22 August 2012

FRC: How credit analysts view and use the financial statements

The focus of the FRC's paper, "How credit analysts view and use the financial statements", is on credit analysts' requirements and what the new information content of the financial statements should be in their opinion, rather than on equity analysts.

To arrive at the recommendation of this paper, staff conducted a series of interviews with credit analysts and bond fund managers. The appendix to this paper considers some issues, such as what bond holders look for when investing.

The following were noted by those interviewed as being of useful content for financial statements. Increased cash flow projection information – it was noted that whilst the financial statements contain comprehensive information on earnings; there is not sufficient forward looking information provided on cash flows; specifically contractually agreed short-term cash outflows such as:

• near-term maturities of financial debt and bank facilities as well as major non-negotiable cash outflows, e.g. to tax authorities or suppliers or on majorinvestment projects;
• derivative arrangements due for renewal and terms of put options written;
• percentage of currency positions which have been hedged;
• pension fund cash flows; and
• hedging of risk (eg. critical commodities such as the price of jetfuel for airlines).

This information is especially useful for credit analysts who need to project cash flows to gauge the risk of borrowers’ defaulting because of mandatory cash outflows exceeding available liquid resources and cash inflows.

Some credit analysts noted that the balance sheet often presents an incomplete summary of a company’s assets and liabilities; for example, valuable assets such as an airline’s landing slots at heavily congested airports are rarely recorded and the accounting for corporate pension obligations is often sensitive to undisclosed assumptions.

Credit analysts noted that more information on operating margins by country and product line would be useful. However they also noted that they understood that entities preferred not to give this information in the financial statements because they considered it to be commercially sensitive.

The structure of a group is also a potential source of risk if intra-group transfers of cash undermine the debt investor’s claims and favour shareholders. For example they could be issuing bonds from a subsidiary and upstream cash to a group that pays dividends. There is also the risk of subordination: the company must satisfy shareholders and bondholders.

Furthermore, the practise of presenting netted information on cash flow and debt items was highlighted as a deficiency. Wherever possible, companies should break down the respective constituents of net figures in their cash flow and debt reconciliation statements. In addition, the absence of underlying information on net debt makes it difficult to analyse the impact of foreign exchange movements, the value of debt acquired or disposed through business combinations and the impact of fair value and fair value hedge adjustments.

Some credit analysts noted that fair value information was on occasions not useful and in some cases could be misleading.

A senior credit analyst said that: "The process of fair valuing many financial assets often rely on models and estimates and is thus susceptible to management judgement, if not manipulation. Fair value accounting is based on the assumption of functioning asset markets which does not apply to the vast majority of financial securities, especially in environment which has been prevailing for many years now."

"Fair value fluctuations have increased the level of ‘noise’ in financial accounts without adding much value, especially fair value gains and losses on assets would often neither be realisable nor relevant as the respective positions are either illiquid or held to maturity. Fair value movements on liabilities are even more obsolete from a credit analyst’s perspective as they do not alter an entity’s contractual obligations to its creditors and thus its risk of default. Overall fair value accounting seems to have made financial accounts more volatile and subject to random factors and/or management judgement. Credit analysts look at balance sheet values to evaluate an entity’s net worth in a going concern scenario and its break-up value in a gone concern scenario. Fair value accounting does not appear useful under either of these objectives, given its above counterproductive effects and flaws, especially in an illiquid market environment."

The conclusions to this review are that the FRC should:

a. seek to influence the IASB to spend more time talking to credit analysts as a separate class of users; and

b. in developing UK financial reporting standards, the needs of debt financers rather than solely equity financers should be considered.

Full paper

© FRC