GROSS VERSUS NET BALANCE SHEET PRESENTATION OF OFFSETTING DERIVATIVES ASSETS AND LIABILITIES

Abstract

Accounting principles state that the net presentation of offsetting assets and liabilities on the balance sheet is improper unless the right of setoff exists. Derivatives dealers and their frequent counterparties engage in master netting agreements (MNAs) that provide a limited right of setoff that is insufficient (sufficient) for net presentation under IFRS (US GAAP). To remedy this presentation difference, as of 2013, IFRS and US GAAP require dealers to disclose the gross, reported, and net amounts of derivatives assets and liabilities that they present net or present gross but cover under enforceable MNAs.
We first study real effects of these mandatory disclosures on dealers’ financial leverage. We posit that dealers prefer market participants to view their leverage as lower. Because the 2013 requirements provide new information for IFRS dealers but not for US GAAP dealers, we hypothesize and provide evidence that the requirements induce IFRS dealers to reduce their derivatives leverage by eliminating unnecessary offsetting derivatives and using MNAs more effectively. We then study the usefulness of the disclosures to market participants. Because the right of setoff provided by MNAs does not eliminate all significant risks of the covered derivatives, we hypothesize and provide evidence that dealers’ net derivatives leverage and disclosure quality under the 2013 requirements inform market participants about dealers’ credit risk uncertainty.

Keywords: Derivatives; dealers; master netting agreements; gross versus net balance sheet presentation; disclosure; real effects; credit risk uncertainty.

JEL Classification: G130, G21, M41