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Liabilities Designated as at Fair Value Through Surplus or Deficit
AG228. When an entity designates a financial liability as at fair value through surplus or deficit, it must determine whether presenting in other comprehensive revenue and expense the effects of changes in the liability’s credit risk would create or enlarge an accounting mismatch in surplus or deficit. An accounting mismatch would be created or enlarged if presenting the effects of changes in the liability’s credit risk in other comprehensive revenue and expense would result in a greater mismatch in surplus or deficit than if those amounts were presented in surplus or deficit.
AG229. To make that determination, an entity must assess whether it expects that the effects of changes in the liability’s credit risk will be offset in surplus or deficit by a change in the fair value of another financial instrument measured at fair value through surplus or deficit. Such an expectation must be based on an economic relationship between the characteristics of the liability and the characteristics of the other financial instrument.
AG230. That determination is made at initial recognition and is not reassessed. For practical purposes the entity need not enter into all of the assets and liabilities giving rise to an accounting mismatch at exactly the same time. A reasonable delay is permitted provided that any remaining transactions are expected to occur. An entity must apply consistently its methodology for determining whether presenting in other comprehensive revenue and expense the effects of changes in the liability’s credit risk would create or enlarge an accounting mismatch in surplus or deficit. However, an entity may use different methodologies when there are different economic relationships between the characteristics of the liabilities designated as at fair value through surplus or deficit and the characteristics of the other financial instruments. PBE IPSAS 30 Financial Instruments: Disclosures requires an entity to provide qualitative disclosures in the notes to the financial statements about its methodology for making that determination.
AG231. If such a mismatch would be created or enlarged, the entity is required to present all changes in fair value (including the effects of changes in the credit risk of the liability) in surplus or deficit. If such a mismatch would not be created or enlarged, the entity is required to present the effects of changes in the liability’s credit risk in other comprehensive revenue and expense.
AG232. Amounts presented in other comprehensive revenue and expense shall not be subsequently transferred to surplus or deficit. However, the entity may transfer the cumulative gain or loss within net assets/equity.
AG233. The following example describes a situation in which an accounting mismatch would be created in surplus or deficit if the effects of changes in the credit risk of the liability were presented in other comprehensive revenue and expense. A Mortgage and Housing Corporation provides loans to customers and funds those loans by selling bonds with matching characteristics (e.g., amount outstanding, repayment profile, term and currency) in the market. The contractual terms of the loan permit the mortgage customer to prepay its loan (i.e., satisfy its obligation to the bank) by buying the corresponding bond at fair value in the market and delivering that bond to the Mortgage and Housing Corporation. As a result of that contractual prepayment right, if the credit quality of the bond worsens (and, thus, the fair value of the Mortgage and Housing Corporation’s liability decreases), the fair value of the Mortgage and Housing Corporation’s loan asset also decreases. The change in the fair value of the asset reflects the mortgage customer’s contractual right to prepay the mortgage loan by buying the underlying bond at fair value (which, in this example, has decreased) and delivering the bond to the Mortgage and Housing Corporation. Consequently, the effects of changes in the credit risk of the liability (the bond) will be offset in surplus or deficit by a corresponding change in the fair value of a financial asset (the loan). If the effects of changes in the liability’s credit risk were presented in other comprehensive revenue and expense there would be an accounting mismatch in surplus or deficit. Consequently, the Mortgage and Housing Corporation is required to present all changes in fair value of the liability (including the effects of changes in the liability’s credit risk) in surplus or deficit.
AG234. In the example in paragraph AG233, there is a contractual linkage between the effects of changes in the credit risk of the liability and changes in the fair value of the financial asset (i.e., as a result of the mortgage customer’s contractual right to prepay the loan by buying the bond at fair value and delivering the bond to the Mortgage and Housing Corporation). However, an accounting mismatch may also occur in the absence of a contractual linkage.
AG235. For the purposes of applying the requirements in paragraphs 108 and 109, an accounting mismatch is not caused solely by the measurement method that an entity uses to determine the effects of changes in a liability’s credit risk. An accounting mismatch in surplus or deficit would arise only when the effects of changes in the liability’s credit risk (as defined in PBE IPSAS 30) are expected to be offset by changes in the fair value of another financial instrument. A mismatch that arises solely as a result of the measurement method (i.e., because an entity does not isolate changes in a liability’s credit risk from some other changes in its fair value) does not affect the determination required by paragraphs 108 and
109. For example, an entity may not isolate changes in a liability’s credit risk from changes in liquidity risk. If the entity presents the combined effect of both factors in other comprehensive revenue and expense, a mismatch may occur because changes in liquidity risk may be included in the fair value measurement of the entity’s financial assets and the entire fair value change of those assets is presented in surplus or deficit. However, such a mismatch is caused by measurement imprecision, not the offsetting relationship described in paragraph AG229 and, therefore, does not affect the determination required by paragraphs 108 and 109.
AG236. PBE IPSAS 30 defines credit risk as ‘the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation’. The requirement in paragraph 108(a) relates to the risk that the issuer will fail to perform on that particular liability. It does not necessarily relate to the creditworthiness of the issuer. For example, if an entity issues a collateralised liability and a non-collateralised liability that are otherwise identical, the credit risk of those two liabilities will be different, even though they are issued by the same entity. The credit risk on the collateralised liability will be less than the credit risk of the non-collateralised liability. The credit risk for a collateralised liability may be close to zero.
AG237. For the purposes of applying the requirement in paragraph 108(a), credit risk is different from asset- specific performance risk. Asset-specific performance risk is not related to the risk that an entity will fail to discharge a particular obligation but instead it is related to the risk that a single asset or a group of assets will perform poorly (or not at all).
AG238. The following are examples of asset-specific performance risk:
(a) A liability with a unit-linking feature whereby the amount due to investors is contractually determined on the basis of the performance of specified assets. The effect of that unit-linking feature on the fair value of the liability is asset-specific performance risk, not credit risk.
(b) A liability issued by a structured entity with the following characteristics. The entity is legally isolated so the assets in the entity are ring-fenced solely for the benefit of its investors, even in the event of bankruptcy. The entity enters into no other transactions and the assets in the entity cannot be hypothecated. Amounts are due to the entity’s investors only if the ring-fenced assets generate cash flows. Thus, changes in the fair value of the liability primarily reflect changes in the fair value of the assets. The effect of the performance of the assets on the fair value of the liability is asset-specific performance risk, not credit risk.
AG239. For the purposes of applying the requirement in paragraph 108(a), an entity shall determine the amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability either:
(a) As the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk (see paragraphs AG240 and AG241); or
(b) Using an alternative method the entity believes more faithfully represents the amount of change in the liability’s fair value that is attributable to changes in its credit risk.
AG240. Changes in market conditions that give rise to market risk include changes in a benchmark interest rate, the price of another entity’s financial instrument, a commodity price, a foreign exchange rate or an index of prices or rates.
AG241. If the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, the amount in paragraph AG239(a) can be estimated as follows:
(a) First, the entity computes the liability’s internal rate of return at the start of the period using the fair value of the liability and the liability’s contractual cash flows at the start of the period. It deducts from this rate of return the observed (benchmark) interest rate at the start of the period, to arrive at an instrument-specific component of the internal rate of return.
(b) Next, the entity calculates the present value of the cash flows associated with the liability using the liability’s contractual cash flows at the end of the period and a discount rate equal to the sum of (i) the observed (benchmark) interest rate at the end of the period and (ii) the instrument- specific component of the internal rate of return as determined in (a).
(c) The difference between the fair value of the liability at the end of the period and the amount determined in (b) is the change in fair value that is not attributable to changes in the observed (benchmark) interest rate. This is the amount to be presented in other comprehensive revenue and expense in accordance with paragraph 108(a).
AG242. The example in paragraph AG241 assumes that changes in fair value arising from factors other than changes in the instrument’s credit risk or changes in observed (benchmark) interest rates are not significant. This method would not be appropriate if changes in fair value arising from other factors are significant. In those cases, an entity is required to use an alternative method that more faithfully measures the effects of changes in the liability’s credit risk (see paragraph AG239(b)). For example, if the instrument in the example contains an embedded derivative, the change in fair value of the embedded derivative is excluded in determining the amount to be presented in other comprehensive revenue and expense in accordance with paragraph 108(a).
AG243. As with all fair value measurements, an entity’s measurement method for determining the portion of the change in the liability’s fair value that is attributable to changes in its credit risk must make maximum use of relevant observable inputs and minimum use of unobservable inputs.
AG244. Derivatives that are embedded in hybrid contracts, but that are not separately accounted for, cannot be
designated as separate hedging instruments.
AG245. An entity’s own equity instruments are not financial assets or financial liabilities of the entity and therefore cannot be designated as hedging instruments.
AG246. For hedges of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument is determined in accordance with PBE IPSAS 4.
AG247. This Standard does not restrict the circumstances in which a derivative that is measured at fair value through surplus or deficit may be designated as a hedging instrument, except for some written options. A written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument (for example, a written call option used to hedge a callable liability).