service-type warranty (and is therefore accounted for as a performance obligation in
accordance with ASC 606). The following decision tree illustrates this
determination:
See Section
5.5 of Deloitte’s Roadmap Revenue Recognition for additional
guidance on each step in the determination of whether a warranty is within the scope
of ASC 606 or is instead within the scope of ASC 460.
5.6.2 Recognition and Measurement of Warranty Obligations
Once an entity determines that its warranty is an assurance-type warranty that is
within the scope of ASC 460’s recognition and measurement guidance, it should
account for its warranty obligation in a manner consistent with its accounting for
other loss contingencies.
ASC 460-10
25-5 Because of
the uncertainty surrounding claims that may be made under
warranties, warranty obligations fall within the definition
of a contingency. Losses from warranty obligations shall be
accrued when the conditions in paragraph 450-20-25-2 are
met.
25-6 The
condition in paragraph 450-20-25-2(a) is met at the date of
an entity’s financial statements if, based on available
information, it is probable that customers will make claims
under warranties relating to goods or services that have
been sold. Satisfaction of the condition in paragraph
450-20-25-2(b) will normally depend on the experience of an
entity or other information. In the case of an entity that
has no experience of its own, reference to the experience of
other entities in the same business may be appropriate.
Inability to make a reasonable estimate of the amount of a
warranty obligation at the time of sale because of
significant uncertainty about possible claims (that is,
failure to satisfy condition [b] in that paragraph)
precludes accrual and, if the range of possible loss is
wide, may raise a question about whether a sale should be
recorded before expiration of the warranty period or until
sufficient experience has been gained to permit a reasonable
estimate of the obligation.
25-7 The
conditions in paragraph 450-20-25-2 may be considered in
relation to individual sales made with warranties or in
relation to groups of similar types of sales made with
warranties. If those conditions are met, accrual shall be
made even though the particular parties that will make
claims under warranties may not be identifiable.
The recognition requirements of ASC 450 apply to warranty obligations, which meet the
definition of a contingency given the uncertainty associated with the volume,
amount, and timing of any future claims that may be made. Because the recognition
requirements of ASC 450 apply to the warranty obligations, there is no initial fair
value guarantee to record in accordance with ASC 460. Therefore, estimates are
required for accruals related to warranty claims; such accruals should be recorded
when the loss is both probable and reasonably estimable in accordance with ASC
450-20-25-2. (See Chapter 2 for further discussion of the application of the
recognition guidance in ASC 450.)
ASC 450-20
25-2 An
estimated loss from a loss contingency shall be accrued by a
charge to income if both of the following conditions are
met:
- Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
- The amount of loss can be reasonably estimated.
The purpose of those conditions is to require accrual of
losses when they are reasonably estimable and relate to the
current or a prior period. Paragraphs 450-20-55-1 through
55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through
55-35) illustrate the application of the conditions. As
discussed in paragraph 450-20-50-5, disclosure is preferable
to accrual when a reasonable estimate of loss cannot be
made. Further, even losses that are reasonably estimable
shall not be accrued if it is not probable that an asset has
been impaired or a liability has been incurred at the date
of an entity’s financial statements because those losses
relate to a future period rather than the current or a prior
period. Attribution of a loss to events or activities of the
current or prior periods is an element of asset impairment
or liability incurrence.
The criteria in ASC 450-20-25-2 are met if (1) it is probable, as of the date of an
entity’s financial statements, that customers will make claims under warranties
related to goods or services that have been sold and (2) the amount of such claims
is reasonably estimable. Generally, an entity may use its own historical information
and experiences to assess the probability of warranty claims related to sales in the
current period. If an entity has no prior experience, it may be appropriate to
consider the experiences of similar entities in the same industry if such
information is known. If an entity cannot reasonably estimate possible claims (and
therefore does not meet the criterion in ASC 450-20-25-2(b)), ASC 450 precludes that
entity from recording a loss accrual.
An assurance-type warranty guarantees to the customer that the goods
or services are free from defects and function in accordance with the entity’s
performance obligation. Therefore, ASC 460-10-25-6 notes that if an entity concludes
that it is unable to estimate its warranty obligation in accordance with ASC
450-20-25-2(b), or “if the range of possible loss is wide,” questions may arise
about whether the associated sale should be recognized before either (1) the
warranty period expires or (2) the entity has enough experience to reasonably
estimate the obligation. Because assurance-type warranties guarantee the performance
of an underlying good or service, if a customer is dissatisfied with the good’s or
service’s ability to function in accordance with the revenue contract, the guarantee
provides for remediation to the customer in the form of further vendor performance.
If an entity is unable to estimate its warranty obligation at the time of delivery,
or the range of loss is wide, the entity should consider whether it is appropriate
to recognize revenue for the sale of the product. For example, ASC 606-10-55-85
through 55-88 discuss whether a customer’s acceptance of a product indicates that
the customer has obtained control of the product. ASC 606-10-55-87 states:
[I]f an entity cannot objectively determine that the good or
service provided to the customer is in accordance with the agreed-upon
specifications in the contract, then the entity would not be able to conclude
that the customer has obtained control until the entity receives the customer’s
acceptance. That is because, in that circumstance the entity cannot determine
that the customer has the ability to direct the use of, and obtain substantially
all of the remaining benefits from, the good or service.
See Chapter
8 of Deloitte’s Roadmap Revenue Recognition for a discussion of
customer acceptance clauses.
An entity does not need to identify the particular customer who will make a warranty
claim in determining whether it is probable that a claim will be made and the amount
is reasonably estimable. A warranty accrual may be recognized for either (1) an
individual sale with a warranty or (2) groups of similar types of sales with
warranties. Using a group of similar types of sales with warranties as the basis for
the reasonable estimate differs from a general reserve, which an entity would be
prohibited from recognizing. (See Section 2.3.1.5 for more information about general reserves.)
Recognition of general reserves is prohibited because it is not probable that the
uncertain future event or events will confirm that a loss occurred on or before the
date of the financial statements. In contrast, a recognized product warranty reserve
is akin to unasserted claims (as discussed in Section 2.3.2.1) related to a loss that, as of the date of the
financial statements, is both probable and reasonably estimable. An entity may need
to draw upon historical experience with similar types of sales with warranties to
conclude that the loss is both probable and reasonably estimable.
5.6.3 Constructive Product Warranties
Even in the absence of a written contractual arrangement with a
customer, a constructive obligation may arise from a historical practice or a stated
intention to perform repairs even if there is no legal requirement to do so.
Section 5.5.3 of
Deloitte’s Roadmap Revenue
Recognition gives an example of a constructive obligation
that is within the scope of ASC 460.
5.6.4 Product Warranty Disclosures
As discussed in Section 5.6.2, if the condition in ASC 450-20-25-2(b) is not met,
ASC 450 precludes accrual of a warranty obligation. In those instances, an entity
must apply the disclosure requirements for loss contingencies in ASC 450-20-50-3
through 50-6. When a warranty obligation is accrued, in addition to applying the
disclosure guidance in Section 5.5 on
guarantees and in Section 2.8 on loss contingencies, an entity should consider the
disclosure requirements below for product warranties. In addition, product
warranties to which the recognition and measurement guidance in ASC 606 applies are
subject to the disclosure requirements in ASC 460-10-50-1 through 50-8.
ASC 460-10
50-8 A
guarantor shall disclose all of the following information
for product warranties and other guarantee contracts
described in paragraph 460-10-15-9:
- The information required to be disclosed by paragraph 460-10-50-4 except that a guarantor is not required to disclose the maximum potential amount of future payments specified in paragraph 460-10-50-4(b)
- The guarantor’s accounting policy and methodology used in determining its liability for product warranties
- A tabular reconciliation of the
changes in the guarantor’s aggregate product
warranty liability for the reporting period. That
reconciliation shall include all of the following
amounts:
- The beginning balance of the aggregate product warranty liability
- The aggregate reductions in that liability for payments made (in cash or in kind) under the warranty
- The aggregate changes in the liability for accruals related to product warranties issued during the reporting period
- The aggregate changes in the liability for accruals related to preexisting warranties (including adjustments related to changes in estimates)
- The ending balance of the aggregate product warranty liability.