Disclosures about offsetting assets and liabilities
INSIGHT ARTICLE |
As we approach year end, with preparations underway for annual reporting requirements, it is important to keep in mind that significant new disclosure requirements related to certain financial instruments are in effect for annual reporting periods beginning on or after January 1, 2013, and require retrospective adoption for all periods presented. Public companies began reflecting these new disclosures in interim financial statements beginning with the first quarter of 2013. Entities are required to disclose information about certain financial instruments and transactions that are either eligible for offset in accordance with U.S. generally accepted accounting principles (GAAP) or subject to an enforceable master netting arrangement or similar agreement. Instruments included in the scope of the new requirements are derivatives (i.e., futures and swaps), sale and repurchase agreements and reverse sale and repurchase agreements and securities borrowing and lending arrangements. Typical entities that are most impacted are financial institutions, broker-dealers and investment companies; however, any entities that have a significant amount of these types of instruments outstanding over reporting period ends can be impacted.
The new requirements were contained in Accounting Standards Update (ASU) 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, which was released in December 2011 by the Financial Accounting Standards Board (FASB), and subsequently amended by the January 2013 issuance of ASU 2013-1, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, herein referred to collectively as “the standard.” The standard is the outcome of a convergence project to resolve differences between U.S. GAAP and International Financial Reporting Standards (IFRS), which resulted in the issuance of similar new disclosure requirements by the International Accounting Standards Board (IASB) through amendments to International Accounting Standard 32, Financial Instruments: Presentation. Currently, IFRS does not allow for offsetting of certain balance sheet items that U.S. GAAP does permit. The difference in presentation has been a concern for those comparing financial statements between entities presenting under U.S. GAAP and those presenting under IFRS. The standard does not go as far as to call for convergence with regards to what instruments can be offset, which was initially the goal of the convergence project. Instead, more permissive offsetting will remain under U.S. GAAP, but the FASB and IASB are jointly requiring disclosure information pertaining to gross and net presentation that will help users of the financial statements to better understand the impact of offsetting and facilitate meaningful comparisons.
It is important that management of entities that hold instruments that are potentially within the scope of the standard understand the new disclosure requirements, and take the time to consider the impact on their financial statements. The new disclosures will require careful consideration, and potentially an in-depth review, of existing contractual arrangements to determine which instruments are subject to the requirements.
What is within the scope of the standard?
As background information, certain criteria must be met for a reporting entity to be able to elect to present financial instruments that are in an asset position net with financial instruments in a liability position. This is relevant, for example, in determining if multiple derivatives with the same counterparty, some of which are in an asset position and some of which are in a liability position, can be reported net on the statement of financial position. FASB Accounting Standards Codification (ASC) 815-10-45 and ASC 210-20-45 are the relevant sections of the ASC that outline the criteria. For example, ASC 210-20-45-1 states that a right of offset exists when all of the following conditions are met:
- Each of two parties owes the other determinable amounts
- The reporting party has the right to offset the amount owed with the amount owed by the other party
- The reporting party intends to offset1
- The right of offset is enforceable at law
While the criteria that establish what can be offset have not changed, the new disclosure requirements apply to all recognized derivative instruments, bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either: (a) offset in accordance with the above mentioned guidance, or (b) subject to an enforceable master netting arrangement or similar agreement. As such, it is important for management to review agreements pertinent to these types of instruments and the reporting entity’s preestablished offsetting policies to understand if they have instruments and transactions that meet the above criteria, and will be subject to the new disclosure requirements. Unfortunately, the terms “master netting arrangement” and “similar agreement” were not defined in the standard. ASC 815-10-45-5 notes the following:
A master netting arrangement exists if the reporting entity has multiple contracts, whether for the same type of derivative instrument or for different types of derivative instruments, with a single counterparty that are subject to a contractual agreement that provides for the net settlement of all contracts through a single payment in a single currency in the event of default on or termination of any one contract.
Determining what agreements constitute or are similar to an enforceable master netting arrangement could be a time-consuming process that may necessitate involvement by legal counsel to consider issues such as whether the netting provisions apply to both parties and are enforceable. Different conclusions can be reached in different legal jurisdictions.
What are the new disclosure requirements?
The objective of the new disclosure requirements is to enable financial statement users to evaluate the effect or potential effect of netting arrangements on the reporting entity’s financial position. To meet this objective, ASC 210-20-50-3 requires reporting entities to separately disclose the following quantitative information at the end of the reporting period for assets and liabilities that are within the scope of the standard:
a. The gross amounts of those recognized assets and those recognized liabilities
b. The amounts offset in accordance with the guidance in Sections 210-20-45 and 815-10-45 to determine the net amounts presented in the statement of financial position
c. The net amounts presented in the statement of financial position
d. The amounts subject to an enforceable master netting arrangement or similar agreement not otherwise included in (b):
1. The amounts related to recognized financial instruments and other derivative instruments that either:
i. Management makes an accounting policy election not to offset.
ii. Do not meet some or all of the guidance in either Section 210-20-45 or Section 815-10-45.
2. The amounts related to financial collateral (including cash collateral).
e. The net amount after deducting the amounts in (d) from the amounts in (c).
In developing these quantitative disclosures, the following points should be kept in mind:
- The amounts of both assets and liabilities subject to set-off under the same arrangement will be disclosed in the respective tables; however, the amounts included in the tables are limited to the amount that is subject to set-off. In other words, if the gross amount of the asset is larger than the gross amount of the liability with which it is offset, the asset disclosure table will include the entire amount of the asset and the entire amount of the liability. However, the liability disclosures table will include the entire amount of the liability, but it will only include the amount of the asset equal to the amount of the liability.
- There are limits on the inclusion of excess collateral in the disclosed amounts, unless the rights to collateral can be enforced across financial instruments.
- The disclosures may be grouped by type of instrument or transaction (e.g., derivatives, repurchase and reverse agreements and securities borrowing and lending agreements), or for items (c) through (e) above, by counterparty. Counterparties are not required to be identified specifically by name; however, generic designations of the counterparties (Counterparty A, Counterparty B, Counterparty C, and so forth) should remain consistent from year to year to maintain comparability, and qualitative disclosures should be considered to give further information about the types of counterparties. If a reporting entity elects to disclose balances by counterparty, individually significant counterparties should be disclosed separately, with remaining insignificant counterparties aggregated into one line item.
- Reporting entities can elect to include derivatives, repurchase and reverse repurchase agreements and securities borrowing and lending transactions in the above quantitative disclosure that are not required to be included to facilitate the reconciliation of amounts presented in accordance with (c) above to the statement of financial position.
In addition to these quantitative disclosures, certain qualitative disclosures are required, including the following:
- Description of the types of rights of set-off associated with master netting arrangements and similar agreements referred to in (d) above, such as conditional rights of set-off
- Description of the terms of collateral agreements for any financial collateral received or pledged (e.g., when the collateral is restricted)
The specific disclosure requirements outlined in the standard are referred to as minimum requirements that reporting entities should supplement as necessary with additional qualitative disclosures to fulfill the objective of the standard; namely, to clearly explain the nature of rights of set-off and related arrangements, and their effect on the entity’s assets and liabilities and its financial position. Additionally, determining how to aggregate information for the quantitative disclosures entails striking the appropriate balance between obscuring important information due to excessive aggregation and obscuring important information due to excessive detail.
What can financial reporting management do to prepare?
If you find yourself approaching year end without a clear implementation plan in mind, the following suggestions may be useful in helping you prepare:
- Given the time commitment that may be involved in determining what instruments will be within the scope of the standard, particularly as it relates to the determination of what agreements constitute or are similar to an enforceable master netting arrangement, management should get the process underway of carefully reading and evaluating agreements, such as the following:
- International Swaps and Derivative Association (ISDA) agreements2
- Derivative clearing agreements
- Global master repurchase agreements
- Global master securities lending agreements
- Determine the most appropriate format for displaying your quantitative offsetting disclosures (by instrument or counterparty)
- Decide if you will incorporate the new disclosures into existing derivative or other disclosures where feasible, keeping in mind that tabular presentation is required, unless another format is more appropriate, and that if the new disclosures are contained in more than one note, it is necessary to cross-reference between the notes
- Determine the appropriate level of aggregation by instrument type or counterparty
- Consider the appropriate description of offsetting arrangements to meet the qualitative disclosure requirements
- Consider reviewing the quarterly filings of public companies in 2013 for examples of how industry participants are meeting the disclosure requirements
- Start the process now by preparing the disclosures and incorporating actual amounts for the comparative period(s) that will need to be included
The following are example quantitative disclosures contained within ASC 210-20-55. Example 1 is by type of instrument and is excerpted from ASC 210-20-55-20, and Example 2 demonstrates the aggregation of amounts in columns (iii) through (v) by counterparty and is excerpted from ASC 210-20-55-22.
A similar table for financial liabilities and derivative liabilities would also be presented.
A similar table for financial liabilities, derivative liabilities and collateral pledged would also be presented.
- This criterion is not relevant for derivative instruments executed with the same counterparty under a master netting arrangement per ASC 815-10-45-5.
- The prevalent view appears to be that standard ISDA agreements constitute enforceable master netting arrangements.
The FASB material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, and is reproduced with permission.