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There are many factors that may impact the measurement of credit risk, including the nature of the instrument being measured (e.g., investment, debt, derivative), whether it is in an asset or liability position, and whether there are quoted prices available that already incorporate credit risk. This section discusses an overall framework that can be applied to assist in the calculation of a credit risk adjustment for a specific asset or liability and discusses specific implementation issues.
Figure FV 8-1 highlights key elements of the credit risk measurement framework.
Figure FV 8-1
Credit risk adjustment framework
Figure 8-1 Credit risk adjustment framework View image

8.2.1 Step one: determine unit of measurement for credit risk

As the first step in measuring credit risk, the reporting entity must determine the unit of measurement (i.e., what is being measured). Credit risk may be measured based on a grouping of instruments that differs from the unit of account for balance sheet presentation purposes.
For example, in measuring the fair value of a derivative instrument, the unit of account is the individual derivative instrument. However, credit risk may be estimated by some market participants on an individual transaction basis, whereas other market participants may evaluate credit risk on multiple contracts involving a single counterparty on a “net” basis if the contracts are covered under one master netting agreement. These factors add another consideration to the calculation. When credit risk is evaluated across a group of individual transactions, entities may be required to allocate the credit risk adjustment to a lower unit of account.
The unit of measurement for purposes of determining the credit risk adjustment (“unit of credit risk measurement”) should incorporate all relevant factors, including the profile of the asset or liability, its type (debt, derivative, or warrant), terms (maturity date and par or notional amount), and other attributes (priority, recourse, and secured or non-secured status). In addition, credit enhancements, such as collateral-posting requirements, master netting arrangements on derivatives, parent company guarantees, and transaction structure should be considered.
Due to the potentially significant effect of these factors on the calculation of the credit risk adjustment, a reporting entity should ensure that it obtains a full understanding of its rights and obligations associated with a particular contract or counterparty prior to calculating the credit risk adjustment. Specific items that may affect the unit of credit risk measurement include the following.
Collateral, guarantees, and credit support
Requirements to post collateral, guarantees, letters of credit, and similar forms of credit enhancement may reduce the potential credit risk exposure. In addition to considering posted collateral, a reporting entity should ensure it has a comprehensive understanding of all credit support arrangements. For example, a provision in an investment agreement that requires the counterparty to post collateral if the counterparty’s credit rating is downgraded will limit the reporting entity’s potential exposure to loss and should be incorporated into the unit of credit risk measurement.
Master netting arrangement or other netting agreements
A master netting arrangement generally provides that multiple derivative contracts with the same counterparty will be offset in the event of a default on any one of the contracts. The netting provisions result in a credit risk exposure based on the “net” position rather than at the individual contract level. Master netting arrangements may also incorporate other positions with the counterparty (e.g., non-derivative obligations and other forms of collateral) in the event of default.
Master netting arrangements or other agreements that allow for the netting of assets and liabilities held with the same counterparty will change the potential risk exposure. For example, assume a company has contracts in both asset and liability positions with a particular counterparty. If the company has a master netting arrangement in place, it may calculate the credit exposure based on the net exposure of the asset and liability positions. However, absent such an arrangement, it would be required to separately calculate the exposure for assets and liabilities based on the market participant view of counterparty credit risk and its own credit risk, respectively.
In evaluating such arrangements, a reporting entity should consider whether the arrangement permits netting across contract types (e.g., interest rate swaps, different types of commodity contracts) or product types (e.g., physical versus cash settlement). The reporting entity should evaluate each legal entity it transacts with separately. In some cases, an arrangement may cover transactions with multiple subsidiaries of a specific company. However, in other instances, each subsidiary may be covered by a separate arrangement. The specifics of such agreements, including their legal enforceability, may have a significant impact on the reporting entity’s exposure to loss and the calculation of the related credit risk adjustment.
Structural and other contract considerations
A particular contract may incorporate other specific risks that may impact credit risk. For example, performance on a particular contract, such as delivery of an asset to a specific counterparty, may depend on receipt of an asset from another counterparty. In that case, the credit exposure on both contracts may be tied to performance by the party responsible for initial delivery. Any such contractual provisions should be considered in developing a credit risk adjustment.
Impact of third-party credit enhancements – perspective of the issuer
In accordance with ASC 825-10-25-13 and ASC 820-10-35-18A, the issuer of a liability with an inseparable third-party credit enhancement (such as a guarantee) should not include the effect of the credit enhancement in the fair value measurement of the liability. The credit risk adjustment for the liability should be calculated as though there were no third-party guarantee, letter of credit, or other form of credit enhancement.
For example, long-term debt and derivative instruments are frequently issued with a third-party guarantee or an underlying credit support arrangement. However, the issuer of the debt or derivative should ignore the credit enhancement in calculating its credit risk adjustment and revert to its own standalone credit risk, not that of the guarantor. Any proceeds received by the issuer are consideration for the liability issued as well as the credit enhancement purchased on the investor’s behalf and should be allocated as such.
This guidance does not apply to credit enhancements granted to the issuer of the liability provided by governmental entities or to arrangements between reporting entities within a consolidated or combined group (for example, a parent and subsidiary or entities under common control).
Impact of third-party credit enhancements – perspective of the holder
Guidance differs for the holder of the instrument (e.g., the investor in a debt security or the counterparty to a derivative liability) with an inseparable third-party credit enhancement. The counterparty should consider the benefit of the enhancement in measuring the fair value of the instrument. However, if the third-party credit enhancement is detachable, there would be two units of account, each of which should be accounted for separately.
Determine exposure to be measured
After a reporting entity has identified and assessed all information that may impact the calculation of credit risk, it should calculate the net asset or liability exposure and determine whose credit needs to be measured. This information will be critical in the overall calculation of the credit risk adjustment. Following are specific examples of application of this guidance.
Example FV 8-1 demonstrates the impact of master netting arrangements on the credit risk adjustment.
EXAMPLE FV 8-1
Impact of master netting arrangements on the credit risk adjustment
As of December 31, 20X1, FV Company has several derivative contracts with Counterparty X as follows:
Type of derivative
Amount
Asset/(liability)
Interest rate swap
$(20,000)
Liability
Interest rate swap
10,000
Asset
Total interest rate swaps
$(10,000)
Net liability
Gas commodity contract
6,000
Asset
Gas commodity contract
5,000
Asset
Electricity commodity contract
8,000
Asset
Electricity commodity contract
(12,000)
Liability
Total commodity contracts
$7,000
Net asset
Total of all contracts
$(3,000)
Net liability
View table
In evaluating its netting and other arrangements with Counterparty X, FV Company determines that it has a netting arrangement that covers the interest rate swaps and a separate master netting arrangement that affects all commodity derivatives, including both gas and electricity contracts.
Considering all of the noted contracts are with the same counterparty, how should management measure credit risk associated with the net $3,000 liability?
Analysis
Management should separately measure credit risk associated with the following:
  • Interest rate swaps – Rights and obligations under these contracts are not eligible to be netted with those relating to the commodity derivatives. Therefore, as of the reporting date, FV Company should measure the credit risk for the net interest rate swap liability based on a market participant’s view of FV Company’s credit standing.
  • Commodity contracts – All commodity contracts are covered by a single master netting arrangement. Therefore, FV Company should measure the credit risk associated with the $7,000 net asset based on a market participant’s view of Counterparty X’s credit.
This example illustrates how the form and substance of commercial agreements can impact the measurement of credit risk and can yield different credit risk adjustments. In this example, if there were no netting arrangements, FV Company would calculate the credit risk adjustment separately for each of the derivatives. Alternatively, if all of the contracts were covered under a single master netting arrangement, credit risk would typically be calculated based on a net liability of $3,000. However, because the swaps and commodity contracts are subject to separate netting arrangements, credit risk should be separately evaluated for the net swap exposure and for the net commodity exposure.

Example FV 8-2 shows the impact of collateral and credit support on the credit risk adjustment.
EXAMPLE FV 8-2
Impact of collateral and credit support on the credit risk adjustment
As of December 31, 20X1, FV Company has several derivative contracts with Counterparty X as follows:
Type of derivative
Amount
Asset/(liability)
Interest rate swap
$(20,000)
Liability
Interest rate swap
10,000
Asset
Total interest rate swaps
$(10,000)
Net liability
Gas commodity contract
6,000
Asset
Gas commodity contract
5,000
Asset
Electricity commodity contract
8,000
Asset
Electricity commodity contract
(12,000)
Liability
Total commodity contracts
$7,000
Net asset
Total of all contracts
$(3,000)
Net liability
In evaluating its netting and other arrangements with Counterparty X, FV Company determines that it has a netting arrangement that covers the interest rate swaps and a separate master netting arrangement that affects all commodity derivatives, including both gas and electricity contracts. Under the CSA governing the commodity contracts, Counterparty X is required to provide $5,000 of cash collateral to FV Company.
Does the posted collateral have an impact on the calculation of the credit risk adjustments for the commodity contracts and the interest rate swaps?
Analysis
As a result of the collateral, FV Company has limited its credit exposure to a net $2,000 commodity asset from Counterparty X, instead of the $7,000 asset calculated in Example FV 8-1. FV Company’s net exposure (the uncollateralized amount) is calculated as follows:
Derivative type
Position
Collateral
Asset/(liability)
Interest rate swaps
$(10,000)
$ —
$(10,000)
Commodity contracts
7,000
(5,000)
2,000
View table
Therefore, FV Company should calculate the credit risk adjustment for the commodity contracts based on the net $2,000 balance. However, the posted collateral has no impact on the calculation of the credit risk adjustment associated with the interest rate swap.
In this fact pattern, depending on the requirements of the underlying agreement, Counterparty X also may have been able to meet its collateral obligation by providing a parent company guarantee or a bank letter of credit.

Example FV 8-3 discusses the impact of credit enhancements on the calculation of credit risk adjustments.
EXAMPLE FV 8-3
Impact of credit enhancements on the credit risk adjustment
As of December 31, 20X1, FV Company has several derivative contracts with Counterparty X as follows:
Type of derivative
Amount
Asset/(liability)
Interest rate swap
$(20,000)
Liability
Interest rate swap
10,000
Asset
Total interest rate swaps
$(10,000)
Net liability
Gas commodity contract
6,000
Asset
Gas commodity contract
5,000
Asset
Electricity commodity contract
8,000
Asset
Electricity commodity contract
(12,000)
Liability
Total commodity contracts
$7,000
Net asset
Total of all contracts
$(3,000)
Net liability
In evaluating its netting and other arrangements with Counterparty X, FV Company determines that it has a netting arrangement that covers the interest rate swaps and a separate master netting arrangement that affects all commodity derivatives, including both gas and electricity contracts. FV Company’s interest rate swaps are supported by a letter of credit issued by Bank B, a third party.
Should FV Company or Counterparty X consider the impact of the letter of credit issued by Bank B when determining the credit risk adjustment?
Analysis
In accordance with the requirements of ASC 820-10-35-18A, the obligor (FV Company) cannot consider the impact of a third-party credit enhancement in determining the credit risk adjustment for its liability. Therefore, FV Company is required to measure the credit risk as of the reporting date based on a market participant’s assessment of its own credit standing, not that of Bank B.
However, Counterparty X would incorporate the impact of the credit enhancement issued by Bank B for FV Company in determining an appropriate credit risk adjustment for the interest rate swap asset recorded on its books. The guidance in ASC 820-10-35-18A has no impact on the measurement of nonperformance by Counterparty X, which may consider the credit enhancement provided by the letter of credit.

Example FV 8-4 evaluates the impact of contracts identified as normal purchases under US GAAP on the credit risk adjustment.
EXAMPLE FV 8-4
Impact of contracts identified as normal purchases under US GAAP on the credit risk adjustment
FV Company has two electricity commodity contracts with Counterparty X and has received collateral from Counterparty X. One of the two contracts qualifies, and has been designated, as a normal purchase in accordance with ASC 815 while the other contract does not qualify for the scope exception. As a result, the normal purchase contract is accounted for as an executory contract and is not recorded nor disclosed at fair value in the financial statements. The contract has a liability balance of $5,000 as of December 31, 20X1 and is subject to the overall commodity master netting arrangement between FV Company and Counterparty X.
How should the credit risk adjustment be determined for the executory contract as FV Company has received collateral from Counterparty X? Should the credit risk adjustment be included in the fair value measurement of the derivatives?

Analysis
If a reporting entity received collateral from a particular counterparty, it should determine whether any of the collateral relates to contracts designated as normal purchases and normal sales contracts. If some of the collateral relates to such off-balance sheet contracts, the reporting entity should allocate the collateral between contracts recorded at fair value and those accounted for as executory contracts prior to the calculation of the credit risk adjustment.
Further, ASC 820 applies to derivatives recorded at fair value in the financial statements, and the credit risk adjustment is intended to reflect the credit risk associated with recognized contracts in the fair value measurement. Therefore, although included in the determination of the credit risk adjustments associated with a specific counterparty, the portion of the credit risk adjustment for such executory contracts and other contracts that are not recorded at fair value on the balance sheet should not be included in the fair value measurement of the derivatives.

Example FV 8-5 assesses the impact of deal structure on the credit risk adjustment.
EXAMPLE FV 8-5
Impact of deal structure on the credit risk adjustment
As of December 31, 20X1, FV Company has several derivative contracts with Counterparty X as follows:
Type of derivative
Amount
Asset/(liability)
Interest rate swap
$(20,000)
Liability
Interest rate swap
10,000
Asset
Total interest rate swaps
$(10,000)
Net liability
Gas commodity contract
6,000
Asset
Gas commodity contract
5,000
Asset
Electricity commodity contract
8,000
Asset
Electricity commodity contract
(12,000)
Liability
Total commodity contracts
$7,000
Net asset
Total of all contracts
$(3,000)
Net liability
In evaluating its netting and other arrangements with Counterparty X, FV Company determines that it has a netting arrangement that covers the interest rate swaps and a separate master netting arrangement that affects all commodity derivatives, including both gas and electricity contracts. One of FV Company’s subsidiaries enters into a structured transaction with Counterparty X and Counterparty Z, moving the in-the-money electricity commodity contract with Counterparty X (the $8,000 commodity asset above) into a separate subsidiary (Subsidiary A). Subsidiary A is purchasing electricity from Counterparty X under this contract. Subsidiary A then enters into a power sales agreement with Counterparty Z. The structure of this transaction is as follows:
Performance on the Counterparty Z sales agreement is dependent on the receipt of the electricity by Subsidiary A from Counterparty X; Counterparty Z has no recourse to the overall assets of FV Company if Subsidiary A fails to perform.
How should FV Company consider the credit risk associated with the sales agreement with Counterparty Z?
Analysis
In this transaction, performance by Subsidiary A on the contract with Counterparty Z depends on the receipt of power by Subsidiary A from Counterparty X. Thus, if the contract with Counterparty Z is in a liability position, FV Company should consider Counterparty X’s credit standing in measuring credit risk, rather than solely considering its own credit risk.
If the Counterparty Z contract were in an overall asset position, FV Company would consider Counterparty Z’s performance risk. In assessing the exposure attributable to Counterparty Z, FV Company should also consider the impact of any collateral held by Subsidiary A associated with the transaction from Counterparty Z (as opposed to collateral from Counterparty X).

8.2.2 Step two: market participant perspective of credit information

In measuring credit risk, a reporting entity should acquire and evaluate information about the probability of default and the cost of transferring the risk to another party. Information that a market participant may consider includes the following:
•  Credit ratings
•  Market credit spreads
•  Credit default swap rates
•  Other public information with respect to a particular or similar entity
•  Historical default rates
This information may be entity-specific or pertain to a similar entity or particular industry sector. When evaluating the effect of credit risk on a fair value measurement, a reporting entity should consider current market conditions and whether the data it is using appropriately incorporates the most recent market trends. Some data sources may be more responsive to current conditions while other information may lag. These factors should be considered to the extent they represent the characteristics of the liability. For example, a holding company rating may not be relevant to the liability of a consolidated subsidiary with its own separate rating and/or different credit characteristics.

8.2.2.1 Evaluating credit information

In evaluating available information, reporting entities should also consider the fair value hierarchy. In determining the fair value of an asset or liability, observable inputs should be prioritized over unobservable inputs. However, observable information may not always be available, or unobservable data may be more appropriate in certain circumstances. If observable, market-based inputs are available, those inputs cannot be ignored and should be appropriately weighed in the measurement.
Historical default rates and recovery data
Tables of historical default and related recovery rates are routinely available through ratings agencies (e.g., Standard & Poor’s, Moody’s). Published default information is typically provided according to credit rating category (e.g., AAA, AA, A) and term (e.g., one year, five years, ten years).
Many reporting entities traditionally used historical default rates to measure credit risk for counterparties with a particular rating. However, reporting entities should understand the limitations of using this default data, without adjustment, when measuring credit risk for purposes of fair value measurement.
ASC 820-10-35-17 requires that the measurement of fair value incorporates a market participant’s perspective of nonperformance risk, including credit risk. Historical default information reflects loss information from a designated period in the past, which may not reflect current market developments. For example, if a reporting entity is developing credit risk adjustments for counterparties that are experiencing financial difficulty, historical default rates generally would not reflect current and emerging information. The fact that the data does not reflect current conditions may become an issue of increasing significance in periods of heightened economic fluctuation. In addition, historical default rates may not sufficiently incorporate a market participant perspective about a specific entity.
In measuring credit risk, market participants may make adjustments for market factors, especially in periods of heightened market volatility, or for transactions involving counterparties that are not highly rated or that are experiencing issues or uncertainty, as reflected in their credit standing. Historical default rates do not incorporate this type of market-based risk adjustment. Such rates do not reflect a current price for credit risk and may not reflect current market perceptions of the future behavior of the obligor. As described below, bond spreads or credit default swap rates may provide a better indication of “market” rates for credit risk because they result from market participant pricing of credit risk for a specified instrument and counterparty. If entity-specific bond yields or credit default swap rates are not available, comparable industry sector credit information may be a more reliable indication of the market view of the risk of default than historical default rates alone.
For these reasons, solely using historical default information to measure credit risk is generally not sufficient. Such information often should be adjusted by incorporating other market data.
Market credit spreads
A credit spread is the difference in yield between two debt instruments that is attributable to a difference in credit standing of the respective issuers. Credit spreads are often quoted in relation to the yield on a credit risk-free benchmark security (e.g., U.S. Treasury bonds) or reference rate (e.g., U.S. Treasury rates or LIBOR). A credit spread for a public company is based on the issuer’s publicly traded unsecured debt or by reference to a debt instrument with similar terms and for which credit exposure is considered to be substantially similar. Credit spread information may be obtained from a financial information network, such as Bloomberg, or other debt pricing and quotation sources.
Compared to using unadjusted historical default rates, credit spreads typically consider the price of credit risk and may provide more current information about a market participant’s view of the credit risk of a particular counterparty. Credit spreads are often a better reflection of a market participant’s perspective. However, there are limitations on the use of this information, as a credit spread is specific to the debt instrument to which it relates, including its liquidity, seniority, tenor, and other terms, and to the instrument’s issuer. Furthermore, credit spreads may not reflect the most current market information as timely as a credit default swap rate (discussed below).
Publicly quoted credit spreads may not be readily available for private companies. When company-specific spreads are not available, it may be appropriate to consider credit spreads on publicly traded debt with a similar credit rating as an input in calculating the credit risk adjustment.
Credit default swap (CDS) rates
A CDS is a swap contract in which one party (the buyer of credit protection) makes a series of payments to another party (the seller) and, in exchange, receives a payoff if a referenced issuer of a debt instrument defaults or on the occurrence of a specified credit event (such as bankruptcy or restructuring).
A CDS rate refers to the current market-implied spread for protection on a given obligor. The rate is typically derived from a CDS price, which is the upfront payment, that, when combined with a series of standard coupon payments, equates to the market-implied price of protection. The standard coupon payments of 100 or 500 basis points are determined based on the credit quality of the reference credit obligation.
The price of credit as expressed by a CDS rate is approximately the annual rate multiplied by the amount of the reference credit obligation, discounted at LIBOR. A CDS is typically cash-settled. However, it may also be physically settled by delivery of the underlying instrument in exchange for payment of the contractual amount.
A CDS resembles an insurance policy in the sense that it can be used by the debt holder to hedge against the risk of loss caused by a default on a specific debt instrument. Unlike an insurance policy, however, the company that purchases the credit protection is not required to actually hold an asset or be at risk for loss. CDS rates are generally the most current information about a market participant’s point of view of an issuer’s credit. CDS rates can be obtained from financial information services (e.g., Bloomberg) or may be estimated based on appropriate pricing inputs.
CDS rates may be quoted for reference securities with different attributes, including, for example, maturity and seniority, and should be adjusted to match these attributes (e.g., comparable length or term of the exposure). Various methods, including interpolation, may be used to adjust the CDS information to the appropriate tenor. Reporting entities should ensure that methodologies are appropriate and consistently applied.
The CDS market
According to the Statistical Release issued by the Bank of International Settlements, “OTC derivatives statistics at end-December 20202” (May 2021), the notional value of the CDS market was $8.4 trillion at the end of 2020. The CDS market is large and rapidly incorporates current market information in comparison to credit ratings or credit spreads. For example, while Lehman Brothers had an investment grade credit rating the Friday before it declared bankruptcy, the cost for obtaining credit protection on Lehman Brothers debt using a CDS was increasingly more costly over the period leading up to this event.
However, the CDS market is primarily an over-the-counter market, and there may be a lack of transparency regarding certain CDS information. In addition, the market is dominated by a few large financial institutions, and some CDS contracts are thinly traded (or may not be traded) and experience significant volatility. Therefore, questions have been raised about the use of unadjusted CDS information in incorporating credit risk in some fair value measurements.
Question FV 8-5
Some CDS information is available for a specific obligation, but it is for CDS contracts that are thinly traded and whose prices are volatile. Should this information still be considered in the calculation of credit risk?
PwC response
Yes. ASC 820-10-35-54A indicates that all reasonably available market information should be considered in the calculation of a credit risk adjustment. Even in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales. However, it is also not appropriate to automatically conclude that any transaction price is determinative of fair value. In determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available.
ASC 820-10-35-54C through ASC 820-10-35-54H reiterate the priority of market information in a fair value measurement by providing factors to consider in determining whether there has been a significant decrease in the volume or level of activity. Those factors may indicate when observable inputs may not be relevant or may require significant adjustment. In addition to cases in which the volume or level of activity has decreased significantly, observable inputs may not be relevant or may need adjustment when the available prices vary significantly over time or among market participants, or the prices are not current.
In addition, ASC 820-10-55-90 through ASC 820-10-55-98 provide an example of an approach to a fair value measurement that includes available market information and the entity’s own assumptions. This example demonstrates specific considerations in incorporating various sources of information in the fair value measurement. As demonstrated in the example, market information obtained from inactive markets still provides a point of reference in the estimation of fair value. Therefore, in assessing the use of a CDS rate, it is appropriate for the reporting entity to consider the source of the information, the liquidity of the market, and other factors.
Identifying all relevant sources of information, evaluating the accuracy of the information, and weighing the relative merits of all available data are difficult and judgmental processes. A reporting entity should document the information considered and the basis for its conclusions.
In addition, a lack of observable key inputs into the determination of the credit risk adjustment, such as in this case, could potentially impact how the valuation is classified in the reporting entity’s fair value hierarchy disclosures. See FV 8.3.

8.2.2.2 Comparing sources of credit information

The following table highlights certain advantages and disadvantages associated with incorporating the various indicators of potential default into a credit calculation.
Figure FV 8-2 compares sources of credit information.
Figure FV 8-2
Comparing credit information
Method
Advantages
Disadvantages
Historical default rates
  • Provides an indication of risk and are widely available
  • Routinely published by a variety of sources
  • May not be indicative of market expectations of the obligor’s current or future behavior
  • Market events may be reflected on a lag
  • Do not reflect entity-specific information
  • Need to obtain additional information on applicable recovery rates/severities
  • Severities and probabilities of default sourced separately (e.g., from different data providers) may not be consistent
  • Severities and probabilities of default are not indicative of the price of credit
Bond prices and yields (credit spreads)
  • Can be obtained for any publicly traded debt instrument
  • Provide a current market view of credit risk
  • Application of market standard recovery rates should result in consistent severity and probabilities of default for a given credit spread
  • Probabilities of default and recovery rates will be internally consistent for a given credit spread
  • May be difficult to apply if publicly traded instruments are not available
  • Tend to be less responsive to current market events than CDS rates
Credit default swaps
  • Provides current market view of credit risk associated with a specific entity
  • CDS rates related to a particular industry segment may be useful in assessing risk
  • Can apply market standard assumptions for recovery rates
  • Probabilities of default and recovery rates will be internally consistent for a given credit spread
  • May be thinly traded and their pricing may be volatile
  • Not available for all companies
  • Limited to shorter maturity length of the CDS curve
  • Application of market standard severity/recovery rates may not be applicable to a particular instrument/counterparty

8.2.2.3 Other considerations

Each company will have unique characteristics and often differing levels of reasonably available market information. For example, a large financial services institution may have a credit rating, multiple tranches of publicly traded debt, quoted credit default swap rates with multiple tenors, and other public information, which may provide strong evidence of a market participant’s assumptions about credit risk. In contrast, a privately held company may have limited public information reasonably available for consideration of the appropriate credit risk adjustment.
If little or no entity-specific information is available, it may be helpful to consider credit default swap benchmarks or other credit benchmarks for the industry. Sector information may also be useful as another benchmark in evaluating counterparties when there is public information available.
When sector information is used in lieu of or to supplement entity-specific information, the reporting entity should adjust the information to align it with the unique characteristics of the asset or liability for which credit risk is being measured. For example, if the average credit rating for the industry is A, but a reporting entity is measuring an instrument issued by a counterparty with a credit rating of BBB, the difference in credit rating suggests a need to incorporate a higher degree of credit risk in the measurement of the instrument versus an instrument issued by others in the reporting entity’s industry.
Question FV 8-6

A reporting entity’s risk management group has developed a certain methodology for considering counterparty credit risk. Is the reporting entity required to consider the same methodology for purposes of measuring fair value for financial reporting?
PwC response
No, but the risk management group’s assessment should be considered. Many reporting entities have implemented risk management processes that manage counterparty exposure. Those processes may include, for example, developing lists of approved counterparties, establishing limits for exposures with a particular counterparty, determining the level of collateral or other credit support required for each counterparty or type of counterparty, pricing credit when collateral or other credit support is considered insufficient, and other related criteria.
In many cases, the approach to managing credit exposure developed by the risk management group will reflect the overall approach to measuring credit risk used by other market participants. Therefore, a reporting entity’s methodology for measuring credit risk for financial reporting purposes should include consideration of information used by its risk management group. If the internal process uses information consistent with market participant assumptions, it may be used as an input when measuring fair value. In all cases, the determination of credit risk adjustments should reflect market participant assumptions and not management assumptions developed by the reporting entity.

8.2.2.4 Approaches to assessing available information

Example FV 8-6 demonstrates approaches to considering and weighting various types of information.
EXAMPLE FV 8-6
Using company-specific market information
In September 20X1, Company B, a gas distribution company, enters into a two-year pay-fixed/receive-floating gas swap with Counterparty M, a gas marketer, based on the NYMEX Henry Hub monthly index. The swap meets the definition of a derivative and Company B will record it at fair value, with changes in fair value reported in the income statement each reporting period. The swap is not subject to a master netting arrangement and no collateral has been posted. As of December 31, 20X1, the fair value of the swap, without any adjustment for credit risk, is a liability of $365,000.
Since the contract is in a liability position, the credit adjustment will be primarily adjusted based on market participant assumptions about Company B’s credit risk (i.e., the amount market participants would require for assumption of this liability in a transfer).
Company B assesses the available credit information as follows:
  • Credit rating – Company B’s credit rating on September 30, 20X1, was BBB, which is generally consistent with comparable companies in the industry. Based on this credit rating, Company B noted that the historical default tables indicate a default rate of less than 0.6% over the term of the swap contract.
  • Credit spreads – Company B’s publicly traded, unsecured debt was trading with yields in the range of 1.4%–1.7% over US Treasury bonds as of December 31, 20X1.
  • Credit default swaps – There are publicly quoted CDS rates available for other debt of Company B with comparable credit exposure and current activity through December 31, 20X1. Company B is able to obtain CDS rates from an information service without undue cost or delay. The CDS rate is approximately 273 basis points for the first year of the contract, decreasing to 258 basis points for the second year. The spreads have been increasingly volatile. Company B incorporates CDS rates in its assessment of counterparty credit risk for its risk management purposes.
How might Company B conclude as it relates to the relevancy of the data points outlined above when determining its risk of default?
Analysis
The use of the credit rating and historical default rate is less likely to form a current market participant’s assumption about credit risk. Therefore, market participants would likely consider other market indicators in assessing credit risk.
Company B should consider the use of credit spreads in the calculation of the credit risk adjustment; however, because it has determined that CDS rates are available and more appropriate for the derivative being measured, these should also be considered. Given the currently volatile credit markets, CDS rates provide a more timely and reliable indicator of credit risk.
Management could conclude that although they have a higher volatility and may be thinly traded, and although the risk of default is minimal and consistent with the risk indicated by historical default rates, CDS rates provide the best estimate with respect to the current market view of its credit risk incorporating the price of credit as of the reporting date from the market participant perspective.

Example FV 8-7 illustrates the weighting of market information.
EXAMPLE FV 8-7
Weighting market information
In September 20X1, Company B, a gas distribution company, enters into a two-year pay-fixed/receive-floating gas swap with Counterparty M, a gas marketer, based on the NYMEX Henry Hub monthly index. The swap meets the definition of a derivative and Company B will record it at fair value, with changes in fair value reported in the income statement each reporting period. The swap is not subject to a master netting arrangement and no collateral has been posted. As of December 31, 20X1, the fair value of the swap, without any adjustment for credit risk, is a liability of $365,000.
Since the contract is in a liability position, the credit adjustment will be primarily adjusted based on market participant assumptions about Company B’s credit risk (i.e., the amount market participants would require for assumption of this liability in a transfer).
Company B assesses the available credit information as follows:
  • Credit rating – Company B’s credit rating on September 30, 20X1, was BBB, which is generally consistent with comparable companies in the industry. Based on this credit rating, Company B noted that the historical default tables indicate a default rate of less than 0.6% over the term of the swap contract.
  • Credit spreads – Company B’s publicly traded, unsecured debt was trading with yields in the range of 1.4%–1.7% over US Treasury bonds as of December 31, 20X1.
  • Credit default swaps – There are no publicly quoted CDS rates available for other debt of Company B with comparable credit exposure and current activity through December 31, 20X1.
There are no quoted CDS rates available for Company B. There is CDS information available for the gas distribution sector. The CDS sector rate was approximately 250 basis points for the first year of the contract, decreasing to 225 basis points for the second year. Recent CDS quotes have been volatile.
Because there are no quoted CDS rates available for Company B, how might Company B conclude as it relates to the relevancy of the existing data points when determining its risk of default?
Analysis
Considering the available information, the credit spreads provide the best company-specific information about potential risk of default. However, if Company B is similar to the companies that comprise the gas distribution sector and correlation exists, management could conclude that the CDS rates, though not company-specific, are more reflective of the current market participant view of credit risk and credit risk can be calculated using the sector-specific CDS rates without adjustment.

Example FV 8-8 demonstrates the evaluation of various types of market information.
EXAMPLE FV 8-8
Evaluating various types of market information
Company B is valuing $1.0 million in mandatorily redeemable preferred stock that it issued to private investors. This stock is classified as debt on the balance sheet under US GAAP. Company B is required to calculate the fair value of the preferred stock for disclosure purposes. In considering the valuation process, management observes that since issuance:
  • market conditions for debt have deteriorated,
  • its sector has been affected by a number of negative factors, and
  • recently there has been a widening of credit spreads.
Company B’s management believes that the company tends to follow industry trends with a slight “positive” factor due to a lower than average debt-to-equity ratio. Company B’s management also obtains the following inputs for consideration:
  • The credit spread on Company B’s public debt is 3%.
  • The public debt is senior to the preferred stock. Due to current credit conditions, Company B’s management believes that an adjustment of 1% is required to reflect the lower seniority of the preferred stock in relation to the public debt. Therefore, the implied credit spread for the preferred stock is 4%.
  • Company B is able to obtain a quote for Company H’s preferred stock that has similar terms and characteristics. The current credit spread implied in this issuance is 4%. Company H has the same credit rating as Company B; however, Company B operates in an industry that has a lower risk profile. Furthermore, Company H’s debt trades at a higher price in its credit category than Company B. Management determines that the difference in sectors and position within its credit category require a downward adjustment of .5%. Therefore, the implied credit spread by these inputs for the preferred stock is 3.5%.
  • Management obtains a quote for a publicly traded series of subordinated debt for Company J, a company within Company B’s sector with a credit rating a grade below Company B’s. The debt has characteristics (e.g., subordination, covenants, and other terms) that are similar to, though not exactly the same as, Company B’s preferred stock. In addition, Company J has covenants that include restrictions beyond those imposed by Company B’s preferred stock. The credit spread on the debt is 6% at the reporting date. Given the additional restrictions and the lower credit quality of Company J, management adjusts the credit spread downward by 1.5%, for an implied spread of 4.5%.
How might Company B evaluate the appropriateness of each of the three implied credit spreads when calculating the credit risk adjustment to determine the fair value of the preferred stock?
Analysis
The three referenced inputs, as adjusted, range from a low of 3.5% to a high of 4.5%. In assessing the appropriate rate to apply in calculating the credit risk adjustment, management should consider the quality of the data sources. As the first price starts with Company B’s own debt and adjusts for the risk in the preferred stock, it could be considered the most relevant. However, the second two inputs reference subordinated debt, which is a better comparison to the subordinated position of the preferred stock. Because the credit markets place a premium on seniority, and because Company B operates in a lower risk sector, the weighting should likely be closer to the subordinated debt spreads. Therefore, in this case, a credit spread of 4.5% may be appropriate.

8.2.3 Step three: calculate credit risk adjustment

There are various methodologies to calculate the credit risk adjustment and to incorporate the adjustment into the measurement of fair value. There is some flexibility in the method selected; however, management should apply a consistent method when performing similar measurements. In addition, a reporting entity must consider all relevant valuation approaches that would be used by a market participant, for which inputs can be obtained without undue effort.
ASC 820-10-35-24A describes three main approaches to measuring the fair value of assets and liabilities:
  • Cost approach
  • Market approach
  • Income approach

In some cases, such as exchange-traded commodity contracts, which are generally collateralized, or a marketable debt security such as a corporate bond, an approach to valuation based on the quoted market price will incorporate nonperformance risk (including credit risk). See FV 8.1.1.1. However, when quoted prices are not available or do not include a credit risk component, other approaches to valuation may be used.
In determining the appropriate methodology to calculate the credit risk adjustment, the reporting entity should consider how a market participant would be expected to approach the calculation. There are a number of approaches used to estimate a credit risk adjustment, and these approaches may evolve over time. Reporting entities should continue to assess their approaches to ensure consistency with current market participant approaches and assumptions.
Although ASC 820 describes three main approaches to measuring fair value, the cost approach assumes that fair value would not exceed what it would cost a market participant to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. For this reason, the cost method is typically used to value assets that can be easily replaced, such as property, plant, and equipment, rather than financial assets or liabilities. Therefore, this section details only the market and income approaches:
  • Market Approach – As prices in traded markets for financial instruments will generally incorporate credit risk, incremental credit risk adjustments are not required. However, information on pricing for other financial instruments, including most derivatives, typically does not include credit risk adjustments because the terms of the observable instrument can be different from the terms of the company’s own instrument being valued. If prices do require adjustment for credit risk, these adjustments can be computed based on market observable information such as CDS rates and credit spreads.
  • Income Approach – When using the income approach, credit risk may be incorporated into the discount rate, the undiscounted expected cash flows, or the discounted cash flows. Credit spreads are often incorporated into the discount rate. CDS rates can be included in several ways, including the following:
    • Discount rate adjustment technique (ASC 820-10-55-10 through ASC 820-10-55-12) – The reporting entity uses the available inputs (CDS rates, bond spreads) to calculate the credit risk adjustment. The credit inputs may be used to directly adjust the discount rate used in the overall fair value calculation (i.e., the reporting entity may add the CDS rate or bond spread to the risk-free rate).
    • Exponential CDS default method – This method takes the CDS rate and extracts from it the implied risk of default, which is then applied to the market value of the unit of measurement and reduced by expected recoveries. A quoted CDS spread may be converted to a risk of default and a credit risk adjustment using the following formula:
      Probability of default (PD) = 1− Exponential [− CDS spread / (1 − recovery rate) × maturity]
      Credit Risk Adjustment (CVA) or Debit Value Adjustment (DVA) = PD × fair value of instrument × (1 − recovery rate)
      Recovery rates are available from published sources depending on the seniority of the obligation and the industry and credit rating of the reporting entity. The reporting entity should assess the probability of default and recovery rates implied from the market for its counterparty and itself, as appropriate, as part of this calculation.
      The size of the credit risk adjustments may vary between different kinds of instruments and between markets or jurisdictions. The determination requires significant judgment. In estimating the size of the credit risk adjustment for any instrument, the reporting entity should consider all relevant market information that is reasonably available. This includes factors such as:
  • Information about the pricing of new instruments that are similar to the one being valued and the extent to which the pricing of such instruments varies with the credit risk of the parties to it
  • The extent to which credit risk is already reflected in the valuation model and assumptions at inception and over the life of the transaction. For example, a derivative valuation that uses a LIBOR discount rate will incorporate the credit risk inherent in LIBOR. However, this may differ from the credit risk inherent in the derivative being valued. Also, some derivative valuations use discount rates other than LIBOR (e.g., OIS) so further adjustments may be required. For example, generally corporate CDS rates are considered as measuring credit risk relative to LIBOR and are appropriate when discounting at LIBOR. If discounting at another rate (e.g., OIS), adjustments to the measure of credit riskiness may be required.
  • The effect of the entity’s own credit risk from the perspective of market participants. This may differ depending on the terms of credit enhancements, if any, related to the liability. It is assumed that: (i) the liability is transferred to a market participant at the measurement date and would remain outstanding; (ii) the market participant transferee would be required to fulfill the obligation; (iii) the liability would not be settled with the counterparty or otherwise extinguished at the measurement date; and (iv) non-performance risk is the same before and after the transfer of the liability [ASC 820-10-35-16(b) and ASC 820-10-35-17]. This chapter addresses the topic of credit risk, while nonperformance risk includes any factors that might influence the likelihood that the obligation will or will not be fulfilled.

8.2.3.1 Examples — calculation of a credit risk adjustment

Reporting entities may use different methods to calculate the credit risk adjustment. We provide some simplified examples below to illustrate various methods of using credit spreads and CDS rates to estimate the credit risk adjustment. The calculation format varies in each example to illustrate different formats in which the credit information may be received and different methods of calculation. As noted, calculations can be complex and may require the use of specialists. The following are brief descriptions of the methods used:
Example FV 8-9: Discount rate adjustment technique – Using a credit spread. This calculation is performed using credit spread information applied to the cumulative exposure.
Example FV 8-10: Discount rate adjustment technique – Impact of different credit sources. This example also demonstrates the use of discount rate adjustment techniques, comparing the results obtained by using CDS rates and credit spreads.
Example FV 8-11: Alternative CDS-based techniques. In this example, the credit risk adjustment of an interest rate swap is calculated using alternative methods of applying CDS spreads.
These examples are not meant to depict the full complexities of valuing credit risk in instruments with fluctuating fair values and other complexities that follow from common features related to derivatives and other financial instruments. For example, changes in the fair value of an instrument that causes its value to change from an asset to liability, or vice versa, present additional considerations. These simplified examples also do not take into account quoting conventions or the timing of cash flows for credit default swaps.
Example FV 8-9 demonstrates a discount rate adjustment technique using a credit spread.
EXAMPLE FV 8-9
Discount rate adjustment technique – using a credit spread
Company B is valuing $1.0 million in mandatorily redeemable preferred stock that it issued to private investors. This stock is classified as debt on the balance sheet under US GAAP. Company B is required to calculate the fair value of the preferred stock for disclosure purposes. In considering the valuation process, management observes that since issuance:
  • market conditions for debt have deteriorated,
  • its sector has been affected by a number of negative factors, and
  • recently there has been a widening of credit spreads.

Company B’s management believes that the company tends to follow industry trends with a slight “positive” factor due to a lower than average debt-to-equity ratio. Company B’s management also obtains the following inputs for consideration:
  • The credit spread on Company B’s public debt is 3%.
  • The public debt is senior to the preferred stock. Due to current credit conditions, Company B’s management believes that an adjustment of 1% is required to reflect the lower seniority of the preferred stock in relation to the public debt. Therefore, the implied credit spread for the preferred stock is 4%.
  • Company B is able to obtain a quote for Company H’s preferred stock that has similar terms and characteristics. The current credit spread implied in this issuance is 4%. Company H has the same credit rating as Company B; however, Company B operates in an industry that has a lower risk profile. Furthermore, Company H’s debt trades at a higher price in its credit category than Company B. Management determines that the difference in sectors and position within its credit category require a downward adjustment of .5%. Therefore, the implied credit spread by these inputs for the preferred stock is 3.5%.
  • Management obtains a quote for a publicly traded series of subordinated debt for Company J, a company within Company B’s sector with a credit rating a grade below Company B’s. The debt has characteristics (e.g., subordination, covenants, and other terms) that are similar to, though not exactly the same as, Company B’s preferred stock. In addition, Company J has covenants that include restrictions beyond those imposed by Company B’s preferred stock. The credit spread on the debt is 6% at the reporting date. Given the additional restrictions and the lower credit quality of Company J, management adjusts the credit spread downward by 1.5%, for an implied spread of 4.5%.

The three referenced inputs, as adjusted, range from a low of 3.5% percent to a high of 4.5% percent. In assessing the appropriate rate to apply in calculating the credit risk adjustment, management considered the quality of the data sources. Because the credit markets place a premium on seniority, and because Company B operates in a lower risk sector, management believes the weighting should be closer to the subordinated debt spreads and estimated a credit spread of 4.5% to be appropriate.
The preferred stock is mandatorily redeemable at its par value of $1 million in 5 years and provides for 20 quarterly dividend payments of $17,500, based on a fixed annual rate of 7%.
The preferred stock rates are as follows:
Pre-credit-adjusted rate
5.00%
Credit spread
4.50%
Total rate
9.50%

How could Company B calculate the credit risk adjustment for the preferred stock using the credit spread?
Analysis
The credit risk adjustment may be calculated using a credit spread by comparing the cash flows discounted at a pre-credit-adjusted rate with those discounted at a credit-adjusted rate at the measurement date as follows:
Cash flows
(un-discounted)
Cash flows discounted at pre-credit-adjusted rate
Cash flows discounted at credit-adjusted rate
Impact of credit
Principal payment at maturity
$1,000,000
$780,009
$625,348
$(154,661)
Quarterly dividend stream of 7%
$350,000
$307,988
$276,059
$(31,929)
Total value
$1,350,000
$1,087,997
$901,407
$(186,590)

Example FV 8-10 demonstrates the impact of using different information sources in the calculation of the credit risk adjustment for a natural gas swap.
EXAMPLE FV 8-10
Discount rate adjustment technique – impact of different credit sources
In September 20X1, Company B, a gas distribution company, enters into a two-year pay-fixed/receive-floating gas swap with Counterparty M, a gas marketer, based on the NYMEX Henry Hub monthly index. The swap meets the definition of a derivative and Company B will record it at fair value, with changes in fair value reported in the income statement each reporting period. The swap is not subject to a master netting arrangement and no collateral has been posted.
Key terms of the contract are as follows:
  • Company B will pay the Henry Hub Monthly Index as published by Inside FERC (trade publication) and will receive $14.00 per MMBtu (i.e., a million British thermal units).
  • The contract has a two-year term starting on October 1, 20X1.
  • The daily notional volume is 10,000 MMBtus.
  • The swap is not subject to a master netting arrangement and no collateral will be posted or received.

As of December 31, 20X1, the fair value of the swap, without any adjustment for credit risk, is a liability of $365,000. As the contract is in a liability position, the credit risk adjustment will be predominantly based on market participant assumptions about Company B’s risk of default (i.e., the amount market participants would require to assume this liability).
Company B has a BBB credit rating and determines that the following credit information is available:
Historical default rates
Credit spread
CDS rates
One year
0.23%
1.74%
2.74%
Two year
0.54%
1.89%
2.58%

Company B determines that the historical default rates are not reflective of market participant assumptions about its risk of default and does not further evaluate this information. Company B determines that a market participant would calculate fair value by applying a discounted cash flow technique (based on the differential between the forward gas curve and the fixed amount per MMBtu under the contract).
How might Company B determine the risk-adjusted rate when calculating fair value by applying a discounted cash flow technique?
Analysis
The risk-adjusted rate to be used in the calculation could be determined by adding either the CDS rate or the credit spread to the discount rate, depending on which one of the two rates (or combination of the two rates) best represents a market participant’s assumptions about credit risk. The potential outcomes vary depending on the adjustment used. The use of the CDS rate is assumed to result in a credit risk adjustment of $11,724 compared to a credit risk adjustment of $8,598 using the credit spread. The reason for the difference in these amounts is that the credit spreads are lower than the CDS rates, which, when incorporated in discounting, results in a lower credit risk adjustment.

Example FV 8-11 illustrates the impact of using alternative CDS-based techniques in calculating the credit risk adjustment using cash flows and the discounting method.
EXAMPLE FV 8-11
Alternative CDS-based techniques
Company C holds an interest rate swap with Counterparty S. Under the terms of the swap, Company C is assumed to make equal net payments of 1% annually on a $33,333,333 notional amount. The swap has a three-year remaining term until maturity. The swap meets the definition of a derivative and Company C records it at fair value, with changes recognized in earnings each reporting period. The swap is not subject to a master netting arrangement and no collateral will be posted or received.
As of September 30, 20X1, the cash flows associated with the fair value of the swap, without any adjustment for credit risk, represent cash outflows of $333,333 at the end of each of the following three years, totaling to an expected outflow of $999,999. As the contract is in a liability position, the credit risk adjustment will be primarily based on market participant assumptions about Company C’s risk of default, liquidity of credit, and other factors (i.e., based on the amount market participants would require for assuming this liability in a transfer). Company C assesses the available credit information and determines that market participants would price credit based on Company C’s CDS rate, which is available by reference to a number of pricing services.
How should Company C calculate the credit risk adjustment using cash flows and the discounting method?
Analysis
The credit risk adjustment would be calculated using cash flows and the discounting method as follows:
Year
Expected outflow
Pre-credit-adjusted discount rate
(%)
CDS quote
(%)
Risk adjusted discount rate
(%)
Pre-credit-adjusted discounted value
Fair value
Risk
adjustment
(t)
(a)
(b)
(c)
(d)=(b)+(c)
e)=(a)/(1+(b)) ^t
(f)=(a)/(1+(d)) ^t
(f)−(e)
1
$333,333
1.00
0.38
1.38
$330,033
$328,796
$(1,237)
2
$333,333
1.50
0.45
1.95
$323,554
$320,704
$(2,850)
3
$333,333
1.70
0.60
2.30
$316,894
$311,352
$(5,543)
Total
$970,481
$960,851
$(9,630)
(a) Expected outflow is the notional amount times the net payment of 1% annually.
(b) Discount rate is the pre-credit-adjusted rate at the three dates.
(c) Default assumptions for senior unsecured credit. CDS quote can be obtained from a pricing service such as Bloomberg.
View table

Based on the calculation, Company C should record a credit risk adjustment of $9,630. Therefore, as of September 30, 20X1, Company C would report a net derivative liability of $960,851. This equals the present value of the net swap cash flows discounted at a rate excluding counterparty credit risk, $970,481, less the credit risk adjustment of $9,630. The impact of the credit risk adjustment should be included in the change in fair value for the derivative that is recorded in the income statement.

Example FV 8-12 illustrates the impact of using exposure profiles and default probabilities in calculating the credit risk adjustment.
EXAMPLE FV 8-12
Company C holds an interest rate swap with Counterparty S. Under the terms of the swap, Company C is assumed to make equal net payments of 1% annually on a $33,333,333 notional amount. The swap has a three-year remaining term until maturity. The swap meets the definition of a derivative and Company C records it at fair value, with changes recognized in earnings each reporting period. The swap is not subject to a master netting arrangement and no collateral will be posted or received.
As of September 30, 20X1, the cash flows associated with the fair value of the swap, without any adjustment for credit risk, represent cash outflows of $333,333 at the end of each of the following three years, totaling to an expected outflow of $999,999. As the contract is in a liability position, the credit risk adjustment will be primarily based on market participant assumptions about Company C’s risk of default, liquidity of credit, and other factors (i.e., based on the amount market participants would require for assuming this liability in a transfer). Company C assesses the available credit information and determines that market participants would price credit based on Company C’s exposure profile and default probabilities.
The credit risk adjustment using the exposure profile and default probabilities over one-year increments would be calculated as follows.
Year
Expected outflow
Pre-credit-adjusted discount rate (%)
Pre-credit-adjusted discounted value
Exposure
CDS quote (%)
Recovery rate (%)
Term default probability (%)
Default probability (%)
Bucket risk
adjustment
(t)
(a)
(b)
(c)=(a)/
(1+(b))^t
(d)=sum of remaining (c)
(e)
(f)
(g)=1−exp
(−(e)/
(1−(f))×t)
(h)=
change
in (g)
−(d)×(h)×
1−(f))
1
$333,333
1.00
$330,033
970,481
0.38
40
0.63
0.63
$(3,668)
2
$333,333
1.50
$323,554
640,448
0.45
40
1.49
0.86
$(3,305)
3
$333,333
1.70
$316,894
316,894
0.60
40
2.96
1.47
$(2,795)
Total
$970,481
2.96
$(9,768)
(a) Expected outflow is the notional amount times the net payment of 1% annually.
(b) Discount rate is the pre-credit-adjusted rate at the three dates.
(d) Exposure is the present value of all the remaining cash flows as of the measurement date.
(e) Default assumptions for senior unsecured credit. CDS quote can be obtained from a pricing service such as Bloomberg.
(f) Recovery rate is the standard assumption for senior unsecured CDS.
View table
Based on this calculation, Company C would record a credit risk adjustment of $9,768. Therefore, as of September 30, 20X1, Company C would report a net derivative liability of $960,713, equal to the present value of the net swap cash flows discounted at a rate excluding counterparty credit risk, $970,481, less the credit risk adjustment of $9,768. The impact of the credit risk adjustment should be included in the fair value change for the derivative that is recorded in the income statement.

Example FV 8-13 illustrates the impact of collateral when calculating the credit risk adjustment.
EXAMPLE FV 8-13
Impact of collateral calculating the credit risk adjustment.
Company C holds an interest rate swap with Counterparty S. Under the terms of the swap, Company C is assumed to make equal net payments of 1% annually on a $33,333,333 notional amount. The swap has a three-year remaining term until maturity. The swap meets the definition of a derivative and Company C records it at fair value, with changes recognized in earnings each reporting period.
As of September 30, 20X1, the cash flows associated with the fair value of the swap, without any adjustment for credit risk, represent cash outflows of $333,333 at the end of each of the following three years, totaling to an expected outflow of $999,999. As the contract is in a liability position, the credit risk adjustment will be primarily based on market participant assumptions about Company C’s risk of default, liquidity of credit, and other factors (i.e., based on the amount market participants would require for assuming this liability in a transfer). Company C assesses the available credit information and determines that market participants would price credit based on Company C’s exposure profile and default probabilities.
Company C is required to collateralize any exposure above $500,000. The exposure profile with collateral (the red line) and without collateral (the gray line) is depicted in the following graph.
The effect of the collateral requirement is to limit exposure to $500,000 for the first two years.
Taking this into account, how might Company C compute the credit risk adjustment using default probabilities?
Analysis
The credit risk adjustment could be calculated using default probabilities as follows:
Year
Bucket exposure
CDS quote (%)
Recovery rate
(%)
Term default
probability (%)
Bucket default probability (%)
Bucket risk
adjustment
(t)
(a)
(b)
(c)
(d)=1−exp(−(b)/
(1−(c))×t)
(e)=change in (d)
-(a)×(e)×(1−(c))
1
$500,000
0.38%
40%
0.63%
0.63%
$(1,890)
2
$500,000
0.45%
40%
1.49%
0.86%
$(2,580)
3
$316,894
0.60%
40%
2.96%
1.47%
$(2,795)
Total
2.96%
$(7,265)
(a) Bucket exposure is the lower of the bucket exposure from the previous example (in which there was no collateral) and the collateral threshold in this example of $500,000.
(b) CDS quote can be obtained from a pricing service such as Bloomberg. Above are the default assumptions for senior unsecured credit.
(c) Recovery rate is the standard assumption for senior unsecured CDS.
View table

Based on this calculation, Company C should record a credit risk adjustment of $7,265. Therefore, as of September 30, 20X1, Company C would report a net derivative liability of $963,216, equal to the present value of the net swap cash flows discounted at a rate excluding counterparty credit risk, $970,481, less the credit risk adjustment of $7,265. The impact of the credit risk adjustment should be included in the fair value change for the derivative that is recorded in the income statement.
Note: the amounts in this example are displayed rounded to the nearest dollar. As a result, there may be minor differences between the amounts in the examples and the amounts produced by a calculation.

Question FV 8-7
What factors should an entity consider when adding a credit risk adjustment to estimates of fair value provided by third parties (for example, quotes from brokers or pricing services)?
PwC response
The entity will need to establish whether any adjustment for credit risk has already been made by the third party in arriving at the fair value estimate. If no adjustment has been made, the entity will need to adjust the estimate unless it can demonstrate that any adjustment would be immaterial (see Question FV 8-2).
If an adjustment has been made, the entity will need to establish the basis for the entire fair value estimate provided, including the basis for the credit risk adjustment and whether the result of the entity’s analysis reasonably depicts the price at which an orderly transaction would take place between market participants on the measurement date.

8.2.4 Step four: allocate credit risk adjustment to each unit of account

After the reporting entity has determined the appropriate credit risk adjustment, the amount should be appropriately classified and disclosed. This process is relatively straightforward when the unit of measurement for the credit risk adjustment is the same as the unit of account for the overall fair value measurement (such as a standalone derivative contract). In that case, the credit risk adjustment is calculated at an individual transaction level. The credit risk adjustment will be incorporated into the fair value measurement of those instruments on the balance sheet, statement of income (or profit or loss), or other comprehensive income, and in the fair value disclosures. When netting of credit exposures is permitted, such as under an International Swaps and Derivatives Association, Inc. (ISDA) master agreement, the credit risk adjustment is typically calculated on a portfolio basis, including all exposures under the ISDA master agreement, and then allocated to each transaction.
There may be specific challenges in allocating credit risk adjustments among items classified as short-and long-term assets and liabilities, net income (or profit or loss), and other comprehensive income, and among items split in the three-level fair value hierarchy disclosures. In addition, allocation of credit risk adjustments measured at the portfolio level may be required to comply with derivatives disclosure requirements in ASC 815 requires derivatives to be disclosed on a gross, transaction-level basis. Accordingly, the credit risk adjustment may need to be allocated to the individual derivative level for that purpose as well.

8.2.4.1 Allocation methods

There are several acceptable methods for the allocation of portfolio-level credit risk adjustment to individual units of account. Other methods also may be used as long as a reporting entity can support that the method is appropriate in the circumstances. The method selected should be consistently applied and clearly disclosed.
Each of the methods below assumes that the reporting entity calculates a net credit risk adjustment for all derivative positions with a specific counterparty with which the reporting entity has a master netting arrangement.
Relative fair value approach
Under the relative fair value approach, the portfolio level credit risk adjustment is calculated based on the net position with a specific counterparty (i.e., incorporating the netting permitted under a netting arrangement). In practice, we have observed two different methods used to allocate the net adjustment. In one method, a portion of the portfolio level credit risk adjustment is allocated to each individual derivative asset and liability with that counterparty. This approach results in recording the portfolio-level credit risk adjustment to both the individual assets and liabilities, based on the relative fair value of the individual derivative to the net position with the counterparty.
Under another acceptable method, the credit risk adjustment on the net position is allocated to all individual contracts in the same position as the net position based on their relative fair values. For example, if a reporting entity was in a net liability position with a specific counterparty, the credit risk adjustment would only be allocated to the liability positions with that counterparty that are subject to the netting arrangement. Asset positions would not reflect a credit risk adjustment.
Relative credit adjustment approach
Under the relative credit adjustment approach, a portion of the portfolio level credit risk adjustment (calculated on the net position) is allocated to each derivative asset and liability based on the relative credit risk adjustment of each of the derivative instruments in the portfolio. This approach will allocate the portfolio credit risk adjustment to each instrument based on the derivation of a credit risk adjustment for each position on a standalone basis.
In order to apply a relative credit risk adjustment approach, the reporting entity will need to calculate the credit risk adjustment on a net and gross basis (i.e., considering a master netting arrangement in one calculation and ignoring it in another). Both calculations are required because in order to calculate a relative credit risk adjustment basis, a derivative’s individual credit risk adjustment would be compared to the net credit risk adjustment of the portfolio.
Marginal contribution approach
Under the marginal contribution approach, a portion of the portfolio level credit risk adjustment is allocated to each derivative asset and liability based on the marginal amount that each derivative asset or liability contributes to the portfolio level credit risk adjustment.
The marginal approach is a “build-up” methodology. The reporting entity starts with a single position and allocates the net credit risk adjustment. The next position is selected and the next allocation is performed. This process continues on an iterative basis. The allocations may differ based on the order of derivatives an entity selects. This method is not generally used in practice and has not been further illustrated in the examples.

8.2.4.2 Portfolio-level credit risk adjustment

Example FV 8-14 demonstrates the application of the relative fair value credit adjustment approach.
EXAMPLE FV 8-14
Application of the relative fair value credit adjustment approach
Company E holds three derivative positions with Counterparty Q as of the reporting date. The fair values prior to any credit risk adjustment are as follows:
Derivative
Amount
Classification
Derivative 1
$(1,000)
Liability
Derivative 2
1,500
Asset
Derivative 3
(2,000)
Liability
$(1,500)
Net liability

The companies have a master netting arrangement that applies to all three positions. All contracts are due within one year. Based on available CDS information, the risk of default associated with Company E is 10% and Counterparty Q’s risk of default is 5%. As the derivatives are in a net liability position, Company E calculates the credit risk adjustment using its own default risk and determines that a portfolio level credit risk adjustment of $150 is required on the net liability position.
To allocate this adjustment for financial reporting purposes, Company E considers the impact of using two acceptable methods of applying the relative fair value approach. Note that only part of the total allocation is demonstrated for each method and for simplicity purposes, the example assumes a severity rate of 100% (i.e., a 0% recovery).
Under the relative fair value approach, how might Company E allocate the total credit risk adjustment to Derivative 1 in its portfolio?
Analysis
Relative fair value – Method 1: The total credit risk adjustment of $150 is allocated to each of the derivatives in the portfolio, based on the relative value of each derivative to the net position with the counterparty. For example, the allocation to Derivative 1 is calculated as follows:
Derivative 1
$(1,000)
Divided by net position
(1,500)
Allocation percentage
66.66%
Multiplied by total credit risk adjustment
150
Allocated credit risk adjustment
$100

Relative fair value – Method 2: The total credit risk adjustment is allocated to only those derivatives in the same position as the net position based on their relative fair values (in this case, only to the liabilities). For example, the allocation to Derivative 1 is calculated as follows:
Derivative 1
$(1,000)
Divided by total liability position
(3,000)
Allocation percentage
33.33%
Multiplied by total credit risk adjustment
150
Allocated credit risk adjustment
$50

Example FV 8-15 demonstrates application of a relative credit risk adjustment approach.
EXAMPLE FV 8-15
Application of relative credit risk adjustment approach
Company E holds three derivative positions with Counterparty Q as of the reporting date. The fair values prior to any credit risk adjustment are as follows:
Derivative
Amount
Classification
Derivative 1
$(1,000)
Liability
Derivative 2
1,500
Asset
Derivative 3
(2,000)
Liability
$(1,500)
Net liability
The companies have a master netting arrangement that applies to all three positions. All contracts are due within one year. Based on available CDS information, the risk of default associated with Company E is 10% and Counterparty Q’s risk of default is 5%. As the derivatives are in a net liability position, Company E calculates the credit risk adjustment using its own default risk and determines that a portfolio level credit risk adjustment of $150 is required on the net liability position.
To allocate this adjustment for financial reporting purposes, Company E considers the impact of using the relative credit approach. Note that only part of the total allocation is demonstrated for each method and for simplicity purposes, the example assumes a severity rate of 100% (i.e., a 0% recovery). 
Under the relative credit risk adjustment approach, how might Company E allocate the total credit risk adjustment to Derivative 1 in its portfolio?
Analysis
Applying the relative credit risk adjustment, the total credit risk adjustment for each derivative is calculated on a standalone basis. For example, the standalone credit risk adjustment for Derivative 1 is calculated as ($1,000) multiplied by 10% (the risk of default for a liability position), which results in a standalone credit risk adjustment of $100. However, note that the standalone adjustment for Derivative 2 would be calculated by applying the risk of default for Counterparty Q, resulting in a standalone credit risk adjustment of ($75).
The net credit risk adjustment of $150 is allocated to each derivative based on its relative standalone credit adjustment. The allocation to Derivative 1 is calculated as follows:
Derivative 1—Standalone credit risk
$100
Divided by total credit risk adjustment for all derivatives on a stand-alone basis (a)
225
Allocation percentage
44.44%
Multiplied by total credit risk adjustment
150
Allocated credit risk adjustment
$67
(a) Sum of the standalone credit risk adjustments for Derivate 1 ($100), Derivative 2 (-$75), and Derivative 3 ($200).
For comparative purposes, the overall results for each of the methods detailed in Example FV 8-14 and Example FV 8-15 are depicted below:
Relative fair
value —
method 1
Relative fair
value —
method 2
Relative
credit
adjustment
Derivative 1
$ 100
$ 50
$67
Derivative 2
(150)
(50)
Derivative 3
200
100
133
Total adjustment
$ 150
$150
$150
Net asset adjustment
$(150)
$ (50)
Net liability adjustment
$ 300
$150
$200

8.2.4.3 Balance sheet classification

A reporting entity may apply one of the methods above for purposes of determining the credit risk adjustment to individual derivative instruments. However, the method may also need to reflect the fact that the derivative instruments may have short- and long-term components. The presence of collateral will also need to be considered.
Example FV 8-16 demonstrates the allocation of the relative fair value approach between current and long term.
EXAMPLE FV 8-16
Allocation of the relative fair value approach between current and long term
Company E holds three derivative positions with Counterparty Q as of the reporting date. Company E’s derivative positions extend over multiple years. The fair values of these positions prior to any credit risk adjustment are as follows:
Current
Long-term
Total
Derivative 1
$ 500
$(1,500)
$ (1,000)
Derivative 2
1,500
1,500
Derivative 3
(1,000)
(1,000)
(2,000)
Net position
$1,000
$(2,500)
$ (1,500)
Note that the time value of money in the calculation of the credit risk adjustment has been ignored for purposes of this example and credit risk is assumed to be independent of time to simplify the presentation.
The companies have a master netting arrangement that applies to all three positions. Based on available CDS information, the risk of default associated with Company E is 10% and Counterparty Q’s risk of default is 5%. As the derivatives are in a net liability position, Company E calculates the credit risk adjustment using its own default risk and determines that a portfolio level credit risk adjustment of $150 is required on the net liability position. Company E has elected gross presentation of derivative assets and liabilities under ASC 815-10-45 and is required to allocate the adjustment to the individual current and long-term positions following a rational and consistent allocation methodology.
If Company E selects the relative fair value approach—method 1, how might a net adjustment of $100 attributable to Derivative 1 be allocated to its current- and long-term portions?
Analysis
Using the relative fair value approach—method 1, a net adjustment of $100 attributable to Derivative 1 could be allocated to the current- and long-term portions as follows:
Derivative 1 – current position
$500
Divided by net position
(1,500)
Allocation percentage
(33.33)%
Multiplied by total credit adjustment
150
Allocated credit adjustment
$(50)
Derivative 1 – long-term
$(1,500)
Divided by net position
(1,500)
Allocation percentage
100%
Multiplied by total credit adjustment
150
Allocated credit adjustment
$150
The overall result for each of the positions applying this methodology is as follows:
Current
Long-term
Total
Derivative 1
$ (50)
$150
$ 100
Derivative 2
(150)
(150)
Derivative 3
100
100
200
Total adjustment
$(100)
$250
$ 150
Net asset adjustment
$(200)
$(200)
Net liability adjustment
$ 100
$250
$ 350
Even though these calculations may become very complicated in the case of a large portfolio with multiple agreements, we believe that allocation to the individual derivatives (or a methodology that materially approximates such allocation) is necessary to comply with the reporting requirements of ASC 820 and ASC 815.

8.2.4.4 Allocation between the income statement and OCI

In some cases, a reporting entity will have derivatives designated in cash flow hedging relationships and derivatives reported at fair value through the income statement with the same counterparty. The methodologies outlined above should also be applied in determining the appropriate allocation of the adjustment between net income and other comprehensive income.
1(1 × $1,000,000)
2(20 × $17,500)
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