Query
Subsidiary has provided a financial
guarantee to a bank for loan taken by Parent. Subsidiary does not charge Parent
any guarantee commission. How is the guarantee accounted in the separate
financial statements of the Parent and Subsidiary assuming the guarantee is an
integral part of the arrangement for the loan?
Response
Subsidiary recognises the financial
guarantee liability (unearned financial guarantee commission) at fair value, in
its books at the date of issuance to the bank. Since the subsidiary does not
receive any consideration from the Parent, it has effectively paid dividends to
Parent. Consequently, the corresponding
debit should be made to an appropriate head under ‘equity’. It would not be
appropriate to debit the fair value of the guarantee to profit or loss as if it
were a non-reciprocal distribution to a third party as it would fail to
properly reflect the existence of the parent-subsidiary relationship that may
have caused Subsidiary not to charge the guarantee commission. Under Ind AS
115, the unearned financial guarantee commission recognised initially will be
amortised over the period of the guarantee as revenue and consequently, the
balance of the unearned financial guarantee commission would decline
progressively over the period of the guarantee. However, in addition to
amortising the unearned financial guarantee commission to revenue, at each
reporting date, Subsidiary is required to compare the unamortised amount of the
deferred income with the amount of loss allowance determined in respect of the
guarantee as at that date in accordance with the requirements Ind AS 109. As
long as the amount of loss allowance so determined is lower than the
unamortised amount of the deferred income, the liability of Subsidiary in
respect of the guarantee will be represented by the unamortised amount of the
financial guarantee commission. However, if at a reporting date, the amount of
the loss allowance determined above is higher than the unamortised amount of
the financial guarantee commission as at that date, the liability in respect of
the financial guarantee will have to be measured at an amount equal to the
amount of the loss allowance. Accordingly, in such a case, Subsidiary will be
required to recognise a further liability equal to the excess of the amount of
the loss allowance over the amount of the unamortised unearned financial
guarantee commission.
As regards the Parent, in the fact
pattern, financial guarantee provided by Subsidiary is an integral part of the
arrangement for the loan taken by Parent from the bank. Therefore, in
accordance with the principles of Ind AS 109, separate accounting of such
financial guarantee is not required. However, the ITFG (Bulletin 16) felt that
as per Ind AS 109, fees associated with the guarantees that are an integral
part of generating an involvement with a financial asset or a financial
liability are taken into account in determining the effective interest rate for
the financial asset/financial liability. Therefore, the provision of guarantee
by Subsidiary without charging guarantee commission is analogous to a distribution/
repayment of capital by Subsidiary to Parent. To reflect this substance, Parent
should credit the fair value of the guarantee to its investment in Subsidiary
and debit the same to the carrying amount of the loan (which would have the
effect of such fair value being included in determination of effective interest
rate on the loan). Subsequently, ITFG revised Bulletin 16. As per the revised
requirement, Parent will debit the fair value of the guarantee to the carrying
amount of the loan. If the investment in subsidiary is accounted at cost or
FVTPL, the corresponding credit will be recognised in the P&L account. If
the investment in subsidiary is accounted at FVTOCI, the credit will be
recognised in the P&L account as dividend received, unless the distribution
clearly represents recovery of part of the cost of the investment.
The
author believes that the accounting of the financial guarantee by the grantor
is inevitable because financial guarantee is a financial liability in
accordance with the definition contained in Ind AS 32. However, there is no
requirement for the beneficiary to record a financial guarantee provided by a
grantor for which no commission is charged, in the way suggested by the ITFG.
This is also the global practice. The implication of the ITFG view is that
in all cases, where any transaction between group companies are subsidised, the
transaction will be recorded at its fair value rather than at the transaction
price. This is certainly not required by Ind AS and could have unintended consequences,
particularly in the case of merger and amalgamation transactions. Furthermore,
it will create opportunities for group companies to create unnecessary credit
going to the P&L account of the separate financial statements. The only
requirement under Ind AS for such transactions would be appropriate disclosures
in accordance with the requirements of Ind AS 24 Related Party Disclosures.
