GASB Statement No. 70, Nonexchange Financial Guarantees, was issued by the Governmental Accounting Standards Board in April 2013 and became effective for years beginning after June 15, 2013 (so this would first be applicable for June 30, 2014, or December 31, 2014, year ends). Not many entities have this new standard on their radar screen, but when it applies, it could be a very big deal. As some governmental entities begin to implement this standard and others continue to apply it going forward, there are certain accounting impacts that everyone needs to ensure are considered. Here is a short overview of the pronouncement, a few specific examples of when it will apply, and a related discussion surrounding the accounting impacts.
A nonexchange financial guarantee exists when one government extends a financial guarantee for the obligations of another government, a not-for profit entity, or a private entity without equal value in return. As part of this guarantee, the government providing the guarantee agrees to indemnify the holder of the obligation if the entity that issued the obligation does not fulfill its payment requirements.
There are two key items to consider when determining if your government is party to a nonexchange financial guarantee:
- The guarantee must be of an obligation of a separate legal entity or individual (yes, that includes blended or discretely presented component units), and
- There is no exchange of equal value related to the guarantee.
One of the keys to distinguishing a nonfinancial guarantee under GASB 70 is that these guarantees always involve three parties:
- The holder of the obligation (the entity to whom the debt is owed)
- The issuer of the obligation (the entity that issued the debt subject to guarantee)
- The entity that extended the financial guarantee (the guarantor)
If your government is either the issuer of a guaranteed obligation or acts as a guarantor of another entity’s debt, GASB Statement No. 70 provides various disclosure requirements. In addition, a government guarantor could also be subject to recording that debt (or a portion of it) on its books and records. If it is “more likely than not” (defined as a greater than 50 percent probability) that a payment by the guarantor will be required, a liability equal to the discounted present value of the best estimate of the future outflows expected to be incurred will be recorded within full accrual financial statements. To the extent that a portion of the liability is “due and payable,” or expected to be liquidated with expendable available financial resources, that piece will also be recorded within the entity’s modified accrual financial statements.
A few of the more common examples where this pronouncement would apply include instances where:
- A school district receives a nonfinancial guarantee from a state government
- A primary government guarantees the debt of its component unit
Guarantees related to special assessment debt are specifically excluded under this standard.
The first challenge organizations will need to address is whether any nonfinancial guarantees even exist. Remember, if such guarantees exist, both the guarantor as well as the issuer of the obligation are subject to disclosure requirements.
If your government is the guarantor on a nonfinancial guarantee, you now need to consider whether GASB 70 would require you to actually record all or part of that obligation on your books (yes, even the guarantor might have a liability to record!). GASB has introduced some new terminology here with the “more likely than not” criteria we’ve previously referenced. Guarantors will need to record a liability if it is “more likely than not” that they will have to make a payment under the guarantee. GASB lays out several qualitative factors to consider when making this determination. A few of the criteria guarantors need to consider relevant to the entity that has issued the obligation are listed below:
- Bankruptcy initiation
- Failure to meet rate covenants, coverage ratios, or default
- Indicators of significant financial difficulty, including loss of major revenue sources, or failure to make payments to paying agents or trustees timely
If it is determined that this “more likely than not” criteria has been met, the guarantor government would record a liability on its financial statements. The amount to record is the present value of the estimated future payments. This would be reported only at the full accrual level, i.e., the government-wide statements or proprietary funds – not in the General Fund or other governmental funds. The transaction would be reported as an expense, not as a receivable from the issuer of the obligation (the classification of the expense would be made in the same manner as other grants or financial assistance payments).
Some would assume that once the guarantor has recorded a liability, the issuer of the obligation would reduce its liability so as to avoid double counting the obligation. This is not the case. Due to the fact that the guarantor is required to record the liability if there is a greater than a 50 percent chance of payment, there is still some uncertainty as to which entity will ultimately make payment. GASB Statement No. 70 specifies that the entity that issued the obligation should continue to recognize the liability until that portion of the liability has been “legally released.” If there is a requirement to repay the guarantor for payments that were made on the obligation, this portion of the liability is reclassified as a liability to the guarantor under both the full accrual and modified accrual basis of accounting until legally released (yes, that last sentence is worth rereading!).
There is one exception to the above. The GASB did recognize concerns when the entities involved in one of these nonfinancial guarantee relationships were a primary government and blended component unit, or two blended component units within the same primary government. In those situations, when the guarantor records the liability, the entity issuing the debt would record a receivable in an equal amount.
Let’s walk through one example: A discretely presented component unit (DPCU) of the City of XYZ issued debt in fiscal year 2006 in the amount of $10,000,000. The City of XYZ guaranteed the debt when it was issued, with nothing provided by the DPCU in return. Over the last several years, the DPCU has been having a difficult time making its required debt payments. The property taxes that were anticipated to be collected to make these debt payments have not fully come to fruition. During fiscal year 2014, the City started to make the required debt payments on behalf of the DPCU, making a payment for approximately $650,000. In addition, the City determined that there is a greater than 50 percent probability that the City will have to make all the remaining debt payments going forward. At the time this determination was made, the discounted present value of the future cash flows (principal and interest) was calculated to be $6,500,000; this amount, therefore, was recorded as a liability on the City’s full accrual financial statements.
Because the City has not legally released the DPCU of this debt, the DPCU will continue to carry this liability on its books. However (and here is where it gets sticky, folks), the DPCU will reclassify the payments made by the City of $650,000 to a current liability (perhaps called “due to the City”) which will now also be required to be recognized on the modified accrual financial statements of the DPCU (if applicable).
What are the key takeaways as they relate to the GASB 70 accounting considerations? First, it is important for both guarantors and issuers of debt that has been guaranteed by another entity to understand the accounting treatment. Guarantors need to be cognizant of these new liability recognition provisions. Issuers of debt that has been guaranteed by another entity will need to understand the impact on their own financial statements when the guarantor pays a portion of the debt – recording a current liability on their modified accrual financial statements. This could impact working capital calculations, and the entity will need to plan for any effects on debt covenants, deficit elimination plans, etc.