November 21, 2019

You are here:  / 210 - Balance Sheet / 815 - Derivatives and Hedging / Situation Analysis / Netting Derivatives on the balance sheet, can I do it?

Netting Derivatives on the balance sheet, can I do it?

Received a question this week from a business partner regarding whether or not an entity is allowed to net derivative assets against liabilities and report the net balance on the face of the balance sheet. As such, let me tell you what I told them.

Short Answer: There is no known divergence in interpretation of the guidance in this area amongst the major accounting firms that I’m aware of. If you have the right of offset with a counterparty under a “master netting arrangement”, then you can net the positions with that counterparty. If not all of your derivative transactions are with the same counterparty (which they usually are not), then you will still be required to present assets and liabilities on your balance sheet even after netting.

Expanded Answer:

Questions of offsetting assets against liabilities in the balance sheet are generally governed by ASC 210-20, Balance Sheet, Offsetting.  Paragraphs 210-20-05-1 through 05-2 state the following.

05-1 This Subtopic provides criteria for offsetting amounts related to certain contracts and provides guidance on presentation. It is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except if a right of setoff exists.

05-2 The general principle that the offsetting of assets and liabilities is improper except where a right of setoff exists is usually thought of in the context of unconditional receivables from and payables to another party. That general principle also applies to conditional amounts recognized for contracts under which the amounts to be received or paid or items to be exchanged in the future depend on future interest rates, future exchange rates, future commodity prices, or other factors.

Further, “Right of Setoff” is a defined term in the glossary as, “A right of setoff is a debtor’s legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying against the debt an amount that the other party owes to the debtor.” However, paragraphs 210-20-45-1 through 45-5 clarify this a bit.

45-1 A right of setoff exists when all of the following conditions are met:

a. Each of two parties owes the other determinable amounts.

b. The reporting party has the right to set off the amount owed with the amount owed by the other party.

c. The reporting party intends to set off.

d. The right of setoff is enforceable at law.

45-2 A debtor having a valid right of setoff may offset the related asset and liability and report the net amount.

45-3 If the parties meet the criteria specified in paragraph 210-20-45-1, specifying currency or interest rate requirements is unnecessary. However, if maturities differ, only the party with the nearer maturity could offset because the party with the longer term maturity must settle in the manner that the other party selects at the earlier maturity date.

45-4 If a party does not intend to set off even though the ability to set off exists, an offsetting presentation in the statement of financial position is not representationally faithful.
45-5 Acknowledgment of the intent to set off by the reporting party and, if applicable, demonstration of the execution of the setoff in similar situations meet the criterion of intent.

However, you may be surprised to know that per 210-20-15-3:

15-3 The general principle of a right of setoff involves only two parties, and exceptions to that general principle shall be limited to practices specifically permitted by the Subtopics listed in this paragraph. Various accounting Subtopics specify accounting treatments in circumstances that result in offsetting or in a presentation in a statement of financial position that is similar to the effect of offsetting. The guidance in this Subtopic does not modify the accounting treatment in the particular circumstances prescribed by any of the following Subtopics:
a. Paragraphs 840-30-35-32 through 35-52 (leveraged leases)
b. Subtopic 715-30 (accounting for pension plan assets and liabilities)
c. Subtopic 715-60 (accounting for plan assets and liabilities)
d. Subtopic 740-30 (net tax asset or liability amounts reported)
dd. Paragraphs 815-10-45-1 through 45-7 (derivative instruments with the right to reclaim cash collateral or the obligation to return cash collateral)
e. Subtopics 940-320 (trade date accounting for trading portfolio positions) and 910-405 (advances received on construction contracts)
f. Paragraph 942-305-45-1 (reciprocal balances with other banks).

You may be wondering why I bothered with ASC 210 if it essentially states that the derivative instruments we’re discussing are scoped out of ASC 210. Well you’ll thank me in a second.

Per ASC 815-10-45-4 through 45-7,

45-4 Unless the conditions in paragraph 210-20-45-1 are met, the fair value of derivative instruments in a loss position shall not be offset against the fair value of derivative instruments in a gain position. Similarly, amounts recognized as accrued receivables shall not be offset against amounts recognized as accrued payables unless a right of setoff exists.

45-5 Without regard to the condition in paragraph 210-20-45-1(c), a reporting entity may offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from derivative instrument(s) recognized at fair value executed with the same counterparty under a master netting arrangement. Solely as it relates to the right to reclaim cash collateral or the obligation to return cash collateral, fair value amounts include amounts that approximate fair value. The preceding sentence shall not be analogized to for any other asset or liability. The fair value recognized for some contracts may include an accrual component for the periodic unconditional receivables and payables that result from the contract; the accrual component included therein may also be offset for contracts executed with the same counterparty under a master netting arrangement. A master netting arrangement exists if the reporting entity has multiple contracts, whether for the same type of derivative instrument or for different types of derivative instruments, with a single counterparty that are subject to a contractual agreement that provides for the net settlement of all contracts through a single payment in a single currency in the event of default on or termination of any one contract.

45-6 A reporting entity shall make an accounting policy decision to offset fair value amounts pursuant to the preceding paragraph. The reporting entity’s choice to offset or not must be applied consistently. A reporting entity shall not offset fair value amounts recognized for derivative instruments without offsetting fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral. A reporting entity that makes an accounting policy decision to offset fair value amounts recognized for derivative instruments pursuant to the preceding paragraph but determines that the amount recognized for the right to reclaim cash collateral or the obligation to return cash collateral is not a fair value amount shall continue to offset the derivative instruments.

45-7 A reporting entity that has made an accounting policy decision to offset fair value amounts is not permitted to offset amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral against net derivative instrument positions if those amounts either:

a. Were not fair value amounts
b. Arose from instruments in a master netting arrangement that are not eligible to be offset.

Deloitte was nice enough to put together an example for you and clarify their position!

815-10-45 (Q&A 03) — Netting Cash Collateral Receivables or Payables With Derivatives Under a Master Netting Arrangement

An entity may enter into multiple derivative contracts with the same counterparty under a master netting arrangement that provides for a single net settlement of all financial instruments covered by the agreement in the event of default on, or termination of, any one contract. At times, such arrangements may require either entity to post collateral with the other entity, depending on which entity is in a net asset position.
For example, Entity A and Entity B have a master netting arrangement that includes all derivative contracts entered into between the two entities. The master netting arrangement grants the entity in the net asset position the right to require the counterparty to provide cash collateral. Assume that as of a given date B is in a net asset position relative to A. Entity A is required to post collateral to B in accordance with the terms of the master netting arrangement. Once the cash collateral is posted to B, A has a right to reclaim the cash collateral (a receivable) and B has an obligation to return the cash collateral (a payable).

Question

Can an entity offset fair value amounts recognized for a cash collateral receivable or payable against the fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement?

Answer

If both of the following conditions exist, the entity must offset the fair value of derivatives included in the master netting arrangement against the fair value amounts recognized for the related cash collateral receivable or payable that arise from those derivative instruments (This assumes any amount recorded for the right to reclaim cash collateral or the obligation to return cash collateral is recorded at fair value or at an amount that approximates fair value. ASC 815-10-45-7 prohibits offsetting “amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral against net derivative instrument positions if those amounts either: a) Were not fair value amounts [or] b) Arose from instruments in a master netting arrangement that are not eligible to be offset.”):

1. An entity has adopted an accounting policy to offset fair value amounts (in accordance with ASC 815-10-45-6).
2. The items to be offset satisfy the criteria in ASC 210-20-45-1 and ASC 815-10-45-5.

The entity is not permitted to offset fair value amounts recognized for derivative instruments without offsetting fair value amounts recognized for the right or obligation to reclaim or return cash collateral (unless the entity determines that the amount recognized for the cash collateral receivable or payable is not at, or does not approximate, fair value).

Assuming that an entity meets the criteria in ASC 210-20-45-1 and ASC 815-10-45-5 and opts to offset fair value amounts, it must apply that accounting policy consistently, disclose its policy, and provide the disclosures required by ASC 815-10-50-7 and 50-8. A reporting entity that has made an accounting policy decision to not offset fair value amounts must separately disclose the amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under master netting arrangements.

Example

On January 1, 20X8, Entity A enters into a forward contract to sell 100 bushels of corn to Entity B at a price of $10 per bushel on April 1, 20X8. Entity A accounts for the contract as a derivative at fair value. The contract falls under a master netting arrangement between A and B, and A has determined that on the basis of the criteria in ASC 210-20-45-1 and ASC 815-10-45-5, a right of offset exists. Entity A has adopted an accounting policy to offset fair value amounts in accordance with ASC 815-10-45-6. Under the master netting arrangement, the entity in the net asset position may require the other entity to post collateral according to a negotiated amount. On March 31, 20X8, A’s forward contract is a liability resulting from market movements in the price of corn. On that date, B requires A to post $500 of cash collateral. Entity A records a receivable for the right to reclaim the collateral and B records a payable for its obligation to return the cash collateral. Entity A determines that its $500 receivable approximates fair value.

Because A’s policy is to offset fair value amounts, in its statement of financial position as of March 31, 20X8, A must offset the fair value amounts recognized for the forward contract (a liability/payable) and its receivable for cash collateral.

And lastly the example:

210-20-45 (Q&A 01) — Netting Derivative Positions on Balance Sheet

Question

Can an entity net its derivative positions on its balance sheet?

Answer

It depends. Derivatives that are reported at fair value on the balance sheet are subject to the right of offset rules under ASC 210-20 and ASC 815-10-45-1 through 45-7. That is, if an entity has several derivatives with the same counterparty, it cannot net the fair values when reporting a net asset or liability unless the right of offset exists under ASC 210-20-45-1 and ASC 815-10-45-5.

For example, an entity has four interest rate swaps with the following counterparties and respective fair values:

Swap #1 with Banker A: fair value of $1 million.
Swap #2 with Banker B: fair value of ($400,000).
Swap #3 with Banker C: fair value of $500,000.
Swap #4 with Banker A: fair value of ($700,000).

When recording these fair values on the balance sheet, the entity may not net the fair values of the four swaps and report a net derivative asset of $400,000. It must evaluate whether the right of offset exists under ASC 210-20-45-1 and ASC 815-10-45-5 for the swaps. Note that one of the requirements (ASC 210-20-45-1(a)) is that the transaction involves only two parties. Assuming there is a master netting agreement with Banker A for swaps #1 and #4, and that the other criteria in ASC 210-20-45-1 and ASC 815-10-45-5 are met, a derivative asset could be recorded for $300,000 representing the net relationship with Bank A. This amount should then be combined with the $500,000 derivative asset (Banker C), resulting in an $800,000 derivative asset for reporting purposes. Under this approach, a derivative liability (owed to Banker B) also should be separately reported in the amount of $400,000.

Entities that elect to offset fair value amounts in accordance with ASC 210-20 and ASC 815-10-45-4 through 45-7 must offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from derivative instrument(s) recognized at fair value and executed with the same counterparty under a master netting arrangement.

Disclaimer: The guidance above from the firm represents their view at a certain point in time, and they have the right (and responsibility IMHO) to change their point of view based on new information or additional discussions with authoritative sources. The above is being reproduced here in part for educational purposes and is not intended to replace the need or requirement of consulting a professional accounting firm to discuss your specific facts or circumstances. The quoted materials above belong to those attributed which are all protected under US copyright laws (see fair use rules that may apply). If I have reproduced any of your content, and you would like it removed or citation updated, please contact me at blaine@popularaccounting.com, and I will rectify immediately.

YOU MIGHT ALSO LIKE

Leave a comment