Ind AS 117: Overview of key implications on accounting for guarantee contracts

Ind AS 117: Overview of key implications on accounting for guarantee contracts

The application of Ind AS 117, Insurance Contracts, notified by the Ministry of Corporate Affairs (MCA) on 12 August 2024 has been deferred for parent, investor or venturer entity having investment in insurers/ insurance companies and they may continue using insurance company’s group reporting package prepared as per Ind AS 104 to prepare their own Ind AS consolidated financial statements. However, other non-insurance companies, while preparing their Ind AS financial statements for the year ended 31 March 2025, need to apply Ind AS 117 to contracts meeting definition of the term ‘Insurance Contract’ as per the standard and covered under its scope. The October 2024 edition of Assurance EYe explains the definition of the term ‘insurance contract’ in detail and various types of contracts entered into by non-insurance companies which may potentially get covered under Ind AS 117. In this article, we provide a broad overview of accounting for insurance contracts and its potential implications on accounting for financial guarantee and performance guarantee contracts, which are likely to be substantially impacted by the issuance of Ind AS 117 and other related developments.

How we see it

• Ind AS 117 deals with accounting for ‘insurance contracts,’ irrespective of whether issued by insurance or non-insurance companies.
• Ind AS 117 contains relatively wide definition of the term ‘insurance contract.’ In practice, many contracts issued by non insurance companies can also meet the definition.
• Unlike Ind AS 104, Ind AS 117 does not provide an option to apply Ind AS 37. Thus, although definition of the term ‘insurance contract’ in Ind AS 117 is similar to that in Ind AS 104, the accounting consequences of contracts meeting the definition will undergo a change.
• The application of Ind AS 117 to non-insurance companies has not been deferred. They need to apply it while preparing financial statements for the year ended 31 March 2025.

Accounting for insurance contracts

While the definition of the term ‘insurance contract’ under Ind AS 117 is similar to that under Ind AS 104, the accounting applicable to ‘insurance contracts’ covered under Ind AS 117 is significantly different. Under Ind AS 104, entities were allowed to ‘grandfather’ their existing accounting practices and continue the same, subject to certain criteria being met. This effectively meant that there was a diversity in practice, and many non-insurance entities were applying Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets, to insurance contracts. However, this is no longer possible since Ind AS 117 contains specific accounting requirements for contracts covered under its scope.

Accounting for insurance contracts under Ind AS 117 is complex and, in many cases, there may be a need to involve an actuary to measure obligation under the insurance contract. Ind AS 117 prescribes three approaches for measurement of Insurance Contracts:

• General Model
• Premium Allocation Approach
• Variable Fee Approach (applied to insurance contracts with direct participation features)

Given below are the salient features of measurement applied in the General Model:

• Estimates and assumptions of the future cash flows consider both inflows and outflows and should reflect the most recent estimates,
• Measurement reflects the time value of money,
• To the extent possible, estimates make maximum use of the observable inputs which are consistent with the market information,
• There is a current and explicit measurement of risk,
• Expected profit is deferred and aggregated in groups of insurance contracts at initial recognition, and
• Expected profit is recognized over the coverage period after adjustments arising from changes in the cash flows assumptions.

On initial recognition, an entity measures a group of insurance contracts at the total amount comprising fulfilment cash flows (FCF) and the contractual service margin (CSM). FCF comprises (a) the estimate of future cash flows, and (b) adjustments to reflect (i) time value of money, (ii) financial risks associated with the future cash flows, and (iii) a risk adjustment for non-financial risk.

The CSM represents unearned profit to be recognized in future as the entity will render insurance services. This is measured on initial recognition of a group of insurance contracts at an amount that results in recognition of no income or expenses on day one. The CSM cannot be negative, as this would indicate the contract is onerous and any loss need to be recognized immediately.

At the end of each subsequent reporting period, the carrying amount of a group of insurance contracts is remeasured to be the sum of the liability for remaining coverage plus the liability for incurred claims, both determined as at that date. The liability for remaining coverage comprises FCF relating to future services, plus a measure of the CSM, which is yet to be earned. The liability to handle and pay already incurred claims arises from past coverage service. It includes also a liability for claims incurred but not yet reported

Financial guarantee contracts (FG contracts)

Financial guarantees can take various legal forms, such as guarantees related to financing arrangements, letters of credit, and credit default contracts. In accordance with Ind AS 109 Financial Instruments, FG contracts are contracts that require the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. FG contracts also meet the definition of an insurance contract under Ind AS 117. They are, however, generally outside the scope of Ind AS 117 and need to be accounted for in accordance with Ind AS 109. However, if the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used the accounting guidance applicable to insurance contracts, then only the issuer has an option whereby it can choose to apply accounting as per either Ind AS 109 or Ind AS 117 to such contracts. In such cases, the election is available on a contract-by-contract basis but is irrevocable. We believe that considering the wordings used, an entity that has previously applied Ind AS 104 to FG contracts can choose to apply either Ind AS 109 or Ind AS 117 to such contracts going forward; however, vice versa change is not possible.

It may be noted that with the issuance of Ind AS 117, there is no change in financial guarantee accounting prescribed under Ind AS 109. Hence, entities, that were accounting for FG contracts under Ind AS 109, will continue to apply the same accounting going forward also. However, considering the change as explained below with regard to meaning of debt instrument, they may need to evaluate higher number of contracts for applying FG contract accounting. Also, the amount and timing of applying FG contract accounting may change

An example explaining accounting for FG contracts as per Ind AS 109 and Ind AS 117 is given later in this article. It may be noted that Ind AS 117 does not change/ impact accounting by the holder of financial guarantees, as it is only applicable to insurer and not to the holder of insurance.

The term ‘debt instrument’ is used in definition of the term FG contract; however, it is not defined in financial instrument or insurance contract standards. Till recently, there was an understanding that an FG contract requires an existing debt for a guarantee contract to be accounted for as FG contract. The IFRS Interpretations Committee (IFRS IC) received a request in 2024 about how an entity accounts for guarantees that it issues. The IFRS IC did not issue any formal interpretations or clarification on this matter. However, considering IFRS IC discussions and other related developments, it has become clearer that IFRS 9 (and, consequently, Ind AS 109) does not explicitly require the debt instrument to exist when the guarantee is issued. If the guarantee covers losses incurred due to failure to make specified payments by a specified debtor for amounts that are due and payable at the point of the guarantee being called, the guarantee is over a debt instrument. As such, these types of guarantees would be financial guarantees if all other criteria for financial guarantees are met. In other words, guarantees over future debt are also covered under definition of financial guarantee.

How we see it

A guarantee over a future debt instrument, such as an undrawn loan commitment, will still qualify as a financial guarantee contract under Ind AS 109. This is despite the fact that the debt instrument does not exist at the time the guarantee is issued. This will require entities to evaluate higher number of contracts for applying FG contract accounting. Also, the amount and timing of applying FG contract accounting may change.

Example 1 – Guarantee provided by a parent to a subsidiary’s banks

A group consists of H Co. (the parent) and S Co. (its wholly owned subsidiary). H Co. has a stronger credit rating than S Co., and S Co. is entering into a loan agreement which will allow S Co. to borrow INR10 billion from a bank over a period of next two years. The loan is repayable in bullet payments after 10 years from the date of sanction. S Co. plans to utilize INR2 billion loan upfront and balance in instalments over the next two years. The bank will charge interest at the rate of 8% per annum to S Co. However, it is willing to reduce the rate to 7.5% p.a. if H Co. guarantees S Co.’s debt. H Co. provides guarantee against full INR10 billion loan of S Co. As per the guarantee arrangement, H Co. will make payments to reimburse the bank for any loss it incurs if S Co. fails to make a payment when due in accordance with the terms of loan arrangement.

In H Co.’s separate financial statements, the guarantee for the entire INR10 billion loan is treated as financial guarantee from day 1 irrespective of the fact that S Co. has utilized only a portion of the loan amount or even if the entire loan amount is unutilized on day 1. Even before the loan is disbursed, the guarantee over an undrawn loan commitment will be treated as a financial guarantee contract and accounted for accordingly. As explained above, H Co. will generally account for such FG contract as per Ind AS 109. However, it will have an option of choosing to apply Ind AS 117 accounting instead of Ind AS 109, only if H Co. has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts.

Financial guarantee/ insurance contracts issued by a parent

A parent company may issue a financial guarantee or other insurance contract that needs to be accounted for under Ind AS 117 or the parent company elects to account for under Ind AS 117 (after meeting prescribed criteria). In most cases, the parent enters into such contracts without receiving any consideration or may receive consideration which is lower than fair value. Since the arrangement provides benefit to the subsidiary, the contract is considered to be in-substance capital contribution/ additional investment in subsidiary. The parent can choose to measure capital contribution using one of below approaches:

• Approach 1: Measure the contract at the fair value. This approach reflects fair value of additional benefit provided to the subsidiary and initial measurement aligns with how a financial guarantee is initially measured under Ind AS 109.
• Approach 2: Measure the contract at the fulfilment cash flows (excluding any margin). This approach reflects liability taken on initial recognition by the entity and CSM (which is residual number) is considered zero. When measuring fulfilment cash flows, the parent should include risk adjustment.

Under both the approaches, subsequent changes in obligation are recognized in the Statement of Profit and Loss, as per Ind AS 117.

The following example explains accounting for FG contract under Ind AS 109 and two approaches of Ind AS 117.

Example

Parent P issues financial guarantee to bank against loan taken by its various subsidiaries.

• Fair value of financial guarantee on the date of issuance (1 April 2022): INR600 million.
• Loan term is three years with amount repayable in bullet payment.
• Guarantee term is also three years, i.e., from 1 April 2022 till 31 March 2025.
• P will reimburse bank for default in repayment of loan during FY 2023-2025.
• Expected defaults: INR450 million in third year. It is assumed that the same amount reflects FCF.
• Effects of discounting, risk adjustment and administration expenses are ignored.
• Actual defaults are in line with the expected defaults on day 1, i.e., there is no change in estimates.
• It is assumed that in its separate financial statements, parent measures investment in subsidiaries at cost, less impairment.
• Tax and related aspects are ignored.

Response

Accounting as per Ind AS 117 (assuming criteria for Ind AS 117 application are met and the parent has elected to use such option)

Approach 1: Fair value accounting

On the date of issuing guarantee, parent will recognize fair value (FV) of guarantee as an obligation and an additional investment in subsidiary. The investment will continue to be reflected as such unless there is an impairment.

The obligation results in FCF of INR450 million and CSM of INR 150 million. CSM will be recognized as income/ revenue over the three years period as insurance services are rendered. The FCF will be recognized as revenue when related obligation arises, i.e., in the third year

Approach 2: FCF value accounting

On the date of issuing guarantee, parent will recognize estimated FCF amount as an obligation and an additional investment in subsidiary. The investment will continue to be reflected as such unless there is an impairment.

The obligation results in FCF of INR 450 and CSM of INR nil. CSM will be recognized as income/ revenue over the three years period as insurance services are rendered. The FCF will be recognized as revenue when related obligation arises, i.e., in the third year.

Financial Guarantee contracts: Accounting under Ind AS 109

On the date of issuing guarantee, the parent will recognize FV of guarantee as an obligation and an additional investment in subsidiary. The investment will continue to be reflected as such unless there is an impairment.

The FG obligation is recognized as revenue over the guarantee period. After initial recognition, the parent also continues to recognize FG obligation measured as per Ind AS 109 at the higher of (i) the amount of the loss allowance determined in accordance with Expected Credit Loss (ECL) requirements of Ind AS 109, and (ii) the amount initially recognized less, when appropriate, the cumulative amount of income recognized in accordance with the principles of Ind AS 115 Revenue from Contracts with Customers. Any change in obligation amount is recognized as expense. See table below for computation of obligation amount.

Performance Guarantee contracts

Performance guarantees (PG) come in many forms and can arise because of the legal form of an arrangement or economic substance. Pre-Ind AS 117, PG contracts not meeting the definition of FG contract and not covered under any other Ind AS were generally accounted for under Ind AS 37, which typically resulted in contingent liability disclosure (unless outflow of economic resources was probable or remote). However, pursuant to Ind AS 117 becoming applicable, such PG contracts may be treated as an insurance contract.

Depending on specific facts and circumstances, different Ind AS may apply to accounting for such guarantee contracts from the issuer perspective:

• Performance guarantees issued in connection with the sale of goods whereby the seller of goods issues the guarantee are accounted for by the issuer under Ind AS 115.
• Accounting for performance guarantee contracts not accounted for under Ind AS 115 will depend on whether they transfer significant insurance risk.
• If PG contracts meet definition of both the term ‘insurance contract’ and the term ‘FG contract,’ then such contracts will generally be accounted for applying Ind AS 109 accounting. However, if the entity meets criteria as stated above for Ind AS 117 application and it elects to apply Ind AS 117, the entity will apply Ind AS 117 accounting.
• If contracts transfer significant insurance risk and thereby meeting definition of the term ‘insurance contract’, but they do not meet definition of the FG contract, such PG contracts are accounted for as an insurance contract applying Ind AS 117.
• If contracts do not transfer significant insurance risk, they are generally accounted for as a financial instrument applying Ind AS 109.

The following example explains accounting for various PG contracts.

Example 2: Performance guarantee contracts: Scenarios and considerations

ABC Limited enters into a contract with XYZ to construct a building, and its parent (P) agrees to compensate XYZ if ABC fails to perform, i.e., complete construction within the prescribed period. The key issue is whether P should account for PG contract under Ind AS 117 or Ind AS 109 in its separate financial statements (SFS).

Scenario 1

• If ABC fails to complete the construction within three years, P will complete construction in the next 6 months and compensate XYZ for losses incurred.
• P has no right to recover losses from ABC.

In this scenario, P will account for PG as an insurance contract under Ind AS 117 for the following reasons:

• P will compensate XYZ (customer) through completion of construction and for losses incurred, if ABC fails to meet delivery timelines.
• The insurance risk is significant for P, as failure to meet delivery times would trigger a payout.
• The contract is not a financial guarantee, as P does not reimburse XYZ for non-payment on a debt instrument.
• In P’s consolidated financial statements (CFS), payments under the guarantee are likely to be treated as penalty or liquidated damages covered under Ind AS 115.

Scenario 2

• If ABC fails to complete the construction on time, XYZ can claim a fixed penalty from ABC under their sales contract.
• XYZ can claim the penalty from P only if ABC fails to pay XYZ.
• P has the right to recover the penalty from ABC if it pays XYZ, due to an indemnity agreement.
• If P fails to pay, XYZ can still claim the penalty from ABC.

In this scenario, P must assess whether PG qualifies as FG contract or an insurance contract:

• Financial Guarantee Contract: The penalty amount does not exist as debt in ABC’s financial statements on the date of issuance of guarantee, but Ind AS 109 requires guarantees over future debt to be treated as FG contract if the guarantee covers losses due to non-payment at the time the guarantee is called. Hence, it is considered as a financial guarantee.
• Insurance Contract: If P compensates XYZ, it can recover the amount from ABC. P must assess if it has accepted significant insurance risk, and if so, the performance guarantee qualifies as an insurance contract.
• In this case, PG contract meets definition both of FG contract as well as insurance contract. Hence, P will account for the arrangement under Ind AS 109 as FG contract. P will have a choice to apply Ind AS 117 (only if it meets criteria for applying insurance contract accounting, refer discussion above).
• In P’s CFS, payments under the guarantee are likely to be treated as penalty or liquidated damages covered under Ind AS 115.

Scenario 3

• If ABC fails to complete the construction, XYZ can claim a fixed penalty from ABC.
• P will pay the penalty to XYZ on behalf of ABC and seek repayment from ABC under pre-agreed terms, regardless of ABC’s payment failure.
• If P fails to pay, XYZ can still claim the penalty from ABC.

In this case, P accounts for PG contract as a loan commitment under Ind AS 109 for below reasons:

• The contract does not meet definition of FG contract, as P’s payment is not dependent on ABC’s failure to pay.
• The arrangement does not have insurance risk but has financial risk. In effect, ABC has offered its customer the right to be paid by its parent P instead of itself.
• From ABC’s perspective, this is akin to a letter of credit which does not meet the definition of an insurance contract because failure to make payment by a specified debtor is not a precondition for P’s payment to XYZ.
• From P’s SFS perspective, it has entered into a loan commitment in which P agrees to make an advance to XYZ with repayment from ABC.
• Even under this scenario, in P’s CFS, payments under the guarantee are likely to be treated as penalty or liquidated damages covered under Ind AS 115.

How we see it

The accounting treatment of PG contracts can vary significantly based on specific facts and terms of the contract. A slight change in terms of contract, such as indemnity clauses, payment terms, or nature of guarantee, can determine whether the contract falls under Ind AS 109 (FG contracts) or Ind AS 117 (Insurance Contracts), leading to significantly different accounting outcomes. Therefore, it is important for entities to conduct a thorough analysis of the contract terms beforehand to ensure that appropriate accounting treatment is applied.

Final thought

Ind AS 117 is applicable while preparing financial statements of non-insurance companies for the year ended 31 March 2025. Thus, it is imperative that entities having contracts whose accounting is likely to be impacted by Ind AS 117, particularly Financial Guarantee or Performance Guarantee contracts, conduct a detailed analysis of all such contracts to ensure that they reach an appropriate and well-supported conclusion. If it is determined that a guarantee contract falls under the scope of Ind AS 117 or the entity elects to apply Ind AS 117 to FG contract (after meeting prescribed criteria), it is possible that the entity may need to involve a professional with specialized knowledge, such as an actuary, to properly assess the associated risk, obligation, and f inancial impact. Actuaries will help in estimating future cash flows, determining appropriate discount rates, and assessing the probability of claims, all of which are crucial in correctly applying the principles of Ind AS 117.