Steven Brice

The euro-zone crisis and implications for financial reporting

A look at the political backdrop in the euro zone as well as some of the financial reporting challenges facing companies and financial institutions during these turbulent times.

May 29, 2012
by Steven Brice

The euro zone is currently facing an extremely challenging economic environment. Strict austerity measures, introduced to tackle debt in the euro zone, are becoming increasingly unpopular. Objections to austerity are having significant implications on the political landscape. This has led to political change in many countries, such as in France where President Nicolas Sarkozy was replaced by his socialist rival, Francois Hollande. The political turmoil has spooked markets around the world.

But Greece is the pressure point; Its economy is in significant trouble. The latest figures are a cause for concern, and political paralysis in Greece is now making it more likely that the country will abandon the euro, devalue its new currency, and effectively start again.

A Greek exit from the euro—referred to in Europe as a “Grexit”—would undoubtedly send shockwaves throughout the euro zone. Many countries would come under significant pressure in their own right.

Chances are that countries such as Spain won’t escape a similar kind of meltdown. As the fourth-biggest economy in the euro zone, Spain accounts for almost 9% of European GDP. The Spanish government has been forced to bail out the troubled Bankia, a Spanish banking conglomerate.

The financial instability in the euro zone has led to an increased focus on the financial health and financial reporting of major European organizations.

ESMA recommendations

The European Securities and Markets Authority (ESMA), for instance, seeks to safeguard the stability of the European Union’s financial system in part by enforcing the application of IFRS among preparers.

In light of current economic developments, ESMA is calling for more disclosure in relation in general to sovereign debt in IFRS financial statements. ESMA also released study results of financial institutions listed in EU-regulated markets on the accounting treatment that they had adopted in relation to the Greek sovereign debt in their midyear financial statements. ESMA has urged preparers to consider the following elements in relation to the material exposures to sovereign debt:

  • Existence of impairment for sovereign-debt-related financial assets
  • Measurement of financial assets related to sovereign debt exposure
  • Disclosures in the year-end IFRS financial statements
  • Greek sovereign debt, specifically accounting matters

ESMA has focused on the area of sovereign debt, but in the current economic climate, the exposure of companies to financial risk has increased in a significant number of areas, including:

  • Impairment of financial assets. While a decline in the European economic outlook is not in itself an indicator of impairment, it may mean the rise in impairment incidents because of Greece. For example, a plunge in interest rates can have a consequential impact on the impairment assessment because impairment losses for financial assets held at amortized cost are determined based on the current expected future cash flows using the original effective interest rate.
  • Measurement of financial assets. Economic decline may cause a higher incidence of debt restructuring. Where renegotiation is on significantly different terms, this would result in derecognition of the original instrument and the recognition of a new instrument.
  • Impairment of nonfinancial assets. The current economic environment may mean that the testing of nonfinancial assets using a discounted cash flow model could result in an increased number of impairments. Preparers should consider carefully those areas of management judgment that are used in the discounted cash flow model, such as discount rates, growth rates, and the extrapolation of forecasts beyond a five-year period.
  • Disclosures. The need for clarity in disclosures made in the financial statements is even more critical in times of economic concern because users need to understand a company’s risk exposure. This is augmented by the need for good narrative reporting that includes a description of the company’s future outlook. The narrative should support the evidence provided in the financial statements.

While the euro zone continues to face significant difficulties, it is increasingly important for companies to focus on narrative reporting, clear disclosures, and robust financial practices. Accounting surprises will certainly be unwelcome by the markets in these difficult times.

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Steven Brice is a technical partner in the financial reporting advisory group for Mazars LLP UK and provides his views on IFRS developments from a European perspective.