Practical guide to IFRS

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Practical guide to IFRS

Financial reporting considerations arising

from current market conditions in Europe

There continue to be significant economic concerns in some European countries that are members of the single currency (the eurozone) as well as potential uncertainty about the single currency itself. Greece continues to experience economic decline. The economic crisis has spread to Portugal, Italy and Spain − as these countries have experienced slower economic growth and higher debt levels − with Ireland also experiencing some difficulties. Austerity programmes aimed at reducing debt levels in these countries have not eliminated the possibility of default on sovereign debt and other governmental obligations.

The fiscal and economic difficulties may have a significant impact on entities that hold sovereign debt from any of the troubled eurozone economies. This impact is likely to be most pervasive in the financial sector. However, any entity that is owed money by the government or a quasi-governmental body from the troubled eurozone economies has sovereign debt risk; management needs to consider whether sovereign debt, trade debtors and other holdings are impaired at 31 December.

Many entities continue to do business with governmental and

quasi-governmental bodies in the troubled eurozone countries as well as hold sovereign debt. Some entities are experiencing:

long delays in payment for current and historical sales;

mandatory restructuring of older unpaid debtors;

statutory rates of interest for delayed payments at below market rates;

significant discounts on factoring receivables where factoring is possible; and

further pricing pressure on products, some of it seemingly retrospective. Other entities have subsidiaries and business activities in the troubled eurozone economies and may face slow growth or decreasing demand for goods and services, pricing pressure and constraints on financing.

This alert sets out the key accounting issues that management should consider when assessing the impact of the current European economic environment on their accounting and reporting, with respect to financial assets and

derivatives, non-financial assets, revenue recognition, provisions, employee benefits and financial statement disclosures.

It is not an exhaustive list of all the issues that may arise. The accounting

consequences are not limited to the financial services sectors; all entities holding government debt or doing business in the relevant countries are exposed to the impact of the current economic climate on their accounting and financial reporting issues.

The issues covered in this practical guide are in two broad categories: those most relevant to the financial services sector and those that are relevant to all entities although the issues are driven by the nature of the transactions or activity. For example, any entity that holds sovereign debt from a troubled economy in the eurozone needs to consider whether those assets are impaired.

The issues addressed in this alert that are most relevant to the financial services sector are:

impairment of financial assets; measuring fair value of financial instruments;

reclassification of financial assets; guarantees and loan commitments; hedge ineffectiveness; and

embedded derivatives.

The issues addressed in this alert that are more broadly applicable are:

going concern;

accounts receivable and revenue recognition;

impairment of non-financial assets; employee benefits;

provisions; taxes;

disclosures; and subsequent events.

Financial instruments and

related issues including

sovereign debt

Greece

European leaders have recently proposed a financial assistance package for Greece (‘the package’). Private holders of Greek government bonds (GGBs) will be asked to contribute towards the relief of Greece’s debt burden. The proposed financial assistance package is expected to require holders of government bonds to accept a reduction in the nominal value of the bonds of at least 50%. The specific terms have not been finalised. However, all investments in GGBs and debt from other government and quasi-governmental bodies should be

considered impaired.

GGBs classified as loans and receivables or held to maturity (HTM), measured at amortised cost, should reflect at least a 50% reduction in contractual cash flows of the bonds, regardless of maturity and whether or not the investor expects to participate in the package. Any GGB classified as available for sale (AFS) should be measured at year-end fair value (see below for fair value considerations).

Any assertions that investments in GGBs are not impaired should be viewed with scepticism.

Other sovereign-debt-troubled eurozone economies

Any financial asset(s) measured at amortised cost or classified as AFS should be assessed for impairment at the end of each reporting period. An

impairment loss should be recorded if there is objective evidence of impairment as a result of one or more events that occurred after initial recognition of the financial asset(s), and where that loss event has an impact on the expected future cash flows of the financial asset(s) that can be reliably estimated [IAS 39.59].

Yields on sovereign debt have risen significantly, resulting in a corresponding fall in the fair values of the sovereign debt. The increase in sovereign debt yields may also have an impact on the debt of corporate and individual borrowers from those countries. The increase in yields does not necessarily result in an impairment. However, consideration should be given to whether the increase in yield is as a result of a loss event that will have an impact on

expected future cash flows. Judgement will be required, based on circumstances existing at year end, as to whether such a loss event has occurred.

Impairment losses are recognised as follows, if a loss event has occurred:

AFS debt investments:the

impairment loss is recognised in profit or loss, including the whole of any cumulative loss previously recognised in other comprehensive income [IAS 39.67]. This amount will include any decrease in fair value (including those arising from increases in interest rates) below amortised cost; it is not limited to the impairment loss that would have been recognised had the asset been measured at amortised cost.

Debt investments measured at amortised cost: the impairment loss is recognised in profit or loss as the difference between the carrying amount of the asset and the current expected future cash flows of the asset discounted at the original effective interest rate [IAS 39.63]. This is likely to differ from fair value, as it will exclude any effect that current market events have had

on the interest rate currently applicable to the asset.

Management should provide sufficient disclosures relating to any material exposures to these investments whether or not any impairment losses have been recorded (see section on disclosures below).

Impairment of equities classified as available for sale

A significant or prolonged decline in the fair value of an investment in an equity instrument below cost is evidence of impairment [IAS 39.61]. The difference between cost and fair value is recognised in profit and loss if such evidence exists [IAS 39.67]. Volatility cannot be ignored when assessing significant or prolonged. Once an AFS equity investment is impaired, any subsequent losses are also recognised in profit or loss until the asset is derecognised [IAS 39 IG E.4.9]. Determining fair value of financial instruments

There is a valuation hierarchy in IAS 39 that emphasises that quoted prices in active markets provide the best evidence of fair value and must be used when available. A valuation technique is used in the absence of quoted prices. Some consideration can be given to thin or inactive markets; this is further discussed below. The objective of using a valuation technique is to establish what the

transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations. The chosen valuation technique incorporates all factors that market participants would consider in setting a price. It is consistent with accepted economic methodologies for pricing financial instruments

[IAS 39.48A]. Further guidance was published by the Expert Advisory Panel and is also incorporated in IFRS 13. The objective of estimating fair value using a valuation technique is to determine a price at which an orderly transaction would take place between market participants on the measurement date, not the price that would be achieved in a forced liquidation or distress sale. Forced liquidation or distress sales are not considered in a fair value

measurement. However, even in times of market dislocation, not all market activity arises from forced liquidations or distress sales. A current transaction price for the same or a similar instrument normally provides evidence of fair value.

Transaction prices cannot therefore be ignored when measuring fair value using a valuation technique, although they might require significant adjustment based on unobservable data. When relevant observable inputs are not available, it is acceptable to use the entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates.

Determining if a market is thin or inactive

Management needs to assess whether current market events mean that there is no longer an active market for certain financial assets for which a market previously existed. This may include markets for sovereign debt of the relevant eurozone countries and markets for assets more indirectly affected. The latter might include the inter-bank market where liquidity has fallen sharply. These secondary effects may affect the fair value of investments. They may also affect the data inputs commonly used in valuation models and raise issues about what data inputs can be considered observable for the purposes of determining fair value under IAS 39. The following factors are relevant in addressing these issues:

The best evidence of fair value is quoted prices in active markets. If such a price exists, the entity must use it.

A market is active if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and those prices represent actual and regularly occurring market transactions on an arm’s length basis [IAS 39 AG71].

Fair value is not the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale [IAS 39 AG69].

Persuasive evidence is required to establish that an observable

A lower than normal volume of transactions does not necessarily mean that the market is inactive and that the observed transactions are distress/forced sales. Similarly, a lower than normal volume of transactions does not necessarily mean that the transactions that are occurring are motivated other than by normal business considerations. An imbalance between supply and demand (for example, fewer buyers than sellers, thereby forcing prices down) is not the same as a

forced/distress transaction. If transactions are occurring between willing buyers and sellers in a manner that is usual and customary for transactions involving such assets, these are not forced/distress sales. The absence of transactions for a short period does not necessarily mean that a market has ceased to be active. If transactions are occurring frequently enough to obtain reliable pricing information, that market would be considered active. An active market needs regularly occurring arm’s length transactions. Therefore, if observed transactions are no longer regularly occurring, or the only observed transactions are distress/forced sales, the market would no longer be considered active. ‘Regularly occurring’ and

‘distress/forced sales’ are matters of judgement. For example, an indicator of a forced/distress sale is a

transaction that results from the seller breaching contractual triggers whose breach requires sale of the assets concerned. However, if there are a number of interested potential buyers and a reasonable period of marketing, even sales resulting from a breach of contract may not be forced or distressed sales.

Financial instruments should be assessed separately when determining if there is an active market. The fact that there is no active market in one financial asset should not be taken to imply that there are no active markets in other similar financial assets.

Measurement of financial assets when markets are inactive

A valuation technique is required if the market for a financial instrument is not

active. Developing suitable valuation techniques in current market conditions can be challenging. The following points should be considered.

The objective of a valuation technique is to establish what the transaction price (that is, the price received for selling an asset) would have been on the measurement date [IAS39 AG75]. The chosen valuation technique should incorporate all factors that market participants would consider in setting a price [IAS 39.48A]. For example, when there is evidence of a change in credit spread or other risks that a market participant would consider in pricing the instrument, the effects of the change is considered in determining fair value [IAS 39 AG78].

The determination of fair value therefore requires consideration of current market conditions, including the relative

liquidity of the market and current credit spreads. The measurement objective remains the same for a model-based valuation as for a valuation using quoted prices in active markets.

Management cannot ignore information about how the market would price the instrument that is reasonably available without undue cost and effort. Such information includes observable market prices for similar assets (whether or not in active markets and including

forced/distress sales). Any such information should be incorporated in management’s valuation technique. Any valuation technique should be calibrated periodically against market transactions in the same instrument or available observable market data, again requiring any actual transactions to be taken into account in establishing the valuation and any differences to be explained [IAS 39 AG76].

To test whether a valuation technique reflects current market conditions, it can be applied to similar assets for which price information is available. If the valuation technique appropriately reflects current market conditions, it should produce approximately the same market price.

Entities that have liabilities measured at fair value should ensure they include the effect of current market events – in

particular, relevant increases in credit spreads – when valuing those liabilities. This may be relevant for derivative liabilities, liabilities classified as held for trading and liabilities to which the fair value option is applied.

Reclassification of financial assets Certain limited reclassifications of financial assets are permitted under IAS 39. These include the reclassification of financial assets classified as held for trading (but not designated under the fair value option) and assets classified as AFS.

A financial asset classified as held for trading may be reclassified to loans and receivables if the financial asset would have met the definition of a loan or receivable and the entity now has the intent and ability to hold it for the foreseeable future or to maturity. Other financial assets may only be reclassified in rare circumstances. The current crisis affecting Greece may be considered a ‘rare’ circumstance; Greek government bonds may therefore be reclassified from the held for trading category to loans and receivables.

Assets classified as AFS may be reclassified as loans and receivables provided: (a) they would have met the definition of a loan or receivable; and (b) the entity now has the intent and ability to hold the asset for the foreseeable future or to maturity. Tainting of HTM portfolio

A sale or reclassification from HTM to AFS due to a significant deterioration in the issuer’s creditworthiness does not call into doubt the holder’s intention to hold other investments to maturity and does not trigger a tainting of the HTM category. Generally, we do not believe sales of Greek government bonds would be considered a tainting event in the current economic conditions. Further analysis is required for sales of other European sovereign debt in order to support that there has been a significant deterioration in creditworthiness since acquisition. This analysis should be on an instrument-by-instrument basis, taking into consideration credit rating

downgrades and deterioration in market-implied credit ratings evidenced by

current credit default swap prices and bond spreads.

Guarantees and loan commitments Some entities – in particular, in the financial sector – may have given guarantees or loan commitments (including liquidity lines) to entities that hold assets affected by current market events. If such guarantees and loan commitments are measured at fair value through profit or loss (FVTPL), the considerations under ‘Determining fair value’ above apply.

For financial guarantees that are not measured at FVTPL and that are accounted for under IAS 39, the amount that is recognised as a liability at each period-end is the higher of the best estimate of the obligation under IAS 37 and the amount recognised at inception as the fair value of the guarantee less cumulative amortisation under IAS 18. To determine the best estimate of the obligation under IAS 37, it is necessary to assess whether it is more likely than not that a payment will be made and, if so, to determine the best estimate of the cash outflow necessary to settle the obligation. The assessment of probability of payment will depend on the credit standing of the underlying debtor or portfolio that is the subject of the guarantee.

For financial guarantees that are accounted for under IFRS 4, ‘Insurance contracts’, the issuer should carry out a loss adequacy test under paragraph 15 of IFRS 4, in accordance with its established accounting policy. Such a test should consider current estimates of all

contractual cash flows and of related cash flows such as claims handling costs. There is no probability threshold established in IFRS 4 for recognition in this case. If the liability adequacy test shows that the carrying value of the liability is inadequate, the entire deficiency is recognised in the income statement.

When loan commitments are not measured at FVTPL, the issuer should consider whether the commitment to lend is an onerous contract. The contract is onerous and a provision should be recognised when the least cost of settlement exceeds the expected benefit under the contract. A provision should

therefore be recognised when it is more likely than not that the initial cash outflow as a result of the loan

commitment will not be fully recoverable due to credit deterioration. The provision will be made based on the discounted net cash outflow in connection with the probable drawdown that is not expected to be recovered [IAS 37.36, 45].

Financial guarantee or derivative Classifying an instrument as a guarantee or a derivative is key to determining the appropriate accounting. The following points should be considering when determining classification:

Financial guarantee contracts (sometimes known as ‘credit insurance’) require the issuer to make specified payments to reimburse the holder for a loss it incurs if a specified debtor fails to make payment when due under a debt instrument’s original or modified terms [IAS 39.9]. That is, the holder is exposed to and has incurred a loss on the failure of the debtor to make payments. These contracts are often written by financial guarantee insurers in the form of insurance contracts, or they may be written by banks and entities that do not operate as insurance entities, in other forms (for example, letter of credit, credit default

contracts).

Credit related guarantees, by

contrast, do not require the holder to be exposed to, and to have incurred a loss on, the failure of the debtor to make payments on the guaranteed asset when due. Such guarantees are not financial guarantee contracts as defined in IAS 39 paragraph 9 and are not insurance contracts as defined in IFRS 4. These guarantees are derivatives that should be accounted for as such under IAS 39. [IAS 39 AG 4(b)].

Hedge ineffectiveness

Entities should be alert to the possibility that hedge ineffectiveness may result from current market conditions. Examples of when such ineffectiveness may arise are set out below. This is not an exhaustive list of all the situations in which hedge ineffectiveness may arise:

Any hedges on GGBs entered into prior to June 2011 are unlikely to remain effective, thus requiring a discontinuation of hedge accounting; Fair value hedges of fixed rate assets using interest rate swaps may be ineffective due to the pricing of the floating leg of the swap to the next fixing date;

The designated hedge risk does not exactly match the hedging instrument − in particular, if the hedged item includes a credit spread that is not mirrored in the hedging instrument; and

There is a change in creditworthiness or credit spreads applicable to the counterparty to a hedging derivative, particularly if there has been a significant increase in counterparty credit risk.

Hedge ineffectiveness resulting from current market conditions may be so great that the retrospective or prospective effectiveness tests in IAS 39 will be failed. Hedge accounting should cease from the last date on which hedge effectiveness was demonstrated. However, if the entity identifies the event or change in

circumstances that caused the hedging relationship to fail the effectiveness criteria, and demonstrates that the hedge was effective before the event or change in circumstances occurred, it

discontinues hedge accounting from the date of the event or change in

circumstances [IAS 39 AG 113].

Where hedging derivatives are in an asset position and counterparties are

experiencing significant financial difficulties (leading to a potential impairment of the derivative position), the prospective hedge effectiveness test needs to be carefully considered. Entities may close out derivatives with

counterparties that are experiencing financial difficulties. In this case, the hedging relationship ceased when the derivatives are closed out.

If entities enter into new derivatives with different counterparties, they will need to designate and document the new hedging relationships that result. Ineffectiveness may arise in these new hedging

relationships if the new derivatives are not entered into with a zero fair value. This ineffectiveness would be a particular

concern for cash flow hedges, as hypothetical derivatives need to be defined to have zero fair values at the inception of the new hedge relationship (or, in the case of options, at or out-of-the-money intrinsic values).

Some entities may have hedged a forecast debt issuance, including the rollover of a commercial paper programme. They will need to assess, in the light of current market conditions, whether the hedged debt issuance is still highly probable to occur without significant delay. If it is not, the criteria for hedge accounting are no longer met, and hedge accounting should cease from the date the forecast debt issuance ceased to be highly probable. If the forecast debt issuance is no longer expected to occur, any amounts previously deferred in OCI should be transferred to profit or loss

[IAS 39.101(b),(c)]. Embedded derivatives

The value of some embedded derivatives may previously have been determined to be immaterial − in particular, if the underlying was linked to an event considered to be remote (such as major changes in sovereign credit spreads or inter-bank rates). Management should be alert to the possibility that the value of such embedded derivatives may have become material as a result of current market events. For example, synthetic collateralised debt obligations contain an embedded credit derivative that in the past was generally considered

immaterial; however, current market conditions have given rise to significant changes in fair value. Another example is perpetual debt investments classified as AFS where, if the issuer does not call the instrument in say five years, the interest rate is reset to usually a much higher rate. Given the lack of liquidity in the current market, these embedded extension options are likely to have a significant fair value.

Entities may seek to amend or change the terms of contracts that contain embedded derivatives in the current economic environment. IFRIC 9 requires a subsequent reassessment of whether an embedded derivative is closely related or not, if there is a change in the terms of the contract that significantly modifies

the cash flows that would otherwise be required under the contract.

Pervasive issues

The current European economic environment might result in reduced availability of credit, illiquidity in short-term funding and declining business performance. This is particularly true for entities operating in the affected

countries such as Greece, Portugal, Ireland, Italy and Spain, but the effects are widespread.

Many entities, including non-financial entities, may be less able to obtain a steady stream of liquidity, and financial institutions are often imposing stringent requirements when entities are

negotiating or re-negotiating finance. Such entities may have difficulty securing funds to meet their borrowing

requirements or to fund acquisitions or capital expenditure projects, potentially raising questions about the going concern assumption.

Increasing credit spreads may also affect the ability of entities to obtain financing at a reasonable cost. The overall

downturn and the austerity measures adopted by certain governments may also affect business performance and the ability of entities to meet their commitments.

These economic developments may give rise to events or conditions that cast doubt about the going concern assumption. Examples of such events include:

fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment; or excessive reliance on short-term borrowings to finance long-term assets;

indications of withdrawal of financial support by debtors and other

creditors;

adverse key financial ratios;

significant deterioration in the value of assets used to generate cash flows; and

inability to comply with the terms of loan agreements.

IAS 1 paragraph 25 requires management to make an assessment of an entity’s ability to continue as a going concern. When management is aware of material uncertainties that may cast significant doubt on an entity’s ability to continue as a going concern, management should assess the appropriateness of the going concern basis and disclose those uncertainties. If the going concern basis is not appropriate, this fact should be disclosed, together with the basis on which the financial statements are prepared, and the reason why the going concern basis is not appropriate. Valuation of outstanding trade receivables

Entities should consider all outstanding trade receivables from governmental and quasi-governmental bodies in troubled eurozone countries for impairment.An impairment loss is calculated based on revised expected cash flows discounted at the receivables’ original effective interest rate (EIR). An EIR may not have been calculated when the receivable was first recognised if discounting was not material. It may be appropriate to determine what the original EIR was for the receivable using interest rates on eurozone sovereign debt of similar terms at the time the original sales were made. Any impairment charge would be recorded as a current period bad debt expense.

Valuation of new trade receivables at initial recognition

Any receivables that are not expected to be collected immediately should be considered for discounting.There is no ‘grace period’ in the revenue standard for receivables that are collected within one year or any other specific period.

Accounts receivable should be discounted at initial recognition, with a

consequential reduction in revenue, if the effect of discounting is expected to be material.

Consideration should be given to discounting all receivables from new sales to governmental or quasi-governmental bodies at initial

recognition.This will involve estimating the date of collection, the actual amounts that will be collected and determining an appropriate interest rate to use.

Estimating the date of collection should use the most recent data available on days sales outstanding for the relevant governmental body, although care should be used relying on payment history if conditions are seen to be deteriorating. History may be an indicator but, in the current environment, history is not always a reliable indicator of the future. All relevant facts will need to be assessed to formulate a judgement of the potential outcome.

Receivables are a form of financing provided to customers, and the

appropriate rate to use when discounting is the rate at which the customer could otherwise borrow on similar terms.For a governmental or quasi-governmental body, a reasonable starting point for estimating the appropriate rate would be the most recent rate at which the

government or local government (for example, regional bodies) has been able to borrow, which is then adjusted for any specific features in the sales contract. Some receivables may be interest-bearing by statute, and there may be evidence that interest is being charged and eventually collected.However, this does not remove the requirement to consider discounting at initial recognition of accounts receivable for new sales.The rate of interest being paid by

governmental bodies is unlikely to be the same as the rate at which they could otherwise borrow.For example, recent auctions of government bonds in Italy resulted in interest rates approaching 7%, Greek government bond rates are above 30%, with Spain and Portugal both above 5%.This contrasts with the current EURIBOR rate of 1%.

Revenue recognition

Management also needs to determine whether revenue should be recognised for current sales and the amount of revenue to be recognised. Management must conclude that it meets the five revenue recognition criteria in IAS 18, ‘Revenue’, in order to be able to recognise revenue. The two criteria that are most under stress in the current economic environment are:

the amount of revenue can be measured reliably; and

it is probable that the economic benefits associated with the transaction will flow to the entity. Management must first determine that it is probable that they will be paid for the goods they have delivered. Slow payment does not, on its own, preclude revenue recognition. However, it may well impact the amount of revenue that can be recognised because the receivable will be discounted at initial recognition. An additional consideration is any price pressure, discounts, caps and clawbacks that may be demanded by governments in the troubled eurozone entities. An estimate of discounts and similar allowances that will be granted in the future, based on current market conditions and practice, should be deducted from the amount recognised as revenue. Revenue should not be

recognised if payment is not expected or the amount of discounts and allowances are expected to be material but cannot be estimated.

Revenue is reduced by any discount recorded at initial recognition expected for slow payment and for expected allowances and discounts. Many entities are immediately factoring receivables at a discount from face value. An entity using this practice should estimate the discount when sales are made and reduce the amount of revenue recognised. The price received from the factor is likely to be a reasonable proxy for expected discounts, allowances and credit risk when

receivables are factored immediately. As an example, the range of discounts is currently estimated at 10%-30% for Greece.

Entities that sell products through a distributor (that is, the distributor purchases the product and re-sells it to the customer) should ensure that that the credit worthiness of the distributor has not deteriorated. Potential indicators of a decline in credit worthiness would be: (i) extension of payment terms; (ii) increase in days sales outstanding; or (iii) increase in partial payments. Distributors may not be in a position to demonstrate an ability to pay until they collect cash from the customer; in which case, the inflow of benefits may not be probable. It may be appropriate to defer revenue from the arrangement until the customer has paid the distributor in such situation.

Entities might continue to sell products to customers even though they may have an outstanding receivable balance from prior sales to that customer that is considered uncollectible. Revenue can be recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity.

Management should therefore carefully evaluate the appropriateness of

recognising revenue and bad debt expense in the same period from the same customer.

Impairment of non-financial assets Current economic difficulties will impact the expected future cash flows to be generated by long-term, non-financial assets such as goodwill, PPE and intangible assets. All businesses with significant non-financial assets related to, located in or selling into any of the troubled eurozone economies should consider the impact when measuring the recoverable amount of non-financial assets. The effects of the economic downturn could impact impairment calculations in several different ways, notably: triggering impairment reviews, affecting key assumptions underlying management’s cash flow forecasts (growth, discount rates) and requiring more sensitivity disclosures.

Indicators of impairment

Management should assess at each reporting date whether there are any indications that an asset is impaired and to carry out an impairment test if such an indicator exists. Goodwill, indefinite-lived intangible assets and intangible assets not yet ready for use need to be tested annually; this annual test does not need to be at a period end. If this annual testing has already taken place but there is a subsequent indicator of impairment, the impairment test will need to be re-performed.

Management should remain alert for indicators of impairment. Among these indicators are:

An increase in market interest rates, triggered by rising sovereign debt yields and credit spreads;

Consumer spending slowing or decreasing;

Significant reductions in assets’ market values over and above that

normally expected from passage of time or use;

Significant changes in the market or economic environment in which the entity operates; and

The carrying amount of the net assets of the entity exceeds its market capitalisation

Key assumptions

Indicators of impairment do not necessarily mean that there is an

impairment loss. The impairment loss, if any, is determined after calculation of the recoverable amount. These calculations, whether based on value in use or fair value less costs to sell, are usually dependent on some key assumptions specific to the assets or cash-generating units (CGUs) being tested. Developing a cash flow forecast for purposes of either a VIU or FVLCTS model needs to be done with caution and regard for the market’s view of economic prospects. Entities should be particularly cautious about economic growth expectations, projections of consumer spending and the cost of capital. We highlight below some factors to consider arising from the recent market events (and the underlying economic environment):

Some of the troubled eurozone countries are in recession;

Economic growth in the remainder of the eurozone has stagnated, and there is speculation that the eurozone will slip back into recession;

Recent market events have affected most sectors, not just the banking sector; and

The cost of borrowing has increased, reflecting the market perception of increased risk particularly for those entities operating in affected regions that may face higher borrowing costs. This re-pricing means that discount rates, including the risk premium specific to the asset or CGU being tested, may well have risen.

Management should be alert for the use of over-optimistic assumptions in cash flow models used for impairment testing in light of the current economic

environment.

Employee benefits

IAS 19, ‘Employee benefits’, requires the discount rate to be determined by

reference to market yields at the balance sheet date on high-quality corporate bonds of equivalent currency and term to the benefit obligations [IAS 19 para 78]. The bonds’ currency should be the currency in which the benefits are to be paid. It might not necessarily be the entity’s functional currency. There is a presumption that a bond should be rated at least AA to be ‘high quality’ for IAS 19 purposes. Where there is no deep market in high-quality corporate bonds, the market yields (at the balance sheet date) on government bonds of equivalent currency and term should be used. The current uncertainty in sovereign debt markets may lead to more focus on the choice of assumptions, particularly discount rates, in some markets. A common currency is used across different countries in the eurozone, which raises a question as to whether discount rate assumptions should be considered at the level of the eurozone or at the individual country. IAS 19 is not clear; we therefore believe there is a policy choice. However, that policy should be applied consistently from year to year, and any change would be a change in an accounting policy under IAS 8, ‘Accounting policies, changes in accounting estimates and errors’. It is unlikely that a change from looking at the eurozone corporate bond rate to looking at an individual country government bond rate would provide more reliable and relevant information.

Many entities use actuaries to help derive appropriate assumptions; however, it is important to keep in mind that the actuary is acting as an expert advising management but that ,management is responsible for the choice of

assumptions. Different actuaries and different actuarial firms use different approaches to develop their advice. Where an actuary uses a different methodology to that used in prior periods, it is important to consider consistency and applicability. A change in methodology should lead to a ‘better’ estimate of the appropriate discount rate and should reflect available data about market yields and the expected cash flows of the benefit plan.

Year-on-year consistency should be considered where there is a change in methodology. For example, if

year-on-year market rates have fallen, the discount rate would also be expected to fall. If a change in methodology leads to a stable or increased discount rate,

management should carefully consider the reasons for the change in

methodology and related disclosure. Typical methodologies are based on deriving a yield curve so that the benefit cash flows assumed in the measurement of the defined benefit obligation can be discounted using a rate appropriate for their duration.

In some markets, yield curves are published for market indices by

investment houses or by banks. Some of the actuarial firms produce in-house yield curves, based on specific data and methodologies, and make them available to clients. The consideration of these yield curves raises a number of issues, including:

Selection of the data to be included in the derivation of a yield curve can significantly affect the results. What basis is used to identify ‘high-quality’ bonds? What pricing data is used to determine yields?

Is all available data about the relevant bonds used, or are some excluded as outliers? If some data is excluded, what is the basis for exclusion? Examples of exclusions might be the highest and lowest yielding 10% of bonds, bonds on credit watch for a possible downgrade, or bonds with embedded options that may distort their yield − for example, early redemption or conversion terms. Pension plan benefit payments can continue for many years beyond the term of bonds that are traded in a market. What methodology is used to extrapolate yields beyond the market data?

There may be very limited numbers of bonds at some durations. What approaches are used where data is sparse?

Once a suitable yield curve is established, it is important to ensure that it is used appropriately. The effective discount rate will be a weighted average of the spot yields in the curve, weighted by the discounted value of the projected plan cash flows. A common metric used when looking at the discount rate and plan

liabilities is the weighted average duration. However, two plans with similar average durations could have different effective discount rates where the projected cash flows have a different spread, depending on the shape of the yield curve. For example, two plans − a pension plan and a plan that pays lump sums on retirement − that have the same weighted average duration could have different effective discount rates because the pension plan benefit payments are spread out over a much longer period. Provisions

IAS 37, ‘Provisions’, requires provisions to be discounted, typically starting with a risk-free rate. The sovereign debt crisis raises a further question on whether downgrading of governments’ credit ratings means that government bond yields no longer provide a risk-free rate. There are some countries for which all the ratings agencies have acted to downgrade government bonds. It is reasonable in these circumstances to conclude that the yield on government bonds is not a risk-free rate and that some level of risk adjustment would be required to establish a risk-free rate The conclusions of different rating agencies in connection with some other countries may vary: one may have downgraded the rating; others may still rank it as AAA. Management should use judgement in these circumstances to determine whether the government bonds remain risk free. The factors that might be considered include the current economic situation in the country and the prospects for the future, together with the actions taken and planned by the

government and the views of the ratings agencies.

Taxes

Management should evaluate the

recoverability of deferred tax assets in the current economic environment,

particularly when current and expected future profits have been adversely affected by market conditions. Deferred tax assets should be recognised only to the extent it is probable that future taxable profit will be available against which the assets can be utilised. Management should consider future

reversals of existing deferred tax liabilities, future taxable profits and tax planning opportunities when evaluating deferred tax assets. Particular attention should be given to the assumptions underlying expected taxable profits in future periods and to the requirement in IAS 12, ‘Income taxes’, to have convincing evidence of future profits when the entity has a history of losses. Convincing evidence of future profits requires more than an expectation of future profits. The assessment should be made on a

jurisdiction-by-jurisdiction basis. Some entities have not provided for deferred taxes on investments in subsidiaries, branches and associates because they control the timing of the reversal, and it is probable the temporary difference will not reverse in the

foreseeable future. These entities should consider whether current economic conditions and their cash needs mean that dividends will be paid up from subsidiaries or that reorganisation might affect their expectations about reversal. Changes in the measurement of the deferred tax asset should be recorded in the income statement unless the deferred tax arose from a transaction that was previously recognised outside the income statement. There have been many changes in income tax legislation in different jurisdictions as a result of crisis. Management should be alert to the implications of these changes in legislation on deferred taxes and to the time at which the changes are

substantively enacted. Disclosures

Current market events are likely to require a number of additional disclosures. Holders of GGBs should provide clear and transparent disclosures about the exposure to GGBs and the accounting they have applied.

Entities should also determine whether broader disclosures about the impact of the European economic environment on their businesses, financial instruments and future revenues is required. Entities should also consider enhanced disclosure surrounding concentration of risk. This may include: (i) volume of business transacted in a particular market or geographic area; (ii) impact on liquidity;

and (iii) discussion of counterparty default risk.

IFRS 7 is of particular relevance; care will be required to ensure the objectives set out in IFRS 7 are met. Specific disclosure requirements to consider are:

IAS 1 paragraph 122 – summary of significant accounting judgements; IAS 1 paragraph 125 – key sources of estimation uncertainty;

IAS 1 paragraph 25 – if there are material uncertainties as to going concern;

IFRS 7 paragraph 10 – the amount of any change in the fair value of a financial liability attributable to movements in the credit risk of that liability;

IFRS 7 paragraph 12-12A – inform-ation about reclassificinform-ations of financial instruments;

IFRS 7 paragraph 27-30 – methods and assumptions used to determine fair value; effect of reasonably possible changes in assumptions where valuation techniques are used not supported by observable market data;

IFRS 7 paragraph 33 – qualitative disclosures in respect of exposure to risk (including credit and liquidity risk), policies for managing risk and methods used to measure risk; IFRS 7 paragraph 34 – summary quantitative disclosures about exposure to risk (including credit and liquidity risk), including

concentrations of risks;

IFRS 7 paragraph 36 to 38 – credit risk disclosures, including the

maximum credit risk exposure arising from loan commitments and

guarantees [IFRS 7 para 36(a)]; IFRS 7 paragraph 39 − liquidity risk disclosures, including how

management manages the liquidity risk arising from the repayment of liabilities and any changes to their liquidity policy; and

IFRS 7 paragraph 40 to 42 – market risk disclosures, including what is regarded as a reasonably possible change in a risk variable under IFRS 7 paragraph 40(a) given current market events.

Subsequent events

The current market conditions require management to consider carefully whether events occurring between the balance sheet date and the date of authorisation should be reflected in the financial statements.

Events after the balance sheet date are either adjusting events or non-adjusting events. Adjusting events provide further evidence of conditions that existed at the balance sheet date – for example, the receipt of information after the balance sheet date, indicating that an asset was impaired at the balance sheet date, or that the amount of a previously

recognised impairment loss for that asset should be adjusted. This could be particularly relevant if further details of the Greek package are announced and it would have an effect on the amount of impairment that is to be recognised.

Non-adjusting events relate to conditions that arose after the balance sheet date − for example, announcing a plan to discontinue an operation after the year end or when there is a decline in market value of investments between the balance sheet date and the date when the

financial statements are authorised for issue. The decline in market value does not normally relate to the condition of the investments at the balance sheet date but reflects circumstances that have arisen subsequently. Management does not therefore adjust the amounts

recognised in its financial statements for the investments.

The carrying amounts of assets and liabilities at the balance sheet date are adjusted only for adjusting events. Significant non-adjusting post balance sheet events aredisclosed.

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. It does not take into account any objectives, financial situation or needs of any recipient; any recipient should not act upon the information contained in this publication without obtaining independent professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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