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This article was first published in the January 2010 edition of Accounting and Business magazine.
The specific items affected by the credit crisis will vary from client to client but are likely to include:
Many companies will need to reduce the price of inventory to achieve sales, possibly resulting in net realisable value being less than cost. At the year-end it may not be obvious which items need to be reduced in value, and overstating the inventory is a risk. More work than usual is likely to be required on the inventory provision.
Many clients will have customers in financial difficulties and so unable to pay amounts outstanding. More allowances to reduce receivables to their realisable values will be required but, as is always the case, the real difficulty lies in predicting which debts may not be recoverable and estimating the amount of the allowances.
If companies are selling fewer items and generating less profit, this will cause a reduction in value in use. Carrying values of assets may therefore exceed recoverable amounts and impairment losses will need to be provided. Property values have fallen in many parts of the world. Since property valuations are subjective, this creates risk for the auditor.
If companies are rationalising and restructuring their operations, then additional liabilities may need to be provided. Provisions may be required to cover such events as redundancy, penalties for lease cancellations, and onerous contracts.
Companies' net pension liabilities may increase if the value of the fund assets in the company pension scheme has declined relative to the pension obligation.
The area that has caused most concern for accountants and auditors is that of financial instruments, especially those which have become illiquid.
IAS 39, Financial Instruments (and its equivalents), requires the valuation at fair value of certain categories of assets, including those which are intended to be sold soon ('held for trading') and which are 'available for sale' in that they are not intended to be held to maturity.
Fair value is intended to be the price that would be charged in an orderly, arm's-length transaction. When markets are active, actual traded prices are likely to represent fair value.
For certain financial assets, volumes of trade have fallen to such an extent that the market has become inactive. Actual transaction prices will not be as good an indicator of fair value as many transactions will be sales by companies facing financial difficulties and prepared to accept a lower price due to their straitened circumstances (and so are not orderly transactions).
Directors may therefore be required to use valuation models rather than market inputs to determine prices, but these present their own problems.
As an illustration, the Black-Scholes model, widely known for its use in the valuation of options, has certain underlying assumptions which limit its accuracy in the real world. For example, it assumes that the risk-free rate is known and constant and that the volatility of the underlying asset is known and constant. With falling interest rates in most developed economies and high volatility of stock markets, these assumptions cannot currently be justified.
Auditors must be aware of the limitations of such models and ensure that adequate disclosure is made of assumptions made in using such models which could affect the calculated valuations.
It should also be noted that directors are unlikely to use such valuation models themselves and are likely to rely on a specialist valuer, for example a chartered financial analyst.
Due to the difficulties of valuing financial assets traded in inactive markets, IAS 39 was revised in October 2008 to allow financial assets held for trading and assets available for sale to be reclassified into other categories.