International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 199
An entity takes into account the effect of its credit risk (credit standing) on the fair value
of the liability in all periods in which the liability is measured at fair value because
market participants valuing the entity’s obligations as assets would take into account the
effect of the entity’s credit standing when estimating the prices at which they would
transact. [IFRS 13.IE31]. Valuation techniques continue to evolve and new concepts are
developing in relation to considering non-performance risk. Whether an entity should
incorporate them into an IFRS 13 fair value measurement depends on whether market
participants would take them into account.
Incorporating non-performance risk into subsequent fair value measurements of a
liability is also consistent with the notion that credit risk affects the initial measurement
of a liability. Since the terms of a liability are determined based on an entity’s credit
standing at the time of issuance (and since IFRS 13 assumes the liability is transferred to
another party with the same credit standing at the measurement date), subsequent
changes in an entity’s credit standing will result in the obligation’s terms being
favourable or unfavourable relative to current market requirements. The standard gives
the following example illustrating how the fair value of the same instrument could be
different depending on the credit risk of the issuer. [IFRS 13.IE32].
Example 14.17: Non-performance risk
Assume that Entity X and Entity Y each enter into a contractual obligation to pay cash (CU 500) to Entity Z
in five years. Entity X has a AA credit rating and can borrow at 6%, and Entity Y has a BBB credit rating and
can borrow at 12%. Entity X will receive about CU 374 in exchange for its promise (the present value of
CU 500 in five years at 6%). Entity Y will receive about CU 284 in exchange for its promise (the present
value of CU 500 in five years at 12%). The fair value of the liability to each entity (i.e. the proceeds)
incorporates that entity’s credit standing.
The effect of non-performance risk on the fair value measurement of the liability will
depend on factors, such as the terms of any related credit enhancement or the nature of
the liability – that is, whether the liability is an obligation to deliver cash (a financial
liability) or an obligation to deliver goods or services (a non-financial liability). The
following example, from the standard, illustrates changes in fair value measurement due
to changes in non-performance risk. As indicated in this example, changes to an entity’s
non-performance risk does not require there to be a change in credit rating. Instead,
such changes are often based on changes in credit spreads. [IFRS 13.IE34].
1008 Chapter 14
Example 14.18: Structured note
On 1 January 20X9 Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note
to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to an equity index.
No credit enhancements are issued in conjunction with or otherwise related to the contract (i.e. no collateral
is posted and there is no third-party guarantee). Entity A designated this note as at fair value through profit
or loss. The fair value of the note (i.e. the obligation of Entity A) during 20X9 is measured using an expected
present value technique. Changes in fair value are as follows:
(a) Fair value at 1 January 20X9 – The expected cash flows used in the expected present value technique are
discounted at the risk-free rate using the government bond curve at 1 January 20X9, plus the current market
observable AA corporate bond spread to government bonds, if non-performance risk is not already reflected
in the cash flows, adjusted (either up or down) for Entity A’s specific credit risk (i.e. resulting in a credit-
adjusted risk-free rate). Therefore, the fair value of Entity A’s obligation at initial recognition takes into
account non-performance risk, including that entity’s credit risk, which presumably is reflected in the proceeds.
(b) Fair value at 31 March 20X9 – During March 20X9 the credit spread for AA corporate bonds widens, with
no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present
value technique are discounted at the risk-free rate using the government bond curve at 31 March 20X9,
plus the current market observable AA corporate bond spread to government bonds, if non-performance
risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (i.e. resulting in a
credit-adjusted risk-free rate). Entity A’s specific credit risk is unchanged from initial recognition.
Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally.
Changes in credit spreads reflect current market participant assumptions about changes in non-performance
risk generally, changes in liquidity risk and the compensation required for assuming those risks.
(c) Fair value at 30 June 20X9 – As at 30 June 20X9 there have been no changes to the AA corporate bond
spreads. However, on the basis of structured note issues corroborated with other qualitative information,
Entity A determines that its own specific creditworthiness has strengthened within the AA credit spread.
The expected cash flows used in the expected present value technique are discounted at the risk-free rate
using the government bond yield curve at 30 June 20X9, plus the current market observable AA
corporate bond spread to government bonds (unchanged from 31 March 20X9), if non-performance risk
is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (i.e. resulting in a
credit-adjusted risk-free rate). Therefore, the fair value of the obligation of Entity A changes as a result
of the change in its own specific credit risk within the AA corporate bond spread.
The standard’s assumption that the non-performance risk related to a liability is the
same before and after its transfer is not intended to reflect reality. In most cases, the
reporting entity and the market participant transferee will have different credit
standings. However, this assumption is important when measuring fair value under
IFRS 13 for the following reasons:
• if the transaction results in changes to the non-performance risk associated with
the liability, the market participant taking on the obligation would not enter into
the transaction without reflecting that change in the price.
IFRS 13 gives the following examples; a creditor would not generally permit a debtor to
transfer its obligation to another party of lower credit standing, nor would a transferee
of higher credit standing be willing to assume the obligation using the same terms
negotiated by the transferor if those terms reflect the transferor’s lower credit standing;
• if IFRS 13 did not specify the credit standing of the entity taking on the obligation, there
could be fundamentally different fair values for a liability depending on an entity’s
assumptions about the characteristics of the market participant transferee; and
• those who might hold the entity’s liability as an asset would consider the effect of
the entity’s credit risk and other risk factors when pricing those assets (see 11.2.1
above). [IFRS 13.BC94].
Fair value measurement 1009
The requiremen
ts of IFRS 13 regarding non-performance risk, when measuring fair
value for liabilities, are consistent with the fair value measurement guidance in IFRSs
prior to the issuance of IFRS 13. Specifically, IFRS 9 refers to making adjustments for
credit risk if market participants would reflect that risk when pricing a financial
instrument. However, the IASB acknowledged that there was inconsistent application
of that principle for two reasons. Firstly, IFRS 9 referred to credit risk generally and did
not specifically refer to the reporting entity’s own credit risk. Secondly, there were
different interpretations about how an entity’s own credit risk should be reflected in the
fair value of a liability using the settlement notion, under the previous definition of fair
value, because it was unlikely that the counterparty would accept a different amount as
settlement of the obligation if the entity’s credit standing changed. [IFRS 13.BC92, BC93]. As
such, adoption of IFRS 13 may have resulted in a change for some entities in this regard.
In developing IFRS 13, there was some debate among constituents about the usefulness
of including non-performance risk after initial recognition because this might lead to
counter-intuitive and potentially confusing reporting (i.e. gains for credit deterioration
and losses for credit improvements). However, in the IASB’s view, this does not affect
how to measure fair value, but rather whether an IFRS should require fair value
measurement subsequent to initial recognition, which is outside the scope of IFRS 13.
The standard is clear that a measurement that does not consider the effect of an entity’s
non-performance risk is not a fair value measurement. [IFRS 13.BC95]. The adoption of
IFRS 9 may have resolved some of these concerns. For financial liabilities designated at
fair value through profit or loss (using the fair value option), IFRS 9 requires fair value
changes that are the result of changes in an entity’s own credit risk to be presented in
other comprehensive income, unless doing so would introduce an accounting mismatch.
If it would introduce an accounting mismatch, the whole fair value change is presented
in profit or loss (see Chapter 46 for further discussion). [IFRS 9.5.7.7].
11.3.1
Liabilities issued with third-party credit enhancements
As discussed at 11.3 above, IFRS 13 requires entities to measure the fair value of a
liability issued with an inseparable third-party credit enhancement from the issuer’s
perspective, i.e. considering the issuer’s credit risk rather than that of the third-party
providing the credit enhancement. This would apply in situations where a credit
enhancement (or guarantee) is purchased by an issuer, then combined with a liability
and issued as a combined security to an investor. IFRS 13’s requirements are based on
the fact that the third-party credit enhancement does not relieve the issuer of its
ultimate obligation under the liability. Generally, if the issuer fails to meet its payment
obligations to the investor, the guarantor has an obligation to make the payments on the
issuer’s behalf and the issuer has an obligation to the guarantor. By issuing debt
combined with a credit enhancement, the issuer is able to market its debt more easily
and can either reduce the interest rate paid to the investor or receive higher proceeds
when the debt is issued.
IFRS 13 requires the fair value measurement of a liability to follow the unit of account
of the liability for financial reporting purposes. The standard anticipates that there may
be instances where, even though it may be inseparable, the credit enhancement may
need to be separated (i.e. separately recognised) for financial reporting purposes.
However, this assumes that: (i) the unit of account is clear in other standards, which may
1010 Chapter 14
not be the case; and (ii) that standards, such as IFRS 9, may permit or require separation
when a credit enhancement is inseparable.
As discussed in Figure 14.4 below, if the unit of account excludes the credit
enhancement, the fair value of the liability measured from the issuer’s perspective in
accordance with IFRS 13, will not equal its fair value as a guaranteed liability held by
another party as an asset. The fair value of the asset held by the investor considers the
credit standing of the guarantor. However, under the guarantee, any payments made by
the guarantor result in a transfer of the issuer’s debt obligation from the investor to the
guarantor. That is, the amount owed by the issuer does not change; the issuer must now
pay the guarantor instead of the investor. Therefore, as discussed at 11.2.1 above, if the
fair value of a third-party guaranteed liability is measured based on the fair value of the
corresponding asset, it would need to be adjusted. [IFRS 13.BC96-BC98].
Figure 14.4:
Liabilities with credit enhancements
Issuer’s perspective
Perspective of the entity that holds the
(i.e. the obligor)
corresponding asset
Credit enhancement provided by the issuer (e.g. collateral or master netting agreement)
Separate unit of
Dependent on the relevant IFRS
Dependent on the relevant IFRS
account?
(e.g. IFRS 9).
(e.g. IFRS 9) and the nature of the credit
Depending on the nature of the credit
enhancement.
enhancement, it may be recognised (e.g.
collateral recognised as an asset in the
financial statements of the issuer) or
unrecognised (e.g. a master netting
agreement).
Considered in the fair
Generally, yes. The fair value
Possibly. If the credit enhancement is not
value measurement?
measurement of a liability takes into
accounted for separately, the fair value of the
consideration the credit standing of the
corresponding asset would take into
issuer. The effect may differ depending on
consideration the effect of the related the
the terms of the related credit
credit enhancement.
enhancement.
Credit enhancement provided by a third-party (e.g. financial guarantee)
Separate unit of
Dependent on the relevant IFRS
Dependent on the relevant IFRS
account?
(e.g. IFRS 9). Likely to be a separate unit
(e.g. IFRS 9) and the nature of the credit
of account and remain unrecognised,
enhancement.
unless the issuer fails to meet its
obligations under the liability.
Considered in the fair
Generally, no. If the credit enhancement is
Possibly. If the credit enhancement is not
value measurement?
accounted for separately from the liability,
accounted for separately, the fair value of the
the issuer would take into account its own
corresponding asset would take into
credit standing and not that of the third
consideration the effect of the related third-
party guarantor when measuring the fair
party credit enhancement.
value of the liability.
Fair value measurement 1011
11.3.1.A
enhancements in a fair value measurement apply to liabilities other than
debt?
The requirements of IFRS 13 for liabilities issued with third-party credit enhancements
apply to all liabilities that are measured or disclosed at fair value on a recurring basis.
Although the requirements would not affect financial liabilities after their initial
recognition if they are subsequently measured at amortised cost in accordance with
IFRS 9, it would apply to the disclosure of the fair value of those liabilities, as required
by IFRS 7.
While an issuer’s accounting for guaranteed debt may be the most common application
of this guidance, the clarification with respect to the unit of account for certain types of
credit enhancements could affect other liabilities, including derivative instruments
measured at fair value in accordance with IFRS 9. Many OTC derivative contracts are
subject to credit support requirements under an International Swaps and Derivatives
Association18 (ISDA) Master Agreement between the derivative counterparties. The
application of this guidance to OTC derivatives will depend on the nature of the credit
support provided. For example, while credit support is typically provided through the
posting of collateral, in certain industries posting a letter of credit (LOC) for the benefit
of a derivative counterparty is not uncommon.
In those instances where a LOC is posted for the benefit of a derivative counterparty,
we believe the requirement in paragraph 44 of IFRS 13, to consider the issuer’s credit
risk rather than that of the third party providing the LOC, would generally apply.
[IFRS 13.44]. If an entity defaults on its derivative contracts, the bank issuing the LOC will
pay the counterparty and the entity’s obligation merely transfers from the original
counterparty to the issuing bank. In other words, the entity will have a continuing
obligation, even in the event it defaults on the derivative. As such, the entity’s non-
performance risk (not that of the bank providing the LOC) would be considered in