The credit crunch's impact on year-ends

As 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.