Can a loan guarantees create liabilities that go on the balance sheet of the guarantor?
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:
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.
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?
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?
Guarantee Expense (Contribution) $40,000
Guarantee Liability $40,000
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.
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:
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.
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.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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Thanks for the additional information Gloria. This topic is interesting.
Great article. Just wanted to add some info regarding the offsetting debit: (source Federal Reserve)
FASB ASC Topic 460-10; formerly FIN No. 45 does not prescribe specific accounting for the guarantor’s offsetting entry when it recognizes a guarantee liability. That offsetting entry depends on the circumstances in which the guarantee was issued, as illustrated in FASB ASC Topic 460-10; formerly FIN No. 45:
(1) If the guarantee were issued in a stand-alone transaction for a premium, the offsetting entry would be the consideration received (such as cash or a receivable).
(2) 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.
(3)If the guarantee were issued in conjunction with the formation of a partially owned business or a venture accounted for under the equity method, the recognition of the liability for the guarantee would result in an increase to the carrying amount of the investment.
(4) If a guarantee were issued to an unrelated party for no consideration on a stand-alone basis (that is, not in conjunction with any other transaction or ownership relationship), the offsetting entry would be to expense.
In most cases, the Reserve Banks enter into agreements accounted for as guarantees for no consideration. In these cases, the fourth situation listed above would be applicable, and the Banks should charge the initial obligation to profit and loss
Thanks Debi. I try. I do enjoy writing and interacting with other accountants such as you.
Thank you for this great article, Charles – you have a gift for explaining things in plain English!
Jim, you know I’m not sure. I had even thought about the effect on the nonprofit’s books. My first thought (in response to your question) was, “well, if ABC Co. has a contribution expense, then Sidewalk has a contribution revenue” and “if Sidewalk has a contribution revenue, what is the debit?” I tried to look this up but found no answer. I tend to think you are right: there is an asset. And the asset is amortized to interest expense.
Charles, great example of something we don’t often think about – balance sheet entries for loan guarantees. I’ll just add – in your ABC Co/Sidewalk Safety example – Sidewalk Safety would have a $40,000 asset, correct?