Financial reporting
outlook 2008
Financial reporting in the spotlight
Financial reporting
                                   outlook 2008
                                   Financial reporting...
IFRS: moving towards a single set
of global accounting standards
There is widespread support for the adoption of a single ...
Financial reporting after
the credit crunch
The credit crunch and market turmoil has focused                 ► The need to...
Fair value accounting                                           US regulatory response to the
There has been considerable ...
Year-end reporting issues
In reporting seasons following on from the credit crunch, a number of issues are likely to need ...
Other year-end reporting issues                                   Reporting issues for FPIs in the US
An FRC review of com...
Financial reporting in context
Credit crunch aside, the relevance of financial reports and accounts       ► Segment report...
Developments that will affect climate change reporting by          There are risks for directors arising from the developm...
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Financial reporting outlook 2008

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Financial reporting outlook 2008

  1. 1. Financial reporting outlook 2008 Financial reporting in the spotlight
  2. 2. Financial reporting outlook 2008 Financial reporting in the spotlight Table of contents In November 2008, Ernst & Young held its second Financial Reporting Outlook conference at The Brewery in London, England. Focusing on emerging issues and leading thinking in financial 1 IFRS: moving towards reporting, this summary of the conference gives a flavor of the critical issues discussed in the presentations. a single set of global accounting standards The credit crunch and financial crisis around the world has thrown an unusually intense and public spotlight on financial reporting. Fair value accounting has come under attack, with 2 Financial reporting after the questions asked about whether or to what extent it might have exacerbated the crisis. credit crunch The focus on fair value accounting has itself intensified debate about the impact of 4 Year-end reporting issues International Financial Reporting Standards (IFRS) – at a time when increasing numbers of countries are moving to adopt them. Momentum behind IFRS continues to build, with the November 2008 G20 meeting of world leaders giving an endorsement to a single global set of 6 Financial reporting in context accounting standards, and the US Securities and Exchange Commission (SEC) publishing its proposed roadmap for IFRS adoption by US issuers. Achieving a uniform set of high-quality accounting standards that is used around the world remains a huge challenge. However, the potential benefits for investors, capital markets and companies continue to provide strong motivation for working towards that goal. Further amendments and improvements to IFRS are expected along the way. In the short term, financial reporting in the post credit crunch world will create many challenges for corporate reporters, with their accounts potentially subject to intense regulatory scrutiny. The following pages consider these issues in a little more depth, looking at: ► IFRS: moving towards a single set of global accounting standards ► Financial reporting after the credit crunch ► Year-end reporting issues ► Financial reporting in context Speakers included: Scott Halliday Jackson M. Day UK Country Managing Partner, Ernst & Young Global Capital Markets Director, Ernst & Young Robert P. Garnett Tim Harris IASB Board Member and Chairman, Group Chief Accountant, Avivia Plc International Financial Reporting Interpretations Committee Mark S. Bergman Partner, Paul, Weiss, Rifkind, Wharton & Garrison Peter Elwin LLP Head of Accounting and Valuation Research, Cazenove Equities Paul Boyle Chief Executive, Financial Reporting Council and Will Rainey Chairman, International Forum of Independent Audit Director of Global IFRS Services, Ernst & Young Regulators David Lindsell Jan Babiak Deputy Chairman, Financial Reporting Review Panel Global Climate Change & Sustainability Services Leader, Ernst & Young Danita K. Ostling US Leader of IFRS Services, Ernst & Young
  3. 3. IFRS: moving towards a single set of global accounting standards There is widespread support for the adoption of a single set of high- Steps towards US adoption of IFRS quality accounting standards across the globe – among preparers, analysts, auditors and other stakeholders. More countries are The SEC’s proposed roadmap for the potential use of IFRS in financial endorsing IFRS. For example, implementation is scheduled for 2009 in statements prepared by US issuers, published in November 2008, Chile, 2010 in Brazil and 2011 in Canada. anticipates that a final decision will be taken in 2011. The decision will be based on what the SEC considers best for the capital markets and investors. Impact of US adoption of IFRS The roadmap proposes that IFRS reporting be phased in, Given the size, strength and depth of the US capital markets, the beginning with large accelerated filers for years ending on or after global objective of a single set of standards cannot be achieved unless 15 December 2014, followed by accelerated filers (years ending on or the US itself adopts IFRS. Converging US GAAP with IFRS is not seen after 15 December 2015) and non accelerated filers one year later. as a practical option – it is not possible to take out all the detailed rules and guidance that has built up around US GAAP. The roadmap also provides that a few companies could adopt IFRS as early as 2010, for financial reports for years ending on or after But there are concerns that, given the need for US approval, IFRS 15 December 2009. To be eligible, companies must meet certain could itself become too rules-based. IFRS is already seen as containing criteria: they must be among the 20 largest companies in their too many rules and mandatory disclosures. This not only takes up industry, and IFRS must be the most prominent reporting framework excessive time for preparers of financial reports and accounts, in their industry. The SEC has identified 34 industries and around 110 but also for auditors who have to make sure that all rules and companies that could be eligible. requirements have been complied with. Under the proposed roadmap, the SEC expects that US issuers would However, efforts will be made to reduce rules in some areas. For still have to provide three years’ of financial information even in the example, the International Accounting Standards Board (IASB) is year of IFRS adoption. This is likely to be unpopular. The SEC is also working to overhaul IAS 39 Financial Instruments: Recognition consulting on how much US GAAP information should be disclosed and Measurement so as to simplify it in three ways: in terms of the by IFRS adopters. One option would require issuers to reconcile IFRS standard’s length, its complexity in application, and its complexity of financial statements to US GAAP for each of the three years covered reported output. by the financial statements – and this requirement would continue Some improvements of IFRS will be required before the SEC and until the SEC made its final decision on the future use of IFRS by US Financial Accounting Standards Board (FASB) will approve IFRS for issuers. This could be a significant deterrent for companies otherwise use by US companies. For example, revenue recognition is one area considering early IFRS adoption. where the US would like greater clarity. The IASB started a project There is evidence of growing corporate support for IFRS adoption in on revenue recognition with FASB in 2002 and a final standard is the US. Many US companies recognize the shortcomings of US GAAP expected to be published in 2011, in line with the SEC’s proposed and anticipate that the less detailed guidance and broader framework roadmap towards IFRS adoption. of the IFRS principles would allow them to better reflect the economic reality of their businesses. Larger companies are already undertaking diagnostic work to identify where there are differences in US GAAP and IFRS that would have an impact on their reporting. Such diagnostic work is not particularly “IFRS adoption is a big job, potentially expensive or resource intensive, but is prudent. Many companies are also beginning to train relevant personnel in IFRS. As European affecting business operations, not experience showed, IFRS adoption is a big job, potentially affecting just pure accounting numbers.” business operations, not just pure accounting numbers. However, some companies may be unwilling to begin preparatory work too Conference attendee early, given that differences between the two GAAPs are expected to decrease in the next few years, and the SEC has yet to make its definite decision. However, leaving any preparation until 2011 could be rather late for those adopting in 2012. Financial reporting outlook 2008 – Financial reporting in the spotlight 1
  4. 4. Financial reporting after the credit crunch The credit crunch and market turmoil has focused ► The need to share experiences of the credit crunch. much attention on accounting and its impact on The IASB and FASB have been organizing roundtables financial reports. A number of issues have attracted to gather input on reporting issues arising from particular debate. the global financial crisis, including responses by governments, regulators and others. The SEC is also holding roundtables and undertaking a study Standard setter independence of fair value. Concerns have been raised over the potential for political ► Financial reporting and prudential reporting are pressure to be exerted on accounting standard setters. different things. Financial reporting is about This was triggered recently by the volatility in accounts producing an unbiased view of a company’s financial and the impact of fair value accounting. position. Prudential regulation (of banks and The aim of creating one set of global accounting insurance companies) is biased, appropriately so, in standards is in a sense a political aspiration. This political favor of account and policy-holders. influence has always been a part of the drive towards IFRS ► In the view of UK regulator the Financial Reporting adoption around the world. However, there is general Council (FRC), corporate reporting has stood up well concern that standard setters – including the IASB – need to the stress-testing of the credit crunch. Accounts to be independent. Though they should be accountable have reflected the impact of bad decisions made by and understand the wider significance of their decisions, banks in the past. independence is essential. Thought may need to be given to how an environment can be created such that politicians accept they should not be taking decisions How can risk transparency be about accounting. Insights could perhaps be gained from the conditions surrounding central banks that have improved? enabled their freedom to set interest rates. The answer does not lie in the provision of long lists of all risks faced by a company. The FRC’s Financial Reporting Review Panel (FRRP) has noted that the companies most Lessons to be learned from the likely to include long lists of risks in their business reviews credit crunch are those that are SEC registered. The problem is that long lists of risks make it hard for readers of accounts to The credit crunch and market turmoil around the world understand them in context and their relative impact. The have focused attention on accounting more than ever panel reminds companies that they should be reporting before. Potential lessons to be learned include: on the principal risks faced in the current environment ► The importance of the transparency of information and having regard to reasonable possible changes in that provided to the market about risk (see below). The environment. Disclosure of risks is likely to warrant more IASB is reviewing IFRS 7 Financial Instruments: panel attention in the future financial reporting season. Disclosures to assess its effectiveness in ensuring Principal risks and uncertainties are also required to be that entities disclose information that reflects their addressed in companies’ half-yearly reports – these risks exposure to risk and in October 2008 the board and uncertainties might not necessarily be the same as at published an exposure draft proposing enhancements year-end. to disclosure about fair value measurement and The IASB stresses communication with investors should liquidity risk. be as if “through the eyes of management”. Companies ► The need for more clarity about how to determine should aim to communicate clearly what they are doing in asset value (see below). If there is no market, the relation to risks faced, and then let the market judge the alternatives could include cost or a company model, reasonableness of that response. but the approach needs to be clear to investors so that values are comparable between companies.
  5. 5. Fair value accounting US regulatory response to the There has been considerable debate about fair value, credit crisis or mark-to-market, accounting and its role in the credit Regulators have responded to the credit crunch, taking crunch and global financial crisis. It is generally accepted action in a number of ways. The SEC, for example, has that there is much work to do to improve fair value acted to stabilize financial markets by: accounting. However, many interested parties believe that fair value remains the best approach to asset valuation ► Taking temporary emergency action to ban in accounts. The FRC, for example, remains supportive short selling of fair value accounting. It believes that information that ► Issuing guidance to banks about how to account for takes account of current market developments is still the credit support of money market funds best information on which to base financial reporting. ► Rulemaking to increase regulation of credit rating However, the credit crisis has triggered some softening agencies and improve transparency about ratings of accounting rules, in response to concerns about lack of consistency in US GAAP and IFRS. For example, the In October 2008, the SEC announced that in the 2008 IASB issued amendments to IAS 39 Financial Instruments: fiscal year it had brought 671 enforcement actions – Recognition and Measurement and IFRS 7 Financial the second highest number in its history. More than Instruments: Disclosures introducing the possibility for US$1b had been returned to harmed investors. The companies applying IFRS to reclassify assets, which was cases concerned issues such as market manipulation, already permitted under US GAAP in rare circumstances. misleading investors, insider trading, accounting fraud and the Foreign Corrupt Practices Act (FCPA). In fact, FASB has been working on additional guidance on the more than half of SEC actions since January 2006 have determination of the fair value of a financial asset in an concerned the FCPA. Although the Act is associated inactive market. The IASB has also issued educational with bribery charges, companies should note that it is an guidance on fair value in illiquid markets. FASB and offence under the Act not to have books and records. the SEC issued some fair value questions and answers to attempt to clarify fair value measurements. Work is The US regulator has also taken a number of aggressive underway by standard setters and regulators on both enforcement actions in relation to the auction rate sides of the Atlantic to improve understanding and the securities markets and the sub-prime mortgage market. application of fair value accounting. The Public Company Meanwhile day-to-day work continues. Recent SEC actions Accounting Oversight Board in the US is also considering of relevance to (current or potential) foreign private additional guidance on fair value for auditors. issuers (FPIs) include the development of Foreign Issuer Reporting Enhancements rules to enhance reporting by FPIs. Amendments have also been made to exemption from registration under Section 12(g) to provide investors with easier access to non-US disclosure documents. The SEC has also proposed requiring companies to provide XBRL-formatted financial statements as a supplement to existing reports. Financial reporting outlook 2008 – Financial reporting in the spotlight 3
  6. 6. Year-end reporting issues In reporting seasons following on from the credit crunch, a number of issues are likely to need careful attention by preparers of accounts, and to receive particular scrutiny from users and regulators. Reporting issues identified by the Impairment testing FRRP The FRRP is expecting that reporting of goodwill impairment will be an important issue in post credit A recent report from the UK’s FRRP drew attention to a crunch reporting. Companies will need to review their number of aspects of reporting that it felt could often estimates and assumptions in relation to goodwill be improved: valuations and the FRRP is expecting to see more goodwill ► Selection of appropriate accounting policies writedowns and more disclosure on goodwill. ► Disclosure of judgments and estimates or assumptions If goodwill is material, IAS 36 Impairment of Assets - although this area was not previously covered by UK requires that enhanced disclosures must be made at year- GAAP and disclosures have improved in the last year, end, where there is a reasonable chance of a possible the panel is still concerned that disclosures are too change in key assumptions. Companies need to take often boilerplate care that they follow appropriate approaches to goodwill impairment testing, and provide sufficient clarity and ► Revenue recognition issues - it can be difficult to see detail in their disclosures. how a company’s business model translates into its accounting policies and financial reporting Assets or cash generating units (CGUs) need to be tested if there are indicators of impairment, such as the carrying The FRRP’s remit now extends to the business review amount of a company’s net assets exceeding its market contained in financial reports. The FRC views the capitalization. When conducting impairment calculations, business review as important for providing the business companies need to consider issues such as: context around the accounting numbers. There is a requirement for companies to disclose principal risks and ► CGU selection - this is influenced by how management uncertainties, and to provide analysis using financial and monitors operations and takes decisions. But this does non-financial key performance indicators. The panel has not override the requirement that CGUs are based on found weaknesses in both areas. independent cash inflows. The panel plans to pay particular attention to the ► Growth rates - judgments on growth rates are accounts of companies that have received a qualified particularly hard to make during an economic audit report. A past review of such accounts suggests downturn, but rates used for the first few years in problems typically occur in relation to more complex a cash flow projection have critical impact on the accounting standards, such as FRS 17 (retirement outcome. benefits) and FRS 20 (share-based payments). Companies ► Future plans - cash flow projections must be based on are expected to comply with all accounting standards to the asset or CGU in its current state. The effects of which they are subject. future plans to which the entity is not committed (such as closures) cannot be included. ► Discount rates - the company’s own weighted average cost of capital or borrowing rates can only be a starting point. ► Sensitivity analysis - cash flows must be based on sound assumptions. IAS 36 includes considerable requirements for disclosures relating to sensitivities, and investors and regulators will pay close attention to the adequacy of such disclosures. 4 Financial reporting outlook 2008 Financial reporting inin the spotlight – Financial reporting the spotlight
  7. 7. Other year-end reporting issues Reporting issues for FPIs in the US An FRC review of companies’ compliance with IAS 37 These will be similar to those for UK companies. The SEC Provisions, Contingent Liabilities and Contingent Assets will focus on restructuring and impairment issues, so found that some companies do not make as much effort to companies are advised to follow a strict interpretation of comply as they should in terms of disclosures relating to the rules. Entities making fair value measurements need liquidity risk. Disclosures should enable users to evaluate to think carefully about the related disclosures they make. the nature and extent of a company’s exposure to liquidity Disclosures in general need to be prepared with care, and risk, and how the company manages this risk. The extent must address risk and uncertainties or key sources of of counterparty exposure needs to be considered. estimation uncertainty. Going concern is also likely to be an important issue in Management’s Discussion and Analysis (MD&A) will be the post credit crunch reporting season. The FRC would an important element of company reporting, addressing like to avoid situations where apparently profitable and issues such as liquidity and capital risks, critical healthy companies suddenly collapse. This may in part be accounting policies and sensitivity analysis. This report avoided by greater transparency in terms of a company’s will also be critical for addressing going concern issues. real financial position and the real risks that it faces. The FPIs are encouraged to think how to use their MD&A most FRC believes users of accounts will not be surprised if a effectively to explain their position. The aim should be company has to report that it is still in discussion with its to communicate information clearly so as to eliminate bankers about renewing facilities. surprises in the market and manage expectations. Disclosures need to be tailored to the reporter’s particular Pension liabilities will require careful assessment. Cash situation. Boilerplate statements will not help the inflows and outflows will need careful estimation, and company with the market or with regulators. judgments made on growth rates and discount rates. Companies should try to explain clearly what they have What key actions can directors take to help them stay out done in their accounts, and to make sure that the story of trouble? These include: they are telling about cash flows is a coherent one. ► Focusing on liquidity needs - for example, assessing Financial instrument disclosures (as in IFRS 7) are also short-term needs, dependence on commercial paper, likely to be increasingly important. The FRC has published alternative sources of funding, extent of saleable a paper on issues found during recent reviews of company assets, potential impact of higher borrowing costs reporting in this area, which preparers of accounts could ► Filing transparent documents - with information as find helpful. through the eyes of management, giving insights into Dividend streaming could be an important issue for many judgments and choices, and containing balanced and companies. Directors need to take care that they are objective disclosures complying with legal formalities. Holding companies that ► Maintaining contemporaneous documentation - to face a dividend lock – with distributable reserves trapped provide explanations for decisions taken in subsidiaries – have a number of options open to them. Relief is available under the amended IAS 27 Consolidated ► Developing processes and following them and Separate Financial Statements or companies can go ► Responding carefully to SEC comment letters - to court to apply for a capital reduction. companies should not rush but prepare a factually Directors should also be prepared for more intense accurate, complete response scrutiny of executive remuneration policies. Financial reporting outlook 2008 – Financial reporting in the spotlight 5
  8. 8. Financial reporting in context Credit crunch aside, the relevance of financial reports and accounts ► Segment reporting - reporting is to be “through the eyes to users remains an issue of debate, while interest continues to grow of management,” but this doesn’t necessarily tally with the in other areas of corporate reporting, particularly in relation to segmental analysis that analysts are interested in. Analysts value climate change. granularity, with information on assets, liabilities, profits and cash flow provided on a divisional basis. Relevance of accounts ► Acquisition intangibles - companies may spend a lot of time estimating and disclosing the value of intangibles such as Company accounts can be hundreds of pages long, but still questions customer lists, but analysts ignore it. Much effort is therefore are asked as to whether the numbers really mean anything. The being spent on activities that do not affect a company’s share FRC has a project underway to look at the relevance of accounts price. and is keen to engage with practitioners. It wants to see whether it is possible to align financial reporting more closely with underlying ► Financial instruments and hedge accounting - the decision to allow business models, and whether that can be done succinctly. banks to suspend their mark-to-market valuations is a concern, making it harder for analysts to make assessments on those banks’ The FRC’s regulatory approach is based on the principal that the best performance and value. In general, hedge accounting disclosures regulator is a well-informed market. This is not to say the market is do not provide the information that analysts need to really a perfect regulator, but it is the best that exists. Therefore, much of understand an entity’s approach and the underlying economics. the FRC’s work is focused on promoting the flow of information to the market. Its overarching aim is to promote confidence in corporate In terms of future changes to accounting standards, analysts accept reporting and governance. that change is costly to preparers and the markets. The benchmark for whether a change is worthwhile should be whether it will lead to a lower cost of capital. Financial reporting from an analyst’s perspective Climate change reporting Information contained in financial reports is important to analysts The credit crisis is unlikely to stall progress towards enhanced climate because it is independently verified and consistent between change reporting – an area where investors and other stakeholders periods and across companies. However, there are some have increasing expectations of companies. The Kyoto Protocol perceived weaknesses. established the goal of global emissions reductions of over 70% Analysts are trying to assess management performance: investors between 2005 and 2050 and there is increased governmental and don’t buy assets, they buy management. They estimate value by regulatory activity in the UK and elsewhere. forecasting future flows based on historic P&L and/or cash flow. Climate change initiatives have implications for accounting and Balance sheets are considered less helpful, though current balance reporting in several ways. For example, there are opportunities sheets are of interest in the post credit crunch era. for cost reduction through “cap-and-trade” schemes which aim In terms of the P&L, an earnings number is more likely to be of interest to reduce gas emissions. But this creates an accounting need in than a figure for total comprehensive income. This is despite the terms of measuring what is being capped and traded. There are difficulties that exist in trying to define earnings. implications for regulation at local, regional and global level. Climate change also creates revenue-generating activities, for example, Some aspects of current financial reporting are particularly through investment in clean technologies. However, it also creates problematic for analysts: expectations (among groups such as customers, suppliers, investors ► Cash flow statements - the bottom line of a cash flow statement and the media) in terms of corporate social responsibility and often cannot be tied into anything else in the financial statements. related reporting. Some kind of reconciliation to net debt in the current and prior year would be useful.
  9. 9. Developments that will affect climate change reporting by There are risks for directors arising from the development UK businesses include the following: of climate change reporting. Climate change disclosures are often unaudited, but they add to the fiduciary and ► Climate Change Bill - the government is inviting statutory duties of directors. There are many methods comments on its proposals for carbon accounting in of disclosure, but directors could be held responsible the UK. for climate change statements that carry misleading or ► Carbon Reduction Commitment - this scheme, which is untrue information. In general, reporting is inconsistent based on an organization’s electricity consumption, is and not comparable between companies, which can due to begin in October 2009 for UK businesses. inadvertently lead to key stakeholders being misled. ► EU Emissions Trading Scheme - in November 2008, Companies are encouraged to participate in the debate the UK held its first auction of carbon trading about climate change reporting and contribute to allowances under Phase II of the scheme. consultations. They are also advised to begin preparing for pending UK and wider regulatory action. They ► IFRS accounting for cap and trade - a project on should note too some encouraging evidence that when this topic is underway, with emissions allowances companies start to measure their carbon footprint, they classified as intangible assets and emissions classified subsequently cut costs. as liabilities. Supporters of climate change reporting would like to see it become as routine as normal accounting. However, there is considerable divergence and complexity on the methods and standards that are currently being applied. Influential guidance comes from the Global Reporting Initiative, which provides 11 principles of reporting, designed for businesses of all sizes and in all industries. Many issues remain to be resolved, but reporting in this area continues to evolve. Financial reporting outlook 2008 – Financial reporting in the spotlight 7
  10. 10. Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. For more information, please visit www.ey.com. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. © 2009 EYGM Limited. All Rights Reserved. EYG no. AU0216 In line with Ernst & Young’s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. 4395.indd (UK) 01/09 Artwork by Ernst & Young Creative Services. www.ey.com

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