By Jamil Khatri, Akeel Master, Chartered Accountants
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Since the start of the global financial crisis in 2008, the credit risk of counter parties has become increasingly important. Globally, the financial environment has been very volatile and has created a lot of uncertainty in the minds of stakeholders as well as prospective investors.
Volatility in credit worthiness of entities, not only has a significant impact on the business of these entities (ability to raise funds and capital at attractive rates), but has also resulted in a unique accounting implications.
This implication arises from provisions relating to gains/ losses due to ‘changes in fair value of financial liability due to changes in ‘own’ credit risk’ in certain cases.
The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board’s (FASB) inclusion of own credit risk in liability measurement has proved controversial over the years. Several media articles have focused on the fact that due to EU accounting rules, banks may have systematically overstated their net assets and distributed non-existent profits as dividends and bonuses.
Let us take an example to understand how change in own credit risk, results in reflecting a better performance and increases the net assets for entities.
Balance sheet for Bank XYZ
*Measured at fair value through profit or loss account Keeping all other external parameters constant, if the creditworthiness of Bank XYZ decreases, it will result in an increase in its credit spreads (as the cost of funds for a more risky instrument will be higher). This in turn will result in a reduction in the fair value of the underlying instruments issued by the Bank. The revised balance sheet of XYZ may be as under (fair value is presumed to be Rs 800)
Balance sheet for Bank XYZ (Rs)
This reduction in the financial liability by Rs 200 is recorded as a gain in the income statement and has a favourable impact on reported PAT and EPS of the Bank.
Relevant accounting literature under IFRS supporting the aforesaid accounting treatment
IAS 39 “Financial Instruments: Recognition and Measurement” permits an entity to classify any financial liability into the category of “Fair value through profit or loss (FVTPL)” when:
• It is acquired or incurred principally for the purpose of selling or repurchasing it in the near term
• Part of a portfolio managed together and evident by recent pattern of short term profit taking
• It contains more than one embedded derivatives.
Generally derivative liabilities, structured financial products etc are recognised by entities at fair value.
IAS 39 requires an entity to reflect credit quality in determining the fair value of financial instruments and related changes in fair value are accounted in the profit and loss account.
Impact on results
During 2011, a number of international banks reported positive earnings in spite of increasing credit spreads i.e., declining credit worthiness. This outcome was due to own-credit-risk adjustments allowed in terms of IAS 39 (referred above) and similar guidance under US GAAP laid down in FASB Standard No. 159 “Fair Value Option for Financial Assets and Financial Liabilities”. Own-credit risk adjustments can result in unrealised losses as well when banks’ creditworthiness improves.
Below is a summary of the impact, this provision had on the performance results of a few large banks
One can logically argue that it is misleading for an entity to report a gain on its liabilities as a direct result of its own creditworthiness deteriorating, particularly as the entity would not be able to realise this gain unless it repurchases its debt at current market prices. However, there is another view in support of fair valuation, which is based on the principle of “increase in shareholder value”. As per this view increase in shareholder value resulting from a credit downgrade is based on differing contractual claims of shareholders and bondholders. Under this approach wealth is transferred from the existing bondholders, who have already committed to a lower interest rate and thus bear the risk of changes in interest rates, to the shareholders. If bondholders had waited to purchase the obligations they may well have received a higher interest rate. Thus, the gain is attributable to the lower interest rate that the entity enjoys in the current period as compared to the market interest rate (for another entity with the present (deteriorated) credit rating).
In India, The Ministry of Corporate Affair (MCA) has issued accounting standards which are aligned to IFRS (known as “Ind AS’), to be notified at a future date. Ind AS 39 “Financial Instruments: Recognition and Measurement” prescribes that in determining fair value of a financial liability, which on initial recognition is designated at fair value through profit or loss, any change in fair value consequent to changes in the company’s own credit risk should be ignored. This was a concious difference from IFRS incorporated under Ind AS. This difference was because Indian standard setters were not comfortable with companies recognising ‘gains’ in the financial statements just because their credit worthiness has deteriorated.
Even Basel III rules, require banks to “derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.” This rule ensures that an increase in credit risk of a bank does not lead to a reduction in the value of its liabilities, and thereby an increase in its common equity.
Given the ongoing volatility in the economic environment, this is an area which needs to be closely monitored, particularly due to the implications on reported financial performance and capital adequacy considerations.
