The User's Perspective
An Exposure Draft approved by the Board in June 2012, Accounting and Financial Reporting for Nonexchange Financial Guarantee Transactions, proposes guidance for reporting the financial guarantees made and received by state and local governments. This article examines what financial guarantees are, why they are important in the governmental environment, and what the GASB is doing related to them.
Governments typically provide a number of types of financial guarantees, which principally involve commitments to ensure that payments take place on debt issued by other entities. Financial guarantees represent potential claims on a government’s resources when it is the provider of a guarantee, and a potential reduction of a government’s obligations when it is the recipient.
A financial guarantee in this context refers to a transaction that involves three parties:
When one government guarantees a financial obligation and does not receive equal value in return, the transaction is called a nonexchange transaction. (This is in contrast to an exchange transaction in which a debt issuer pays a fee to a credit enhancement company to insure its outstanding debt.) In these cases, the guarantor government has agreed to assure payment to a third party if the issuer is not able fulfill its obligation to pay the third party itself. Guarantor governments generally enter into guarantees of this nature with a goal to assist other entities within their jurisdiction to obtain more favorable interest rates.
In one example of a nonexchange financial guarantee transaction, a state might guarantee the debt of a school district to cover circumstances in which the school district, for whatever reason, runs short of sufficient resources to make payment on their debt obligation. When this type of arrangement is in place, it provides an additional assurance to the bondholders and serves to minimize their credit risk.
The recent economic environment has resulted in a level of financial stress that has impacted many governments and governmental entities. It has revealed some financial guarantees that were made or received in the past but are only now becoming known. The apparent increased incidence of financial guarantee arrangements between governments—and their potential to result in claims—has emphasized the need for clear and consistent recognition and disclosure guidance that is specifically crafted for the government environment.
Numerous types of state and local government entities issue and receive financial guarantees, including general purpose governments (such as states, counties, and cities), special-purpose governments (like a housing finance authority), and governmental entities that engage in business-type activities (like operating a hospital).
Governments—both guarantors and debt issuers—currently account for financial guarantees by applying accounting and financial reporting guidance that derives from a variety of sources, including guidance that was originally designed for the business environment. Under the existing private sector-oriented guidance, a guarantor government would recognize a liability for the guarantees it has extended only when it is probable that payment would be made.
While that guidance was originally designed to address exchange transactions occurring in the private sector, the guidance now proposed by the GASB addresses nonexchange transactions in which the governmental guarantor is not receiving resources of equal value in return.
If the provisions of the Exposure Draft are ultimately reflected in final standards, governments both offering and receiving guarantees would have appropriate guidance that is specifically intended for governmental entities. The new guidance would address circumstances and conditions as they typically arise in the governmental environment.
The Exposure Draft proposes that a government guarantor that extends a nonexchange financial guarantee would recognize a liability on the face of its financial statements when qualitative factors indicate that it is more likely than not the guarantor would actually make a payment under the agreement. Generally, this will result in liabilities being recognized earlier than under current standards.
The government guarantor would determine the amount of the liability by making a best estimate of the discounted future outflows expected to be incurred. When a best estimate cannot be devised and only a range of estimated future outflows can be determined, the amount of the liability recognized would be the minimum amount falling within the range. For example, if qualitative factors indicate that a government guarantor will more likely than not be required to make a guarantee payment and the government’s best estimate is $100,000, the government guarantor would record a liability in the amount of $100,000. In this same example, if there is no estimate better than another estimate but the government expects to make a payment of between $30,000 and $120,000, the government guarantor would record a liability in the amount of $30,000.
The proposal identifies qualitative factors that a guarantor might consider when determining if payment on its guarantee is more likely than not. The qualitative characteristics could include such things as the issuer undergoing a significant financial difficulty, like the loss of a major revenue source or a breach of a debt covenant that requires immediate payment. An extreme example of a qualitative factor would be an issuer entering into bankruptcy protection proceedings.
In circumstances in which a government extends groups of similar guarantees, the proposed Statement would require a government to assess qualitative factors and historical data on frequency of default in relation to the group of guarantees rather than each individual guarantee. The is very different from the existing private-sector-oriented guidance, under which a guarantor government recognizes a liability for guarantees it has extended only when it is probable that payment would be made.
The proposal would require an issuer government that is required to repay a guarantor for making a payment on a guaranteed obligation or legally assuming the guaranteed obligation to continue to report a liability until it is legally released as an obligor. When an issuer government is released as an obligor, it would recognize revenue from being relieved of the obligation.
The proposed statement also would clarify the information required to be disclosed by governments that extend and receive financial guarantees as a result of nonexchange transactions.
A government that extends financial guarantees as a result of a nonexchange transaction should disclose the following information about the guarantees by type of guarantee:
A government that has outstanding obligations that have been guaranteed by another entity should disclose the following information about the guarantees by type of guarantee:
If the Exposure Draft’s proposals are ultimately reflected in a final Statement, it would result in more useful information being available to users of governmental financial statements. This information would enable them to identify and better understand the financial guarantees that are extended and received by state and local governments. In addition, it would help users to assess the possibility that a government guarantor may be facing addition claims on its available resources as a result of issuers not fulfilling their obligations. This information also would allow them to more easily get a handle on the resources that are potentially available to an issuer government under a financial guarantee, should it find itself in particularly difficult financial circumstances.
Read the News Release
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