Understanding DVA (Debt Value Adjustment)

 

Recently there has been a consistent stream of news reports on debt value adjustment (DVA) and possibility of FASB getting rid of this concept.

What is DVA?

In order to explain concept of DVA in layman language, assume that company A has floated long term bonds with face value of $100. Further consider a drop in credit rating of company A and a resultant fair market value of $70 for this bond. Concept of DVA allows company A to recognize difference ($100 – $70 = $30) as revenue.

Concept of DVA was  introduced by FASB in 2007 after intense lobbying by financial companies, such as Merrill, Morgan Stanley, Goldman Sachs and Citigroup, which wrote letters to FASB arguing that it wasn’t fair to make them mark their assets to market value if they couldn’t also mark their liabilities. Their argument was that firm’s liability on day of reporting is lower because it can buy back its debt instruments from market at reduced price. (ref:  Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math )

Detractors of  DVA find it against principle of conservatism, which states that accountant must choose reporting alternative that will result in less net income and/or less asset account. Argument against DVA is that if firm attempts to buy back its instruments,

1.  It will need to borrow money at a higher rate in line with its reduced credit rating, and

2. Bond holders may decide not to sell their instruments and to wait for duration of bond and wait for full payment.

How to identify DVA in annual report of a company

Unfortunately DVA is not shown on balance sheet as a line item. You will need to read full annual report and search for word like “DVA” or “Fair market value of liabilities”. For example, following is an extract from page 55 of Bank of America Corporation’s (Ticker: BAC) annual report for 2011

[“Net income decreased $3.3 billion to $3.0 billion in 2011 primarily driven by a decline of $4.2 billion in sales and trading revenue. The decrease in sales and trading revenue was due to a challenging market environment, partially offset by DVA gains, net of hedges. In 2011, DVA gains, net of hedges, were $1.0 billion compared to $262 million in 2010 due to the widening of our credit spreads.”]

BAC’s  net income, inclusive of DVA for 2011 and 2010 was $2.967B and $6.297B respectively. If you get rid of DVA fluctuations, actual income numbers for two years are really $1.967B and $6.035B!

Today most commentators agree that DVA rule must go. I fully agree.

 

I look forward to your feedback, comments and suggestions on this post.