Affect of Impairment Testing and Off-Balance Sheet Liabilities on Reliability of Financial Statements - Essay Example

Supervisor ACCOUNTING 500A FALL 2008 A critical analysis of How Impairment Testing and Off-Balance Sheet Liabilities Affect the Reliability of Financial Statements. By: November, 2008 TABLE OF CONTENTS 1.0 Introduction 1.1.1 How impairment testing and off balance sheet Liabilities affect the Reliability of Financial Statements 1.1.2 Conclusion 1.1.3 References 1.0 Introduction The main problems facing the international accounting standard board IASB are appropriately determining the fair value of an asset or liability. The IASB requires companies to estimate the fair value by either making reference to an active market for the instrument in the case where the instrument is trading in an active market or use an appropriate valuation model to estimate the value of the instrument (Eipstein and Jermacowicz 2007). The main question that arises now is how well can users of financial instruments rely on these valuation models Different valuation models lead to different figures for the same instrument. In addition slight changes in the assumptions underlying the valuation models may lead to significant changes in the estimates of fair value for a single instrument (Wilson and Ernst and Young 2001). When an instrument is not traded in an active market there is great uncertainty about the ultimate amount that can be realized from the instrument in a transaction between knowledgeable willing parties in an arms length transaction (Eipstein and Jermacowicz 2007). In July 2002, the European Union issued a regulation requiring all EU-listed companies to prepare their year-end accounting standards in compliance with IFRS as from December 31st 2005. Following the recent wave of accounting scandals at Enron, Tyco International and WorldCom, as well as the greater concern for off-balance sheet liabilities, the IFRS has issued a number of standards (IAS 32 Financial Instruments Disclosure and Presentation, IAS 39 , IFRS 7 Financial Instruments Disclosures, and IAS 17 Leases) to help reduce bright lines that enable companies to use off-balance sheet financing. In this paper the developments in respect of convergence between national and international accounting standards since 1st January 2005 to present day will be discussed. The impact that off-balance sheet financing and impairment testing may have upon the reliability of financial statements will also be discussed. In the light of all these, the next section argues in respect to the theme of this paper. 1.1.1 How impairment testing and off balance sheet Liabilities affect the Reliability of Financial Statements IAS 36 requires companies to test assets for impairment. Basically, the standard requires that tangible assets should be tested for impairment when there is an indication that an asset might be impaired. (Epstein and Jermacowicz, 2007). However, intangible assets having an indefinite useful life must be tested annually for impairment. The impairment test is required to be applied to a cash generating unit, that is, the smallest group of assets for which the entity has identifiable cash flows. During an impairment test, the carrying amount of an asset or group of assets in the cash generating unit is compared with the fair value or value in use (value in use is calculated as the present value of the cash flows expected to be generated from using the asset). The higher of value in use and fair value is taken and compared with the carrying amount and an impairment loss is recognized if the carrying amount is higher than the higher of fair value and value in use. (Epstein and Jermacowiz, 2007). IAS 36 also requires a company to determine at each reporting date whether there are conditions that would indicate that impairment may have occurred and further provides a set of indicators of potential impairment some of which include (Epstein and Jermacowiz, 2007: p. 247): Market value declines for specific assets or cash generating units, beyond the declines expected as a function of asset aging and use; Significant changes in the technological, market, economic, or legal environments in which the enterprise operates, or the specific market to which the asset is dedicated; Increase in the market interest rate or other market-oriented rate of return such that increases in the discount rate to be employed in determining the value in use can be anticipated, with a resultant enhanced likelihood that impairments will emerge; Declines in the (publicly-owned) entity's market capitalization suggest that the aggregate carrying value of assets exceeds the perceived value of the enterprise taken as a whole; There is specific evidence of obsolescence or physical damage to an asset or group of assets; There have been significant internal changes to the organization or its operations, such as product discontinuation decisions or restructurings, so that the expected remaining useful life or utility of the asset has seemingly been reduced; and Internal reporting data suggest that the economic performance of the asset or cash generating unit is, or will become, worse than previously anticipated. From the foregoing, we can conclude that impairment of assets has a negative impact on the non-current assets of a listed entity. This is true given that impairment leads to loss recognition and a subsequent reduction in the value of the asset which in turn reduces the total asset base. Impairment of assets also enables the company to show the true value of the company and increases investor's reliability on the financial statements. Off-balance sheet assets and liabilities refer to assets and liabilities that are not disclosed in the balance sheet. These types of assets and liabilities have been found to be damaging given that they enable company management to manipulate investor's beliefs about the contents of financial statements. For example, a company may have an incentive to hold off-balance sheet assets if it wants to understate earnings so as to enable it overstate them in future (conservative accounting). Companies may also have an incentive to use off-balance sheet liabilities if they don't want investors to know the actual amount of debt that they carry. For example Enron, had a number of special purpose entities through which it had a lot of off-balance sheet liabilities. (Chandra et al., 2006). If these liabilities were held in Enron's balance sheet, it could have been possible for investors to better understand the financial position of Enron, and the Enron scandal could have been avoided. Following from the increase use of off-balance sheet financing, regulators and accounting standard setters have taken a number of measures to limit their use. For example, the IASB issued IAS 17 Leases to help reduce the number of leases that are classified as operating leases. It should be noted that operating leases are not reported as a liability in the balance sheet, whereas finance leases are reported in the balance sheet as a liability. (Epstein and Jermacowiz, 2007). IAS 17 has increased the number of leases to be reported as finance leases, thereby greatly reducing the possibility of classifying leases as operating leases which increases the likelihood of off-balance sheet liabilities. This therefore helps the users of financial statements to better understand the financial position of the entity. In addition, the IASB issued IAS 32 Financial Instruments: Disclosure and Presentation with the objective of enhancing user's understanding of the significance of on-balance sheet and off-balance sheet financial instruments to an enterprise's financial position, performance, and cash flows. IAS 32 addresses this issue in the following ways: 1. Clarifying the classification of a financial instrument issued by an enterprise as a liability or as equity. 2. Prescribing strict conditions under which financial assets and liabilities may be offset in the balance sheet. 3. Requiring a broad range of disclosures about financial instruments, including information as to their fair values. IAS 32 requires an entity to use substance over form in deciding whether to classify a financial instrument as equity or liability. The election to classify a financial instrument as either an equity or liability instrument must be made at the time the instrument is initially recognized and this decision cannot be changed in subsequent periods when circumstances change. The classification is not subsequently changed based on changed circumstances. A financial liability involves a contractual obligation either to deliver cash or another financial asset, or to issue another financial instrument, under terms that are potentially unfavourable to the issuer. An instrument that does not give rise to such a contractual obligation is an equity instrument. (Deloitte Touche Tomatsu, 2008; Epstein and Jermacowiz, 2007) IFRS 7 issued on the 18th of August 2005 by the IASB supersedes IAS 30 Disclosures in Financial Statements of Banks and Similar Institutions and IAS 32. (KPMG, 2006). IFRS 7 recognises that the techniques used for measuring and managing risk exposure arising from financial instruments have evolved. (KPMG, 2006). The standard reflects this changing environment and makes a number of improvements to the disclosure framework for risks arising from financial instruments. The main objective of the standard is to introduce disclosure requirements that enable users of financial statements to evaluate the significance of financial instruments to the entity's financial position, and performance, as well as the nature and the extent of risk arising from financial instruments to which the entity is exposed, and how the entity manages those risks. (KPMG, 2006). IAS 39 Financial Instruments: recognition and measurement provides further guidance on the impairment of financial assets. According to the standard, "financial asset or group of assets is impaired, and impairment losses are recognised, only if there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset. An entity is required to assess at each balance sheet date whether there is any objective evidence of impairment. If any such evidence exists, the entity is required to do a detailed impairment calculation to determine whether an impairment loss should be recognized". [IAS 39.58] cited by (Deloitte Touche Tomatsu, 2008). 1.1.1 Conclusion To a greater extent one can see that the new accounting standards have helped to reduce the use of off-balance sheet liabilities. This has greatly increased the relevance and reliability of financial statements since users can now better understand, the financial position, performance and cash flows of an entity before making investment decisions. BIBLIOGRAPHY Ding Y., Hope O., Jeanjean T. Stolowy H. (2007). Differences between domestic accounting standards and IAS: Measurement, determinants and implications. Journal of Accounting and Public Policy 26, pp. 1-38 Ding Y., Jeanjean T. Stolowy H. Why do national GAAP differ from IAS The role of culture The International Journal of Accounting, vol. 40 pp. 325- 350 KPMG (2006) IFRS 7 for Corporates. International Financial Reporting Standards. www.kpmg.com Delloite Touche Tomatsu (2008). IAS 39 Financial Instruments: Recognition And Measurement http://www.iasplus.com/standard/ias39.htm Ndubizu G. A., Sanchez M. H. (2006). 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