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Asset and liability offsetting

Date recorded:

Clarifying amendments to IAS 32

At the July 2011 IASB-only meeting, the Board decided not to proceed with finalising the proposals in the offsetting exposure draft and retain the existing offsetting guidance in IAS 32 Financial Instruments: Presentation. However, the Board asked the staff to explore ways to address the areas of diversity in practice identified during the offsetting project. Those areas of diversity primarily focused around:

  1. the meaning of 'currently has a legally enforceable right of set-off'
  2. the application of the simultaneous settlement criterion
  3. the treatment of collateral and margin
  4. issues around unit of account.

 

Meaning of 'currently has a legally enforceable right of set-off'

IAS 32 does not provide specific guidance as to the meaning of currently having a legally enforceable right of set-off. The offsetting exposure draft instead proposed that an entity have an unconditional and legally enforceable right to set off in order to qualify for offsetting. The exposure draft states that an unconditional right of set-off is one in which the exercisability is not contingent on the occurrence of a future event while a legally enforceable right of set-off is enforceable in all circumstances (both in normal course of business and on default, insolvency or bankruptcy of one of the counterparties).

The staff asserted during the meeting that the exposure draft proposals were not intended to change practice for IFRS preparers but highlighted inconsistencies in the interpretation of the word 'currently' in IAS 32. The staff believe that while IAS 32 does not specifically refer to an 'unconditional right', if a right of set-off were contingent or conditional on a future event then an entity would not currently have a legally enforceable right.

The exposure draft also specified that the right of set-off should be in all circumstances. However, current practice has often interpreted the term 'currently' to mean a right exercisable under current conditions (or in the normal course of business). The staff highlighted that the IAS 32 criterion does not refer to a currently enforceable right but rather to rights the entity currently has. To avoid inconsistent application, the staff believes the Board should clarify in IAS 32 that the right of set-off must be legally enforceable both in the normal course of business and in the event of default, bankruptcy and insolvency.

The exposure draft also stated that the right of set-off be enforceable on default, insolvency or bankruptcy of one of the counterparties. Some felt that this changed IAS 32 because they felt only the default, insolvency or bankruptcy of the counterparty should be considered rather than the reporting entity itself as doing so is inconsistent with a going concern basis of the financial statements. However, the staff believe that such an argument is would be inconsistent with the principles and objectives in both the exposure draft and IAS 32.

One of the IASB members had concerns with the staff view that the right of set-off be enforceable in all circumstances by one of the counterparties as they felt that a going concern basis is used in other areas of accounting and therefore this approach would be inconsistent. Another of the IASB members had issues with the staff not recommending any changes to the 'currently' guidance in IAS 32 and would prefer incorporation of the term 'unconditional' as used in the exposure draft.

The Board tentatively decided to not to add further clarification or application guidance with respect to the use of the word 'currently' in 'currently has a legally enforceable right of set-off'. However, the Board will include application guidance to confirm that a right of set-off should be legally enforceable both in the normal course of business and in the event of default, bankruptcy and insolvency of one of the counterparties.

Simultaneous settlement

IAS 32 requires that an entity must intend to settle on a net basis or realise the asset and settle the liability simultaneously in order to set-off financial assets and financial liabilities. The exposure draft also utilised the term simultaneous settlement and defined the term as when 'settlements take place at the same moment (ie there is exposure to only the net or reduced amount). Many respondents to the exposure draft asserted that simultaneous settlement is currently interpreted in various manners but a requirement of 'at the same moment' would be inconsistent with settlement practices. For example, many have taken a view under IAS 32 that settlement through a clearing house would always meet the simultaneous settlement criterion. Others have analogised to ASC Topic 210-20-45-11 under US GAAP related to offsetting of repurchase and reverse repurchase agreements.

Based on the feedback received by constituents and the acknowledged diversity in current practice under IAS 32, the Board tentatively decided to clarify the definition of net settlement in the application guidance of IAS 32 to include gross settlement mechanisms with features that eliminate or result in insignificant credit and liquidity risk and under which processing of receivables and payables occur in a single settlement process. The staff will likely include guidance on distinguishing factors for such gross settlement mechanisms including:

  • financial assets and financial liabilities that meet the right of offset criterion are submitted for processing at exactly the same point
  • once submitted for processing, the transactions cannot be cancelled or altered
  • there is no potential for the cash flows arising from the assets and liabilities to change once they have been submitted for processing unless the processing fails
  • if the processing of one asset or liability that is offset against another fails, then the processing of the related security used as collateral also fails
  • processing is carried out through the same settlement depositary
  • there is a high likelihood that an intraday credit facility is available and would be honoured until the settlement process is complete.

 

Treatment of collateral and margin

IAS 32 currently allows collateral that meets the offsetting criteria to be offset against recognised financial assets or financial liabilities. However, the exposure draft proposed prohibiting offsetting assets pledged as collateral or the obligation to return collateral obtained against the associated financial assets and financial liabilities. Many respondents raised issue with the treatment of collateral and margin as they felt the proposed guidance was more restrictive than current IAS 32. Some clearing houses require counterparties to provide or receive variation margin on a daily basis based on fair value changes for the effect of discounting and settlement of contracts based on the net position of certain asset classes or product types; these payments often meet the IAS 32 offsetting criteria today. The staff further analysed this issue and noted no existing practice issues or concerns around netting of collateral under IAS 32. One Board member inquired about collateral that could be clawed back, but another Board member reiterated that such an arrangement would not qualify for offsetting currently under IAS 32. The Board tentatively decided to not include the additional guidance from the exposure draft in IAS 32 around collateral arrangements such that existing practice would continue unchanged.

Unit of account

Current IAS 32 and the proposals in the exposure draft did not specify the appropriate unit of account for applying offsetting (e.g. the individual financial instrument level or specific cash flow level). Many respondents to the exposure draft requested clarification on the unit of account for offsetting. The feedback identified existing diversity in practice with regards to application of the unit of account for offsetting. Energy companies often apply the offsetting criteria to identifiable cash flows while financial institutions often apply the offsetting criteria to the entire financial assets and financial liabilities as the volume of transactions would make applying to individual cash flows impractical and burdensome. The IASB staff agree that applying offsetting to individual cash flows may conceptually be preferable, but they had concern over how to operationalise such a requirement for large financial institutions. One alternative would be to develop a practical expedient to scope out certain entities where offsetting individual cash flows may be impractical, but defining the correct set to scope out could also prove difficult. As a result, the staff recommended the Board not provide additional guidance regarding unit of account and permit the current diversity in practice to continue. The Board tentatively decided not to add additional guidance regarding unit of account to IAS 32.

Effective date and transition

Consistent with the proposals for the offsetting disclosure requirements, the staff recommended the amendments to IAS 32 to provide additional application guidance also be retrospectively applied with an effective date of annual periods beginning on or after 1 January 2013. One of the Board members questioned the staff's assertion that the amendments were not changing IAS 32 and if so then why retrospective application was necessary. Another Board member clarified that there would be no use of hindsight in applying the clarifying amendments retrospectively. The Board tentatively decided to require retrospective application and an effective date for annual and interim reporting periods beginning on or after 1 January 2013 for the clarifying amendments to IAS 32.

The staff received permission from the Board to proceed with drafting the amendments to IAS 32. Two Board members mentioned they are likely to dissent to the amendments.

Offsetting disclosures - Effective date and transition

During the July IASB-only meeting, the staff had presented the Board with proposed effective date and transition requirements for the offsetting disclosures. The staff recommended retrospective application of the disclosure requirements and an effective date of annual and interim reporting periods beginning on or after 1 January 2013.

The Board expressed general support of the proposals but did not take an official vote because of the limited participation during that meeting. Since that meeting, the FASB has tentatively agreed on the same staff proposals. During this meeting, the IASB tentatively decided to require retrospective application of the disclosures with an effective date of annual and interim reporting periods beginning on or after 1 January 2013.

The staff received permission from the Board to begin drafting. No Board members expressed that they planned to dissent to the disclosure amendments.

Location of offsetting guidance

IAS 32 currently includes the guidance regarding offsetting financial assets and financial liabilities. However, some comment letter respondents to the exposure draft suggested the offsetting requirements be included in IFRS 9 Financial Instruments so that all guidance for financial instruments are contained within a single standard. However, the staff feel that IFRS 9 is a replacement of IAS 39 and that presentation is a separate issue and should continue to be included in IAS 32. Additionally, the joint disclosure requirements on offsetting developed with the FASB would be included in IFRS 7 Financial Instruments: Disclosures with the other disclosure for financial instruments rather than IFRS 9.

One Board member expressed his support for the disclosure requirements to be a part of IFRS 7 but a preference for the offsetting guidance to be part of IFRS 9 rather than IAS 32. He suggested the IFRS 9 already contains presentation guidance with regards to changes in fair value being recognised in earnings or other comprehensive income. For endorsement purposes, he believed a single standard would be preferable. However, the staff responded that doing so would push the effective date back, likely until 2015, and the staff felt that the diversity in practice issues identified should be resolved more timely.

The Board tentatively decided that the offsetting criteria and amendments to the offsetting application guidance be contained within IAS 32 and that the proposed offsetting disclosure requirements be contained within IFRS 7.

The Board also discussed whether any consequential amendments were necessary to other IFRSs. The staff identified two other standards that have linkages to the offsetting criteria in IAS 32: IAS 12 Income Taxes and IAS 19 Employee Benefits. However, the staff note that neither IAS 12 nor IAS 19 contains the term 'currently' and therefore the additional application guidance would not impact those standards. The Board tentatively decided that no conforming amendments to other IFRSs were required based on the additional application guidance made to IAS 32.

The Board then considered whether their due process requirements had been met. The Board agreed that appropriate due process had occurred and that re-exposure was not required. However, one IASB member felt the additional application guidance to IAS 32 should be re-exposed.