Derivative and embedded-feature valuation for financial reporting

A plain swap is two legs of cash flows, a fixed leg and a floating leg, each discounted to the reporting date. The floating leg is projected from the forward curve for its index, and both legs are discounted on the curve that matches the collateral and the market convention. The fair value is the difference between the legs, adjusted for credit.

The index matters more than it used to. The UK Financial Conduct Authority set June 30, 2023 as the cessation date for the overnight and the 1-, 3-, 6- and 12-month US dollar LIBOR tenors, and ASU 2022-06 extended the ASC 848 relief for contract modifications to December 31, 2024, after which it could no longer be applied. Floating legs that used to reference LIBOR now reference a replacement rate such as SOFR, so each valuation has to name the curve, its source and its date.

When the inputs are interest rates and yield curves observable at commonly quoted intervals, and observable for substantially the full term, the measurement is Level 2 (IFRS 13 paragraphs 81 and 82, with ASC 820 setting the same levels). The workpaper is a valuation date, a curve, a discount factor per cash flow and a result that can be re-performed in a spreadsheet by the auditor.

A Level 1 input is an unadjusted quoted price in an active market for an identical item. A Level 2 input is observable, directly or indirectly, other than a Level 1 price. A Level 3 input is unobservable and reflects the assumptions market participants would use, including assumptions about risk (IFRS 13 paragraphs 76, 81, 86 and 87; ASC 820 uses the same three levels). When a measurement uses inputs from more than one level, it takes the level of the lowest input that is significant to the whole (paragraph 73).

The levels are typical, not automatic. A swap with a long tail beyond the observable curve, or a counterparty spread taken from a thin market, can drop to Level 3.

The label also changes the disclosure. After ASU 2018-13, a nonpublic entity discloses transfers into and out of Level 3 and purchases and issues of Level 3 items in place of a full roll-forward, and it is not required to give the narrative on measurement uncertainty (ASC 820-10-50-2F). A public business entity gives that narrative and the range and weighted average of significant unobservable inputs.

A simple warrant with a fixed strike and no features goes through Black-Scholes. Features that change the payoff, such as down-round protection, anti-dilution ratchets, early exercise or settlement in a variable number of shares, need a lattice or Monte Carlo model that can follow the path of the share price.

Four inputs carry most of the result. The underlying equity value is the hardest. Finbryn does not set it: management provides it from its own analysis or from a third-party appraisal it has engaged. Volatility comes from a peer set of listed companies, with the peers and the look-back window documented. Expected term follows the contract or an exercise assumption. The risk-free rate is read from the Treasury curve on the valuation date.

Because most of these are Level 3, the file shows the sensitivity of the result to each. When the item being valued is an equity security that carries a contractual sale restriction, ASU 2022-03 says the restriction is not part of the security's unit of account and is not considered in measuring its fair value. It applies to entities other than public business entities for fiscal years beginning after December 15, 2024, with extra disclosures about the nature and remaining duration of the restriction.

Three parties are involved: management, which owns the fair value; a preparer, which builds the file; and the auditor, which tests it. The auditor may use its own specialist to evaluate a Level 3 item and may ask for an independent valuation where the estimate is significant. That is the auditor's call, not the preparer's.

Independence also limits who can prepare the number. For an SEC registrant, 17 CFR 210.2-01(c)(4)(iii) treats an appraisal or valuation service for an audit client as impairing independence, unless it is reasonable to conclude that the results will not be subject to audit procedures. Valuations that feed the balance sheet are subject to audit procedures, so the registrant's own audit firm generally cannot value them. Finbryn is not an auditor, is not engaged by your audit firm and does not prepare valuations for a company whose financial statements a firm affiliated with Finbryn audits or reviews.

For valuation professionals who are AICPA members, the Statement on Standards for Valuation Services (VS Section 100) applies, and the AICPA also publishes a Financial Instruments Performance Framework for complex instruments. Ask your auditor early which items it plans to test with its own specialist, and tell us, so the file is organized the way that specialist will want to read it.

A derivative's fair value reflects the credit risk of the party that owes the money. IFRS 13 paragraph 42 says the fair value of a liability reflects non-performance risk, which includes the entity's own credit risk, and paragraph 43 requires the entity to consider its own credit standing. For the asset side, the counterparty's credit risk goes into the measurement in the same way. ASC 820 sets the same principle.

For a swap, that produces a credit valuation adjustment on the counterparty's side and a debit valuation adjustment on the company's side. The inputs are a credit spread for each, taken from the company's borrowing cost or a comparable benchmark, and the expected exposure profile of the swap over its life.

When a company manages a group of derivatives with one counterparty on the basis of net exposure, paragraph 48 allows an exception to measure the group at the price that would be received or paid for a net position. The memo records whether that election was made. A swap accounted for under the private-company simplified hedge accounting approach can use settlement value, which leaves non-performance risk out; the file labels that figure as settlement value and keeps it apart from fair value.