CVA (credit value adjustment) and DVA (debit value adjustment) are now commonly used terms and considered standard fare for audit. But that wasn’t always the case. We look at how far we have come on the CVA compliance and audit journey in the last decade.
There is no doubt that CVA (credit value adjustment) and DVA (debit value adjustment) were front of mind in 2014. Corporations with a 31 December balance date and outstanding financial instruments discovered there was now something else to be calculated for inclusion in the annual accounts.
We moved from a world where a valuation was just something you took from the bank, plugged into the accounts and moved on – to something more complex.
Initially it was sensitivity analysis on the outstanding instruments. What would the effect be if exchange rates moved up 10% or interest rates moved down 1%? Interesting, but not necessarily that important, especially as this analysis is only on the hedged position not on what isn’t hedged.
If you only hedged 20% of your expected future exposure because you are waiting for the exchange rate to move in your favour, then you will know the effect on 20% of your business, but not the other 80%. The sophisticated investor might look through this\ – most won’t.
Enforcing CVA compliance in question
Then came CVA and DVA as considerations in valuing a financial instrument. It asked the question: what is the impact if my counterparty falls over, or if I fall over, on the value of my outstanding instruments? While highly relevant during and immediately after the GFC by 2014 it was not straightforward to calculate, was a requirement under the recently released IFRS 13, and not something a bank was going to provide.
At the time it was difficult to gauge how hard auditors would push to have these numbers included – particularly as some of the numbers appeared to be immaterial. For example: if you have short dated foreign exchange deals, the numbers are small>If you have long dated interest rate swaps the numbers are more material. Either way it wasn’t something that could be calculated on the back of an envelope.
Enough, already!
Which is why – at the time – it was seen as a very real problem for CFOs and auditors. The standards moved down a path whereby the fair value of a financial instrument wasn’t straightforward anymore, or easily obtained.
The relevant purpose was debateable and cries of “enough already” were loud and clear from CFOs who had enough to worry about without debating the benefits or otherwise of the new standards. It meant the audit dollar was getting squeezed at every turn in an environment where the audit itself was under more scrutiny and regulation than ever before.
What we now know
At the time it appeared CFOs may be quite justified to push back when it comes time to including CVA in their valuations – given the usefulness and materiality of the numbers. It was too soon to tell whether the audit fraternity accept this or if you would still need to calculate the numbers to decide on their materiality.
A decade further along, hindsight is a wonderful thing.
By no means is every financial instrument subjected to the requirements of CVA/DVA and, for sure, the “materiality test” is rolled out often as a reason to not do the calculation, however, corporates and auditors alike have much greater awareness of this complex area of financial valuations. We field more questions about CVA/DVA methodologies and provide workshops and examples of how the numbers are calculated. We are still a long way off from widespread adoption of CVA compliance or the enforcing of CVA/DVA adjusted valuations for corporates.