What Is a Contingent Guarantee?
A contingent guarantee is a guarantee of payment made by a third-party guarantor to the seller or provider of a product or service in the event of non-payment by the buyer.
Understanding Contingent Guarantees
Contingent guarantees generally are used when a supplier does not have a relationship with a counter-party. The buyer pays a contingent guarantee fee to the guarantor, usually a large bank or financial institution. If the buyer fails to make the payment, the third party will make a payment on their behalf.
A guarantor differs from a cosigner. A cosigner is co-owner of the asset and is named in the ownership document. The guarantor has no claim to the asset purchased by the borrower under the loan agreement, and only guarantees payment of the loan. The lender will normally ask for a cosigner if the borrower’s qualifying income does not meet the lender's requirement. The cosigner’s additional income or assets bridge any financial gap. Under the guarantor agreement, the borrower may have sufficient income but limited or poor credit history.
- A contingent guarantee is a guarantee of payment made by a third party guarantor to the seller or provider of a product or service if the buyer cannot pay.
- If it is likely to become a confirmed obligation, an accountant should record a contingent liability on a balance sheet.
Contingent guarantees are a common feature of international trade, especially when vendors conduct business with new customers in overseas markets. Contingent guarantees also are used as a risk-management tool for large international projects with countries that have a high degree of political or regulatory risk, as well as in certain income-oriented financial instruments.
A contingent guarantee is not an actual confirmed liability for a company until it is likely they'll have to make good on the guarantee.
Companies must account for contingent guarantees as contingent liabilities, which indicates a potential loss may occur at some point in the future. This liability is not yet an actual, confirmed obligation. A contingent obligation is most meaningful to financial analysts, who need to understand the probability of such an issue becoming a full-fledged liability. An accountant should record a contingent liability on a balance sheet if it is likely to become a confirmed obligation.
Contingent Guarantee vs. Letter of Credit
A contingent guarantee differs from a letter of credit (LC), which is more commonly used in international trade. A contingent guarantee is employed only upon non-payment after a stipulated period by the buyer, while an LC is payable by the bank as soon as the seller effects shipment and satisfies the terms of the LC. LCs help mitigate factors such as distance, legal requirements and counter-party reputation.
Because a letter of credit typically is a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferrable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.