Financial reporting in the spotlight
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
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.
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
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
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
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
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
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
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
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.
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
Financial reporting outlook 2008 – Financial reporting in the spotlight 3
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
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
► 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
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
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
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
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
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.
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
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.
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