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New rules on New rules on guarantees of debtguarantees of debt

FIN No. 45 – Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (November 2002)

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FIN45 Covers guarantee contracts that have FIN45 Covers guarantee contracts that have any of the following 4 characteristicsany of the following 4 characteristics

1. Contracts that contingently require the guarantor to make payments to the guaranteed party based on an “underlying” Examples:

Irrevocable standby letter of credit which guarantees payment of a specified obligationMarket value guarantee of asset owned by the guaranteed partyGuarantee of the market price of common stock of the guaranteed partyGuarantee of the collection of cash flows from assets held by special purpose entity

2. Performance standby letter of credit or similar arrangements in which guarantor must make payments to the guaranteed party in the event of another entity’s failure to perform under a nonfinancial contract

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Covers guarantee contracts that have Covers guarantee contracts that have any of the following 4 characteristicsany of the following 4 characteristics

3. Indemnification agreements that require guarantor to make payments to the indemnified party (guaranteed party) based on changes in an “underlying” such as an adverse judgment in a lawsuit, imposition of additional taxes due to adverse interpretation of the law

4. Indirect guarantees of the indebtedness of others even though the payment to the guaranteed party may not be based on an underlying asset, liability, etc., of the guaranteed party.

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THE INTERPRETATIONTHE INTERPRETATION

The issuance of a guarantee obligates the guarantor (issuer) in two respects:1. The guarantor undertakes an obligation to stand

ready to perform over the term of the guarantee if the event that the specified triggering events or conditions occur

This is the noncontingent part of the obligation

2. The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur

This is the contingent part of the obligationNew Disclosure – FIN 45

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Key point of FIN 45Key point of FIN 45

FASB 5 should not be interpreted as prohibiting the guarantor from initially recognizing a liability for a guarantee even though it is not probable that the payments will be required under that guarantee.

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Measurement of obligationMeasurement of obligation

a. The premium received or receivable – when the guarantee is issued in a standalone arm’s-length transaction with an unrelated party

b. When the guarantee is part of a transaction with multiple elements, estimate the fair value of the guarantee. Consider the premium which would be required by the guarantor

to issue a standalone guarantee with an unrelated party In the absence of observable transactions for identical or similar

guarantees, use expected present value measurement techniques

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Measurement of obligationMeasurement of obligation

c. If a guarantor must recognize a guarantee at inception because it is probable and can be estimated (FASB 5), the amount to initially recognize is the GREATER of the fair value of the guarantee (as measured above) or the contingent liability amount required under paragraph 8 of Statement 5.

d Not for profit situation: guarantees provided as a contribution to an unrelated party (like a loan guarantee by a community foundation to a nonprofit entity), the guarantee (gift) should be measured at the fair value of the guarantee and NOT considered merely a conditional promise to give.

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The debit side is not prescribedThe debit side is not prescribed

Some examples provided in FIN 45 include:a. If a premium is received, the debit would be to cash or

receivable.b. If the fair value of the premium is an allocation of the receivable

or cash received on a transaction that involves other assets, liabilities, etc., the allocation to the guarantee will affect the calculation of the gain or loss on the transaction.

c. If the guarantee is associated with the acquisition of a business accounted for under the equity method, the guarantee would increase the carrying value of the investment.

d. In an operating lease situation, the guarantee would affect prepaid rent.

e. If no consideration is received, the offsetting entry would be to expense.

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Disclosures Required – FIN 45Disclosures Required – FIN 45

a. Nature of the guarantee including, the approximate term, how the guarantee arose, and the event or circumstance that would require the guarantor to perform under the guarantee.

b. Maximum potential amount of future paymentsc. Current carrying amount of the liabilityd. Nature of (1) any recourse provisions that would enable

guarantor to recover from third parties any of the amounts paid under the guarantee and (2) any assets held either as collateral or by third parties that the guarantor would be able to liquidate to recover any of the amounts paid.

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Disclosures Required – con’tDisclosures Required – con’t

e. FOR PRODUCT WARRANTIES. The disclosure of the maximum amount of future payments requirement above is waived. Instead: 1. The accounting policy and methodology used to determine its

liability for product warranties including any deferred revenues associated with extended warranties.

2. A tabular reconciliation of the changes in the guarantor’s aggregate product warranty for the reporting period.

Beginning balance Aggregate reduction for payments made or services provided Aggregate increase for new warranties issued during period Aggregate changes in the liability related to pre-existing warranties

(changes in estimate) Ending balance

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Example from Recent F/SExample from Recent F/S

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New rules on New rules on redeemable preferred redeemable preferred stockstockSFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (May 2003)

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Redeemable financial instrumentsRedeemable financial instruments

Mandatorily redeemable financial instrument shall be classified as liability

ExceptionsRedemption is contingent

Required only upon liquidation or termination of the reporting entity

Required only if an uncertain future event occurs Becomes liability only when the event becomes certain to

occur Certain not probable!

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Other redeemable securitiesOther redeemable securities

Classify as liability:Obligation to repurchase equityObligations to issue variable number of

shares

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Measurement of liabilityMeasurement of liability

Financial instruments that meet these requirements are initially measured at fair value

Most are then re-measured at fair value and the subsequent changes in fair value are recognized in earnings

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Reporting on StatementsReporting on Statements

Balance sheet required description:“Shares subject to mandatory redemption”Should be on separate line and not

commingled with other liabilities Income statement transition

Through “cumulative effect of a change in accounting principle”

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DisclosuresDisclosures

Nature and terms of the financial instruments including rights and obligations Amount that would be paid or number of shares that

would be issued and their fair value “as if settled” at reporting date

How changes in fair value of issuer’s equity shares impact the settlement amount

Maximum amount issuer could be required to pay Maximum number of shares that might have to be

issued And several more items (see paragraph 27)

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Example financial instrumentExample financial instrument

Trust-preferred securities A financial institution establishes a trust or other entity that is

consolidated with the financial institution The trust issues mandatorily redeemable preferred stock and

uses the proceeds to purchase from the financial institution an equivalent amount of junior subordinated debt

The financial institution pays interest to the trust, the trust uses the funds to pay the dividends

Why they exist Upon consolidation, the intercompany transaction (payment of

interest) disappears along with the debt (and the receivable on the trust’s books)

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Example financial instrumentExample financial instrument

Trust-preferred securitiesUnder the new rules, the financial institution

will have to report INTEREST EXPENSE and DEBT instead of dividends and redeemable preferred stock

FAS 150 Appendix A includes other examples to aid implementation of the new rules

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Additional Pension Additional Pension DisclosuresDisclosures

FAS 132 (revised 2003)

Revised again by FAS 158 (2006)

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New Disclosures for Public EntitiesNew Disclosures for Public Entities

Percentage of total plan assets by categories like equity securities and debt securities More detailed categories are encouraged if it would

help assess risk and long-term expected rate of return

Narrative discussion of investment policies and strategies

Narrative discussion of how the expected rate of return was determined

Accumulated benefit obligation

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New Disclosures for Public EntitiesNew Disclosures for Public Entities

Benefits expected to be paid to retirees in each of the next five years and in aggregate thereafter (presumably NOT the present value of benefits)

Estimated employer contribution that will be made during next fiscal year

Weighted averages for assumptions in tabular form Discount rates, rates of compensation increase,

expected long-term rate of return, etc. Measurement dates used to determine PBO,

etc.

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ExamplesExamples

Appendix C provides illustrations that should be useful in doing the footnote for the TDT project (Spring 2007)

Illustration 1 is probably your “best bet” but you need to get the changes from FAS158

You MIGHT be able to find “real examples” of the new disclosures since the rules were effective for fiscal years beginning after 12/15/06

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FSP of interestFSP of interest

Note that FSP158-1 (Feb 21, 2007) contains Update of Illustrations, Application GuidanceDon’t hit ‘print’ – 257 pages!Fixes examples in FAS87, FAS88 & FAS106

as related to issuance of FAS158. FAS132R was “fixed” in FAS158 so is not included in this FSP

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More to come on pensionsMore to come on pensions

November 10, 2005, FASB decided to add a comprehensive project to its technical agenda on accounting for postretirement benefits including pensions and to conduct that project in two phases.

Phase 1 Completed by issue of FAS 158 Require that funded or unfunded status be recognized on

balance sheet (e.g., difference between PBO and Plan Assets for pensions)

Phase 2 (multi-year project in collaboration with IASB) Comprehensively consider measurement & display of various

elements of post-retirement benefits