Read our guide to non-profits and financial guarantee arrangements
Overview: motive and the accounting solution for financial guarantees made to advance a social purpose for the public benefit
For-profit accounting has an underlying focus on the capability of an entity to generate cash flows with the primary purpose of providing a financial return to the providers of risk capital. In offering guarantees as an aspect of trading, the entity is exposing investors to cash-flow risk from events outside of the entity’s control and so identifying cash-outflows from credit losses or calling in of guarantees is important to infirm investment decisions and to assess trading risk and profitability.
It is contended that in large part these commercial considerations simply do not apply to most non-profits, especially charities. If this is true the accounting should reflect this,
It is accepted that cash flow considerations can apply where non-profits, for example charities, offer guarantees as part of trading for profit to generate cash-flows, for example by underwriting the trading risk of a wholly owned trading subsidiary as a mechanism to secure better credit terms for the subsidiary from lenders. However, non-profits may offer guarantees as part of activities to further purposes for the public benefit where guarantees are in substance contingent gifts or commitments. To present these arrangements as expected credit losses arising from trade arguably misleads the user of the financial statements as to the purpose and nature of these transactions.
Advancing non-profit activities through guarantees
IFRS 9, Financial Instruments includes financial guarantee contracts in the section on liabilities and the proposal to extend the expected credit loss model in IFRS 9 to these contracts could potentially cover not-for-profit guarantee arrangements.
This paper proposes that for those entities eligible and choosing to be classified as a ‘public benefit entity’ under FRS 102 an alternative option to measuring and disclosing financial guarantees is available where the activities to which the guarantee relate are wholly or mainly for the purpose of advancing public benefit.
In these cases the non-profit entity chooses to offer a financial guarantee to further its purposes by facilitating through the guarantee the activities of the beneficiary and the guarantee is in place of financing by way of a grant or concessionary loan.
Therefore since the guarantee is not related to a for-profit trade assessing the expected credit losses arising from the guarantee, the non-profit entity would apply section 21 Provisions and Contingencies using the ‘best estimate’ approach set out in paragraph 21.7 where it is probable at the reporting date that the entity will be required to settle a liability arising from the making of the guarantee and that obligation can be measured reliably (paragraph 21.4). Where these conditions are not met, the guarantee is disclosed as a contingent liability (paragraph 21.12).
Given that the guarantees arise from activities for the public benefit, the application of discounted cash-flow methodology to calculate the present value of the best estimate to facilitate the imputing of a financing element is arguably misleading because imputing a finance charge to a transaction for public benefit is not providing meaningful information to the user of the accounts. The approach taken for the measurement of concessionary loans at nominal value with an annual review for impairment is a much better contextual fit (see section 34 paragraphs PBE34.90 and PBE34.91) but in the case of making a financial guarantee there is no asset, rather only a potential obligation.
Any income incidental to making the financial guarantee is arguably better treated as income in the reporting period when receivable rather than treated as a financial instrument assessed over the term of the guarantee provided the premium paid is nominal or at below market value because this demonstrates that the asset (income) is not related to a for-profit trade and the guarantee was not therefore entered into as part of extended credit arrangements or as an inducement to trade by the guarantor.
Two non-profit scenarios are identified with a proposed solution and supporting rationale (basis for conclusions) for each. One involves a nil premium and the other a below market premium. It is suggested that in substance the treatment and disclosure be the same for both due to the shared context of furthering public benefit.
2A Activities to further the activities of the guarantor for the public benefit
In making a financial guarantee for a nil premium to advance purposes for the public benefit, the non-profit has no financial return and therefore the financial motive is wholly absent. Instead, the guarantee is a means by which the beneficiary can obtain third party financing to advance a project for the public benefit that takes forward both its and the guarantor’s aims.
The most likely example is in a group context where both entities involved are non-profits with shared governance through common trustees or one entity being the corporate trustee of the other or the guarantor is the sole owner of a wholly owned subsidiary.
Glossary
Public benefit is defined as an activity or undertaking for the purposes of furthering the objectives of a public benefit entity or public benefit entity parent.
Accounting treatment: as per section 21 of FRS 102 as set out above
Disclosures: as per section 21 of FRS 102 as set out above.
2B Guarantees as a form of social investment by the guarantor
In making a financial guarantee for a below market rate of return to advance purposes for the public benefit, the financial return is incidental but not the primary reason for the guarantee and therefore, although present, the financial motive is secondary to the purpose of making the guarantee. Instead, the guarantee is a means by which the beneficiary can obtain third party financing to advance a project for the public benefit that takes forward both its and the guarantor’s aims.
The most likely example is a non-profit looking to enable beneficiaries who are unable to obtain credit or can only obtain credit on very poor terms, to enjoy credit from a third party such as a bank and the financial guarantee is offered to put the beneficiary in good standing as a credit risk. The below market premium is levied not to raise income but rather to act as a form of market discipline to the beneficiary to bring structure to the relationship with the guarantor as part of an ongoing educational activity. The advantage to the non-profit is in not having to directly handle a portfolio of credit arrangements for which it would need expertise and infrastructure and the advantage to the beneficiary is that access to normal credit will enhance their future creditworthiness should they keep up with the loan, and the loan will relieve their economic situation or assist them in trade or business thereby relieving poverty.
Calculating a notional expected credit loss to the guarantor is a false analogy as the guarantor is not offering a guarantee to further a for-profit trade - rather it is furthering its aims in partnership with the beneficiary and third-party providers or risk capital. If it is a financial instrument, then its form is of a social investment and not a commercial trade.
Glossary
Public benefit is defined as an activity or undertaking for the purposes of furthering the objectives of a public benefit entity or public benefit entity parent.
Social investment is defined as ‘where a relevant act of a charity is carried out with a view to both:
Accounting treatment: as per section 21 of FRS 102 as set out above
Disclosures: as per section 21 of FRS 102 as set out above.
About the author
Nigel Davies FCCA was until January 2022 Joint Chair of the Charities SORP Committee and of the SORP-making body responsible for the development of the Charities SORP.