Implementation Issues in the Accounting & Reporting of Guarantees & Indemnities

(FIN 45)

Rodney W. Hurd, Founding Member Montgomery Street Financial Group

Jeffrey Ellis, Partner Grant Thornton LLP

FASB Interpretation No. 45 (FIN 45)FASB Interpretation No. 45 (FIN 45)FASB Interpretation No. 45 (FIN 45)FASB Interpretation No. 45 (FIN 45)

Guarantor’s Accounting and Disclosure Requirements for Guarantees,

Including Indirect Guarantees of Indebtedness of Others

Issued November 2002

FIN 45: Overview

g Expands disclosuredisclosuredisclosuredisclosure requirements for financial statements issued after

12/15/02

g “Clarifies” that a guarantor is required to recognize, at the inception of the

guarantee, a liabilitya liabilitya liabilitya liability for the fair value of a “stand ready” obligation (deemed

insurance premium for accepting exposure to loss)

g Impacts the accounting and reporting of certain guarantees and

indemnification agreements, notably residual value guarantees provided by

lessees in operating leases and “all events” tax indemnities

FIN 45: Impact on Leasing

g New business activities will trigger liability recognition and/or expanded

disclosures for “remote” contingencies

g Net leasing arrangements (e.g., representations, indemnities)

g Complex risk/reward allocations (e.g., lease with RVG/FPPOs)

g Sale activities (e.g., sales with vendor support, portfolio sales)

g FIN 45 excludes certain contingent obligation entirely from its scope

g Lessee provided residual value guarantees under capital leases

g “Acts or omissions” guarantees and indemnities

g “Contingent rent” as defined by FAS 13

g Guarantees that preclude sale treatment or gain recognition (e.g.,

manufacturer guarantees of residual value related to operating leases in

excess of 10% of fair value)

g Transactions covered by other authoritative literature that addresses the

impact of guarantees

FIN 45: Impact on Leasing

Lessee generally will need to recognize a liability at fair value for its representations, warranties, guarantees, and indemnities unless it can show that its contingent obligation relates solely to its “own future performance” (e.g., excess wear-and-tear or return and maintenance provisions, permitted use)

Lessee affiliates and third parties (e.g., RVI providers) will need to disclose information about the nature and extent of credit supportg Guarantees among affiliates (e.g., parent guarantees, subsidiary

guarantees, or common control guarantees)g Guarantees accounted for as a derivative at fair value (e.g., residual

value insurance, credit default swaps)

g The original lessee under a sublease or substitution agreement where it is relieved of the primary obligation under the original lease and becomes secondarily liable under the new lease will need to disclose its contingent exposure

FIN 45: Broader Impact

Sample footnote disclosures or commentaries about FIN 45 follow:

The adoption of FIN 45 is not anticipated to have a material effect on the Company’s financial position or results from operations.

The impact of FIN 45 on the Company’s future consolidated financial statements will depend on whether the Company enters into or modifies any material guarantee arrangements.

Without FIN 45, warranty costs and warranty reserve fund balances might not have become public information.

FIN 45: Overview of Implementation Process

Scope: Identify which contracts (or contractual provisions) involve exposure to risk of loss that fall within the broad scope of FIN 45

Critical Analysis: Determine whether the exposure to loss requires footnote disclosure or balance sheet recognition (or both)

g Certain exposures qualify for a specific scope exclusion

g Others require footnote only disclosures, including guarantees issued before January 1, 2003

g Others require balance sheet recognition and footnote disclosures

g Initial valuation: Determine the appropriate valuation technique to use

g The offsetting debit: Determine the nature of the offsetting debit (e.g., prepaid or current period expense)

g Subsequent Accounting & Reporting: Involves making an accountingpolicy decision on amortization and updating contingent exposures

g Other: Consider interaction with FIN 46

Scope: Characteristics Determine Applicability

g Guarantees requiring payments based on change in an underlying relating

to an asset, liability or equity security of the guaranteed party

g Financial standby LC

g Market value guarantee on financial or non-financial asset (e.g., RVG)

g Guarantee of market price of common stock of guaranteed party

g Guarantee of collection of cash flows from financial assets held by

guaranteed party (e.g., financial guarantees)

g Performance guarantees related to a third party’s failure to perform

g Indemnification agreements that function like guarantees (e.g., tax

indemnities triggered by a change in law or rates)

g Indirect guarantees of the indebtedness of others

Scope: Items Entirely Excluded from FIN 45

Guarantees issued by insurance/reinsurance companies

Lessee provided residual value guarantees on capital leases

Contingent rent obligations

Vendor rebates

Guarantees whose existence prevents sale treatment or gain recognition (e.g., vendor guarantee of operating lease rentals in excess of 10% of the fair value/sales price)

g Certain Performance Guarantees or Indemnities

g “Own future performance” exception

g Provision that the guarantor will not take a certain future action

FIN 45: Items Subject to Disclosures Only

g Intercompany guarantees

g A guarantee provided by an original lessee that has become secondarily liable under a new lease that relieved original lessee as primary obligor.

g Performance of nonfinancial assets (e.g., product warranties)

g Contingent consideration issued in connection with business combinations

g A guarantee for which the guarantor's obligation is reported as equity under GAAP (may be null set with Statement 150 now issued); and

g Statement 133 derivatives meeting the characteristics of a guarantee or indemnification

Scope Quiz

Which of the following items come within the scope of FIN 45?

1.) The lessee and lessor agree to change the rentals in a manner that does not create a new lease under FAS 13. The amendments made to the original lease agreement (dated September 30, 2002) do not affect any indemnities and guarantees.

2.) Same as 1.) above except that the change also involves a change to the residual value guarantee.

3.) Same as 1.) except that change creates a new lease under FAS 13.

4.) An existing lessee assigns all of its rights and obligations to a new lessee. The original lease was entered into on June 30, 2002 and the assignment was effectuated on June 30, 2004.

Scope Quiz (continued)

5.) An existing lessor assigns all of its right, title and interest in a lease to a new lessor. The assignor has no continuing involvement with the risks and rewards of the leased property. The lease was entered into on September 30, 2002.

6.) A lessee and lessor entered into a build-to-suit lease on March 31, 2002 and the lessee provides certain guarantees and indemnifications. The property was substantially completed on September 8, 2003.

7.) A new lease entered into after December 31, 2002, imposes anobligation on the lessee to pay a return fee if it elects to return the property. The lessee is not obligated to pay a fee if it elects to renew or purchase the leased property.

Scope Quiz (continued)

8.) A lessee is contingently obligated to make a payment to the lessor upon return of the property to the lessor for damage, excess wear and tear, or excessive usage.

9.) A lessee is contingently obligated to make a tax indemnity payment to the lessor if the property no longer qualifies as predominately used in the United States.

10.) A lessee and lessor enter into a build-to-suit construction arrangement. The lessee serves as the contractor and guarantees the performance of its subcontractors.

FIN 45: Overview of Disclosure Requirements

g Report each guarantee or group similar guarantees

g Requires disclosure of

g The nature of the guaranteenature of the guaranteenature of the guaranteenature of the guarantee

h Term

h How guarantee arose

h Triggering events or circumstances

g The maximum potential amountmaximum potential amountmaximum potential amountmaximum potential amount of future payments (undiscounted)

required to be made under the guarantee (except product warranties)

h No reduction for possible recoveries

h State if unlimited

h Disclose if unable to estimate maximum potential amount

g The current carrying amountcarrying amountcarrying amountcarrying amount of the guarantor’s obligation

g The nature of recourse provisions and assets held as collateralnature of recourse provisions and assets held as collateralnature of recourse provisions and assets held as collateralnature of recourse provisions and assets held as collateral

FIN 45: Initial Recognition and Measurement

g FIN 45 introduces the “stand ready” concept

g Guarantors must recognize a liabilityrecognize a liabilityrecognize a liabilityrecognize a liability for the stand ready obligation at

the issuance of the guarantee

Initial liabilityInitial liabilityInitial liabilityInitial liabilityType of guaranteeType of guaranteeType of guaranteeType of guarantee

g Same as aboveg Issued as contribution- Community foundation’s loan guarantee program to assist not-for-profits obtain financing at a reasonable cost (gift of support)

g Estimate of guarantee’s fair value(premium that would be required in standalone arm’s- length transaction)

g Issued as part of a transaction with multiple elements- Selling an asset- Entering into an operating lease

g Cash premium received or receivable (provided at fair value)

g Issued in a standalone arm’s-length transaction

FIN 45: Measurement of Fair Value

g MarketMarketMarketMarket:

g If observable market exists, fair value determined based on the

premium required by guarantors for issuing similar guarantees

g ModelModelModelModel:

g Absent observable market, fair value determined by simulating

different cash flow scenarios, and judgmentally weighting and

discounting them to account for time value of money (or similar

valuation techniques)

g FIN 45 does not provide guidance if probability weightings cannot be

validly made because of the lack of observable data

FIN 45: Measurement of Fair Value

g Guidance for ModelsGuidance for ModelsGuidance for ModelsGuidance for Models

g Relevant GAAP: FASB Concepts Statement 7: “Using Cash Flow

Information and Present Value in Accounting Measurements,” issued

February 2000

g Objective: estimate the consideration (e.g. fee) required to:

h Settle the stand-ready obligation with the counterparty, or

h Transfer the obligation to an entity of comparable credit standing

g Method: sum of the probability-weighted present values in a range of

estimated cash flows

FIN 45: Overlap Issues

g Overlap between FIN 45 and FAS 5Overlap between FIN 45 and FAS 5Overlap between FIN 45 and FAS 5Overlap between FIN 45 and FAS 5

g In the event that the guarantor is required to recognize a liability

under FAS 5 for the related contingent loss at the time a guarantee

is issued, the liability to be recognized shall be the greater of:

(a) The amount that satisfies the fair value objective (FIN 45 ¶9)

(b) Contingent liability amount required to be recognized at inception under

FAS 5 ¶8.

Other Potential Overlaps

FAS 13 – definition of minimum lease payments

EITF 95-1 – vendor sales with minimum residual value guarantees

FAS 140 – asset or portfolio sales

FIN 45: Offsetting Debit

g FIN 45 provides the following limited guidance on the offsetting debit for an amount required to be recognized as a liability.

Prepaid rentResidual Value Guarantee provided by lessee under operating lease

ExpenseGuarantee issued to unrelated party for no consideration on standalone basis

Increase carrying amount of investmentGuarantee issued in conjunction with formation of partially owned business or venture (equity method)

Proceeds received are allocated first to guarantee (at fair value), then to sale (affects gain or loss)

Guarantee issued in conjunction with sale of assets, a product, a business

Cash or receivableGuarantee issued in a standalone transaction for a premium

Offsetting debitOffsetting debitOffsetting debitOffsetting debitType of guaranteeType of guaranteeType of guaranteeType of guarantee

FIN 45: Subsequent Accounting

g FIN 45 does not describe in detail subsequent accounting

g However three alternative methods are suggested:

g Leave on the B/S at the full amount until expiration (or settlement) and then reverse to earnings

g Use a systematic and rational amortization approach

g Reduce the liability by the changes in the fair value of the guarantee

g The straight-line method might be allowable in amortizing the “fair value” amounts recognized under a residual value guarantee based on its use by insurance company providers (for “low risk” coverage)

g When loss on guarantee is probable, reduce accrual to extent of remaining liability

FIN 45: Potential Solutions for Leasing

g Approach 1: Limit guarantees, indemnities, etc. to “acts or omissions”

relating solely to “future performance”

g Design triggers based on the counterparty’s “own future performance”

g Look to insurance providers for the shortfall in desired coverage

g Seek to pass along the insurance cost (or “deemed” insurance cost) to

the lessee or portfolio buyer

g Approach 2: Retain “cover the waterfront” coverage for contingencies

g Design triggers based on the counterparty’s “own future performance”

g Use “mark to market” measurements for relevant markets only

g Retain “mark to model” providers (e.g., valuation firms) to develop

reasonable “fair value” estimates

FIN 45: Case 1 – Second Loss Guarantee

g A lessee under a tax leasetax leasetax leasetax lease provides a second loss guarantee to the

lessor in case EBO is not exercised (RVI or RVG structure).

g FIN 45 requires that the fair value of the guarantee be recognized as a

liability by the guarantor.

g Quotes from third parties providing “RVI” exist in the market.

g Premiums quoted by RVI issuers typical range in the 12% - 16% of

insured value for second loss guarantees in longlonglonglong term deals (15-20

years).

g Fair value of the guarantee could be directly derived from these market

quotes, however relevance remains questionable since no trades (actual

issuance of RVI after EBO date) have been observed.

FIN 45: Case 2 – Residual Value Guarantee

g Lessee provides first loss guarantee (RVG) of 85% of estimated fair value at end of lease term (5 years)

g Lessee required to recognize fair value of RVG as a liability. Since no market comparables, expected PV measurement should be used.

g Table below displays a series of possible values of the asset in Yr 5 and probability of occurrence based on FMV(Yr5) of $100 estimated at issuance

1.951.951.951.95TotalTotalTotalTotal

0.302%1585

0.505%1090

0.6513%595

0.5025%298

-45%0100

-10%0102

Weighted Weighted Weighted Weighted expected value expected value expected value expected value

Probability of Probability of Probability of Probability of occurrenceoccurrenceoccurrenceoccurrence

Payment under Payment under Payment under Payment under GuaranteeGuaranteeGuaranteeGuarantee

Possible valuesPossible valuesPossible valuesPossible values

FIN 45: Case 2 – Residual Value Guarantee

g Lessee downside risk is relevant; upside potential is ignored

g The probability-weighted expected loss (1.95) is converted to a “fair

value” estimate under 2 principles under “mark-to-model”

g Don’t leave anything out

g Don’t make up what you don’t know

g Elements comprising “fair value” estimate

g Expected cash flow outflow under the guarantee

g Risk premium to compensate for uncertainty of cash outflow

g Profit margin

FIN 45: Case 2 – Residual Value Guarantee

g Guidance for estimating the risk premium:

g Include if the amount is “identifiable, measurable, and significant”

g Exclude if the amount “cannot be evaluated by comparison to

marketplace information” or “may be small relative to the potential

measurement error in the estimated cash flows”

g Draw on “matrix pricing, option-adjusted spread models, and

fundamental analysis” valuation techniques

FIN 45: Case 2 – Residual Value Guarantee

g Guidance for estimating the profit margin:

g Should be “easier” than estimating the risk adjustment

g Any manager who “regularly” deals with contractors should be able to estimate the amount of estimated profit that they include in job prices, particularly since it is often part of the “negotiating process”

g The estimation task may be “so unusual” that any estimate would be “speculation”

g The profit margin and risk premium may be so “intertwined” that “neither can be estimated”

g Fall back measurement:

g If a reliable estimate cannot be developed, the “present value of expected cash flows, discounted at a risk-free rate of interest, may be the best available estimate of of fair value in the circumstances”

FIN 45: Case 2 – Residual Value Guarantee

g Scenario 1: No reliable estimate can be made

g Expected future cash flow: $1.95/$100 of exposure

g Risk free rate: Like-term US Treasury note (5 years) is 3.3%

g Present value of the expected cash outflow is: 1.65, or $1.65/$100

of exposure

g “Fair value” equals the present value amount

FIN 45: Case 2 – Residual Value Guarantee

g Scenario 2: A reliable estimate of risk premium and profit margin can be made (e.g., lessee has insurance underwriting expertise)

g The functional specifications of a “mark-to-model” valuation must include the following elements:

g Prescribe methodology to be used in predicting value of equipment

g Define capacity to absorb loss (infrastructure, credit rating, etc.)

g Define future status of market (e.g., “balanced” vs. “stressed”)

g Establish target profitability

FIN 45: Case 2 – Residual Value Guarantee

g Key inputs in processing “mark to model” estimate

g Use Monte Carlo method to simulate future equipment values.g Accept premium-based exposure to loss equal to 40% of the insured

value based on remarketing infrastructure and risk capital-based thereafter

g Predict future market for equipment as “balanced”

g Predict future market of insurance providers as “competitive”

g Target 20% as the required return on risk adjusted capital

g If the model returns $2 per $100 of exposure (as a minimum), the “fair value” of the residual guarantee obligation would be estimated at $3.65 per $100 of exposure, or $1.65 (risk-free) plus $2.00 (risk premium and profit margin)

FIN 45: Case 3 – “All Events” Tax Indemnities

g Under an “all events” indemnity clause, the lessee is obligated to make a payment to the lessor to offset the adverse impact on the lessor’s yield and/or its after-tax cash arising from an adverse tax law change or tax settlement in any and all circumstances (other than lessor negligence)

g FIN 45 applies since the indemnity does not relate solely to the lessee’s future performance

g Given the lack of market for tax indemnities protection, lessee must use a model to determine the fair value of the contingent obligation

g FASB has provided the following guidance:

g Develop a base case, a worst case and a best case scenario

g Weight the scenarios according to probability of occurrence

g Compute fair value of obligation according to CON 7 methodology

Implementation Steps for FIN 45

g Process and Controls to Identify Guaranteesg Review standard and non-standard contracts for potential guarantees g Develop policies and procedures to identify guarantees upon contract

initiation

g Establish Accounting Policies and Develop Fair Value Methodologiesg Determine accounting policies for guarantees by type, specifically

addressing how the liability will be released to the I/S and where the debit will be recorded upon issuance

g Consider implications regarding the need to record guarantees at fair value, including the determination of key assumptions and the possible need for a valuation specialist

g Financial Statement Disclosuresg Develop reporting package information in order to capture appropriate

information including the nature and key terms of guarantees, the maximum amount of future payments the guarantor could be required to make under the guarantee, product warranties, and other required disclosures

g Develop draft of proposed footnote disclosures for review

Contact Information

Jeffrey EllisPartnerGrant Thornton LLP175 W. Jackson StreetChicago, IL 60604Tel: 312.602.8991e-mail: jeffrey.ellis@gt.com

Rodney W. HurdFounding MemberMontgomery Street Financial GroupP.O. BoxIncline Village, NV 75006Tel: 415.307.3011e-mail:rwh@montgomerystreetfinancial.com