Query No. 8 Subject: Disclosure of bank guarantees/indemnity bonds.[1] A. Facts of the Case 1. A public sector company which undertakes construction projects on turn-key basis is required to submit bank guarantees/indemnity bonds of the following types in the normal course of its business:
(a) Guarantees for securing contracts as per the bidding requirements
Under these guarantees, the banker agrees to make payment to the client (i.e., the party in whose favour the guarantee is given) in the following circumstances:
(i) If the bidder (i.e., the company) withdraws its bid during the period of bid validity specified in the ‘Form of Bid’, or
(ii) if the bidder, having been notified of the acceptance of its bid, during the period of bid validity,
(a) fails or refuses to execute the Form of Agreement in accordance with the ‘Instruction to Bidders’, if required, or
(b) fails or refuses to furnish the Performance Security in accordance with the ‘Instruction to Bidders’.
(b) Guarantees for performance of the contract
When the company’s bid is accepted and it is awarded the contract, the company is required to deposit a certain sum of money as ‘security deposit’ for faithful execution of the contract as per the terms and conditions of the bid. According to the querist, the clients invariably accept bank guarantee in lieu of the ‘security deposit’. Under this type of guarantee, the banker agrees to pay the amount mentioned in the guarantee to the client if the company fails to perform the contract as per the terms and conditions.
(c) Guarantees for release of payments against execution of work
The company is contractually liable to rectify, free of charge, the defects that arise during the defect-liability period. As a safeguard against the company’s failure to discharge its obligation during the defect-liability period, certain balance payment is retained till the expiry of the defect-liability period. In most contracts, 90% to 95% of contract payments are released on execution of the work and the balance is to be released after the expiry of the defect-liability period which may range from one year to three years. However, the clients often agree to release the balance payment against submission of a bank guarantee of equal amount. In the case of such bank guarantees, the banker is required to pay the money only if the company fails to perform its contractual obligation of defect rectification.
(d) Guarantees/Indemnity Bonds for getting mobilisation advance
Some of the contracts entered into by the company provide for payment of 10% to 15% of the contract value by the client as mobilisation advance on signing of the contract against submission of bank guarantee of equal amount. The objective of such an advance is to help speedier mobilisation of men and materials so that work can be executed in time. The money so advanced is required to be refunded by the company through on-account-payments as pre-agreed. In the case of such bank guarantees, the banker is required to pay the money if any loss or damage is suffered by the client due to breach of the contract, primarily if the mobilisation advance is not paid back or adjusted against the value of goods/services provided to the client.
2. The querist has stated that the company has been showing the guarantees/indemnity bonds at 1(a) and 1(b) above as contingent liability in the financial statements in the following manner:
“Note to Accounts
Contingent liability not provided for:
(i) Guarantees provided by the bankers on behalf of the company Rs. xxx.
(ii) Indemnity bonds given to the clients in lieu of bank guarantees Rs. xxx.” B. Queries 3. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
C. Points Considered by the Committee 4. The querist has sought the views of the Committee only about the treatment of guarantees and indemnity bonds mentioned in paragraphs 1(a) and 1(b) above given by the bankers on behalf of the company. The querist has not raised any query in respect of the guarantees of the nature specified in paragraph 1(c) and paragraph 1(d) above. As such, the Committee’s views are restricted to the accounting treatment of only the guarantees/indemnity bonds of the nature specified in paragraphs 1(a) and 1(b) above.
5. The Guidance Note on ‘Guarantees and Counter-Guarantees Given by Companies’ issued by the Institute of Chartered Accountants of India categorises guarantees into certain classes. Paragraph 3.1 of the Guidance Note states as below:
“3.1 The method of disclosure would depend upon the nature of the guarantee. It is possible to group guarantees into the following classes:
6. In respect of guarantees falling under paragraph 3.1(c) above, paragraph 3.4 of the Guidance Note states as below:
“3.4 Guarantees which fall in category (c) of paragraph 3.1 above are often issued to public authorities who require guarantees to be furnished to them either by the company itself or by its bankers in order to protect such authorities from any financial loss which they may suffer as a result of the non-performance of obligations or the commission of defaults by the companies concerned. For example, an importer may be required to furnish a bond or guarantee to the Customs Authorities which would protect the latter in case the importer either fails to perform certain statutory obligations under the Customs Act and Regulations or commits any statutory defaults. Similarly, the Railway Authorities may require a guarantee from companies which wish to transport goods without prepayment of freight or which wish to avail of any other facilities offered by the Railways. In all such cases, there is no liability - either actual or contingent - which requires to be disclosed, nor does the mere submission of a guarantee constitute a contingent liability. Where the guarantee is furnished as security against statutory defaults, there is no reason to believe that a company will commit a statutory default or that it will fail to comply with its statutory obligations. In any case, this is a matter which is in the control of the company itself and the commission of a statutory default by the company in the future of its statutory obligations cannot be said to involve the existence of a contingent liability, even though in any such eventuality, the company would be financially liable for penalty or damages. It should also be recognised that all companies face a situation of this type and if disclosure is to be made at all, it should be made by all companies and not merely by those which have furnished a guarantee against the financial liability which they may incur in the future by the commission of statutory defaults or by the non-observance of statutory requirements. If it is accepted that a situation of this type does not involve any actual or contingent liability, it must equally be accepted that there is no obligation to disclose the guarantees given by the company in respect of its possible future obligations. The question which should be asked is whether any event had taken place at the balance sheet date - or even at the date the balance sheet is signed which has resulted in a liability. The mere possibility or chance of such an event taking place in the future would not involve any question of contingent liability on the balance sheet date. It is therefore suggested that no disclosure need be made - either of the possible future liability or of the guarantee which has been given in order to cover such possible future liability. It would not be appropriate in such cases to suggest that disclosure of the guarantee may be made by way of abundant caution or in order to provide additional information to the shareholders and others, because such disclosure, in fact, can be positively misleading, by conveying a false impression to the casual reader of the balance sheet as to existence of actual or contingent liabilities related to such guarantee.”
7. The Committee is of the view that the guarantees of the nature described in paragraphs 1(a) and 1(b) above [namely, (a) guarantees given by bankers for securing the clients against the company’s (bidder’s) withdrawal of the bid during the period of bid validity or its failure to execute ‘Form of Agreement’ or furnish the Performance Security, and (b) guarantees given by bankers in lieu of ‘security deposit’ securing the clients against non-performance by the company of the contracts as per stipulated terms] fall under the category of guarantees dealt with in paragraph 3.1(c) of the aforesaid Guidance Note and should be dealt with as recommended in paragraph 3.4 thereof.
8. The essence of paragraph 3.4 of the aforesaid Guidance Note is that the guarantees of the nature dealt with therein do not require a disclosure unless they involve any actual or contingent liability. There is, thus, a need to assess whether any such guarantee involves an actual or contingent liability.
9. The indemnity bonds issued by the company in lieu of bank guarantees of the nature described in paragraphs 1(a) and 1(b) above are of the nature of promises by the company for its own performance. In accordance with paragraph 3.4 of the Guidance Note reproduced above, these also do not per se require to be disclosed in the financial statements.
10. Paragraphs 10, 11 and 16 of Accounting Standard (AS) 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’, deal with the treatment of contingencies that may result in a loss and require as follows:
“10 The amount of a contingent loss should be provided for by a charge in the statement of profit and loss if:
“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.”
“16. If disclosure of contingencies is required by paragraph 11 of this Statement, the following information should be provided:
11.While mere furnishing of guarantees/indemnity bonds does not per se result in a contingent liability, the company should assess the possibility of loss arising from the furnishing of such guarantees/indemnity bonds. Thus, where in respect of a guarantee/indemnity bond, a loss is probable and a reasonable estimate of its amount can be made, it would be necessary to make a provision. If either of these conditions is not satisfied and the possibility of loss is not remote, appropriate disclosures as required by AS 4 would have to be made.
D. Opinion
12. Based on the above, the Committee is of the following opinion on the queries raised in paragraph 3 above :
(i) A provision for the loss should be made if both the following conditions are satisfied:
- The loss is probable.
- A reasonable estimate of the amount of the loss can be made.
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[1] Opinion
finalised by the Committee on 4.3.1999.
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