Recently, certain issues have been raised regarding the determination of the fair value of derivatives under FASB Statement No. 157, Fair Value Measurements, and the effect on assessing hedge effectiveness of fair value hedges under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. Statement 157 indicates that credit risk (both the counterparty’s and the entity’s own) affects the determination of the fair value of derivatives and establishes, as a valuation premise, that derivatives (or aspects of derivatives) may be valued as a group. Statement 157 became effective for derivatives for calendar-year reporting entities on January 1, 2008.

Some reporting entities pool derivatives by counterparty to estimate the appropriate credit valuation adjustment in determining the fair value of that pool. At issue is whether and how that pooled credit adjustment affects the assessment of effectiveness of an individual designated derivative in a fair value hedge relationship. Specifically, constituents have questioned (1) whether credit risk must be considered in hedge effectiveness assessments and (2) if so, whether credit risk can be considered separately through qualitative analysis. In recent conversations, the SEC staff clarified how reporting entities should treat credit risk in fair value hedge effectiveness assessments.

Background

Under Statement 157, a reporting entity should consider both its own credit risk and the credit risk of the counterparty when determining the fair value of its derivatives. A reporting entity will generally determine the value of multiple derivatives with a single counterparty subject to a master netting arrangement on a portfolio basis. That is, a reporting entity estimates portfolio-level adjustments for certain risks (e.g., credit) and allocates them to the different levels in the fair value hierarchy to provide the disclosures required by Statement 157. However, the reporting entity may not allocate these adjustments down to the individual derivative unit.

Considerations

Under Statement 133, a reporting entity may elect fair value hedge accounting for its derivatives if certain requirements are met. One requirement is that the change in the fair value of the derivative must be highly effective in offsetting changes in the fair value of the hedged risk, as determined through a periodic assessment of hedge effectiveness. Note that for Statement 133 purposes, each individual derivative in a master netting arrangement is considered a separate unit of account. Many constituents have questioned whether, when a reporting entity performs the "long-haul method" (as opposed to the shortcut method) to assess whether a fair value hedge relationship is highly effective, a reporting entity needs to consider a portion of the portfolio-level credit adjustment when the designated derivative is part of such a portfolio.

Unlike in cash flow hedge effectiveness assessments, in which the assessment of credit risk may be limited to an assessment of the possibility of whether the counterparty to the derivative will default, in fair value hedge effectiveness assessments, the SEC staff confirmed that reporting entities must consider the impact of credit risk on the fair value of the designated derivative, as discussed in Statement 133 Implementation Issue No. G10, "Cash Flow Hedges: Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative." However, reporting entities may separately demonstrate the credit risk effect of the designated derivative on the effectiveness of the hedge relationship by performing a qualitative analysis in which the entities determine that the changes in fair value that are attributable to credit risk would not affect the highly effective nature of the fair value hedge. Note that in this circumstance, the assessment of the effectiveness of the designated hedging relationship, excluding the effect of the credit risk of the derivative, should be quantitative. Stated differently, reporting entities can exclude credit risk from their periodic quantitative fair value hedge effectiveness assessments when they determine qualitatively that credit risk would not cause the hedging relationship to fail its periodic effectiveness assessment.

This qualitative determination should take into account (1) the magnitude of the credit valuation adjustment in relation to the portfolio size and (2) the level of effectiveness of each individual hedging relationship before considering credit risk. The SEC staff did not provide detailed guidance on how a reporting entity would determine whether it needs to perform a qualitative or quantitative analysis. The qualitative assessment may include, for example, a determination, at the portfolio and individual counterparty levels, that the credit risk adjustment is insignificant.

When a reporting entity cannot or does not determine qualitatively that credit risk would not cause the hedging relationship to fail its periodic effectiveness assessment, it must include credit risk in its periodic quantitative assessments of fair value hedging relationships. Statement 133 requires reporting entities to perform this assessment at the individual hedge relationship level (i.e., individual derivative level). If the reporting entity, in its determination of fair value of its derivatives, estimates a credit adjustment at a portfolio level, the following four methods are considered acceptable alternatives for allocating the portfolio-level credit adjustment to the individual derivative unit:

• Relative fair value approach — An entity may allocate a portion of the portfolio-level credit adjustment to each derivative asset and liability on the basis of the relative fair value of each of the derivative instruments to the portfolio.
• In-exchange or “full credit” approach — An entity may use the derivative's stand-alone fair value (in-exchange premise), which would take into account the credit standing of the parties and ignore the effect of the master netting arrangement.
• Relative credit adjustment approach — An entity may allocate a portion of the portfolio-level credit adjustment to each derivative asset and liability on the basis of the relative credit adjustment of each of the derivative instruments to the portfolio. This approach would require use of an in-exchange premise to calculate a credit adjustment for each instrument.
• Marginal contribution approach — An entity may allocate a portion of the portfolio-level credit adjustment to each derivative asset and liability on the basis of the marginal amount that each derivative asset or liability contributes to the portfolio-level credit adjustment.

The SEC staff indicated that it would not object to any of these methods. Other rational methods of allocation may be appropriate. Reporting entities should always consistently apply the selected method and should consider disclosing it in the financial statements if it is deemed a significant accounting policy.

Transition

The SEC staff provided relief to reporting entities that may not have followed the procedures in this Financial Reporting Alert (i.e., to those entities that did not include credit risk in their prospective assessments of effectiveness). The staff indicated that it would not object to continued application of fair value hedge accounting if reporting entities consider the impact of credit risk (either qualitatively or quantitatively) before issuing their financial statements, provided that the other requirements for hedge accounting were met. On a go-forward basis, reporting entities would need to have contemporaneous documentation of the impact of credit risk on fair value hedge effectiveness assessments (as part of their prospective assessments) to qualify for hedge accounting.

Because of the complexity in applying hedge accounting, we urge reporting entities and auditors to consult with derivative accounting specialists.

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