Financial Reporting in Turbulent Markets

  

 

A key challenge for financial reporting in 2008 is the matter of how best to address the effects of the current events taking place in the credit and financial markets. 

 

This situation reflects a growing reluctance on the part of investors to take risks and on the part of financial institutions to lend money.  This trend has its roots in risky mortgage loans, but its reach is far broader, affecting businesses in virtually every sector. 

 

Not surprisingly, the key reporting challenges reflect the reasons for the current state of the markets. Concerns about the quality of the assets that serve as collateral for loans, credit downgrades by rating agencies, use of securitizations, and sophisticated valuation models have all played a contributing role. At the same time, the list of suggested and/or required responses to these concerns has grown, thanks to efforts by accounting standard-setters and capital market regulators to improve the accounting and reporting for many of these same factors in recent years.  

 

The areas of concern that are most likely to raise accounting and financial reporting questions are as follows.

 

            • Quality of underlying assets

            • Credit downgrades by rating agencies 

            •  Valuation models and assumptions

            • Off-balance sheet entities

            • Loan commitments and modifications

            • Impairment of investments

            • Financing costs and liquidity issues

            • Risks and uncertainties

 

 

 

While no single factor could have caused the current market conditions, it seems clear that the turmoil started in the summer of 2007 when investors began to express concerns about subprime residential mortgage loans, (i.e., loans to borrowers with weak credit histories).  This situation spread to other parts of the credit markets, and many of the  concerns are of broad interest to investors today.  

 

Among the principal factors and concerns leading to today’s market conditions are the following:

             

• Quality of underlying assets. As home prices dropped during the past year, the risks of foreclosures rose, and investors grew skeptical of the quality of the assets underlying the subprime loans.  In some cases, the quality was difficult to assess because of a lack of adequate documentation.

 

• Credit downgrades by rating agencies.  At the same time, rating agencies became less willing to accept projections of repayments from borrowers with little or no credit history, resulting in refinements of their rating systems and downgrades. 

             

• Securitizations of asset-backed instruments.  The exposures to losses on subprime loans were especially difficult to assess due to a wave of financial innovation in which investment bankers packaged the subprime loan receivables with other assets into instruments known as collateralized debt obligations (CDOs). The inherent complexity of these instruments makes them difficult to analyze and value. 

 

• Use of valuation models. Typically, the holders of CDOs are large investors, such as hedge funds, who evaluate these instruments using sophisticated models. In mid-2007, some of these investors were surprised to find their models had obscured the risks involved by incorporating assumptions about rising real estate values. These assumptions were based on historical trends, but the historical norms were no longer representative of the current real estate markets.  

 

The realization that the models may have been a problem came too late for several funds. Their widely publicized demise created a ripple effect that spread throughout the credit markets to bond insurers and other types of financing and debt instruments.  Shortly thereafter, in a clear demonstration of how intertwined today’s capital and credit markets have become, companies everywhere found themselves with a surprisingly broad and difficult set of accounting and reporting challenges. 

  

 

 

Just as important, the ripple effects of the credit crunch are creating challenges in industries other than the financial sector. The challenges affect businesses and employee benefit plans.  Some of these entities may have never invested in a subprime mortgage, or they may have invested only indirectly through hedge funds, mutual funds, and other investment vehicles. Nevertheless, they face challenges ranging from the increased likelihood of valuation losses or impairment write-offs to the need for additional disclosures about troublesome matters, such as risks and uncertainties or even an entity’s ability to continue as a going concern. The main challenges are summarized below.

 

• Valuation of asset-based securities. In the absence of observable market values, growing numbers of companies have started to expand their use of model-based valuation techniques. These types of valuations are under close scrutiny now. Models should reflect market prices of similar investments.

 

• Impairment. Many companies hold auction rate securities in their investment portfolios, and these securities can be vulnerable to impairment in today’s credit markets. Typically, auction rate securities are carried at market value, for example, as trading or available-for-sale securities under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. These securities should be evaluated for impairment using the guidance in Statement 115.

 

• Higher financing costs. Many US companies are facing higher costs on the short-term debt used to fund their day-to-day operations. These pressures are most likely to affect industries closely connected to subprime mortgages, such as construction. For some companies, the implications for financial reporting may be limited to the need to reflect the impact of higher interest rates or lower demand for commercial paper. Others may need to make additional disclosures to reflect their inability to meet their existing debt obligations or to refinance. 

• Liquidity and going concern issues. If a company’s liquidity and/or ability to continue as a going concern is dependent on rolling over short-term borrowings, (such as commercial paper, repurchase agreements, or advances under revolving credit agreements), the company should consider the risks associated with existing short-term borrowings that will need to be repaid when they mature.  A number of issuers of commercial paper have been shut out of that market in recent months, and counterparties to repurchase agreements have either been (a) declining to roll over the agreements or (b) requiring additional collateral.  It is not inconceivable that lenders under revolving credit agreements could invoke “material adverse change” clauses to deny new advances.  These conditions may need to be disclosed.  

 

• Risks and uncertainties. Where appropriate, a company should disclose risks and uncertainties associated with investments in debt securities, concentrations of credit risk, or anticipated financing for purposes such as acquisitions. Investors will be watching closely for signs of deteriorating credit quality. Near the top of their list of potential trouble spots are: 

            − Companies that are highly leveraged and are not current with their reporting or SEC filings. (Some note holders may be able to claim technical default and demand early repayment.)

           − Companies that rely on acquisitions to fuel growth and need debt financing to continue to make those acquisitions. (These companies may be especially vulnerable to tight credit or higher interest rates.)  

           − Companies with significant short-term debt exposure and net debt positions or weak cash flows. (These companies may find it difficult to compete for capital in tight credit markets.)

 

Companies that have not yet adopted FASB Statement 157,  are encouraged to meet with their accounting firm to determine if now is the right time to consider the impact of adoption of these  “Fair Value Measurements”.