The supplement to the May 2008 edition of IFRS News covers credit crunch accounting issues.

• Credit crunch and related market turbulence: Practical implications for preparers of financial statements
• Economic crisis: IASB told to improve guidance
• Viewpoint: Can the IASB do more?
• Top 10 impairment issues
• Effect on employee benefits accounting
• Accounting issues arising from 'credit crunch'

Credit crunch and related market turbulence: practical implications for preparers of financial statements

The challenging market conditions continue. We are seeing big write-downs and writeoffs in the financial services sector. The markets continue to be volatile, and central banks are injecting liquidity into debt markets. But these conditions and their consequences, including the almost unprecedented lack of trust that has been and still is evident in the inter-bank markets, have an impact beyond the banking and financial
services sector. Leader of PricewaterhouseCoopers’ Global Accounting Services, Richard Keys, explains.

The market conditions are most immediately felt by those fair valuing financial instruments. Fair value in accounting itself has come under attack from some quarters accused of making the problems worse. Fair value is not perfect, but most agree it is a more relevant measure than historical cost for financial instruments. What needs further attention is how fair value is applied in illiquid markets and how and when models should be used for its determination.

Any balance sheet measurement is most relevant at the balance sheet date. Fair value information can only provide a fix on value at the point in time it is measured. While it is likely to be the best indicator available, its relevance will also depend on, among other factors, the volatility of the market inputs and whether the instruments valued are actively traded or are held for the longer term. What it does provide is an important indicator of risk profile and exposure but to fully understand this and put it into the context of a particular business requires further and more specific disclosures. It is going to be important to examine whether the first-time adoption of IFRS 7 in 2007 has facilitated this better understanding and context or has resulted in just another set of information disclosures from which it is difficult to distinguish the ‘wood from the trees’.

All companies need to account for the effect of the recent economic turmoil on the business. The accounting should not get in the way of management’s strategy for coping with market conditions. But management needs to start thinking about disclosure and informing the market about how it is handling the tough conditions. They should also be thinking about how different parts of the business are affected: the market inputs they use in impairment testing, the implications for employee benefits, hedge effectiveness and other issues around financial instruments. This supplement addresses all these areas and offers practical guidance on the actions management can take.

We all have to take into account the credit crunch and volatility ‘game’. There is no choice.

Economic crisis: IASB told to improve guidance

The G7 group of most industrialised nations last month called on the Board to improve its guidance for off-balance sheet entities in these times of economic crisis.

The G7 finance ministers and Central Bank Governors said in a statement following their meeting in Washington last month: “The IASB… should initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress”.

It also urged the IASB, as well as the Basel Committee, IOSCO and the Joint Forum, to “accelerate their timetables of work to conclude their efforts by end-2008”.

The Board has begun a standard-by-standard review of fair value measurement. The project team is also creating an informal valuation advisory group to provide practical input about measuring fair value and about valuation issues generally.

In addition, as one of the responses to the FSF recommendations, the IASB is putting together an advisory group to help address in particular the issue of valuing financial instruments in illiquid markets.

In response to the FSF recommendations, the Board is accelerating the derecognition and consolidation projects. In the case of the consolidation project, it is issuing an exposure draft without first publishing a discussion paperand is proposing the same for its project on derecognition. However the IASB underlines that “whilst there is a clear need to make swift progress with these projects, this has to be balanced with maintaining appropriate due process and public consultation”.

Sir David Tweedie, chairman of the IASB, said on the conclusions of the FSF: “We are supportive of the recommendations set out in the FSF report and will work with others to ensure that any lessons to be learnt from the crisis are dealt with appropriately”.

The IASB and the other multi-lateral organisations are to provide an update at the next G7 meeting in June. The Financial Stability Forum, which produced the report for the G7 on the contributing factors to the recent turmoil in the financial markets, has also been asked to produce a ‘comprehensive follow-up report’ later in the year.

Other issues identified in the FSF report, and termed “immediate priorities for implementation within the next 100 days” by the G7, include:

• companies’ prompt and robust disclosure of risk exposures, write-downs and fair value estimates for complex and illiquid instruments in upcoming mid-year reporting;
• strengthened capital positions and risk management practices, including rigorous stress-testing, overseen by supervisors;
• revised liquidity risk management guidelines from the Basel Committee by July 2008; and
• a revised code of conduct for credit rating agencies from IOSCO.

Viewpoint: can the IASB do more?

The chairman of PricewaterhouseCoopers’ Corporate Reporting Task Force, Roger Marshall, talks to IFRS News about the G7 recommendation that the IASB improve its guidance for off-balance sheet entities (see p2). The views expressed below are his own.

Are the G7’s concerns that current IASB guidance is inadequate in times of economic crisis well founded?

The current accounting model is not ideal. The IASB [in its recent discussion paper Financial Instruments: 'A Replacement of IAS 39 Financial Instruments: Recognition and Measurement' is looking at improvements in the area of financial instruments that can be made both in the long and short term. Their long-term goal appears to be to fair value everything. Certainly fair values are frequently the best measure – for example, of derivatives or financial instruments traded in active markets. However, I don’t believe the Board has fully addressed the difficulties around fair valuing many financial instruments, which are rarely if ever traded.

Preparers already struggle to come up with meaningful fair values on some instruments once a quarter let alone once a month and do not use this information for decision-making purposes. Given the number of practical and conceptual difficulties, I see fair valuing everything as a long way in the future.

Part of the current difficulties stem from the complexity of the current standard, which is caused in part by the significant anti-abuse provisions. I think the Board focuses too much on anti-abuse measures. There is a concern that these rules also distort presentation. It’s always a balance, but I believe the current standard is too far tipped towards anti-abuse concerns.

It would be useful to users of financial statements if companies could provide analysis of where a financial instrument’s fair value is ‘real’ (ie, based on observable market prices) compared with where models have been used. US GAAP already requires this. I also believe that more guidance on fair valuing financial instruments in thin or completely illiquid markets would be welcome. Some preparers are concerned about valuing assets at fire sale prices, which they do not consider impaired and are not proposing to sell; I think these concerns are legitimate.

What can the IASB do to address the G7/FSF’s concerns? Should they attempt to fix the accounting?

As noted above there are things the Board could do in giving guidance on valuing illiquid instruments and increasing disclosures. However, in general I don’t believe changing the
accounting standards is the appropriate way to deal with each year’s economic problems. The IASB has a long due process and cannot respond in a timely way to urgent issues. What is more, anything that is agreed would be enshrined in the accounting standards for years; next year there will be a different issue that needs addressing, and we will end up having more and more disclosure requirements about yesterday’s issues.

We are almost half-way through the year. By time IASB can implement any measures, it will be so late in the year as to put preparers and auditors under a lot of pressure. Even additional mandatory disclosures can be onerous as IFRS 7 showed. The Board therefore needs to be careful in coming up with new requirements and needs to avoid knee jerk reactions.

Looking forward, I wonder whether it is the securities regulators that are best placed to respond to such short-term issues. They can mandate the disclosures they require from companies listed on their exchanges. This could be done much more quickly than changes to the financial reporting standards, and the requirements can be removed easily when they are no longer necessary. IOSCO mandating a common disclosure platform would ensure that global comparability wasn’t compromised.

Is more disclosure by companies going to help users?
More disclosure about holdings of financial instruments and about the extent of model based valuation is helpful, but where should management put that disclosure? Are the financial statements always the most appropriate place? The financial statements are already so complex that they have ceased to be a communication tool to normal investors. I think sometimes the company’s website is more suitable. Management can reassure the shareholders with additional disclosure and can update it regularly, rather than being tied to the annual reporting timetable. There is an opportunity for PwC to provide assurance on this information; increasingly, I believe, assurance will be provided on such time sensitive information rather than only once or twice a year.

I think that minimum disclosure in the financial statements should be mandatory, but I don’t think a mandatory format for detailed disclosure will always enhance users’ understanding.

What could a well-governed company do to respond to this without there being a change in the standards?

Many companies have already provided significant additional disclosures to their shareholders to address specific concerns. Those that do not should not be surprised at having a higher cost of capital.

Top 10 impairment issues

The last 12 months have been marked by increasing volatility in global markets and signs of economic downturn. Management may experience significant impairment charges in the coming months. Olivier Scherer, Caroline Woodward and Dave Walters from PwC’s Global Accounting Consulting Services have compiled a list of the top 10 areas to watch out for. They have ranked them in reverse order of importance, working up to their top tip!

10. Start impairment testing early
The impairment test process takes time. It includes identifying impairment indicators, assessing or reassessing the cash flows, determining the discount rates, testing the reasonableness of the assumptions and benchmarking the assumptions with the market. The process has to begin early – don’t leave it until the last minute, as no one likes nasty surprises. Goodwill does not have to be tested for impairment at the year end; it can be tested
earlier. But if any impairment indicator arises at any balance sheet date, the impairment assessment has to be updated.

9. Comply with the disclosure requirements
IAS 36, Impairment of Assets, and IAS 1, Presentation of Financial Statements, have many disclosure requirements. Market regulators around the world have spotted that some companies are not including all the required disclosures. For example, don’t forget to disclose discount rate and long-term growth rate assumptions in a discounted cash flow model for both value in use and fair value less cost to sell; and describe what the key assumptions are and what they are based on. Sensitivity analysis is also even more relevant when the markets are volatile. There is no exemption from disclosures.

8. Allocate goodwill to the appropriate CGUs
When goodwill is acquired, it needs to be allocated to all the cash-generating units (CGUs) or groups of CGUs expected to benefit from the acquisition. These may include CGUs in the existing as well as the acquired business. Think about how the goodwill is going to be ubsequently tested for impairment before finalising the allocation process.

7. Watch foreign currency cash flows
Estimate future cash flows in the currency in which they will be generated. They should be discounted using a discount rate appropriate to that currency.

6. Compare like with like
Make sure the cash flows being tested are consistent with the assets being tested. Watch for consistency when including or excluding working capital from the CGU. Also make sure that the forecast cash flows make allowance for investment in working capital if the business is expected to grow.

5. Reconcile the conclusion to the current environment
When you’ve finished your detailed calculations, check that the final answer makes sense by comparison to any market data (for example, share prices and analysts reports).

4. Pay attention to market capitalisation
Market capitalisation below net asset value is an impairment trigger, and calculations of recoverable amount are required. If the market capitalisation is lower than a value-in-use calculation, challenge the VIU assumptions. For example, the cash flow projections might not be as expected by the market, and the reasons for this must be plausible.

3. Scrutinise the discount rate
Watch out for illogical discount rates. Interest rates set by governments are falling in many territories, but other factors affect discount rates in impairment calculations. These include corporate lending rates, cost of capital and risks associated with cash flows, which are all increasing in the current volatile environment and can potentially result in an increase of the discount rate.

2. VIU must comply with the standard
In a VIU test the cash flows exclude the costs and benefits of future reorganisations (unless the reorganisation has been provided for in the accounts under IAS 37) and also the costs and benefits of future enhancement capital expenditure. This means the cash flow forecasts for a VIU test may differ from the cash flows in the board-approved budgets for future years.

1. Cash flows in the impairment calculations must be reasonable and supportable
Forecasts prepared months ago (before the full effects of the downturn became clear) may need to be revised. Forecasts need to be based on the latest management-approved budgets or forecasts, but these do need to be reasonable and supportable. For example, they should be consistent with analysts’ forecasts for the sector and the views of other third-party experts and economic forecasters.

Effect on employee benefits accounting

The credit crunch and other current market conditions don’t just have an effect on assets; they also impact on the measurement of employee benefits. Richard Davis explains.

Pensions
IAS 19 requires post-employment benefits to be valued using a discount rate based on high-quality corporate bond yields (at least where there is a deep market). In territories where there are deep markets in high-quality corporate bonds, we are used to seeing charts that plot duration against yield with only a few outliers and maybe a range of plausible yield curves; however, the range of credible answers has been relatively narrow. This year, the same charts are more scattered, with a spread measured in hundreds of basis points rather than tens. When you examine the details, you find that the higher yielding bonds are all financial institutions. The bonds are still rated ‘AA’ by the credit agencies, but the markets seem to take the view that some ‘AA’-rated bonds are not as high quality as others.

Where does this leave preparers and auditors when it comes to setting and auditing discount rate assumptions? There are two main issues:

• The methodologies that have been used in the past to set assumptions may not be robust enough to cope with current circumstances; and
• The range of assumptions that can be reasonably justified, both in absolute terms and without being inconsistent with past practice, is going to be wider than at any time since IAS 19 (revised 1998) (or for that matter SFAS 87) was introduced.

• implied volatility based on traded options with a life of at least one year; and
• historical volatility considered over a time period equal to the expected life of the option.

Accounting issues arising from ‘credit crunch’

Many people around the world are continuing to feel the impact of the credit crunch. As entities approach their interim reporting, they should be alert to some of common issues we have seen recently under IFRS. Jessica Taurae explains.

Fair value
The illiquidity in some markets continues to lead to difficulties in establishing the fair value of some financial assets and liabilities. The best evidence of fair value under IAS 39, Financial Instruments: Recognition and Measurement, is quoted prices in active markets. Where these are not available, entities use valuation techniques to estimate the fair value. A valuation technique must incorporate all factors that market participants would consider in setting a price. Determining fair value therefore requires consideration of current market conditions, including the relative liquidity of the market and current credit spreads. Entities cannot ignore current information about how the market would price the instrument nor should entities use information that is available post the balance sheet date to ‘update’ their fair value estimates. In addition, if an entity is looking to place reliance on a fair value provided by a third party (for example, a broker quote or pricing service), it needs to understand how the third party has derived that valuation and whether it is in accordance with the requirements of IAS 39 (for example, does it represent actual transaction prices or just indicative prices).

Impairment of financial assets
IAS 39 focuses on having objective evidence of impairment before a loss can be recognised. Companies will need to consider whether current market conditions imply there is objective evidence of impairment for their financial assets. Loans to sub-prime customers or loans to other entities with sub-prime exposures will have objective evidence of impairment as those customers default. However, if an entity has available for sale (AFS) debt securities whose fair value has decreased, perhaps significantly, because of illiquidity and rising interest rates, that on its own is not considered objective evidence of impairment for AFS debt securities under IFRS. If there is objective evidence of impairment of an AFS debt investment, the amount of the impairment loss recognised in profit or loss includes the whole of any cumulative loss previously recognised in equity. This will include any fall in fair value below amortised cost and is not limited to the impairment loss that would have been recognised had the asset been measured at amortised cost. In addition, given the current lack of liquidity, entities may be experiencing shortages of cash. This may lead to trade receivables being doubtful or bad debts, as often it will be the suppliers that are paid last in these times.

Embedded derivatives
The value of some embedded derivatives may previously have been determined to be immaterial, in particular if the underlying was linked to an event considered to be remote (such as a large change in credit spreads). Companies should be alert to the possibility that the value of such embedded derivatives may have become material as a result of recent market events. For example, many companies had previously concluded that value changes in the embedded credit derivative in synthetic collateralised debt obligations were immaterial and therefore had not accounted for them. Under current market conditions, the embedded derivative’s fair value is now more likely to be material, in which case that change in fair value must be reflected in profit or loss.

Consolidation of SPEs
Companies with exposure to special purpose entities that have not previously been consolidated under SIC-12 should be alert to the need to reconsider the consolidation decision – for example, if the funding or capital structure of as SPE is amended, this triggers a reassessment of who should consolidate it under SIC-12. This includes the case where a company (for example, the sponsor, or entity that set up the SPE) steps in to support an SPE when it had no previous contractual obligation to do so.

Reclassifications
In response to current market conditions, it has been suggested that fair value accounting be suspended or changed for certain financial instruments, or that businesses should apply their own models, which may show a less volatile long-term scenario. However, IAS 39.50 prohibits the reclassification of a financial instrument into or out of the FVTPL category while it is held. Accordingly, it is not appropriate to reclassify financial instruments out of the FVTPL category as a result of recent market events.

Hedge accounting
Companies may be experiencing some hedge ineffectiveness as a result of recent market conditions. For example, if entities had designated fair value hedges of fixed rate assets using interest rate swaps, ineffectiveness may arise due to the re-pricing of the floating leg of the swap. If entities had not designated their hedged risk carefully, they may have hedge ineffectiveness arising from changes in credit spreads that are not mirrored in the hedging instrument. Others that have hedged forecast debt issuances, including the rollover of commercial paper, will need to ensure that the hedged debt issuance is still highly probable of occurring. If not, the criteria for hedge accounting are no longer met, and the hedge accounting should cease.

Disclosures
IAS 34, Interim Financial Reporting, governs the requirements of interim reporting under IFRS. Current market events are likely to require a number of additional disclosures. For example:

• Further deterioration of the credit exposures reported in the annual financial statements that resulted in the accounting of losses that are unusual because of their nature, size or incidence;
• The fact that certain financial instruments have ceased to be traded in an active market during the interim period and that a valuation technique has been used to measure their fair value;
• The use of different valuation techniques (a method of computation) compared to those utilised for the amounts included in the annual results;
• A significant change in the financial risk management approach of the entity which would be disclosed under IFRS 7 if the quantitative disclosure of the entity’s exposure to financial risks and its sensitivity to market risks reported at the end of the financial period is not representative of its exposure and sensitivity during the period.

• exposures to SPEs distinguishing between those that are or are not consolidated, as well as the nature of the entity’s involvement with SPEs, and maximum exposure to losses;
• exposures to collateralised debt obligations and a breakdown by underlying collateral (for example, sub-prime) and related hedging.