The credit risk adjustment should be reconsidered in each period in which fair value measurements are reported, because the market view of credit risk will vary depending on the credit quality of the counterparties, the value of the underlying asset or liability, market volatility, and other factors that are dynamic. The following discussion highlights some of the questions that may arise in practice as reporting entities consider measurement of the credit risk adjustment.
Question FV 8-1
For assets and liabilities reported at fair value, is an evaluation of credit risk required each reporting period if there has been no change in credit rating since origination?
Yes. A credit risk adjustment should reflect all changes in the price of credit as well as changes in the creditworthiness of the reporting entity or the counterparty, as applicable, which may not be reflected in their credit ratings. For example, a decline in the reporting entity’s credit default swap rate, or an overall change in the credit spreads for the reporting entity’s industry sector may indicate a change in the market price of its credit. Credit spreads and risk can change without a change in credit ratings. The credit risk adjustment should incorporate all available market information, including changes in the company’s standing within its credit category, changes in the market price of credit or the market value of the asset or liability being measured, as well as other factors.
Excerpt from ASC 820-10-55-59
On January 1, 20X7, Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to the Standard & Poor’s 500 index. No credit enhancements are issued in conjunction with or otherwise related to the contract (that is, no collateral is posted and there is no third-party guarantee). Entity A elects to account for the entire note at fair value in accordance with paragraph 815-15-25-4. The fair value of the note (that is the obligation of Entity A) during 20X7 is measured using an expected present value technique. Changes in fair value are as follows:
b. Fair value at March 31, 20X7. By During March 20X7, the credit spread for AA corporate bonds widens, with no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the treasury yield curve at March 31, 20X7, plus the current market observable AA corporate bond spread to treasuries, if nonperformance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (that is, resulting in a credit-adjusted risk-free rate). Entity A’s specific credit risk is unchanged from initial recognition. Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally. Changes in credit spreads reflect current market participant assumptions about changes in nonperformance risk generally, changes in liquidity risk, and the compensation required for assuming those risks.
As this example illustrates, a reporting entity is required to assess credit risk each period, even if there is no change in the related credit rating, because adjustments for credit are not triggered solely by a change in credit rating. In fact, the credit risk to the entity changes simply because of the passage of time. Because there is less time for the parties to default, absent other changes to the counterparty credit standing, the default probabilities will typically be lower.
Question FV 8-2
In estimating fair value at a point in time, can entities assume the effect of credit risk on a financial instrument’s fair value is immaterial?
No. However, an entity may be able to demonstrate that for some financial instruments the effect of credit risk is immaterial, provided it has sufficient evidence to support this. For example, this might be the case if:
- any credit risk is substantially mitigated, for example, by the posting of collateral or netting arrangements; or
- there is persuasive evidence that the credit riskiness of the parties to the transaction has not changed and that all parties continue to have low credit risk.
What comprises sufficient evidence that the effect of credit risk is immaterial will vary depending on the facts and circumstances. Such evidence could be qualitative or quantitative. A numerical calculation may not be required in all cases.
The assessment should take into account the effect on both the financial instrument’s carrying amount and on hedge effectiveness for derivatives in hedging relationships. For example, if a hedge relationship is near 100% effective before considering the effect of credit risk, it may be easier to demonstrate that any adjustment would not materially affect the financial statements than if a hedge is, say, close to 80% effective before considering the effect of credit risk. This is important because even a minor change could result in the hedge not meeting the 80%—125% practice-accepted threshold to qualify for hedge accounting. See FV 6.8
for further hedge accounting considerations.
Question FV 8-3
If the original contract price included an adjustment for credit risk, does the reporting entity need to continue to evaluate the credit risk adjustment each period?
Yes. The effect of nonperformance risk, including credit risk, is typically priced into the terms of a contract at inception, but should be re-evaluated each reporting period. For example, credit risk may be incorporated into the pricing of a derivative instrument through an adjustment to the interest rate, other pricing terms, or contractual credit enhancements (such as requirements to post collateral or letters of credit).
Similarly, credit risk is priced into long-term debt through the credit spread, which may vary depending on seniority of debt and other factors that impact credit risk. Because those terms are established as part of the contractual arrangement and dictate the contractual cash flows, some reporting entities have questioned whether an ongoing evaluation of credit risk is necessary in connection with the fair value measurement process at each reporting date.
Typically, commercial contract terms do not include provisions that reset pricing or cash flows due to changes in credit spreads or the credit standing of the issuing entity. As a result, credit risk should be reconsidered each period to incorporate contractual and market changes that may impact the credit risk measurement. Note that some contracts may require the posting of additional collateral or other credit enhancements for credit deterioration or other changes in fair value. This type of protection may impact the calculation of the credit risk adjustment but does not eliminate the requirement to re-evaluate the potential exposure to credit risk at each reporting date.
Question FV 8-4
If a reporting entity intends to settle a non-prepayable liability shortly after the end of the reporting period (i.e., the borrower intends to negotiate with the lender an early termination of the agreement after the reporting date), can settlement value be used as a proxy for fair value?
No. The basic premise in the calculation of the fair value of a non-prepayable liability pursuant to ASC 820
is that the liability remains until its maturity. Therefore, fair value should be determined based on the transfer value of the liability, inclusive of nonperformance risk. Any difference between the settlement amount and the fair value measurement of the liability should be recognized in the period of settlement.
If the liability includes a prepayment option that was not separated as an embedded derivative, the terms of the prepayment option would impact the calculation of fair value. For example, if the prepayment option is deep in-the-money, the fair value may be close to the strike price as market participants would anticipate the prepayment of the liability by the borrower in the near term and therefore value the prepayment option considering such a possibility.