Journal Entries

This recurring website feature highlights articles from The GASB Report, the GASB’s monthly newsletter. The current article appeared in the June 2012 issue.

GASB Issues Exposure Draft on Financial Guarantee Transactions

In June, the GASB approved for issuance an Exposure Draft of a proposed Statement, Accounting and Financial Reporting for Nonexchange Financial Guarantee Transactions. The comment deadline is September 28.

The Exposure Draft proposes guidance regarding the recognition and disclosure of financial guarantees made and received by state and local governments. Governments typically provide several types of financial guarantees, which are primarily associated with commitments to ensure payments on debt issued by other entities.

For the purposes of this proposal, a financial guarantee refers to a transaction that involves three legally-separate parties:
  1. The guarantor or entity providing the guarantee of a separate entity’s legal obligation
     
  2. The issuer—the entity that issues the obligation that is being guaranteed, and
     
  3. The bondholder—the entities that purchase the obligation.
When a government is the provider of a financial guarantee, the guarantee represents potential claims on its resources. When a government receives a guarantee, the guarantee represents potential resources.

When a government guarantees the financial obligation of another government and the guarantor government does not receive equal value in return, the transaction is referred to as a nonexchange transaction. Guarantor governments typically enter into the kind of financial guarantees at issue here with a goal to assist other entities within their jurisdiction to reduce borrowing costs. Guarantees of this nature provide an additional assurance to bondholders and serves to minimize their credit risk.

Many types of state and local governmental entities issue and receive financial guarantees, including general purpose governments, special-purpose governments, and governmental entities that engage in business-type activities.

Existing Guidance

While some relevant accounting and financial reporting guidance for financial guarantees does exist within GASB literature, it derives from a variety of sources. Governments primarily apply the accrued loss contingency guidance contained in Statement No. 62, Codification of Accounting and Financial Reporting Guidance Contained in Pre-November 30, 1989 FASB and AICPA Pronouncements, which was carried forward from the Financial Accounting Standards Board’s Statement No. 5, Accounting for Contingencies, FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss, and FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others.

This guidance was originally designed to address exchange transactions occurring in the private sector. Consequently, it addresses circumstances not typically encountered in the government environment. The guidance now proposed by the GASB, however, is expressly designed to address governmental entities. Specifically, the proposed guidance addresses nonexchange transactions in which the governmental guarantor is not receiving resources of equal value in return, which is typically the case for financial guarantees in the government environment.

Due to the increasing prevalence of these kinds of guarantees and the potential for them to result in claims due to the current economic climate, there is a need for clear and consistent recognition and disclosure guidance that derives from a single source and is designed specifically for nonexchange transactions that occur in the government environment.

What Would the Proposal Require?

The proposed Statement would require a government that extends a financial guarantee to recognize a liability if and when qualitative factors indicate that it is more likely than not that the government will actually make a payment as a result of the guarantee agreement. Qualitative factors could include such events as the issuer experiencing a significant financial hardship, like the loss of a major revenue source; breaching a debt contract, such as a failure to meet rate covenants; or initiating the process of entering into bankruptcy protection proceedings or a financial reorganization. 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 amount of the liability to be reported would be the best estimate of the costs expected to be incurred. When there is no best estimate but a range of estimated costs can be established, the amount of the liability would be the minimum amount within the range.

The proposed Statement would provide that a government that is required to repay a guarantor for making a payment on a guaranteed obligation or legally assuming the guaranteed obligation should continue to report a liability until legally released as an obligor. In situations in which a government is released as an obligor, the government would recognize revenue as a result of being relieved of the obligation.

Note Disclosures

In addition, the proposed Statement would clarify the information required to be disclosed by governments that extend and receive financial guarantees as a result of nonexchange transactions. The disclosures proposed are designed to provide users of governmental financial information with information about the nature and amount of the financial guarantees entered into by governments, including the parties to the agreement, and the period covered by the guarantee.

Proposed Effective Date

The requirements of the proposed Statement would be effective for periods ending after June 15, 2013. Early application would be encouraged.

How to Obtain Copies of the Exposure Draft

Copies of the Exposure Draft may be downloaded free of charge from www.gasb.org. The comment deadline is September 28. Additional details on how to provide comments to the GASB on the proposal are available in the front of the Exposure Draft.