How to Account for a Purchased Credit Default Swap as Protection Against a Reference Entity's Default Risk
Recording a CDS that provides credit protection on a reference entity's bonds — with FV changes driven by the reference entity's credit spread movements recognized in earnings each period.
| Account Name | Type | Debit ($) | Credit ($) |
|---|---|---|---|
| Credit Default Swap — Fair Value Asset | Asset (+) | 4,200,000.00 | - |
| FV Gain on CDS (Non-Operating — Credit Spread Widened) | Income (+) | - | 4,200,000.00 |
| CDS Premium Expense (Running Spread Paid Quarterly) | Expense (+) | 850,000.00 | - |
| Cash (Running Premium Paid to Protection Seller) | Asset (-) | - | 850,000.00 |
💡 Accountant's Note
A credit default swap (CDS) is a credit derivative where the protection buyer pays a periodic premium (running spread times notional, typically quarterly) to the protection seller. In exchange, if the reference entity defaults, the protection seller pays the loss to the buyer. CDS are derivatives — measured at FV through earnings. The FV increases when the reference entity's credit spread widens (credit deteriorates) — a gain for the protection buyer. Hedge accounting for CDS is possible (fair value hedge of the underlying bond's credit risk) but rarely designated because the hedge relationship requires strict correlation between the CDS reference entity and the hedged bond.
Practitioner & Systems Framework
💻 ERP Architecture
CDS fair value is determined by: (1) the present value of expected future premium payments, (2) the present value of the expected credit event payment (probability of default times loss given default), discounted at the risk-free rate plus the CDS spread. In practice, CDS FV is obtained from Bloomberg (CDSW function) or the dealer's mark. The upfront payment (for CDS trading with a standard coupon) is the initial FV — it represents the difference between the standard coupon and the credit spread. The running premium is expensed ratably over each payment period. Credit event payoff: if default occurs, recognize the settlement as income (full notional minus recovery value) and derecognize the CDS.
⚠️ Audit Flags
CDS FV at reporting date requires Level 2 (observable CDS spread from a liquid market) or Level 3 (model-based for illiquid names) measurement. Auditors confirm CDS spreads from Bloomberg or Markit data. If a credit event has occurred or is imminent, the CDS FV should be near par (approaching the full settlement amount) — a CDS showing a small FV when the reference entity is in distress indicates a valuation error. ISDA documentation must be reviewed to confirm the CDS covers the specific bonds held and the standard events of default.
📄 Required Documentation
CDS confirmation (ISDA Credit Derivatives Definitions, reference entity, reference obligation, notional, spread, maturity), CDS FV at each period-end (Bloomberg CDSW or dealer mark), running premium payment records, ISDA credit event definition coverage analysis, counterparty credit risk assessment, hedge designation analysis (if designated in a fair value hedge relationship).
Automate this entry with the JEH Accounting Suite
Stop doing manual entry. Our VBA-powered ERP automatically generates your ledgers, Trial Balance, and Financial Statements.
No Subscriptions. Own your data.
Expert Analysis by Qusai Ahmad
General Accountant Supervisor & IFRS Specialist
Specialized in SAP GUI automation and Middle Eastern tax compliance. Building digital tools for the next generation of finance leaders.
Related Journal Entries
Derivatives & Financial Instruments
How to Designate a Pay-Fixed Receive-Variable Interest Rate Swap as a Fair Value Hedge of Fixed-Rate Debt
Derivatives & Financial Instruments
How to Designate a Pay-Fixed Receive-Variable Interest Rate Swap as a Cash Flow Hedge of Floating-Rate Debt
Derivatives & Financial Instruments