1.13  Query:   

  Letter of commitment for issuing debt guarantees, whether a contingent  liability.

1. Under its shipping finance activities, a nationalised bank is required to give deferred payment guarantee (DPG) on behalf of the buyer to the seller of ship, covering payment of the price of the ship/tanker in instalments. The said guarantee is given at the time of delivery of the ship. However, as per the querist, the ship-building yards usually demand a “Letter of Commitment” (LOC) from the buyer’s bank undertaking irrevocably to issue a DPG when the delivery of the vessel is made by the yard, before they start building the vessel. This letter of commitment is effective from the date of effectuation of the relevant ship building contract.

2.  As per the querist, the deferred payment guarantee to be issued by the bank constitutes a contingent liability for the bank. However, a question has been raised as to whether the letter of commitment (LOC) should also be treated as a contingent liability. The querist is of the view that the letter of commitment (LOC) does not constitute a contingent liability for the bank, because of the following reasons:

(i)         The LOC is in the nature of an assurance to issue a DPG at a later date, i.e., only on delivery of the ship, as per the terms of the contract. The purpose of such letter as per the querist, appears to be to enable the yard to start building the ship with the assurance that on delivery of the ship, a DPG guaranteeing payment of the price of the ship in instalments as per the contract by the buyer would be issued by the bank.

(ii)        A contingent liability is undertaken on behalf of a customer guaranteeing certain performance by the latter; in this case, such a contingent liability arises only when the DPG is issued. Therefore, although the LOC may lead to incurring of a contingent liability but this is dependent upon the seller delivering the ship as per the contract. If the seller fails to deliver the ship, the question of DPG would not arise at all.

(iii)       The LOC is an undertaking to undertake a contingent liability at a future date and by itself does not become a contingent liability. As per the querist, therefore, it is like a letter of sanction of advance facilities including guarantee facilities to an applicant.

3.The querist has sought the opinion of the Expert Advisory Committee as to whether the letter of commitment issued by the buyer’s bank undertaking irrevocably to issue a deferred payment guarantee at a later date constitutes a contingent liability for the bank.

                                                                                       Opinion                             May 6, 1994

1. The Committee notes paras 3.1, 10 and 11 of Accounting Standard (AS) 4 on ‘Contingencies and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India, which read as follows:

“3.1      A contingency is a condition or situation, the ultimate outcome of which, gain or loss, will be known or determined only on the occurrence, or non-occurrence, of one or more uncertain future events.”

“10.      The amount of a contingent loss should be provided for by a charge in the statement of profit and loss if:

(a)        it is probable that at the date of the financial statements events subsequent thereto will confirm that (after taking into account any related probable recovery) an asset has been impaired or a liability has been incurred as at that date, and

(b)        a reasonable estimate of the amount of the resulting loss can be made.”

“11.      The existence of a contingent loss should be disclosed in the financial statements if either of the conditions in paragraph 10 is not met, unless the possibility of a loss is remote.”

2.The Committee is of the view, on the basis of the above, that a contingency condition is said to exist when-

(i)         there existed a condition or a situation on the reporting date, which may result into incurrence of a liability or loss to the reporting entity, and

(ii)        the final resolution of such condition or situation depends on occurrence or non-occurrence of one or more future events.

The contingencies so assessed to be existing at the reporting date are either provided for by way of a charge in the statement of profit and loss as per para 10 of Accounting Standard (AS) 4, or are disclosed by way of a note as per para 11 of Accounting Standard (AS) 4, as reproduced at para 1 above.

3. The Committee is of the view that in the given facts and circumstances of the case, the condition or situation which would give rise to a contingency for the bank is the delivery of the vessel by the seller to the buyer on which date the deferred payment guarantee comes into effect. Accordingly, the Committee is of the opinion that issuance of a letter of commitment undertaking irrevocably to issue a deferred payment guarantee in future in favour of the seller of the vessel by the buyer’s bank does not constitute a contingent liability for the bank until and unless the underlying vessel is delivered in accordance with the terms of the contract related thereto. The bank, therefore, need not disclose the fact of issuance of such letters of commitment in its financial statements where the underlying vessel has not been delivered upto the reporting date.

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