Overview
Mandatory lock-downs of ‘non-essential’ businesses and the effects of the pandemic on both supply and demand have been mitigated by a wide range of measures to help economies through these unprecedented times. Many governments around the world have used financial loan guarantees as part of their response to the COVID-19 pandemic.
Ensuring businesses have adequate access to finance, often on favourable terms, has been a key part of the response by policy makers, including loan guarantees to support banks in lending to business.
Financial guarantees are generally being issued where governments wish to provide indirect funding to businesses, for example to ensure they have sufficient cash to be able to operate at a time when sales have reduced significantly or perhaps have stopped completely. By guaranteeing all or part of the loans made by banks and other financial institutions to businesses, governments hope to minimise the economic damage caused by normally viable businesses being unable to operate during the pandemic. If a business fails or cannot repay for whatever reason, then the bank or financial institution concerned can recover all or part of the unpaid loan balance from the relevant government instead.
Financial loan guarantees: financial reporting problem areas
This article focuses on some of the key financial reporting problem areas that could arise when accounting for financial loan guarantees under International Public Sector Accounting Standards (IPSAS). The accounting treatment under International Financial Reporting Standards (IFRS) or US generally-accepted accounting principles (US GAAP) may be different.
Irrespective of the accounting standards applying, the accounting for financial loan guarantees will differ depending on the terms and conditions of each specific arrangement.
In most cases, financial loan guarantees are required to be recorded as a liability in the balance sheet at their fair value when they are issued, with expected credit losses that exceed the initial fair value recognised subsequently.
The key accounting issues are:
a. determining the fair value of non-commercially based transactions; and
b. determining the expected credit losses associated with the guarantees over time.
Both of these issues are likely to require additional information that is probably not readily available from internal systems. Good planning is required to obtain the necessary information so as to ensure the accounting treatment is complete, accurate and timely.
The provision of loan guarantees is distinct from lending directly to businesses or providing financial support by deferring tax payments into the future, which give rise to receivables on the asset side of the relevant government balance sheet. (The accounting for receivables is not part of this overview.)
Initial measurement – fair value at inception
IPSAS 41 Financial Instruments, requires financial guarantee contracts to be recognised at fair value.
This is normally straightforward in a commercial transaction, as the fair value at inception will typically be equal to the value of the premium paid in exchange for being granted a guarantee.
However, most governments are providing guarantees at no cost as part of their COVID support measures, and so the amount to be recorded for each financial guarantee so issued will need to be determined on an alternative basis.
IPSAS 41 provides guidance on determining a fair value in these circumstances1, through the use of a valuation technique to establish what the transaction price should have been on the measurement date. These need to be assessed as if the guarantee had been issued in return for a premium in an arm’s length exchange, motivated by normal operating considerations.
A key consideration at this point is whether the government has the necessary information to determine the fair value, which is likely to be very challenging given the uniqueness of the support being provided by governments. There is unlikely to be an active market with observable prices for these guarantees and valuation techniques may rely on mathematical models which consider financial risk.
IPSAS 41 states2 that if no reliable measure of fair value can be determined, either by direct observation of an active market or through another valuation technique, then an entity is required to measure the financial guarantee contract at the amount that is expected to be paid out under the guarantee - the ‘loss allowance’ or the ‘expected credit losses’ expected to be incurred on the guarantee.
The government may not have all the information needed to determine fair value at inception and so may need to fall back on an estimate of expected credit losses when guarantees are issued. Key considerations should be:
- What has the government done to make sure it has access to the information it needs to be able to do its accounting correctly?
- How will an entity know the expected default rate of the loans issued given it is only the guarantor and does not have access to the individual loan books to assess the credit risk?
- To what extent do subsequent events affect any assumptions made and have these been documented adequately?
Subsequent recognition – higher of fair value at inception or expected credit losses
After initial recognition, financial guarantees will subsequently be measured at the higher of:
1. The amount initially recognised (fair value);
2. The amount of the expected credit loss at the reporting date.
Government entities who have issued the financial guarantees must estimate the expected credit loss of the amounts borrowed to determine whether or not it is higher than the initial fair value. They may also require this information to determine the initial measurement if the fair value at inception can’t be determined accurately.
Expected credit losses are the weighted average losses caused by customers not paying the money they owe, with the weight being the probability of default.
As per IPSAS 41, an entity is expected to recognise 12-month expected credit losses if the credit risk has not increased significantly since initial recognition. These are the expected credit losses that result from default events that are possible within 12 months after the reporting period. This is not the amount of the expected cash shortfall limited to 12 months, instead it is the entire expected loss over the lifetime of the loan weighted by the probability that the loss will occur in the next 12 months.
However, should the credit risks increase significantly then lifetime expected credit losses need to be recognised (stage 2 and 3). That is the expected losses of the loans that could occur at any stage over the lifetime of the loans.
IPSAS 413 provides examples of the types of information that may be relevant in assessing changes in credit risk. Making these judgements in economically volatile times will present challenges. Some jurisdictions have recently announced extensions to their various schemes, some focusing on particular sectors. These extensions in themselves could be seen as possible impairment indicators since the implicit assumption is that the effected entities would not be able to conduct business as usual.
Financial guarantees provided to central banks
In addition to providing financial loan guarantees to commercial banks and other financial institutions, many governments have also issued guarantees to their central banks for quantitative easing and other interventions undertaken to support monetary policy.
Depending on the structure of the government concerned, there may be a need to record such guarantees in departmental or governmental financial statements that do not include the central bank. These intra-governmental liabilities would then need to be eliminated in consolidated whole-of-government accounts that incorporate the financial operations and balance sheet of the central bank.
The fair value at inception and subsequent expected credit losses of guarantees issued to central banks are likely to be much smaller than guarantees over lending to vulnerable businesses suffering during the pandemic. Most central bank guarantees cover funding provided to well-capitalised commercial banks and large corporates, together with purchases of investment-grade corporate bonds. Despite that there is still a risk of non-payment and so there are likely to be expected credit losses to recognise.
Example – a 100% financial loan guarantee granted to a commercial for loans to small businesses
As an example, consider a financial loan guarantee provided to a commercial bank to cover loans made to small businesses in a particular area. No premium is paid by the commercial bank, and when the guarantee is issued the probability-weighted expectation is that 20% of business loans will not be repaid.
In the first instance, determining the fair value at inception will be difficult as this is not a commercial transaction. However, there may be market or proprietary data available that provides information on how such a guarantee could be priced. For the sake of this example, we assume that a CU500m guarantee in these circumstances might be valued at CU110m (say). Hence, the fair value at inception of CU110m would be recorded as a liability in the balance sheet on day 1.
For simplicity, the expected credit loss on the guarantee remains at 20% or CU100m – less than the fair value at inception - at the end of the first reporting period, and so no adjustment would be required to the carrying value of the financial loan guarantee at that point.
However, during the second reporting period the outlook deteriorates and the expected credit loss on the guarantee rises to 30% or CU 150m. Hence, the government concerned would need to record a charge of CU 40m in increasing the carrying value from CU110m to CU150m.
Some or all of this charge could be reversed if the expected credit loss and hence the associated liability reduces in subsequent periods. However, the carrying value cannot go below the initial carrying value (CU 110m) irrespective of whether that was originally determined to be the fair value at inception or the estimated credit loss at inception.
COVID loans – a potential debt straight-jacket
Many businesses, small and large, have increased their debt by taking out COVID related loans to survive the pandemic. But while many of these loans were issued at favourable rates with deferred interest payments, these loans not only sit on top of existing loans, they are being used to replace lost sales and to cover costs.
There is growing concern that this additional debt could seriously dampen the economic recovery as companies face having to service their debt rather than invest in their businesses to expand.
In the UK, for example, the Government has provided guarantees to banks to lend in excess of £45bn to more than one million businesses, many of them very small. Neither the Government nor the banks will wish to see thousands of businesses close down after being pursued for failing to pay back the loans. The Government does not want the political fallout and the banks are still repairing their reputation following the 2008/09 financial crisis.
Richard Hughes, the new head of the Office for Budget Responsibility (OBR), in his previous role with the Resolution Foundation, a UK-based think tank, has suggested linking loan repayments to business earnings and that anything remaining due after a specific time period is cancelled. This would ensure companies are paying back the loans only if they recover themselves. If the loan repayments are linked to future earnings this may suggest a modification to the loan and have an impact on the accounting by Government.
Applying principles-based standards (such as IPSAS) requires professional judgement in estimating certain balances and this will be more difficult in a volatile and uncertain economic climate.
Many jurisdictions have spent a lot of taxpayers’ money to support individuals and businesses to protect jobs and prevent an immediate economic collapse. Applying accrual based accounting standards is part of wider Public Finance Management to enable good decision making but to also hold those charged with governance to account.
Eventually the effectiveness of these interventions will have to be evaluated and will no doubt be judged by the success of the economic recovery. Having timely and accurate data is paramount, especially when the reverberations could be felt for a long time to come.
Appendix – Relevant accounting standards to consider
Adjusting or non-adjusting events after the reporting period
A fundamental principle in the preparation of accounts is that they should reflect conditions that existed at the reporting date. Events that occur after the reporting date but before the accounts are authorised for issue are either adjusting or non-adjusting events. IPSAS 14 Events after the reporting date provides more guidance.
The general consensus is that the pandemic is a non-adjusting event for the vast majority of entities with a 2019 year end. On 30 January 2020, the World Health Organisation (WHO) announced the Coronavirus as a global health emergency and on 11 March 2020 it announced that the virus was a global pandemic.
For entities with a 31 March 2020 year end, the outbreak is likely to be considered a current-period event that will also require ongoing evaluation of events after the reporting date. For entities with January or February 2020 reporting periods, it is more challenging to determine if events after the reporting period are adjusting or non-adjusting events.
Significant judgement will be required to determine the conditions that existed at the reporting date and whether, therefore, the amounts recognised in the accounts need to be adjusted (impairment, fair value, liabilities etc). This judgement will be heavily dependent on the reporting period in question, the relevant government’s individual circumstances, and the particular events under consideration.
Many jurisdictions have announced delays in accounting and audit deadlines which will mean that as time passes, entities will need to keep reviewing and assessing their best estimates of balance sheet liabilities as more information becomes available.
Finally, it should be noted that if going concern assumptions are no longer appropriate for a government entity, such as a Government Business Enterprise, then IPSAS 14 requires this to be reflected in its financial statements. In this case the distinction between adjusting and non-adjusting events is superseded by the guidance relating to going concern (IPSAS 14.17-24).
Recognition - meeting the definition of a financial guarantee
IPSAS 41 Financial Instruments defines a financial guarantee as a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs if a specified debtor fails to make payments when due in accordance with the terms of a debt instrument.
The guarantees provided as part of COVID-19 support are likely to be in scope of IPSAS 41 but if they do not meet the definition of a financial guarantee then other relevant standards should be considered, such as IPSAS 19 Provisions, Contingent Liabilities and Contingent Assets.
1 See IPSAS 41.AG131 - 136 Return to article
2 IPSAS 41.AG136 Return to article
3 IPSAS 41.AG181 Return to article