International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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macro-economic factors, which do not
affect entity or affect entity to a lesser or
greater extent
Debt issuance credit
• Market observable
• Information can be outdated and may
spread
• Information can be current, in case a
require an adjustment for illiquidity
recent issuance can be referenced (or
• As it is not always possible to reference a
where pricing terms are available
recent issuance, a judgemental adjustment
ahead of debt issuance)
may be required to bridge gap between
• Easy to source from third party data
debt issue date and derivative valuation
providers and/or from treasurer,
date (i.e. financial reporting date)
through communications with the
• May require a judgemental adjustment
banks
due to maturity mismatch of debt
issuance and derivative to be valued
Credit rating/
• Rating agency data available for most
• Information can be outdated
historical default
entities
• Conversion to probability of default may
information (e.g.
• Easy to source from third party data
be based on historical information
Moody’s publication
providers
• May require an adjustment from long-term
of Historic Probability
average measure to a ‘point-in-time’
of Default)
measure
• Not associated with a specific maturity;
ratings are generally long term average
estimates of creditworthiness, which may
not be appropriate for short term derivatives
Internal credit risk
• May be applied by most entities
• Based on unobservable information
analysis
• Ability to customise internal models
• Information can be outdated
• May not be consistent with what other
market participants would use
Fair value measurement 1017
11.3.4
Does the existence of master netting agreements and/or CSAs
eliminate the need to consider an entity’s own credit risk when
measuring the fair value of derivative liabilities?
IFRS 13 is clear that non-performance risk should be considered from the perspective of
the liability being measured, not the entity obligated under the liability. As such, non-
performance risk may differ for various liabilities of the same entity. This difference may
result from the specific terms of the liability (e.g. seniority or priority in the event of
liquidation) or from specific credit enhancements related to the liability (e.g. collateral).
Bilateral collateral arrangements, master netting agreements and other credit
enhancement or risk mitigation tools will reduce the credit exposure associated with a
liability (or asset) and should be considered in determining the fair value of the liability.
Although these agreements reduce credit exposure, they typically do not eliminate the
exposure completely. For example, most CSAs do not require collateral to be posted
until a certain threshold has been reached, and once reached require collateral only for
the exposure in excess of the threshold. Therefore, while the existence of master netting
agreements or CSAs mitigates the effect of own credit risk on the fair value of a liability,
their presence alone would not enable an entity to ignore its own credit risk. Entities
should assess their credit exposure to a specific liability when determining how their
own credit risk would affect its fair value.
11.3.4.A
Portfolio approaches and credit mitigation arrangements
When calculating derivative credit adjustments, reporting entities may factor in their
ability to reduce their counterparty exposures through any existing netting or collateral
arrangements. The measurement exception in IFRS 13 (see 12 below) allows a reporting
entity to measure the net credit risk of a portfolio of derivatives to a single counterparty,
assuming there is an enforceable arrangement in place that mitigates credit risk upon
default (e.g. a master netting agreement). [IFRS 13.48].
• Netting arrangements
A master netting agreement is a legally binding contract between two
counterparties to net exposures under other agreements or contracts (e.g. relevant
ISDA agreements, CSAs and any other credit enhancements or risk mitigation
arrangements in place) between the same two parties. Such netting may be effected
with periodic payments (payment netting), settlement payments following the
occurrence of an event of default (close-out netting) or both. In cases of default,
such an agreement serves to protect the parties from paying out on the gross
amount of their payable positions, while receiving less than the full amount on their
gross receivable positions with the same counterparty.
IFRS 7 requires disclosure of the effects of set-off and related netting on an entity’s
financial position (see Chapter 50 for further discussion).
In situations where an entity meets the criteria to apply the measurement
exception in IFRS 13 (discussed at 12 below), it will still need to assess whether it
has the practical ability to implement a credit valuation method which reflects the
net counterparty exposure. This can be challenging, particularly for those entities
that do not have systems in place to capture the relevant net positions by
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debtor/counterparty. Also, an allocation of the portfolio level adjustments is
required, as discussed at 11.3.4.B below.
A further complication arises if the net exposure represents the position across
different classes of derivatives (e.g. interest rate swaps and foreign exchange
forwards). Basic valuation methods can attempt to approximate a net position through
the creation of an appropriate ‘modelled net position’ representing the net risk.
• Collateral arrangements
In many instances, counterparty credit exposure in derivative transactions can be
further reduced through collateral requirements. Such arrangements serve to limit the
potential exposure of one counterparty to the other by requiring the out-of-the-money
counterparty to post collateral (e.g. cash or liquid securities) to the in-the-money
counterparty. While these and other credit mitigation arrangements often serve to
reduce credit exposure, they typically do not eliminate the exposure completely.
Many collateral agreements, for example, do not require collateral to be posted
until a certain threshold has been reached, and then, collateral is required only for
the exposure in excess of the threshold. In addition, even when transactions with
a counterparty are subject to collateral requirements, entities remain exposed to
what is commonly referred to as ‘gap risk’ (i.e. the exposure arising from
fluctuations in the value of the derivatives before the collateral is called and
between the time it is called and the time it is actually posted).
Finally, collateral arrangements may be either unilateral or bilateral. Unilateral
arrangement
s require only one party to the contract to post collateral. Under
bilateral agreements, both counterparties are subject to collateral requirements,
although potentially at different threshold levels.
Given their ability to reduce credit exposure, netting and collateral arrangements are
typically considered in determining the CVA for a portfolio of derivatives. This can add
to the complexity of the calculation as total expected credit exposure should be
determined not just for a single derivative contract (whose value changes over time), but
for a portfolio of derivative contracts (which can include both derivative assets and
derivative liabilities). Simply taking the sum of the CVA of individual trades could
dramatically overstate the potential credit exposure, as it would not take into account
positions in the portfolio with offsetting exposures. Consequently, when netting
agreements and collateral arrangements are in place, and a company has elected to
measure its derivative positions with offsetting credit risk using the measurement
exception in IFRS 13, the expected exposure is generally analysed at the portfolio level
(i.e. on a net basis).
11.3.4.B
Portfolio-level credit adjustments
The measurement exception (the portfolio approach) permits measuring non-
performance risk of derivatives with the same counterparty on a portfolio basis (see 12
below), allowing the mitigating effect of CSAs and master netting agreements to have
their full effect in the financial statements taken as a whole. The use of the measurement
exception does not change the fact that the unit of account is the individual derivative
contract, a concept particularly important when an individual derivative is designated
as a hedging instrument in a hedging relationship.
Fair value measurement 1019
There is no specific guidance under IFRS on how portfolio level credit adjustments
should be allocated to individual derivatives. A number of quantitative allocation
methods have been observed in practice and have been accepted as long as a reporting
entity is able to support that the method is: (a) appropriate for its facts and
circumstances; and (b) applied consistently. Given the renewed focus on credit
adjustments, it is likely that valuation methods will become more sophisticated and new
techniques and refinements to the above portfolio allocation techniques will arise.
11.4 Restrictions preventing the transfer of a liability or an entity’s
own equity
A liability or an entity’s own equity may be subject to restrictions that prevent the
transfer of the item. When measuring the fair value of a liability or equity instrument,
IFRS 13 does not allow an entity to include a separate input (or an adjustment to other
inputs) for such restrictions. This is because the effect of the restriction is either
implicitly or explicitly included in other inputs to the fair value measurement. The
standard gives the example of both a creditor and an obligor accepting a transaction
price for a liability with full knowledge that the obligation includes a restriction that
prevents its transfer. In this case, the restriction is implicitly included in the price.
Therefore, further adjustment would be inappropriate. [IFRS 13.45, 46]. In Example 14.16
above, the fair value of the decommissioning liability was not adjusted for the existence
of a restriction because that restriction was contemplated in developing the inputs to
the valuation techniques used to measure fair value.
Paragraph 46 of IFRS 13 states that a separate adjustment for lack of transferability is
not necessary for either the initial or subsequent fair value measurement of a liability.
This differs from the treatment of asset restrictions. [IFRS 13.46]. IFRS 13 considers liability
restrictions and asset restrictions differently because:
• restrictions on the transfer of a liability relate to the performance of the obligation
(i.e. the entity is legally obliged to satisfy the obligation and needs to do something
to be relieved of the obligation), whereas restrictions on the transfer of an asset
relate to the marketability of the asset; and
• unlike assets, virtually all liabilities include a restriction preventing their transfer.
As a result, the effect of a restriction preventing the transfer of a liability would, in
theory, be consistent for all liabilities.
The standard also appears to assume that the effect of a restriction on the fair value of
a liability remains constant over the life of the liability. Therefore, no additional
adjustments are required in subsequent measurements if the effect of the restriction was
already captured in the initial pricing of the liability. Unlike restrictions on assets, which
typically expire and whose effect on fair value changes over time, restrictions on
liabilities usually remain throughout the life of the obligation.
The Basis for Conclusions to IFRS 13 states that if an entity is aware that a restriction on
transfer is not already reflected in the price (or in the other inputs used in the
measurement), it would adjust the price or inputs to reflect the existence of the restriction.
[IFRS 13.BC99, BC100]. However, in our view this would be rare because nearly all liabilities
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include a restriction and, when measuring fair value, market participants are assumed by
IFRS 13 to be sufficiently knowledgeable about the liability to be transferred.
11.5 Financial liability with a demand feature
IFRS 13 states that the ‘fair value of a financial liability with a demand feature (e.g. a
demand deposit) is not less than the amount payable on demand, discounted from the
first date that the amount could be required to be paid’. [IFRS 13.47]. This is consistent
with the requirements in IFRS 9. In many cases, the observed market price for these
financial liabilities would be the demand amount, i.e. the price at which they are
originated between the customer and the deposit-taker. Recognising such a financial
liability at less than the demand amount may give rise to an immediate gain on the
origination of the deposit, which the IASB believes is inappropriate.
[IFRS 13.BCZ102-BCZ103].
12
FINANCIAL ASSETS AND LIABILITIES WITH OFFSETTING
POSITIONS
IFRS 13 specifies that the concepts of ‘highest and best use’ and ‘valuation premise’ are
not relevant when measuring the fair value of financial instruments. Therefore, the fair
value of financial assets and financial liabilities is based on the unit of account prescribed
by the IFRS that requires (or permits) the fair value measurement, which is generally the
individual financial instrument. However, IFRS 13 provides a measurement exception
that allows an entity to determine the fair value of a group of financial assets and
liabilities with offsetting risks based on the sale or transfer of its net exposure to a
particular risk (or risks), if certain criteria are met. [IFRS 13.48]. This measurement
approach is an exception to the principles of fair value because it represents an entity-
specific measure (i.e. an entity’s net risk exposure is a function of the other financial
instruments specifically held by that entity and its unique risk preferences).
It may be
possible for entities to offset multiple risks (e.g. both market and credit risks)
within the same portfolio. In addition, since the focus is on offsetting risks, entities may
offset credit and market risks stemming from a group of financial instruments at
different levels of aggregation. For example, under IFRS 13, management could continue
its existing practice of offsetting credit risk at the counterparty level (e.g. based on its
portfolio of interest rate swaps with a particular counterparty) while offsetting market
risks on a more aggregated portfolio basis (e.g. based on its portfolio of interest rate
swaps with all counterparties), provided all of the criteria in 12.1 below are met.
This guidance is largely consistent with practice under IFRS prior to adoption of IFRS 13
when determining valuation adjustments for derivative instruments related to bid-ask
spreads and credit risk.
12.1 Criteria for using the portfolio approach for offsetting positions
Entities that hold a group of financial assets and liabilities are generally exposed to
market risks (e.g. interest rate risk, currency risk or other price risk) and to the credit
risk of each of its counterparties. IFRS 13 allows entities to make an accounting policy
choice (see 12.1.1 below) to measure the fair value of a group of financial assets and
Fair value measurement 1021
liabilities based on the price that would be received to sell a net long position or transfer
a net short position for a particular risk exposure (that is, a portfolio approach). In order
to use the portfolio approach, entities are required to meet all of the following criteria,
both initially and on an ongoing basis:
• the entity manages the group of financial assets and financial liabilities on the basis
of the entity’s net exposure to a particular market risk(s) or credit risk, in
accordance with the entity’s documented risk management or investment strategy;
• the entity provides information based on the group of financial assets and financial
liabilities to the entity’s key management personnel; and
• the entity measures (either by requirement or by choice) the financial assets and
financial liabilities at fair value in the statement of financial position at each