Question

In: Accounting

a) Tom Goodly Ltd guarantees the bank overdraft of Pete Smith Ltd during 2018. Tom Goodly...

a) Tom Goodly Ltd guarantees the bank overdraft of Pete Smith Ltd during 2018. Tom Goodly Ltd’s reporting period ends on 30 June each year. At the time of providing the guarantee, Pete Smith Ltd was in a sound financial position. During late 2019, due to the outbreak of the COVID-19 pandemic, international trading conditions deteriorated to such an extent that Pete Smith Ltd incurred substantial losses. Finally, on 25 July 2020, Pete Smith Ltd was forced to file for protection from its creditors.

Required:

Explain how Tom Goodly Ltd would report the guarantee provided to Pete Smith Ltd in its financial statements ending

i) 30 June 2019

ii) 30 June 2020

Solutions

Expert Solution

FGC- FINANCIAL GUARANTEE CONTRACT

1)Initial Recognition as on 30 June 2019

An issued FGC is a financial liability and is initially recognised at fair value. If the FGC is issued to an unrelated party at arms-length, the initial fair value is likely to equal the premium received. If no premium is received (often the case in intragroup situations), the fair value must be determined using a different method that quantifies the economic benefit of the FGC to the holder.

2) During late 2019, due to the outbreak of the COVID-19 pandemic, international trading conditions deteriorated to such an extent that Pete Smith Ltd incurred substantial losses hence the report of guarantee as on 30 June 2020 is as under

the FGC is measured at the ‘higher of’:

  1. Expected Credit Loss (ECL) allowance, and
  2. The amount initially recognised (ie fair value) less any cumulative amount of income/ amortisation recognised.

Alternatively, it is possible to designate the FGC at fair value through profit or loss - but only in cases of an accounting mismatch or if the FGC is part of a portfolio that is managed and its performance evaluated on a fair value basis.

For the expected credit loss under IAS 37 a provision is not recognised until an outflow of resources is probable and the amount is reliably measurable . However, under IFRS 9, there is no ‘probable’ threshold; instead, a minimum of 12 month ECL is required to be recognised at all times.

Nevertheless, entities are required to apply these new requirements which may present implementation challenges, including:

  • The measurement of ECL which must take into account the possibility of a credit loss occurring and incorporate forward looking information
  • Assessing and tracking the underlying borrower’s risk of default to identify a significant increase in credit risk.

This could be particularly challenging for corporate entities with cross company guarantee structures that may not previously have attracted an IAS 37 provision and where there may be a lack of relevant credit risk information.


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