Credit Crunch – Accounting Questions Raised |
The liquidity crisis has dominated credit markets over the past twelve months. Although the primary shock to global financial markets arose due to the sub-prime mortgage crisis in the U.S., the effect has been felt globally due to widespread use of structured securities and leveraged funding of ever-increasing complexity. This has led to lenders and investors re-evaluating their willingness to provide funding with a resulting lack of liquidity which has impacted entities and individuals on a global basis.
The credit crunch, as it has become known, has raised many serious questions regarding risk management and prudential supervision processes. It has also highlighted a number of concerns regarding the effectiveness of accounting standards to ensure that financial reporting is providing clear and early information regarding difficulties being encountered by entities.
The Accounting Questions
A number of bodies have carried out work in this area and have suggested that the main areas which require analysis and further development of standards are:-
• The consolidation model, particularly in the context of special-purpose entities (SPE’s)
• Derecognition and the disclosures provided about off-balance sheet items
• The requirement to measure many financial instruments at fair value and how that requirement should be applied particularly in illiquid markets
• The disclosures that should be provided to support the measure used.
While these have been identified as the main areas of concern, it is also considered necessary to examine whether other improvements in standards are necessary in the light of recent experience.
The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) have undertaken to share information on the key messages that emerge during the credit crunch and discuss the measures to be taken. The standard-setters have also recognised that while projects in these key areas have been on the agenda, recent turmoil has heightened the need to accelerate progress and come up with comprehensive and agreed upon standards which address the key issues.
While improvements to standards are necessary, standard-setters consider that some issues that have arisen are more compliance issues than fundamental problems with existing standards.
FSF Report – IASB Response
The Financial Stability Forum (FSF), a global organisation of regulators and central bankers has issued a report on ‘Enhancing Market and Institutional Resilience’. The report analyses the issues that have led to the recent turmoil in financial markets worldwide and makes recommendations for addressing those issues.
Regarding accounting and disclosure standards, the report recommends the following:-
• The IASB should improve the accounting and disclosure standards for off-balance sheet vehicles on an accelerated basis and work with other standard setters toward international convergence. It expresses concern that standards should require the risk exposures and potential losses associated with off-balance sheet entities to be clearly identified and presented in financial disclosures. The standards which are of particular relevance in this regard are derecognition, which may for example enable assets to be removed from balance sheets through securitisations, and consolidation in relation to special purpose entities.
The IASB has responded to this recommendation by stating that it already has had in progress two projects which have as a key objective to improve the robustness of accounting for off-balance sheet vehicles, being
- the consolidation project which identifies when an entity should be brought on to another entity’s balance sheet, and
- the derecognition project which examines when assets should be removed from the balance sheet.
Both of these projects are joint projects with the FASB under the IASB/FASB Memorandum of Understanding. The IASB has accelerated the completion of both projects with an exposure draft of the consolidation standard due to be published in the second half of 2008 and progress also expected on the derecognition standard during that period.
• International standard setters should enhance accounting, disclosure and audit guidance for valuations.
The IASB has responded that as part of its fair value measurement project, it has formed an expert advisory panel to identify valuation and disclosure issues encountered in practice in the current market environment. The objective is to strengthen its standards to achieve better disclosures about valuations, related methodologies and the uncertainties associated with valuations. The IASB also expects to enhance its guidance on valuing financial instruments when markets are no longer active.
CESR – Draft Statement on Fair Value
The EU Committee of European Securities Regulators (CESR) has published a draft statement ‘Fair Value Measurement and Related Disclosures of Financial Instruments in Illiquid Markets’. The statement, when finalised, will provide guidance to preparers and auditors in the current financial market situation when the next financial statements are being prepared.
The draft statement comments that the starting point for the measurement of financial instruments is the assessment of whether the financial instrument is traded on an active market, where measurement is by reference to quoted prices, or a non-active market where measurement is determined by using valuation models.
On the identification of active and non-active markets, the statement stresses:-
• That as judgement is required, a well documented valuation policy is needed which should be consistent across time and across financial instruments, and
• The criteria for considering whether a market is active or non-active require careful consideration and may not be just a matter of frequency or size of transactions.
CESR highlights that the use of valuation models entails a significant amount of judgement, requiring documentation of the criteria, the assumptions and the inputs to the valuation models to ensure consistency. In order to improve the quality of the estimates of fair value that result from the use of valuation models, entities must have processes in place to calibrate the models against observable data.
CESR also emphasises that clear disclosures are necessary for users to understand the complexity of many business situations, the different business rationales for holding financial instruments and the uncertainty around fair values, with good disclosure practices being a natural counterpart to the use of judgement in measurement. The CESR draft statement sets out some disclosures that issuers should consider when their holdings of financial instruments in illiquid markets are material. The statement also provides an example of how entities could present a useful summary of their procedures in tabular form.
Market confidence has been badly shaken during the financial turmoil of the past year. Measures need to be taken in a number of areas as a matter of top priority to begin to restore lost confidence. It is essential that those accounting issues which have been further highlighted during this turmoil are addressed with both speed and thoroughness. In achieving this it is also important that any additional or revised standards do not add further complexity to financial reporting in a manner which makes it still more difficult for investors to understand the messages being presented. Investors and the public in general must have confidence that the information presented and disclosed is of a quality that enables users to understand its significance.
First published in the August issue of Finance Magazine online.
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