Ifrs 13 Fair Value Measurement
OVERVIEW
OVERVIEW
The concept of a single fair value measurement standard began in 2005 when the IASB initiated a project to provide guidance to entities on how they should measure the fair value of assets and liabilities when required by multiple Standards. This Standard does not prescribe when fair value measurement is required but rather how that fair value should be derived and lays out the disclosures required in terms of fair value
measurements. The IASB feels that guidance on measuring fair value has been added to IFRS on a piecemeal basis over a number of years, resulting in complex, vague and, at times, inconsistent guidance. This can be seen in the Application Guidance on fair value in IAS 39 Financial Instruments: Recognition and Measurement. Many auditors and large companies employed Application Guidance (AG) 69 82 when determining
how to calculate fair value. For example, AG 69 states that fair value reflects the credit quality of the instrument, while AG 82 calls for credit risk to be considered as a factor when determining fair value.
However, while most entities have been monitoring credit risk with respect to derivatives, only a few of the largest organizations are currently monitoring this risk on a quantitative level.
Treasurers and financial controllers will now be able to look to IFRS 13, as opposed to IAS 39, for guidance on calculating the fair value of their derivatives. However, the new approach defined in this standard, combined with significantly larger credit margins and reduced liquidity, could well result in significantly different fair values and accounting
outcomes than treasurers and their CFOs have seen previously.
What has changed?
The Standard has principally changed the definition of fair value from what was previously defined in IAS 39. The basis is now of an exit-price notion and uses a fair value hierarchy similar to what is defined in IFRS 73. This results in a market-based, rather than entity-specific measurement.
IFRS 13.9 defines fair value 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.
In contrast IAS 39.9 defines fair value as The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction.
As such there are some key differences between these two definitions, of which the notion being to exit the liability rather than to settle the liability is key. This is important from the perspective of incorporation of credit risk as will be noted further in this paper.
Although this new definition seems fairly straightforward and intuitive at first glance, in practice it will significantly affect the fair values of many common derivative positions. When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or liability under current market conditions, including assumptions about risk. As a result, an entitys intention to hold an asset or settle or otherwise fulfill a liability is not relevant when measuring fair
value.
Entities will now need to consider their counterpartys credit in determining fair value when an instrument is an asset, and
they will need to consider their own credit risk when an instrument is a liability. This is explicitly stated in IFRS 13.42:
The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited
to an entitys own credit risk (as defined in IFRS 7: Financial Instruments: Disclosures). Non-performance risk is assumed
to be the same before and after the transfer of the liability.
Combined with the significant widening of credit spreads since the financial crisis and particularly in Europe over the last
year, fair value adjustments for credit may often be significant.
The Warning Signs
Corporate treasurers may look for warning signs across their portfolios to determine where the greatest impact of this new
standard will likely occur. In general, the factors determining the size of these credit adjustments are:
a) Tenor of cash flows
The longer-dated the transaction, the higher the risk of default; hence, the credit adjustment tends to be larger. For example,
a 10 year swap has greater credit risk embedded in it than a three-month forward exchange contract. Typically, the following
scenarios could potentially result in material credit value adjustments:
Large interest rate hedge portfolios the longer term nature of interest rate exposures lends itself to larger credit
adjustments. There need not be a large volume of deals, just significant positions.
Significant strategic commodity hedging positions over the medium to long term for example, mining companies often
have large hedge positions for anticipated exposures as part of their banking covenants.
Strategic foreign exchange positions such as for large capital expenditure or infrastructure projects
The graphical analysis below shows fixed leg (in blue) and floating leg (in green) discounted cash flows of a typical
interest rate swap. The purple bars on the floating leg and the red bars on the fixed leg illustrate the amended discounted
cash flows once a credit adjustment is made. Here, the size of the adjustment increases as the duration of the cash flow
extends into the future.
b) Size of asset/liability position at each reporting date
It follows that the larger the asset or liability at reporting date, the larger the probable adjustment will be for credit. Treasurers
will want to focus on the areas where large fair values exist (or could exist) when analyzing the impact of credit on fair values.
c) Credit spread of entities and counterparties.
In general, the lower the credit quality, the higher the credit margin and the larger the credit value adjustment. Naturally, if an entity or counterpartys ratings are AA or better, the scope for large adjustments is reduced, even in the current market. Over
the last 12 months, ratings of BBB or less have seen some large movements in their credit spreads, particularly as a result
of the Euro crisis where some banking counterparts in the EU have credit spreads of up to 600 basis points. This means
that even if a rating remains unchanged, significant volatility can occur in the credit adjustment. Tracking this and applying
the proper credit curve poses unique challenges.
d) Master netting agreements
Companies must consider the impact of their netting agreements on their credit adjustments, particularly when making
an initial assessment as to whether their net derivative exposure is an asset or a liability for each counterparty. The net
exposure to a particular counterparty should always be considered prior to determining the nature of the credit spread to
be applied. Similarly care should be taken over what is allowed to be netted in terms of different asset classes and across
subsidiaries within the group.
e) Nature of collateral agreements
For companies with collateral agreements, credit risk may be reduced or in some cases completely eliminated. However,
how collateral agreements are applied can be difficult to understand when considering the nature of those agreements,
e.g. zero threshold versus some other threshold, incorporating potential collateral calls, two-way collateral agreements, etc.
Treasurers may want to examine their existing collateral agreements and consider the potential impact on the credit risk
position across the portfolio.
Valuation Techniques
The principles-based standard of IFRS 13 does not prescribe a methodology for making credit adjustments to transactions
or quoted prices. Rather IFRS 13.61 states:
An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data is available
to measure fair value, maximizing the use of relevant observable inputs and minismising the use of unobservable inputs.
Paragraph 62 goes on to state that there are three widely used valuation techniques, namely the market approach, the cost
approach and the income approach. The key challenge for treasurers will be how to capture the non-performance risk or
risk premium associated with a derivative asset or liability.
Within the Application Guidance of the standard, paragraphs B12-B30 provides sample techniques to calculate this risk
premium. The most commonly applied technique amongst U.S. companies is the Discount Rate Adjustment Technique.
Obtaining Good Credit Data
Using the most appropriate technique is one part of the problem, but sourcing accurate, robust credit data itself can be
as equally difficult in the current market environment. Many companies look to the bond or CDS markets or to credit
ratings to determine an appropriate spread over LIBOR for representing their counterparties and their own credit. Based
on experience of implementing Topic 820 in the US, many believe that a companys quoted CDS spreads provide the best
guide of corporate non-performance risks. Many institutions are concerned that credit ratings can become out of date quite
quickly and CDS spreads seem to capture credit risk far quicker. Risky bond spreads are not preferred as in the current
market environment they also include liquidity premiums, which do not reflect non-performance risk, but rather the general
scarcity of funds available for borrowing.
However, obtaining good credit data when a company is not a rated organisation, does not issue bonds (or not recently
anyway), and has no active CDS market in its name, is another issue. Such situations can occur most commonly when a
corporate seeks to models its own credit, and there often are no easy answers. Many companies look to find comparablysized
organizationsin the same industry and geography and rated with an active CDS marketto use as a proxy for its
own credit. As such entities should raise their proposed calculations with their auditors as early as possible to avoid any
unpleasant surprises at year end.
In terms of counterparty credit, although financial institutions have enjoyed more liquid credit, bond, and CDS ratings/
spreads than companies have in the past, the new reality is that financial institutions are highly exposed to the Euro crisis,
high levels of consumer debt, fair-market valuations in an illiquid market, and the implosion of the banking system subject to
increasing regulatory changes. This has often led to counterparty credit spreads being wider than an entitys own credit an
almost unthinkable situation given most companies policies around the credit rating of their counterparties. It is no longer
acceptable to simply say entities are dealing with the top tier banks in the UK and therefore no adjustment is required for
credit risk.
Similarly the Implementation Guidance to IAS 39: F4.3 Hedge effectiveness: counterparty credit risk deals with counterparty
risk and states that an entity must consider the likelihood of default by the counterparty to the hedging instrument in
assessing hedge effectiveness.
This gives some hint that credit risk may cause ineffectiveness in itself, even if the hedge and hedged items cash flows
are completely matched. The derivative itself must include the fair value adjustment made for credit risk either of the
counterparty or the entity depending if the position is in an asset or a liability. However questions are being asked about the
hedged item or hypothetical derivative in a cash flow hedge relationship.
Many existing hedge relationships are documented exclusive of credit i.e. designation of the risk to Libor related interest
rate movements. Therefore this would imply that only the hedge itself will be adjusted for credit as you are not hedging
for credit risk in the hedged item. If so, then previously perfectly effective hedges will now have ineffectiveness equal to
the derivatives credit adjustment. (This is because it would not be appropriate to strip out the credit valuation adjustment
of the derivative as there are only two instances where you can split the fair value of a derivative in a hedge relationship
(IAS39.74).
For hypothetical derivatives used in cash flow hedge relationships there has been differing interpretations. It has been
argued that since it is a perfect hedge of the designated risk, then it is a perfect hedge with the counterparty of the actual
hedge; therefore, the same credit adjustment to the actual swap should be applied to the hypothetical. It follows, then, that
the hypothetical derivative should also be valued with the same credit curve as the actual swap, regardless of whether the
hypothetical is in an asset or a liability position, resulting in no ineffectiveness due to credit risk.
An alternate view is that the hypothetical derivative reflects the cash flows of the hedged item, and only the entitys credit
could be applicable if credit were to be taken into account. If credit has been excluded from the hedge item, then no credit
adjustment would be applied to the hypothetical. As a result hedge ineffectiveness may arise.
Auditors in the U.S. have required clients to assess and measure hedging relationships under any of these views. The
answers to these questions are material, can be expected to result in more income statement volatility, and in the worst
case, cause previously effective hedge relationships to fail the effectiveness assessment going forward. Many companies
already struggling and frustrated with the complex rules of hedge accounting will now have to contend with even more
complexity in terms of assessment and measurement in their hedging relationships. Therefore, it is important that when
entities consider a hedge accounting software solution, they choose a system that is flexible enough to handle any auditor
requirement. We are still eagerly awaiting the Exposure Draft on the Hedge Accounting section of IFRS 9 but it is not yet
known how much, if any, detail will be provided with regards to the incorporation of credit risk in the assessment of hedge
effectiveness.
Conclusion and Timing
IFRS 13 is applicable for annual periods beginning on or after 1 January 20134. Earlier application is permitted. It is clear
that incorporating non-performance risk can have a profound impact on valuations as well as assessment and measurement
calculations for those applying hedge accounting under IAS 39. Most organisations will have to actively monitor both their
own credit ratings as well as the credit ratings of their counterparties on a quantitative level. Improvement to systems will
be a must, not just for the credit component of fair values, but to make the appropriate adjustments to hedge accounting.
Coupled with this is the need for accurate and up to date credit data to be used in such calculations.
Fortunately for reporting entities, comparative numbers will not be required however 2013 is just around the corner so
companies need to initiate the process now and consider system changes to meet the requirements of IFRS 13.
by: Reval
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