RSS feedsAs the pre-year end December audits start to get under way, there is going to be more than the usual frisson of anticipation among financial directors and auditors. The credit crunch, which is determinedly hanging around, is bound to have an unwelcome impact on year-end figures, although at this stage there is uncertainly over how much impact.
While it is the banks and other financial institutions that have been in the spotlight over accounting for financial instruments, such as asset-backed commercial paper, they are not alone as users of complex financial instruments. Quoted non-financial corporates are big users of financial instruments: interest rate and foreign exchange instruments are common fare and banks have been keen to sell more exotic instruments to companies and their pension funds. And all of these will be under even more year-end auditing scrutiny.
All’s fair
Accounting and more particularly fair value accounting was placed in the firing line with banks struggling to find any meaningful valuations from a market in meltdown. But the idea of fair value somehow contributing to the credit crisis was dismissed by the International Accounting Standards Board, which said the markets would still be in the same situation if historical costing accounting was in use rather than market values.
Andrew Vials at KPMG said: “Companies have to book many financial instruments at fair value. If you can get a price in an active market then that is fair value. If there is a lack of liquidity with few transactions taking place, then you may only be able to get prices that are pretty depressed and that is not good news for results.”
Vials says some may argue that a shortage of readily available prices means that they represent distressed sale, rather than active market prices and under the accounting rules for financial instruments, they would argue that the price of a forced transaction or a distressed sale should not drive reported fair values. However, if FDs doing preliminary sums think the distressed sale excuse may produce the equivalent of a get out of jail card, they better have their arguments well thought out. Vials described the idea of establishing that the price was based on a distressed sale as “a pretty high hurdle”.
Don’t bank on loans
Different sectors will have their own worries. Banks and their auditors will be
staring hard at the loan book. The collapse in market confidence means that
banks are left with loans on their books they would have preferred to parcel up
and sell on. With an unwillingness to lend still a general problem, auditors
should be asking some tough questions over impairment. Is the loan book priced
correctly or are there potential losses already known around committed funds?
Another accounting issue of interest to shareholders and directors which is affected by current market conditions is stock options. Fair valuations of stock options are struck at a particular date based on market prices and with the indices bouncing around this increased volatility will tend to drive up option values and hence the amount of the expense.
While there has been so much angst over fair values in light of the market turmoil, it is entirely appropriate that this is the year that sees the compulsory implementation of FRS 7 Financial Instruments: Disclosure. Replacing IAS 32, the two main categories of disclosure required by the standard are information about the significance of financial instruments and, second, about the nature and extent of risk arising from those instruments.
The questions swirling around fair value continue to provoke interest. At the end of October, rating agency Fitch produced a US-focused report entitled Market Turmoil and Accounting: 10 key questions examining how the fair value measurements and disclosure are helping analysts and investors obtain the information they require to understand the repercussions of the recent market disruption. While fair value remains controversial, what is less in dispute is the idea that financial reporting should promote and provoke transparency and that the purpose of financial reporting is to reflect the economic reality even if it means reporting on bad news of instability and volatility.
While there seems to have been a stream of bad news from the banking sector in the US, with the exception of Northern Rock, the credit crunch hasn’t produced too many horror stories this side of the Atlantic. But whether that is because there isn’t any or whether the lack of quarterly reporting has just delayed the emergence of the details, FDs should already be in a place to judge. However, it will be the first quarter of 2008 when the prelims are published that the damage of the credit crunch highlighted by the impact of the fair value rules on UK plc will become clearer to investors.
