1 JANUARI e JAARGANG NUMMER 2 ACCOUNTING FOR CRISIS the role of the accountant in the current financial crisis Interviews: Hans Gortemaker Gineke Bossema Artikelen: Sanjay Bissesur Liz Hickey Pieter Veuger Philip Wallage Victor Maas FINANCIËLE STUDIEVERENIGING Amsterdam
3 Inhoudsopgave Colofon Colofon Inhoudsopgave Uitgever Financiële Studievereniging Amsterdam Hoofdredacteur Teun van der Velden Druk Grafiplan Nederland B.V. DTP Thijmen Galekop Advertenties Fiducie verschijnt vier keer per jaar. Voor advertenties kan contact worden opgenomen met de Financiële Studievereniging Amsterdam FSA Hoewel deze uitgave de uiterste zorg is nagestreefd kan voor de aanwezigheid van eventuele (druk) fouten en andersoortige onvolledigheden niet worden ingestaan en aanvaarden de auteur(s), redacteur(en) en uitgever in deze geen aansprakelijkheid. Alle rechten voorbehouden. Niets uit deze uitgave mag worden verveelvoudigd, opgeslagen in een geautomatiseerd gegevensbestand, of openbaar worden gemaakt, in enige vorm of op enige wijze, hetzij elektronisch, mechanisch, door fotokopieën, opnamen, of enig andere manier, zonder vooraf gaande schriftelijke toestemming van de uitgever. VOORWOORD FIDUCIe 5 Teun van der Velden Aan het woord: ARTIKELEN: Hans Gortemaker 6 Gineke Bossema 8 The role of fair value accounting in the 10 current financial crisis Sanjay Bissesur IFRS and the implications of the credit crisis only 16 relevant for Financial Institutions, right? Wrong read on to see why. Liz Hickey Is de verslaggeving van financiële instrumenten binnen 22 IFRS aan fundamentele revisie toe? Pieter Veuger Enkele oorzaken en gevolgen van de financiële crisis 30 Philip Wallage De kredietcrisis en de rol van de controller 36 Victor Maas 3
5 Voorwoord Fiducie Accounting for Crisis De vraag wat er in de financiële markten is gebeurd, is breed uitgemeten in verschillende media. Inmiddels wil het publiek niet meer weten wat er is gebeurd, maar wat er te gebeuren staat. De vinger wijst in de richting van de toezichthouder en de rating agencies. De grote lijnen zijn dus duidelijk, maar waar blijven de accountants? Deze groep wordt in de grote media nauwelijks onder de aandacht gebracht. Wat is dan die invloed op -en van- het vakgebied van accounting en control? Moeten er andere, meer, of juist minder regels komen? Welke verantwoordelijkheid hebben de verschillende kantoren? Wat is de invloed van IFRS geweest en wat zijn de accounting implicaties voor zowel financials als niet-financials? De tweede Fiducie van dit collegejaar adresseert bovenstaande vragen op een wetenschappelijke en gedegen wijze. Verschillende professionals en academici werpen hun blik op het geheel en vormen deze Fiducie tot een interessante en nodige discussieverbreding van de veelbesproken crisis. De Financiële Studievereniging Amsterdam biedt u voldoende stof tot nadenken in dit nieuwe jaar en nodigt u van harte uit op de FSA Mastercourse die deze Fiducie zal toelichten. Deze Mastercourse wordt verzorgd door professor Gortemaker en professor Wallage. Het zal een complement zijn aan de Fiducie en vindt plaats op 13 januari aan de Universiteit van Amsterdam. Voor meer informatie aangaande de Mastercourse kunt u terecht op Teun van der Velden Penningmeester FSA
6 Aan het woord: Hans Gortemaker Prof. Hans Gortemaker RA Hoogleraar accountancy aan de Erasmus Universiteit te Rotterdam Adviseur PricewaterhouseCoopers Intervieuw door Teun van der Velden 6 Wat denkt u dat er zou moeten veranderen in het vakgebied van accountancy naar aanleiding van de crisis? Als er wordt gekeken naar de code Tabaksblat kunnen er een aantal zaken veranderen. In de code staat dat bedrijven naast de verslaggeving over financiële informatie ook verslag moeten doen van de risico s en de interne beheersingsmaatregelen van een bedrijf. Op het moment dat deze bedrijven dit daadwerkelijk netjes doen, kan de accountant met betrekking tot de interne beheersing van de financiele risico s een mededeling doen. Dit betekent dus ook dat het werkveld van de accountant wordt verbreed met een grotere kennis van risk management? Een accountant moet er inderdaad voor gaan zorgen dat het team dat de bedrijfscontrole uitvoert voldoende kennis heeft over de risico s en de maatregelen van interne beheersing die gepaard gaan met de bedrijfsvoering. Zo kan er expliciet een mededeling worden gedaan met betrekking tot de interne beheersingmaatregelen gericht op financiele risico s. Het hoger management wordt op deze manier gedwongen om zich bewust te zijn van de risico s binnen de eigen huishouding. De media betrekken de accountantskantoren nog nauwelijks in de huidige financiële crisis. Dit in tegenstelling tot de situatie in Hoe kijkt u naar deze ontwikkeling? De media hebben inderdaad nog weinig aandacht besteed aan de accountantskantoren. In 2002 tijdens de grote debacles rondom Enron en Ahold schreef de pers met grote letters: Where were the auditors?. Men vroeg zich destijds hardop af wat de accountantskantoren fout deden. Hoewel je de verschillende gevallen niet allemaal op één hoop mag gooien, overheerste dit beeld wel degelijk. Dit heeft dan ook geleid tot de ondergang van één van de Big 5, Andersen. Destijds was het belangrijkste doel voor de sector om het vertrouwen terug te winnen van de maatschappij, dit had immers een flinke deuk opgelopen. Als het vertrouwen in de accountantskantoren mist is het beter om helemaal te stoppen met het beroep. Dit leidde tot vernieuwde wet- en regelgeving voor bedrijven, maar ook onder accountants werden de regels aangescherpt. In Nederland heeft dit bijvoorbeeld geleid tot de instelling van de Autoriteit Financiële Markten, de AFM. Deze maatregelen hebben naar mijn idee het gewenste effect gehad en het vertrouwen teruggewonnen. Kunt u een vergelijking maken tussen de situatie van toen en nu? Destijds was de informatie fout, maar presteerde in de breedte de bedrijven niet slecht. Nu is de informatie niet fout, maar zijn de resultaten van verschillende bedrijven slecht. Dit is natuurlijk gekomen door de subprime problemen. Ik heb verhalen gehoord die ik niet kan bevestigen dat zelfs hotdogverkopers hypotheken verkochten! Het bekende verhaal van de financiële producten die in mandjes zijn gestopt en vervolgens zijn verhandeld is de oorzaak van de crisis. Waar ik echt van geschrokken ben is dat hoger management totaal geen idee heeft gehad welk risico er aan deze producten kleefde. Kunt u de rol van de accountant, de toezichthouder en de rating agencies vergelijken? De vingers gaan tot op heden vooral in de richting van de rating agencies die onvoldoende onafhankelijk waren en de risico s verkeerd hebben ingeschat. Deze bedrijven maken nu mee wat de accountants in 2002 meemaakten. Ook toen werden er vraagtekens gezet bij de onafhankelijkheid van de accountant. Verder is ook de toezichthouder onder vuur
7 Op het moment dat een markt waarin deze producten worden verhandeld zo goed als wegvalt, hoef je hier als accountant niet voor te blozen. gekomen. Men heeft zich afgevraagd of de centrale banken wel adequaat hebben gereageerd op de ontwikkelingen op de financiële markten. Deze partijen beargumenteerden dat zij niet de juiste tools hebben gehad om beter te reageren. Ook het internationale toezicht was onvoldoende om op een juiste manier te reageren. Als de vinger zou worden gewezen naar de accountant wil ik graag iets zeggen ter verdediging van deze groep. Wanneer zaken worden gewaardeerd tegen marktwaarde dit gebeurd in IFRS en er daadwerkelijk een markt voor deze producten is, is dit op zich niet verkeerd. Op het moment dat een markt waarin deze producten worden verhandeld zo goed als wegvalt, hoef je hier als accountant niet voor te blozen. Dit zijn zulke extreme omstandigheden en het is niet de taak van de accountant om dit te voorzien. in overeenstemming met het accounting framework. Persoonlijk sta ik hier zeer huiverig tegenover. Ik vind dat op het moment dat het economisch risico van bepaalde zaken bij de onderneming ligt dan hoort dit op de balans te staan. Als accountant heb ik hier in het verleden mij al mee bezig gehouden. Juristen bedenken soms constructies die wat mij betreft best iets kritischer mogen worden bekeken. Als je de contracten goed bekijkt en bepaalt waar nou daadwerkelijk het economisch risico ligt, zie je dat sommige zaken gewoon op de balans thuishoren. 7 Bij Enron in 2002 en bij Fortis kortgeleden speelde de off-balance problematiek een rol. Hoe kijkt u tegen deze problematiek aan? Er gelden bepaalde criteria voor zaken die buiten de balans geplaatst worden. De accountant moet uiteraard kijken of er gehandeld wordt
8 Aan het woord: Gineke Bossema Drs.Gineke Bossema RA Partner KPMG Intervieuw door Teun van der Velden 8 Hoe wordt de huidige crisis beleeft door de mensen op de werkvloer bij KPMG? Het is voor ons als accountantskantoor constant hands-on. Wij zijn continu bezig met wat de crisis betekent voor onze klanten, maar ook wat het betekent voor KPMG. Voor onze klanten is dit natuurlijk belangrijk, maar voor de controle verandert er ook het één en ander. Hoe wij hiermee om dienen te gaan wordt redelijk internationaal aangestuurd. Omdat de crisis is begonnen in de VS was er daar al eerder een reactie hoe hier mee om te gaan. Op het moment dat het overwaaide naar Europa haakte wij hier op aan. In eerste instantie betrof het alleen banken en andere financiële instellingen. Toen bleek dat de crisis zich begon uit te breiden naar de reële economie werd ook hierop aangehaakt. De aanpak van de controle moest hierop worden aangepast. We hebben er inmiddels voor gezorgd dat de nieuwe risico s die zijn ontstaan goed in kaart zijn gebracht en dat dit ook wordt meegenomen in de aanpak van de controle. Het werkveld van de accountant verandert dus ook daadwerkelijk door de crisis? Op dit moment is er nog niet veel veranderd, maar er is wel iets gaande. De laatste jaren zijn de controles over het algemeen uitgevoerd op basis van een stijgende lijn. Er was sprake van hogere winsten, hogere omzet en ga zo maar door. Door de trendbreuk die we nu zien is er sprake van een dalende lijn waar men rekening mee dient te houden. In sommige sectoren gebeurt gewoon nog maar weinig. Dit vraagt dus om een hele andere controle aanpak. In het verleden keek men vooral naar het juistheidaspect, waar men nu naar het volledigheidsaspect kijkt. Dit vraagt om extra alertheid en tijdens besprekingen met klanten dient expliciet te worden nagevraagd of er nog bijzonderheden zijn. Bij Enron in 2002 en bij Fortis kortgeleden speelde de off balance problematiek een rol. Hoe kijkt u tegen deze problematiek aan? Off-balance theorie is zeer complex en het is niet mijn specialisme. Voor de uitwerking in de financiële rapportage bestaat diverse wet- en regelgeving waar klanten zich aan moeten houden. De accountant controleert of klanten deze regels juist hebben toegepast. Als in het maatschappelijk verkeer besloten wordt dat deze wet- en regelgeving adequaat is, hebben ondernemingen de mogelijkheid om bepaalde zaken buiten de balans te plaatsen. Dit beïnvloedt de kredietwaardigheid van de onderneming en kan positief zijn voor de bedrijfsvoering. Als er nu besloten wordt dat de regelgeving onvoldoende of niet goed is dan moet hier iets aan gedaan worden. Hier kan de accountant zich dan weer op baseren. Denkt u dat een accountant een actievere rol kan spelen in de risicoanalyse van een bedrijf? Achteraf praten is altijd makkelijk, maar wat er nu gebeurt is ook zodanig uniek in de historie dat hierop anticiperen in risico-analyses niet realistisch zou zijn geweest. Je kunt je als accountant wel afvragen of de modellen
9 In sommige sectoren gebeurt gewoon nog maar weinig. Dit vraagt dus om een hele andere controle aanpak. die werden gebruikt om bepaalde zaken te waarderen adequaat zijn om een goede analyse te geven met betrekking tot de risico s van een bedrijf. De modellen zijn in het verleden ontwikkeld op basis van de informatie die toen bekend was. Voortschrijdend inzicht leert ons nu dat er nog meer scenario s mogelijk zijn. Dit zal in aangepaste modellen moeten worden meegenomen. Wat vindt u van een model waarin de toezichthouder en de accountant meer gaan samenwerken om tot betere regelgeving te komen? Op zich kan samenwerking tussen deze partijen goed werken. Er moet natuurlijk wel gekeken worden naar de verschillende verantwoordelijkheden die partijen hebben. Ik denk verder dat dit iets voor in de toekomst is. De focus ligt nu op het tot rust brengen van de markt. Ook hier hebben alle partijen hun rol te vervullen en dient men de verantwoordelijkheid te nemen. Dit geldt voor bedrijven, financiële instellingen, accountants en toezichthouders. 9
10 The role of fair value accounting in the current financial crisis Tekst: Dr. Sanjay Bissessur Assistant Professor Accounting, Amsterdam Business School, Universiteit van Amsterdam 10 Introduction Recently, Martin Sullivan, the former chief executive of AIG, testified before the U.S. Congress on the oversight hearings that examine the events that caused the financial crises and the $700bn Trouble Assets Relief Program (TARP). According to Sullivan, a single accounting rule had caused his firm s near collapse (Kirchgaessner, 2008). He stated that above all, the unintended consequences of Mark-to-Market accounting rules were to blame. Mark-to-Market, or fair-value accounting requires firms to value securities they hold at market prices, rather than the price at which they were purchased or some other value. Regulators put the rules in place to keep companies from hiding losses. Perhaps the importance of accounting rules is overstated. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. However, the risk is also that exaggerated write-downs in the current credit crunch are rapidly reducing the banking system s capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more write-downs and more fire sales. At best, banks will have to keep selling cheap equity to keep themselves afloat. At worst, massive regulatory insolvency lies ahead. In this article I discuss the issue of Mark-to-Market, or Fair Value Accounting, and the role it played in the financial crisis. Mark-to-Market Accounting The accounting rules that allegedly played a major role in the current financial crisis have their origin in the previous financial crisis during the aftermath of the Dot.com bubble. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley (SOX). The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002, is a United States federal law enacted on July 30, 2002 in response to a number of major corporate and accounting scandals including those affecting Enron and WorldCom. Among the regulations of SOX were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. For example, Enron would book a profit on a contract to buy or sell energy years in the future based on its own expectations of how much the contract would be worth over time. But Enron never tried to gauge what others in the market might think the contracts were worth. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards forced companies to value or mark their assets according to a different set of standards and levels. The rules require a company to declare the value of assets at fair value, or whatever price prevails in the market, no matter how sharply those prices swing. The attractions of fair-value accounts are straightforward 1. By basing values on recent prices ( marking to market ), they paint a truer picture of a firm s financial health than historical-cost measures. These gauge net worth from the arbitrary dates when assets and liabilities were first booked. In principle, fair-value accounting makes a firm s viability plainer and enables shareholders and regulators to spot financial trouble more quickly. The difficulty lies in part in the increasing use of so-called market values to determine prices for items that companies aren t necessarily selling. This has become especially tough since the debt crisis has caused large parts of markets to seize up, meaning there often aren t any prices to use as reference points. Indeed, Martin Sullivan, AIG s chief executive, said in March 2008 on the firm s conference call that he doesn t expect the losses to be permanent. We are obviously witnessing and living through extraordinary market conditions, he said. We are trying, as are many others, to value very complex instruments. (Reilly, 2008) AIG and a number of other major financial firms argue that its write-downs were unrealized. In other words, they may never actually result in a true charge to the company. These companies may feel that they are being forced to take big financial hits on holdings that they have no intention of actually selling at current prices. The firms argue they are strong enough to simply keep the holdings in their portfolios until the crisis passes. Forcing companies to value securities based on what they would fetch if sold today could be considered an attempt to apply liquidation accounting to a going concern. In this case, the fair value accounting approach is amplifying the market turmoil, leading to write-downs that are excessive. As a result prices and ultimately values have been disconnected. Alternative accounting strategies don t offer much for markets as well. One alternative is to value a security based on what the buyer originally paid for it. However, this approach risks giving investors outdated information. For instance, supporters of the market-value approach say it will help prevent the kind of long-term economic malaise that gripped Japan in the 1990s, when that country s banks sat 1 See also The Economist A book-keeping error. 30 August.
11 The regulations were passed to prevent a repeat of Enron, but regulations are always a work of hindsight 11 on problem-loans, which never regained their original values. The new rules may help prevent major world economies from suffering the kind of malaise that gripped Japan in the 1990s, as banks there sat on mountains of dud loans for years without writing them down. However, the companies main concern currently is that fair value accounting is distorting returns and speeding the financial crisis, even as investors wonder if companies may be overestimating potential losses to establish cookie-jar reserves. Fair value accounting and the International Accounting Standards Board. With the purpose of achieving its objectives relating to financial reporting and more specifically with the aim of providing useful decision-making information that is relevant, faithfully presented and comparable, the International Accounting Standards Board (IASB) has introduced fair value accounting into international accounting standards. The IASB defines the term fair value as follows 2 : Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. In the application guidance for IAS 39 regarding financial instruments, the IASB states that the published market price is the best evidence of fair value for financial instruments. In addition, the IASB distinguishes between two groups of financial assets and liabilities: assets held and liabilities to be issued, and assets to be acquired and liabilities held. For the first group of financial instruments an entity is required to use the current bid price if market prices exist and for the second group of financial instruments the appropriate market price is the asking price. 2 See also:
12 12 The IASB advises that if the asking price of the current bid is not available, the entity should refer to the price of the most recent transaction. On the other hand, there are financial instruments with a non-active market. For those assets and liabilities, valuation techniques (similar transactions, discounted cash flow analysis and option pricing models) need to be applied for determining fair value estimates. The IASB lists some of the factors an entity needs to take into consideration when applying fair value accounting. Those factors are: The time value of money (government bonds or lower borrowing rate) Credit risk (the premium over the basic interest rate for credit risk) Foreign currency exchange prices Commodity prices Equity prices Volatility Prepayment risk and surrender risk Servicing costs for financial instruments The IASB promotes the fair value approach as the only measure that will increase the informativeness and relevance of accounting income. However, many economists believe that the volatility of accounting data lead by subjectivity in estimates, lack of an active market and experience may result in misleading accounting information and a decreased relevance of reporting. Certain scholars assert that fair value accounting may reduce the value relevance of a company s key performance indicators, net income and net assets. Jermakowicz & Gronik-Tomaszewiski (2006) list five reasons explaining why fair value estimation may cause higher financial results volatility in comparison with results reported under local accounting standards: recognition of more financial assets and liabilities (including derivates) at fair value; tougher rules on the requirement to record special-purpose vehicles or similar structures on the balance sheet; more rigorous assets impairment review; a compulsory annual impairment test of goodwill; and the requirement to recognize actual gains and losses in the financial statements. Ball (2006) states that fair value accounting is more informative than historical costs only under two conditions: Observable market prices that managers cannot materially influence due to less than perfect market liquidity; or Independently observable, accurate estimates of liquid market prices. He questions the reliability of financial statements under fair value accounting by pointing out that there are numerous potential problems when applying fair value. According to him the five big concerns related to fair value accounting in practice are: Lack of market liquidity Managers incentives for manipulating fair value estimates for assets and liabilities without active market Fair value accounting may fail in financial crisis Noisy estimates Increased opportunities for manipulations. He points out that the lack of liquid market prices may cause managerial manipulations and noise estimations. He questions the reliability of financial statements under fair value accounting. Schipper (2005) draws attention to the high possibility of making intrinsic errors when there is no liquid market. Her big concern is the lack of experience, confusion and disagreement among the accountants on using fair value and the failure of the fair value approach to provide information about the most likely ultimate statement account. She defines three sources of confusion related to the fair value approach of hypothetical current exchange. These are: not required existing market fair value accounting incorporates not the most likely outcome but the dispersion of possible outcomes change in estimates does not imply unreliability of previous estimates Danbolt & Rees (2007) claim that the value relevance of fair value accounting is greater than GAAP and historic cost only when valuations can be made objective and unambiguous. When valuation is ambiguous, the value relevance is expected to be low and significant earnings management can be expected. Academic literature addressing fair value accounting in the banking industry Landsman (2006) provides a summary of the US-based and international research addressing the question of whether fair value accounting information is value relevant for investors in the banking sector in terms of relevance and reliability. The common scholars view, according him, is that gains and losses estimates contain too many measurement errors. He points out a greater volatility of the net income measured by using the fair value approach than the historical costs approach. Landsman (2006) emphasizes the three main factors that cause additional volatility. These factors are:
13 changes in the bank s assets and liabilities fair values measurement errors of the fair values changes usage of the mixed-attribute model. Landsman (2006) suggests that the effect of the third factor can be reduced if all instruments are recognized at fair value. Barth et al. (2001) provide a review of the value relevance studies related to the fair value of debt and equity securities held by banks, banks loans and derivatives. Reliability of the measurement is the central question in the summarized studies. Barth et al., (2001) conclude that debt and equity securities estimated by using fair value are perceived by investors as more relevant than historical costs measures. Some studies provide evidence for decrease in reliability of fair value estimates due to measurement errors. Barth et al. (2001) point out that the measurement error can be substantial enough to eliminate its value relevance. According to them, there are controversial findings regarding the relevance and reliability of bank loans and uncertainty about the reliability of derivatives fair value estimates. Hodder et al. (2006) analyze the volatility of three income measures in the banking industry: reported net income, reported comprehensive income, and a constructed measure of full fair-value income. Their findings suggest that full fair-value income has the greatest volatility but because of that it better captures the bank s market risks and consequentially it has a higher association with bank returns. They advocate the use of fair value accounting in the banking sector and propose using fair value accounting for all financial instruments. To summarize the literature overview, scholars doubt whether fair value accounting will enhance accounting information. Moreover, they are concerned about the possibility of a reduced quality of earnings under IFRS caused by lack of experience, measurement errors, lack of an active market and increased opportunities for earnings management. Some economists believe that historical costs accounting provides more reliable information than fair value accounting. However, value relevance research provides controversial findings related to the contribution of fair value accounting in the banking industry (Pencheva, 2007). A recent paper explains how fair-value accounting might be a mixed blessing. Plantin et al., (2008) conclude from their theoretical model that fair-value accounting could sometimes generate fluctuations in asset values that distort the very price information that it puts such store by. The paper examines the incentives of a bank faced with a choice between selling a loan or keeping it on the balance sheet. Because the bank knows its borrower better than anyone else, it has the best idea of what the loan is really worth. Its managers are rewarded according to the accounting profit of the bank. If loans are valued at historical cost and market values are rising, the loans are likely to be sold if this is the only way of realising profit, even if the market undervalues them. The banks managers take a profit and get paid accordingly, although shareholders would be better off if the loans were kept. Fair-value accounting gets around this agency problem. Loans do not have to be sold to cash in on their rising value: marking the assets to their market value has the same beneficial effect on profits and on managers pay. However, in the wrong circumstances fair-value accounting could also induce wasteful sales of long-term, illiquid loans. Left on the books and marked to market, a loan will be valued at the price at which others have managed to sell. But when there are only a few potential buyers that may be especially low. So managers will be tempted to sell in the hope of a better price. Because all banks with similar assets face the same incentives, they will all sell, driving the price down. Their shareholders would have been better off had the loans been kept until they fell due. The temptation to sell is greater for longer-term loans. In this way, a fair-value regime can itself distort the very prices that are supposed to reflect the true worth of assets. The prospect of lower prices can encourage selling which drives down prices further. The information derived from market prices becomes corrupted, and the result is a growing divergence between reported net worth and true value. The theoretical model of Plantin et al., (2008) is a challenge to the ideal of fair-value accounting: that more information is always better. Although it is technically feasible to mark to market even idiosyncratic assets such as loans to small businesses, it might not be desirable. The authors point to a well-established principle in economics, that incremental moves towards perfect competition are not always good. Eliminating one market imperfection (such as poor information) need not bring the ideal of a frictionless economy closer, because this may magnify the effect of remaining distortions (such as managerial short-termism or illiquid markets). The paper also underlines some lessons about market liquidity that have been painfully 13
14 learned outside of academia in the recent market troubles. There is a fair chance that asset markets will stay liquid (in the sense that willing sellers are matched with willing buyers), as long as the actions of market participants are essentially random. But anything that co-ordinates the actions of sellers, in this case, the disclosure required by fair-value accounting can easily lead to sharp movements in asset prices. Plantin et al., (2008) argue that the choice between these measurement regimes boils down to a dilemma between ignoring price signals, or relying on their degraded versions. 3 However, in the wrong circumstances fair-value accounting could also induce wasteful sales of long-term, illiquid loans Conclusion 14 There are controversial views among accountants and bank regulatory organizations about the benefits of fair value accounting generally as well as for the banking industry specifically. The rules are complicated. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses. The regulations were passed to prevent a repeat of Enron, but regulations are always a work of hindsight. Perhaps regulatory regimes will mitigate future crises. Maybe, a few years from now, there will be a magazine cover with someone we ve never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. In the interim, there will almost certainly be a wave of regulations designed to prevent the flood that has already occurred, some of which are likely to trigger another crisis down the line. Until we can have a more rational, measured public discussion about what government and regulations can and should do vis-à-vis financial markets, we are unlikely to break the cycle. 4 References Ball, R. (2006). International Financial Reporting Standards (IFRS): Pro and Cons for Investors. Accounting & Business Research. No. 36 (Special Issue), pp Barth, M., Beaver, W., Landsman, W. (2001). The relevance of the value relevance literature for financial accounting standard setting: another view. Journal of Accounting and Economics. No. 31, pp Danbold J., Rees W. (2007). An Experiment in Fair Value Accounting: UK Investment Vehicles. European Accounting Review, vol. 17, no. 2, July, pp Hodder, L., Hopkins, P., Wahlen, J. (2006). Risk-relevance of fair value income measures for commercial banks. The Accounting Review. Vol. 81, No. 2, pp Jermakowicz, E.K., Gronik-Tomaszewski, S. (2006). Implementing IFRS from the Perspective of EU Publicly Traded Companies. Journal of International Accounting, Auditing and Taxation. No. 15, pp Landsman, W. (2006). Fair value accounting for financial instruments: Some implications for bank regulation. Bank for International Statements.No Working paper. Pencheva, D. (2008). The value relevance of CFO under IFRS in the banking industry. Master Thesis. University of Amsterdam Kirchgaessner, S. (2008, October 8). AIG under fire for $370,000 resort trip. The Financial Times. Plantin, G, H. Sapra and HS Shin. (2008). Marking-to-Market: Panacea or Pandora s Box? Journal of Accounting research. Volume 46 Issue 2, Pages Reilly, D. (2008, March 1). Wave of Writ-off rattles market. The Wall Street Journal, p. A1. Schipper, K. (2005). The Introduction of International Accounting Standards in Europe: Implications for International Convergence. European Accounting Review. Vol. 14, No. 1, pp See also The Economist A book-keeping error. 30 August. 4 See also The Wall Street Journal Bad Accounting Rules Helped Sink AIG. 17 September.
16 IFRS and the implications of the credit crisis only relevant for Financial Institutions, right? Wrong read on to see why. Tekst: Drs. Liz Hickey RA Senior Manager Ernst & Young 16 It seems that every day now you open the newspaper or listen to the news and hear of another financial institution that has either gone bankrupt or received a massive capital injection from a government. Therefore it may seem that the credit crisis and the related accounting implications affect only large financial institutions. However, nothing could be further from the harsh reality. Certainly, banks are facing tough issues currently including determining amounts required to be written down to income on financial instruments held, establishing fair values for items such as complex structured products where markets have effectively ceased to operate, dealing with the lack of funds resulting from the interbank markets drying up, collapse of counterparties which had issued instruments used for hedging and so on. However, Corporates have their own juicy list of issues to deal with, which should prove no less interesting. Read on to learn of some of the main risks, both business and financial, facing all entities, Financials and Corporates, as a result of the current financial crisis, and especially the implications for an entity reporting under IFRS. Money, money, money A challenge facing many entities currently is liquidity. Events in the markets and the present state of the economy in general are creating difficulties related to both maintaining current financing and liquidity sources and finding new ones. Many lending institutions are requiring higher credit standards from potential borrowers. Companies are finding that changed credit terms are making it more difficult to comply with provisions of debt agreements. Violations of provisions of existing debt agreements are frowned upon more than previously. Existing debt covenants that were met in the past without problems may seem more onerous now. An entity that could previously quickly refinance maturing debt may now find it much more expensive to do so, or may find that it takes longer to arrange financing. Sources of long-term debt are also scarcer than previously. In addition, entities may simply find it more difficult to service the debt they are carrying. Lines of credit with one year terms may historically have been renewed without issue. However, in the current climate entities may encounter difficulties with renewals and going concern issues should not be ruled out, especially if the entity is highly leveraged. From a business perspective it is vital for an entity to have a plan or strategy for liquidity risk management. The importance of this is reflected in the fact that IFRS requires disclosure in the financial statements of what that liquidity risk management policy is. Also, a maturity analysis of financial liabilities must be presented to give the reader better insight into when the entity will need funding to repay those liabilities. Collectibility of receivables Creditworthiness that s what it s all about, right? All entities need to take a very close look at their customers to see how the credit crisis has affected them. For example, those operating in industries that supply building materials, equipment or other similar items may certainly be subject to increased collectibility risks given the fact that the construction industry seems to have ground to a halt worldwide. There exists the very real possibility that receivables may be impaired which would require a write down to be recognised in income. IFRS lists a number of events which may have an effect on the estimated future cash flows from receivables and may give evidence of impairment. These include: significant financial difficulty of the debtor; the probability that the debtor will become bankrupt; national or economic conditions such as an increase in the unemployment rate in the area of the debtors, a decrease in property prices for mortgages in the area or simply adverse changes in industry conditions that affect the debtors. Note also that it is not only a reduction in sales which can reduce bottom line profits impairment charges are booked against profits also, and in the current markets the amounts can be very significant. A related issue is customer returns. Entities which provide their customers with the right of return may now need to reassess historical return statistics to ensure they are properly estimating customer returns. The possibility that revenue recognition may need to be postponed until such estimates can be made should also be kept in mind. Inventory That the crisis is having a knock on effect on consumer spending is evident. It is logical then that consumer goods are remaining longer in stock at points of sale. The effect of this from an accounting perspective is that there is a real possibility of valuation issues for stocks of inventory. Net realisable value may have now fallen below original cost or items may even have become obsolete. Current levels of inventory may be consistent with levels held previously, but
17 It is logical then that consumer goods are remaining longer in stock at points of sale given the present climate, such levels may now represent excess amounts. Entities experiencing liquidity issues as discussed above may feel it necessary to reduce prices on their inventories in order to create sales to raise necessary cash. Entities selling items such as kitchens and bathrooms are subject to increased risks as the housing market seems to have all but ground to a halt. If no houses are being bought, not that many new kitchens and bathrooms will be sold either. Another feature to keep in mind is that of time-lag. Whereas it is evident that the slow down in consumer spending is affecting car sales now take the discussion regarding government bail outs of the car giants in the US for example downstream companies in the automotive industry, such as component suppliers for example, will probably be affected in months to come. Therefore, it is vital that entities take a close look at their businesses now, and to project what they think circumstances will look like in the future. From an IFRS perspective inventories need to be carried on the balance sheet at the lower of cost and net realisable value, so if it is expected that the items will be sold only at a price lower than original cost, a write down to that lower amount must occur, and that will be recognised in the income statement. Goodwill Impairment Under IFRS, if an entity acquires a subsidiary at a price higher than the value of the underlying assets and liabilities acquired, it will recognise some or all of that excess as Goodwill, a separate asset, on the Balance Sheet. Such an asset represents an amount paid by the acquirer in anticipation of future benefits expected to be realised from the acquisition. Goodwill is required to be examined at least on a yearly basis to ensure that the carrying amount is not higher than the benefits expected in the future. However, such a test should take place more frequently if events or circumstances occur which indicate that such an impairment has actually occurred. Given the declining economic conditions there is the real issue that Goodwill recognised by many entities may no longer be recoverable. This could mean that the benefits expected previously to be recovered from the Goodwill, the excess paid for the subsidiary, are no longer expected to be recouped. An entity should investigate whether earnings have remained at a level consistent with budgeted levels which could indicate that goodwill is in fact recoverable. Or have earnings been lower than expected or are lower earnings expected in the next year? If competitors have reported production reductions in response to lower demand this may well be a cause for concern. Also, it should be investigated whether market multiples for entities in the same industry sector have declined. In addition, if an entity s stock price and market capitalisation imply that the fair value of a reporting unit is less than its carrying value this is also an indicator. All of these factors may be indicators of impairment, but it should be kept in mind that the current market conditions in general can probably be considered an impairment indicator regardless of other factors. Under IFRS when testing Goodwill for possible impairment it is necessary first to allocate that goodwill to each unit of the acquirer s which is expected to benefit from any synergies of the business combination which led to recognition of the goodwill. Such units are called cash 17 7
18 Or have earnings been lower than expected or are lower earnings expected in the next year? 18 generating units and are the smallest identifiable group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Then, the recoverable amount of each cash generating unit needs to be determined. The recoverable amount is the higher of fair value less costs to sell and value in use. If either of these amounts exceeds the unit s carrying amount, it is not impaired and there is no necessity to estimate the other amount. It may be possible to determine fair value less costs to sell, even if there is no traded price, but in the current climate it may be a real challenge to come up with a reliable estimate. If a reliable estimate of the amount obtainable from the sale of the cash generating unit cannot be made the value in use will need to be used as the recoverable amount. When estimating the value in use of a cash generating unit an estimation of the future cash inflows and outflows expected from continuing use and the ultimate disposal of the cash generating unit must be made, and then the appropriate discount rate needs to be applied to those cash flows. A number of issues arising from the crisis exist connected to this calculation. Possibly the biggest impact of the crisis will be on cash flows. For example, the reasonableness of the entity s cash flow projections needs to be questioned. The greatest effect will probably relate to next years cash flows as they will have the largest effect on the impairment test. As growth slows down sales cash inflows, will decline and the more risk there is the less certain the projections will be. How soon is an entity projecting a recovery and what is the substantiation for that timing? This will mean that simply rolling forward the cash flow projections from last year will not be an option. The effect of increasing costs will also need to be taken into account in projecting cash outflows. Also, has the entity updated the interest rate used for discounting the cash flows? It is important that the rate used should be based on long-term interest rates and it should also not be entity specific. Entities may encounter significant difficulties in preparing these calculations but for accounting purposes this would not be a viable argument to allow non performance of an impairment test. Also, because the recoverable amounts of cash generating units are getting lower correct application of the impairment test is becoming crucial as the risk of booking an impairment increases. Fair value what s all the fuss about? An oft heard cry in the last months is that accountants and fair values have caused or at least exacerbated the problems of the credit crisis. IFRS requires certain financial instruments to be carried at Fair Value. These instruments could be for example shares or debt instruments which are held for trading, so those for which the intention is to sell again in the near future, or those which are part of a portfolio of similar instruments where profits are made, or derivative instruments. Fair value is the value at which an instrument could be exchanged between what is termed knowledgeable willing parties in an arms length transaction. If an instrument is quoted on an active market this is generally the best evidence of fair value. Reference could be made to recent transactions or to quoted prices of similar instruments. Quotes from broker or other pricing services may also be a source of fair value or valuation techniques could be used. As a result of the current crisis activity on markets has slowed down and this has raised issues relating to valuation. For example, when is a market inactive? Can management s estimates be used to determine fair value? Identifying forced transactions Is it acceptable to use broker quotes? The determination of whether a market is inactive or not is not a clear cut one. An entity needs to take all factors into account, and even if it is thought that a market is inactive the most recent transaction will be the basis for the final value. It is just that more work will need to be put into determining whether that observed price gives evidence of fair value or whether and what adjustments will be required to that price to come up with the fair value of the instrument. So the issue is not whether the market is inactive or not, but whether the observed price reflects the actual fair value of the instrument. If observable prices do not exist or when significant adjustments would need to be made to any observable prices, fair value may need to be determined using a valuation model. There have been those who have asserted that a fundamental view should be taken, and so say current levels of risk should not be factored into the projections to be used in the model as they are illogical and do not represent the cash flows expected over the whole life of the instrument. Such an approach would attempt to value instruments at managements estimate of future cash flows ignoring current risk factors. However, a fair value calculation should represent the price at which the market would price an instrument now, taking all factors such as illiquidity and credit risk into account. Therefore, a value derived using a fundamental value approach does not represent a true fair value under IFRS. The effect of this is that many instruments have shown severe declines in fair value resulting in large hits to income in recent months. Another argument has been that actual transactions in instruments were forced transactions, and so can be ignored for the purposes of determining fair value. A real fair value does not represent a transaction which was forced, so by implying that transactions were in fact forced, there are those who would want to ignore those lower transaction prices and thereby avoid having to recognise impairment losses. However, even when a market becomes inactive it is not appropriate to consider all