Understanding Derivative Valuations and Treasury Accounting

Background

Changes in the way derivative valuations are determined and accounted for has led to an expansion in the Treasurer’s roles and responsibilities. With ninety-four percent of the world’s largest corporations using derivatives to manage risk, understanding regulatory and accounting standards, as well as differing valuation methods, is critical to a Treasurer’s success.

At one time, derivatives were considered an off-balance-sheet activity. Later, they were recorded and carried at book value, or at the notional value of the derivative. In recent years, accounting boards have recognized derivatives should be carried at fair value per market conditions. This is tied to the exit price concept and forces the entity to consider what price the derivative would fetch if it needed to be sold today.

In a recent webinar, “Understanding Derivative Valuations and Treasury Accounting,” Shan Anwar, of Bloomberg’s corporate treasury product team, and David Wiggins, corporate treasury specialist at Bloomberg, offered insight on derivative valuations and accounting for treasury products.

Derivative Valuations

Derivative valuations are based on three components: future cash flows, present value of future cash flows and the valuation model used. “The first thing to establish is what you know and what you don’t know,” Wiggins said. “Derivatives are usually a combination of known cash flows and what has yet to be determined.”

“Assumptions we had in valuation prior to the credit crisis don’t really hold,” Wiggins said. Valuation models have made advancements in light of the global financial crisis. This is a result of changes in the way that entities are thinking about risk. Wiggins mentioned market data, terms of the contract, counterparty details and legal agreements as the ingredients of valuation.

There is now a particularly strong emphasis on counterparty credit risk. Entities must try to calculate the likelihood and impact of a counterparty defaulting. This has resulted in increased collateralization as means of mitigating risk by using margins. Bilateral credit support annexes and central counterparty clearing are two types of collateralization that provide protections against counterparty defaults, but these can impact liquidity. Unsecured interbank lending is now severely restricted and what remains comes at a much higher cost. In determining valuation, Wiggins recommended thinking of the value as risk-free and then adding the risk back in. Overnight index swap discounting is used in determining the risk-free rate.

Accounting boards call for companies to evaluate non-performance risk in determining fair value. This non-performance risk includes the entities’ own credit. To adjust for credit risk, counterparty valuation adjustments and debit (or debt) valuation adjustments are used. A unilateral CVA only anticipates the possibility of the counterparty defaulting while a unilateral DVA only accounts for the possibility of default from the entity. A bilateral adjustment takes into account that both parties can default.

A derivative can shift between being treated as an asset to being treated as a liability over the course of its life. Two distinct methods are used for evaluating credit. Initially, the current exposure method was more commonly used. This more simplistic method looks at each valuation date and determines if it is an asset or liability. CVA is applied to assets and DVA is applied to liabilities. Discount curves are used to reflect the credit spread. This method does not take into consideration that a derivative might be an asset today but a liability in the future. It also fails to account for how the future value will change over time.

The potential future exposure method accounts for the likelihood of default, the expected value of the contract in the future, and the variability of future values. It also accounts for the amount an entity would likely be able to recover in a default. This method is preferred over the current exposure method, and many auditors are now pushing clients towards these more sophisticated models.

Treasury Accounting

Historically, Treasurers didn’t deal with many accounting issues, but the prevalence of derivatives has changed that. “The impact from an accounting perspective on those transactions can be huge on your financial statements,” Shan Anwar said. Treasury accounting consists of three main areas: realized accounting, unrealized accounting and hedge accounting.

Realized accounting involves accounting for cash settlements of treasury products. Examples of this include interest settlements, principal payments and maturity cash flows. Treasurers must take into consideration the source of these settlements and determine if it is practical for them to calculate and track these transactions manually or use an automated system. Decisions must also be made regarding the source of market data. Daily spot rates or monthly averages may be used.

Unrealized accounting takes a different approach. It involves accounting for derivatives at fair value and for other products, like loans, at book value. The considerations for Treasurers involve the source of the market data input used for valuations and following the appropriate disclosure requirements. Decisions should also be made regarding the frequency of these valuations. Auditors should be involved in validating valuation sources and systems. Treasurers should be prepared for changing paradigms as systems are constantly evolving, and auditors’ expectations will continue to rise to a higher standard.

Hedge accounting allows corporations to offset volatility changes in derivative valuations used to hedge an exposure. It allows the accounting of a hedging relationship to align with the actual economic situation. A fair-value hedge reduces risk to changes in the fair value of existing assets and liabilities and firm commitments. A derivative and its underlying instrument would both be marked-to-market and would offset each other.

Because Treasurers have more responsibilities today, they require more specialized skill sets. These requirements are often not met with increased resources. Processes and systems must also be able to keep pace with changing methodologies and inquiring auditors. Best practices call for centralizing treasury accounting within the treasury department because of the complexity of these topics. Formally documented and clearly defined roles and responsibilities provide clarity for employees and auditors. Integrated systems that capture trades and account for them are also recommended.