Wednesday, May 12, 2010

"Own Credit" Liability Rules Explained

What is the own credit issue?

The accounting effect of changes in the credit risk of a financial liability is referred to “own credit”.

Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognized in the P&L.

Many investors find this result counter-intuitive and confusing.

This was confirmed in responses to the IASB’s June 2009 discussion paper Credit Risk in Liability Measurement and in the user questionnaire on own credit that the IASB issued as part of its outreach activities.

The IASB undertook outreach on the issue of own credit in preparation for the publication of this ED, including discussions with preparers, audit firms, regulators and investors.

What did investors tell the IASB?--Extensive input was obtained from investors, including a questionnaire to which there were more than 90 responses. Whilst there was a range of responses, in general investors confirmed that:
  • P&L volatility caused by own credit does not provide useful information (except for derivatives and liabilities held for trading);
  • they did not want us to develop a new measurement method; but • information on the effects of own credit can still be useful.

In response to the input received, the ED proposes a limited change that addresses the issue of own credit for financial liabilities that an entity chooses to measure at fair value by introducing a two-step approach.

The two-step approach proposed in the ED would address the P&L volatility arising from own credit as follows:
• the fair value change of liabilities under the FVO would be recognized in P&L;
• the portion of the fair value change due to own credit would be reversed out of P&L and recognized in other comprehensive income.

Current Requirement
Income statement (P&L)

Liabilities under fair value option
100 total change in fair value

100 Profit for the year
===================

Proposed Two-Step Approach
Income statement (P&L)
Liabilities under fair value option
100 Step 1 – Total change in fair value
(10) Step 2 – Change in fair value from own credit
90 Profit for the year

===================

Statement of comprehensive income
Liabilities under fair value option
10 Step 2 – Change in fair value from own credit

===================

No other changes are proposed for financial liabilities.

The current requirements for the measurement of financial liabilities would not be changed in any other way.

Importantly, the current requirements to split structured debt into a ‘vanilla’ instrument measured at amortized cost and a derivative component measured at fair value (bifurcation) would remain. As a result, those who prefer to bifurcate financial liabilities when relevant could continue to do so.

P&L volatility will no longer result from changes in own credit while information on own credit will still be available for investors.

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