The Financial Accounting Standards Board (FASB) recently issued guidance clarifying which types of transactions will be subject to enhanced disclosure requirements for companies that offset assets and liabilities on their financial statements. The guidance, found in Accounting Standards Update (ASU) 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, narrows the scope of offsets that will require balance sheet disclosures and should alleviate concerns raised after FASB issued the requirements in late 2011.
For some years now, FASB has been working with the International Accounting Standards Board (IASB) to converge US Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards (IFRS). As part of this project, the two bodies proposed new criteria for offsetting that were more limited than the existing GAAP criteria.
Offsetting is the practice of using a net amount for an asset and a liability to show a single amount on the balance sheet, rather than showing separate gross figures for both the asset and the liability. GAAP permits offsetting for derivatives that are subject to legally enforceable netting arrangements with the same party, even if the offset rights are available only in the event of default or bankruptcy.
For example, a company might have a derivative asset with a fair value of $200 million and a derivative liability with a fair value of $150 million, both with the same party. If the criteria are met, the company can offset the derivative liability against the derivative asset in its balance sheet, resulting in the presentation of only a net derivative asset of $50 million.
IFRS doesn’t allow the offset of derivatives. As a result, the assets and liabilities would appear smaller on balance sheets prepared under GAAP than on balance sheets prepared under IFRS. The disparity makes it difficult to compare balance sheets that aren’t prepared under the same standards.
Initial disclosure requirements
After receiving feedback on their proposed criteria for a single offsetting model, FASB and IASB opted to retain their separate existing models. They did, however, agree on new joint disclosure requirements, which FASB released in December 2011 in ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. That guidance requires enhanced disclosures about financial instruments and derivative instruments that are either offset on the balance sheet in accordance with Accounting Standards Codification (ASC) Section 210-20-45 or ASC Section 815-10-45, or subject to an enforceable master netting arrangement or similar agreement.
A master netting arrangement consolidates individual contracts into a single agreement between two counterparties. If one party defaults on a contract included in the arrangement, the other can terminate the entire arrangement and demand the net settlement of all contracts. The disclosures are intended to allow financial statement users to evaluate the effect or potential effect of netting arrangements on the company’s financial position.
Under the guidance, the rules apply to derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and lending agreements. Companies must disclose the gross amounts subject to offset rights, amounts that have been offset and the related net credit exposure. Companies are also required to disclose expanded information about the collateral pledged in netting arrangements and a description of the offset rights associated with covered assets and liabilities subject to netting arrangements.
When companies began preparing financial statements in anticipation of the new requirements, they raised concerns with FASB about the standard’s broad definition of financial instruments. In particular, they noted that many contracts include standard commercial provisions allowing either party "to net" in the event of default, similar to an enforceable master netting arrangement. These provisions are seen as a credit enhancement, not as a primary source of credit mitigation.
Manufacturing companies, for example, often have netting arrangements with their customers for product and supply purchases. If such contracts were included within the scope of the new requirements, companies would need to engage in a comprehensive review of all of their contracts to determine whether each one contained such provisions and therefore required enhanced disclosures. This would substantially increase compliance costs, with minimal value provided to financial statement users.
In response to the feedback, FASB issued the new guidance found in ASU 2013-01. This guidance specifically limits application of the earlier guidance to the following instruments that are the most likely to result in significant differences in presentation under GAAP vs. IFRS:
- Derivatives (including bifurcated embedded derivatives) accounted for under provisions of ASC Topic 815, Derivatives and Hedging,
- Repurchase agreements and reverse repurchase agreements, and
- Securities borrowing and lending transactions.
If these instruments are subject to an enforceable master netting arrangement or similar agreement, the enhanced disclosures are required regardless of whether they’re actually offset on the balance sheet.
The guidance in ASU 2013-01 makes clear that the guidance in ASU 2011-01 doesn’t apply to unsettled regular-way trades (trades that are settled within the normal settlement cycle for that type of trade), or ordinary trade payables or receivables.
The ASU 2013-01 guidance also gives companies the option of including in their disclosures all other recognized derivatives, repurchase and reverse repurchase agreements, and securities borrowing and lending transactions to facilitate reconciliation to line items in the balance sheet.
Notably, the IASB hasn’t issued similar clarifying guidance to its disclosure requirements. Thus, absent amendment to IFRS, fewer financial instruments will be subject to enhanced disclosure under GAAP than under IFRS.
Effective date unchanged
The guidance in ASU 2013-01 makes no change to the effective date specified in the ASU 2011-11 guidance. Companies must apply the new disclosure requirements for annual reporting periods beginning on and after January 1, 2013, and interim periods within those annual periods. The required disclosures should be provided retrospectively for all comparative periods presented on a balance sheet.
If you have questions about whether the new requirements affect you or how to comply with them, contact your accounting advisor.