Evaluation of the FASB's Proposed Accounting and Disclosure Requirements for Guarantors

Abstract

INTRODUCTION The May 22, 2002 FASB Exposure Draft, Guarantor's Accounting and Disclosure Requirements, Including Indirect Guarantees of Indebtedness of Others (hereafter ED), addresses initial recognition, initial measurement, and disclosure issues related to guarantees. Although it undertook the guarantee project in conjunction with its project on consolidation guidance related to special-purpose entities (SPEs), the FASB addressed guarantees in a separate project because guarantees also arise in situations other than those associated with SPEs. The ED calls for recognition and increased disclosure of the liability associated with a guarantor's obligations under guarantees. It takes the position that a guarantee obligates the guarantor in two respects: (1) the guarantor undertakes a noncontingent obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur and (2) the guarantor undertakes a contingent obligation to make future payments those triggering events or conditions occur. The noncontingent obligation occurs when the guarantor commits to the guarantee, while the contingent obligation occurs only when certain future conditions arise; for example, the entity whose debt is guaranteed defaults on payments. While the ED is not explicit on the nature of the noncontingent liability, we believe it is best characterized as deferred revenue for most guarantees. An example in the ED sets the stage for this interpretation: if a seller-guarantor issues to its customer's bank a guarantee of the customer's loan whose proceeds are used to pay the seller for the assets being purchased, the failure to recognize a liability for the issuance of the guarantee overstates the profit on the sale. (1) Just as an insurer charges a premium as compensation for its exposure to losses, the guarantor in this example must be compensated for its guarantee commitment and resulting exposure under the guarantee--the noncontingent element. (2) This example suggests that a portion of the proceeds from the sale be deferred, and recognized over the period of time covered by the guarantee. The ED calls for the guarantor to recognize as a liability the fair value of the noncontingent element of the guarantee, (3) and confirms the applicability of FASB Statement No. 5, Accounting for Contingencies, to the contingent element of the guarantee. The ED also identities four disclosure items to be provided by the guarantor. These include: * the nature of the guarantee, including how it arose and the circumstances that require the guarantor to perform under the guarantee, * the maximum potential amount of (undiscounted) payments the guarantor could be required to make under the guarantee, * the current carrying amount of the liability, and * the nature of (1) any recourse provisions that enable the 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 can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee. The ED raises issues related to valuation of contingent liabilities, financial statement recognition vs. footnote disclosure, and effects of increased footnote disclosure. This article examines academic research relevant to the issues raised in the ED and presents the views of the AAA Financial Accounting Standards Committee (FASC) (hereafter the Committee) on the ED. The Committee based these views on inferences from existing research findings, an understanding of the Conceptual Framework, and views expressed in previous Committees' communications with the FASB and IASC on guarantees related to transfers of financial assets and contingent liabilities. (4) REVIEW OF RELATED ACADEMIC LITERATURE Capital Markets (Archival) Research Valuation Implications of Contingent Liabilities Capital markets research provides evidence that contingent liabilities are relevant to capital market participants' valuation decisions. …