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Accounting alert 2011/01 - Financial reporting in an environment of uncertainty

Considerations for financial reporting at 30 June 2011

Author: Frank Betkowski and Debbie Hankey, Accounting Technical Group

Background

The June 2011 reporting season continues the themes of previous reporting periods – particularly those of uncertainty and volatility.

As the global economy struggles to emerge from the global financial crisis, shocks from ongoing economic and political crises, together with a series of natural disasters both in Australia and globally, have the potential to undermine confidence and create further uncertainty. The threat of further shocks cannot be discounted.

On top of global developments, Australian-specific uncertainties exist in terms of tax and legislative reform in the context of a finely balanced federal parliament, the move towards a carbon pricing mechanism for Australia, and other developments.

This ongoing variability has been reflected from a financial reporting perspective by IFRS, which is effectively designed to reflect the underlying volatility in prices, values and other variables in financial statements. Accordingly, the current reporting period continues the ‘challenge’ of bringing all these competing factors together to produce a set of financial statements reflecting economic realities, market expectations and operating conditions.

Impact on financial reporting

The continuing uncertain economic climate and volatility in key variables will present entities with ongoing challenges in complying with IFRS.

The table below provides a broader perspective on the areas of IFRS that may require additional attention in the current financial climate:

Area Example considerations
Impairment
  • Underlying assumptions on cash flows used in valuation models need to be recalibrated to reflect current economic conditions
  • Changes, both positive and negative, in short term interest rates and risk premiums, and their effects on discount rates, need monitoring
  • Inflation assumptions may be difficult to determine
  • Impact of retranslation of foreign currency fair value adjustments (including goodwill) on the carrying amounts of cash-generating units, particularly where large currency movements have occurred
  • Entities with operations in jurisdictions experiencing political unrest may need to consider further adjusting discount rates to reflect any increased sovereign risks
Earnings per share
  • Options and similar instruments may move into to out of the money due to share market price volatility
Loans, borrowings and other financing
  • Classification of debt as current or non-current in light of actual and potential covenant breaches and unusual embedded terms which may be triggered in the current economic climate or due to political developments in certain countries, natural disasters or other events
  • Careful review of new and/or renegotiated borrowing facilities to identify key covenants and other compliance considerations and ensure these are monitored
  • Possibility of embedded derivatives in old or newly renegotiated contracts that may have value in the current climate, even if previously immaterial or not identified
Provisions and other long-term obligations
  • Potential provisions arising out of natural disasters or other events
  • Long-term discount rates may materially impact the carrying amount of provisions as interest rates become more volatile
  • Reassessment of onerous contracts
Receivables
  • Recoverability of trade receivables may have improved or changed
  • Disclosures around allowances for credit losses need to be carefully considered
Investments
  • ‘Available-for-sale’ reserves that are in debit (losses) may need to be recycled to the income statement, directly impacting profit or loss
  • Subsequent increases in value of available-for-sale equity instruments are recognised in equity rather than profit or loss
Held for sale assets
  • Reconsider whether the criteria for classification as ‘held-for-sale’ continues to be satisfied where sale transactions have not been finalised
  • Reassessment of disposal strategies may result in reclassifications ‘in’ / ‘out’ of the ‘held-for-sale’ category
Financial instruments
  • Some instruments may continue to present difficulties in determining fair value
  • Impact of counterparty risk on fair values
  • Reassess likelihood that group or other guarantees may be called upon
  • Whether contracts which previously met the ‘own use’ exemption under AASB 139 Financial Instruments: Recognition and Measurement are no longer able to meet the exemption requirements due to contracts being net settled or changes in expected supply and demand, force majeure events arising from natural disasters or other events, and other circumstances
Hedge accounting
  • Effectiveness testing of hedging arrangements may come under pressure in volatile markets if key variables move outside expected ranges
  • Whether a hedged forecast transaction can still be demonstrated to be highly probable may be impacted by changes in demand or supply or difficulties caused by natural disasters
Share-based payments
  • Valuation of share-based payment arrangements under AASB 2 Share-based Payment can be more judgemental where key valuation variables depart from historical trends or move quickly
  • Accounting for cancellation or modification of share-based payment schemes can have a significant impact on reported profits
  • Unforeseen accounting and tax consequences of scheme modifications
Deferred taxes
  • Application of the ‘probable profits’ test for deferred tax assets, including carry forward tax losses
Special purpose entities
  • (Voluntary) changes to the structure of special purpose entities or their relationship with sponsoring or other entities may result in consolidation

Disclosure considerations

IFRS contains extensive disclosure which can come into play in preparing financial reports in volatile or uncertain times. Whilst every entity will face different facts and circumstances, some of the major areas where the need for informative disclosure may arise as a result of the current economic climate include:

  • Judgements made in applying accounting policies and key sources of estimation uncertainty (AASB 101 Presentation of Financial Statements)
  • Financial instrument disclosure – liquidity and market risk, fair values of financial instruments, defaults and breaches, sensitivity analysis and the new requirements for disclosure about fair values in a ‘three level hierarchy’ (AASB 7 Financial Instruments: Disclosures)
  • Information about impairments, reversals of impairments, assumptions and sensitivity analyses (AASB 136 Impairment of Assets)
  • Uncertainties around provisions and contingent liabilities (AASB 137 Provisions, Contingent Liabilities and Contingent Assets)
  • Events after the end of the reporting period (AASB 110 Events After the Reporting Period)
  • Information about significant changes to the compensation of key management personnel, including the award of bonuses (AASB 124 Related Party Disclosures).

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