Àn update for directors of listed companies: responding to increased country and currency risk in financial reports

Source: Financial Reporting Council

Executive Summary

This Update for Directors has been prompted by the current economic uncertainties facing a number of countries around the world. This Update aims to draw together a number of the more significant issues directors may reflect when considering how best to provide a balanced and understandable assessment of a company’s position and prospects in the context of increased country and currency risk. The issues Directors could consider include, where relevant:

• The company’s exposure to country risk, direct or to the extent practical indirect through financial instruments but also in terms of exposure to trading counterparties (customers and suppliers);
• The impact of austerity measures being adopted in a number of countries on the company’s forecasts, impairment testing, going concern considerations, etc.;
• Possible consequences of currency events that are not factored into forecasts but may impact reported exposures and sensitivity testing of impairment or going concern considerations; and
• A post balance sheet date event requiring enhanced disclosures to avoid misleading investors.

The examples referred to in this Update are not intended to be comprehensive but to provide a stimulus to Directors and Audit Committees, who are better able to judge the relevance of these and other related issues to the company’s particular circumstances.

Similar guidance has also been issued by other regulators in recent months, including ESMA’s November 2011 public statement “Sovereign Debt in IFRS Financial Statements” [2] which Directors may also want to consider.

Introduction

The purpose of this Update is to draw Directors’ attention to the importance of conveying a balanced and understandable assessment of a company’s position and prospects in the context of increased country and currency risk. In particular, it identifies some of the more significant annual and interim reporting requirements that Directors of Listed Companies may consider if a company has a material exposure to country and/or currency risk.

Country and/or currency risks have seen significant change in the last year. Of particular note are the risks arising from regime changes in the Middle East, the funding pressures on certain European countries and curtailment of capital spending programmes. The outcome of these events remains uncertain. However, the austerity measures being widely adopted in Europe will likely mean significant changes to growth rates and demand for consumer products in those countries. Similarly, to the extent relevant, consideration could also be given to outcomes such as one or more Euro area countries being forced to exit the Euro area.

These conditions may give rise to delays or other defaults on contracts with customers and other trading partners exposed to, or based in, countries experiencing difficulties, and/or may affect expectations of future business volumes and margins.

Analysts and investors are likely to pay particular attention to these risks over the next few months given the very high level of uncertainty about further developments. Thus, it is particularly important at this time that, Directors focus sufficient attention on the relevant strategic and operational risks and that companies make clear the nature and scope of their direct and to the extent practical indirect exposures to these country and/or currency risks. Companies have the opportunity to manage the risk that markets misunderstand their exposures by ensuring that they explain clearly their relevant material risks and how management is mitigating them, and keep the market up to date as further developments arise.

The various reporting requirements of Laws and Regulations set out below are derived from different sources and relevant disclosures may often appear in different parts of an annual or interim report. However, it may be helpful to investors and other users if they are brought together in one section of an annual or interim report so that all of the effects and risks of the most recent crisis can be more easily understood.

Whilst this Update draws attention to the more relevant specific requirements of Laws and Regulations, Directors will also be aware of the overarching requirement that their financial statements must give a true and fair view. This may necessitate additional disclosures where an issue is not explicitly addressed by the Law or relevant accounting standards.

Audit committees are likely to want a detailed understanding of country and currency risks facing the business, even if only to review the steps taken to identify the material risks. For material exposures they are likely to want a full understanding of how those risks have been identified, assessed and managed, their impact on the carrying amount of assets and liabilities reported in the annual/interim reports and how sensitive those carrying amounts are to reasonably possible changes in the estimates and assumptions used by management when preparing the annual report.

Auditors are required to express an opinion on the truth and fairness of the annual financial statements and on whether the information provided by the Directors’ Report is consistent with those financial statements. Auditors are also required to read all of the financial and non‐financial information in the annual report and to consider whether there are any inconsistencies or misstatements of fact that may undermine the credibility of the financial statements on which they have reported. In the current economic climate auditors are likely to be assessing whether country and currency risks are significant risks that require special audit consideration.

Overall position, prospects and business model

The FRC published a limited update to the UK Corporate Governance Code (The Code) in June 2010 [3]. The Code requires Directors of listed companies to provide a balanced and understandable assessment of a Company’s position and prospects and to comment specifically on how the company operates for the long term (its business model) and whether there are risks to it continuing as a going concern.

A company that has significant trading relationships with businesses or governments facing increased uncertainty should explain how its business model and financial position might be affected by a default or other significant event.

Going concern and principal risks and uncertainties

The Listing Rules require Directors of Listed Companies to make certain disclosures about Going Concern [Listing Rule 9.8.6R (3)]. The FRC updated its guidance for Directors on Going Concern in 2009 to take account of initial experience from the credit crisis in this regard [4].

The Companies Act also requires Directors to describe the the principal risks and uncertainties facing their business [Companies Act 2006 Section 417(3)(a)]. The Financial Reporting Review Panel has expressed its view that these disclosures should include an explanation of actions taken and processes adopted to mitigate the effects of those risks and uncertainties (Annual Report 2011[5]).

IFRS also requires Directors to make an assessment of the entity’s ability to continue as a going concern [IAS 1.25‐26]. Going concern and principal risks and uncertainties change over time as a business develops and as the business environment changes. Thus these disclosures need to be revisited when preparing each set of annual or interim report and accounts.

Where a company is significantly exposed to increased country and currency risks, Directors may need to enhance their disclosures in this area including how these risks are mitigated. For example, a company that has significant balances outstanding or business relationships with the public sector in a country in severe financial difficulties (and/or implementing austerity measures) will likely need to disclose that fact and indicate the future events that could impact on amounts outstanding and future trading volumes. In such instances, consideration will also need to be given to additional going concern disclosures such as the key assumptions made by management as part of the going concern assessment.

The opportunity should also be taken to look at the disclosures in aggregate to ensure that risks which have become less relevant are reduced or removed from the report.

Potential impairment of non-financial assets

IFRS contains specific requirements to test non‐financial assets for impairment [IAS 36]. In relation to goodwill and intangibles which are not amortized they must be tested at least on an annual basis. Other non‐financial assets should be tested whenever there is a trigger for impairment.

A material exposure to adverse developments in country and/or currency risk is likely to trigger an impairment assessment for material non‐financial assets that carry that exposure at each annual and interim reporting date. For example, a company that sells most of its output to consumers in a country implementing austerity measures is likely to need to consider whether the property, plant and equipment may be impaired given the potential impact of those measures on growth rates, consumer spending, etc.

IFRS provides specific procedures to be undertaken when assessing whether a non‐financial asset has been impaired [IAS 36.12‐14]. The requirements differ to some degree depending upon whether the asset is property, plant and equipment, a specific intangible or goodwill. However, the common approach is to make a best estimate of future cash flows and to discount these cash flows at the rate that would be required at the balance sheet date by an investor.

In relation to goodwill, IFRS requires management to stress test their impairment assessments using reasonable possible adverse changes in the assumptions used to generate the forecast cash flows [IAS 36.134(f)]. If an impairment would have been recorded under these reasonably possible adverse assumptions, then additional disclosures are required to explain this.

Potential impairment of financial assets

IFRS also contains specific requirements for impairment assessments of financial assets [IAS 39.58]. The standard identifies a set of potential triggers for when an impairment assessment should be undertaken. Specific impairment calculations should be made depending upon the classification of the financial asset.

Impairment losses need to be determined on a case by case basis reflecting the specific facts and circumstances. The fact that government debts have already been provided against would not necessarily mean that all debts due from corporates in that country should be provided against, but it is likely that an impairment assessment would be warranted. For example, UK banks have already posted impairment charges against loans to the Greek Government but that does not mean that all Greek corporate debt requires an impairment charge (although it may be subject to risks – see below).

IFRS 7 requires detailed disclosures to be made of provisions made against loans and receivables [IFRS 7.16] as well as disclosures about any loans and receivables that are past due at the end of the period [IFRS7.36‐37].

IFRS 7 also requires detailed disclosures about concentrations of risk [IFRS7.34(c) and IFRS 7.B8] highlighting that Directors should apply judgment when identifying concentrations of risks and describing the circumstances of the company which would need to be taken into account.

Directors should consider changes to significant concentrations in the context of these requirements. IFRS 7 also requires detailed disclosures about credit risk, liquidity risk and other market risks. Directors need to consider the impact of the economic conditions on such disclosures.

Risk of change in carrying amount of assets and liabilities

IFRS contains a disclosure requirement in relation to the sources of estimation uncertainty in the carrying amount of assets and liabilities [IAS 1.125]. If there is a significant risk that there could be a material change in the carrying amount of an asset or liability due to changes in uncertain estimates within the following twelve months, then the fact needs to be disclosed. For example, a provision may not be required against material amounts (to the extent it is not carried at fair value [IAS 1.128]) due from a government in turmoil, but disclosure would be warranted of the amounts outstanding [IAS 1.125‐133].

Ensuring that this disclosure has been properly made will necessitate assessing each of the material country and/or currency risks, reconsidering the underlying assumptions about a reasonable range of potential outcomes, and estimating how such different circumstances might affect the value of the relevant assets and liabilities.

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[1] Given the current economic uncertainties companies may not be able to assess all indirect exposures. In such circumstances, it should identify such indirect exposures to the extent it is practical to do so.

[2] ESMA’s public statement “Sovereign Debt in IFRS Financial Statements” issued in November 2011 can be downloaded from ESMA’s website here http://www.esma.europa.eu

[3] The FRC’s UK Corporate Governance Code (The Code) updated in June 2010 can be accessed here http://www.frc.org.uk/publications/pub2284.html

[4] The FRC’s 2009 guidance for Directors on Going Concern can be found here http://www.frc.org.uk/publications/pub2140.html

[5] The Financial Reporting Review Panel’s Annual Report 2011 can be accessed here http://www.frc.org.uk/images/uploaded/documents/FRRP%20Annual%20Report%202011%20final.pdf