Netting Receivables And Liabilities
Situation
Netting assets and liabilities is known as "offsetting." It is the display of a recognized asset and a recognized liability as one net amount in a financial statement. If the amount of the recognized asset is the same as the amount of the recognized liability, then the net or combined amount of both is zero; and, as a result, no amount would appear in the financial statement. If the two amounts are not the same, the net amount of the offset is presented in the financial statements and classified in the manner of the larger item.
Response
APB-10 (Omnibus Opinion - 1966) discussed the general principle of offsetting in the balance sheet in terms of income tax accounts. The opinion included the statement that offsetting assets and liabilities in the balance sheet is improper except where a right of setoff exists.
The general financial reporting principle that offsetting assets and liabilities is improper except where a right of setoff exists usually is considered in the context of unconditional receivables from and payables to another party. FASB Interpretation 39 extended this principle to conditional amounts recognized for contracts under which the amounts to be received or paid, or items to be exchanged, depend on future interest rates, future exchange rates, future commodity prices, or other factors.
Interpretation 39 (¶5) specified four criteria that must be met for the right of setoff to exist. (1) Each party owes the other party specific amounts. (2) The reporting party has the right to set off the amount payable, by contract or other agreement, with the amount receivable from the other party. (3) The reporting party intends to set off. (4) The right of setoff is enforceable by law. (The third criterion raises the importance of managerial intent in the conditions to be met.)
One variation of this general policy stated in Interpretation 39 is that fair value amounts may be offset when they are recognized for forward, interest rate swap, currency swap, option, other conditional or exchange contracts executed with the same counterparty under a master netting arrangement. The reporting entity may choose to offset in this case and the policy selected must be followed consistently (FASB 107 ¶ 3). In 1994, FASB's Interpretation 41 Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements established six conditions that must be met for an entity to have the option to offset:
- The agreements are executed with the same counterparty.
- The agreements have the same settlement data.
- The agreements are executed in accordance with a master netting arrangement.
- The items under the agreement exist in "book entry form."
- The agreements will be settled on a securities transfer system.
- The enterprise intends to use the same account at the clearing bank to settle its receivable and its payable.
Since neither the four criteria provided in Interpretation 39 nor the six conditions set forth in Interpretation 41 are satisfied, Teachum university does not have the authority to net its receivable from the ABC Corporation with its liability to the corporation. According to GAAP, the university's assets and liabilities are not overstated.