Balance Sheet Netting

Balance Sheet Netting

Background

As alignment between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) is a common goal in working towards International Financial Reporting Standards (IFRS) there needs to be a single approach to financial assets and liabilities on the balance sheet. Currently, there is not alignment between IFRS and GAAP regarding netting these entries. The major problem with the inconsistency of the reporting is that there is not comparable data between companies that use GAAP vs. IFRS. As the deadline, June 2011, for convergence nears it is important to align the treatment of this topic.

The current treatment for GAAP is it is allowable to net assets and liabilities with counterparty when there is a legally enforceable right to set-off and the company intends to settle on a net basis. There are exceptions to this rule, “firms trading derivatives under a single master netting agreement with the same counterparty have an option to report assets and liabilities on a net basis, something that is also allowed for repos and reverse repos that meet specific requirements.” (Pengelley 2011) A result of the netting under GAAP results in shorter balance sheets.

The current treatment for IFRS does not include this exception. IFRS rules require firms to report derivatives on a gross basis. The difference between GAAP and IFRS is substantial for the banking industry and leads to material differences in their balance sheets.

Proposal

The new proposal would amend GAAP and IFRS which would eliminate man of the industry specific netting that occurs. The new proposal would have to meet three criteria. It would require an unconditional right of set-off. The second requirement is it would be legally enforceable right to set-off. This cannot be contingent on a future event. The third requirement is there has to be intent to settle on a net basis or simultaneously. Provided that all of these criteria were met, offsetting would be required.

Results

If it is adopted it would make it less confusing when comparing results using GAAP vs IFRS. This is mainly a result of having one method for reporting vs. two different methods. If this proposal becomes the new guideline then the contracts can be changed to accommodate the changes, however, this could take a lot of money and time. Another result is an increase in the size of balance sheet accounts in the US. This can be a dangerous outcome which could lead to more complicated balance sheets. The educated users