Current economic conditions financial reporting considerations

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1 No August 2011 Technical Line Financial reporting development Current economic conditions financial reporting considerations In this issue: Overview... 1 Risk-free interest rate... 2 Derivatives and hedging activities... 2 Investments in debt and equity securities... 3 Equity securities... 3 Debt securities... 4 Goodwill and indefinite-lived intangible assets... 4 Postretirement benefits... 5 Money market funds... 5 Regulatory capital... 5 Subsequent events... 5 Other disclosure considerations... 6 Quantitative and qualitative disclosures about market risk... 6 What you need to know The recent downgrade by Standard & Poor s (S&P) of the long-term credit rating of the US and current economic conditions raise a number of financial reporting considerations. Notwithstanding S&P s downgrade, we believe US Treasury rates can continue to be used as the risk-free interest rate in applying US GAAP at this time. We expect that all movements in US Treasury rates represent movements of the benchmark interest rate. Companies should continue to monitor ongoing developments and consider their potential financial reporting effects. Overview The S&P downgrade of the long-term sovereign credit rating of the United States one notch to AA + from AAA was primarily an economic event, but it has financial reporting implications. The 5 August 2011 S&P downgrade affects only longer-term maturities. The other two main credit-rating agencies, Moody s Investors Service (Moody s) and Fitch Ratings (Fitch), have not taken similar action. In fact, both Moody s and Fitch affirmed their credit ratings, but warned that downgrades were possible if lawmakers fail to enact debt-reduction measures or the economy weakens. The downgrade has resulted in significant volatility in the global financial markets. Some market participants also have cited concerns about economic growth in the US economy and unemployment levels, as well as potential effects from issues related to European sovereign debt, as contributing to recent volatility. The S&P downgrade and current economic conditions raise a number of financial reporting considerations that are further discussed in this publication.

2 Risk-free interest rate US GAAP often requires the use of a risk-free interest rate or credit-adjusted riskfree interest rate to discount future cash flows. For example, risk-free interest rates (or credit-adjusted risk-free interest rates) are used in the following measurements: Asset retirement obligations Environmental liabilities (when the criteria for discounting are met) Financial guarantee liabilities of financial guarantee insurers In addition, risk-free interest rates are often a component of fair value measurements determined using an income approach. For example, a risk-free interest rate is often used to develop an appropriate discount rate when a discounted cash flow model is used to estimate fair value. In addition, the risk-free interest rate is a required assumption in most option-pricing models. US Treasury rates are commonly used as the risk-free interest rate for financial reporting purposes. The term risk-free interest rate is not defined in the Master Glossary of the Accounting Standards Codification (ASC), but the definition of the benchmark interest rate included in the Master Glossary and in ASC describes the risk-free interest rate as a rate that has no default risk. While US GAAP generally does not prescribe how the risk-free interest rate should be determined, the risk-free interest rate in the US is commonly based on US Treasury yields. This approach is consistent with the guidance provided in ASC with respect to the minimum inputs that should be considered in an option pricing model used to value an employee stock option. That guidance generally indicates that a US company issuing options on its own shares would generally use implied yields based on the US Treasury zero-coupon yield curve as the risk-free interest rate. The recent downgrade has resulted in questions about whether US Treasury rates should continue to be used when references are made to the risk-free interest rate. While S&P has downgraded the US long-term sovereign credit rating, we observe that the other major rating agencies have affirmed their credit ratings of the US. Moreover, at the time of this publication, US Treasury yields have declined since the downgrade was announced. Without any further guidance from the Financial Accounting Standards Board (FASB) or Securities and Exchange Commission (SEC) staff, we believe it is still appropriate to use US Treasury rates as the risk-free interest rate for financial reporting purposes. Derivatives and hedging activities We also believe it is still appropriate for derivatives that refer to the price or rate of US Treasury securities to be eligible for accounting hedges of benchmark interest rate risk under ASC 815. The FASB defines benchmark interest rate in ASC as follows: A widely recognized and quoted rate in an active financial market that is broadly indicative of the overall level of interest rates attributable to high-credit-quality obligors in that market. It is a rate that is widely used in a given financial market as an underlying basis for determining the interest rates of individual financial instruments and commonly referenced in interest-rate-related transactions August 2011 Technical Line Current economic conditions financial reporting considerations

3 In theory, the benchmark interest rate should be a risk-free rate (that is, has no risk of default). In some markets, government borrowing rates may serve as a benchmark. In other markets, the benchmark interest rate may be an interbank offered rate. The status of US Treasury rates as widely recognized and quoted in an active financial market is not affected by the downgrade. What might change are the views of market participants, who so far still view US Treasurys as a benchmark that is broadly indicative of the overall level of interest rates attributable to high-credit-quality obligors in that market. Market participants do not appear to have changed their view that US Treasurys provide a benchmark interest rate. Movements in the benchmark US Treasury rate are influenced and will continue to be influenced by changes in market participants perceptions of the US government s ability to honor such obligations. It is not possible to isolate, in an accounting sense, which movements in the US Treasury rate stem from changes in perceptions of default and those that are pure rate movements. Because it is not possible to isolate such movements and measure them, we continue to believe that all movements in US Treasury rates represent movements of the benchmark, as defined in ASC 815. As a result, changes in perceptions about the creditworthiness of the US government would not be considered sources of hedge ineffectiveness in hedges of interest-rate risk. If the downgrade of US long-term sovereign debt has a ripple effect on financial instruments used in collateral arrangements that back derivative contracts, counterparties may require additional postings of collateral. Without such supplemental postings, counterparties to derivatives may need to consider whether any loss of collateral value affects the credit valuation adjustment 3 component of the derivative s fair value (e.g., carrying value). Investments in debt and equity securities The recent declines in the global financial markets may require accounting for and disclosure of other-than-temporary impairments (OTTI) of both equity and debt securities. Equity securities An equity security is considered impaired when its fair value is below its cost basis. Whenever an equity security is impaired, an entity should assess whether the impairment is other than temporary. This evaluation is based on two key assessments. The first is an assessment of whether and when an equity security will recover in value. Factors that should be considered include the duration and severity of the impairment and the financial condition and near-term prospects of the issuer. The second assessment is whether the investor has the intent and ability to hold that equity security until it recovers its value. There is no bright line or safe-harbor in either the duration or severity of an impairment to indicate if it is other than temporary. As declines in fair value become more severe, a company must do more analysis and collect more objective evidence to support an assertion that it anticipates a recovery in fair value and has the intent and ability to hold the security until it recovers August 2011 Technical Line Current economic conditions financial reporting considerations

4 Companies should continue to consider current economic conditions, including the recent declines in the equity markets, to determine whether any impairments are other than temporary. If an impairment is other than temporary, the cost basis of the impaired equity security should be written down to fair value and the realized loss should be charged to earnings. Debt securities Although the debt markets have generally not experienced the same negative reaction to the downgrade that the equity markets have, the downgrade may require a company to recognize an OTTI on a debt security in certain circumstances. A debt security is considered other-than-temporarily impaired if its fair value is less than its amortized cost basis and (1) the company has the intent to sell the impaired debt security (that is, the company has decided to sell the impaired security), (2) it is more likely than not that the company will be required to sell the impaired security or (3) the company does not expect to recover the entire amortized cost of the security. Some companies may be required to hold investments only in AAA-rated debt instruments. If a company in this situation concludes that the downgrade of the US long-term sovereign credit rating by S&P will more likely than not require the company to sell any of its holdings of US government-issued debt instruments, the company will be required to recognize an OTTI on debt instruments whose fair value is less than their amortized cost basis. In these unlikely circumstances, the debt instruments are written down to fair value and any realized loss is charged to earnings. Goodwill and indefinite-lived intangible assets Companies are required to test goodwill and indefinite-lived intangible assets for impairment at least annually, and more frequently if events or changes in circumstances between annual tests indicate that the asset may be impaired. While not all inclusive, ASC provides examples of events and circumstances 5 that may require an interim impairment test. We believe that it is unlikely that the downgrade would in and of itself be considered an event that would trigger an interim impairment test. However, changes in economic and market conditions as a result of the downgrade may lead a company to conclude that one or more of these events and circumstances have occurred, which might require an interim test. When considering interim impairment factors, companies will need to consider the effect that recent market volatility and developing economic conditions will have on forecasted earnings and cash flows. The SEC staff also has said registrants should provide early warning disclosures in Management s Discussion and Analysis (MD&A) if it is reasonable to expect a material impairment in a future period. Also, the SEC staff may question a registrant about the adequacy of its disclosures when there appear to be indicators of impairment but the registrant has not recognized an impairment charge. The SEC staff has advised registrants that the assumptions underlying their impairment analyses should be consistent with other accounting measurements and nonfinancial disclosures in their SEC filings August 2011 Technical Line Current economic conditions financial reporting considerations

5 Postretirement benefits Recent market activity could have implications on the measurement of postretirement benefit obligations. For example, declines in equity markets and potential changes in interest rates could have a significant effect on the fair value of plan assets and the funded status of plans, as well as the long-term expected rate of return on plan assets. Postretirement benefit obligations should continue to be discounted at discount rates derived from bonds that are of high quality (at least Aa on Moody s rating scale). While the measurement of postretirement plan assets and obligations generally occurs at the end of the fiscal year, interim disclosures may be appropriate in certain circumstances. For example, some companies have elected an accounting policy to recognize changes in the value of plan assets and obligations each year (in the fourth quarter), rather than defer those gains and losses over a longer period. If plan asset values remain depressed, those companies may report significant losses on plan assets in the fourth quarter. Those companies should consider whether to provide disclosures in their interim period MD&A about potential losses. Risk-based capital for banks, insurance companies and brokerdealers is not affected by the downgrade. Money market funds Money market funds are primarily regulated under the Investment Company Act of 1940 (the Act) and the rules adopted under that Act, particularly Rule 2a-7. This rule requires a money market fund to maintain its portfolio in a short-term weighted average maturity consisting of instruments in the top two tiers given by rating agencies. Because S&P affirmed its highest short-term sovereign credit rating of A-1+ on the US, S&P s downgrade of the US s long-term sovereign credit rating may not have a direct effect on money market funds. However, money market funds could be affected by downgrades of other holdings as a result of further actions by S&P or other credit-rating agencies. Regulatory capital Bank regulatory capital rules will not be affected by the downgrade of the long-term sovereign credit rating of the US. The US banking regulatory agencies have recently confirmed that the US Treasury security risk weights used for risk-based capital purposes, as well as the risk weights for other securities issued or guaranteed by the US government, will not change. The regulators also said that other federal banking agency regulations would not be affected by the downgrade. Likewise, the National Association of Insurance Commissioners and the Financial Industry Regulatory Authority (FINRA) have issued statements to their constituents confirming that the downgrade will not affect capital measure requirements. Subsequent events ASC provides guidance on accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Some subsequent events require adjustment to the financial statements. Others require only disclosure August 2011 Technical Line Current economic conditions financial reporting considerations

6 Disclosure of the S&P downgrade of the US long-term sovereign debt as a subsequent event would be required only if the downgrade had a direct and significant effect on a company s financial statements. While we generally do not expect the downgrade s effects to be significant enough to require disclosure by most companies, this determination should be based on the individual facts and circumstances. Companies that expect the downgrade and related equity market declines to affect their future operations should consider the requirements of Item 303 of Regulation S-K in determining whether discussion of the expected effects of these events is required in MD&A. Other disclosure considerations Companies should continue to revisit their disclosures about risks, critical accounting policies and fair value accounting, including: Taking a fresh look at financial statement disclosures addressing risks, uncertainties and concentration of risks Companies should continue to revisit their disclosures about risks and uncertainties. Challenging whether previously disclosed market risks should be updated to reflect current conditions Considering the SEC staff s view that MD&A should make investors aware of the sensitivity of financial statements to methods, assumptions and estimates underlying the financial statements The SEC continues to focus on disclosures of Liquidity and Capital Resources. In September 2010, the SEC published interpretive guidance (FR-83) intended to improve liquidity and capital resources disclosures in MD&A. While FR-83 does not amend existing SEC rules or create additional disclosure requirements, it highlights the need for disclosure of a registrant s liquidity and funding risks by clarifying disclosure requirements about liquidity, leverage ratios and the contractual obligations table. 7 Quantitative and qualitative disclosures about market risk Item 305 of SEC Regulation S-K (the Market Risk Rule) requires quantitative and qualitative market risk disclosures about all financial instruments to be presented outside the financial statements in both annual reports on Form 10-K and in registration statements. Market risk is a broad term referring to economic losses due to adverse changes in the fair value of a financial instrument. The Market Risk Rule affects most registrants as nearly all have some financial instruments that may expose them to market risk. The Market Risk Rule clarifies that the market risk disclosures must be updated in quarterly reports (that is, Form 10-Qs) when there have been material changes in information reported for the most recently completed fiscal year. Given recent events, management should carefully evaluate its market risk disclosures and consider whether updated disclosures are required in annual and quarterly reports August 2011 Technical Line Current economic conditions financial reporting considerations

7 Next steps The capital markets will continue to react to the S&P downgrade in the weeks and months ahead. Companies should continue to monitor developments and consider any effects on their financial reporting. Endnotes: ASC Topic 815, Derivatives and Hedging ASC Topic 718, Compensation Stock Compensation Chapter 4 of our Financial Reporting Developments publication, Accounting for Derivative Instruments and Hedging Activities (SCORE BB0977, November 2010) contains extensive guidance on the accounting considerations associated with credit risk in derivative contracts. Appendix D of our Financial Reporting Developments publication, Fair Value Measurements and Disclosures, (SCORE BB1462, June 2010) contains guidance on credit valuation adjustments for derivative contracts. ASC Topic 350, Intangibles Goodwill and Other See ASC ASC Topic 855, Subsequent Events Refer to our Hot Topic, SEC issues MD&A guidance: Liquidity and capital resources for further information (SCORE CC0304, September 2010) Ernst & Young Assurance Tax Transactions Advisory 2011 Ernst & Young LLP. All Rights Reserved. SCORE No. BB2170 About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with Ernst & Young LLP or other professional advisors familiar with your particular factual situation for advice concerning specific audit, tax or other matters before making any decision August 2011 Technical Line Current economic conditions financial reporting considerations