IASB and FASB issue proposals to address single largest balance sheet difference

Published on 08 February 2011 2 comments

The IASB and FASB have issued proposals that would eliminate the single largest balance sheet difference between the two accounting frameworks today.

IFRS preparers’ ability to ‘net’ or offset certain financial assets and liabilities can create trillion dollar differences on the balance sheet compared with entities reporting under US GAAP.

So, although there would be little change for entities reporting under IFRS, it would have a major impact on US GAAP preparers, particularly financial institutions. 

Under current US GAAP, an entity can elect gross or net presentation for derivatives and collateral subject to master netting agreements. The ability to elect net presentation under US GAAP is an ‘exception’ to the existing offsetting criteria. The proposals would eliminate this exception, as they require offset only when net cash flows, rather than gross, are exchanged between a financial asset and liability. This is not the case for derivatives, where cash flows actually are exchanged gross.  This is because the master netting agreement only allows net cash flows in the event of default of one of the counterparties rather than in the normal course of business.

There is no consensus among users on the usefulness of presenting gross or net information about financial assets and liabilities on the face of the balance sheet.  Whichever basis is used on the balance sheet however, most users say they would like the data on the other basis in the notes. So what do you think should be presented on the face of the balance sheet? Does it matter if the information on both bases is available?

The International Swaps and Derivatives Association (ISDA) believes the proposal to report derivatives on a gross basis rather than net on the balance sheet is ‘counterintuitive, may lead to complexity in practice and can obscure the real position of the entity’.  It goes on to say that it is likely to be ‘misleading when presenting the leverage, credit risk and liquidity risk position of an institution. Misperceptions regarding the risk exposure of derivatives users may impede the ability of corporations, government entities and financial institutions to effectively manage the business and financial risks to which they are exposed.’

The boards say that the presentation of gross amounts of assets and liabilities generally provides more relevant information than a net presentation. In particular, they believe the gross amounts of derivative assets and liabilities are more relevant to users of financial statements than net amounts for assessing the liquidity or solvency of an entity. A derivative can generally be settled or sold at any time for an amount equal to its fair value.  So the boards believe that gross amounts generally provide better information about the entity’s derivatives portfolio and its exposure to risk.

There is likely to be a fierce debate on this topic. While the boards’ arguments appear sensible for non-financial companies, the ISDA has a point that gross numbers may give a misleading picture of the amount of leverage in a financial institution. Whose view do you support? 

Regardless of views on this issue, all entities that have derivatives subject to master netting agreements will be required to provide gross and net information in the notes to meet the user request for, t both gross and net information..  So even though this ED does not propose a change for the balance sheet under IFRS, entities will still need to obtain the information to be disclosed in the notes.

I’d be interested as ever to hear your thoughts.

John


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Comments (2)

IVAN GRIXTI commented:

This is definitely another step forward in the right direction. Netting off can also show significant movements in the calculation of ratios, eg neeting off cash in hand and at bank with a bank overdraft can significantly change the current asset ratio calculation. Hence, removing all possibilities of netting off will improve an interested user's analytical analysis of a set of financial statements.

John H commented:

Thanks for offering your views. I agree that netting off can make a huge difference to the calculation of some ratios. Interestingly, most users do not appear to mind either presentation providing both bases are disclosed in the notes but some users, particularly in the US, are fiercely opposed to the change in presentation. As an example of what it would mean to them, if the big five US banks have to gross up their derivative positions this would add some $7 trillion to their balance sheet totals.

John Hitchins

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