What it is:
With a guaranteed loan, a party other than the borrower has promised to take responsibility if the borrower cannot make the payments. The entity assuming this responsibility is called the guarantor.
How it works/Example:
Let's assume Company XYZ would like to borrow $100,000 from a bank to buy a piece of equipment. Although the business loan using flows from other parts of his life and assets if Company XYZ is unable to generate enough cash on its own to repay the .
Guarantors don't always guarantee the entire amount of a liability. They might only guarantee the repayment of interest or principal, for example, but not both. Sometimes more than one entity might guarantee a loan; in these cases, each guarantor is usually only responsible for a pro rata portion of the debt, but in other cases, each guarantor may be responsible for the other guarantors' portions if they also default on their responsibilities.
Guarantees are common in the student loan industry, whereby the federal government guarantees to people who are generally young and without real history. This guarantee induces banks to lend to students and guarantees that the banks will be repaid.
Why it matters:
Guarantees mitigate risk, but it is important to guarantor is already struggling for other reasons. Regardless, guarantees provide an extra layer of security, which is why guaranteed often get higher credit .
Historically, if the are public companies, they disclosed the nature and size of their guarantees (often for loans their subsidiaries have borrowed) in the to their financial statements. But in 2002 the Financial Accounting Standards Board (FASB) issued Interpretation 45, stating that guarantors must book the fair value of the guaranteed loan as a liability on the balance sheet and that they must do so at the inception of the guarantee. Some guarantees, such as those that are accounted for as derivatives, those issued by insurance companies, and some guarantees issued by leasing companies, are exempt from this rule. It is important to that guarantees issued between parents and their subsidiaries do not have to be booked as balance sheet liabilities.
All guarantees must, however, be disclosed. The guarantor must disclose the nature of the guarantee ( , history and events that would the guarantor on the hook), the maximum potential liability under the guarantee, and any provisions that might enable the guarantor to recover any paid out under the guarantee.