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The eurozone crisis and U.S. financial reporting.

Whether the eurozone's finances are falling apart or getting patched back together, the shakiness of the situation is sending ripples of contagion to American shores. Risks are rising, assets are impaired, currencies are insecure, measurements are getting tricky, disclosures are getting complicated and capital is shifting. Around the world, financial reporting is facing unprecedented challenges.

Never has it been more important for companies to accurately, honestly and consistently disclose the details of their financial condition and, in so doing, their exposure. In times of uncertainty, nothing nurtures tranquility more than transparency. Solid information is a pillar in shifting financial sands.

James Nayler, a senior manager with BDO International Ltd., warns that Europe's problem is America's problem.

"The economic problem in parts of Europe is potentially a highly contagious disease, with the ability to cross national borders and spread globally," Nayler says. "Therefore U.S. organizations could be just as exposed as their European counterparts with the extent of exposure (direct or indirect) determining just how sick an organization could become. As no one has yet come up with a cure, the consequences could be fatal unless the exposure is appropriately managed."

Every American company with connections to Europe--subsidiaries, operations, trading partners, markets, suppliers, investments or currencies--needs to report on the impact of events, even possible events, in the European Union.

Steven Brice, a partner with United Kingdom audit firm Mazars LLP, says that European instability is global.

"Europe currently has significant uncertainty in capital markets linked to the sovereign debt crisis along with many banks still needing to be bailed out or balance sheets recapitalized," Brice says.

"This economic backdrop is not helping business. In a global economy U.S. financial executives still need to be concerned about the financial instability in Europe. Europe is a major trading partner of the U.S., accounting for about 20 percent of U.S. exports." Furthermore, Brice says, "U.S. banks have significant credit risk with Europe. Confidence needs to return to benefit all businesses and a stronger Europe will aid growth in the U.S."

Nothing bolsters confidence like good information. Even when it's bad, it's good--that is, even if the information is troublesome, it's better than no information. But rapidly changing situations can render good information bad if it reflects what was rather than what is.

A Heads Up newsletter from Deloitte LLP, "The Danger Zone: Financial Reporting Implications of the Eurozone's Economic Struggles," outlines several areas where companies need to review and quite likely revise their financial reporting. It points out the importance of assumptions when economies are in a jittery flux. Consistency becomes crucial.

Preparers of financial statements need to assess the need, appropriateness and impact of changes in assumptions from previous periods. The users of these statements need to understand why the assumptions changed or didn't change.

Differences between International Financial Reporting Standards and U.S. generally accepted accounting principles need to be dealt with clearly and consistently. When the European Securities and Markets Authority calls for more disclosures on impaired sovereign debt in IFRS statements, how does an American chief financial officer use GAAP to please the U.S. Securities and Exchange Commission?

The Deloitte report also warns that economic pressures inevitably raise the risk of impairment of financial and nonfinancial assets. Investors need to know whether market prices have dropped, whether overstretched equipment could become compromised, whether cash flows have shifted, whether investments (especially sovereign debt) are, and will be, as good as they used to look.

They need to know whether long-lived assets will live as long as previously assumed. They need a company's best guess on currency exchange rates. They need to have an understanding of the intangibles and they need to know what happens to goodwill when nations go broke.

Everybody's unsure about Europe's companies. How are they being affected--and how might they be affected--by work stoppages and civil unrest, by lurches in national budgets, by capital restrictions and denial of credit or by changes in financial and nonfinancial regulation? Is there a risk of cost of inventory exceeding market value?

As Europe considers restructuring, companies are likely to do the same, pulling out of countries such as Greece or moving, for example, into defined benefit plans. Financial reports need to reflect projected termination benefits. Managers need to reassess retirement plan assets, portfolios, yields, indexes and assumptions across the board. As countries and companies suffer their ups and downs, some debt restructuring will become increasingly necessary.

The users of financial reports need to know where financial instruments stand. Fair value hierarchies are subject to change. Anything issued by a European government probably deserves its own footnote.

Hedge accounting deserves a review. Depending on what's hedged and what happens in Europe, hedge accounting rules may not apply, and therefore earnings on hedging may come out a bit twisted. As interest rate and currency risks slip, hedge effectiveness has to be reassessed.

At what point should management's discussion and analysis mention the impact of a eurozone break-up--the legal uncertainties of re-denominating a contract, the plan for dealing with devaluation and inflation, the vision of a worst-case scenario? Who will be the first to match "unrecoverable" with "ungovernable?"

Just as Europe cannot be ignored in financial reports, neither can its lessons. Lack of financial information and deceptive financial information only pave the road to financial disaster. Investors, lenders and governments need to know the financial condition of companies. It is incumbent on companies to review the elements of their financial reports and use them to speak truth.

IASB Chair Outlines Financial Instrument Standards

When banks went into their infamous tailspin in 2008, it was hardly the first time that banking lost control when a bubble popped. It's been happening throughout U.S. history, a cycle that's predictable right about the time it's too late to do anything about it. And each time, authorities come up with a plan to prevent recurrence.

To what extent can accounting standards predict, if not prevent, disastrous downturns? Hans Hoogervorst, chairman of the International Accounting Standards Board, expressed some thoughts on that question in a speech before the 3rd European Central Bank (ECB) Conference on Accounting, Financial Reporting and Corporate Guidance for Central Banks in Frankfurt in June.

Hoogervorst began by making it clear that accounting standard setters are not in the business of promoting economic stability. They produce the tools of transparency, but it's up to others to use transparency to promote stability, he said. Likewise, they do not produce standards to make things appear stable.

"Quite frankly, we are sometimes suspicious that we are being asked to put a veneer of stability on instruments that are inherently volatile in value," Hoogervorst told the bankers. "Our standards should not create volatility that is not already there economically. But, if volatility exists, our standards certainly should not mask it."

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Fair value accounting, he pointed out, has been a bone of contention on just that issue. Critics of fair value accounting claim that it exacerbates and exaggerates cyclical upturns and downturns. That is true to some extent, so the ECB and Basel Committee are asking IASB to limit the use of fair value accounting.

But Hoogervorst maintains that volatility is in the nature of the beast known as finance. The best that accounting can contribute is the kind of information that can see volatility before it happens. One way to do that, he believes, would be to replace the current impairment model, the incurred loss model, with an expected loss model. The former is now seen as providing too little too late when the woes of 2008 brought the world to the brink of economic collapse.

The incurred loss model wasn't entirely inadequate. Hoogervorst is convinced that it could have been applied more vigorously. There were plenty of triggers but no political will to push it. Nevertheless, IASB and Financial Accounting Standards Board are trying to hammer out a model that looks ahead to impending impairment rather than noting that it is already happening. This is part of the boards' joint project on accounting for financial instruments.

Hoogervorst explained: "The basic principles of this model are as follows. From Day One, for all new financial assets, an allowance balance needs to be built up that captures the expected losses in the next 12 months. If credit quality deteriorates subsequently to such an extent that it becomes at least reasonably possible that contractual cash flows may not be recoverable, lifetime losses need to be recognized. We will not try to define exactly what 'reasonably possible' means, but it primarily refers to the inflection point when the likelihood of cash shortfalls begins to increase at an accelerated rate as an asset deteriorates."

Hoogervorst acknowledged that the model requires a certain amount of judgment because there is no precise way to predict when the probability of default starts to accelerate. Market indicators would play a role in that judgment. Fair value would contribute valuable information even for assets measured at amortized cost. And that seems to be what the market needs: valuable information.

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Glenn Alan Cheney (glenncheney@comcast.net) is a freelance writer in Hanover, Conn.
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Title Annotation:FINANCIAL REPORTING
Author:Cheney, Glenn Alan
Publication:Financial Executive
Geographic Code:4E
Date:Sep 1, 2012
Words:1525
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