Understanding and Accounting for Credit Default Swaps: A Comprehensive Guide

Written by Andrew in Accounting Tutorials,Finance Tutorials,Tutorials

Introduction to Credit Default Swaps (CDS)

A Credit Default Swap (CDS) is a financial derivative that allows an investor to “swap” or offset their credit risk with that of another investor. In essence, a CDS is a form of insurance against the default of a borrower. The buyer of a CDS makes periodic payments to the seller and, in return, receives a payoff if the borrower defaults on the loan.

Key Terms and Concepts

Before diving into the accounting for CDS, it is important to understand some key terms and concepts:

  1. Credit Event: A situation such as a default, bankruptcy, or restructuring that triggers the payoff of the CDS.
  2. Protection Buyer: The party that purchases the CDS to hedge against the credit risk of a borrower.
  3. Protection Seller: The party that sells the CDS and receives periodic payments from the protection buyer.
  4. Premium/Spread: The periodic payment made by the protection buyer to the protection seller.

Accounting for Credit Default Swaps

Accounting for CDS can be complex, involving both initial recognition and subsequent measurement. The accounting treatment for CDS follows the guidelines set by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP).

Initial Recognition

At the inception of the CDS contract, both the protection buyer and the protection seller must recognize the financial instrument on their balance sheets.

Journal Entries for Initial Recognition

For the Protection Buyer:

Debit: Derivative Asset (CDS) [Fair value of CDS]
Credit: Cash [Premium paid]

For the Protection Seller:

Debit: Cash [Premium received]
Credit: Derivative Liability (CDS) [Fair value of CDS]

Subsequent Measurement

After initial recognition, the CDS must be measured at fair value through profit or loss. This means that any changes in the fair value of the CDS will impact the income statement of both parties.

Journal Entries for Subsequent Measurement

For the Protection Buyer:

If the fair value of the CDS increases (indicating increased credit risk of the borrower):

Debit: Derivative Asset (CDS) [Increase in fair value]
Credit: Gain on CDS (Income Statement) [Increase in fair value]

If the fair value of the CDS decreases (indicating decreased credit risk of the borrower):

Debit: Loss on CDS (Income Statement) [Decrease in fair value]
Credit: Derivative Asset (CDS) [Decrease in fair value]

For the Protection Seller:

If the fair value of the CDS increases (indicating increased credit risk of the borrower):

Debit: Loss on CDS (Income Statement) [Increase in fair value]
Credit: Derivative Liability (CDS) [Increase in fair value]

If the fair value of the CDS decreases (indicating decreased credit risk of the borrower):

Debit: Derivative Liability (CDS) [Decrease in fair value]
Credit: Gain on CDS (Income Statement) [Decrease in fair value]

Worked Examples

Let’s go through some worked examples to illustrate the accounting for CDS.

Example 1: Initial Recognition

Company A (Protection Buyer) enters into a CDS contract with Company B (Protection Seller) to hedge against the default risk of XYZ Corporation. The fair value of the CDS at inception is $100,000, and the annual premium is $5,000.

For Company A:

Debit: Derivative Asset (CDS) $100,000
Credit: Cash $5,000

For Company B:

Debit: Cash $5,000
Credit: Derivative Liability (CDS) $100,000

Example 2: Subsequent Measurement

Assume that after one year, the fair value of the CDS has increased to $120,000 due to an increase in the credit risk of XYZ Corporation.

For Company A:

Debit: Derivative Asset (CDS) $20,000
Credit: Gain on CDS (Income Statement) $20,000

For Company B:

Debit: Loss on CDS (Income Statement) $20,000
Credit: Derivative Liability (CDS) $20,000

Example 3: Credit Event

If a credit event occurs (e.g., XYZ Corporation defaults) and the CDS contract specifies a payout of $150,000:

For Company A (Protection Buyer):

Debit: Cash $150,000
Credit: Derivative Asset (CDS) $150,000

For Company B (Protection Seller):

Debit: Derivative Liability (CDS) $150,000
Credit: Cash $150,000

Hedging and Credit Default Swaps

CDS can be used as a hedging instrument under hedge accounting rules. To qualify for hedge accounting, the entity must designate the CDS as a hedge at inception and must document the relationship between the hedged item and the hedging instrument.

Journal Entries for Hedge Accounting

Assume Company C uses a CDS to hedge against the default risk of its bond investment in Company D. The bond has a carrying amount of $1,000,000, and the CDS has a fair value of $100,000.

For the hedge relationship:

Debit: Derivative Asset (CDS) $100,000
Credit: Cash $100,000

If the fair value of the bond decreases to $900,000 and the CDS increases to $150,000:

Debit: Loss on Bond (Income Statement) $100,000
Credit: Bond Investment $100,000

Debit: Derivative Asset (CDS) $50,000
Credit: Gain on CDS (Income Statement) $50,000

Conclusion

Accounting for Credit Default Swaps involves recognizing and measuring these derivatives on the balance sheet and through profit or loss. By understanding the initial recognition, subsequent measurement, and the implications of credit events, companies can effectively manage and report their exposure to credit risk. Using worked examples and journal entries, we’ve illustrated the key steps and considerations for accounting for CDS, providing a comprehensive guide for students and professionals alike.

Further Reading and Resources

  • IFRS 9 Financial Instruments
  • ASC 815 Derivatives and Hedging
  • Financial Accounting Standards Board (FASB) website
  • International Accounting Standards Board (IASB) website

Exercises

Exercise 1: Initial Recognition and Measurement

Company E enters into a CDS contract with Company F to hedge against the default risk of GHI Corporation. The fair value of the CDS at inception is $50,000, and the annual premium is $2,500. Provide the journal entries for both companies.

Exercise 2: Subsequent Measurement

After one year, the fair value of the CDS in Exercise 1 has increased to $70,000. Provide the journal entries for both companies.

Exercise 3: Credit Event

If GHI Corporation defaults and the CDS contract specifies a payout of $80,000, provide the journal entries for both companies.

By completing these exercises, you will gain a deeper understanding of the accounting for credit default swaps and be better prepared to handle similar transactions in practice.

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