Banks and other financial institutions often act as loan guarantors -- agreeing to repay a borrower's debt if that person defaults on the obligation. A bank doesn't do this just to be nice, of course. It charges a fee to provide the guarantee. Such fees must be accounted for in the bank's books when they're collected. If the bank winds up having to make good on the guarantee, that must be accounted for, too. And if the borrower repays the loan as promised, the fees become revenue for the bank.
Fees Initially Unearned Revenue
Bank guarantee fees are service charges that banks receive from a party to a financial transaction, such as a lender or a borrower. In exchange for the fee, the bank guarantees the payments from one party to the other within a specified period. Bank guarantee fees are recorded as unearned revenue when collected, because they are not fully earned until the bank has fulfilled its obligation. Banks recognize the fees as revenue gradually, as time passes within the guarantee period.
A bank that offers a guarantee is incurring a contingent liability, one that depends on whether the payments are made as agreed. That contingent liability is recognized and recorded on the balance sheet if the occurrence of the future event to confirm the liability is probable and the amount of loss from realizing the contingent liability can be reasonably estimated. In recording a contingent liability in relation to the bank guarantee fees, banks also record an accrued expense in the income statement in the same amount of potential loss from the contingent liability.
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The contingent liability becomes an actual liability it the bank ends up having to make the payments as guaranteed. After fulfilling its payment obligation, the bank cancels its previously recorded contingent liability and records a cash payment in the balance sheet. By realizing the contingent liability as an actual liability, a bank effectively recognizes the cost or loss in connection with the bank guarantee fees.
Removing the Liability
The contingent liability is eventually removed from the balance sheet if the bank incurs no payments during the time it provides the payment guarantee. At that point, the bank guarantee fees are fully recognized as revenue for the bank, and a gain is recorded in the income statement. As a result of the removal of the contingent liability, the gain cancels out the previously accrued expense when establishing the contingent liability, and does not add to the net profit for the bank.