Do Loan Guarantees Create Liabilities?
By Charles Hall | Accounting
Can a loan guarantees create liabilities that go on the balance sheet of the guarantor?
Yes.
Recording Loan Guarantees
FASB 5 (now ASC 450) has been with us for some time. It states that a company should record a contingent liability if two things occur:
- The liability is subject to estimation (you can calculate it)
- It is probable that the liability will be paid
ASC 450 addresses these contingent liabilities.
FIN 45 (now ASC 460) was issued in the early 2000s to clarify that some loan guarantees create liabilities–even when there is no loan default. ASC 460 deals with noncontingent liabilities. And it’s the noncontingent piece that confuses everyone (including me). So let’s first take a look at noncontingent liabilities.
Noncontingent Liability
ABC Co. guarantees a $2,000,000 loan of XYZ Co. (an unrelated entity); in exchange, XYZ agrees to pay a fee of $50,000.
Should ABC Co. record a liability for the guarantee? Yes.
What’s the entry?
Dr. Cr.
Accounts Receivable $50,000
Guarantee Liability $50,000
The standard allows the guarantor to use the guarantee fee as a practical expedient to valuing the loan guarantee.
What if there is no guarantee fee? For instance, let’s say ABC Co. guarantees a loan for Sidewalk Safety Nonprofit, Inc. This guarantee is provided to the nonprofit free of charge. How would ABC Co. record this guarantee?
First ABC Co. would need to determine the value of the guarantee. If Sidewalk Safety’s interest rate is 8% without the guarantee, but now it’s 4%, then you can compute the differential using present value calculations. Let’s say the result is $40,000, what is the entry?
Dr. Cr.
Guarantee Expense (Contribution) $40,000
Guarantee Liability $40,000
Guarantee of Related Party Debt
What if the loan guarantee is for an entity owned by the same parties? If the guarantee is on the debt of a related entity under common control, ASC 460-10-25-1 exempts the guarantor from the requirement to record the guarantee liability.
Next, we’ll see how to relieve the guarantee liability.
Guarantee Liability – In Subsequent Periods
After inception, the fair value liability (for both examples above) is taken to income as the guarantor is released from risk; the liability is to be adjusted to fair value at the period end.
ASC 460 does not provide detailed guidance as to how the guarantor’s initial liability should be measured after its initial recognition. Depending on the nature of the guarantee, the guarantor’s release from risk is recognized with an increase to earnings using one of three methods:
- Systematic and rational
- Deferring until expiration or settlement of the guarantee
- Remeasurement at fair value (for guarantees accounted for as derivatives)
You now know how to account for the noncontingent liability, but what if the guaranteed party defaults on the loan. Now the guarantor needs to record the loan as a liability.
Contingent Liability
For example, what if Sidewalk Safety defaults on the loan? Then ABC Co. needs to book a liability for the remaining debt. Sidewalk Safety’s default triggers ASC 450.
This is the contingent piece of the equation (for which no amount is typically recorded at the inception of the guarantee). Upon Sidewalk Safety’s default, the debt amount is subject to estimation and payment is probable. ABC Co. is on the hook for the remaining debt.