International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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(e.g. the right may be triggered or exercisable only on the occurrence of some future
event, such as the default, insolvency or bankruptcy of one of the counterparties). Even
if the right of set-off is not contingent on a future event, it may only be legally
enforceable in the normal course of business, or in the event of default, or in the event
of insolvency or bankruptcy, of one or all of the counterparties. [IAS 32.AG38A].
The revised application guidance makes it clear that, in order for an entity to currently
have a legally enforceable right of set-off, the right: [IAS 32.AG38B]
• must not be contingent on a future event; and
• must be legally enforceable in all of the following circumstances:
• the normal course of business;
• the event of default; and
• the event of insolvency or bankruptcy of the entity and all of the counterparties.
The nature and extent of the right of set-off, including any conditions attached to its
exercise and whether it would remain in the event of default or insolvency or
bankruptcy, may vary from one legal jurisdiction to another. Consequently, it cannot be
assumed that the right of set-off is automatically available outside of the normal course
of business. For example, the bankruptcy or insolvency laws of a jurisdiction may
prohibit, or restrict, the right of set-off in the event of bankruptcy or insolvency in some
circumstances. [IAS 32.AG38C]. Therefore, contractual provisions, the laws governing the
contract, or the default, insolvency or bankruptcy laws applicable to the parties need to
be considered to ascertain whether the right of set-off is enforceable in the
circumstances set out above. [IAS 32.AG38D]. In assessing whether an agreement meets
these conditions, entities will need to make a legal determination, which may involve
obtaining legal advice.
The basis for conclusions suggests that to meet the criteria for offsetting, these rights
must exist for all counterparties. Thus, if one party, including the reporting entity, will
not or cannot perform under the contract, the other counterparties will be able to
enforce that right to set-off against the party that has defaulted or become insolvent or
bankrupt. [IAS 32.BC80]. However, the revised application guidance above appears to
focus only on whether the rights of the reporting entity are legally enforceable. It is also
clear that the above reference to ‘all of the counterparties’ 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.
In our view, normally the standard and its application guidance would prevail over the
basis for conclusions and we consider that the IASB’s most likely intention, consistent
with the wording in the body and application guidance of the standard, was to require
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only the reporting entity to have a legal right to set off in the circumstances noted above
– including, in the event of the reporting entity’s own default, insolvency or bankruptcy.
The requirement that a reporting entity must be able to legally enforce a right of set-off
in the event of its own bankruptcy 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. It also means that the reporting
entity may need to obtain legal advice as to whether its legal right to net settle will
survive the bankruptcy laws of the jurisdiction in which it is located.
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. Unless the insolvency laws in the relevant jurisdiction would force net
settlement, such contracts would fail the IAS 32 criteria because the reporting entity
cannot enforce such rights of set-off in the event of its own bankruptcy, regardless of
the fact that in practice it is highly unlikely that the non-defaulting party would insist on
gross settlement. 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 speaking, these
contracts are structured this way because entities do not intend to settle net other than
in situations of default. In other circumstances, entities need to determine if the right to
enforce net settlement would survive their own bankruptcy.
A right of set-off that can be exercised only upon the occurrence of a future event is
often referred to as a ‘conditional’ right of set-off. For example, an entity may have a
right of set-off that is exercisable on changes to particular legislation or change in
control of the counterparties. Conditional rights of set-off such as these do not meet the
offsetting criteria and, hence, the financial asset and financial liability subject to such
rights of set-off would not qualify to be offset.
As the description of a right of set-off itself envisages an amount being due to each party
either now or in the future, the passage of time and uncertainties relating to amounts to
be paid do not preclude an entity from currently having a legally enforceable right of
set-off. The fact that payments subject to a right of set-off will only arise at a future date
is not in itself a condition or form of contingency that prevents offsetting. [IAS 32.BC83].
However, if the right of set-off is not exercisable during a period when amounts are due
and payable, then the entity does not meet the offsetting criterion as it has no right to
set off those payments. Similarly, a right of set-off that could disappear or that would no
longer be enforceable after a future event that could take place in the normal course of
business or in the event of default, or in the event of insolvency or bankruptcy, such as
a ratings downgrade, would not meet the currently (legally enforceable) criterion.
[IAS 32.BC84].
Some contracts include representation clauses under which the right to set-off is
automatically invalidated if any undertakings or representations in the contract turns
out to be incorrect in a material respect. In our view, such clauses would generally not
render the right of set-off a conditional right of set-off.
In certain circumstances, an entity may, in order to exercise its right of set-off, need to
unilaterally take a procedural action within its control. For example, an entity may be
Financial
instruments:
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required to notify the counterparty, in the form of a letter in advance, in order to effect
net settlement under the terms of the contract. In some cases, an entity may need to
apply to a court to effect set-off when a counterparty becomes bankrupt (as a matter of
process), although that right is assured and is upheld in the event of default of a
counterparty in that jurisdiction. In our view, the mere fact that such actions are needed
before an entity can exercise the right of set-off would not make the exercisability of
that right contingent on a future event. However, in the
latter example, the probability
of favourable or unfavourable judgement from the court would have to be assessed
separately as part of the ‘legal enforceability’ requirement to conclude whether the right
of set-off meets the offsetting criteria in IAS 32.
Unlike US GAAP, IAS 32 does not specify a particular level of assurance required to
meet the ‘legally enforceable’ criterion. Instead, it leaves such determination to
judgement and consideration of the relevant facts and circumstances. In practice,
entities are expected, in their day to day business, to obtain reasonable assurance on
enforceability of contractual rights as part of prudent risk management regardless of the
accounting requirements.
7.4.1.B
Master netting agreements
It is common practice for an entity that undertakes a number of financial instrument
transactions with a single counterparty to enter into a ‘master netting arrangement’ with
that counterparty. These arrangements are typically used by financial institutions to
restrict their exposure to loss in the event of bankruptcy or other events that result in a
counterparty being unable to meet its obligations. Such an agreement commonly creates
a conditional right of set-off that becomes enforceable, and affects the realisation or
settlement of individual financial assets and financial liabilities, only following a
specified event of default or in other circumstances not expected to arise in the normal
course of business. Entities who enter into such master netting agreements other than
not meeting the legal right of set-off requirement also typically do not intend to settle
net in the normal course of business.
Where an entity has entered into such an agreement, the agreement does not provide
the basis for the offset of assets and liabilities unless both of the offsetting criteria are
satisfied. [IAS 32.50]. For enforceable master netting arrangements that create a
conditional right of set off, this will typically be the case only if the default (or other
event specified in the contract) has actually occurred. When financial assets and
financial liabilities subject to a master netting arrangement are not offset, the effect of
the arrangement falls within the scope of the disclosure requirements of IFRS 7
(see 7.4.2 below).
7.4.1.C Criterion
(b):
Intention to settle net or realise the gross amount
simultaneously (‘the net settlement criterion’)
An entity’s intention to settle net or settle simultaneously may be demonstrated through
its past experience of executing set-off or simultaneous settlement in similar situations,
its usual operating practices or by reference to its documented risk policies. Thus,
incidental net or simultaneous settlement of a financial asset or financial liability does
not meet the criterion above.
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The requirement for an intention to settle net or to settle simultaneously is, however,
considered only from the reporting entity’s perspective.
IAS 32 notes that an entity’s intentions with respect to settlement of particular assets
and liabilities may be influenced by its normal business practices, the requirements
of the financial markets and other circumstances that may limit the ability to settle
net or simultaneously. [IAS 32.47]. In practice, even though a reporting entity has the
right to settle net, it may settle gross either because of lack of appropriate
arrangements or systems to effect net settlement or to facilitate operations which
would likely preclude offsetting.
Simultaneous settlement of two financial instruments may occur through, for example,
the operation of a clearing house in an organised financial market or a face-to-face
exchange. [IAS 32.48]. The procedures of the clearing house or exchange may provide that
the amount to be paid or received for different products be settled gross. However, such
payments may be made simultaneously. Hence, even though the parties may make
payment or receive payment separately for different product types, settlement occurs
at the same moment and there is exposure only to the net amount.
The standard states that the reference to ‘simultaneous’ settlement in the conditions for
offset above is to be interpreted literally, as applying only to the realisation of a financial
asset and settlement of a financial liability at the same moment. [IAS 32.48]. For example,
the settlement of a financial asset and a financial liability at the same nominal time but
in different time zones is not considered to be simultaneous.
Nevertheless, it became apparent to the IASB that there was diversity in practice related
to the interpretation of ‘simultaneous’ settlement in IAS 32. In practice, due to
processing constraints, settlement of gross amounts rarely occurs at exactly the same
moment, even when using a clearing house or settlement system. Rather, actual
settlement takes place over a period of time (e.g. clearing repos and reverse repos in
batches during the day). Arguably, therefore, ‘simultaneous’ is not operational and
ignores settlement systems that are established to achieve what is economically
equivalent to net settlement. Consequently, IAS 32 has often been interpreted to mean
that settlement through a clearing house does meet the simultaneous settlement
criterion, even if not occurring at the same moment. The IASB agreed that some, but
not all, settlement systems should be seen as equivalent to net settlement and, in order
to reduce diversity of accounting treatment, introduced guidance into IAS 32 in
December 2011 to clarify how criterion (b) should be assessed in these circumstances.
[IAS 32.BC94-BC100].
The amendments explain that if an entity can settle amounts in a manner such that the
outcome is, in effect, equivalent to net settlement, the entity will meet the net settlement
criterion. This will occur if, and only if, the gross settlement mechanism has features
that (i) eliminate or result in insignificant credit and liquidity risk, and that (ii) will
process receivables and payables in a single settlement process or cycle. For example,
a gross settlement system that has all of the following characteristics would meet the net
settlement criterion: [IAS 32.AG38F]
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• financial assets and financial liabilities eligible for set-off are submitted at the same
point in time for processing;
• once the financial assets and financial liabilities are submitted for processing, the
parties are committed to fulfil the settlement obligation;
• there is no potential for the cash flows arising from the assets and liabilities to
change once they have been submitted for processing (unless the processing fails
– see next item below);
• assets and liabilities that are collateralised with securities will be settled on a
securities transfer or similar system (e.g. delivery versus payment), so that if the
transfer of securities fails, the processing of the related receivable or payable for
which the securities are collateral will also fail (and vice versa);
• any transactions that fail, as outlined in the previous item above, will be re-
entered
for processing until they are settled;
• settlement is carried out through the same settlement institution (e.g. a settlement
bank, a central bank or a central securities depository); and
• an intraday credit facility is in place that will provide sufficient overdraft amounts
to enable the processing of payments at the settlement date for each of the
parties, and it is virtually certain that the intraday credit facility will be honoured
if called upon.
The IASB deliberately chose the language above so that it was clear that settlement
systems established by clearing houses or other central counterparties should not
automatically be assumed to meet the net settlement criterion. Conversely, irrespective
of the names used in a particular jurisdiction, other settlement systems may meet the
net settlement criterion if that system eliminates or results in insignificant credit and
liquidity risk and processes receivables and payables in the same settlement process or
cycle. [IAS 32.BC101].
7.4.1.D Situations
where offset is not normally appropriate
An entity may enter into a number of different financial instruments designed to
replicate, as a group, the features of a single financial instrument (such a replication is
sometimes referred to as creating a ‘synthetic instrument’). For example, if an entity
issues floating rate debt and then enters into a ‘pay fixed/receive floating’ interest rate
swap, the combined economic effect is that the entity has issued fixed rate debt.
IAS 32 argues that each of the individual financial instruments that together constitute
a ‘synthetic instrument’:
• represents a contractual right or obligation with its own terms and conditions;
• may be transferred or settled separately; and
• is exposed to risks that may differ from those to which the other financial
instruments in the ‘synthetic instrument’ are exposed.
Accordingly, when one financial instrument in a ‘synthetic instrument’ is an asset and
another is a liability, they are not offset and presented on an entity’s statement of
financial position on a net basis unless they meet the offsetting criteria. [IAS 32.49(a), AG39].
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