GROSS VERSUS NET BALANCE SHEET PRESENTATION OF OFFSETTING DERIVATIVES ASSETS AND LIABILITIES
70 Pages Posted: 12 Jun 2020 Last revised: 19 Feb 2021
Date Written: February 18, 2021
Accounting rules allow the net balance sheet presentation of offsetting assets and liabilities only when the reporting firm has the right to set off these positions. Derivatives dealers and their frequent counterparties engage in master netting agreements (MNAs) that cover many derivatives with largely offsetting gross fair values. MNAs provide a limited right of setoff that is insufficient (sufficient) for net presentation under IFRS (US GAAP), and they provide control rights to the non-defaulting counterparty that render the timing, completeness, and fairness of any net settlement of the covered derivatives uncertain. To provide comparable information regarding the effects of MNAs on financial statements, as of 2013 both IFRS and US GAAP require firms to disclose the gross, reported, and net fair values of derivatives assets and liabilities that are presented net on the balance sheet or are presented gross and covered under enforceable MNAs.
We posit that dealers want their net derivatives exposures to be viewed as small and low risk by market participants. Because the 2013 disclosures provide new information about net derivatives fair values for IFRS dealers but not for US GAAP dealers, we hypothesize and provide evidence that the 2013 disclosure requirements have larger and more significant real effects for IFRS dealers, which reduce the extent of their offsetting gross derivatives and increase the effectiveness of their use of MNAs, than for US GAAP dealers. Because MNAs provide a limited and right of setoff and non-defaulting parties the ability to exercise discretion over that right, we hypothesize and provide evidence that dealers’ reported net derivative fair values and disclosure quality under the 2013 requirements help users of financial reports evaluate the dealers’ credit risk uncertainty. These results suggest that MNAs do not eliminate all significant risks of the covered derivatives assets and liabilities.
Keywords: Derivatives, dealers, master netting agreements, gross versus net presentation, disclosure, real effects, credit risk uncertainty
JEL Classification: G130, G21, M41
Suggested Citation: Suggested Citation