Accounting news. Financial reporting during the global economic crisis. In this issue

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1 Accounting news A national Audit & Assurance publication Financial reporting during the global economic crisis During the last 4 months, the world has seen the worst global economic crisis in decades. This has many ramifications for both auditors and preparers of financial statements for the upcoming December 2008 and June 2009 reporting seasons. There are the obvious impacts such as possibly having to reclassify debt as current and possible impairment due to poor performance. However there are many other impacts. This newsletter seeks to give you some food for thought. The last 4 months in summary: World stock markets have fallen by over 40% since 30 June Major US and UK banking names have gone into liquidation or are being nationalised. Significant devaluation of the Australian dollar against the USD and Yen. Forecast increased unemployment. Significant market liquidity problems. Significant day-to-day share market volatility. Significant falls in commodity prices. The IASB throwing out due process and issuing a standard in 1 day. The global economic crisis (GEC) takes preparers, auditors and users of financial statements into a In this issue Impairment - goodwill, intangibles with definite lives and PPE Derivative gains and losses Classification of current/non-current liabilities Debt conversion/debt forgiveness Impairment of financial assets - available for sale and loans & receivables Provision for redundancy and closures Onerous contracts Going concern whole new world of accounting issues and uncertainty. As a result, preparing both full year and half year financial reports at 31 December 2008 will be challenging. Key issues likely to arise include: impairment goodwill, intangibles with definite lives and PPE; derivative gains and losses; classification of current/non-current liabilities; debt conversion/debt forgiveness; impairment of financial assets - available for sale and loans and receivables; provision for redundancy and closures; onerous contracts; and going concern. 1

2 Impairment - goodwill, intangibles with definite lives and PPE AASB 136 Impairment of Assets requires that entities assess at each reporting date whether there is any indication that an asset may be impaired. If there are any indications then the entity must estimate the recoverable amount of the asset. In assessing whether there is any indication that an asset may be impaired, entities shall consider, as a minimum, various external and internal sources of information as follows: External sources Asset s market value has declined significantly more during the period than would be expected as a result of the passage of time or normal use. Significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated. Market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset s value in use and decrease the asset s recoverable amount materially. The carrying amount of the net assets of the entity is more than its market capitalisation. Internal sources Evidence indicates obsolescence or physical damage to an asset. Significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite. Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected. Goodwill Under normal circumstances goodwill only has to be tested for impairment annually, but given the likelihood that some of the impairment indicators mentioned above may now be present, impairment testing will most likely be required again at December 2008, including impacts for the GEC. It is also likely that forecast cash flows used to justify recoverable amounts of goodwill in prior years will have to be significantly adjusted to reflect the impact of the GEC; including for: fall in demand; Australian dollar at 67c USD; lower interest rates (5%?); current commodity prices; and availability of product. With a number of sectors/industries only starting to feel the impact of the GEC on their trading performance, it may be very difficult to determine sales forecasts and which month/quarter is normal in order to set budgets. Intangibles with definite useful lives and PPE Intangibles with definite useful lives and property, plant and equipment (PPE) are not required to be tested for impairment unless there has been an indication that there has been an impairment event. Again, application of the external and internal impairment indicators could well give rise to impairment testing on intangibles such as brands, patents, licences and capitalised development costs etc as well as items of PPE such as specialised machinery and plant and equipment. Derivative gains and losses The wild movements in interest rates, exchange rates and commodity prices will result in very large derivative gains and losses for the next reporting period. Interest rate swaps Fearing that interest rates were rising, companies that had prudently entered into interest rate swaps in the early half of 2008 will be sitting on significant derivative losses. As all derivatives must be marked to market, this will significantly weaken a company s balance sheet, regardless of whether they qualify for hedge accounting. If the company does not apply/ qualify for hedge accounting the profit and loss impact could be significant. In the money derivative contracts With the fall in the AUD and commodity prices, it is likely that a number of entities will be holding significant derivative gains, i.e. those importers that locked in at 95c and those miners that locked into record commodity 2

3 prices. These derivatives must be marked to market and the corresponding asset recognised. In this new world, the spectre of credit risk with derivative counterparties is becoming a major issue. To justify recognising such an asset, it is likely that auditors will be requesting information as to the credit worthiness of the counterparty. It can be very difficult to determine who the derivative counterparty is, and in these days of turmoil and banking collapse, the credit rating of the counterparty. Again, if hedge accounting is not applied, this derivative will result in a significant impact to the income statement. These profits could in themselves trigger payments of bonus/options etc. which may not be valid based on the true underlying performance of the entity. Classification of current/ non-current liabilities The GEC corporate collapses and the liquidity squeeze mean that the classification of liabilities as current or non-current will be very topical this year. This will be coupled with asset write downs, reduced profits, potential fall in market capitalisation and potentially major derivative losses. Further, the likelihood of automatic refinancing may well be a thing of the past. If a loan covenant is breached at year end and the bank has not agreed as at the year-end that the breach has been waived and they will not demand payment for 12 months, then the loans is classified as a current liability, regardless if the loan is subsequently refinanced or the breach rectified etc. We are commonly seeing situations where it only becomes apparent that covenants have been breached after completion of the financial statements, posting of impairment losses, recognising derivative losses etc. In such cases, remediation is impossible. It is therefore imperative a very close watch is maintained on the covenant position. Debt conversion/debt forgiveness In a growing number of circumstances, loans are being converted to equity, commonly from a parent to a loss making/illiquid subsidiary but also by note holders or convertible note holders left with no choice but to accept equity. Basically if the loan is forgiven because it is converted into shares, there should be NO income statement impact. The journal entries would be as follows: Dr Cr Loan Equity If the loan is completely forgiven for no consideration Dr Cr Loan Income statement There are further complications to consider in a number of conversions (refer below) Converted into more shares than originally stipulated When convertible notes are converted, they may be converted giving more equity instruments than originally intended, the extra shares being to induce conversion or early conversion. In this case the fair value of the additional shares issued to settle the liability should be recognised in the income statement. Loan was carried at amortised cost It is relatively common for inter-company loans to carry zero or low rates of interest. These loans are recorded at fair value on initial recognition, with the discount being unwound over the life of the loan using the effective interest rate method. The issue then arises how to account for the entries when the loan is converted part way through its initial term. Example: Holding Company A issues a $1,000 interest free loan to Subsidiary B, term is three years and the fair value of the loan on day 1 is $700. On initial recognition Subsidiary B records the loan as follows: Dr Cash $1,000 Cr Loan $700 Cr Equity $300 At the end of years 1& 2 the discount is unwound as follows: Dr Interest expense $100 Cr Loan $100 3

4 Example (cont d): The loan is converted into equity at the end of year 2 and entries should be as follows: Dr Loan Cr Equity $900 OR Dr Loan Dr Interest expense Cr Equity $1,000 $900 (the amortised cost of the loan) $900 (the face value of the loan) $100 (the unrecognised discount) The literature would appear to allow either method. Impairment of financial assets - available for sale and loans and receivables AASB 139, paragraph 58, requires that an entity shall assess at each reporting date whether there is any objective evidence that a financial asset or group of financial assets is impaired. If any such evidence exists, the entity shall apply paragraph 63 (for financial assets carried at amortised cost), paragraph 66 (for financial assets carried at cost) or paragraph 67 (for available for sale financial assets) to determine the amount of any impairment loss. The significant falls in the world stock markets will most likely see significant write downs in the carrying values of investment portfolios (normally classified as available for sale ( AFS )). Available for sale financial assets Under paragraph 61, a significant or prolonged decline in the fair value of an investment in an equity instrument below its cost is also objective evidence of impairment. The criteria are either significant or prolonged, so it is most likely that there will be a large number of significant falls in value of investments in equity instruments at 31 December This fall in value below cost will be recognised as an expense. It should be further recognised that if the markets subsequently recover, impairment losses recognised in profit or loss for an investment in an equity instrument classified as available for sale shall not be reversed through profit or loss (paragraph 69). The standard does not define what is significant nor what is prolonged so there will be continued debates between preparers and auditors as to the exact definition of significant, i.e. 5 %, 10 %, 15 %??? Impairment of loans and receivables The GEC has significantly increased the exposure of companies to credit risk, with the unthinkable happening, and historic banking names collapsing and the ripples being felt more and more in the real economy. The question of impaired loans and receivables will therefore be high on the priority list in preparing the 31 December financial statements. The adoption of AASB 139 saw the removal of many general bad debt provisions due to the requirement in paragraph 59 to only recognise an impairment provision if there is objective evidence that an impairment event had happened. However prepares and auditors now need to revisit the requirements of paragraph 59 which states that financial assets are only impaired and impairment losses only incurred if there is objective evidence of impairment as a result of one or more loss events that have had an impact on the estimated future cash flows of the financial asset (or group of financial assets) that can be reliably estimated. It may not be possible to identify a single event that caused the impairment. Objective evidence that a financial asset or group of financial assets may be impaired could therefore result from one or a combination of the following observable loss events (extracted from AASB 139, paragraph 59): (a) Significant financial difficulty of the issuer or obligor; (b) A breach of contract, such as a default or delinquency in interest or principal payments; (c) The lender, for economic or legal reasons relating to the borrower s financial difficulty, granting to the borrower a concession that the lender would not otherwise consider; (d) It becoming probable that the borrower will enter bankruptcy or other financial reorganisation; (e) The disappearance of an active market for that financial asset because of financial difficulties; (f) Observable data indicating that there is a measurable decrease in the estimated future 4

5 cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group, including: (i) adverse changes in the payment status of borrowers in the group (e.g. an increased number of delayed payments or an increased number of credit card borrowers who have reached their credit limit and are paying the minimum monthly amount); or (ii) national or local economic conditions that correlate with defaults on the assets in the group (e.g. an increase in the unemployment rate in the geographical area of the borrowers, a decrease in property prices for mortgages in the relevant area, a decrease in oil prices for loan assets to oil producers, or adverse changes in industry conditions that affect the borrowers in the group). give rise to a constructive obligation at reporting date unless the entity has, before reporting date: (a) started to implement the restructuring plan; or (b) announced the main features of the plan to those affected by it in a sufficiently specific manner to raise a valid expectation in them that the entity will carry out the restructure. If the entity starts to implement a restructuring plan, or announces its main features only after reporting date, no provision for restructuring is recognised in the financial statements at reporting date. However, under AASB 110 Events after the Balance Sheet Date, disclosure is required about the restructure as a nonadjusting event. Given the GEC it may well be difficult to conclude that an impairment event has not happened and that significant impairment provisions should not be raised against loans and receivables. Provisions for redundancy and closures For a large number of years, Australian companies have operated in relatively prosperous economic times and a number of principles in respect of recognising redundancy provisions may have been forgotten. Given the GEC it is likely these principles will unfortunately start to be at the front of peoples minds. Under AASB 137, paragraph 72, a constructive obligation to restructure only arises when the entity has a detailed formal plan for the restructuring and has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it. Further, the detailed formal plan for the restructuring must identify at least: the business or part of the business concerned; the principal locations affected; the location, function and approximate number of employees who will be compensated for terminating their services; the expenditures that will be undertaken; and when the plan will be implemented. If the management or board of directors decide to restructure before the reporting date, this does not Onerous contracts The drastic impacts of the GEC may result in companies with onerous contracts, for example: excess lease space following downsizing or project cancellations; locking into unfavourable sales contracts in AUD when major inputs are sourced overseas; being unable to source products from the original supplier due to supplier going out of business; transferring source of supply of goods and services offshore; or being forced to enter into very competitive tendering bids. The full extent of the loss on these contracts must be recognised as at 31 December

6 October 2008 Going Concern With major collapses being announced weekly, the issue of going concern is another significant feature of reporting in the GEC. Companies face: uncertain demand; uncertain commodity prices; uncertain exchange rates; and potential credit rationing. Going concern will perhaps be the greatest discussion point during the upcoming reporting season. Remember that AASB 101 Presentation of Financial Statements requires that when preparing financial reports, management must make an assessment of the entity s ability to continue as a going concern. The financial statements must then be prepared on a going concern basis unless management either intend to liquidate the entity or cease trading, or has no realistic alternative but to do so. When management is aware of material uncertainties that may cast doubt upon the entity s ability to continue as a going concern, details of these uncertainties must be disclosed in the financial statements. A wide range of factors can be considered relating to current and expected profitability, debt repayment schedules and potential sources of financing. However, given the uncertainty created by the GEC, many businesses may find it extremely difficult to: establish reasonable forecasts; demonstrate alternate sources of funding; and show compliance with bank covenants and the willingness of banks to extend a helping hand. Conclusion So in summary, the GEC has created a period of extreme uncertainty for both preparers and auditors of financial statements. In most of our lifetimes, we have not experienced anything like the current crisis. Uncertainty is the name of the game and preparers and auditors will have to adapt quickly to current conditions and required accounting amendments for 31 December 2008 financial report. Better get started... Remember that when making the assessment, management must take into account all information about the future, which is at least, but is not limited to 12 months from the reporting date (although auditors look at least 12 months beyond the date that the financial statements and audit report are signed). For more information Phone or visit NSW/ACT Wayne Basford Telephone wayne.basford@bdo.com.au Northern Territory Casmel Taziwa Telephone casmel.taziwa@bdo.com.au North Queensland Greg Mitchell Telephone greg.mitchell@bdo.com.au South Australia Greg Wiese Telephone gregory.wiese@bdo.com.au Tasmania Craig Stephens Telephone craig.stephens@bdo.com.au Western Australia Glyn O Brien Telephone glyn.obrien@bdo.com.au Queensland Tim Kendall Telephone timothy.kendall@bdo.com.au Victoria Nick Burne Telephone nick.burne@bdo.com.au BDO Kendalls is a national association of separate partnerships and entities. Disclaimer: This publication is issued exclusively for the general information of clients and staff of BDO Kendalls. The contents are not a substitute for specific advice and should not be relied upon as such Accordingly, whilst every care has been taken in the presentation of the publication, no responsibility is accepted for persons acting on this information. Liability limited by a scheme approved under Professional Standards Legislation. 6