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5.5 Credit risk in individual financial liabilities under the FVO
Publication date: 31 Mar 2022
us Fair value guide
When the entity’s credit deteriorates, the interest rate used to discount the cash flows increases, causing the fair value of the liability to decrease, which results in an accounting gain. When the entity’s credit improves, the interest rate decreases, the fair value of the liability increases, and the result is an accounting loss.
To address the counterintuitive impact on profit or loss arising as a result of a reporting entity’s choice to measure its own liabilities at fair value, the FASB included guidance to record the effect of changes in own credit risk in other comprehensive income (OCI) in ASC 825.
5.5.1 Scope: instrument-specific credit risk
Under ASC 825, when the fair value option is elected for financial liabilities, changes in fair value due to changes in instrument-specific credit risk will be recognized separately in OCI. This provision does not apply to financial liabilities that are required to be measured at fair value with changes in fair value recognized in current earnings (e.g., derivative instruments).
The guidance also applies to hybrid financial liabilities that an entity has elected to account for at fair value in accordance with ASC 815, Derivatives and Hedging. An example of a hybrid financial liability is a debt obligation that is indexed to the price of gold and requires cash settlement. If the feature indexed to the price of gold is considered an embedded derivative, it would require separate accounting. Rather than separately accounting for the embedded derivative, an entity may irrevocably elect to initially and subsequently measure the hybrid financial liability in its entirety at fair value with changes in fair value reported in earnings. When doing so, an entity should still present separately in other comprehensive income the portion of the total change in fair value that results from a change in instrument-specific credit risk.
The accumulated gains and losses due to changes in instrument-specific credit risk are recycled from accumulated other comprehensive income and recognized in earnings over the life of the liability, or upon settlement if it is settled before maturity.
Measurement of the instrument-specific credit risk ASC 825-10-45-5 allows, but does not require, preparers to measure the change in instrument-specific credit risk as the portion of the periodic change in fair value that is not due to changes in a base market rate, such as a risk-free interest rate (the “base rate method”). An alternative method, however, may be used if it is considered to faithfully represent the portion of the total change in fair value resulting from a change in instrument-specific credit risk. The selected methodology is a policy election and will need to be disclosed and consistently applied to each financial liability from period to period.
The SEC staff has stated that the base rate method would not be appropriate when it does not appropriately isolate the portion of the total change in fair value resulting from instrument-specific credit risk.
An example when reporting entities would not be able to use the base rate method is a hybrid financial liability that consists of a debt obligation that is indexed to the price of a commodity, such as gold. This is because the fair value of that hybrid financial liability will be impacted, in part, by the price of the commodity. As a result, reporting entities would need to perform an alternative calculation to isolate the instrument-specific credit risk.
The FASB did not intend to change how entities were identifying and measuring changes in instrument-specific credit risk from what had been previously disclosed under US GAAP. While no guidance was formally included in the codification, we understand that the FASB believes that entities could continue their practices in this area both with respect to disclosure and measurement of what is included in OCI.
See FSP 20.6.3.1 for the disclosure requirements related to changes in instrument-specific credit risk on liabilities for which the fair value option has been elected.
5.5.2 Accounting mismatch
During its deliberations on ASU 2016-01, the FASB also discussed instances when preparers elected the fair value option on non-recourse liabilities to avoid a mismatch in recognition from the assets that support them, such as in collateralized financing entities (see FV 6.2.7). They noted that some entities do not disclose changes in instrument-specific credit risk for nonrecourse liabilities. We understand that for these liabilities, entities can continue their current practice under the new guidance (i.e., if no amount is disclosed as instrument-specific credit risk, then no amount should be presented in OCI).
5.5.3 Changes in foreign currency rates
Questions have arisen regarding the interaction between the guidance in ASC 825 on instrument-specific credit risk and ASC 830, Foreign Currency Matters, when the fair value option is applied to financial liabilities denominated in foreign currency. Specifically, the questions relate to how an entity should account for changes due to a combination of changes in instrument-specific credit risk and foreign currency exchange rates.
We believe that changes in foreign exchange rates should impact both current earnings and OCI. Further, we believe that the amount reflected in AOCI is the portion of the change in fair value due to changes in instrument-specific credit risk in the currency in which the instrument is denominated, remeasured at period-end spot foreign exchange rates. Using other methods for measurement would result in balance sheet amounts that are translated at different rates, which is generally not acceptable.
Example FV 5-1 illustrates the calculation of the instrument-specific credit risk for inclusion in OCI.
EXAMPLE FV 5-1
Measurement of changes in instrument-specific credit risk on a foreign denominated liability
FV Company, an entity with US dollar functional currency, issues a liability denominated in euros on January 1, 20X1 and elects to measure it at fair value through profit or loss under the FVO. The fair value of the liability at issuance is €100. The principal and all accrued interest will be paid four years from inception.
At December 31, 20X1, the fair value of the liability is €110 (ignoring accrued interest). FV Company determines that €2 of the change in fair value is due to the change in the instrument-specific credit risk of the liability.
At December 31, 20X2, the fair value of the liability is still €110. There was no change in instrument-specific credit risk of the liability during the year.
Exchange rates ($ for €1):
January 1, 20X1: |
1 |
||
December 31, 20X1: |
2 |
||
December 31, 20X2 |
2.5 |
How should FV Company reflect the change in the instrument-specific credit risk in OCI?
Analysis
FV Company should measure the amount to be recognized in OCI in its functional currency. It should remeasure the €2 (the portion of the total change in value that was due to changes in instrument-specific credit risk) based on period end spot rates (€2 × 2 = $4).
The fair value of the liability measured in the functional currency is $220 (€110 × 2), so the journal entry would be:
Dr. Loss |
$116 A |
|
Dr. OCI |
$4 B |
|
Cr. Debt liability |
$120 C |
A Change in fair value related to factors other than change in instrument-specific credit risk ($120-$4)
B The change in fair value due to instrument-specific credit risk x the spot rate on 12/31/X1 (€2 × 2)
C Fair value at 12/31/X1 ($220) less fair value at issuance ($100)
In 20X2, FV Company would perform a similar computation, on a cumulative basis. First, it would measure the €2 (the portion of the total change in value that was due to changes in instrument-specific credit risk) based on period end spot rates (€2 × 2.5 = $5).
The amount recognized in OCI on a cumulative basis would be the changes in instrument-specific credit risk since inception, remeasured at period end spot rate. The journal entry for the period would take into account what was recognized in prior periods.
The fair value of the liability measured in the functional currency is $275 (€110 × 2.5), an increase of $55 since the prior year end, so the journal entry would be:
Dr. Loss |
$54 A |
|
Dr. OCI |
$1 B |
|
Cr. Debt liability |
$55 C |
A Change in fair value related to factors other than change in instrument-specific credit risk ($55-$1)
B The cumulative change in instrument-specific credit risk ($5) less the amount previously recognized ($4)
C Fair value at 12/31/X2 ($275) less fair value at 12/31/X1 ($220)
The cumulative amount recognized in AOCI (in this case, $5), equals the cumulative change in instrument-specific credit risk since inception (€2) translated at the period-end spot rate (2.5 dollars/euro).
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