Netting and Offsetting: Reporting derivatives under US GAAP and IFRS

Historically, the Europe-based International Accounting Standards Board (IASB) has permitted significantly less balance sheet offsetting than the U.S.-based Financial Accounting Standards Board (FASB).

This paper sets out the key differences between these approaches and explains the reasoning that leads to the current position. The terms of netting, offsetting and set-off are often used to express the same notion but they are very different concepts. A better understanding of the terminology and the way in which derivatives are traded, managed and settled provides an understanding of why U.S. GAAP accounting standard setters have consistently agreed to reporting derivatives net rather than gross on the balance sheet and why this differs from reporting under International Financial Reporting Standards (IFRS).

The paper covers the following topics:

• Why is netting/offsetting an issue?

• Differences between securities, loans, receivables and derivatives

• Portfolio management

• The Interest Rate Swap and Credit Default Swap markets

• The efficacy of netting and collateral as risk mitigation techniques

• The offsetting rules under U.S. GAAP and IFRS

• Criteria for derivatives and repo markets

• New offsetting disclosures

• The new Basel III Leverage Ratio

The paper is intended to give the reader an insight into the different offsetting requirements under IFRS and U.S. GAAP and their impact on liquidity, collateral and the new Basel III Leverage Ratio. The paper articulates the reasons ISDA favours reporting derivatives ‘net’ instead of ‘gross’ on the face of the balance sheet.

ISDA believes that net presentation, in accordance with U.S. GAAP, provides the most faithful representation of an entity’s financial position, solvency, and its exposure to credit and liquidity risk. Individual derivative transactions that are subject to enforceable master netting agreements should be eligible for netting in the balance sheet on the basis that such financial statement presentation is most faithfully representative of an entity’s resources and claims and provides the most useful information for investment decisions.

The basis for our view is that, upon termination of transactions subject to a master netting arrangement, the individual derivative receivables do not represent resources to which general creditors have rights and individual derivative payables do not represent claims that are pari-passu to the claims of general creditors. Upon termination of a contract by the nondefaulting party, derivative asset “resources” are unavailable to satisfy other claims; further, the net termination amount (including the collateral amounts) under the Close Out Netting provisions 5

Netting and Offsetting: Reporting derivatives under U.S. GAAP and under IFRS May 2012

of the ISDA Master Agreement is not subject to stay under bankruptcy laws which govern the most significant capital markets, unlike other claims. Accordingly, we believe that the current U.S. GAAP principles are superior.

The paper is recommended for anyone seeking a deeper understanding of the practical application of the offsetting rules and the new disclosure requirements for derivatives and other financial instruments published by the FASB and the IASB in December 2011.

Documents (1) for Netting and Offsetting: Reporting derivatives under US GAAP and IFRS