The introduction of IFRS 13 in January 2013 was, in part, recognition of the mispricing of market credit risk that had resulted in the near collapse of financial markets in 2008. IFRS 13 requires “fair value” to include a credit adjustment for financial instruments such as FX forwards, FX options and interest rate swaps representing the credit worthiness of each counterparty to the transaction. It makes sense to adjust valuations by a credit component. IFRS 13 bases fair value on an “exit price” of the security i.e. the price at which you can go to the bank and close out an existing transaction. Whether you are buying or selling a financial instrument the bank will naturally add a margin so it is counter-intuitive to mark-to-market a position without a credit component.
What has been most surprising about the introduction of IFRS 13 has been the lack of engagement by auditors to champion the credit adjustment component of valuations. Often lack of materiality is cited as the reason for not asking companies to provide the credit adjustment when put in context of other risks within the business, but how can the adjustment be deemed non-material if the calculation is never done?
Given the deterioration of credit conditions over the last few months it will be interesting to see if auditors continue to stand-by the “non-material” argument or whether there is a move towards compliance of the IFRS 13 accounting standard.
At Hedgebook we do not dispute that the credit adjustment adds little value to a business and is another thing to ensure year-end financial reporting is dragged on, however, we have made it easy and low-cost to achieve. The CVA module within the HedgebookPro app allows the user to create credit curves, assign them appropriately to the relevant instruments and produce a report to satisfy audit requirements.
For a demo of Hedgebook’s CVA/DVA functionality, register your interest here.