Financial Statements#

Valuation control signs off the fair values that appear in the balance sheet, and the movements in those values that appear in the profit and loss account (P&L). This page follows one illustrative trading book from the desk mark to the published numbers, with a table for each step.

All amounts are invented and are in £ million. They are chosen so that every table ties to the others, which is also the test that valuation control applies to the real numbers.

Where fair value reaches the statements#

Fair value in the primary statements#
Statement	What valuation control affects	Where it comes from
Balance sheet	Financial assets and liabilities at fair value: trading securities, derivative assets and derivative liabilities, and short positions.	The desk mark, less the valuation adjustments agreed by valuation control. See IFRS 13: Fair Value Measurement.
Income statement (P&L)	Trading income, which is the desk’s P&L plus the change in the valuation adjustments in the period.	Every movement in a reserve is a charge or a credit to P&L. See IFRS 9: Financial Instruments for which fair value changes go to P&L and which go to other comprehensive income (OCI).
Notes	The fair-value hierarchy, the Level 3 reconciliation and the valuation techniques.	The levelling and the evidence described in Fair-value hierarchy: Levels 1, 2 & 3.

From desk mark to balance sheet fair value#

The desk marks its positions to mid-market prices. The fair value is an exit price (see IFRS 13: Fair Value Measurement), so valuation control takes the desk mark and applies the adjustments needed to reach it:

\[\text{Fair value} \approx \text{Desk MTM} + \sum_i \text{recognised valuation adjustment}_i\]

The table builds that up for the derivative portfolio. A negative number reduces the value of the net asset.

Bridge from desk mark to fair value, derivatives, at the reporting date#
Item	£m	Note
Desk mark-to-market (mid)	1,250.0	Desk
IPV adjustment	(18.5)	Marks that differ from independent data
Bid-offer and close-out reserve	(22.0)	Mid to exit price
Model reserve	(9.5)	Known model limitations
CVA	(31.0)	Counterparty credit
DVA	12.0	Own credit
FVA	(14.0)	Funding. Treatment varies
Fair value in the balance sheet	1,167.0	Net derivative position

The adjustments follow the ones in XVA: An Introduction to Valuation Adjustments. How funding and capital adjustments are treated varies between firms (see IFRS 13: Fair Value Measurement), so the FVA line depends on the firm’s accounting policy.

The balance sheet#

The net derivative position is shown gross, as assets and liabilities. The table is a short extract of the fair-value lines.

Balance sheet extract, financial instruments at fair value#
£m	Assets	Liabilities
Trading securities	2,400.0
Derivatives	1,480.0	(313.0)
Short positions		(650.0)
Total at fair value	3,880.0	(963.0)

Derivatives are 1,480.0 less 313.0, which is the 1,167.0 net in the bridge. A control check is that the two agree.

Notes to the table:

Trading securities: bonds and equities held for trading, measured at fair value through profit or loss (see IFRS 9: Financial Instruments). They are valued at the quoted price multiplied by the quantity, so most are Level 1.
Derivatives: swaps, options, forwards and similar contracts. A contract with a positive fair value is an asset and one with a negative fair value is a liability. The values are after the valuation adjustments in the bridge. Assets and liabilities are only offset against each other where the IAS 32 criteria are met, which is a legally enforceable right to set off and an intention to settle on a net basis.
Short positions: securities that the bank has sold but does not own, borrowed to deliver. They are a liability at fair value, so a rise in the price is a loss. They are usually quoted securities and so Level 1.

The levels in the notes#

The same balances are analysed by level in the notes to the accounts.

Note

IFRS 13 requires this disclosure: for each class of assets and liabilities measured at fair value, the firm discloses the amounts in each level of the hierarchy. It is a note disclosure, not a line on the face of the balance sheet. The same applies under US GAAP (ASC 820). See IFRS 13: Fair Value Measurement.

Fair-value hierarchy, assets and liabilities at fair value#
£m	Level 1	Level 2	Level 3	Total
Trading securities	2,100.0	280.0	20.0	2,400.0
Derivative assets		1,360.0	120.0	1,480.0
Total assets	2,100.0	1,640.0	140.0	3,880.0
Derivative liabilities		295.0	18.0	313.0
Short positions	650.0			650.0
Total liabilities	650.0	295.0	18.0	963.0

The levels must add to the balance sheet totals. Level 3 is 3.6% of the assets, which is small in value but is where most of the judgement lies.

The P&L#

Each valuation adjustment is a balance that moves from one reporting date to the next. The increase in a reserve is a charge to P&L, and the release of a reserve is a credit.

Roll-forward of valuation adjustments, derivatives#
£m	Opening	Charge to P&L	Closing
IPV adjustment	14.5	4.0	18.5
Bid-offer and close-out reserve	18.5	3.5	22.0
Model reserve	11.5	(2.0)	9.5
CVA	24.5	6.5	31.0
DVA	(9.5)	(2.5)	(12.0)
FVA	11.0	3.0	14.0
Total	70.5	12.5	83.0

The closing balance of 83.0 is the total of the adjustments in the bridge (1,250.0 less 1,167.0). The charge of 12.5 is what reaches the income statement.

Trading income#
£m	Amount
Desk trading P&L, before adjustments	410.0
Increase in IPV adjustment	(4.0)
Increase in bid-offer and close-out reserve	(3.5)
Release of model reserve	2.0
Increase in CVA	(6.5)
Increase in DVA	2.5
Increase in FVA	(3.0)
Release of deferred day-one profit	1.5
Trading income in the income statement	399.0

The first six adjustments come from the roll-forward and add up to the charge of 12.5. The day-one release is covered below. The desk reports 410.0, and the accounts report 399.0. Valuation control explains the difference of 11.0, line by line.

Example: an IPV result#

Independent price verification compares the desk mark with an independent price for each position. If the difference is more than a threshold, the position goes into the IPV adjustment.

IPV results for four positions#
Position	Desk mark	IPV mark	Difference	Threshold	Outcome
10-year GBP swap, Level 2	12.40	12.35	0.05	0.25	Within threshold. No adjustment.
Corporate bond, Level 2	50.00	49.90	0.10	0.50	Within threshold. No adjustment.
20-year EUR swaption, Level 2	8.60	7.90	0.70	0.30	Over threshold. Adjust by 0.70.
Structured credit note, Level 3	15.00	12.20	2.80	1.00	Over threshold. Adjust by 2.80.

The adjustments of 3.50 are part of the IPV adjustment of 18.5 in the bridge. The policy decides whether the adjustment is the whole difference or only the amount above the threshold, and it must be applied consistently.

Example: day-one profit#

Suppose the bank sells a structured product to a client for 10.0, and the model value is 8.8. The model depends on an unobservable correlation, so the fair value is not evidenced by observable data. The 1.2 difference cannot be recognised on day one under IFRS 9: Financial Instruments. It is deferred and released over time. This example releases it in a straight line over the four-year life.

Deferred day-one profit#
Year	Opening deferred	Released to P&L	Closing deferred
1	1.20	0.30	0.90
2	0.90	0.30	0.60
3	0.60	0.30	0.30
4	0.30	0.30	0.00

The deferred balance is not a valuation adjustment from the desk’s point of view, but it reduces the carrying amount, so valuation control tracks it.

How the release is defined#

IFRS 9 allows the deferred difference to be recognised in profit or loss only to the extent that it arises from a change in a factor, including time, that market participants would take into account when pricing. It does not prescribe a method, so the firm sets a policy. The usual choices are:

Straight line over the life of the trade, as in the example above.
When the inputs become observable, so the balance is released when the unobservable input moves to observable data, for example when a Level 3 correlation becomes Level 2.
At maturity or termination, so the balance is released in full when the trade ends, is closed out, or is sold.
Following the risk profile, so the release tracks the trade’s risk or the behaviour of the model, not the calendar.

The policy is documented, applied consistently, and agreed with the auditors.

The pattern is separate from how often the release is booked. The release is calculated at each period close, which is daily or monthly for management accounts and quarterly or half-yearly for published accounts. The total for a year is the same whichever frequency is used. In the example, 0.30 a year is 0.025 a month.

Example: Level 3 reconciliation#

For recurring Level 3 balances, the notes reconcile the opening to the closing balance.

Level 3 derivative assets#
£m	Amount
Opening balance	105.0
Gains in the income statement	18.0
Settlements	(12.0)
Transfers into Level 3	14.0
Transfers out of Level 3	(5.0)
Closing balance	120.0

The closing balance agrees to the Level 3 derivative assets in the hierarchy table. The notes also give the gains that relate to positions still held at the date, and the sensitivity to the unobservable inputs. See Fair-value hierarchy: Levels 1, 2 & 3.

A valuation control view#

The tables above are a set of reconciliations, and valuation control owns them:

Desk to ledger: the desk mark, plus the adjustments, equals the fair value in the general ledger. In the example, 1,250.0 less 83.0 is 1,167.0, which is also 1,480.0 less 313.0.
Reserves to P&L: the movement in each reserve equals the charge or credit in trading income, so the opening balance, the P&L and the closing balance agree.
Levels to balance sheet: every position has a level, and the levels add up to the balance sheet totals.
Level 3 roll-forward: the opening balance plus each movement equals the closing balance, and each movement has a supporting reason.
Explain the movement: the difference between the desk P&L and the reported P&L is explained, line by line, to the finance team and to the auditors.
Link to capital: the same reserves are netted against the prudent valuation adjustment. See Prudent Valuation.

These checks form part of the internal control over financial reporting. See Sarbanes-Oxley: Internal Controls over Financial Reporting.