Last update 07/01/2020
Offsetting – Identifying, recognising and measuring both an asset and a liability as separate units of account, but presenting them in the statement of financial position as a single net amount.
Offsetting, otherwise known as netting, takes place when entities present their rights and obligations to each other as a net amount in their statements of financial position. (IFRS 7 13A – 13F)
IAS 32 42 is one of few IFRS paragraphs regarding offsetting: A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an entity:
- currently has a legally enforceable right to set off the recognised amounts; and
- intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
In other words, netting is allowed if this aligns the net asset or liability to the expected cash in- or outflow.
Another offsetting rules is included in the accounting for a transfer of a financial asset that does not qualify for derecognition. The entity shall not offset the transferred asset and the associated liability (see IFRS 9 3.2.22). This is a situation involved in a continued involvement in transferred assets. When an entity continues to recognise an asset to the extent of its continuing involvement, the entity also recognises the associated liability. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is:
- the amortised cost of the rights and obligations retained by the entity, if the transferred asset is measured at amortised cost, or
- equal to the fair value of the rights and obligations retained by the entity when measured on a stand-alone basis, if the transferred asset is measured at fair value. (IFRS 9 3.2.17)
The above measurement basis may often result in a liability amount on initial recognition that is a ‘balancing figure’ that will not necessarily represent the proceeds received in the transfer.
This is in contrast to the treatment for transfers that do not qualify for derecognition through retention of risks and rewards where the entire proceeds are accounted for as collateralised borrowing (see Transfers that do not qualify for derecognition).
However special rules are necessary to account for transfers involving continuing involvement. The standard makes this clear by providing that “despite the other measurement requirements in this standard”, measuring the transferred asset and the associated liability in the manner described above reflects the rights and obligations that the entity has retained. (IFRS 9 3.2.17)
In January 2011 the IASB and the FASB published an ED, Offsetting Financial Assets and Financial Liabilities. This was in response to requests from stakeholders and recommendations from the Financial Stability Board and the Basel Committee on Banking Supervision to achieve convergence of the Boards’ requirements for offsetting financial assets and financial liabilities.
A right to set-off must be available today rather than being contingent on a future event and must be exercisable by any of the counterparties, both in the normal course of business and in the event of default, insolvency or bankruptcy.
Also, the amendments clarify that the determination of whether the right meets the legally enforceable criterion will depend on both the contractual terms entered into between the counterparties as well as the law governing the contract and the bankruptcy process in the event of bankruptcy or insolvency.
The realization of financial asset and settlement of a financial liability is simultaneous if the settlement occur “at the same moment”. However gross settlement that does not occur simultaneously may also meet the principle and criteria of offsetting if a single settlement process results in cash flows being equivalent to a single net amount.
Counterparty (or counterparties) right of set-off
IAS 32 (as amended) does not require all parties to currently have a legal right to set off; the standard focuses on the reporting entity and requires only the reporting entity to currently have a right of set-off and that right must be legally enforceable in certain circumstances.
This emphasis on the right of set-off in the hands of the reporting entity, regardless of whether the counterparty has an equivalent right, is also clear from the Application Guidance which states
‘’… an entity must currently have a legally enforceable right of set-off. This means that the right of set-off: (a) must not be contingent on a future event; and (b) must be legally enforceable in all of the following circumstances: (i) the normal course of business; (ii) the event of default; and (iii) the event of insolvency or bankruptcy of the entity and all of the counterparties.’’
It is clear from the above guidance that the reference to ‘all of the counterparties’ in (b) above pertains to the legal enforceability in the circumstances listed (i.e., the normal course of business, the events of default, insolvency or bankruptcy), and not who holds the set-off right.
This issue is relevant in situations where only one party to a netting agreement has the legal right of set-off. An example could be when a financial institution has both the intent to settle net and an enforceable right to set off its customers’ loans against its customers’ deposits in: (a) the normal course of business; (b) upon default, bankruptcy or insolvency of the customers; and (c) upon its own default, bankruptcy or insolvency, but the customer does not have an equivalent right.
Applying the wording in the Basis for Conclusions (as noted above) to this example could be interpreted to imply that the financial institution would not set off the amounts due and payable under the customers’ loans and deposits. However, the standard would indicate that the offsetting criteria, as stipulated, have been met.
Legally enforceable right of set-off in a reporting entity’s own bankruptcy
This requirement simply means that the counterparty (or counterparties) to a netting agreement must not have the ability to force gross settlement in the event of the reporting entity’s default, insolvency or bankruptcy. If, however, according to a netting agreement, the counterparty can insist on settling the amounts due and payable between the parties on a gross basis, this would mean that the reporting entity may not achieve a net amount in the event of its own bankruptcy.
Many contracts give only the non-defaulting party the right to enforce the netting provisions in case of default, insolvency or bankruptcy of any of the parties to the agreement. Such contracts would fail the IAS 32 criteria because the reporting entity cannot enforce such rights of set-off in its own bankruptcy.
In practice, most of these contracts would not achieve offsetting under IAS 32 anyway, because the legal right of set-off available under such contracts is usually not enforceable in the normal course of business. Generally, these contracts are structured this way because entities do not intend to net settle other than in situations of default. For all other situations, entities need to determine if the right to enforce net settlement would survive their own bankruptcy.
See also: The IFRS Foundation
