Recent market disruption is focusing attention on the upcoming annual reports of European and other banks, particularly with respect to how they treat asset valuations and impairment.
To examine the range of accounting options and possible outcomes for banks that apply International Financial Reporting Standards (IFRS), Standard & Poor’s Ratings Services released two FAQs: “FAQ: IFRS Reporting And Options For Banks In A Souring Market” and “FAQ: Will Banks That Apply IFRS Consolidate More Special Purpose Entities?”.
The options available to banks in how they treat assets under IFRS could lead to a significant range in their final reported results. The picture is further clouded by the difficulty in determining the fair values of various assets if market conditions sour, affecting prices derived from those markets, and at the very least producing dynamic results that are linked to market conditions at the balance sheet date, to the extent that fair value accounting methods are applied.
“The complexity of, and discretion allowed under, IFRS may also lead to different treatments of the same assets among banks and even for similar assets within an institution,” Standard & Poor’s credit analyst and co-author of the report, Sue Harding said.
“As such, definitive answers on what banks will do are not, and cannot be, provided. We do, however, set out possible accounting scenarios that can be useful in establishing expectations of how wide the range of possibilities could be. We also cover certain accounting uncertainties that are currently being discussed by banks and their auditors,” Ms. Harding added.
For banks in particular, accounting concerns that relate to the current market environment include the write-down of various financial assets; increasing disclosure of, and exposure to, on or off-balance-sheet risks and contingencies; and the potential for expanding the scope of consolidation.
Key analytical issues include:
— Although several banks have announced expected writeoffs, actual reported credit, impairment, and full fair value losses may differ, as they can only be measured at the balance sheet date and given dynamic markets, may change between any bank’s announcement and their year end. Additionally, we expect difficulties in measuring fair value, and any increase in credit losses incurred to be accounted for over time.
— Banks will have limited ability to stop fair valuing assets and liabilities that have been fair valued previously. For many of these, gains and losses are recognised immediately in earnings, so impairment charges are automatically taken as a result of declines in fair value.
— Determining fair value will be an even more subjective exercise than in times of more stable and liquid markets, as valuations may be based on prices obtained from less active markets, or derived from valuation models that use fewer market inputs or market inputs taken from less active markets.
Of particular interest in the current conditions is the potentially expanded scope for banks to consolidate special purpose entities (SPEs), such as asset-backed commercial paper (ABCP) conduits, under IFRS.
In many instances, banks already consolidate SPEs under IFRS, but this year, they may consolidate a higher number due to changes in their structural relationships with the SPEs that indicate additional support or assumption of risk by the banks.
“Banks’ financial statements seldom provide even the most basic information on SPEs and whether or not they are consolidated. However, we expect banks to make a lot of their recent disclosures in press releases and other communications more widely available in annual financial statements,” co-author of the report Eddie Khamoo said.
