A closely related issue to determining fair value of financial
instruments is the recognition of deferred day 1 profit or
loss. We have entered into transactions, some of which will
mature in the long-term, where we determine fair value
using
valuation models for which not all material inputs are
market observable prices or rates. We initially recognize
such a financial instrument at the transaction price, which is
the best indicator of fair value, although the value obtained
from the relevant valuation model may differ. Such a difference
between the transaction price and the model value is
commonly referred to as “day 1 P / L”. We do not immediately
recognize that initial difference, usually a gain, in profit
or loss because the applicable accounting literature prohibits
immediate recognition of day 1 profit. The accounting
literature does not, however, address its subsequent recognition
prior to the time when fair value can be determined
using market observable inputs or by reference to prices for
similar instruments in active markets. It also does not address
subsequent measurement of these instruments and
recognition of subsequent fair value changes indicated by
the model.
Our decisions regarding recognizing deferred day 1 profit
p are made after careful consideration of facts and
circumstances
to ensure we do not prematurely release a
portion of the deferred profit to income. For each transaction,
we determine, individually, the appropriate method
of recognizing the day 1 profit amount in the income statement.
It may be amortized over the life of the transaction, or
deferred until fair value can be determined using market
observable
inputs, or realized through settlement. In all
instances,
any unrecognized day 1 profit is immediately
released
to income if fair value of the financial instrument
in question can be determined either by using market observable
model inputs or by reference to a quoted price for
the same product in an active market.
Changes in fair value after day 1 resulting from changes in
observable parameters or otherwise indicated by the model
are recognized immediately in the income statement independently
of the release of deferred day 1 profits. See Note 26e)
to the Financial Statements for quantitative information on
deferred day 1 profit or loss.
