Accounting For Guarantee Fee Paid To A Party Other Than A Lender

This article aims to discuss:
-Discuss the accounting treatment of guarantee fee paid (subsequent to initial payment) to a party other than the lender while computing effective interest rate on financial liability.

Introduction

Ind AS 109, Financial Instruments requires financial instruments to be initially recognised at their fair value (i.e. generally the transaction price) plus or minus directly attributable transaction costs. Ind AS 109 also introduces the concept of Effective Interest Rate (EIR) for financial instruments measured at amortised cost and defines it as ‘the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability’. The EIR thus computes the effective interest earned on loans granted/effective cost incurred on loans received.

In addition, financial assets (excluding equity instruments) that are classified into the Fair Value through Other Comprehensive Income (FVOCI) category also require the application of the EIR method for recognition of interest income.

The EIR is calculated on initial recognition of a financial instrument and considers all contractual terms of the instrument and other fees and transaction costs that are an integral part of the EIR of a financial instrument.
In this article we aim to discuss the accounting for guarantee fee paid subsequent to initial payment to a party other than the lender while computing EIR.

Background

The Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI) has considered an issue on accounting treatment of guarantee fee paid to the Government of India (GOI) in relation to the loan taken by an entity from a foreign lender. On the basis of this issue, it issued an opinion on ‘Computation of Effective Interest Rate on Borrowings ’.

In the given case, a power sector entity entered into a loan agreement for Euro 500 million with a foreign lender for financing its projects. The loan agreement with the lenders sets out the rate of interest and fees payable by the company to the lenders. This loan is guaranteed by GOI for due and punctual payment of the principal, interest and other charges through separate guarantee agreement. The company is required to pay an initial guarantee fee to the GOI on the sanctioned amount and thereafter, subsequent guarantee fee is payable on first April of every year on the amount outstanding at the beginning of the year as per the office memorandum of Ministry of Finance, GOI.
As per the loan agreement, guarantee provided by the GOI in this case is a precondition for obtaining and continuing with the loan facility. As per the terms of the agreement, in case the loan continues, guarantee will also continue and therefore, during the term of loan, the guarantee is not cancellable.
Accounting issue

The company initially recognised the foreign loan at fair value minus transaction costs and subsequently measured at amortised cost using the EIR method as per Ind AS 109. However, while calculating the EIR on above mentioned borrowing, the company only considered the cash flows arising under the loan agreement towards interest and fees payable to the lenders. The guarantee fee is not payable to the lenders, but it is payable to the GOI. An issue arose whether the guarantee fee should be considered for the purpose of computing the EIR.
As per Appendix A to Ind AS 109, when calculating the EIR, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest, transaction costs, and all other premiums or discounts.

Analysis

Ind AS 109 provides that in applying the EIR method, an entity identifies transaction costs and fees that are an integral part of the EIR of a financial instrument. Fees that are an integral part of the EIR of a financial instrument are treated as an adjustment to the EIR, unless the financial instrument is measured at fair value, with the change in fair value being recognised in profit or loss.
In addition, Ind AS 109 provides examples of fees that are an integral part of the EIR of a financial instrument. Origination fees paid on issuing financial liabilities measured at amortised cost is an example of fees that is an integral part of EIR method. While transaction costs include fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and security exchanges, and transfer taxes and duties, transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.

Additionally, transaction costs are incremental costs that are directly attributable to the acquisition or issue of a financial liability. Ind AS 109 further clarifies that an incremental cost is one that would not have been incurred if the entity had not acquired or issued the financial instrument.
In the context of given case, EAC concluded on the basis of the guidance in Ind AS 109, the guarantee fee paid to GOI (initially as well as subsequently) is an incremental cost which is directly attributable to the acquisition of the loan facility as this cost would not have been incurred if the company had not incurred the loan liability. Additionally, the terms of loan agreement specify that the guarantee provided by the GOI in this case is a precondition for obtaining and continuing with the loan facility. Therefore, the financial guarantee fee paid (initially as well as subsequently) by the company should be considered for computation of EIR while measuring the loan liability at amortised cost to comply with Ind AS 109.

Conclusion

The companies should evaluate the costs incurred in relation to borrowings for determining whether the costs incurred are incremental costs and are directly attributable to the acquisition or issue of a financial liability. Consider all the relevant facts and circumstances and available guidance while arriving at an appropriate conclusion.