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One of the key challenges for many reporting entities in estimating fair value in accordance with the fair value standards has been determining and incorporating the impact of nonperformance risk, including credit risk, into the fair value measurement.
Nonperformance risk is the risk that an entity will not perform on its obligation. This risk should be incorporated into a fair value measurement using a market-based estimate that follows the framework of the fair value standards and should be measured from the perspective of a market participant. The concept of nonperformance risk incorporates credit risk and other risk factors, including regulatory, operational, and commercial risks. Credit risk is often the largest component of nonperformance risk, and at times, the risks are referenced interchangeably. Although nonperformance risk, including credit risk, may have been a factor in determining the price of certain instruments, the price of the risk may not be separately observable, making it difficult to determine an appropriate measurement methodology and the inputs necessary to make a reasonable fair value estimate.
This chapter focuses on key considerations for incorporating credit risk into the measurement of fair value. Reporting entities should also consider the other components of nonperformance risk in developing fair value measurements.
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