Question

State how derivatives and changes in their values are reported under US GAAP and IFRS.

Answer 1

Derivatives and changes in their values are reported under US GAAP:

Accounting for Derivative Instruments:

Under current US, and international accounting standards, an entity is required to measure derivatives instruments at the fair value, or mark –to-market (MTM), with changes in the fair value of MTM to be recognized through income statement.

Fair value is defined under US, accounting standards, as “the price that will be received to an asset, or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. International accounting standards, define fair value slightly differently as “the amount for which asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. “ Non – Performance risk or the risk that an obligation will not be fulfilled (also known as credit risk ) is also required to be incorporated into the fair value measurement.

Mentioned in the attachment.

Derivatives and changes in their values are reported under IFRS:

Contractually linked instruments (tranches):

Any derivatives in the Special Purpose Entity structure should therefore reflect a risk that is present in either the assets or the liabilities or both to achieve amortised cost accounting for the tranche. In addition, the credit risk of the tranche must be equal to or lower than the weighted average credit risk of the underlying pool of financial instruments.

Derivatives in underlying pool of assets: SPE holds floating-rate EUR assets and issued fixed-rate GBP notes contractually linked to the assets. The SPE has entered into one swap that is a pay EUR floating and receive GBP floating, and a second swap that is a pay GBP floating and receive GBP fixed. Both these swaps would meet the requirements in paragraph B4.24(b) of IFRS 9 of aligning the cash flows of the tranches with the cash flows of the pool of underlying instruments. The holder may therefore be able to measure its investment at amortised cost. However, if the SPE had a derivative that introduced a third currency – say USD − or had derivatives with a nominal value in excess of the amount of assets, this would not align the cash flows. The tranche would have to be measured at fair value through profit or loss.

Derivative with optionality in underlying pool of assets: An SPE holds a fixed-for-floating swap that also hedges pre-payment risk such that if the underlying pool of fixed rate assets pays down early, the derivative is cancelled with no further amounts to pay. This is to ensure there are no excess derivatives and no fair value gains/losses on settlement, as when the assets pre-pay, the notes prepay. This feature would not fail the requirements of paragraph B4.24 of IFRS 9; the holder may therefore be able to measure its investment at amortised cost.

Investments in CDOs : An entity has an investment in a cash CDO where the issuing SPE holds the underlying referenced assets. Cash CDOs may qualify for amortised cost accounting as long as the underlying assets qualify for amortised cost accounting and the other requirements of IFRS 9 for contractually linked instruments are met. However, investments in synthetic CDOs (where the SPE has a credit derivative that references particular exposures) would not qualify, as the derivatives on the reference exposures do not have cash flows that are solely payments of principal or interest, nor do they align the cash flows in a way permitted by IFRS 9.

Embedded Derivatives: Many embedded derivatives introduce variability to cash flows that is not consistent with the notion that the instrument’s contractual cash flows solely represent the payment of principal and interest. However, if an embedded derivative was not considered closely related under the existing requirements, this does not automatically mean the instrument will fail to qualify for amortised cost treatment under the new standard. There are some embedded derivatives such as interest caps and floors that may have required bifurcation under IAS 39 but may pass the ‘solely payments of principal and interest test’. Nevertheless, most hybrid contracts with financial asset hosts are likely to fail the ‘solely payments of principal and interest’ test and be measured at fair value in their entirety. The accounting for embedded derivatives in non-financial host contracts and financial liabilities currently remains unchanged.

Entities are still required to separate derivatives embedded in financial liabilities where they are not closely related to the host contract – for example, a structured note where the interest is linked to an equity index. The separated embedded derivative continues to be measured at fair value through profit or loss, and the residual debt host is measured at amortised cost. The accounting for embedded derivatives in non financial host contracts also remains unchanged.

The treatment of financial assets and liabilities under IFRS 9 is not symmetrical. The existing embedded derivative guidance in IAS 39 is retained in IFRS 9 for financial liabilities and non-financial instruments; this results in some embedded derivatives being separately accounted for at fair value through profit or loss. However, embedded derivatives are no longer separated from financial assets. Instead, they are part of the contractual terms that are considered in determining whether the entire financial asset meets the cash flow test (solely payments of principal and interest) to be measured at amortised cost or whether it must be measured at fair value through profit or loss.

The new part of IFRS 9 changes the accounting for financial liabilities that an entity chooses to account for at fair value through profit or loss, using the fair value option. For such liabilities, changes in fair value related to changes in own credit risk are presented separately in OCI. The eligibility criteria for the fair value option remain the same and are based on whether: the liability is managed on a fair value basis; electing fair value will eliminate or reduce an accounting mismatch; or the instrument is a hybrid that would require separation of an embedded derivative.

Financial liabilities that are required to be measured at fair value through profit or loss (as distinct from those that the entity has chosen to measure at fair value through profit or loss) continue to have all fair value movements recognised in profit or loss with no transfer to OCI. This includes all derivatives (such as foreign currency forwards or interest rate swaps), or an entity’s own liabilities that it considers as ‘trading’.

The changes in the fair value of a liability may arise due to changes in value of a derivative embedded in that liability rather than changes in benchmark interest rates. In that situation, changes in the value of the embedded derivative must be excluded in determining the amount of own credit risk that is presented in OCI.​​​​​​