Published: April 01, 2013
IFRS 13 ‘Fair Value Measurement’ came into effect from January 2013. It requires us to take into account counterparty and credit risk, part of non-performance risk, in the revaluation of financial hedging instruments. Some important questions need to be addressed, such as: How do we calculate this risk? What reports will have to be provided and disclosed? And finally how to simulate the potential impacts on the income statement? If we think only about IFRS 9 we are forgetting this other standard applicable now.
Through focusing on the future IFRS 9 (which will not become effective until January 2015), we might almost forget IFRS 13 coming into force, and one of its major impacts on treasurers (yet another one). Treasurers sometimes focus on certain problems, such as OTC derivatives and the risk of being required to post cash as collateral, to the point of forgetting others. They are so obsessed with certain measures that they see as unfair (rightly) that they forget the mandatory aspect of reporting to ESMA via trade repositories. This latter measure nevertheless comes into force as of 2013. It seems to us that we should first focus on current priorities and ensure we can fulfil our obligations as soon as they come into force. IFRS 13 is now on our list of reports to be provided, to comply with all the new accounting regulations and standards. This accounting standard demands a minimum of thought to assess the scope of information to be provided, how to produce it and extract it from the computer systems and finally to understand the potential impact on the company’s balance sheet and income statement. IFRS 13 was published in November 2006 (that long ago). It is largely inspired by its US cousin SFAS 157 in the measurement principles that it adopts.
When we deal in OTC type financial instruments for hedging purposes, for example, in IFRS we have to revalue them at every accounting period close. But what is the ‘fair’ value of such an instrument? The ‘fair value’ is the financial and mathematical value calculated by the difference between the NPV (Net Present Value) of the instrument and the NPV of a perceived identical and opposite contract that cancels it out. In short it is the difference between the first instrument and the instrument that needs to be traded to unwind the deal, discounted to present value. Any Treasury Management System (TMS) worthy of the name should do that with no problem. However, this ‘fair’ value – estimated on the basis of market data (mark-to-market) – does not take account of counterparty risk or counterparty default. If the counterparty defaults you will not receive delivery of the currency or commodity or interest rate that was the subject of the original deal. The idea was therefore additionally to incorporate the concept of the risk of default of the other contracting party. This risk was not taken into account when revaluing the financial instrument portfolio. For 12 years (for the IAS 39 pioneers), treasurers have been revaluing their financial instruments in a partial and ultimately incomplete manner. IFRS 13 is intended to put that right. ‘Risk-free’ interest rates or yield curves are taken as the basis for assessing whether the present value of the instrument is positive (an asset) or negative (a liability). To this value we would therefore apply a CVA (Credit Value Adjustment), depressing the instrument’s value for counterparty risk and conversely we would reduce (because it is negative) the negative value of a liability to recognise and record our own credit risk (Debit Value Adjustment).
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Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This is an exit price. Fair value takes into account the characteristics of an asset or liability. IFRS 13 takes up the much-heralded hierarchy of data to be used in measuring fair value. The IASB has set down three input levels in its hierarchy. The data to be used must be that which a market participant would itself take into consideration. The techniques used must also be noted in the disclosures and annual reports.[[[PAGE]]]
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Turning to the methodology to be applied, we have to ensure that we can gather all the necessary information and apply the appropriate calculations and simulations to it. The financial literature, as is often the case with new accounting standards, is somewhat laconic. So we have to make up our own religion, testing it with the external auditors. That is no easy job. We therefore suggest the following approach:
1. Identify the type of ISDA agreement signed and who it is signed with to understand any payment netting agreements (generally for a single currency and a single transaction).
2. Identify whether any CSA (Credit Support Annex) type agreements exist, requiring collateral to be posted which would have the effect of removing all counterparty risk. There may be other types of agreement which would further reduce counterparty risk and its potential impact.
3. We must check the technical capabilities of the software application being used (in general the TMS itself) or another peripheral application such as REVAL or consider whether some auxiliary facility could carry out the calculations or provide the financial data. Depending on the methods adopted, which may be very sophisticated or based on probabilities – as in financial organisations for example – we have to equip ourselves with more or less powerful software applications.
4. When the method and the software able to provide the data have been decided upon, in principle we have to export the data to spreadsheets to apply the calculations for measuring the impacts that might potentially reduce the theoretical mark-to-market value.
5. We could then run simulations or stress tests, using assumptions of sharp counterparty deterioration.
6. We would then have to produce special reports for audit purposes and for disclosure in the annual report. Here again, we are in uncharted territory.
IFRS 13 is a subject that is more complex than it seems at first glance. An impact study and prior tests are a must. Depending on the volumes, the number of portfolio transactions, and the types of hedges used (e.g., interest rate, FX, commodities, equity, etc.) and the complexity of the derivatives being dealt in, these calculations can be relatively unwieldy, especially if we do not have an IT application that is suitable and able to export to spreadsheets. Even with a sophisticated TMS, you have to extract the data, format it and add what is needed for line by line calculations, to produce the required reports.
The effectiveness test may be impacted by this CVA/DVA adjustment. We therefore need to estimate it, simulate it and understand it to anticipate any potential ineffectiveness that might affect the P&L and the hedge accounting strategy.
As so often, the complexity arises from the lack of clarity in the standards and the lack of practical examples and comparisons. With the new measures, you always have to start with a relatively clean sheet and the pioneers have to forge the approach and produce the documents without detailed existing guidelines. We also have to try to keep the approach we adopt simple, to keep down the time that needs to be devoted to this new accounting requirement.[[[PAGE]]]
Other types of approach of course exist, sometimes more complex or more mathematical, but not necessarily more correct or accurate for that. Any approach, whatever it may be, must be approved in advance by the independent auditors. The sophistication of the transactions and the software used, together with the size of the transactions, may justify use of more specific or more complex methods.
Credit risk based on their CDS levels can be calculated easily. We can work on an averaging basis or by period (the latter approach being more painstaking). If we use a detailed approach, line by line, applying the impact of credit risk (as a plus or minus depending on the NPV) we will arrive at a combined overall result that can be recognised in the accounting records.
In the two examples given, we have calculated the negative impact on the discounted (NPV) portfolios, whether positive or negative, in valuing them at the date of the accounts close in question. The method is simple and quite easy to use. However, it comes as no surprise that almost no treasury software publisher has proactively offered solutions and anticipated the needs of its users. But here they have a wonderful opportunity to demonstrate the quality and power of their software. These reports will be built up a little by little, as users demand them, over time. Once again, the pioneers are to a certain extent suffering from a lack of support and vision. It is up to them to devise an appropriate report suited to their treasury work environment. We also note there is no requirement for comparatives in the first year. This should make the treasurers’ jobs easier.
In this counterparty risk valuation aspect, IFRS 13 is not as complex as it might be. It is simply a constraint and one more report to be disclosed. The new valuation, however, is even more ‘fair’ than the one that preceded it, through incorporating (more or less satisfactorily) this concept of bilateral counterparty risk. We have to sing IFRS 13’s praises once again for at least providing early clarification of what needs to be done and stating which measurement techniques need to be adopted, depending on the specific circumstances. Life in IFRS accounting is a long river, which is far from being calm. What we have to do now, therefore, is to comply with this new requirement.
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