Offsetting of financial assets and financial liabilities

Offsetting of financial assets and financial liabilities – IAS 32 prescribes rules for the offsetting of financial assets and financial liabilities. It specifies that a financial asset and a financial liability should be offset and the net amount reported when and only when, an enterprise (IAS 32 42 ): Offsetting of financial assets and financial liabilities

Offsetting is usually inappropriate when: Offsetting of financial assets and financial liabilities

  • several different financial instruments are used to emulate the features of a single financial instrument (a ‘synthetic instrument’);
  • financial assets and financial liabilities arise from financial instruments having the same primary risk exposure (for example, assets and liabilities within a portfolio of forward contracts or other derivative instruments) but involve different counterparties;
  • financial or other assets are pledged as collateral for non-recourse financial liabilities;
  • financial assets are set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation (for example, a sinking fund arrangement); or  Offsetting of financial assets and financial liabilities
  • obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of a claim made under an insurance contract.

Offsetting of financial assets and financial liabilities

An entity is required to offset a financial asset and financial liability when, and only when, the entity currently has a legally enforceable right to set-off and intends to settle the asset and liability on a net basis or realise the asset and settle the liability simultaneously.

The accounting rules have been amended to clarify:

  • That the right of set off must be available today – That is, it is not contingent on a future event;
  • That the right of set off must be legally enforceable for all counterparties in the normal course of business, as well as in the event of default, insolvency or bankruptcy; and
  • That gross settlement mechanisms, such as through a clearing house, with features that both (i) eliminate credit and liquidity risk; and (ii) process receivables and payables in a single settlement process, are effectively equivalent to net settlement and as a result they would satisfy the criterion in these instances.

Master netting agreements where the legal right of offset is only enforceable on the occurrence of some future event, such as default of the counterparty, does not typically meet the offsetting requirements.

Another offsetting rule is included in the accounting for a transfer of a financial asset that does not qualify for derecognition. The entity shall not offset the transferred asset and the associated liability (see IFRS 9 3.2.22). This is a situation involved in a continued involvement in transferred assets. When an entity continues to recognise an asset to the extent of its continuing involvement, the entity also recognises the associated liability. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is:

  1. the amortised cost of the rights and obligations retained by the entity, if the transferred asset is measured at amortised cost, or
  2. equal to the fair value of the rights and obligations retained by the entity when measured on a stand-alone basis, if the transferred asset is measured at fair value. (IFRS 9 3.2.17)

The above measurement basis may often result in a liability amount on initial recognition that is a ‘balancing figure’ that will not necessarily represent the proceeds received in the transfer.

In January 2011 the IASB and the FASB published an ED, Offsetting Financial Assets and Financial Liabilities. This was in response to requests from stakeholders and recommendations from the Financial Stability Board and the Basel Committee on Banking Supervision to achieve convergence of the Boards’ requirements for offsetting financial assets and financial liabilities.

A right to set-off must be available today rather than being contingent on a future event and must be exercisable by any of the counterparties, both in the normal course of business and in the event of default, insolvency or bankruptcy.

Also, the amendments clarify that the determination of whether the right meets the legally enforceable criterion will depend on both the contractual terms entered into between the counterparties as well as the law governing the contract and the bankruptcy process in the event of bankruptcy or insolvency.

The realization of financial asset and settlement of a financial liability is simultaneous if the settlement occur “at the same moment”. However gross settlement that does not occur simultaneously may also meet the principle and criteria of offsetting if a single settlement process results in cash flows being equivalent to a single net amount.

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Offsetting of financial assets and financial liabilities

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