SPECIAL UPDATE | Inversions Lower Tax Liabilities, … · RATINGS EDITORIAL Vice President,...
Transcript of SPECIAL UPDATE | Inversions Lower Tax Liabilities, … · RATINGS EDITORIAL Vice President,...
SPECIAL REPORT
UNRAVELING ACCOUNTING COMPLEXITY
What Should Global Investors Focus On Today? (p. 12)
Inflated Loss Reserves Could Deflate Bank Capital Ratios
New Revenue Accounting’s Implications For Investors
Regulators Take The Initiative To Tame Ambiguity
Activism’s Impact On Credit Quality Can Vary
CreditWeek®
The Global Authority On Credit Quality | September 17, 2014
SPECIAL UPDATE | Inversions Lower Tax Liabilities, But May Impair Credit Ratings
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M I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O N
M I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O N
M I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O N
M I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O N
M I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O NM I D M A R K E T E V A L U A T I O N
MID-MARKET EVALUATION A PURPOSE-BUILT BENCHMARK OF CREDITWORTHINESS
The European mid-market funding environment has reached a crucial juncture. Mid-market companies are increasingly seeking to diversify their funding sources. Yet progress on linking them with willing capital has been slow. While investors and intermediaries have shown great interest, they have, to-date, struggled to understand and benchmark the relative credit risk of different mid-market companies.
We believe the answer lies with increased transparency. As such, we have launched Mid-Market Evaluation, an independent assessment of mid-sized companies’ creditworthiness. Mid-Market Evaluation is intended to help investors and intermediaries better navigate this complex and opaque market. Ultimately, it may also help to facilitate companies’ access to alternative sources of funding.
Mid-Market Evaluation is currently available in a limited number of countries. To learn more, contact us at [email protected] or visit www.standardandpoors.com/midmarket
The analyses, including ratings, of Standard & Poor’s and its affiliates are opinions and not statements of fact or recommendations to purchase, hold, or sell securities. They do not address the suitability of any security, and should not be relied on in making any investment decision. Standard & Poor’s does not act as a fiduciary or an investment advisor except where registered as such.
A Mid-Market Evaluation is not a credit rating. While the product is based on S&P Ratings’ corporate credit rating methodology, the analytical process is simplified and adjusted for mid-market companies.
CreditWeek_MME_03.indd 1 01/07/2013 17:19:40
RATINGS EDITORIALVice President, Editor-in-Chief Bob Arnold
ASIA-PACIFICFelicity Neale, Managing EditorMelbourne: Editorial Managers: Mohammed Mazlan, Jason Mills. Beijing:Translators: Wen Zhen Du, Jun Zhang. Hong Kong: Managing Editor: Alison Dunn.Mumbai: Senior Copy Editor: Thomas Jacob; Copy Editor: Shweta Koli. Seoul:Editorial Manager: Jiwoo Choi. Singapore: Editorial Manager: Kenneth Chung
EUROPE & MIDDLE EASTChris Fordyce, Managing EditorLondon: Senior Editorial Managers: Claire Evans, Roy Holder, Alexandria Vaughan;Editorial Managers: Glen Carlstrom, Julie Dillon; Senior Editors: Heather Bayly,Emily Williamson; Editors: Hannah Collins, Sam Foster, Rekha Jogia, Joanna Lewin.Madrid: Editorial Manager: Carol Strain-Guzman; Editors: Alisha Forbes, Ana-MariaOliver Diaz. Paris: Features Editor: Rose Marie Burke; Senior Editor: JennyFerguson; Editor: Samantha Shields. Frankfurt: Senior Editorial Manager: JennieBrookman; Editor: Alexander Wolf. Moscow: Editor: Jennifer Howard. Stockholm:Senior Editor: Bernadette Stroeder. Tel Aviv: Editor and Translator: Gary Smith
JAPANKeiji Sunaga, Managing EditorTokyo: Senior Editorial Managers: Kai Ruthrof (Melbourne), Namiko Uchida;Senior Copy Editors: Etsuko Kuratani, Kwee Chuan Yeo; Copy Editors: LeeroyBetti, Akiko Ishiwata, Yoshiko Minagawa, David Postilion (Chicago), Takae Saho;Translators: Yukiko Etani, Fumiko Hattori, Kumiko Kimura, Isabelle Nagata,Kazue Peck (New York), Satoko Tanaka
LATIN AMERICACecilia Cárdenas Rubio, Managing EditorMexico City: Editor: Karina Montoya; Translator: Haydee López São Paulo: Managing Editor: Marcos Viesi; Editor: Celina Moraes; Translator:Elis Regina Lavanholi
NORTH AMERICA
Corporates & Governments/Structured Finance:David Brezovec, Managing EditorSenior Editorial Managers: Elizabeth Kusta (Chicago), Kathy J. Mills, Greg Paula,Perry Sass, Fatima Tomas; Editorial Managers: Dana Cetrone, Zachary Conway,Margaret Dodge, Lawrence Hayden IV, Alex Ilushik, Jeanne King, Rae Nudson,John Walsh, Samuel Zanger; Features Editor: Jonathan Greene; Senior CopyEditor: Rosanne Anderson; Copy Editors: Davis Chu, Sarah Taylor Cook (MexicoCity), Maureen Cuddy, Cora Frazier, Georgia Jones, Thomas V. Reilly, KelliannVolsario, Sara Weber, Hilary Weissman; Assistant Editors: Lynne Evans, Matthew Gardener, Caitlin VenoEditorial Quality: Managing Editors: Larry Dark, Brian Murphy; Senior EditorialManager: Laura leGrand; Manager, Editorial Education: Peter Dinolfo; SeniorFeatures Editors: Ted Gogoll, Joe Maguire, Robert McNatt; Features Editor:Gillian Wong; Senior Copy Editor: Dolores Graham
Public Finance: Clint Winstead, Managing EditorSenior Editorial Managers: Ai Leng Choo, Erika Dyquisto (San Francisco); Editorial Managers: Edward Lazellari, Jo Parker (Toronto); Copy Editors: PeterBurke, Douglas Jacobs-Moore, Michelle Leary (San Francisco), Albert Lim (San Francisco), Valerie Lord (Toronto), Miguel Martin-Garcia (Toronto), Jennifer Ochaba (San Francisco); Assistant Editor: Jonathan Sachs
RatingsDirect: Judy Gordon, Managing Editor
Administrative Assistant: Linda Merizalde
ELECTRONIC PRODUCTION & DISTRIBUTIONCreative Services: Director: Elizabeth Naughton; Senior Managers: Heidi Dolan,John J. Hughes, Stephen Napoles; Manager: Henry Tom; Designers: MauraGibbons, Barrie Singer; Production Manager: Terese Barber (Melbourne);Electronic Production Specialist: Dianne Darbouze; Production Supervisor:Lori McCaskill; Senior Production Assistant: Michele Rashbaum
STANDARD & POOR’S RATINGS SERVICESPresident Neeraj Sahai
Executive Managing Directors Yann Le Pallec, Ichiro Miyake
Executive Managing Director, Associate General Counsel Adam Schuman
Executive Managing Director, Chief Economist Paul J. Sheard
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PUBLISHINGRatings Operations Tina Morris, Managing Director
Product Management Charles Warburton, Senior Director
Business Operations Jeffrey Simon, Vice President
Regional Management David Pagliaro, Europe; Clemens Thym, Asia-Pacific
CreditWeek®September 17, 2014 | Volume 34, No. 35
EDITOR’SDESK
Accounting has come a long way from the simple ledger, wherein revenuesand expenses would be dutifully recorded by a firm’s bookkeeper.Today’s complex financial systems, however, require accounting standards
that provide a high degree of transparency and comparability for investors andregulators across the globe. Moreover, the International Accounting StandardsBoard (IASB) and the Financial Accounting Standards Board (FASB) havejoined forces, with varying degrees of success, to make this happen.
This week’s special report focuses on the demands new accounting standardsare placing on issuers, including their impact on the bottom line and whetherthey will help create more transparency and comparability for investors and regu-lators. Credit analyst Joyce Joseph says, “Underlying issues, such as accountingand financial reporting that differ internationally, afford optional approaches,and represent business transactions in uneconomic or opaque ways, continueto introduce—or perpetuate—complexity in financial statements.”
The IASB and FASB have claimed success on the release of new converged stan-dards governing companies’ revenue recognition from customer contracts. Thesewill have very broad implications for companies and require a major implemen-tation effort on their part. But how will this affect accurate analysis of thesecompanies’ results? As credit analyst Mark Solak notes, companies can apply anumber of strategies to maximize positive investor perceptions, includingrestructuring contracts, employing varying adoption dates, and using multipletransition methods.
As Warren Buffet once observed, “In the long run, managements stressingaccounting appearance over economic substance usually achieve little of either.”
In addition to our special report, we address some U.S.-based companies’ strategyof merging with, or acquiring, a non-U.S. firm to reduce their tax liabilities, a prac-tice known as “tax inversion.” Although these companies may also benefit fromeasier access to their overseas cash, a significant portion of them could seereduced credit quality. “An effective inversion strategy should make sense for busi-ness fundamentals and not just for tax reasons, considering that acquisitions withrobust tax benefits often command a higher price multiple, which companies mayhave to finance with increased debt,” cautions credit analyst David Wood. On topof this, there may be a backlash from U.S. politicians and customers.
Brian MurphyManaging Editor
2 www.creditweek.com
September 17, 2014 | Volume 34, No. 35
Unraveling Accounting Complexity: What Should Global Investors Focus On?By Joyce T. Joseph, CPA, New York
Evolving standards governing accounting and financial reporting arecausing growing concern among investors and other financialstatement users about how to analyze certain business transactionsand other financial information about a company. Far-reachingchanges are imminent such as how companies recognize revenue intheir financial statements and report operating leases globally.
15 What The New Revenue Accounting Standards May Mean For InvestorsBy Mark W. Solak, CPA, New York
Sweeping changes are coming to howcompanies worldwide recognizerevenue in their financialstatements. Companies are justbeginning the extraordinary,multiyear implementation effort. Thescope of the changes and the impact tocompanies’ processes, controls, andsystems has been widely documented.But more importantly, what benefitswill the new standards provide toinvestors and what obstacles mightthey pose to analysis?
18 Could Ballooning Loss Reserves From NewAccounting Rules Deflate Bank Capital Ratios?By Jonathan Nus, CPA, New York
New rule changes for the way banks estimate creditlosses in their financial reports likely will have asignificant impact on banks applying InternationalFinancial Reporting Standards (IFRS) or U.S. generallyaccepted accounting principles (U.S. GAAP). The keyobjective is to shift the accounting for credit losses toa more forward-looking, counter-cyclical creditimpairment model that will require earlier recognitionof credit losses.
27 Why Activism’s Impact On Credit Quality Can Be Positive, Negative, Or NeutralBy Laurence P. Hazell, New York
Activist interventions at companies have grownsubstantially over the past several years, with theaverage market value of targets rising sharply, and agreater impact on rated enterprises. Strategies havebeen developed and alliances formed, which wouldhave been unthinkable just a few years ago. Oneexample is the proliferation of hedge funds and thecollaborations they have forged with deep-pocketedinvestors, or even with other rated issuers.
30 U.S. Statutory Accounting Principles: A Common SetOf Principles, With An Uncommon Set Of PracticesBy David B. Chan, CPA, New York
Some investors have voiced concerns about theconsistency and transparency of insurance companies’financial reporting, noting the need fortargeted improvements to U.S.GAAP—including more robustdisclosures. The FinancialAccounting StandardsBoard (FASB) is currentlyevaluating insurancecontract accounting, butthe potential changes andtheir effect on financialstatements remain unclear.
12SPECIAL REPORT
CONTENTS
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 3
37 EMEA Corporates Remove $14 Billion Of DebtBecause Of New IFRS Joint Venture AccountingBy Imre Guba, London
Significant changes to IFRS have causedfluctuations in key financial statement line itemsand metrics for some Europe, Middle East, andAfrica (EMEA) corporates. The introduction ofIFRS 11 “Joint Arrangements” by the InternationalAccounting Standards Board (IASB) aims atbetter reflecting the underlying economicsubstance of joint arrangements inthe respective owning companies’financial statements.
43 With IASB And FASB Lease Accounting Likely ToDiverge, Disclosures Will Be Critical
46 Taming Ambiguity: Regulators Take The Initiative To Clarify Alternative Performance Measures
50 IFRS Accounting Choices: An Impediment ToFinancial Statement Comparability
55 Pursuit Of Comparability: Disclosure Rules Make U.S.And European Banks Less Like Apples And Oranges
64 Back To The Drawing Board On FASB’s AccountingFor Insurance Contracts: An Opportunity Lost Is AnOpportunity Gained
70 Farewell, Discontinued Operations: U.S. FinancialStatement Analysis Just Got Harder
74 Analyzing U.S. Rate-Regulated Utilities: The Magic Of Regulatory Assets And Liabilities
82 Inversions Lower Tax Liabilities, But Also CanImpair Credit RatingsBy David P. Wood, New York
Tax-driven corporate inversion strategies, in whichU.S. companies seek to acquire entities in countrieswith lower tax rates and reincorporate overseas,account for a small but growing fraction of mergersand acquisitions in 2014. A significant proportion ofpending large inversion transactions likely will hurtcredit ratings if completed. The credit positives ofthese inversions are often outweighed by negativecredit consequences, including higher leverage.
FEATURES
U.S. Energy Companies Are Contemplating YieldCos As A Financing Vehicle 5
Rescue Of African Bank Ltd. Does Not Set A Precedent ForFuture Support Models 6
U.S. Auto Sales Remain On Track With Our 2014 Base-Case Scenario 6
Consumer-Driven Health Care Is Rising, Presenting GrowthOpportunities For Retail And Hospital Companies 7
Not-For-Profit Children’s Hospitals Median Ratios ReflectContinued Stability 7
New Jersey GO Debt Rating Lowered To ‘A’ From ‘A+’ On Rising Long-Term Liabilities 8
Dollar General Corp.’s Hostile Bid For Family Dollar StoresFurthers The Uncertainty Regarding Potential Acquisition 8
McDonald’s Weaker-Than-Expected Sales In August Might Lead To Weaker Profits; No Impact On Credit Ratios Expected 9
Corporate And Infrastructure Sukuk Issuance Likely To Rise,Despite A Recent Dip 10
New Share Issuance Could Strengthen Bank of East Asia’sCapitalization; Ratings Unaffected 10
RATINGS TRENDSFixed Income Research 87Fixed Income Indices 90Sovereign List 91
Topic Date Location
EMEA Healthcare Seminar Sept. 18, 2014 Frankfurt
Request for Comment: Covered Sept. 18, 2014 LondonBonds (Presentation in English)
Risk Driven Investment Analysis Education
Information on all Risk Driven Investment Analysis Educationcourses is available on Standard & Poor’s Web site atwww.standardandpoors.com. Select Research & Analysis underStandard & Poor’s Ratings Services, then Webcasts & Eventsunder the Research & Analysis tab.
Topic Date Location
Developing a Corporate Sept. 25-26, 2014 São PauloCredit Rationale
U.K. Insurance Seminar Oct. 2, 2014 London
SEMINARS
CREDIT SPOTLIGHT
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Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 5
CREDITSPOTLIGHT
YieldCos, which first madean appearance in 2013,
may be the next big thing forenergy companies, especiallyfor companies in the renew-able sector, according to thereport titled “Standard &Poor’s Takes A Look At TheEmerging YieldCo FinancingVehicle,” published Sept. 8,2014, on RatingsDirect.
YieldCos are tax-efficientvehicles that own highly con-tracted assets and, similar tomaster limited partnerships,distribute most of the cashflow from those assets toinvestors (although the taxtreatment differs). Investorslike YieldCos because theyoffer higher returns than canoften be found in today’s low-rate environment, while ener-gy companies are findingthem attractive because theirstructure results in a lowercost of capital that allowsthem to competitively mone-tize operating assets, includ-ing thermal infrastructure andpower-generating assets. Thatcan be a key factor in raisingcash when, as is the case forsome renewable poweroptions, there is less of anoperational track record andinvestors, unfamiliar withnewer technologies, may need
added financial incentives tocompensate them for therisks they’re taking when arelatively new business is stillevolving. The YieldCo is a relatively new vehicle;Standard & Poor’s currentlyrates two of these vehicles.
A YieldCo is a publicly trad-ed company—a C-Corp—that isusually structured as a limitedliability corporation, whichholds a portfolio of assets withhighly contracted and verypredictable cash flow. Theytypically achieve this by spin-ning off de-risked operatingassets from a parent company,which simultaneously retainsother assets that are in devel-opment or under construction.A YieldCo, however, has taxa-tion rules that differ fromeither a corporation or a mas-ter limited partnership.
We have assigned a ‘BB+’rating to NRG Yield Inc., a com-pany investing in conventionaland renewable assets (see “NRGYield Inc. Is AssignedPreliminary ‘BB+’ CorporateCredit Rating, Stable Outlook,”published July 29, 2014). Wealso assigned a ‘BB-’ rating toTerraForm Power Inc., a solar-focused YieldCo sponsored bySunEdison Inc. (see “TerraFormPower Inc. Assigned Preliminary
‘BB-’ Rating,” published June 17,2014). Other newly incorporat-ed YieldCos include NextEraEnergy Partners L.P., TransAltaRenewables, Pattern Energy,and Abengoa Yield (all unrated).
Most YieldCos will likelybe assessed in the “fair” or“weak” business risk profilecategory under our corporatemethodology. We see thesmaller size, lack of a trackrecord, changing businessrisk profiles as the entitiesbecome acquisitive, andunestablished financingstrategies of the YieldCos asmajor credit constraints.Given that many YieldCosexpect to manage to a 3x to3.5x debt to EBITDA finan-cial policy, we expect themto be in the “significant”financial risk profile basedon our medial volatilityfinancial ratio guidance. Thisgives a typical YieldCo a‘bb/bb-’ rating anchor. Our
ratings could be higher, orlower, than this anchordepending on the YieldCo’sslate of operating assets,likely path to growth, andcomparable peer analysis.
Under Standard & Poor’s poli-cies, only a Rating Committeecan determine a Credit RatingAction (including a CreditRating change, affirmation orwithdrawal, Rating Outlookchange, or CreditWatch action).This commentary and its sub-ject matter have not been thesubject of Rating Committeeaction and should not be inter-preted as a change to, or affir-mation of, a Credit Rating orRating Outlook.
Analytical Contacts:
Aneesh Prabhu, CFA, FRMNew York (1) 212-438-1285
Nora PickensNew York (1) 212-438-2257
Olayinka FadahunsiNew York (1) 212-438-5095
U.S. Energy Companies Are Contemplating YieldCos As A Financing Vehicle
Investors like YieldCos because they offerhigher returns than can often be found intoday’s low-rate environment…
6 www.creditweek.com
CREDITSPOTLIGHT
The South African ReserveBank (SARB’s) swift rescue
of African Bank Ltd. (ABL)after its failure last monthshows that it has the appetiteand ability to address failuresof banks that are not systemi-cally important, according tothe report, “What The RescueOf African Bank Ltd. ImpliesFor Future Support OfSystemically Important BanksIn South Africa,” publishedSept. 8, 2014.
“We nevertheless don’tbelieve the central bank couldhave applied the same resolu-tion process in the event ofthe failure of a larger, systemi-cally important South Africanbank that would necessitatesaving senior creditors,” saidcredit analyst Matthew Pirnie.
SARB placed ABL (not
rated) under curatorship toresolve a potentially unorderlydefault after ABL had warnedthat it faced a record loss forthe financial year and wouldneed to raise at least SouthAfrican rand 8.5 billion, itssecond capital-raising in lessthan a year.
Under this rescue, equityholders and subordinated note
holders have been fully bailedin and senior creditors took a10% haircut.
Given ABL’s limited marketsize, lack of retail deposits,and monoline nature, its fail-ure didn’t represent a risk tothe financial system, thereport argues. Therefore,beyond the reduced prospectsfor support of its subordinatedcreditors, it provides limitednew insight into how theauthorities would manage thefailure of a larger and morecomplex systemically impor-tant bank funded by short-term deposits.
A failure and resolution ofany of the four largest banks,each with a market shareabove 20%, would have agreater effect on the economyand the financial system than
the failure of ABL, which hadonly a 3% market share ofloans. The economic impactwould be larger, interconnect-edness between the banks andthe wider financial systemwould be greater, and a mar-ket-led solution from withinSouth Africa less likely. “Wetherefore believe that subordi-nated creditors of SouthAfrican banks, even systemicones, would be unlikely to ben-efit from government support ifa bank failed,” said Mr. Pirnie.
SARB is currently workingon an updated framework fora resolution and recoveryregime to ensure that systemi-cally important banks have acredible and predictable wayto return to viability or under-go an orderly wind-down withminimal loss of confidence inthe financial system. SARBaims to introduce the updatedframework in November 2014and it remains to be seenwhether, unlike in ABL’s case,the authorities will providesupport to the benefit of sen-ior creditors if a systemicallyimportant bank failed.
Under Standard & Poor’s poli-cies, only a Rating Committeecan determine a Credit RatingAction (including a CreditRating change, affirmation orwithdrawal, Rating Outlookchange, or CreditWatch action).This commentary and its sub-ject matter have not been thesubject of Rating Committeeaction and should not be inter-preted as a change to, or affir-mation of, a Credit Rating orRating Outlook.
Analytical Contacts:
Matthew D. PirnieJohannesburg (27) 011-214-1993
Jones T. GondoJohannesburg (27) 011-214-1996
Rescue Of African Bank Ltd. Does Not Set APrecedent For Future Support Models
U.S. light-vehicle salesgained further momen-
tum in August, increasingabout 5% year over year witha seasonally adjusted annualrate (SAAR) of 17.5 millionunits, said Standard & Poor’sin a recent report, “U.S. AutoSales Continued To GainMomentum In August AndRemain On Track With Our2014 Base-Case Scenario,”published Sept. 8, 2014. Thisis the highest level sinceJanuary 2006, according toWard’s AutoInfoBank.
The SAAR was significant-ly higher than our revisedfull-year estimate of 16.5 mil-
lion units as higher retaildemand (about 86% of totalsales), continued credit avail-ability at low interest rates,incentives, favorable leasedeals, and steady economicgrowth fueled growth.
The underlying fundamen-tals of the U.S. economy,such as steady improvementin manufacturing activity,unemployment levels, andconsumer sentiment supportour baseline forecasts forGDP growth of 2.1% in 2014and 3% in 2015, because weexpect private-sectorstrength to offset continuedgovernment austerity.
We believe that con-sumers will continue toreplace aging vehicles withnewer and better models.“The combination of rela-tively low interest rates andsome cash rebates for vehi-cle purchases should alsoboost sales and, along withthe slowly recovering hous-ing market, lend support tosteady light-vehicle salesfor the next 12 to 18months,” said credit analystNishit Madlani.
Analytical Contact:
Nishit K. MadlaniNew York (1) 212-438-4070
U.S. Auto Sales Remain On Track With Our 2014 Base-Case Scenario
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 7
The U.S. health care sys-tem is becoming more
consumer-driven as individu-als are now more involved indecisions related to the carethey receive. According to arecently published report,consumerized health care isincreasing, partly because ofthe growing prevalence ofhigh deductible plans alongwith increased access to cov-erage resulting from theAffordable Care Act (ACA).
High deductible plans arecausing some headaches forhealth care providers—keep-ing utilization depressed. U.S.retail companies, specificallydrugstores, are realizingquickly that this consumeriza-tion trend is an opportunity,even beyond their existingpharmacy businesses. TheACA is expanding health careaccess and adding more pres-sure on primary care capacity
and the retailers can see agrowth opportunity asproviders of health care serv-ices. Over the past few years,large drug chains have adjust-ed their business models andexpanded their role beyond atraditional establishmentwhere customers fill prescrip-tions or purchase miscella-neous items such as cosmet-ics, candy, or magazines. Forexample, CVS Health’s recent
name change from CVSCaremark and its decision tostop selling tobacco nearly amonth earlier than planned,shows further evidence thatthe company remains focusedon consumer health.
The possible credit impactsfor both hospitals and drug-stores are only beginning tosurface, but we think now isthe time for investors to focusmore closely on the shifting
landscape. Unfavorabletrends, such as low utilizationresulting, in part, from highdeductible plans, as well asemerging changes in the pay-ment environment contributeto Standard & Poor’s negativeoutlook on hospitals. Forretailers, despite GDP growthand data pointing to lowerunemployment, retail salescontinue to be anemic.
(For the full report, see “TheConsumer-Driven Health CareSystem: The Landscape ForDrugstores, Hospitals, AndInsurance Companies IsShifting,” published Sept. 8,2014, on RatingsDirect.)
Analytical Contacts:
Mariola BorysiakNew York (1) 212-438-7839
Tulip LimNew York (1) 212-438-4061
Hema SinghHightstown (1) 212-438-7254
Consumer-Driven Health Care Is Rising, Presenting GrowthOpportunities For Retail And Hospital Companies
U.S. not-for-profit chil-dren’s hospitals are like-
ly to remain stable in thenext year or two althoughchanges on the horizon,including those related tohealth care reform, couldaffect the sector’s traditionalniche role, Standard & Poor’ssaid in the report, “U.S. Not-For-Profit Children’s HospitalsMedian Ratios Remain SoundBut Long-Term ChallengesCould Affect Business Model,”published Sept. 8, 2014.
Median ratios for fiscal
2013 stayed strong orimproved from a year earlier,reflecting a stable credit pro-file that should be sustain-able, given the financial flexi-bility of many providers.
“We believe the sector ismanaging well even thoughmany providers no longerhave the wide margin of finan-cial strength compared withthe larger pool of rated acutecare stand-alone hospitals,”said credit analyst SuzieDesai. “Nonetheless, the finan-cial profile is generally more
robust than that of stand-alone providers,” she added.
Standard & Poor’s rates 21stand-alone children’s hospi-tals, all of which are inde-pendent providers that arenot a part of a larger generalacute care hospital or healthcare system.
Under Standard & Poor’spolicies, only a RatingCommittee can determine aCredit Rating Action (includ-ing a Credit Rating change,affirmation or withdrawal,Rating Outlook change, or
CreditWatch action). Thiscommentary and its subjectmatter have not been the sub-ject of Rating Committeeaction and should not beinterpreted as a change to, oraffirmation of, a Credit Ratingor Rating Outlook.
Analytical Contacts:
Suzie R. DesaiChicago (1) 312-233-7046
Kevin J. HolloranDallas (1) 214-871-1412
Martin D. ArrickNew York (1) 212-438-7963
Not-For-Profit Children’s Hospitals Median Ratios Reflect Continued Stability
Standard & Poor’s has low-ered its rating on New
Jersey’s general obligation(GO) bonds to ‘A’ from ‘A+’.Standard & Poor’s lowered itsrating on New Jersey’s appro-priation-backed debt to ‘A-’from ‘A’, and its rating on NewJersey’s moral obligation debtto ‘BBB’ from ‘BBB+’.Standard & Poor’s alsoremoved the ratings fromCreditWatch, where they hadbeen placed with negativeimplications on June 2, 2014.The outlook is stable.
“The downgrade reflectsour view that New Jersey willface increased long-term pres-sures in managing its long-term liabilities and that therevenue and expenditure mis-alignment will grow based onreduced funding of the state’sunfunded actuarial accruedliability,” said credit analyst
John Sugden.At the same time,
Standard & Poor’s assigned its‘A-’ rating and stable outlook toNew Jersey EducationalFacilities Authority’s highereducation facilities trust fundsseries 2014A. The state is issu-ing the series 2014 trust fundbonds to fund capital improve-ment grants to certain public
and private higher educationinstitutions. The ‘A-’ ratingreflects the appropriation riskassociated with the bonds aswell as the state’s generalcreditworthiness.
The ‘A’ GO rating on NewJersey reflects our assessment of:● A trend of structurally
unbalanced budgets thatinclude only normal cost
funding of pension obliga-tions and reliance on one-time measures that are con-tributing to additional pres-sure on future budgets;
● Lack of consensus amongelected leaders on how toreturn to structural balance;
● A large and growingunfunded pension liability;
● Significant postemploymentbenefit obligations; and
● An above-average debt burden.In our opinion, credit
strengths include New Jersey’s:● Diverse economic base,
which is showing signs ofimprovement but has a longway to go to full recovery;
● High wealth and incomes,which are still among thehighest of the 50 states.On May 21, the state identi-
fied an additional $1 billion, or3.2% of budget, revenueshortfall for fiscal 2014 fromthe governor’s Februarybudget message. The statealso reduced its revenue fore-cast for fiscal 2015 by $1.7billion, or 5%, from the gover-nor’s fiscal 2015 budget mes-sage to account for lowerbaseline revenues and areduction to the estimatedgrowth rate to 3.9% from5.8%. To offset these revenuereductions, the governor iden-tified just over $1 billion inspending reductions for fiscal2014 and $1.7 billion in fiscal2015, tied primarily to areduction in its pension con-tribution—a departure fromthe administration’s own pen-sion reform efforts.
New Jersey continues tostruggle with structural imbal-ance and the governor’s deci-sion to reduce pension contri-butions in fiscal 2014 and2015 highlights the fact thatthe state lacks the revenuesto comply with its ownagreed-on contribution to the
8 www.creditweek.com
CREDITSPOTLIGHT
Standard & Poor’s corpo-rate credit and issue-level
ratings on Dollar GeneralCorp. remain on CreditWatchwith negative implications,where we placed them onAug. 18, 2014, following theannouncement that DollarGeneral has commenced atender offer to acquire all theoutstanding shares of FamilyDollar Stores Inc. for $80 pershare in cash. The price ismonetarily superior to DollarTree Inc.’s $74.50 a shareoffer, but central to the out-come is the antitrust implica-
tions of any potential FamilyDollar acquisition.
Dollar General has said itwould sell up to 1,500 storesto obtain antitrust approvaland says it can now beginthe antitrust review processand present its positiondirectly to the Federal TradeCommission.
Given the potentiallydrawn out regulatory andshareholder processes thatcome with this hostile bid, allof our ratings on FamilyDollar Stores also remain onCreditWatch with negative
implications, where weplaced them on July 28, 2014.We will continue to monitorthe details and timing of anypotential transaction closelyover the near term, with keyrating factors to includespecifics of any store divesti-tures and the Family Dollarshareholder response to thelatest Dollar General offer.
Analytical Contacts:
Diya G. IyerNew York (1) 212-438-4001
Kristina KoltunickiNew York (1) 646-276-0214
Dollar General Corp.’s Hostile Bid For Family Dollar Stores Furthers The UncertaintyRegarding Potential Acquisition
New Jersey GO Debt Rating Lowered To ‘A’ From ‘A+’On Rising Long-Term Liabilities
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 9
pension system. In our view,the governor’s decision todelay pension funding, whileproviding the necessary toolsfor cash management andbudget control, has significantnegative implications for thestate’s liability profile.Pension funded levels, whichwere expected to decline untilthe state reached the fullfunding of annual requiredcontribution (ARC), are nowexpected to decline muchmore significantly and placeincreased pressure on futurefunding requirements. Thestate’s projections of decliningfunded levels assumed notonly that the 2014 and 2015payments would be made inaccordance with the three-sevenths and four-seventhsrequirements, but also thatthose funds, once invested bythe pension system, wouldresult in additional investmentreturns at 7.9%. Based on pre-liminary updated estimates,the state expects its pensionfunded level, absent any otheraction by the state, to declineto 48.24% by 2019. This, how-ever, assumes that New Jerseywill resume payments on four-sevenths of ARC basis startingin fiscal 2016 and continuingthrough 2019. Revenues in fis-cal 2016 would have toincrease by approximately 5%from estimated revenues infiscal 2015, just to fund theincreased pension payment.
Although in his State of theState and budget messagesthe governor called for addi-tional pension reform efforts,there has been no formal pro-posal released. In August2014, the governor createdand appointed members to acommission (New JerseyPension and Health BenefitStudy Commission) to providerecommendations on how to
achieve sustainability of pen-sion and health benefits inthe state. The governorvetoed the legislature’s pro-posals to increase taxes tocontinue to fund pensions;therefore, it is likely that any
pension reform proposals willbe primarily focused onchanges to retirement andhealth benefits, rather thanon increased funding. In theabsence of consensusbetween the legislative andexecutive branches, any typeof pension solution is likely tobe delayed and result inmounting financial pressures
for the state in the long term.The stable outlook reflects
our expectation that NewJersey will ultimately retain astrong ability to fund its debtobligations as they come duedespite a likelihood, in ourview, that its budget will con-tinue to be structurally imbal-anced and that reliance onone-time measures will remainat or close to current levels.The current rating also accom-modates some additional dete-rioration in the state’s pensionfunded levels, which webelieve is likely given thestate’s demonstrated lack ofcommitment when it comes tofunding its annual contribu-tions. Beyond the two-yearoutlook horizon, the ratingcould come under renewedpressure if there is inaction byelected leaders to addresslong-term liabilities and thefunded level of New Jersey’sretiree liabilities continues toerode. More immediate pres-sure on the rating would likelybe the result of unanticipated
liquidity strain or if—within thenext two years—the state’sbudget or liability situationweakened more than we cur-rently anticipate. On the otherhand, until the state imple-ments fiscal reforms that bringits budgetary condition intostructural alignment withoutrelying on optimistic forecast-ing, we don’t anticipate raisingthe rating. At this point, givenits structural fiscal challenges,even if the economy and rev-enues were to match or out-pace New Jersey’s forecast, it’sunlikely to result in a higherrating. Furthermore, we alsoexpect that larger budgetreserves and improved execu-tion when it comes to retireeliability reform efforts wouldlikely accompany improve-ment in the state’s credit quality.
Analytical Contacts:
John A. SugdenNew York (1) 212-438-1678
David G. HitchcockNew York (1) 212-438-2022
McDonald’s Corp.’sdecreased
global compara-ble-store saleswill likely leadto lower profitsthan we previ-ously anticipatedfor the third quarter.A 14.5% decline in Asia-Pacific, Middle East, andAfrica highlighted the salesdecline, which followed thecompany’s issues with a sup-plier in China. Furthermore,the 2.8% comparable-store
sales decline in theU.S. was also mod-
erately weakerthan expectedas well and inour view likely
indicates thatthe company lost
market share in themonth. Nonetheless, we
expect the company to main-tain credit ratios appropriatefor the current rating, andwe also believe sales per-formance will rebound in thecoming months. It is likely
that leverage should still bearound the 2x area this year,slightly weaker than the 1.8xto 1.9x that we previouslyexpected, but still comfort-ably better than the levelthat we pointed to in our out-look that would trigger anegative rating action.Accordingly, we are not tak-ing any rating actions at this time.
Analytical Contact:
Charles Pinson-RoseNew York (1) 212-438-4944
McDonald’s Weaker-Than-Expected Sales In August Might Lead To Weaker Profits; No Impact On Credit Ratios Expected
…the rating couldcome under renewedpressure if there isinaction by electedleaders to addresslong-term liabilitiesand the funded levelof New Jersey’s retireeliabilities…
Corporate and infrastruc-ture sukuk issuance is like-
ly to rise over the next fewyears, despite the dip in issuesover the past eight monthscompared with the same peri-od of 2013, said Standard &Poor’s in the report, “WhyCorporate And InfrastructureSukuk Issuance Is Declining,Despite Healthy Prospects,”published Sept. 8, 2014.
Corporate and infrastructureissuance has trended down-ward this year in the GulfCooperation Council (GCC) andMalaysia, dropping 33% and7%, respectively. In contrast,total sukuk issuance (includingfinancial institutions and sov-ereigns) grew by 19% in theGCC and by 6% in Malaysiaover the same period.
“We attribute the decline incorporate and infrastructuresukuk in large part to cheapand ample bank liquidity, whichhas made issuers less reliant on
the capital markets, said creditanalyst Karim Nassif. “Theoverall small pool of sukukissuers, and seasonal factorssuch as the early Ramadan this
year, have also played a role,”Mr. Nassif added.
“We nevertheless believecorporate and infrastructuresukuk issuance will increaseagain over the next few yearsas companies’ refinancingneeds grow and as entitiesestablish themselves as sukukissuers,” said Mr. Nassif.
Corporate and infrastructureissuance is likely to remainmore volatile and difficult topredict than total sukukissuance. It will likely remainlargely a function of the specificneeds of the corporate andinfrastructure entities that com-prise the pool of sukuk issuersin the GCC and Malaysia.
Continued high levels of bankliquidity and uncertainty amonginvestors about compliancestandards continue to hold backgrowth of the corporate andinfrastructure sukuk market.“The creation of local or regionalinstitutional investment frame-works—for example, to enablepension or insurance funds toinvest in sukuk—would go someway, we believe, toward creat-ing a deeper and more liquidsukuk market,” said Mr. Nassif.
Under Standard & Poor’s poli-cies, only a Rating Committeecan determine a Credit RatingAction (including a Credit Ratingchange, affirmation or with-drawal, Rating Outlook change,or CreditWatch action). Thiscommentary and its subjectmatter have not been the sub-ject of Rating Committee actionand should not be interpreted asa change to, or affirmation of, aCredit Rating or Rating Outlook.
Analytical Contacts:
Karim NassifDubai (971) 4-372-7152
Tommy TraskLondon (44) 20-7176-3616
Corporate And Infrastructure Sukuk Issuance LikelyTo Rise, Despite A Recent Dip
10 www.creditweek.com
CREDITSPOTLIGHT
Standard & Poor’s ratingson The Bank of East Asia
Ltd. (BEA; A/Stable/A-1,cnAA+/cnA-1) are not affect-ed by the bank’s potentialnew equity issuance toSumitomo Mitsui BankingCorp. (SMBC).
While we expect the pro-posed transaction tostrengthen BEA’s capitalbase, it is unlikely to materi-ally affect the bank’s busi-ness strategy. The proposedtransaction will increaseBEA’s risk-adjusted capitalratio to about 8% from 7%, ifSMBC buys the shares atHong Kong dollar 33.35 pershare—the closing marketprice on Sept. 5, 2014.
However, the ratio willremain commensurate withBEA’s capital and earningsscore, which we assess as“adequate,” and under whichwe forecast the bank’s risk-adjusted capital ratio to be7% to 10% over the next 18 to24 months.
SMBC entered into a non-binding memorandum ofunderstanding with BEA fora proposed subscription of222 million new shares. Thepotential transaction couldincrease SMBC’s stake inBEA to 17.5% from 9.6%,making it one of the bank’slargest shareholders. Thetimeline of the transaction isundisclosed, and the trans-
action is subject to regulato-ry approval.
Under Standard & Poor’spolicies, only a RatingCommittee can determine aCredit Rating Action (includ-ing a Credit Rating change,affirmation or withdrawal,Rating Outlook change, orCreditWatch action). Thiscommentary and its subjectmatter have not been the sub-ject of Rating Committeeaction and should not beinterpreted as a change to, oraffirmation of, a Credit Ratingor Rating Outlook.
Analytical Contact:
Cheul Soo Cho, CFAHong Kong (852) 2533-3559
New Share Issuance Could Strengthen Bank of EastAsia’s Capitalization; Ratings Unaffected
“We attribute the decline in corporate and infrastructure sukuk in large part to cheap and ample bank liquidity…”
ACCOUNTING CONFERENCE 2014:UNRAVELING COMPLEXITY
Join us on September 30 for our Accounting Hot Topics Conference, Unraveling Accounting Complexity: What Should Global Investors Focus on Today?
You’ll hear the views of our credit analysts and accounting team, along with capital market and industry experts, as they discuss the latest in global accounting developments. Featured topics include:
• Financial statement disclosures
• Proposed financial instrument and insurance contracts models
• Leases
• Revenue recognition
• International accounting convergence
• Potential increased transparency related to audits
The conference will be held in New York City and is complimentary. Space is limited — please visit www.SPRatings.com/AccountingConference2014 for additional details and to register today.
The statements and opinions expressed by non-Standard & Poor’s Ratings Services employees are their own and do not necessarily reflect the views of Standard & Poor’s Ratings Services.
The analyses, including ratings, of Standard & Poor’s and its affiliates are opinions and not statements of fact or recommendations to purchase, hold, or sell securities. They do not address the suitability of any security, and should not be relied on in making any investment decision. Standard & Poor’s does not act as a fiduciary or an investment advisor except where registered as such.
Copyright © 2014 by Standard & Poor’s Financial Services LLC. All rights reserved.STANDARD & POOR’S and S&P are registered trademarks of Standard & Poor’s Financial Services LLC. www.SPRatings.com
SPECIAL REPORTFEATURES
12 www.creditweek.com
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 13
Evolving standards governing accounting and financial
reporting are causing growing concern among investors
and other financial statement users about how to analyze
certain business transactions and other financial information
about a company. Far-reaching changes are imminent such as
how companies recognize revenue in their financial statements
and report operating leases globally. Other emerging standards
mean bank managements will have to consider more forward-
looking information when estimating credit losses, requiring
earlier recognition of credit losses th at will affect bank capital
worldwide. Quite positively, European regulators have taken steps
to propose clarification of alternative performance measures. Still,
Standard & Poor’s Ratings Services believes underlying issues,
such as accounting and financial reporting that differs
internationally, affords optional approaches, and represents
business transactions in uneconomic or opaque ways, continue to
introduce—or perpetuate—complexity in financial statements.
UNRAVELING ACCOUNTINGCOMPLEXITYWhat Should Global InvestorsFocus On?
14 www.creditweek.com
SPECIAL REPORTFEATURES
International Commonality: Not Far EnoughThe Financial Accounting StandardsBoard (FASB) and the InternationalAccounting Standards Board (IASB) havedemonstrated that joint rule-makingintended to converge accounting stan-dards and improve global comparabilityfor financial analysis is not completelyachievable. There were, in our view,some significant successes. For example,the finalized revenue-recognition stan-dards introduced a virtually unifiedframework (see “What The New Revenue
Accounting Standards May Mean For
Investors,” on p. 15). Further, the IASB elim-inated proportionate consolidation, whichenhances comparability and consistencyacross International Financial ReportingStandards (IFRS) reporters and at aglobal level (see “EMEA Corporates
Remove $14 Billion Of Debt Because Of
New IFRS Joint Venture Accounting,” on
p. 37). It also seems the boards remainin tune regarding one of the mainobjectives of the lease accountingproject, which is to bring most oper-ating leases on balance sheet.However, future lease accounting maybecome less converged; certain leasesmay still remain off balance sheet; andinconsistencies may exist within eachindividual accounting regime ( see
“With IASB And FASB Lease Accounting
Likely To Diverge, Disclosures Will Be
Critical,” on p. 43).Other important areas did not con-
verge. For example, accounting rules foroffsetting financial assets and liabilitiesdiffer significantly under IFRS and U.S.Generally Accepted AccountingPrinciples (GAAP), especially for bankswith large derivatives positions, but stan-dard setters took a major strideregarding footnote disclosures that canenable improved analysis (see “Pursuit Of
Comparability: Disclosure Rules Make U.S.
And European Banks Less Like Apples And
Oranges,” on p. 55). Also, new IFRS rulesand expected U.S. GAAP standards aremarkedly dif ferent as they relate toestablishing expected credit lossallowances. Many factors suggest amove to an expected credit loss methodin accounting may have a significant
impact on bank capital ratios upon tran-sition and some banks may take businessactions to counteract the results (see
“Could Ballooning Loss Reserves From New
Accounting Rules Def late Bank Capital
Ratios?” on p. 18).FASB and the IASB further parted
ways regarding the accounting for insur-ance contracts, and while this diver-gence is disappointing, FASB’s worktowards targeted improvements couldaid more refined analysis of insurancecompanies (see “Back To The Drawing
Board On FASB’s Accounting For
Insurance Contracts,” on p. 64).
Accounting And ReportingOptionalityWe believe certain accounting choicesapplied by companies can create hurdlesfor analysis while adding little valuableinformation to understanding a com-pany’s financial condition and perform-ance (see “IFRS Accounting Choices: An
Impediment To Financial Statement
Comparability,” on p. 50). In this light, wewelcome the European Securities &Markets Authority’s work toward pro-posed guidelines aiming to improvetransparency, neutrality, and compara-bility of alternative performance meas-ures (APMs) for European companies. Iffinalized, the paper’s draft guidelines willlikely improve issuers’ communicationabout how they manage their businesses,foster comparability and unbiased finan-cial information, and better enable usersof financial statements to understandAPMs (see “Taming Ambiguity: Regulators
Take The Initiative To Clarify Alternative
Performance Measures,” on p. 46).
Be Aware Of Other Industry-Specific ChallengesWe believe it is beneficial to considersector-specific nuances in accounting
and disclosure information. In the insur-ance industry, to address some of theperceived shortfalls and uncertaintyrelated to GAAP accounting for insurers,investors and other financial statementusers may look to insurers’ statutoryfinancial statements to gauge compa-nies’ performance and financial strength.However, we believe investors and otherfinancial statement users need to exer-cise caution when taking this approach.The insurance sector has unique “pre-scribed and permitted practices” allow-able under statutory accounting thathinder the comparability of statutory
financial statements and may complicatefinancial analysis (see “U.S. Statutory
Accounting Principles: A Common Set Of
Principles, With An Uncommon Set Of
Practices,” on p. 30).In addition, U.S. regulated electric,
natural gas, and water utilities have theunique ability to use special accountingrules that allow them to record assetsand liabilities based on how their regu-lators permit the utilities to recovercosts from customers. U.S. GAAP forutilities also dif fers from IFRS stan-dards, which generally do not take intoaccount the effects of rate regulation(see “Analyzing U.S. Rate-Regulated
Utilities: The Magic Of Regulatory Assets
And Liabilities,” on p. 74).We want to make investors and other
financial statement users better aware ofcertain analytical hurdles when makinguse of financial statements and relatedfinancial measures. CW
Certain accounting choices can create hurdles for
analysis while adding little valuable information to
understanding a company’s financial condition…
Analytical Contact:
Joyce T. Joseph, CPANew York (1) 212-438-1217
For more articles on this topic search RatingsDirect with keyword:
Accounting
Sweeping changes are coming to howcompanies worldwide recognize rev-enue in their financial statements—
and thus, potentially, to how investors andothers should analyze them. On May 28,2014, the Financial Accounting StandardsBoard (FASB) and the InternationalAccounting Standards Board (IASB) jointlyreleased new converged standards gov-erning companies’ revenue recognitionfrom contracts with customers. Upon therelease of the new standards, the boards
What The New Revenue AccountingStandards May Mean For Investors
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 15
Overview
● The new harmonized FASB and IASB
revenue accounting standards intro-
duce a (virtually) unified framework
for all industrial companies across
both accounting regimes. However,
the application of some provisions
that require greater judgment than
current guidance may cause revenue
recognition practices within an
industry to diverge, potentially
resulting in decreased comparability.● The new standards generally affect
only the timing of recognition;
however, they could affect the actual
amount of reported revenue in some
cases, as when a contract contains a
significant financing component.● Changes to revenue recognition
principles could lead companies to
change the way they structure their
contracts with customers to maxi-
mize the commercial and financial
reporting (i.e., perception) benefits.● Enhanced disclosures may help
financial statement users gain a more
complete understanding of compa-
nies’ revenue-generating activities.● Varying adoption dates and
multiple transition methods could
impair comparability between
peers and obfuscate earnings
trends during the transition years.
declared victory, saying that the new stan-dards will provide “...enhancements to thequality and consistency of how revenue isreported while also improving compara-bility in the financial statements of compa-nies reporting using InternationalFinancial Reporting Standards (IFRS) andU.S. generally accepted accounting princi-ples (U.S. GAAP).”
Companies are just beginning theextraordinary, multiyear implementationeffort. The scope of the changes and theimpact to companies’ processes, con-trols, and systems has been widely docu-mented. But more importantly, whatbenefits will the new standards provideto investors and what obstacles mightthey pose to analysis?
A Common FrameworkThe boards’ concerted effort has resultedin a common approach to revenue recogni-tion for virtually all companies, where pre-viously there was some degree of diver-gence within and among the twoaccounting regimes. The standards’ coreprinciple is that a company should recog-nize revenue to depict the transfer of goodsor services to customers in amounts thatreflect the consideration (i.e., payment) towhich the company expects to be entitledin exchange for those goods or services. Todo this, companies will follow five steps:● Identify the contract(s) with the cus-
tomer;● Identify the separate performance
obligations in the contract;● Determine the transaction price;● Allocate the transaction price to sepa-
rate performance obligations; and● Recognize revenue when (or as) each
performance obligation is satisfied.In theory, this single framework
should result in greater consistency inrevenue recognition between industriesbecause it removes industry-specificguidance that was prevalent under U.S.GAAP and eliminates dif ferencesbetween U.S. GAAP and IFRS. However,the standards could, at least for a while,lead to divergent approaches within cer-tain industries due to greater relianceupon estimations by management andthe abolition of long-standing, com-monly understood industry practice.
How this framework will affect eachcompany’s revenue is difficult to deter-mine without a detailed analysis of aparticular company’s contracts.However, certain industries—includingtelecom, software, real estate, and enter-tainment and media—could see signifi-cant changes in their patterns of recog-nition. Relative to existing practice, itappears there will be an overall accelera-tion of revenue recognition in these andother sectors, creating a greater discon-nect between the timing of revenuerecognition and the receipt of cash fromthe customer. This will result in anexpansion of assets on the balance sheetas unbilled revenues (or “contractassets”) grow. Some of the reasons forthis acceleration are:● The inclusion of variable consideration,
subject to certain limitations, in thedetermination of the contract price;
● The removal of the contingent rev-enue cap on multiple-elementarrangements; and
● For the software industry, the removal ofcertain hurdles to revenue recognition.We believe this disconnect between
revenue recognition and cash collection,plus the exposure to management sub-jectivity, could decrease the quality ofreported earnings.
Recognized Revenue May DifferFrom The Cash ReceivedWhile the new standards generally affectonly the timing of revenue recognition, insome cases they could alter the actualamount of reported revenue. As part ofdetermining the contract transaction price,companies will be required to assesswhether a contract contains a significantfinancing component (either explicitly orimplicitly), based on certain criteria. If acompany determines that a contract con-tains a significant financing element, theamount of revenue recognized under thecontract will be different from the amount ofcash received from the customer. For trans-actions that are deemed to contain a signifi-cant financing element, revenue will be lessthan the cash received when payments aremade after performance, but will exceed thecash received when payments are receivedin advance of performance. Companies will
report the difference between the revenuerecognized and cash received as eitherinterest income (when payment lags per-formance) or interest expense (when pay-ment precedes performance).
Additionally, the standards allow a com-pany not to apply the time value of moneyprovisions if the company expects, at thecontract’s inception, that the period betweenwhen the entity transfers a promised goodor service to a customer and when the cus-tomer pays for it will be one year or less.However, by electing to apply the time valueof money concept to prepayments fromcustomers, companies could inflate revenueand margins relative to their peers that donot elect this policy. Financial statementusers should remain aware of this possibility,understand if revenue, interest income, orinterest expense has been affected by thisprovision for a particular company, andunderstand if peer companies are treatingsimilar contracts in a like manner.
As part of our current analysis, there arelimited instances where we recognize anembedded financing component within arevenue transaction, for instance in thecases of streaming transactions (see “Key
Credit Factors For The Metals And Mining
Upstream Industry,” published Dec. 13, 2013,
on RatingsDirect) and volumetric produc-tion payments (see “Key Credit Factors For
The Oil And Gas Exploration And Production
Industry,” published Dec. 12, 2013).However, this provision may introduce thisphenomenon more frequently than wecurrently employ it, potentially leading toan undesirable change in the amount ofrevenue and interest recognized for certaintransactions. While we are open to theconcept, we hope that application is lim-ited and at a minimum is consistent withina sector for similar transactions.
Accounting ArbitrageThe new accounting model could lead tochanges in how companies construct con-tracts with customers, particularly if com-panies see an opportunity to optimize thebalance between economics and investorperception. While such contract structuringis most often reserved for financing-typetransactions (e.g., leases), the extent andpervasiveness of these standards couldcause companies to make changes to their
16 www.creditweek.com
SPECIAL REPORTFEATURES
contracts with customers either to takeadvantage of or avoid certain aspects ofthe standards. This would not be withoutprecedent. Consider how contracts in thesoftware industry evolved in response tothe current prescriptive rules for revenuerecognition: To enable faster revenuerecognition, software companies modifiedtheir contracts by limiting the discountsthey offered, and stopped promising to pro-vide future software.
While it is impossible to predict what sec-tors or entities might make such contractualchanges, investors and other financial state-ment users should consider this possibility.Depending on the nature and extent of anycontractual changes, there could be creditimplications for individual companies,which we would evaluate case by case.
Expanded Disclosures Could Benefit FinancialStatement UsersPerhaps the standards’ greatest benefit tofinancial statement users will be the signifi-cant expansion of disclosures. The new stan-dards require companies to disclose suffi-cient qualitative and quantitative informationto enable users of financial statements tounderstand the nature, amount, timing, anduncertainty of revenue and cash flowsarising from contracts with customers. Wefavor the required disclosures, which include:● A disaggregation of revenue recog-
nized from contracts with customersinto categories that depict how thenature, amount, timing, and uncer-tainty of revenue and cash flows areaffected by economic factors;
● A reconciliation of contract balances;● Information about performance obli-
gations, including when performanceobligations are typically satisfied,signif icant payment terms, thenature of the goods or servicespromised to be transferred, obliga-tions for returns, refunds, or othersimilar obligations, and types ofwarranties and related obligations;
● Information about a company’sremaining performance obligations;
● The costs to obtain or fulfill contracts; and● The significant judgments and
methods a company used in applyingthe standards’ principles.
Disclosures are key factors when ana-lyzing a range of information related torevenue recognition. These disclosuresshould provide investors and other finan-cial statement users with greater insightinto companies’ revenue-generatingactivities, enabling better analysis ofreported revenues and forecasting offuture revenues.
The Method And Timing OfAdoption May Cause ConfusionDuring The Transition PeriodUnfortunately, despite all of the compro-mises involved with creating the newstandards, the boards did not agree onuniform adoption dates which couldmake results less comparable for peercompanies during the transition years.The adoption dates are as follows:● For U.S. GAAP public companies, the
standard is ef fective for annualreporting periods beginning after Dec.15, 2016, including interim periodswithin that reporting period. Earlyapplication is not permitted.
● For U.S. GAAP nonpublic companies,the standard is effective for annualreporting periods beginning after Dec.15, 2017, and interim periods withinannual periods beginning after Dec.15, 2018. A nonpublic entity may electto apply this guidance earlier, but noearlier than the ef fective date forpublic companies.
● For IFRS companies, the effective dateis for annual reporting periods begin-ning on or after Jan. 1, 2017. Earlyadoption is permitted.While we believe it unlikely that IFRS
companies will rush to adopt that stan-dard earlier than necessary (because ofthe extensive changes that will be neces-sary to their systems, processes, con-trols, and financial reporting), investorsand other financial statement usersshould be aware of the possibility.
In terms of the method of adoption,the boards were in agreement; however,they have allowed two different methods(retrospective or modified retrospective)to be used at the election of the issuers.
Under the retrospective approach,companies would apply the new guid-ance as if it had been in effect since the
inception of all their contracts with cus-tomers for all periods presented. Webelieve this approach is optimal forfinancial statement users because itwould provide the most comparableinformation across periods and wouldenhance the predictive value of the his-torical reporting. Unfortunately, evenunder the retrospective approach, theboards have provided a few practicalexpedients applicable to certain con-tracts to ease the burden of adoption.Companies can choose to use none,some, or all of these practical expedi-ents as long as they make certainrelated disclosures. We believe theseoptions could impair both the compara-bility between periods for a particularcompany as well as the comparability ofinformation between peer companiesduring the transition.
Under the modified retrospectiveapproach, companies would reflect thenew accounting only in the year of adop-tion and not restate comparativeperiods. Instead, the companies will berequired to disclose what effect the newstandard had on each financial statementline item in the year of adoption. Webelieve this approach is the least favor-able for investors and other financialstatement users, as it will impair compa-rability and obfuscate profitability trends.
Only Time Will TellAs with most new accounting standards,practice will evolve over time. We arehopeful that the boards’ goal ofimproved quality, consistency, and com-parability of revenue is realized, but onlytime will tell. In the meantime, investorsand other financial statement usersshould begin to familiarize themselveswith the impending changes and con-sider how it will affect their analysis. CW
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 17
Analytical Contacts:
Mark W. Solak, CPANew York (1) 212-438-7692
Joyce T. Joseph, CPANew York (1) 212-438-1217
Shripad J. Joshi, CPA, CANew York (1) 212-438-4069
For more articles on this topic search RatingsDirect with keyword:
Accounting
SPECIAL REPORT
18 www.creditweek.com
FEATURES
Sweeping new rule changes for theway banks estimate credit losses intheir financial reports likely will have
a significant impact on banks applyingInternational Financial ReportingStandards (IFRS) or U.S. GenerallyAccepted Accounting Principles (U.S.GAAP). The changes are the culminationof a key objective to shift the accountingfor credit losses to a more forward-looking, counter-cyclical credit impair-ment model that will require earlierrecognition of credit losses—a weakness
highlighted during the last financial crisis.As a result, capital and earnings couldbecome less predictable and bank man-agements may seek to build higher cap-ital buf fers to mitigate this ef fect,although the extent to which bank regu-lators will adapt regulatory capitalrequirements remains to be seen. Higherloan-loss reserve levels may also affectbanks’ planned distributions of capital inthe form of dividends or share buybacks.Standard & Poor’s Ratings Servicesbelieves bank managements may take
Could Ballooning LossReserves From NewAccounting Rules DeflateBank Capital Ratios?
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 19
Overview ● Moving from the existing “incurred” credit loss model—which only considers past
and current events when estimating credit losses—to an “expected” credit loss
model that requires consideration of likely future outcomes will result in an
earlier recognition of credit losses that better reflects their timing. ● The new models will likely result in higher credit loss allowances on adoption of
the new accounting standards, decreasing banks’ capital. All else being equal, our
analysis suggests that among the top 100 global banks we rate, Western
European banks could see core tier 1 ratios falling by an average of 53 basis
points (bps) for each 10% rise in new required reserves. ● U.S. banks’ core tier 1 ratios would fall by much less, by 12 bps for each 10% rise
in allowances; however, the U.S. expected single-measurement model will result
in relatively higher-percentage increases in loan-loss reserves for U.S. banks
compared with banks using IFRS’ dual-measurement approach.● The new accounting rule changes could lead some banks to shift loan product
strategies, favoring shorter-duration loan products over longer-term loan
products to achieve a more favorable accounting outcome. In extreme cases,
bank management may decide to curtail the underwriting of new loan products.● We prefer the proposed U.S. expected credit loss model—primarily because it
requires the immediate recognition of all expected credit losses—over the IFRS
model, which is based on subjective evidence of credit deterioration over time.
More importantly, the lack of convergence between IFRS and U.S. GAAP in this
critical area of bank financial reporting creates unnecessary complexity in
understanding financial reporting and undermines peer analysis globally. We
therefore believe investors would be best served if banks using IFRS disclosed
their estimated lifetime credit losses.
EDITOR’S NOTE: Please see the full version of this article on RatingsDirect to view the table on the Top100 Banks Reviewed In Our Sample.
actions such as increased pricing on cer-tain loan products or shortening loandurations, to help offset the potentialaccounting consequences.
The new requirements are mandatoryunder IFRS for accounting periods begin-ning Jan. 1, 2018. We expect the require-ments for U.S. GAAP to be finalized in thefirst quarter of 2015, with mandatoryapplication unlikely to be before 2018(with 2019 likely). In both cases, the newrules will require bank managements toconsider more forward-looking informa-
tion when estimating credit losses (suchas loan loss provisions), including inter-nally developed or third-party macroeco-nomic assumptions and forecasts. Thisimplies that, although management’sjudgment will remain a key factor in theestimation of credit losses, there will beless scope to delay or spread the recogni-tion of such losses to future periods,which we believe benefits investors.
The new IFRS credit loss requirementswere set out in IFRS 9 (FinancialInstruments) published July 24, 2014, by
the International Accounting StandardsBoard (IASB). The new rules apply to awide range of financial assets, includingmost loans and receivables, financialassets that are required to be measured atfair value through other comprehensiveincome, trade receivables, and leasereceivables. The scope extends to manyoff-balance-sheet loan commitments andfinancial guarantee contracts. While IFRS9 itself allows companies to adopt the newrequirements earlier than 2018, companiesin the EU cannot do so until the EU legallyendorses the standard, and the timing ofthat is not yet clear. Similar restrictionsalso apply in other jurisdictions. Given thesignificant changes that IFRS 9 brings, webelieve most banks will need until 2018 toprepare for adopting the standard, and weare unlikely to see significant rates of earlyadoption by banks using IFRS.
Like IFRS 9, we expect the FinancialAccounting Standards Board’s (FASB’s)revised requirements for credit losses—an Accounting Standards Update (ASU)“Financial Instruments—Credit Losses(Subtopic 825-15)”—once finalized, toapply to a wide range of financial assetsand affect a wide range of companies,but we believe large global banks aremost likely to feel the impact.
IFRS 9 and the expected U.S. GAAPrules will be markedly different, becausethe respective standard-setters failed toachieve convergence in this importantarea of accounting, particularly forbanks. IFRS 9 has a “dual measurement”approach, under which a 12-monthexpected loss allowance is establishedwhen the underlying asset (such as aloan) is recognized. The rules require alifetime loss allowance if the credit riskof the asset deteriorates significantly.The expected U.S. GAAP model uses a“single measurement” approach thatrequires a lifetime loss allowance to beestablished at the time the underlyingasset is recognized. We believe this lackof convergence creates unnecessarycomplexity in understanding financialreporting and undermines peer analysisglobally. Bank regulators may need tostep in to mandate additional disclosuresin banks’ financial statements to addressthis complexity.
20 www.creditweek.com
SPECIAL REPORTFEATURES
7% 10%
54% 57% 57%
27%
46%
11% 13% 13%
0102030405060708090
100
(%)
Mortgages SMEs Corporate Other retail Securities
Greater than 100% Increase of 50% to 100% Increase of 0% to 50%
No change Smaller allowance
Chart 1 | Potential Impact Of IFRS 9 On Credit Loss Allowance
Expected increase in credit loss allowance:
SMEs—Small and midsize enterprises.
Source: Deloitte-Fourth IFRS Global Banking Survey. Survey participants (banks) were asked to estimate the impact
on their credit loss allowances assuming IFRS 9 were to apply in the current credit environment. © Standard & Poor’s 2014.
41%
3%
17%
56%
14%
13%
10%
4%14%
14%
3%
13%3%
(5.0)(4.5)(4.0)(3.5)(3.0)(2.5)(2.0)(1.5)(1.0)(0.5)0.0
10 15 20 25 30 35 40 45 50 55 60 65 70
(%)
75 100
U.S. banks Canada banks Western Europe banks
EEMEA banks Asia-Pacific banks Latin America banks
Chart 2 | Impact On Core Tier 1 Ratios From Rising Credit Loss Allowances For Top 100 Rated Banks, By Region
(%)
(Based on 2013 year-end data)
Sources: Capital IQ, Standard & Poor’s estimates. © Standard & Poor’s 2014.
Higher Credit Losses May Have A Meaningful Impact On Bank CapitalMany factors suggest that a move to anexpected credit loss method in accountingmay have a significant impact on transition.For example, the IASB’s fieldwork, whichinvolved 15 companies (including majorbanks) indicates that on transition to IFRS9, credit loss allowances would increase:● By 25% to 60% on nonmortgage port-
folios; and● By 30% to 250% on mortgage portfo-
lios (1).A June 2014 global banking survey by
Deloitte gathered the views of 54 banks:29 based in the Europe, Middle East, andAfrica (EMEA) region; 17 in Asia-Pacific;and 8 in North America (2). This includes14 banks that the Financial Stability Boardhas classified as Global SystemicallyImportant Financial Institutions (G-SIFIs).The survey revealed that:
● More than half believe credit loss pro-visions will increase by up to 50% as aresult of IFRS 9 (see chart 1);
● 70% believe IFRS 9 will increaseCommon Equity Tier 1 (CET1) capitalrequirements, because accountingprovisions will be higher than regula-tory expected losses; and
● European banks reported the largestincreases.Regulatory impact studies in the U.S.
also show credit impairment accountingchanges could have sizable implications. Ina Sept. 16, 2013, speech about the possibleeffect on U.S. banks, Thomas J. Curry, headof the Office of the Comptroller of theCurrency (OCC, which supervises nationalbanks, federal savings associations, and thefederal branches and agencies of foreignbanks), said the OCC’s impact analysisshowed credit loss allowances wouldincrease by 30% to 50% across the U.S.banking system if the proposed U.S. GAAP
model was applied, with the effect on indi-vidual banks depending on specific factorssuch as each bank’s loan portfolio (3).
These reports clearly indicate that themove to the new more forward-lookingcredit loss models in IFRS and U.S. GAAPwill be significant for banks globally.However, we believe estimating the effecton individual banks is difficult because itwill depend on a host of factors. Theseinclude a bank’s region of operations,business model, loan portfolio mix, under-writing standards, assumptions used,reserve levels in the current credit cycle,and asset write-off policies, as well as theeconomic environment at the time ofimplementation and the accountingregime in place. Banks also may takeactions to address some of the accountingresults. Despite these challenges, webelieve investors should be aware of thepotential effect on existing capital meas-ures under various potential scenarios if
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 21
(Based on 2013 year-end data)
—Average % decrease in core Tier 1 ratio if allowance rises by—
10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 100%
U.S. banks (0.12) (0.18) (0.24) (0.31) (0.37) (0.43) (0.49) (0.55) (0.61) (0.67) (0.73) (0.79) (0.85) (0.92) (1.22)
Canada banks (0.10) (0.14) (0.19) (0.24) (0.29) (0.34) (0.38) (0.43) (0.48) (0.53) (0.58) (0.63) (0.67) (0.72) (0.96)
Western Europe banks (0.53) (0.79) (1.06) (1.32) (1.59) (1.85) (2.12) (2.38) (2.65) (2.91) (3.18) (3.44) (3.71) (3.97) (5.30)
EEMEA banks (0.17) (0.25) (0.33) (0.42) (0.50) (0.59) (0.67) (0.75) (0.84) (0.92) (1.00) (1.09) (1.17) (1.26) (1.67)
Asia-Pacific banks (0.16) (0.24) (0.32) (0.40) (0.47) (0.55) (0.63) (0.71) (0.79) (0.87) (0.95) (1.03) (1.11) (1.19) (1.58)
Latin America banks (0.35) (0.52) (0.69) (0.87) (1.04) (1.21) (1.39) (1.56) (1.74) (1.91) (2.08) (2.26) (2.43) (2.60) (3.47)
Top 100 rated banks (0.30) (0.45) (0.60) (0.75) (0.90) (1.05) (1.20) (1.35) (1.50) (1.65) (1.80) (1.95) (2.10) (2.25) (3.01)
Sources: Capital IQ, Standard & Poor’s estimates.
Table 1 | Impact On Core Tier 1 Ratios From Rising Credit Loss Allowances For Top 100 Rated Banks, By Region
(Based on 2013 year-end data for capital and a five-year average loan loss allowance)
—Average % decrease in core Tier 1 ratio if alllowance rises by—
10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 100%
U.S. banks (0.15) (0.23) (0.30) (0.38) (0.45) (0.53) (0.60) (0.68) (0.75) (0.83) (0.90) (0.98) (1.05) (1.13) (1.50)
Canada banks (0.09) (0.14) (0.19) (0.24) (0.28) (0.33) (0.38) (0.42) (0.47) (0.52) (0.56) (0.61) (0.66) (0.71) (0.94)
Western Europe banks (0.42) (0.63) (0.84) (1.05) (1.26) (1.47) (1.68) (1.89) (2.10) (2.31) (2.52) (2.73) (2.94) (3.15) (4.20)
EEMEA banks (0.18) (0.27) (0.35) (0.44) (0.53) (0.62) (0.71) (0.80) (0.88) (0.97) (1.06) (1.15) (1.24) (1.33) (1.77)
Asia-Pacific banks (0.14) (0.21) (0.28) (0.35) (0.42) (0.48) (0.55) (0.62) (0.69) (0.76) (0.83) (0.90) (0.97) (1.04) (1.38)
Latin America banks (0.32) (0.48) (0.64) (0.80) (0.96) (1.12) (1.28) (1.44) (1.60) (1.76) (1.92) (2.08) (2.24) (2.40) (3.20)
Top 100 rated banks (0.26) (0.39) (0.52) (0.65) (0.78) (0.92) (1.05) (1.18) (1.31) (1.44) (1.57) (1.70) (1.83) (1.96) (2.62)
Sources: Capital IQ, Standard & Poor’s estimates. Data is based on banks’ 2013 year-end annual reporting (for capital) and the average of 2009-2013 loan loss provisions, where available.
Table 2 | Impact On Core Tier 1 Ratios From Rising Credit Loss Allowances For Top 100 Rated Banks, By Region
higher credit loss requirements—whetherunder IFRS 9 or expected U.S. GAAP—currently were applied.
Key Ratios For The Top 100Banks We Rate Would Slip, Some SignificantlyWe reviewed the potential impact on regu-latory core tier 1 capital under potentially
various rising credit loss allowance sce-narios for the top 100 global banks we rate,grouped by region. We also examined theeffect of potentially rising credit lossallowances on Standard & Poor’s risk-adjusted capital (RAC) measure. We useRAC ratios to measure the adequacy ofbank’s capital, regardless of the type ofbank or where it operates. We found that,
on average, for every 10% rise in theallowance, the core tier 1 ratio drops by 30bps and the RAC ratio drops by 19 bps.
Most large banks that are subject toBasel II or Basel III rules apply theinternal ratings-based (IRB) approach onthe bulk of their loan portfolios in theirregulatory capital calculations. The IRBapproach replaces the accounting creditloss allowances with a (usually higher)expected loss amount calculated underBasel rules. However, for simplicity, themethodology we use here assumes thatincreases in credit loss allowances foraccounting purposes directly translateinto a deduction from regulatory capital(see appendix).
Banks In Western Europe Would Take The Biggest HitWestern European banks could experi-ence the most significant drop in capitalfrom a rise in credit loss allowances (see
table 1 and chart 2). For every 10% rise inthe allowance, Western European banks’core tier 1 ratios tumble, on average, by53 bps. For Eastern Europe, Middle Eastand Africa (EEMEA) banks, the fall incore tier 1 ratio averages 17 bps. Theimpact on western European banks isvery dif ferent from that on banks inNorth America, which fare considerablybetter. In the U.S., core tier 1 ratios dropby 12 bps on average for each 10% risein credit loss allowances; in Canada, thedrop is 10 bps on average.
In other regions, our analysis showsthat higher credit loss allowances mayalso significantly affect banks in LatinAmerican, with core tier 1 ratios fallingby an average of 35 bps for each 10%rise in allowances. For Asia Pacific banks,the impact is similar to that for U.S.banks, with core tier 1 ratios falling by anaverage of 16 bps for each 10% rise inthe allowance.
If credit loss allowances rise by up to50%, as some expect (including the OCCfor the U.S. banking system and respon-dents to Deloitte’s Fourth GlobalBanking Survey), we estimate that for U.S.banks, core tier 1 ratios could take a hit ofup to 61 bps. Western European bankscould take a hit of up to 265 bps—morethan four times as much.
22 www.creditweek.com
SPECIAL REPORTFEATURES
U.S. banks Canada banks Western Europe banks
EEMEA banks Asia-Pacific banks Latin America banks
Chart 3 | Impact On Core Tier 1 Ratios From Rising Credit Loss Allowances For Top 100 Rated Banks, By Region
Based on 2013 year-end data for capital and a five-year average loan loss allowance
(5.0)(4.5)(4.0)(3.5)(3.0)(2.5)(2.0)(1.5)(1.0)(0.5)0.0
Decrease in core Tier 1 ratio (%)
10 15 20 25 30 35 40 45 50 55 60 65 70
Increase in credit loss allowance (%)
75 100
Data are based on banks’ 2013 year-end annual reporting (for capital) and the average of 2009 to 2013 loan loss
provisions, where available.
Sources: Capital IQ, Standard & Poor’s estimates.
© Standard & Poor’s 2014.
(3.0)
(2.5)
(2.0)
(1.5)
(1.0)
(0.5)
0.0
10 15 20 25 30 35 40 45
Increase in credit loss allowance (%)
50 55 60 65 70 75 100
Decrease in Tier 1 ratio (%)
U.S. banks Canada banks Western Europe banks
EEMEA banks Asia-Pacific banks Latin America banks
Chart 4 | Impact On RAC Ratios From Rising Credit Loss Allowances For Top 100 Rated Banks, By Region
(Based on 2013 year-end data)
RAC—Risk-adjusted capital. RAC ratios are based on banks’ 2013 year-end annual reporting, where available.
Sources: Capital IQ, Standard & Poor’s estimates.
© Standard & Poor’s 2014.
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 23
While our analysis is based on banks’2013 year-end data, we observed similartrends when using average allowancelevels over the past five years, ratherthan 2013 levels, which are benefittingfrom favorable asset quality trends—andrelatively lower reserve coveragelevels—in some regions, such as the U.S.and Canada (see table 2 and chart 3).
Analysis Of The Impact On RACRatios Shows A Similar PictureWe also analyzed the impact of risingcredit loss allowances on our RAC ratios.
We define RAC as total adjusted capitaldivided by risk weighted assets (see
“Criteria: Financial Institutions: Bank Capital
Methodology And Assumptions,” published
Dec. 6, 2010, on RatingsDirect). WesternEuropean banks again face the greatest hitfor each 10% increase in credit lossallowances, showing a 27-bp fall in RACratios. U.S. banks show RAC ratios fallingby 9 bps for each 10% rise in allowances;Canadian banks’ RAC ratios fell by lessthan 1 bp. For Latin American banks, theimpact was 20 bps; for Asia-Pacific banks,it was 13 bps. While the degree to which
the RAC ratio declines is lower than theeffect on core tier 1 ratios, we believe thetrends are still meaningful (see chart 4).
Regional Differences Likely AreAttributable To Many FactorsThe differences in the magnitude of thecapital impact across banks in differentregions result from a combination of fac-tors, including:● Differences in business models. There
is generally a greater level of disinter-mediation in U.S. banks comparedwith European banks, with the latter
Credit-impairedLifetime expected Lifetime expected financial assets
12-month expected credit losses credit losses (lifetime expectedMortgage loans—loss allowance credit losses (collectively assessed) (individually assessed) credit losses)
Loss allowance as of Jan. 1 X X X X
Changes due to financial instruments recognized as of Jan. 1: X — X —
Transfer to lifetime expected credit losses X X X —
Transfer to credit-impaired financial assets X — X X
Transfer to 12-month expected credit losses X X X —
Financial assets that have been derecognized during the period X X X X
New financial assets originated of purchased X — — —
Write-offs — — X X
Changes in models/risk parameters X X X X
Foreign exchange and other movements X X X X
Loss allowance as of Dec. 31 X X X X
Source: International Accounting Standards Board.
Table 3 | Illustrative Disclosure Of Changes In Expected Credit Losses
Credit-impairedLifetime expected Lifetime expected financial assets
12-month expected credit losses credit losses (lifetime expectedMortgage loans—gross carrying amount credit losses (collectively assessed) (individually assessed) credit losses)
Gross carrying amount as of Jan. 1 X X X X
Individual financial assets transferred to lifetime expected credit losses X — X —
Individual financial assets transferred to credit-impaired financial assets X — X X
Individual financial assets transferred from credit-impaired financial assets X — X X
Financial assets assessed on collective basis X X — —
New financial assets originated or purchased X — — —
Write-offs — — X X
Financial assets that have been derecognized X X X X
Changes due to modifications that did not result in derecognition X — X X
Other changes X X X X
Gross carrying amount as of Dec. 31 X X X X
Source: International Accounting Standards Board.
Table 4 | Illustrative Disclosure Of Changes In Gross Carrying Amounts Of Assets
retaining a relatively larger proportionof loans on their balance sheets.
● Differences in asset write-off policies.Legal processes such as foreclosure tendto be slower in some jurisdictions (suchas countries in southern Europe), so itcan take longer for impaired assets to bewritten off from the balance sheet.Therefore, banks in such jurisdictionsoften carry high levels of provisioningagainst impaired assets for a longer time.The methodology we use here does not
specifically adjust for these factors; e.g.,because of disclosure limitations, we havenot adjusted the methodology for assets thatare already substantially or fully provisionedand are thus unlikely to attract further provi-sions under the new credit loss models.
The New IFRS 9 Credit LossModel Does Not Go Far EnoughThe new IFRS 9 model is an “expectedloss” model that requires companies to
consider expected future losses whenestimating credit loss allowances. Themodel requires a dual-measurementapproach, with the recognition of an ini-tial (day 1) credit loss allowance thatrepresents 12 months of expected creditlosses for all financial assets in thescope of the model, updated at eachreporting period. The model requiresthe recognition of lifetime expectedcredit losses, but only when manage-ment decides the credit risk of the finan-cial asset has significantly increasedsince its initial recognition.
This means that, for assets that are per-forming as banks originally expected—including the vast majority of most banks’loan portfolios—the model would onlyreflect a portion of expected credit losses.Management must then judge whichassets have experienced significantincreases in credit risk and recognize alifetime loss allowance for those assets.
We believe the dual-measurementapproach of the IASB’s expected lossmodel will lead to inconsistencies acrossbanks, because the judgments bankmanagements apply about whetherassets have experienced significantincreases in credit risk are likely to varyand may be subject to bias (e.g., wheremanagement may be influenced by earn-ings targets). It is not yet clear whetherthe disclosure requirements in IFRS 9(detailed below) will help financial state-ment users to identify such variances.We believe the IFRS 9 approach doesnot go far enough to dampen the pro-cyclical effects of loan losses becauseloan-loss allowances may start to riseonly after the start of an economicdownturn and spike once the economytakes its sharpest turn for the worse.
We believe FASB’s single-measure-ment approach (i.e., lifetime losses oninitial recognition of the underlyingasset) is conceptually more robust, sim-pler, and less ambiguous than theIASB’s dual measurement approachand would provide better informationrelated to credit losses for our analysis(see “FASB’s Proposal Set To Revamp
Accounting For Credit Losses, But Fails To
Achieve Convergence With International
Accounting,” published July 11, 2013).
Forward-Looking AssumptionsWeigh Heavily On ExpectedReserve Levels, As Do Other FactorsManagements’ expectations about thefuture—whether credit quality indica-tors are getting better or worse—rela-tive to their historical experience likelywill drive a significant part of theallowance level. However, the range ofpossible losses largely will depend onother factors, such as the compositionof a bank’s loan portfolio or existingaccounting policies for credit lossallowances, which could change dra-matically before a bank implementsthese accounting standards.
In the EU, the European CentralBank’s (ECB’s) comprehensive assess-ment of the largest Eurozone banksuses more standardized definitions ofnonperforming loans and may be
24 www.creditweek.com
SPECIAL REPORTFEATURES
—Consumer credit card —Consumer automotivegross carrying amount— gross carrying amount—
Lifetime 12-month Lifetime 12-month
Internal grade 1-2 X X X X
Internal grade 3-4 X X X X
Internal grade 5-6 X X X X
Internal grade 7 X X X X
Total X X X X
Source: International Accounting Standards Board.
Table 5 | Illustrative Disclosure Of Credit Risk Of Financial AssetsBy Internal Rating Grades
—Consumer credit card —Consumer automotivegross carrying amount— gross carrying amount—
Lifetime 12-month Lifetime 12-month
AAA to AA X X X X
B X X X X
BBB to BB X X X X
B X X X X
CCC to CC X X X X
C X X X X
D X X X X
Total X X X X
Source: International Accounting Standards Board.
Table 6 | Illustrative Disclosure Of Credit Risk Of Financial Assets By External Rating Grades
stricter than those many banks use forat least some of their por tfol ios.Reporting for year-end 2013 saw anumber of banks in the EU recognizinghigher credit loss allowances as theypositioned themselves to pass the ECBassessment (results to be published inOctober 2014).
In the U.S., if the FASB lifetime expectedcredit loss model is finalized as pro-posed, banks with loan books heavilyweighted toward home equity lines ofcredit (HELOCs) or other revolving loancommitments likely will see steeperhikes in the allowance. These loan prod-ucts may be performing well, but a sig-nificant volume have yet to reach theirend-of-draw periods. Under an expectedloss approach, banks would be requiredto consider fully drawn and amortizingHELOCs, in addition to forward-lookingexpectations and their macroeconomicviews, when determining an appropriateallowance. Similarly, this approach couldalso significantly affect banks with a highproportion of Commercial and Industrialloans (C&I)—which have grown at aspectacular pace in many regions.
Regulators Likely Will RequireAdjustments From AccountingCredit Loss Allowances ForRegulatory Capital CalculationsIt is not yet clear how bank regulatorswill respond to the new accountingrequirements for credit losses. Webelieve regulators will still require banksto factor in additional credit losses intheir calculation of regulatory capital.Regulators require sufficient capital tocover expected and unexpected losses,and the new accounting is only intendedto cover expected losses. In addition,regulators may decide the newaccounting does not cover expectedlosses sufficiently, particularly for the ini-
tial 12-month credit loss allowance forperforming assets under the IFRS model.Regulators may also remove the tier 2capital add-back currently allowed,where the accounting provision is higherthan the Basel expected loss amount.
For Every Accounting Action,There May Be An Equal AndOpposite ReactionAs accounting rules change underIFRS and U.S. GAAP to capture banks’expected losses, it is likely many bankmanagements will address the poten-tial impact on earnings and capital.This could involve a variety ofchanges, including increasing pricingon certain loan products (such as cor-porate loans or mortgages) to compen-sate for higher loan provisions, whichcould counteract some of the higherexpenses with higher revenues overthe life of the loan. Banks may shiftloan product strategies, favoringshorter-duration loan products overlonger-term loan products. Forexample, some banks—to achieve amore desirable accounting result—could add renewal options to contrac-tual terms to shorten the duration ofcertain commercial loan products.Some long-term revolving credit prod-ucts, often withdrawn on short notice,could become a smaller share ofbanks’ loan portfolios because bankswould need to consider these loanproducts on a fully drawn basis toestablish reserve levels. In extremecases, bank management teams maydecide to signif icantly cur tai l theunderwriting of new loan productssimply to avoid both the accountingconsequences of establishing reservesand taking an earnings hit in a specificreporting period, particularly whenearnings are already under pressure.
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 25
It is not yet clear how bank regulators will respond
to the new accounting requirements for credit losses.
The effect of these rules may deterpotential new market entrants, and theoutcomes could have broader eco-nomic consequences.
Major Differences UndermineGlobal ComparabilityThe lack of convergence between U.S.GAAP and IFRS means impairmentanalysis will be based on two markedlydifferent accounting approaches, creatingunnecessary reporting and market confu-sion and undermining peer analysis.Credit loss allowances and key metricsthat are not directly comparable createsignificant disadvantages for investors. Inthe absence of greater similarity and con-sistency between the IASB and FASB, webelieve investors would be best served ifbanks using IFRS disclosed their esti-mated lifetime credit losses. IFRS 9 doesnot specifically require this, but in ourview, bank regulators should considermandating this type of additional disclo-sure to provide investors with relevant,globally comparable information oncredit losses (see tables 3, 4, 5, and 6 for
illustrative examples of disclosure require-
ments mandated under IFRS 9).In addition to the reform of credit loss
accounting, IFRS 9 serves as a singleaccounting standard that includes final-
ized requirements for the classificationand measurement of financial instru-ments and general hedge accounting. Therules for classifying financial instrumentsfor IASB purposes may differ from thosein the soon-to-be-released U.S. GAAPaccounting standard, which could lead tofurther global peer incomparability.
We Do Not Discern A Bank’sFinancial Strength From Capital Metrics AloneCapital metrics do not tell the full storyof a bank’s f inancial strength. Ourrating methodology provides a widerpicture by assessing whether financialreports adequately recognize andmeasure risks and by analyzing banks’ability to generate capital. Indeed,many banks around the globe haveaccelerated their leverage reduction orare implementing a range of otheroptions to improve capital and leveragemetrics in response to more demandingregulatory requirements under Basel III.Potentially higher credit losses and theireffect on capital represent another gapthat banks must consider. However,even as banks’ capital metrics improveor worsen under our definitions, we donot view capital as a single factor trig-gering rating changes. CW
NOTES:In this article:● The data in table 1 and chart 2 are based on
banks’ reported 2013 year-end reported reg-ulatory capital figures and 2013 reportedloss reserves. Increases in loss reserves arededucted from capital (the numerator in thecapital ratio). No adjustment was made forRWAs (the denominator), because thesample (top 100 rated banks) was assumedto be the IRB approach for the bulk of theportfolios, in which RWAs are based ongross exposures.
● The data in table 2 and chart 3 are thesame as in table 1 and chart 2, but five-yearaverage (2009-2013) loss reserves wereused, rather than just 2013 loss reserves.
● The data in chart 4 are based on banks’2013 RAC ratios and 2013 reported lossreserves. Increases in loss reserveswere deducted from RAC (the numer-ator in the RAC ratio) and no adjust-ment was needed for our RWAs (thedenominator), because they are basedon gross exposures.
FOOTNOTES(1) IASB Staff Paper 5B: Outreach Feedback
Summary—IASB, 22-26 Jul. 2013. Availableat http://www.ifrs.org/Meetings/MeetingDocs/IASB/2013/July/05B-Impairment.pdf
(2) Fourth Global IFRS Banking Survey—Deloitte, June 2014. Available athttp://www.iasplus.com/en-gb/publica-tions/global/surveys/fourth-global-ifrs-banking-survey/file
(3) Remarks by Thomas J. CurryComptroller of the Currency Before theAICPA Banking ConferenceWashington, D.C, Sept. 16, 2013.Available at: http://occ.gov/news-issuances/speeches/2013/pub-speech-2013-136.pdf
26 www.creditweek.com
SPECIAL REPORTFEATURES
Our methodology considered the potential impact on regulatory core tier 1 capital
ratios and Standard & Poor’s RAC ratios from a range of higher credit loss
allowances. The sample consisted of the top 100 banks we rate, which we further
classified based on their region:● The U.S.;● Canada;● Western Europe;● Eastern Europe, the Middle East, And Africa (EEMEA);● Asia-Pacific; and● Latin America.
As data points, we used:● Core Tier 1 Capital for 2013;● Regulatory Risk Weighted Assets for 2013;● Total Adjusted Capital (TAC) for 2013;● Standard & Poor’s Risk Weighted Assets (RWA) before diversification for 2013;● Gross Loan Balances for 2013; and● Five years’ allowance for Loan Losses (i.e., 2009, 2010, 2011, 2012, 2013).
Appendix
Analytical Contacts:
Jonathan Nus, CPANew York (1) 212-438-3471
Osman Sattar, ACALondon (44) 20-7176-7198
Joyce T. Joseph, CPANew York (1) 212-438-1217
Rohina Verdes, CAMumbai (91) 22-4040-5829
For more articles on this topic search RatingsDirect with keyword:
Accounting
Activist interventions at companies have grown
substantially over the past several years, with the average
market value of targets rising sharply, and a greater
impact on enterprises rated by Standard & Poor’s Ratings
Services. Strategies have been developed and alliances formed,
which would have been unthinkable just a few years ago. One
notable example is the proliferation and sophistication of hedge
funds and the collaborations they have forged with large, deep-
pocketed investors, or even with other rated issuers. These and
other types of activism, challenging a board-centric model of
governance, allow us to outline our approach to activism when
analyzing the creditworthiness of a rated entity.
Why Activism’s Impact On Credit QualityCan Be Positive, Negative, Or Neutral
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 27
Q. What is Standard & Poor’s approachto activism?
A. Activism comes in many varieties andtakes many forms. Shareholder activismcomes to mind first because it is generallythe most voluble, and through the annualand special corporate meeting process itattracts the most attention from investors,issuers, and commentators. But the actionsof a wide census of other stakeholders alsohave influence on the managements andboards of the enterprises that we rate. Theseinclude political, social, and environmentalactivism; the voices of customers andemployees; and communities in which theenterprise operates. The legal and regula-tory spheres also wield significant influenceon an enterprise and have for many years.
We also consider the actions of anissuer’s counterparties, customers, credi-tors, and other holders of direct or indi-rect debt instruments. Their influencemay be far less visible, but we believe thedepth of the credit markets makes themno less significant. So, while activism thatmakes the headlines is predominantly ofthe shareholder variety, our approach to,and analysis of, activism’s impact needsto include these many variants to providea comprehensive review of their effecton credit quality.
Q. Is such a broad approach to activi-sm really useful and useable byStandard & Poor’s?
A. One risk with this broad approach isthat it can easily include behaviors thatmerely are the exercise of a stake-holder’s everyday rights and responsibili-ties. We have to make analytical judg-ments across a broad spectrum of anenterprise’s credit-relevant actionsalongside those with an interest in (orinf luence on) it, and we believe thisbroad definition puts the right emphasison making those judgments on a case-by-case basis. The bigger risk would beadopting too narrow a definition thatexcluded the diversity and ingenuity ofactivist initiatives.
Another problem with a narrow defini-tion, at least from our credit rating per-spective, is that the public company, the
usual domicile of activism, is just one ofthe many types of enterprise that werate but not the only type where activismoccurs. In addition, we rate entities inmany different jurisdictions and coun-tries, and their laws, regulations, and cul-tures add significant complexity todefining activism largely based on andconfined to an Anglo-Saxon public com-pany concept of shareholder and stake-holder rights.
Q. Whether a rating agency viewsactivism broadly or narrowly, doesn’t italways assess activism negatively?
A. That view is understandable but mis-leading, at least as far as our ratings areconcerned. It might hold true if thefocus is exclusively based on a percep-tion that most activists are, for example,hedge funds that pursue initiatives withthe sole goal of carving out value forshareholders. But even in cases thatmight be characterized that way, the riskis that automatically labeling a hedgefund as activist and a credit-negativecould underplay or even miss initiativesthat could have a positive impact on therated enterprise’s business position andfinancial condition over time.
The perception that we have a negativeview of activism also reflects semantics. Arating on an enterprise is a point-in-time,forward-looking opinion on the creditwor-thiness of that obligor to make interest pay-ments and principal repayments on out-standing debt in a timely fashion. Manycorporate and activist initiatives will, in ouropinion, lower the enterprises’ ability toservice those obligations. Consequently,these ratings will very often have their out-look changed to negative or CreditWatchnegative. However, “negative” is not areflection on, or evaluation of, activist ormanagement ideas. Rather, it reflects ouropinion, based on available facts and evi-dence, that the management initiative—e.g.,a large acquisition or an activist’s call for asubstantial sale of assets (or vice versa)—hurts the business and financial profiles thatprovide the anchor for the current rating.
Remember that an optimal rating for anenterprise is not necessarily a high one.While a higher rating may secure lower-
cost debt financing, it likely will alsoimpose a higher proportion of balance-sheet equity, which may not be the bestway to improve an enterprise’s competi-tive position. The credit rating’s primaryfunction is to provide an opinion on therisks that bondholders and other creditorsassume in taking on exposure to an enter-prise, so we view the actions of manage-ment and activists through the same lens.
Many activist initiatives are theproduct of significant research into theenterprise, based on beliefs about and acommitment to improving its businessand, if not immediately, then over time,its debt-servicing capabilities. Activistsseek rewards for their efforts, but theiractions are not necessarily or automati-cally credit-negative.
Q. Can you provide examples of where activists arguably have had a pos-itive impact?
A. The complexities that often charac-terize activism played out recently withDell Inc. Its founder, Michael Dell, andtechnology investor Silver Lake Partnersorchestrated transactions to take thecompany private through a leveragedbuyout (LBO) in early 2013. Subsequentdevelopments, including alternative pro-posals suggested by veteran shareholderactivist Carl Icahn and significant valua-tion questions raised by many Dellinvestors, led to a complex set of inter-actions among the founder, the board,and investors. Included in those pro-posals was one for an appraisal rightsprocess, which would have allowed theDelaware Court of Chancery (where Dellis incorporated) to provide an inde-pendent share valuation.
We placed our rating on CreditWatchwith negative implications when the “goingprivate” transaction was announced. Thenwe lowered it on weak operating perform-ance, and then lowered it out of investmentgrade altogether when the LBO eventuallyclosed. Still, the current ratings now have apositive outlook based on our assessmentof Dell’s debt-reduction expectations. Thisis one example of “insider activism” leadingto a positive outlook on a newly nonpublicentity rating, albeit at a lower level.
28 www.creditweek.com
SPECIAL REPORT | Q&AFEATURES
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 29
Another example illustrating the role ofactivists viewed positively from a credit perspective is Equity Commonwealth,which changed its name from Common -Wealth REIT at the end of July 2014.CommonWealth REIT’s credit measureshad weakened over the past several years,ref lecting lackluster suburban officemarket fundamentals. In response to thatdeterioration, former managementannounced the launch of a $450 millionpublic equity offering and related debttender offer in March 2013.
Shareholders critical of the dilutiveeffect of the offering, particularly whenthe share price was then below theenterprise’s net asset value, raised signif-icant concerns about CommonWealth’sasset-allocation decisions as well as theexternal management structure andgovernance profile generally. A lengthyand protracted battle for the controland future direction of this REIT culmi-nated in the board’s replacement by theactivist nominees.
However, the very prominent roleactivists played over a protracted periodwas not the primary cause of the ratingdowngrade in June 2013. Rather, it wasour expectation for weak operating per-formance. We will continue to assessmanagement and the board thoseactivists put in place for both positiveand negative impacts on credit quality, inthe same way that we assessed theformer management.
A good illustration of the rapid evolu-tion and continuing ingenuity of activismis the attempt by Valeant Pharma -ceuticals International Inc. and PershingSquare Capital Management to orches-trate a takeover of Allergan Inc. Thisparticular ongoing struggle between tworated entities and well-known share-holder activist William Ackman illus-trates how our ratings analysis remainsimpartial when it comes to the actions ofactivist and issuer alike.
Among the credit-relevant questionsour analysts have addressed is: “Howdoes the combination of these two com-panies affect the level of business risk?”While the merged companies couldimprove Valeant’s business risk profile, amerger could also pose challenges to
Allergan’s research and development,which helps it preserve market share,maintain profitability, and generatestrong organic revenue growth over thelong run. Allergan is on CreditWatchwith negative implications, but thatreflects the lower rating of the potentialacquirer, as well as the likelihood thatany alternative transaction would raiseadjusted net leverage. It does not reflectthe activist intervention alone.
In another example, Darden RestaurantsInc. is dealing with a fully fledged proxycontest for control of its 12-memberboard of directors. Although StarboardValue LP is leading the effort to oust thecurrent board, we first noted activistengagement in October 2013, whenBarington Capital Group took a stake inDarden’s common stock. This initial foraydid not af fect our rating or outlook,although we presumed that Barington andDarden management would discussstrategic financial initiatives. We loweredour rating eight days earlier on weak salesand earnings trends.
Darden’s dispute with certaininvestors deteriorated sharply when itsboard and management decided to sellits seafood restaurant chain, RedLobster. We placed the ratings onCreditWatch with developing implica-tions, meaning that the ratings could beraised, affirmed, or lowered, dependingon our reevaluation of Darden’s businessrisk and financial risk profiles at the con-clusion of the transaction. In response tothe proposed sale announcement,Starboard initiated a process to call aspecial shareholder meeting to discussthe Red Lobster sale price, but the salewas concluded and proceeds were usedto repay the company’s senior notes.
Our response to the completed RedLobster transaction was to remove theratings from CreditWatch and assign anegative outlook, reflecting our expecta-tion that operating performance atDarden’s Olive Garden chain could beweaker than management expected. Thedownside scenario for the rating doesnot differentiate between continued orchanged control after the upcomingshareholder meeting (originally sched-uled for Sept. 30 but now set for Oct. 10).
Rather, it depends on the aggressivenessof the financial or operating strategiespursued by the current board and man-agement or their replacements.
Q. How does this perspective on activismalign with your assessments of manage-ment and governance?
A. Management and board responsesto activists provide us with crucialinsights into management’s flexibility inmeeting new challenges and the boardof directors’ responsiveness andengagement. The evidence provided bytheir collective ability to communicatetheir vision and strategy for the com-pany, their willingness to listen to andconsider alternative perspectives, andultimately, their ability to constructivelyadopt a new direction or convincinglyarticulate why their own current plansare the appropriate ones provide uswith critical data points in this veryqualitative area of analysis.
So, in addition to our evaluationabout the effect that activist proposalsmay have on creditworthiness in termsof the issuer’s business and financialrisk profiles, responses to activismcreate an important opportunity togather significant information about thequalities of the entity’s corporate leaders.Correspondingly, we can make the sameevaluation and judgments about how theactivists, of whatever variety, articulatetheir own plans and proposals.
Our approach to the credibility of thestrategy and the creditworthiness ofthe proposals does not dif fer nordepend on who is making them. Theissue, from a credit perspective, iswhether the navigational skills of themanagement, or activist, will improveor deteriorate the rated enterprise’sdebt-servicing capabilities. CW
Analytical Contacts:
Laurence P. HazellNew York (1) 212-438-1864
Joyce T. Joseph, CPANew York (1) 212-438-1217
For more articles on this topic search RatingsDirect with keyword:
Activism
SPECIAL REPORT
30 www.creditweek.com
FEATURES
Some investors have voiced concerns about the consistency and
transparency of insurance companies’ financial reporting, noting
the need for targeted improvements to U.S. generally accepted
accounting principles (GAAP)—including more robust disclosures. The
Financial Accounting Standards Board (FASB) is currently evaluating
insurance contract accounting, but the potential changes and their
effect on financial statements remain unclear. To address some of the
perceived shortfalls and uncertainty related to GAAP accounting for
insurers, investors and other financial statement users may look to
insurers’ statutory financial statements to gauge these companies’
performance and financial strength. However, Standard & Poor’s
Ratings Services believes investors and other financial statement users
need to exercise caution if taking this approach. The U.S. statutory
accounting framework provides a common set of principles, but also
allows modification by states and insurers. These unique “prescribed
and permitted practices” allowable under statutory accounting—which
are essentially state-specific and company-specific deviations from the
general statutory accounting principles—hinder the comparability of
statutory financial statements and complicate financial analysis.
U.S. StatutoryAccounting PrinciplesA Common Set Of Principles, WithAn Uncommon Set Of Practices
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 31
Overview● U.S. statutory financial statements may be a useful option for financial statement
users who view U.S. GAAP as inadequate, but they can introduce analytical risks.● Prescribed and permitted practices—a statutory reporting convention unique to
the insurance industry—create unique accounting that may undermine
consistency and comparability.● Prescribed and permitted practices are not separately presented or identified on
the face of the statutory balance sheet or summary of operations, so it is critical
that users look to the footnotes to fully understand what accounting practices
insurers are applying and their effect on key financial ratios.● Our research indicates that twice as many companies recorded higher surplus
because of prescribed or permitted practices than those that recorded lower levels.
We generally rely on U.S. statutory orGAAP financial statements when per-forming our credit analysis of U.S.-domiciled insurance companies. Whenusing an insurer’s U.S. statutory finan-cial statements, we may make analyt-ical adjustments to the company’sreported surplus for which the effect ofany prescribed or permitted practicesis included. While our analysis con-siders the quantitative and qualitativeeffects of these practices on surplusand other key ratios, our analyticaladjustments focus on reflecting under-lying economic realities and may notbe specific to a particular prescribed orpermitted practice ( see “Ref ined
Methodolog y And Assumptions For
Analyzing Insurer Capital Adequac y
Using The Risk-Based Insurance Capital
Model ,” publ ished June 7, 2010, on
RatingsDirect) . Financial statementusers may likewise need to considerthe ef fect of these unique statutorypractices in their analyses to ensurethat they understand the f inancialinformation being captured.
Statutory Accounting DiffersMarkedly From GAAPInsurance companies are regulatedstate by state in the U.S. Each state hasan appointed or elected insurancecommissioner who, with his or herrespective insurance staff, oversees the
financial condition of insurance com-panies domiciled in their state. Thisfinancial oversight aims to help ensurethat pol icyholders and cla imantsreceive the requisite benefits frompolicies sold. The preamble to theNational Association of InsuranceCommissioners’ (NAIC) Statements ofStatutor y Accounting Principles(SSAPs), which form the basis of U.S.insurance statutory reporting, high-lights that “regulatory perspectivesdiffer markedly from the perspectivesof other users of insurers’ accountinginformation.” This point is evident inthe accounting: While GAAP is morefocused on measuring earnings andmatching revenue and expenses fromperiod to period, U.S. statutor yaccounting—which is designed to aidregulatory oversight—takes a morestressed approach in assessing theability to pay claims.
Unlike GAAP and other accountingframeworks that refer to a single, com-prehensive set of accounting princi-ples, U.S. statutory accounting offers asimilar ly comprehensive set ofaccounting principles but allows formodification by states and insurancecompanies. This point becomes clearwhen reading an auditor’s repor tincluded within a set of financial state-ments. For GAAP financial statements,opinions generally read “ ...in con-
formity with accounting principlesgenerally accepted in the United Statesof America,” whereas statutory opin-ions generally read “ ...in accordancewith practices prescribed or permittedby the department of insurance of (theinsurer’s state of domicile).”
Prescribed accounting practices, asdefined in the SSAPs, are essentiallystate-specific accounting practices thatdeviate from the NAIC’s SSAPs andapply to al l insurance enterprisesdomiciled in that state. These practicescreate state-specif ic accountingregimes that hinder the comparabilityof insurance companies domiciled indifferent states.
Permitted accounting practices, on theother hand, include practices an insurerhas specifically requested that departfrom NAIC SSAPs or state-prescribedaccounting practices, and which theinsurer’s domiciliary state regulatoryauthority approves. These practicescreate company-specific accountingregimes that make comparability difficultnot only state-to-state, but even com-pany-to-company within a state.
While the NAIC’s SSAPs provide asolid and consistent accounting founda-tion, prescribed and permitted practicesallow some flexibility to adapt to statelaws and insurer-specific conditions.While flexibility in managing and regu-lating surplus levels is beneficial to
32 www.creditweek.com
SPECIAL REPORTFEATURES
Number of companies State with a permitted practice
Vermont 49
New York 46
Texas 26
Pennsylvania 25
Wisconsin 14
Florida 12
Iowa 10
Washington, D.C. 10
Tennessee 10
Missouri 10
Note: We used U.S. statutory data from NAIC’s InfoPro database, which may exclude certain U.S. statutory data that are not submitted to the National Association of Insurance Commissioners, or not submitted in annual statement form.
Table 1 | 2013 Top 10 States
Number of companies State with a permitted practice
Vermont 27
Texas 16
Nevada 16
New York 13
South Carolina 12
Michigan 12
Washington, D.C. 11
Pennsylvania 10
Delaware 8
Arizona 7
Note: We used U.S. statutory data from NAIC’s InfoPro database, which may exclude certain U.S. statutory data that are not submitted to the National Association of Insurance Commissioners, or not submitted in annual statement form.
Table 2 | 2013 Top 10 States
Number of companies State with a permitted practice
Texas 15
Michigan 8
New York 8
Wisconsin 7
Vermont 6
Delaware 5
Georgia 4
Minnesota 4
Montana 4
Pennsylvania 4
Note: We used U.S. statutory data from NAIC’s InfoPro database, which may exclude certain U.S. statutory data that are not submitted to the National Association of Insurance Commissioners, or not submitted in annual statement form.
Table 3 | 2003 Top 10 States
insurance companies and their regula-tors, such deviations from NAIC SSAPsreduce comparability and consistencyfor other potential users of U.S. statu-tory financial statements. Financialstatement users thus may need to lookpast the balance sheet and incomestatement to the accounting practicesfootnote to truly understand what typeof statutory accounting a company maybe applying and its impact on key meas-ures of financial strength.
The U.S. GAAP Accounting AndFinancial Reporting EnvironmentContinues To Quickly Evolve,Leaving Financial StatementUsers Potentially Looking ForOther OptionsInsurance accounting under GAAP cur-rently is in flux, considering the FASB’sdecision to halt its convergence effortswith the International AccountingStandards Board (IASB) and insteadidentify targeted improvements to U.S.GAAP. Conclusions are not yet finalizedregarding the proposed changes theFASB will adopt, specifically for long-duration contracts, where the effectsmay be significant. If the FASB movesforward with certain concepts similar towhat it had proposed (and later aban-doned) in the Insurance Contracts(Topic 834) exposure draft, such as theperiodic unlocking of assumptions (e.g.,mortality and morbidity) or use of a dis-count rate with liability characteristicsto measure contract liabilities, webelieve financial-statement users mayfind analysis difficult because of greatercomplexity or increased income state-ment volatility (see “Back To The Drawing
Board On FASB’s Accounting For
Insurance Contracts: An Opportunity Lost
Is An Opportunity Gained,” on p. 64).
In addition, comments the FASBreceived on its exposure draft high-lighted that the number and use of non-GAAP measures may increase if com-plexity or volatility obscure GAAPfinancial reporting (see “Analytical
Dilemmas When Using Non-GAAP
Measures In The U.S. Insurance Sector,”
published Feb. 18, 2014). Given the risksrelated to potential targeted FASB
improvements and the reliability andconsistency of non-GAAP measures,users may increasingly turn to U.S. statu-tory financial statements. As such, it isimportant to understand the analyticalobstacles that may exist in U.S. statutoryfinancial statements when contemplatingtheir use for analysis.
State-Specific PrescribedPractices Hamper ComparabilityAn insurer may be licensed in many, ifnot all, U.S. states, but is generallydomiciled in one state that is respon-sible for regulating the entity. State-spe-cific prescribed accounting practicesremain largely consistent over time andgenerally don’t change unless newSSAPs are adopted or new or amendedstate law is passed. Our review of
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 33
Health (16%)
Life (21%)
Property &casualty (63%)
Chart 1 | Prescribed Practices By Sector In 2013
Note: We used U.S. statutory data from National Association of Insurance
Commissioners’ (NAIC) InfoPro database, which may exclude certain
U.S. statutory data that are not submitted to the NAIC, or not submitted
in annual statement form.
© Standard & Poor’s 2014.
180102030405060708090
100
(%)
2013 2003
Health Life Property & casualty
Chart 2 | Change In Permitted Practices, By Sector*
*Number of companies that recorded permitted practices in their 2013 and 2003 statutory financial statements.
We used U.S. statutory data from the National Association of Insurance Commissioners’ (NAIC) InfoPro database,
which may exclude certain U.S. statutory data that are not submitted to the NAIC, or not submitted in annual
statement form.
© Standard & Poor’s 2014.
31
16
163
38
54
NAIC financial data from insurancecompany fil ings indicated that 316companies—including some of thelargest U.S. insurance companies intheir respective sectors—filed annualstatements in 2013 in which a pre-scribed accounting practice had animpact on their reported net income orsurplus. Nearly two-thirds of the enti-ties that utilized prescribed accountingpractices were property and casualtyinsurers (see chart 1).
Because prescribed practices arestate-specific, we also broke out the databy state (see table 1). To gain furtherinsight into what types of prescribedpractices are in use, we took an in-depthlook at the two states with the largestvolumes, Vermont and New York.
In Vermont, most of the prescribedpractices relate to risk-retention groups,which are group self-insurance plans orgroup captives formed to increase theaffordability and availability of commer-cial liability insurance. The Liability Risk
Retention Act (LRRA) addresses regula-tion of risk retention groups at a federallevel, but states still vary in their viewand regulation of these groups. Forexample, the NAIC notes three pre-scribed practices for Vermont in its 2013“States’ Prescribed Differences from NAIC
Statutory Accounting Principles” guide, oneof which allows risk retention groups toreport under GAAP as opposed to SSAP.The varying regulatory treatment andpractices of risk retention groups was thetopic of a 2011 study by the U.S.Government Accountability Office (“Risk
Retention Groups: Clarifications Could
Facilitate States’ Implementation of the
Liability Risk Retention Act”). The reportnoted, “Evidence suggests that riskretention groups may choose to domi-cile in a particular state, partly due tosome financial and regulatory advan-tages such as lower minimum capital-ization requirements”—a statement thatmay explain the variations in prescribedpractices we observed.
In New York, the NAIC’s guide noted23 prescribed practices for which NewYork law overrides the SSAPs. In ourdata set, one of the most common pre-scribed practices specific to propertyand casualty insurers related to creditprovided under New York Regulation 20,which allows certain offsets to the provi-sion for reinsurance (companies usingthis practice will report a higher surplusthan companies that do not).
The nature of adjustments related toprescribed practices varies, with theimpact to reported surplus potentiallybeing significant. A comprehensiveunderstanding of these practices,including any effects on financial state-ment line items and overall surplus, willbe critical to financial analysis.
Permitted Practices Increased Significantly Over The Past DecadePermitted practices, while allowedunder SSAPs, were expected by the
34 www.creditweek.com
SPECIAL REPORTFEATURES
State Company name Reported surplus ($) NAIC surplus ($) Difference ($) Change (%)
Arizona Phoenix Health Plans Inc. 13,121,807 393,671,346 (380,549,539) (96.7)
Prescribed and/or permitted practice: Decrease generally relates to invested assets that exceeded Arizona prescribed limits, and as such were nonadmitted.
Arkansas American Service Life Insurance Co. 763,008 3,932,013 (3,169,005) (80.6)
Prescribed and/or permitted practice: A life insurer’s investment in an affiliated company is limited to 5% of the insurer’s admitted assets under Arkansas law. As such, the excess value is nonadmitted.
Florida Florida True Health Inc. 3,339,309 14,261,499 (10,922,190) (76.6)
Prescribed and/or permitted practice: Florida requires insurers to nonadmit investment in affiliate and electronic data processing equipment and software asset balances, which would be admitted under NAIC SSAP.
Texas Cass County Life Insurance Co. 344,397 616,923 (272,526) (44.2)
Prescribed and/or permitted practice: Texas requires insurers to nonadmit the value of equity investments that exceed 15% of capital and surplus. If theaggregate amount of investments rated NAIC 6 exceed 1% of total assets, these balances are also nonadmitted.
Missouri Shelter Mutual Insurance Co. 1,556,904,068 1,647,334,054 (90,429,986) (5.5)
Prescribed and/or permitted practice: Company cars are admitted assets under Missouri prescribed practices, whereas they are nonadmitted under NAIC SSAP. Missouri also allows companies to record reserves for earthquake and weather-related catastrophe losses as an underwriting deduction.
Texas American General Life Insurance Co. 12,656,146,118 12,750,666,174 (94,520,056) (0.7)
Prescribed and/or permitted practice: Decrease generally relates to recording higher reserves on its deferred annuity contracts in excess of the minimumstandard required under NAIC SSAP.
Tennessee BlueCross BlueShield Of Tennessee Inc. 1,676,610,734 1,683,434,567 (6,823,833) (0.4)
Prescribed and/or permitted practice: Decrease relates to prescribed limits on equity investments and nonadmitting assets with a rating by the NAIC SecuritiesValuation Office (SVO) of 4, 5, or 6.
We used U.S. statutory data from the National Association of Insurance Commissioners’ (NAIC) InfoPro database, which may exclude certain U.S. statutory data that are notsubmitted to the NAIC, or not submitted in annual statement form.
Table 4 | Companies Using Permitted And Prescribed Practices
NAIC to be limited. According to ourdata, the number of companies usingpermitted practices, which had animpact on their reported net income orsurplus, has more than doubled since2003, to 219 in 2013 from 101 in 2003,with most of the increase coming fromthe property and casualty sector (see
chart 2, and tables 2 and 3).Again, a key factor contributing to
the increase in permitted practicesbetween 2003 and 2013 were from riskretention groups. Most of Vermont’spermitted practices, as with its pre-scribed practices, relate to risk reten-tion groups. Nevada, South Carolina,and Washington, D.C., also have largeconcentrations of risk retention groups,which contribute to their high count ofpermitted practices. A majority of thesecompanies either did not exist or didnot obtain a permitted practice in 2003.While risk retention groups are a mainfactor for the increase in the pastdecade, the count of permitted prac-
tices in all remaining states are alsogenerally higher than their 2003 statis-tics, with permitted practices that varyin nature company-to-company.
Company-Specific AnalysisHighlights Various Practices, And The Dramatic Impact OnReported SurplusConsidering the uniqueness of pre-scribed and especially permitted prac-tices, and the effects they can have ona company’s reported surplus, we per-formed further analysis on a randomsample of companies that reported anincrease or decrease in surplus due toeither a prescribed or permitted prac-tice in 2013 (see table 4). We looked atthe surplus each insurer reported onits balance sheet as well as the surplusthe insurer would have reported if itwere in ful l compliance with theSSAPs (which we refer to as the NAICSurplus). We then calculated both thedollar and percentage change, which
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 35
State Company name Reported surplus ($) NAIC surplus ($) Difference ($) Change (%)
Maine MMG Insurance Co. 87,706,063 85,823,902 1,882,161 2.2
Prescribed and/or permitted practice: Increase generally relates to permitting the company-owned aircraft to be admitted as an asset, which would benonadmitted under NAIC SSAP.
New York Empire HealthChoice Assurance Inc. 1,711,878,986 1,667,942,862 43,936,124 2.6
Prescribed and/or permitted practice: Increase generally relates to admitting reinsurance recoverables, prepaid broker commissions, and overdue localgovernment premiums as assets, when under NAIC SSAP they would be nonadmitted assets.
New York American Home Assurance Co. 5,091,686,090 4,640,434,347 451,251,743 9.7
Prescribed and/or permitted practice: Increase relates to the prescribed allowance to discount nontabular workers compensation reserves and the creditprovided under NY SAP Regulation 20, which allows certain offsets to the provision for reinsurance.
Indiana Indiana Lumbermens Mutual Insurance Co. 19,093,763 9,886,723 9,207,040 93.1
Prescribed and/or permitted practice: Increase relates to permitting an investment in affiliate to be admitted as an asset without audited financial statements (a requirement under SSAP 97 in order to admit the asset).
Pennsylvania Excalibur Reinsurance Corp. 226,966 (34,246,019) 34,472,985 100.7
Prescribed and/or permitted practice: Several permitted practices related to admitting assets (settlement adjustments, promissory notes, parent indemnityagreements) which would be nonadmitted under NAIC SSAP. Prescribed discounting of reserves also contributed to the increase in surplus.
Texas Facility Insurance Corp. 91,665,566 (336,776,203) 428,441,769 127.2
Prescribed and/or permitted practice: Increase is mainly driven by the state allowance to account for a reinsurance transaction as prospective. The remainingincrease relates to discounting loss reserves and recording invested assets at fair value.
Delaware Ironshore Risk Retention Group Inc. 1,015,357 37,001 978,356 2,644.1
Prescribed and/or permitted practice: In Delaware (consistent with certain other states) risk retention groups can prepare financial statements in accordance with GAAP as opposed to SSAP. Delaware also allows letters of credit to be recorded as admitted assets.
Table 4 | Companies Using Permitted And Prescribed Practices (continued)
ranged—in both direct ions—fromminimal (less than 1%) to massive (inone case, more than 2,600%). Thenature of the prescribed or permittedpractices was similarly varied.
Although this random sample maynot be representative of the entirepopulation, i t helps i l lustrate howmuch permitted or prescribed prac-tices can affect an insurer’s reportedstatutory surplus and how they canessentially create company-specificaccounting regimes.
Equally concerning is the lack ofguidelines or restrictions related topermitted practices and the lack ofcomparability with those of peer com-panies. The respective domiciliarystate and commissioner have full dis-cret ion to g rant or refuse suchrequests and do not require permis-sion from any other group or regula-tory body. Further complicating mat-ters is the fact that permitted practicescan change every year. So, while manycompanies reported no prescribed orper mitted pract ices in their 2013statutory financial statements, thatdoes not mean they will not next year,or have not in prior years. Insurers arerequired to disclose their prescribed orpermitted practices, but putting allcompanies on the same accountingplat for m could be a tedious andmanual task.
We also observed that most per-mitted and prescr ibed pract icesappear to increase the reported sur-plus for insurance companies. Ourdata indicated that the use of pre-scr ibed or per mitted pract icesincreased the reported surplus formore than twice the number of com-panies than it lowered. As such, cer-tain companies with a permitted orprescribed practice could be perceived
as having a stronger capital positionthan other companies purely due todifferences in their accounting. Thispoint underscores the fact that finan-cial-statement users will need to lookpast the face of the financial state-ments to understand what thereported surplus actually reflects.
We Consider The Effect Of Prescribed And PermittedAccounting Practices In Credit AnalysisWhen performing our credit analysisof an insurer, we are mindful of stateprescribed and permitted practicesunder U.S. statutory accounting. Whenusing our proprietary statutory capitalmodel for rat ings, we rely on aninsurer’s statutor y f inancial state-ments, and thus default to theaccounting practice of the state ofdomicile. However, we may make ana-lyt ical adjustments in our capita lassessments as necessary, and high-light material adjustments in our ana-lytical report for an insurance com-pany. Even if we do not make suchadjustments in our analysis, we fre-quently address material permittedpractices in our insurance company-specific reports. CW
36 www.creditweek.com
SPECIAL REPORTFEATURES
Equally concerning is the lack of guidelines or
restrictions related to permitted practices and the
lack of comparability with those of peer companies.
Analytical Contacts:
David B. Chan, CPANew York (1) 212-438-7313
Michael E. GrossSan Francisco (1) 415-371-5003
Jonathan Nus, CPANew York (1) 212-438-3471
Joyce T. Joseph, CPANew York (1) 212-438-1217
Vesna M. NaidooNew York (1) 212-438-8554
For more articles on this topic search RatingsDirect with keyword:
Accounting
EDITOR’S NOTE: The opinions stated hereinrepresent Standard & Poor’s Ratings Services’view on the potential effect of IFRS 11 JointArrangements. Our comments do not affect ourratings criteria.
Significant changes to InternationalFinancial Reporting Standards (IFRS)have caused f luctuations in key
financial statement line items and metricsfor some companies in Europe, MiddleEast, and Africa (EMEA). The introductionof IFRS 11, “Joint Arrangements,” by theInternational Accounting Standards Board(IASB) aims to better reflect the underlyingeconomic substance of joint arrangementsin the respective owning companies’ finan-cial statements.
EMEA Corporates Remove $14 Billion Of DebtBecause Of New IFRS Joint Venture Accounting
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 37
Overview● The initial application of IFRS 11
removed $73 billion of assets and
$14 billion of debt from the largest
EMEA corporates’ balance sheets.
It has also resulted in significant
changes in some key financial
statement lines and metrics. ● Credit metrics (such as cash flow
leverage ratios) may have been
negatively affected by the new
accounting. However, we do not
expect any changes in our
corporate credit ratings as a direct
consequence of such changes, as
change in financial reporting on
its own is unlikely to affect
companies’ credit quality. ● We believe the elimination of pro-
portionate consolidation enhances
comparability and consistency not
only across IFRS reporters but also
at a global level. However, it does
not eliminate the need for our case-
by-case assessment to apply ana-
lytical adjustments. Our analytical
treatment may revert to gross
reporting of joint arrangements
when we believe such presentation
better depicts the underlying eco-
nomics of the business.
We consider that the new standard hadvarying effects on owning companies’financial metrics. However, in general, thecompanies’ share of the joint arrange-ments’ fixed and current assets and debtthat appear as separate gross amounts inthese consolidated financial statementscould now appear on a one-line (net)basis. Measures such as earnings beforeinterest, taxes, depreciation, and amorti-zation (EBITDA) and cash f low fromoperations may see some variability.
Standard & Poor’s Ratings Servicesdoesn’t expect to change its corporatecredit ratings because the new joint
arrangement accounting standard isunlikely to affect the underlying creditquality of companies owning joint arrange-ments. Nonetheless, enhanced disclosures,such as those provided under newaccounting standards, could provide addi-tional insight on potential risks that we con-sider in our analysis. We remain focused onany changes in business behavior andrelated risks because these could affect ourview of a company’s creditworthiness.
Last year, we published a commentaryon IFRS 11, including an impact analysison the 20 largest IFRS reporters that werate in the metals and mining and oil and
38 www.creditweek.com
SPECIAL REPORTFEATURES
(60) (50) (40) (30) (20) (10) 0
Fixed assets
Current assets
Debt
Operating profit
EBITDA
Cash flow from operations
Chart 1 | IFRS 11 Impact On Key Reporting Measures On EMEA’s Largest Entities (Bil. US$)
© Standard & Poor’s 2014.
(60) (50) (40) (30) (20) (10) 0
Fixed assets
Current assets
Debt
Operating profit
EBITDA
Cash flow from operations
(%)
Chart 2 | IFRS Impact On Key Reporting Measures For Previous Proportionate Consolidation Users
© Standard & Poor’s 2014.
gas sectors across EMEA and Asia-Pacific.Because of the increased attention frommarket participants on this topic, we haveextended our research to assess the effecton the 50 largest nonfinancial companies inEMEA for which we issue credit ratings.
The commentary explains the keychanges to the accounting rules and howthose changes may affect financial state-ments analysis (see the Appendix and “How
New Accounting For Joint Business Ventures
Will Affect Financial Statements Analysis,”
published July 29, 2013, on RatingsDirect).
Some Companies ShowSignificant Declines In ReportedDebt Balances And ReducedProfitability MeasuresOur updated study assesses the impact ofthe initial adoption of IFRS 11 on thelargest (by revenues) 50 nonfinancial com-
panies in EMEA for which we issue creditratings. Our sample included public andconfidential ratings from all industrial sec-tors. In our study of impact analysis, weused the restated figures reported by eachcompany in its latest annual or interimfinancial information for periods endingbetween June 30, 2013, and Aug. 29, 2014.
Nine companies in our samplereported material impact on adoption ofIFRS 11. We considered the effect to bematerial when the company reported itto be material (or significant) or whenthe disclosed transitional reconciliationshowed fluctuation over 2% in any oneof the following financial metrics: cashflow from operations, EBITDA, oper-ating profit, debt, current assets, or fixedassets. All figures used in the study areas reported by the companies in theirlatest financial information and exclude
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 39
(4) (3) (2) (1) 0 1 2 3 4 5
Fixed assets
Current assets
Debt
Operating profit
EBITDA
Cash flow from operations
(%)
Chart 3 | IFRS 11 Impact On Key Reporting Measures For Companies Moving To Gross Reporting
© Standard & Poor’s 2014.
© Standard & Poor’s 2014.
Chart 4 | Classification And Accounting Under IFRS 11
Classification:(based on the investor’srights and obligationsin relation to thejoint arrangement
Unstructuredarrangements
Accounting Assets, liabilities, revenues, and expenses
Equity methodof accounting
Joint operation
Joint venture
Structured arrangements
Evaluate the effect of thelegal form AND the jointcontractual agreement’s
terms and conditionsAND other relevant
facts and circumstances
40 www.creditweek.com
SPECIAL REPORTFEATURES
all of our potentially relevant analyticaladjustments (see Appendix).
Following delayed EU endorsement(effective Jan. 1, 2014), most EMEA com-panies have now also switched to IFRS 11.However, five large European companieshave yet to do so (see table 1). Of that group,three expect no material changes to theirreported figures, and we have no informa-tion on the likely effect for the other two asthey haven’t provided an impact analysis intheir latest financial statements or are stillassessing the effects IFRS 11 will have.One company prepares its financialreporting in accordance with U.S. generallyaccepted accounting principles (U.S.GAAP)—which is comparable to the newIFRS 11—and will continue to do so.
Of the nine companies that reportedmaterial changes, we observed a com-
bined decline in the key financial lineitems and metrics (see char t 1). Theoverall decline was a result of two mainreasons with opposite effect.
First, the elimination of proportionateconsolidation had a substantial negativeimpact on the reported figures. Seven com-panies that previously elected the propor-tionate consolidation method—and havenow transitioned to the equity method ofaccounting—essentially removed indi-vidual assets and liabilities and replacedthem with a net amount representing theinvestment in the joint arrangement.
This reduction was slightly counter-balanced by the increase in those twocompanies’ reported figures that wereapplying equity accounting, but foundthat the new standard now requires themto override the legal boundary of the
—Reported under IFRS 11— —Not yet reported under IFRS 11— Reports under U.S. GAAP
Material No material Material effect Material effect Effect effect effect likely unlikely unclear No impact
9 35 — 3 2 1
Table 1 | The Likely Effect Of IFRS 11 On The Financial Metrics Of The Top 50 Largest Corporations In EMEA
Potentially significant effect on the financial statements Potentially minimal effect on the financial statements
Structured arrangements classified as Unstructured arrangements classified as joint operations joint operations
Proportionately consolidated structured Equity accounted structured arrangements arrangements classified as joint ventures classified as joint ventures
Table 3 | Effects Of Classification Under IFRS 11 Of Financial Statements
—Debt/EBITDA— —Cash flow from operations/debt—
Previously Previouslyreported (x) Restated (x) reported (%) Restated (%)
Company 1 1.2 1.2 73 72
Company 2 2.6 2.6 29 29
Company 3 1.2 1.2 58 60
Company 4 21.6 21.8 (10) (10)
Company 5 3 3 18 18
Company 6 1.1 1.3 52 53
Company 7 1.5 1.6 37 31
Company 8 1.3 1.3 72 72
Company 9 2.7 4.5 30 17
*The table shows one core (debt/EBITDA) and one supplementary (cash flow from operations/debt) credit payback ratio for those nine corporates that reported material changes as a result of adopting IFRS 11. The ratios were calculated by using the companies’ restated reported figures and do not include our usual analytical adjustments, due to the lack of publicly available information at this stage of the reporting cycle.
Table 2 | Hypothetical Credit Payback Ratios Based On Reported Figures*
joint arrangement and report assets andliabilities separately, i.e., a gross method.These companies increased theirreported fixed and current assets alongwith the respective share of the jointarrangement’s debt.
While most of the financial statementlines or metrics decreased by less than5%, some companies experienced muchlarger declines. We observed a fall of $13billion (an average of 10%) in the com-bined reported EBITDA and $7 billion (anaverage of 9%) in the combined reportedcash flow from operations (see chart 2).
The impact on the balance sheet iseven more remarkable. The new presen-tation wiped off $61 billion worth of fixedassets, $16 billion of current assets, andapproximately $15 billion of reporteddebt from the combined consolidated
position. The net balance sheet positionof these arrangements is now collapsedinto a single line on the balance sheet andreported as an investment.
Overriding the legal structure and, there-fore, changing from equity accounting toreporting individual assets and liabilitieshad an opposite impact on the reported fig-ures. Two companies collectively increasedreported debt by approximately $500 mil-lion and fixed assets by over $5 billion as aconsequence of gross reporting. They alsorestated EBITDA and cash flow from oper-ations measures, although the changeswere relatively small (see chart 3).
Credit Metrics May Have Been Negatively AffectedAlthough the figures show large changes,leverage metrics were not materially
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 41
The New Accounting Standard Shifts Focus From A Joint
Arrangement’s Legal Structure To Its Investors’ Rights And
Obligations
There are various ways an investor can participate in its
investee’s decision-making process. When such participation is
contractually shared and requires unanimous consent from
other investors, joint control exists between those investors. In
our analysis, we believe that the transition to IFRS 11 is
unlikely to affect investors’ joint control such that the arrange-
ment becomes an associate or a subsidiary of one investor.
The new accounting standard brings about two changes
that we believe will have significant ramifications for some
financial statements. In two situations, however, these
changes will have minimal effect (see table 3).
The first change that we consider will have a significant
effect is that now a separately structured arrangement’s legal
form is no longer the single most important factor in its classi-
fication. The new standard specifies that the joint contractual
agreement’s terms and conditions, and other relevant facts
and circumstances such as the joint arrangement’s design or
purpose should also be taken into account. These considera-
tions may override the arrangement’s legal form in deter-
mining the joint arrangement’s classification.
IRFS 11 allows for two types of joint arrangement—joint
operations and joint ventures. Specifically, when an investor
in a joint arrangement has rights to the arrangement’s assets
and obligations for its liabilities, it is party to a joint operation,
and when it has rights to the arrangement’s net assets, it is
party to a joint venture (see chart 4). The accounting method
depends on this new classification. Joint operations are
accounted for as if the investor conducts the operation itself,
that is, recognizing the assets and revenues it controls and the
liabilities and expenses it incurs. Joint ventures are accounted
for in the owning company’s consolidated accounts using the
equity method.
The elimination of proportionate consolidation as an
accounting policy choice for joint ventures is the second sig-
nificant change that IFRS 11 brings about (see table 3). All
joint ventures must now be accounted for in the owning com-
pany’s financial statements using equity accounting. This will
affect these companies’ financial statements and, conse-
quently, their financial metrics.
Of the two situations where we do not expect to see signifi-
cant repercussions for financial statements, the first is where
there is no legal separation between investors and their joint
arrangements—for example, in the case of jointly controlled
assets or operations—the investors must have rights to the
arrangement’s assets and obligations for its liabilities. The
new standard classifies these unstructured arrangements as
joint operations. Investors’ income statements, balance
sheets, and cash flow statements will still report shares of the
joint operation’s assets, liabilities, revenues, and expenses and
operating cash flows. In the second, the owning company
applies equity accounting for its structured arrangement and
will not override the legal form when reassessing the classifi-
cation under IFRS 11.
Overview of the accounting change Excerpted from “How New Accounting For Joint Business Ventures Will Affect Financial Statements Analysis,”published July 29, 2013.
affected on all the companies we studied.In general, credit payback ratios couldimprove or deteriorate, depending onwhether the joint arrangement is over- orunder-leveraged compared to the rest ofthe consolidated group (see table 2).
Although we base our rating assess-ment on our adjusted figures, the tableshows that, generally, these metricswere not significantly affected, save forCompany 9. We do not expect anychanges in our corporate credit ratingsas a result of applying a newaccounting standard because financialreporting is unlikely to affect compa-nies’ under lying credit quality.Accounting changes do not influencethe economics of the joint arrange-ments or the consolidating companies’under lying cash f lows. We focusinstead on any changes in businessbehavior and related risks, as theserisks could affect our view of a com-pany’s creditworthiness.
Pro Rata Consolidation RemainsA Useful Tool In Analyzing JointVenture InvestmentsWe believe some benefits follow from theabolition of proportionate consolidation,consistency, and comparability amongIFRS reporters improve when accountingchoices are eliminated. Furthermore, theaccounting for joint ventures was animportant difference between IFRS andU.S. GAAP, and the new standard elimi-nates this difference. We believe the con-
vergence should, therefore, improve com-parability on a global level, but we mayrevert to such gross reporting as part ofour analytical procedures.
Pro rata (or even full) consolidationmay be appropriate if we believe currentnet reporting does not appropriatelyreflect the relationship between the jointarrangement and its corporate investors.One such example is the case ofEverything Everywhere Ltd. (EE), which isa key joint venture of Deutsche TelekomAG (BBB+/Stable/A-2). DeutscheTelekom AG accounts for EE by using theequity method of ac counting (i.e., net);however, we apply analytical pro-rata con-solidation because we believe the associ-ated risks are better captured in a grossway (see “Deutsche Telekom AG,” published
June 30, 2014). We often make similar ana-lytical adjustments to issuers in the U.S.real estate and health care sectors (see
“Key Credit Factors For The Homebuilder
And Real Estate Developer Industry,” pub-
lished Feb. 3, 2014, and “How Standard &
Poor’s Evaluates U.S. Health Care Service
Companies That Invest In Joint Ventures,”
published Oct. 20, 2011).Proportionate consolidation of joint
arrangements is not, however, the bestanalytical treatment in all cases. When acompany is exposed to potentially non-recourse debt in relation to its jointarrangement, we may simply add that tothe company’s reported debt figure. Forexample, in accordance with IFRS 11,corporates may achieve net reporting of
joint ventures and, therefore, excludetheir share of the joint arrangement’sdebt even if they are exposed to suchdebt. Gross reporting is only requiredwhen the company is exposed to thejoint arrangement’s obligations and alsohas rights (or direct access) to the jointarrangement’s assets. Any company,therefore, that is responsible for debt buthas no such direct rights to the assetswould need to revert to net reportingand exclude any share of the debt fromits consolidated reported debt figure.This may lead to inappropriate depictionof the underlying economics. In suchcases, increasing a company’s debtburden by the respective nonrecoursedebt likely will be justified in ouradjusted financial metrics.
In other cases, financial statement users’application of pro rata consolidation as ananalytical treatment is inherentlyunachievable because of the lack of pub-licly available and sufficient information. Insuch cases, we then aim to reflect the com-pany’s exposure to its joint venture qualita-tively in our credit rating analysis.
When companies change their jointarrangement accounting and presenta-tion from the equity method and nowshow separate assets and liabilities,along with increased performance andcash f low measures, we are likely toaccept such accounting in our analyt-ical treatment. This is because webelieve overriding an arrangement’slegal form under IFRS 11 better reflectseconomic substance in a company’sfinancial statements.
No matter the financial reportingchanges from the new standard, wewill continue reviewing each issuerindividually to assess whether its rela-tionship with its affiliates necessitatesanalytical adjustments. CW
Analytical Contacts:
Imre GubaLondon (44) 20-7176-3849
Sam C. Holland, ACALondon (44) 20-7176-3779
Joyce T. Joseph, CPANew York (1) 212-438-1217
42 www.creditweek.com
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Method of calculating financial metrics:● We translated the restated data based on the same foreign exchange rate that
was applicable for the restatement period as applied on our Global Credit Portal.● Companies may have transitioned at different periods. Our study focuses on
transitional balance sheets and immediate periods following that balance sheet
date. Some companies have yet to present full-financial-year results. When only
a six-month period was presented, we multiplied the respective performance
and cash flow measures to achieve comparability on an annual basis.● All figures used in the tables are reported figures and, therefore, exclude our
analytical adjustments.● The quantified impact of the IFRS 11 transition may also include the impact
arising from the first time application of IFRS 10, “Consolidated Financial
Statements,” when only the combined effect was publicly reported.
Appendix
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Accounting
Until recently, the accounting project aimed at bringing all
leases onto company balance sheets was a prime
example of the International Accounting Standards
Board (IASB) and Financial Accounting Standards Board (FASB)
working together to produce a unified global accounting
solution. Unfortunately, during their recent deliberations
following the comments received in response to the 2013
Exposure Draft, the two boards diverged in several key areas.
With IASB And FASB LeaseAccounting Likely To Diverge,Disclosures Will Be Critical
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 43
With the Boards unlikely to reverse thesedevelopments, future lease accounting willbecome less converged than the current,broadly aligned, accounting treatment.Certain leases will still remain off balancesheet; and inconsistencies will exist withineach individual accounting regime.Standard & Poor’s Ratings Services believesthese challenges require the developmentof a comprehensive lease disclosurepackage. We prefer the IASB’s proposedlease accounting approach, and we suggestdisclosures that should help investors andother financial statement users analyzeleases under the respective accountingregimes and bridge the gap between thesetwo diverging accounting proposals.
All Is Not Lost—At Least (Almost)All Leases Will Now Be OnBalance SheetThe two boards are rightly keen to stressthat they are still aligned regarding the mainobjective of the lease accounting project—to bring operating leases on balance sheet.We fully support this proposed changebecause we have long held that the currentaccounting distinction between operatingleases (reflected in financial statements on apay-as-you go basis) and finance/capitalleases (accounted for in a manner similar toa debt-financed acquisition of an asset) issubstantially artificial. Under both types ofleases, the lessee contracts for the use of anasset and enters into a financing arrange-ment. As a result, we adjust reportedamounts to eliminate the operating orfinance lease distinction by capitalizing leaseobligations that corporate issuers accountfor as operating leases. We principally adjustby capitalizing the net present value of dis-closed future minimum lease payment com-mitments and by adjusting profitability andcash-flow measures used in our analysis toreflect our view of the financing nature ofthis activity (see “Corporate Methodology:
Ratios And Adjustments,” published Nov. 19,
2013, on RatingsDirect). Therefore, we viewthis proposed change as a significantimprovement in lease accounting.
The unfortunate exception to this generalimprovement is that certain leases willremain off balance sheet under both boards’proposed new accounting. Moreover, whatis off balance sheet may be different for
FASB and IASB reporters, and sometimesinconsistent within these reporting popula-tions. Both boards are proposing an exemp-tion for short-term leases (12 months orless). While recognizing that they’re offeringthis exemption as a practical relief for com-panies, we find it unhelpful, and not justbecause we prefer the technical purity ofhaving absolutely all leases on balancesheet. It is also problematic because theexemption is being offered as an option—i.e.,some companies will include a liability forshort-term leases and others will exclude it.That will compromise comparability.
Complicating matters further, the IASBalone is proposing to provide a separateexemption for leases of large volumes ofsmall assets (such as laptops and officefurniture). We believe this accounting dif-ference between International FinancialReporting Standards (IFRS) and U.S.Generally Accepted Accounting Principles(GAAP), as well as potentially allowingcompanies an option to apply the exemp-tion, will make comparisons between dif-ferent companies more challenging. Ourcredit ratings are relative, and ourapproach to financial statement analysis iscomparative. The comparability of finan-cial information between issuers is criticalto facilitating this analysis.
Why The IASB’s Approach Is PreferableThe most significant area of divergencebetween the two boards is in the wayleasing transactions will be presented incompanies’ income statements andstatements of cash flows. In response tofeedback from us and other users offinancial statements to the 2013 LeasesExposure Draft, the IASB decided toabandon the previous proposal to havetwo dif ferent types of treatment forleases (see “FASB/IASB Leases Proposal
Falls Short of Expectations,” published
Sept. 19, 2013). The IASB proposal is nowin line with our recommendation: Asingle approach to income statementattribution and cash flow classification,with the lease expense in the incomestatement split between amortization ofthe right-of-use asset and interestexpense, and with the cash paid splitbetween cash paid relating to principal
and interest amounts of the lease lia-bility. We support this proposal becausewe view all leases as a form of financing,and we believe the balance sheet,income statement, and statement ofcash flows should all present leases asfinancing transactions.
The FASB also modified its proposalfor the income statement and statementof cash flows. While still having two dif-ferent types of lease accounting, the splitbetween those methods will now bebased on the existing operating leaseversus finance lease distinction. Financeleases will be accounted for in theincome statement and statement of cashf lows as described earlier under theIASB’s proposed method. However,operating leases will continue to bereflected in the income statement as asingle expense on a straight-line basis,with the cash paid for lease paymentsaccounted for as a single operating cashflow in the statement of cash flows.
We believe having two different cate-gories of leases for the income statementand statement of cash flows will createunnecessary accounting complexity. Theincome statement and statement of cashflows treatment of operating leases willnot reflect our view of operating leasesas financing transactions, and is inconsis-tent with their proposed treatment on thebalance sheet as financing transactions.Having identical transactions accountedfor differently in the income statementand statement of cash flows by IFRS andU.S. GAAP reporting companies will notaid global peer analysis.
No Single Amount Can Capture The Economic Reality Of Lease ArrangementsComprehensive lease disclosures are acritical facet in financial statement users’ability to understand the risks and uncer-tainties related to lease arrangements.Regardless of the lease accounting onthe balance sheet, no single amount canprovide a complete picture of the eco-nomics of these arrangements. Manylease transactions are complex and com-monly include options, guarantees, andother contingent features. Some leasesmay be contingent on other financial
44 www.creditweek.com
SPECIAL REPORTFEATURES
statement items (e.g., revenue); othersare contingent on variables that seldomare disclosed (e.g., performance or usageof an asset). Moreover, lease transac-tions have traditionally been—and likelywill remain, under the proposals—struc-tured to achieve a desired economic andaccounting result. For these reasons, it isimperative the boards develop areporting package that provides financialstatement users with more robust insightinto the amounts, timing, and uncer-tainty of cash flows arising from leases.
In addition to the boards’ proposedquantitative and qualitative disclosures,we believe financial statement users willbenefit from the following information,which we would prefer to see as tables:● An expected realistic range of future
cash outf lows related to all leases(short- and long-term aggregated bymajor lease type), taking into accountmanagement’s expectations for renewaloptions and variable lease payments;
● Historical minimum cash rent pay-ments over the periods presented;
● Historical variable cash rent paymentsover the periods presented;
● Weighted average lease terms; and● Weighted average discount rate used
(and inflation rate assumptions).An expected realistic range of cash
outflows related to leases should be dis-closed because lease commitments arejust the starting point, not an end game.
Because lease transactions could bestructured in many ways with variouscontingent features, it would help if leasedisclosures include a range of plausiblecash outflow scenarios (aggregated bymajor lease type), along with the min-imum lease commitments and theamounts recorded on the balance sheet.These possible scenarios should betreated similarly to other contingenciesand take into account expected optionrenewals and variable lease payments.This would provide financial statementusers with greater insight about theextent to which cash flows could mean-ingfully change from minimum leasecommitments and allow users to con-duct more informed scenario analysis.
Historical minimum and variable cashpayments are relevant for understanding
business prospects. Both minimum andvariable cash rent payments should bedisclosed over the periods presented infinancial statements. This informationprovides important insight about thenature of lease expense and allowsfinancial statement users to better fore-cast these commitments in the contextof a company’s business plans andstrategy. For example, if projectedgrowth or revenue depends on the cash-generating ability of a leased asset, dis-closure of the nature of lease expense isimportant for projecting more accu-rately expected margins and earnings. Itwould also help if companies includenarrative disclosure if they expect toshift from fixed payment leases to thoseon a variable basis.
Disclosure of lease terms providesuseful information for peer comparisons.Companies can have dramatically dif-ferent lease profiles relative to theirpeers. Therefore, to identify companieswith significant short- or long-term leasecontracts and enable straightforwardpeer comparison, disclosure of theweighted-average remaining lease termwould be useful.
Disclosure of the assumptions used,such as the discount rate, is relevant andmeaningful. We believe informationabout the underlying assumptions usedis important for analysis. Some financialstatement users may want to derivetheir own computation of lease liabili-ties—e.g., including variable rents andpayments expected in additionalrenewal periods—using a present valueapproach. Disclosure of key assump-tions used would help refine analysis.
Financial Statement Users Will Still Need To Bridge The GAAP, AndDisclosures Must Enable ThisIf the two boards continue on this path,with different income statement treat-ments for a large number of leases,financial statement users will at thevery least require disclosures enablingthem to make their analytical adjust-ments to bridge the differences. For us,it will be most important for the FASBto mandate that U.S. GAAP companies
provide disclosures that let us makeadjustments for operating leases so ouranalytically adjusted income statementand cash flow metrics will reflect thosetransactions as if they were accountedfor similar to the IASB model. This willrequire quantification of the straight-line lease expense and the associatedliability and weighted-average discountrate, allowing us to estimate how thesplit of the straight-line expense toamortization and interest componentswould look under IFRS.
What Is Worse, Accounting ThatIs Flawed But Converged, OrImproved But Diverged?Many commentators are extremely dis-appointed that the two boards are likelyto arrive at dif ferent answers to theaccounting for leases. Some questionwhether the overall future position willbe worse than the status quo. Yes, havingmore leases on balance sheet is animprovement, but will that be more thanoutweighed by diminished global com-parability on the income statement andstatement of cash flows?
We do not subscribe to this view.Overall, the lease project will be a forcefor good by increasing awareness ofcompanies’ underlying lease leverage.As long as the boards take the opportu-nities available on disclosures, the resultshould be significantly enhanced trans-parency about the nature of companies’lease arrangements and, importantly,the resulting range of potential cashflows. However, it is imperative that theboards mandate sufficient disclosures sothat users of financial statements canmake analytical adjustments to recon-cile the different approaches. The solu-tions will end up divergent, but theymust be bridgeable. CW
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 45
Analytical Contacts:
Sam C. Holland, ACALondon (44) 20-7176-3779
Joyce T. Joseph, CPANew York (1) 212-438-1217
Jonathan Nus, CPANew York (1) 212-438-3471
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Accounting
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FEATURES
In February 2014, the European Securities & Markets
Authority (ESMA) published a consultation paper, “ESMA
Guidelines on Alternative Performance Measures,” which
included several proposed guidelines aiming to improve
transparency, neutrality, and comparability of alternative
performance measures (APMs) for Europe-based companies.
Standard & Poor’s Ratings Services believes that, if finalized, the
paper’s draft guidelines will improve issuers’ communication
about how they manage their businesses, foster comparability
and unbiased financial information, and better enable financial-
statement users to understand APMs. In certain important
respects—such as requiring an explanation of the use of APMs
and reconciliation between the APM and the most comparable
financial statement measure—the proposals are helpfully aligned
with the SEC’s regulations governing the use of non-GAAP
(generally accepted accounting principles) measures in the U.S.
Taming AmbiguityRegulators Take The Initiative To ClarifyAlternative Performance Measures
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 47
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SPECIAL REPORTFEATURES
We have long made the case that how com-panies report APMs—e.g., “adjusted profit”or “underlying profit”—can be extremelymisleading. Unlike the audited figures pre-pared under accounting frameworks suchas International Financial ReportingStandards (IFRS) and U.S. GAAP, which arecalculated following certain rules andbroadly comparable, companies can cur-rently define APMs any way they want. In arecent study of the FTSE 100 corporates,we found that 21 companies excludedrestructuring charges from their measure ofunderlying earnings (or other adjusted profitmeasures), despite having restructuringcharges in each of the past four years offinancial reporting (see “Why Inconsistent
Reporting Of Exceptional Items Can Cloud
Underlying Profitability Results At Nonfinancial
FTSE 100 Companies,” published Feb. 18,
2014, on RatingsDirect). For this reason, westrongly support regulators’ recent efforts todevelop better guidance in this area. Still, inour opinion, they can do more to bring thishighly subjective area of financial reportingunder control. ESMA’s main February 2014proposals require that issuers should:● Explain the use of APMs;● Disclose a reconciliation of an APM to
the most relevant amount presented inthe financial statements;
● Disclose in an appendix to the publi-cation definitions of all APMs used;
● Give less prominence, emphasis, orauthority to APMs presented outsidefinancial statements than measuresdirectly stemming from financial state-ments prepared in accordance with theapplicable financial reporting framework;
● Explain the reasons for changing the defi-nition and/or calculation of an APM;
● Provide comparatives and/or restate-ments when an APM changes; and
● Provide explanations when a companyno longer uses an APM.For our detailed views on the consul-
tation paper, see “Standard & Poor’s
Ratings Ser vices Responds To ESMA
Guidelines On Alternative Performance
Measures,” published May 16, 2014.We welcome ESMA’s efforts to improve
transparency, neutrality, and comparabilityof APMs, but we believe the guidelinescould go further to achieve these aims. Webelieve in addition to providing a reconcili-
ation of an APM to the most relevantamount presented in the financial state-ments, it is also vital that companiesexplain why management deems it appro-priate to remove (or include) each recon-ciling item to derive the APM. For example,if management excludes the amortizationof acquired intangible assets from theissuer’s adjusted operating profit figure, wewant to know why it believes excluding thisitem gives a more relevant depiction of thebusiness performance. In our view, theexplanations provided should not be boiler-plate but instead should be tailored to thenature of the issuer’s business and themanner which management deems appli-cable to understanding its business.
We commented that the finalized guide-lines should include standardized defini-tions for commonly used APMs, such asEBITDA. This would enhance consistencyand comparability and discourage thepotential inappropriate use of APMs.
Commentators Broadly Support Action, But VoiceCommon ConcernsA review of the comment letter responsesfiled on ESMA’s Web site indicates generalsupport for some degree of additional reg-ulatory action on APMs. However, nationalstandard setters, issuers, accounting firms,and other market constituents raisedseveral common concerns. These aresummarized below:● The scope of application is too broad: The
guidelines appear to apply to any docu-ments including regulated information(such as analyst presentations, brochures,investor-day material) that national regula-tors currently do not review.
● The definition of an APM is too wide:The guidelines might capture toomany measures in a company’sannual report. Some commenterssuggested a tighter definition thatmore explicitly addresses financialperformance measures.
● The requirement for APMs to be dis-played with less prominence is widelyunpopular, with commentators believingequal prominence should be acceptable.
● Several raised concerns that the pro-posed guidelines will lead to a prescrip-tive, compliance-based approach that
will be overly burdensome and couldlead to more boilerplate disclosures.
● Others suggested that ESMA needs toarticulate more clearly what is wrongwith the current regulatory guidelineson APMs (including guidelines issuedby its predecessor organization, theCommittee of European SecuritiesRegulators) and provide more empir-ical evidence illustrating the problem.
Could ESMA Go Further OnAlternative Profit Measures?In our comment letter to ESMA, we statedour approval for the steps the U.K. regu-lator, the Financial Reporting Council, tookin November 2013. It made various recom-mendations concerning the reporting ofexceptional items that companies excludefrom their APMs, perhaps the most impor-tant subset of alternative performancemeasures. These recommendations gobeyond ESMA’s proposals. We believefinancial statement users across Europewould benefit from issuers applying theserecommendations. Therefore, we wouldsupport ESMA developing similar aspectsas part of its final guidelines, expected tobe published during 2014’s fourth quarter.The recommendations include:● The approach taken in identifying
additional items that qualify for sepa-rate presentation should be even-handed between gains and losses,clearly disclosed, and applied consis-tently from one year to the next.
● Where the same category of materialitems recurs each year and in similaramounts (e.g., restructuring costs), com-panies should consider whether suchamounts should be included as part ofthe underlying profit.
● Where significant items of expense areunlikely to be finalized for a number ofyears or may subsequently be reversed,the income statement effect of suchchanges should be similarly identified asadditional items in subsequent periodsso readers can track movementsregarding these items between periods.
● The tax ef fect of additional itemsshould be explained.
● Material cash amounts related to addi-tional items should be presentedclearly in the cash flow statement.
Should APMs Be Audited?When APMs are disclosed only in themanagement discussion and analysissection (the front half) of an annualreport, auditing standards merely requireauditors to read this accompanyinginformation to check that it’s consistentwith the knowledge they acquire in thecourse of performing the audit.However, if management incorporatesAPMs into financial statements, thenauditing standards require auditors toensure that the financial statements givea “true and fair” view, a more desirablelevel of audit assurance. For this reason,where such APMs are disclosed, wewould prefer them to be incorporatedinto the financial statements.
In our opinion, more prescriptiveguidance is required to assist auditors, inparticular as they scrutinize APMs suchas EBITDA or underlying earnings. Wewould even support exploring the idea ofAPMs themselves being audited to thesame rigorous degree as the IFRS per-formance measures presented in thefinancial statements.
Ambiguity Slowly Is BeingTamed, But Investors ShouldRemain SkepticalWe welcome enhanced regulator yscrutiny on APMs, which makes ushope we can eventually enter a newera of financial reporting, with compa-nies less likely to present (and auditorsmore ready to challenge) misleadingAPM disclosures. Realistically, anysuch improvements wil l l ikely begradual, and complete comparability inreporting of APMs may never becomeachievable. For this reason, we believeinvestors and other users of financialstatements should exercise profes-sional skepticism and carefully scruti-nize APMs before reaching their ownview of a company’s performance. CW
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 49
Analytical Contacts:
Sam C. Holland, ACALondon (44) 20-7176-3779
Joyce T. Joseph, CPANew York (1) 212-438-1217
For more articles on this topic search RatingsDirect with keyword:
Taming Ambiguity
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FEATURES
The ability to compare the financial performance and
position of peer companies is critical for analysts,
investors, and other users of financial statements.
Standard & Poor’s Ratings Services believes that accounting
choices—particularly available to companies reporting under
International Financial Reporting Standards (IFRS)—can
create hurdles for analysis while adding little valuable
information. We recognize that some accounting
choices let companies “tell their story” and treat
transactions in a manner appropriate to their
business models. But often, different companies
report identical transactions differently, with no
apparent justification.
IFRS Accounting ChoicesAn Impediment To Financial Statement Comparability
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 51
Low-Hanging FruitMany of these needless accountingchoices could easily be eliminated. Oneexample is the classification of interestin the cash flow statement: Under U.S.generally accepted accounting princi-ples (GAAP), companies have to clas-sify their cash interest paid andreceived (as well as dividends received)as part of operating cash flows, a clas-sif ication to which we subscribe.
Unfortunately, under IFRS there is no suchuniform reporting. International Ac -counting Standard (IAS) 7, Statement ofCash Flows, allows companies to classifyinterest paid as either operating orfinancing cash f lows, and to classifyinterest and dividends received as eitheroperating or investing cash f lows.Therefore, to compare two companies’operating cash flows in a like-for-likemanner, analysts must make adjustments.
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—Deutsche Telecom, presenting items as operating cash flows— —Vodafone, presenting items as investing or financing—
2013 (mil. €) 2014 (mil. £) Reclassify* Adjusted Increase (%)
Dividends received 273 Net cash flow from operating activities 6,227 3,592 9,819 58
Cash generated from operations 15,092 Dividends received from associates 4,897 — — —and joint ventures*
Interest paid (2,961) Dividends received from investments* 10 — — —
Interest received 886 Interest received* 582 — — —
Net cash from operating activities13,017 Net cash flow from investing activities 30,743 — — —
Interest paid* (1,897) — — —
Net cash flow from financing activities (34,249) — — —
*Extracted from the cash flow statement.
Table 1 | Differing Approaches To Presentation Of Cash Interest And Dividends Received
Accounting choice Standard & Poor’s preferred choice Alternative choice
Income statement presentation of gains/losses on sale of busineses Below operating profit* Part of operating profit
Standard & Poor’s methodology: In calculating our adjusted measures such as EBITDA and funds from operations, we view gains/losses on the sale of businesses asnon-operating items and remove them from operating profit if they are reported as such.
Classification of pension interest in income statement Classified as an interest expense Classified as an operating expense
Standard & Poor’s methodology: We include pension interest expense within our adjusted interest expense metric. If pension interest is classified as an operatingexpense, we make an adjustment to add that amount back to operating profit and EBITDA.
Treatment of hedging derivatives in the income statement Hedge accounting—so the financial No hedge accounting, with the derivativestatements reflect the economically marked-to-market and the change in fair valuehedged arrangement hitting the income statement each period
Standard & Poor’s methodology: Where we have sufficient information, we exclude any unrealized fair gains/losses on derivatives not related to current-year activity,so that the income statement represents the economic hedge position achieved in the current year (that is, as if hedge accounting had been used).
Preparation of a direct or indirect cash flow statement Indirect cash flow statement Direct cash flow statement
Standard & Poor’s methodology: We have no specific methdology, but we prefer the indirect cash flow statement (which bridges the income statement to the cashflow statement) because it includes useful information about non-cash reconciling items and working-capital movements.
Measurement of debt on the balance sheet Amortized cost Fair value option
Standard & Poor’s methodology: Where companies report debt at fair value rather than at amortized cost, we adjusted the reported figure to reflect the amortizedcost amount. If the amortized cost figure is not shown in the financial statements, we may estimate it, based on the amount originally received or the face valueplus accrued but unpaid interest.
Classification of accrued interest on the balance sheet Included in reported debt Excluded in reported debt
Standard & Poor’s methodology: We reclassify as debt any accrued interest that is not already included in reported debt.
*These presentational options arise because operating profit, while commonly disclosed by companies, is not an IFRS-defined measure.
Table 2 | How Standard & Poor’s Addresses Certain Accounting Choices
An unsophisticated reader of financialstatements might miss this point andreach the wrong conclusion about a com-pany’s ability to generate future cash flowsrelative to its peers.
Two companies in the telecom sector—Deutsche Telekom AG and VodafoneAG—illustrate the point (see table 1). IfVodafone’s cash interest and dividendsreceived are reclassified as operating cashf lows to mirror Deutsche Telekom’sreporting, Vodaphone’s operating cashflows increase by £3.6 billion, or 58%.
Accounting Options AndPreferred AccountingSeveral other accounting options underIFRS impede analysis. Consequently, wedeveloped corporate credit ratingmethodology that addresses these (see
“Corporate Methodology: Ratios And
Adjustments,” published Nov. 19, 2013, on
RatingsDirect, and table 2). To the extentpossible, using the methodology detailedat the bottom of each row in table 2, wemake adjustments to the reported finan-cial statements of companies that chosethe approach in the third column. Ourgoal is to create a view of their financialsthat’s comparable to our preferredapproach, in column two.
Investors Should Be Wary OfThese Accounting DifferencesAs long as companies can chooseamong the variety of options offeredby IFRS, investors, among others, mustbe aware when comparing theirreported financial metrics. Table 1shows how reported cash f low fromoperations for Vodafone could havebeen £3.6 billion (or 58%) higher had itclassi f ied interest and dividendsreceived in the same way as DeutscheTelekom did. Similarly, the accountingoptions in table 2 can cause materialdiscrepancies in critical financial met-rics, such as reported operating profitand reported debt. Where certain met-rics are important for analysis anddecision-making, financial statementusers should determine whether todevelop their own methodology tofacilitate more accurate comparisonsbetween peer companies.
Recent Opportunity Missed For Improving PensionsAccounting boards have passed uprecent opportunities to standardizereporting options, suggesting that thismay not be a priority. The recent revi-sions to IAS 19 Employee Benefits,effective in 2013, were, in our view,largely improvements, and an opportu-nity for the International AccountingStandards Boards (IASB) to fix a long-standing complaint about the IFRSapproach to accounting for pensioninterest in the income statement. Underthe old version of IAS 19, companieswere able to classify the interest relatingto pensions as either a finance cost(which we believe is the appropriateclassification) or as an operatingexpense. We were encouraged that theexposure draft for the revised version ofIAS 19 contained the following proposal:
“An entity shall present net intereston the net defined benefit l iabil ity(asset) as part of finance costs in profitor loss.” We view this as an appropriateapproach because pension interest, asthe name suggests, is clearly an interestor f inance cost, arising due to theunwinding of the discount on a liabilitydue to the passage of time.
When the final revised version of IAS19 Employee Benefits was published,however, we were disappointed to seethat the Board had performed a volte-face on that proposal, so that the guid-ance reverted to the old approach—which does not specify how pensioninterest should be presented.
Future Accounting StandardsStill Allow For Unhelpful ChoicesUnhelpful accounting choices appear likelyto riddle important future accounting stan-dards. An example is lease accounting,where the proposals within the most recentexposure draft—issued jointly by the IASBand the Financial Accounting StandardsBoard (FASB) in 2013—would allow com-panies a variety of options. One notableexample concerns short-term leases, whichcompanies potentially will choose to eitherinclude or exclude in their balance sheetlease liability. Another option centers onthe proposed methods of transition to the
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 53
54 www.creditweek.com
SPECIAL REPORTFEATURES
new accounting standards. These would letcompanies apply either a full retrospectiveapproach or a modified retrospectiveapproach, with various other options alsoburied within these two methods (see “With
IASB And FASB Lease Accounting Likely To
Diverge, Disclosures Will Be Critical,” pub-
lished Sept. 4, 2014).Optionality on transition will also rear its
ugly head when the recently published rev-enue recognition standard becomes effec-tive. In the final standard, IFRS 15 RevenueFrom Contracts With Customers, publishedin May 2014, the boards decided to allow acompany to choose whether to apply IFRS15 retrospectively to each prior period pre-sented (with optional practical expedients)or retrospectively according to an alterna-tive transition method (see “What The New
Revenue Accounting Standards May Mean
For Investors,” published Sept. 8, 2014).
Now Is The Time For The IASB ToSeize The OpportunityTurning back to the pension interestpoint mentioned earlier, the IASBexplained the rationale for not requiringthis to be shown as a financing item inthe basis of conclusions appendix to thefinal accounting standard. The complica-tion was that one seemingly isolatedchange could have important ramifica-tions elsewhere in the accounting rules.
The board would also have needed toconsider in due course whether it shouldapply similar treatment to amountsrelated to the passage of time in otherprojects, such as revenue recognition,insurance contracts, and leases. Theboard concluded that this would bebeyond the scope of the project and thatit should consider this aspect of presen-tation in the statement of profit or lossand other comprehensive income morebroadly as part of the financial state-ment presentation project.
In other words, the IASB recognized thatvarious issues need to be dealt with, but putoff doing so. We contend that now is theright time for issues around accountingoptions to be addressed, because otherprojects currently underway would meshwell with such an initiative.
In addition to the financial statementpresentation project mentioned earlier,the IASB has begun the DisclosureInitiative (a broad-based initiative toexplore how disclosures can be improved)and the Conceptual Framework, the goalof which is to set out the concepts thatunderlie the preparation and presenta-tion of financial statements. While thereview of accounting options does notcurrently appear to be focused on theseprojects, the IASB is examining relatedissues. For example, an April 2014 IASBstaff paper on the Disclosure Initiativeincludes the tentative decision toimprove the cash flow statement through“...general alignment of classification ofcash inflows and outflows with the sec-tors and categories in the statement ofcomprehensive income...” This mayaddress the first accounting option illus-trated in table 1. Such a piecemealapproach may lead to improvements incertain areas. But we would encouragethe IASB to instead take a holisticapproach to dealing with accountingoptions and consistent presentation offinancial data. In our view, the currentprojects offer a rare opportunity for theIASB to rid its rules of pointlessaccounting choices. CW
Unhelpful accounting choices appear likely to riddle
important future accounting standards. An example
is lease accounting…
Analytical Contacts:
Sam C. Holland, ACALondon (44) 20-7176-3779
Joyce T. Joseph, CPANew York (1) 212-438-1217
For more articles on this topic search RatingsDirect with keyword:
IFRS Accounting
The accounting rules applicable in Europe and the U.S. for offsetting
financial assets and financial liabilities cause significant differences
between amounts presented in the balance sheets prepared under
International Financial Reporting Standards (IFRS) and those prepared under
U.S. Generally Accepted Accounting Principles (GAAP), especially for banks with
large derivative positions. As a result, it was virtually impossible to compare the
size of a European bank with a U.S. bank using their balance sheets, or certain of
their accounting-derived financial ratios. These analytical challenges were
reduced this year when the first-quarter and interim financial statements were
released by U.S. and European banks: For the first time, they are required to have
comparable disclosures regarding offsetting of financial assets and financial
liabilities. This makes it easier for investors and other financial-statement users to
make valid comparisons between European and U.S. bank balance sheets
prepared under two different accounting regimes. Their balance sheets will still
follow different accounting rules, but for financial-statement users that dig into
the footnotes, information to enable a better comparison is available. Basel III
leverage ratio rules aim to address differences in netting provisions under IFRS
and U.S. GAAP by clarifying how derivatives exposures are calculated for
regulatory purposes but the new accounting disclosures shed light on how
meaningful the differences are in terms of what is reported. Standard & Poor’s
Ratings Services believes the use of regulatory reports—such as the Pillar 3
reports—remains critical in bridging the financial information gaps.
Pursuit Of ComparabilityDisclosure Rules Make U.S. And European Banks Less Like Apples And Oranges
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 55
Overview● Enhanced balance sheet offsetting
disclosures provide improved
transparency into banks’ gross
and net financial exposures. ● The relative size of bank balance
sheets under differing accounting
regimes can be analytically mis-
leading without reference to the foot-
notes in the financial statements.
Further, leverage and profitability
measures are globally incomparable
without adjustments for the differ-
ences in accounting standards. ● In calculating leverage ratios,
regulators in the U.S. and Europe
stipulate net presentation of
financial assets and financial
liabilities, which is more closely
aligned with U.S. GAAP than IFRS.● We favor net presentation as per-
mitted under U.S. GAAP because it
is the way instruments and counter-
party exposures are managed by
most entities; therefore, providing
the most relevant information.
Balance Sheet OffsettingDisclosures Are UsefulEnhancementsAfter failing to achieve convergence ontheir accounting rules for balance sheetoffsetting in June 2011, the FinancialAccounting Standards Boards (FASB)and the International AccountingStandards Board (IASB) retained theirexisting offsetting models and instead
agreed to align their disclosure require-ments in December 2011. This enablesinvestors to better compare financialstatements prepared in accordance withIFRS and those prepared in accordancewith U.S. GAAP. The requirements forU.S. and IFRS reporting banks on howthey net derivatives should make com-parisons easier. U.S. banks beganreporting more details in the footnotes of
56 www.creditweek.com
SPECIAL REPORTFEATURES
0
500
1,000
1,500
2,000
2,500
3,000H
SBC
*
JPM
orga
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(Bil. US$)
Chart 1 | Comparison Of Total Assets Of Selected U.S. And European Financial Institutions As Reported Under U.S. GAAP And IFRS
2,671
2,220 2,175 2,102
1,704
1,240
Total assets as reported on Dec. 31, 2013
*IFRS amounts per annual report in U.S. dollars. §IFRS amounts per annual report converted to U.S. dollars.
Source: 10-Ks and/or annual reports for the year ended Dec. 31, 2013.
833912
1,880
2,416
0
500
1,000
1,500
2,000
2,500
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Chart 2 | Comparison Of Total Assets Of Selected U.S. And European Financial Institutions Under U.S. GAAP
2,132 2,102
1,164 1,126
Total assets under U.S. GAAP on Dec. 31, 2013*
*Standard & Poor’s estimates for IFRS reporters. §IFRS amounts per annual report converted to U.S. dollars.
Source: 10-Ks and/or annual reports for the year ended Dec. 31, 2013.
© Standard & Poor’s 2014.
808833912
1,426
1,880
2,416
quarterly financial statements in 2014,making it possible to calculate their grossderivatives assets and liabilities morecomparably with international standards.
In accordance with the new disclosurerequirements, an entity is required todisclose information to enable users ofits financial statements to evaluate theef fect or potential ef fect of netting
arrangements on its financial position,including the effect or potential effect ofrights of setoff associated with recog-nized derivatives (including bifurcatedembedded derivatives), repurchaseagreements, and reverse repurchaseagreements, and securities lending andsecurities borrowing transactions thatare either offset on the balance sheet, or
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 57
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
JPM
orga
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hase
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a
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C
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Mor
gan
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ley
UB
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(Bil. US$)
Chart 3 | Comparison Of Total Assets Of Selected U.S. And European Financial Institutions Under IFRS
3,530
2,975
1,503
Total assets under IFRS on Dec. 31, 2013*
*Standard & Poor’s estimates for U.S. GAAP reporters. §IFRS amounts per annual report converted to U.S. dollars.
Source: 10-Ks and/or annual reports for the year ended Dec. 31, 2013.
© Standard & Poor’s 2014.
1,2401,7041,713
2,1752,2202,6262,671
0123456789
Cit
igro
up
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ank
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and
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C H
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JPM
orga
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hase
Bar
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s
UB
S
Deu
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ank
(%)
U.S. GAAP§ IFRS†
Chart 4 | Comparison Of Tier 1 Capital Over Total Assets Under U.S. GAAP And IFRS For Selected U.S. And European Financial Institutions*
7.95 7.95
4.234.93
4.06 4.25 4.18
6.00
3.15
*Tier I capital is as reported in the form 10-Ks and/or annual reports for the year ended Dec. 31, 2013.
The definition of Tier 1 capital may vary by country and accounting standards in use. §For U.S. GAAP reporters,
IFRS percentage is based on Standard & Poor’s estimates. †For IFRS reporters, U.S. GAAP percentage is based
on Standard & Poor’s estimates.
© Standard & Poor’s 2014.
6.416.49
4.69
6.867.33
5.92
7.427.45
5.43
7.68
5.69
subject to an enforceable master nettingarrangement (MNA) or similar agree-ment, whether or not they are offset onthe balance sheet. To summarize, at aminimum, an entity is required to dis-close at the end of the reporting period(quarterly for U.S. banks and quarterly orhalf-yearly for European banks) the fol-
lowing information separately for recog-nized assets and recognized liabilities:(a)The gross amounts of those assets
and liabilities;(b)The amounts offset in accordance
with the offsetting guidance to deter-mine the net amounts presented inthe balance sheet;
(c)The net amount presented in the bal-ance sheet (i.e., a- b);
(d)The amounts subject to an enforceableMNA or similar agreement that man-agement chooses not to offset or thatdo not meet the conditions in the offset-ting guidance, along with the amountsrelated to cash and financial instrumentcollateral (whether recognized or unrec-ognized on the balance sheet); and
(e)The net amount after deducting itemd from item c.We believe regulatory reporting dis-
closures will still be very useful. UnderPillar 3, large banks are required to makecertain minimum disclosures withrespect to certain defined key capitalratios and elements on a quarterly basis,regardless of the frequency of financialstatement publication. Because theleverage ratio is an important supple-mentary measure to the risk-based cap-
58 www.creditweek.com
SPECIAL REPORTFEATURES
(0.6)
(0.4)
(0.2)
0.0
0.2
0.4
0.6
0.8
1.0
Gol
dman
Sac
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HSB
C H
oldi
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ank
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ank
of S
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and
U.S. GAAP* IFRS§
Chart 5 | Comparison Of Core Earnings Over Average Assets Under U.S. GAAP And IFRS For Selected U.S. And European Financial
0.88
0.47
0.850.68
0.78
0.48 0.390.23
0.05
As of Dec. 31,2013. *For U.S. GAAP reporters, the IFRS percentage is based on Standard & Poor’s estimates.
§For IFRS reporters, the U.S. GAAP percentage is based on Standard & Poor’s estimates.
© Standard & Poor’s 2014.
(3.6)(0.51)
0.10
0.34
0.550.56 0.51
0.76 0.700.58
0.31
—As of December 2012— —As of December 2011—
Derivative Derivative Notional Derivative Derivative Notional(Mil. $) assets liabilities amount assets liabilities amount
Derivatives not accounted for as hedges
Interest rates 584,584 545,605 34,891,763 624,189 582,608 38,111,097
Credit 85,816 74,927 3,615,757 150,816 130,659 4,032,330
Currencies 72,128 60,808 3,833,114 88,654 71,736 3,919,525
Commodities 23,320 24,350 774,115 35,966 38,050 799,925
Equities 49,483 43,681 1,202,181 64,135 51,928 1,433,087
Subtotal 815,331 749,371 44,316,930 963,760 874,981 48,295,964
Derivatives accounted for as hedges
Interest rates 23,772 66 128,302 21,981 13 109,860
Currencies 21 86 8,452 124 21 8,307
Subtotal 23,793 152 136,754 22,105 34 118,167
Gross fair value/notional amount of derivatives 839,124 749,523 44,453,684 985,865 875,015 48,414,131
Counterparty netting (668,460) (668,460) (787,733) (787,733)
Cash collateral netting (99,488) (30,636) (118,104) (28,829)
Fair value included in financial instruments owned 71,176 80,028
Fair value included in financial instruments sold, but not yet purchased 50,427 58,453
Table 1 | Goldman Sachs (Annual) Disclosure In The 10-K For Year Ended Dec. 31, 2012
Balance sheet offsetting subjectto enforceable MNAs was
available in 2012 disclosures.
ital requirements, it was agreed that thisPillar 3 requirement applies to the dis-closure of the leverage ratio: The BaselCommittee’s January 2014 leverage ratioframework proposed public disclosure,starting Jan. 1, 2015. For a bank to meetthis additional requirement, at a min-imum, certain items must be publiclydisclosed quarterly, irrespective of thefrequency of financial statement publica-tion: the Basel III leverage ratio (i.e.,
based on the average of the monthlyleverage ratios over the quarter) and twoend-of-quarter figures—the numerator(Tier 1 capital), the denominator(Exposure Measure).
We separately reviewed the balancesheet offsetting disclosures of GoldmanSachs & Co. and Barclays PLC for the yearsended Dec. 31, 2013, and Dec. 31, 2012, tocompare the changes in disclosures fromthe prior year (see tables 1, 2, 3, and 4).
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 59
—As of December 2013— —As of December 2012—
Derivative Derivative Notional Derivative Derivative Notional(Mil. $) assets liabilities amount assets liabilities amount
Derivatives not accounted for as hedges
Interest rates 641,186 587,110 44,110,483 584,584 545,605 34,891,763
Exchange-traded 157 271 2,366,448 47 26 2,502,867
OTC-cleared 266,230 252,596 24,888,301 8,847 11,011 14,678,349
Bilateral OTC 374,799 334,243 16,855,734 575,690 534,568 17,710,547
Credit 60,751 56,340 2,946 376 85,816 74,927 3,615,757
OTC-cleared 3,943 4,482 348,848 3,359 2,638 304,100
Bilateral OTC 56,808 51,858 2,597,528 82,457 72,289 3,311,657
Currencies 70,757 63,659 4,311,971 72,128 60,808 3,833,114
Exchange-traded 98 122 23,908 31 82 12,341
OTC-cleared 88 97 11,319 14 14 5,487
Bilateral OTC 70,571 63,440 4,276,744 72,083 60,712 3,815,286
Commodities 18,007 18,228 701,101 23,320 24,350 774,115
Exchange-traded 4,323 3,661 346,057 5,360 5,040 344,823
OTC-cleared 11 12 135 26 23 327
Bilateral OTC 13,673 14,555 354,909 17,934 19,287 428,965
Equities 56,719 55,472 1,406,499 49,483 43,681 1,202,181
Exchange-traded 10,544 13,157 534,840 9,409 8,864 441,494
Bilateral OTC 46,175 42,315 871,659 40,074 34,817 760,687
Subtotal 847,420 780,809 53,476,430 815,331 749,371 44,316,930
Derivatives accounted for as hedges
Interest rates 11,405 429 132,879 23,772 66 128,302
OTC-cleared 1,327 27 10,637 — — —
Bilateral OTC 10,076 402 122,242 23,772 66 128,302
Currencies 74 56 9,296 21 86 8,452
OTC-cleared 1 10 869 — — 3
Exchange-traded 73 46 8,427 21 86 8,449
Commodities 36 — 335 — — —
Exchange-traded — — 23 — — —
Bilateral OTC 36 — 312 — — —
Subtotal 11,513 485 142,510 23,793 152 136,754
Gross fair value/notional amount of derivatives 858,933 781,294 53,618,940 839,124 749,523 44,453,684
Table 2 | Goldman Sachs (Annual) Disclosure In The 10-K For Year Ended Dec. 31, 2013
● For select U.S. banks: We noted certainadditional items disclosed including:break-down of instruments by category;financial collateral (in addition to cashcollateral); and amounts that have notbeen offset in the financial statements.U.S. banks were already reportingamounts offset in the balance sheet, e.g.,counterparty netting and cash collateralsubject to MNAs (see tables 1 and 2).
● For select European banks: There issome additional information providedin the new disclosures, most signifi-cantly the amounts subject to theenforceable MNAs (the primary reasonfor netting by U.S. banks). Previous dis-closures did not require companies toinclude them in their financial state-ments (see tables 3 and 4).
● Greater clarification on disclosures:Prior to the issuance of the disclo-sures, there was no consistency in thebalance sheet offsetting disclosures.Therefore, repurchase and reverserepurchase agreements were generallynot a part of these disclosures.However, the accounting standardupdate includes the following financialinstruments within its scope:Recognized derivative instrumentsaccounted, including bifurcatedembedded derivatives; repurchaseagreements and reverse repurchase
agreements; and securities borrowingand securities lending transactions.Additionally, the balances disclosed in
the financial instrument collateral disclo-sures required by the standard may ormay not be included in the balancesheet, e.g., the collateral associated witha reverse repurchase agreementaccounted for as a secured lending trans-action would not be recorded on the bal-ance sheet. Although such collateral isnot recognized in the financial state-ments, it is required to be capturedunder the new disclosure requirements.
Notes: (a) A, B, and C are the sameinformation provided in the 2012 and 2013financial statements—just in a differentformat. (b) Financial collateral of £53,183million in table 4 is more than the cash col-lateral held of £46,855 million in table 3likely because the disclosure in 2013 per-tains to financial collateral as compared toonly cash collateral in 2012. In this regard,it should be noted that U.S. GAAP gener-ally permits offsetting of fair valueamounts recognized for multiple derivativeinstruments executed with the same coun-terparty under a MNA and fair valueamounts recognized for the right toreclaim cash collateral (a receivable) or theobligation to return cash collateral (apayable) arising from the same MNA asthe derivative instruments.
60 www.creditweek.com
SPECIAL REPORTFEATURES
—As of December 2013— —As of December 2012—
Derivative Derivative Notional Derivative Derivative Notional(Mil. $) assets liabilities amount assets liabilities amount
Amounts that have been offset in the consolidated statements of financial condition
Counterparty netting (707,411) (707,411) 668,460 668,460
Exchange-traded (10,845) (10,845) (11,075) (11,075)
OTC-cleared (254,756) (254,756) (11,507) (11,507)
Bilateral OTC (441,810) (441,810) (645,878) (645,878)
Cash collateral (93,643) (24,161) 99,488 30,636
OTC-cleared (16,353) (2,515) (468) (2,160)
Bilateral OTC (77,290) (21,646) (90,020) (28,476)
Fair value included in financial instruments owned/financial instruments sold, but not yet purchased 57,879 49,722 71,176 50,427
Amounts that have not been offset in the consolidated statements of financial condition
Cash collateral received/posted (636) (2,806) (812) (2,994)
Securities collateral received/posted (13,225) (10,521) (17,225) (14,262)
Total 44,018 36,395 53,139 33,171
Table 2 | Goldman Sachs (Annual) Disclosure In The 10-K For Year Ended Dec. 31, 2013 (continued)
New in the 2013 disclosure areamounts that have not been offset
in the balance sheet
Balance-sheet offsetting subjectto MNAs is also provided in the2013 disclosures—broken downfurther by derivative products
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 61
Analysis of derivatives (audited)
(The tables below set out the fair values of the derivative assets together with the value of thoseassets subject to enforceable counterparty netting arrangements for which the Group holds offsettingliabilities and eligible collateral)
Derivative assets (audited)
As of Dec. 31, 2012 Balance sheet assets £m Counterparty netting £m Net exposure £m
Foreign exchange 59,479 50,084 9,395
Interest rate 354,992 299,068 55,924
Credit derivatives 29,797 25,497 4,300
Equity and stock index 10,985 6,821 4,164
Commodity derivatives 13,893 6,202 7,691
Total derivative assets 469,146 387,672 81,474
Cash collateral held 46,855
Net exposure less collateral 34,619
As of Dec. 31, 2011
Foreign exchange 63,886 53,570 10,316
Interest rate 376,162 315,924 60,238
Credit derivatives 63,313 51,930 11,383
Equity and stock index 13,202 8,944 4,258
Commodity derivatives 22,401 10,224 12,177
Total derivative assets 538,964 440,592 98,372
Cash collateral held 51,124
Net exposure less collateral 47,248
Table 3 | Barclays Bank (Annual Disclosure) In The Annual Report For theYear Ended Dec. 31, 2012
A B
C
—Amounts subject to enforceable netting arrangements—
—Effects of offsetting on balance sheet— —Related amounts not offset—
Amounts not Net amounts subject to
Gross Amounts reported on Financial Financial Net enforceable netting Balance sheetAs of Dec. 31 amounts £m offset £m the balance £m instruments £m collateral £m amount £m arrangements £m total £m
Derivative financial assets 608,696 (295,793) 312,903 (258,528) (41,397) 12,978 11,432 324,335
Reverse repurchase agreementsand other similar secured lending 246,281 (93,508) 152,773 — (151,833) 940 34,006 186,779
Total assets 854,977 (389,301) 465,676 (258,528) (193,230) 13,918 45,438 511,114
Derivative financial liabilities (603,580) 296,273 (307,307) 258,528 36,754 (12,025) (13,327) (320,634)
Repurchase agreements andother similar secured borrowing (253,966) 93,508 (160,458) — 159,686 (772) (36,290) (196,748)
Total liabilities (857,546) 389,781 (467,765) 258,528 196,440 (12,797) (49,617) (517,382)
As of Dec. 31, 2012
Derivative financial assets 879,082 (420,741) 458,341 (387,672) (53,183) 17,486 10,815 469,156
Reverse repurchase agreements andother similar secured lending 244,272 (100,989) 143,283 — (142,009) 1,274 33,239 176,522
Total assets 1,123,354 (521,730) 601,624 (387,672) (195,192) 18,760 44,054 645,678
Derivative financial liabilities (869,514) 419,192 (450,322) 387,672 52,163 (10,487) (12,399) (462,721)
Repurchase agreements andother similar secured borrowing (259,078) 100,989 (158,089) — 157,254 (835) (59,089) (217,178)
Total liabilities (1,128,592) 520,181 (608,411) 387,672 209,417 (11,322) (71,488) (679,899)
Table 4 | Barclays Bank (Annual Disclosure) In The Annual Report For The Year Ended Dec. 31, 2013
CNew disclosure in 2013
B A
How The Size Of Banks ComparesOn An As-Reported BasisUnder the two separate accountingregimes followed by banks, HSBC appearsto be the largest global financial institutionbased on total assets reported, followed byJPMorgan Chase, Deutsche Bank, andBarclays. This is based purely on their bal-ance sheets, without taking into considera-tion the balance sheet offsetting disclosuresin the notes to the financial statements (see
chart 1). Three of the top four are Europeanbanks—primarily due to the grossing-up ofthe balance sheet under IFRS.
The Comparison Under AGlobally Consistent AccountingFramework Would YieldDifferent OutcomesWe compared selected large U.S. and Europeanfinancial institutions using an “as if” reportedunder IFRS for U.S. banks and U.S. GAAP basisfor European banks as it relates to offsetting offinancial assets. JPMorgan Chase would be thelargest bank in terms of total assets if they allfollowed U.S. GAAP. HSBC Bank PLC would bethe second-largest bank, primarily because oflesser derivative activities on a comparablebasis. Using these estimates, Bank of Americaand Citigroup (both U.S. banks) would roundout the largest four banks based on total assets(see chart 2). Three of the largest four banksunder this scenario are U.S. banks.
Under the as if IFRS basis, JPMorganChase would remain the largest financialinstitution based on total assets, followedby Bank of America, HSBC, and Citigroup(see chart 3). Three of the largest four are,again, U.S. banks, if IFRS was the commonaccounting language.
U.S. Regulatory Treatment And Basel III Lean Toward Net PresentationPresently, total assets as provided in regulatoryreports such as the Y-9C Report (in case ofholding companies), Call Report, and ThriftFinancial Report, and therefore the related U.S.regulatory ratios, are computed predominantlyusing the total asset net presentation amountsreported on the balance sheet. The gross pres-entation under IFRS would result in a weakerleverage ratio than currently computed underU.S. banking regulatory requirements.Accounting differences between U.S. GAAPand IFRS create two very different scenarios.Under the as-if IFRS basis, Citigroup continuesto have the largest Tier 1 Leverage Ratio. Welooked at how U.S. banks would potentially beaffected under IFRS (grossing up of assets) (see
table 5 and chart 4). We only adjusted totalassets; Tier 1 Capital used is as defined.
The design of the Basel III leverage ratiorequirements makes the regulatory out-come indifferent to the accounting regimeof the bank. The Basel III reforms intro-duced a relatively simple, transparent, non-risk-based leverage ratio to act as a supple-mentary measure to the risk-based capitalrequirements (see “The Basel Committee’s
Revised Leverage Ratio Relaxes Its Calibration
Requirements, But Preserves Its Value,” pub-
lished Jan. 31, 2014, on RatingsDirect). Theleverage ratio is intended to be one thatensures broad and adequate capture of on-and off-balance-sheet leverage of banks,among other things. Implementation of theleverage ratio requirement has begun, withpublic disclosure requirements that startJan. 1, 2015. Under Basel III, the leverageratio is calculated in a comparable manneracross jurisdictions, adjusting for differencesin accounting standards. (The Baselleverage ratio applies to “AdvancedApproach” banks in the U.S. called the “sup-plementary leverage ratio.” Banks using the“Standardized Approach” only comply withthe “simple leverage ratio.”) The BaselCommittee emphasizes the importance ofconsistent and common disclosure acrossbanks to allow market participants to com-pare the capital adequacy of banks acrossjurisdictions and to reconcile leverage ratiodisclosures with banks’ published financialstatements from period to period.Additionally, internationally active banks
62 www.creditweek.com
SPECIAL REPORTFEATURES
—Tier 1 leverage ratio (%)—
As reported by U.S. banks IFRS§
Citigroup 7.95 5.69
Goldman Sachs 7.95 4.23
Bank Of America 7.68 5.43
Morgan Stanley 7.33 4.06
JP Morgan Chase 6.86 4.69
*As reported in the annual reports for the yearended Dec. 31, 2013, compared with Tier 1 leverageratios under the as-if IFRS basis for selected U.S.financial institutions. §Standard & Poor’s estimates(based on total reported assets under IFRS).
Table 5 | Tier 1 Leverage Ratios*
will be required to provide leverage ratiodisclosures using common templates.
In our view, what goes on balancesheets (gross presentation under IFRSand net presentation under U.S. GAAP)may affect how much capital banks arerequired to have (before any analyticaladjustments). Regulatory capital rules areintended to ensure a bank has sufficientcapital to absorb expected and unex-pected losses. With this backdrop, wenote that the international leverage ratiomeasures calculated under Basel IIIadjust for differing accounting standardsand apply a netting approach primarilyfor two reasons: The existing U.S. GAAPand IFRS netting differences, and theview that a regulatory netted amount isrelevant for leverage computations.
Comparable Metrics AreImportant For Peer AnalysisAnother aspect of reporting under the twodifferent accounting frameworks is the ana-lytical impact the accounting differenceshave on the peer comparability of certainkey metrics. For example, we multiply theasset exposure amounts by the associatedrisk weight to arrive at risk-weighted assets.The sources of the risk exposure amountsinclude data from banks that report Basel IIor Basel III Pillar 3 disclosure, if available,or data from the published accounts ofbanks that do not use the Basel II frame-work (non-Basel II banks). For U.S. banks,we generally use holding companies’ quar-terly regulatory reports as the source. Wemay complement these data sources withany additional available information. Ourgoal is to use a consistent framework tocapture adjusted exposure.
If banks were to disclose consistentasset balances, a wide number of asset-based ratios that not only focus on assess-ment of capital strength but also on prof-itability, asset quality, and liquidity, wouldlikely become more comparable acrossregions. A key metric such as core earn-ings-to-average-assets provides informa-tion on the profitability of assets based onrecurring earnings. We compared this keymetric as of Dec. 31, 2013, under the twoaccounting standards (see chart 5). For fur-ther information on the definition of coreearnings, see “Quantitative Metrics For
Rating Banks Globally: Methodology And
Assumptions,” July 17, 2013.
Net Presentation And RegulatoryDisclosures Hold The KeyWe believe net presentation as permittedunder U.S. GAAP is consistent with the wayinstruments and counterparty exposuresare managed by most entities, thereforeproviding the most relevant information tofinancial statement users. Gross presenta-tion may lead to better analysis of marketrisks as well as liquidity risk and cash flows;however, with daily settlements or collateralpostings, liquidity risk changes every day,making gross presentation less meaningful,because the actual sale of derivatives maynot be possible at the gross amounts.Additionally, the Basel Committee proposesthe use of net information (plus regulatoryadd-ons) to calculate leverage, which is asimple, unweighted measure used to distin-guish how adequately capitalized financialinstitutions are relative to one another. Webelieve reporting derivatives on a grossbasis rather than a net basis on the balancesheet may obscure the company’s financial
risks, particularly when presenting leverage,credit risk, and liquidity risk positions.
Financial statement users will benefitfrom a combination of disclosures in finan-cial statements and regulatory reports (Y-9CReport, Pillar 3) to obtain comparable infor-mation under U.S. GAAP and IFRS. The bal-ance sheet, and therefore financial metricsbased on total assets or total liabilities (or onfinancial assets and liabilities), will continueto differ significantly (see table 6 for key differ-
ences between U.S. GAAP and IFRS). In deter-mining our analytical adjustments, we con-sider how bank regulators generally treatcapital, but our capital analysis is foundedon our own risk-adjusted capital framework,and our capital ratios are different fromthose of regulators. Bank regulators focuson issues at a national or regional level whendefining their capital measures: Our goal isto produce capital measures that are glob-ally comparable. CW
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 63
Topic U.S. GAAP IFRS
Offsetting financial assets andfinancial liabilities Optional if certain criteria are met. Required if all criteria are met.
Criteria Entity may offset assets and liabilities if a right of Requires offsetting if the following criteria are met: setoff exists. It exists when all of the following conditions The reporting entity “currently has a legally are met: Each of two parties owes the other determinable enforceable right to set off”; and the reporting entity amounts; the reporting entity has the right to set off the intends either to settle on a net basis, or to realize amount owed with the amount owed by the other party; the asset and settle the liability simultaneously.the reporting entity intends to set off; and the right of setoff is enforceable by law.
Exceptions The following may be netted: Derivatives subject to master No exceptions.netting arrangements (including cash collateral); and certain repurchase and reverse repurchase agreements.
Table 6 | Key Balance Sheet Offsetting Differences: U.S. GAAP Vs. IFRS
Analytical Contacts:
Shripad J. Joshi, CPA, CANew York (1) 212-438-4069
Joyce T. Joseph, CPANew York (1) 212-438-1217
Jonathan Nus, CPANew York (1) 212-438-3471
Osman SattarLondon (44) 20-7176-7198
Matthew B. Albrecht, CFANew York (1) 212-438-1867
Richard BarnesLondon (44) 20-7176-7227
Rohina VerdesCRISIL Global Analytical Center, an S&P affiliateMumbai
For more articles on this topic search RatingsDirect with keyword:
Disclosure Rules
SPECIAL REPORT
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FEATURES
Following years of working with theInternational Accounting StandardsBoard (IASB) to achieve a single and
converged accounting standard related toinsurance contracts, the FinancialAccounting Standards Board (FASB) hasdecided to abandon that plan and moveforward in a new direction—on its own.The decision to focus on targeted—ratherthan more pervasive—changes is a disap-pointment to us from an accounting con-vergence standpoint, but provides anopportunity for the FASB to deliver spe-cific accounting and disclosure enhance-ments, aiding more refined analysis ofcompanies in the insurance sector. Withconvergence efforts halted, Standard &Poor’s Ratings Services agrees with theFASB that targeted improvements to U.S.generally accepted accounting principles(GAAP) are preferable to the significantoverhaul of accounting that would haveoccurred if the insurance contracts (Topic834) accounting proposal (the exposure
draft) issued in June of 2013 had beenadopted. We hope the new direction takenwill provide improved symmetry betweenthe accounting and economic depictionsof business transactions, and promoteinvestor confidence through added finan-cial statement transparency. In this com-mentary, we present our view of potentialenhancements that can be made to cur-rent U.S. GAAP reporting by U.S. insurers,which we believe can help improveaccounting and financial reporting.
We have long believed that a converged,high-quality insurance accounting standardwould provide the most benefit to financialstatement users (see “Global Insurance
Accounting Proposals Signal Radical Change,
But Fall Short Of Complete Convergence,”
published Oct. 16, 2013, on RatingsDirect).Accounting convergence clearly has itsmerits in our global credit analyses by pro-viding a common starting point to applyour global criteria; however, because theFASB and IASB are headed down separate
Back To The Drawing BoardOn FASB’s Accounting ForInsurance ContractsAn Opportunity Lost Is An Opportunity Gained
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 65
Overview
● We are disappointed that convergence will not be achieved, but hope targeted
improvements will provide accounting and financial reporting enhancements to
aid more refined analysis of insurance companies.● Accounting inconsistencies for premium deficiency assessments and the
treatment of death and other insurance benefit features in long-duration
contracts should be rectified.● Accounting enhancements to long-duration contract liability measurement,
including the calculation of discount rates, and deferred-acquisition cost will
benefit financial statement users.● We believe property and casualty, or short-duration contract, loss reserves
require enhanced disclosures for disaggregated claim count and paid and
incurred losses; key assumptions applied in loss reserving; the duration and
discount rates used; and in the calculation of probable maximum loss metrics.● We do not believe disclosure resolves poor accounting or takes precedence to
financial statement presentation, but it can help bridge accounting models that
present information differently.
paths, we believe the most effective andinsightful changes would be in the form ofdisclosure (see appendix for further detail on
the recent FASB developments related to insur-
ance contract accounting).
Premium DeficiencyAssessments Provide LittleValue, Because Of TheInconsistency In The PropertyAnd Casualty And Life SectorsWe believe there are opportunities forimprovement in the accounting and finan-cial reporting of premium deficiencyassessments that will boost consistencyand aid more forward-looking analysis.Premium deficiency is the probable loss oninsurance contracts, calculated at the levelan insurer manages, prices, and services itsbusiness. Given these broad terms, insurers
are afforded great flexibility in defining thislevel, creating significant diversity in prac-tice. If the premium deficiency is assessedat too high a level, it can create a cliff-typeconsequence where a premium deficiencymay not be recognized in a timely mannerand, when it eventually is recorded, theadjustment may be significant to a com-pany’s results. If the premium deficiencyassessment is performed at too granular alevel, users may have difficulty interpretingit, because the main drivers and accountcomposition are obscure. We support per-forming the assessment at the line of busi-ness level based on standardized classifica-tions, similar to that seen in statutoryannual statements.
Further complicating the currentanalysis is a company’s ability to adopt amethodology that either includes orexcludes anticipated investment income.This option creates incomparabilitywhen analyzing companies, and maycause companies who include antici-
pated investment income to be per-ceived as having stricter or improvedunderwriting standards when comparedwith those of peers, whereas it maysolely relate to an accounting policyelection. We believe the inclusion ofanticipated investment income shouldbe either mandated or excluded, andapplied consistently.
Sensitivity analysis related to premiumdeficiency assessments also should beprovided, i.e., how close a company maybe to recording a deficiency. This canbenefit financial statement users indeveloping a prospective view to gaugerisk and underwriting profitability relatedto a particular line of business, ratherthan factoring in a premium deficiencyafter it has already been recorded in thefinancial statements.
Long-Duration ContractAccounting Assumptions ShouldBe Updated And DisclosedOne improvement, included in the expo-sure draft, that we would like to see theFASB consider relates to the measurementof liabilities, specifically updating assump-tions used for traditional long-duration con-tracts. Under GAAP, the assumptions (e.g.,mortality and morbidity) insurers use to cal-culate long-duration contract policyholderbenefits are virtually locked in (i.e., they arenot updated unless the existing contract lia-bilities, together with the present value offuture gross premiums, become insufficientto cover the present value of future benefitsto be paid to—or on behalf of—the policy-holders and to recover unamortized acqui-sition costs). To more comprehensivelyreflect risks and uncertainties inherent inlong-duration contracts, we believe theassumptions a company applies should bereevaluated to consider all currently avail-able information at the time of reporting.
We believe these assumptions should beupdated at least annually, and view quarterlyupdates necessary when significant or mate-rial changes occur in the context of the spe-cific entity’s circumstances. The meaningand application of the term “significant” aredebatable, and will need to be more thor-oughly defined in the final standards.Nevertheless, we believe updating insignifi-cant assumption changes quarterly maycreate unnecessary volatility, and might notrepresent true risk related to the long-tailnature of the business. To the extentassumptions are periodically updated, pre-mium deficiency (already noted as an areawith increased diversity in practice)becomes less of an issue, because unlockingassumptions from a premium deficiencymay not be necessary, or potentially as sig-nificant, if assumptions are updated on atimely basis. Additional disaggregated dis-closure on key assumptions and qualitativefactors applied should also be enhanced toprovide financial statement users’ furtherinsight on management views.
Discount Rates Applied ShouldReflect Characteristics Of TheContract LiabilityA controversial topic in the exposure draftwas the calculation of the discount rateused to measure contract liabilities. UnderGAAP, traditional long-duration contract lia-bilities for insurance companies are dis-counted based on the estimated investmentyields (net of related investment expenses)expected at the contract issue date.Consistent with the exposure draft, webelieve the discount rate used should reflectthe characteristics of the liability; however,we recognize the complexities that wouldbe encountered in calculating such a rate(e.g., adjusting for illiquidity and credit risk).Additional challenges arise when explainingthe interest rate movement and the compo-nents driving the period-over-periodchange. A discount rate reflecting liabilitycharacteristics may be more theoreticallysound, but it comes at the expense ofincreased subjectivity and incomparabilitybecause of significant inputs and assump-tions that may not be fully observable. Wetherefore believe the discount rate shouldbe supported by robust sensitivity disclo-sures and additional qualitative information
66 www.creditweek.com
SPECIAL REPORTFEATURES
U.S. regulators and accounting standard-setters are
putting disclosure at the top of their agendas…
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 67
about the derivation of the assumptionsand judgments and its impact on the finan-cial statements. These might include adescription of processes to select discountrates, detail surrounding market inputs(and more importantly, unobservableinputs), and quantitative analysis of sensi-tivities and the impact of discount ratechanges on the financial statements andkey performance metrics. Providing thisinformation will benefit peer analysis andprovide insight about the subjective aspectsof measuring contract liabilities.
Deferred Acquisition CostRelated To Long DurationContracts Is Overly Complex,And Adds Unnecessary VolatilityDeferred acquisition cost (DAC) is a rela-tively simple concept by which acquisi-tion expenses are capitalized and amor-tized over a period of time to matchrevenue and expenses. For short-dura-tion contracts, the accounting is fairlystraight forward and generally consis-tently applied, especially after the adop-tion of FASB Accounting StandardUpdate 2010-26 (Topic 944) which raisedthe bar on capitalization requirements,reducing flexibility and inconsistency.
Long-duration insurance contracts, onthe other hand, include multiple accountingmodels depending on the type of contract,so comparability becomes very difficult forfinancial statement users. In addition, theestimated gross profits and estimated grossmargins used to calculate DAC amortiza-tion can be very complex, because of thelevel of estimation related to variablesincluding mortality, persistency, and invest-ment returns. DAC also adds unnecessaryvolatility to the financial statements via theprospective and retrospective adjustmentsmade at the end of each reporting periodto reflect changes in estimates or poten-tially experience true-up adjustments. Wewould prefer the FASB enhance DACaccounting by requiring a simpleraccounting model, applied consistentlyacross all long-duration contracts. In ourratings analysis, we generally provide up to50% credit of the overall life DAC balancein our calculation of total adjusted capital,if we consider it reasonable to assumethese costs will be recovered—even under
stressed scenarios. We therefore want theprocess of adjusting DAC to be as simpleas possible (see “Refined Methodology And
Assumptions For Analyzing Insurer Capital
Adequacy Using The Risk-Based Insurance
Capital Model,” published June 7, 2010).
Accounting For Contracts With Death Or Other InsuranceBenefit Features Can ProduceVaried Results For EconomicallySimilar ContractsBased on current GAAP, dif ferentaccounting conclusions may be reachedbased on the form of the contract that thebenefit feature is attached to (e.g., variable-life and variable-annuity), although thesubstance of the benefits is similar. Thiscreates comparability issues when ana-lyzing life insurers, because each companymay apply different accounting treatmentsfor economically similar transactions.Inconsistencies are also created by thecomplexity of the accounting, whichrequires an assessment of the type of ben-efit (e.g., guaranteed minimum accumula-tion benefits and guaranteed minimumwithdrawal benefits), the phase the benefitrelates to (i.e., accumulation or pay-out)and other factors specific to the contract.Insurance companies must then evaluatewhether certain annuitization benefitsshould be accounted for separately as anembedded derivative or treated consis-tently with the overall contract subject toinsurance accounting. We believe anaccounting model should be applied basedon the economics of the feature and con-sistently accounted for, no matter the hostcontract to which it is attached.
Loss Reserves Should Be A Focus Area For DisclosureEnhancement Related ToProperty And Casualty InsurersActuarially determined loss reservesoften are the largest liability on insur-ance company balance sheets. A rela-tively minor change in assumptionsunderlying the reserves can significantlyalter the current-period earnings for aparticular insurer, so it is critical for com-panies to provide granular informationand insight into key assumptions orjudgments, to assist financial statement
users in performing peer analysis and togain comfort on the sufficiency of thereserve to support future claims. Ex -amples of useful information we wouldlike to see disclosed by insurers include:
Disaggregated claim count and paid and
incurred loss information by line of busi-
ness. Similar to “Schedule P” included inU.S. statutory financial statements for aspecific legal entity, loss and lossexpense, loss payments and incurredbut not reported (IBNR) reserves pre-sented by a defined line of business on aconsolidated basis would be useful andinsightful to financial statement users.Companies disclose the aggregate lia-bility that may be multibillion dollar bal-ances for some, spanning numerouslines of businesses yet affording littleinsight for financial statement users, asit contains many components includingcase reserves for reported claims andreserves for IBNR claims for every lineof business underwritten. The reservesbegin to tell a story when reserve devel-opment can be analyzed by accidentyear and underwriting year by line ofbusiness, because each line of businesscovers unique risks. We believe thisinformation will give financial state-ment users further insight into reservedevelopment and assist analysts withunderstanding the adequacy of a com-pany’s reserving process. Standardizedline-of-business reporting also will aidbetter peer comparisons, shed light onrelative underwriting standards, andhelp identify sector trends. Claim countinformation also is useful whenassessing the frequency and severity oflosses by line of business.
Loss reserving key assumptions and judg-
ments by line of business. Qualitative infor-mation regarding the loss reserve esti-mate can be crucial in peer analysis andin assessing reserve suf ficiency. Webelieve additional information on projec-tion methods the company applied andthe key assumptions and adjustmentsmade to derive the loss reserve, segre-gated by line of business, will providetransparency and insight.
Provide with- and without-type disclosure
related to discount rates. For balancesreported on a discounted basis, companies
should disclose the duration and discountrate (or the undiscounted balance) so thatanalysts can understand how managementis applying the effects related to the timevalue of money. This would better enablefinancial statement users to apply adjust-ments, as necessary.
Probable Maximum Loss (PML) metrics.
Commonly used in the insuranceindustry, PML metrics estimate exposurebased on certain types of catastrophicevents, and have become increasinglymore sophisticated, with enhancementsin technology related to the models.Considering the exposure property andcasualty insurance companies have tocatastrophes and the significant financialstrain it can cause for an insurer, PMLamounts are important in understandinga company’s risk exposure and appetite.PMLs can be uniquely defined by com-pany, and do carry significant assump-tions and judgments, making for difficult
comparisons. We encourage more stan-dardization related to models companiesmay use, key judgments and assump-tions they may apply, and—at a min-imum—robust disclosure providingbetter insight into the nature of the vari-ables included to derive these metrics.
Disclosure Continues To Be A Focal Point For Regulators And Standard-SettersU.S. regulators and accounting standard-setters are putting disclosure at the top oftheir agendas, noting that current disclo-sures may be ineffective and, at times,provide extensive detail without givingthe key message for financial statementusers. Disclosures continue to increaseafter the financial crisis, which high-lighted business and market failures, andin response to numerous SEC commentletters that companies received. Thatsaid, volume is not a proxy for quality
68 www.creditweek.com
SPECIAL REPORTFEATURES
Significant FASB decisions change the direction of the Insurance Contracts ProjectAt its meeting on Feb. 19, 2014, the FASB made key decisions regarding the insur-
ance contracts proposal that significantly changed the direction of the project.
Key takeaways included:● Reduced scope. Rather than creating a contract-based accounting model, the
FASB has reverted back to an activity- or entity-based model. Board members
noted that a contract-based model, while logical from a theoretical perspective,
is not very practical if numerous and complex scope exceptions would be
required. Although the FASB is narrowing the scope to insurers, they noted
there may be additional scope inclusions that will be addressed case by case.● Targeted improvements. The FASB decided to focus on identifying targeted
improvements to GAAP reporting for long-duration contracts. The building-
block approach from the prior proposal may serve as a reference when consid-
ering improvements to current GAAP, but it will not be the starting point. This
decision was driven by several factors, including the low likelihood of conver-
gence with the IASB proposal and the significant cost and complexity related to
the FASB’s proposal. With respect to the accounting for short duration con-
tracts, improvements will be limited to disclosure, citing the overwhelming sup-
port received in comment letters on the current GAAP accounting model.
The FASB directed its staff to conduct additional research and perform outreach
on potential targeted improvements and current practice issues related to existing
long-duration accounting models under GAAP. These potential focus areas were
presented to the FASB board on April 16, 2014, and agreement was reached for
certain topics to be deliberated in future meetings.
The IASB is continuing its now separate path to finalizing its insurance con-
tracts proposal, as it deliberates on the remaining comment areas.
Appendix
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 69
and substance, as is becoming apparentto financial statement users, regulators,and accounting standard-setters. Twonotable work streams in process are theFASB’s disclosure framework project,and the SEC’s comprehensive review ofits own disclosure requirements, ema-nating from its study performed as arequirement under the Jumpstart OurBusiness Startups Act. We support theefforts underway by the FASB and SEC,and believe they should work together toensure disclosure requirements are com-prehensive and streamlined withoutbeing redundant between the require-ments of GAAP and SEC Regulation S-X.
The FASB’s disclosure framework andinsurance contracts project can help pro-vide the information financial statementusers need to support refined analysis ofcompanies and increase investor confi-dence across the sector. In our responseletter to the FASB, we explained aspects ofa revamped disclosure framework thatcould benefit analysis (see “The FASB’s
Disclosure Framework Will Change The
Financial Reporting Landscape,” published
Dec. 7, 2012). At minimum, the disclosureframework should require insurers to con-sistently disclose accounting policy selec-tions and applications; the related balancesin the financial statements and accountcomposition; the significant assumptionson which material account balances arebased; the events that could cause theseassumptions and balances to change; andan assessment of the probability or likeli-hood of such changes occurring. Theinformation in the disclosures should alsoenable forward-looking analysis. The dis-closure framework has great potential tointroduce significant improvements toaccounting standards broadly.
Disclosure Cannot Remedy PoorAccounting, But Can Help Bridgethe “GAAP” Between TwoDifferent Accounting RegimesRobust disclosure gives us insight intowhat is—and is not—ref lected inreported financial information. Whenwe believe the accounting construct,judgments, or estimates do not reflectthe true economics of the transaction,we can adjust or remove the related
effect in the financial information withthe detail provided in disclosures.Disclosure can also aid meaningfulpeer comparisons, because comparingfinancial statements balances alonedoes not provide the entire story, norare balances alone sufficient to meetour needs. When calculating certainratios (e.g., total adjusted capital) aspart of our ratings process, we employa long-standing practice of makinganalytical adjustments to an insurer’sreported results, whether reported inSEC filings or insurance statutory fil-ings. These adjustments producemeasures that meaningfully reflect ourview of underlying economic realitiesand improve comparabil ity amonginsurers. This enhances the analyticalrelevance and consistency of the keyperformance metrics we use in ourcredit analysis. We generally make ouranalytical adjustments based on finan-cial statement disclosures, so attentionto the information provided in thefootnotes is vital.
As noted in our article related to theinsurance contracts proposals by theFASB and IASB, disclosures are keyfacets in analyzing a range of informa-tion for insurers, not only related toinsurance contracts b ut also financialinstruments, including risk sensitivities,credit and counterparty concentration,asset-liability management practices,valuation and other assumptions, liq-uidity risks and considerations, and sig-nificant changes in these factors (see
“Standard & Poor’s Ratings Ser vices
Comments On The IASB’s and FASB’s
Insurance Contracts Proposals,” published
Dec. 23, 2010). CW
Analytical Contacts:
David B. Chan, CPANew York (1) 212-438-7313
Rodney A. Clark, FSANew York (1) 212-438-7245
Joyce T. Joseph, CPANew York (1) 212-438-1217
Jonathan Nus, CPANew York (1) 212-438-3471
For more articles on this topic search RatingsDirect with keyword:
Accounting
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FEATURES
Farewell, DiscontinuedOperationsU.S. Financial Statement Analysis Just Got Harder
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 71
The segregation of discontinued operations from, and
therefore the reporting of, continuing operations in the
income statements of companies is a helpful aspect of
financial reporting. By separately reporting the results of
discontinued operations using a sufficiently low threshold for
inclusion, companies effectively recast their historical income
statements on a pro forma basis for disposal activities, making
trend analysis and forecasting easier. A newly issued U.S.
accounting standard is raising the threshold as to what qualifies
as a discontinued operation so that fewer disposals will be
reported as discontinued operations. As a result, Standard &
Poor’s Ratings Services believes “continuing operations” likely
will be tainted by the results of dispositions that no longer meet
the higher threshold, thereby providing less relevant historical
financial information and potentially hampering analysis.
Overview● The results of continuing operations as reported in the income statements of U.S.
companies will be tainted by dispositions that no longer meet the definition of
discontinued operations, providing less relevant historical financial information
and potentially distorting trends and hampering analysis. ● Financial statement users will have to rely on management to provide needed
information that may not be disclosed under the new rules to make their own pro
forma adjustments. We encourage companies to provide the transparency
financial statement users need for their analysis.● Although companies are not required to implement the new threshold until
reporting periods beginning after Dec. 15, 2014, early adoption is permitted.
Companies may use the relaxed standards beginning in the first quarter of 2014,
so financial statement users could be affected immediately.● While the new standard requires expanded disclosures, particularly about cash
flows of discontinued operations and individually significant dispositions that do
not meet the definition of a discontinued operation, the potential decrease in
frequency of discontinued operations reporting and the condensed nature of the
required disclosures limit their usefulness.
Changes May ObscureContinuing OperationsUnder U.S. GAAP, companies mustrepor t the results of discontinuedoperations separately from continuingoperations, both in current and com-parative periods. Until recently, thethreshold for what constituted a dis-continued operation was low. By sepa-rately reporting the results of discon-tinued operations using a sufficientlylow threshold for inclusion, companiesef fect ively recast their historicalincome statements on a pro formabasis for disposal activities, makingtrend analysis and forecasting easier.
On April 10, 2014, the FinancialAccounting Standards Board (FASB) issued“Accounting Standards Update (ASU) No.2014-08—Reporting Discontinued Oper-ations and Disclosures of Disposals ofComponents of an Entity.” Under thenew standard, only those disposed com-ponents (or components held-for-sale)representing a strategic shift that have(or will have) a major effect on opera-tions and financial results will bereported as discontinued operations.Examples of a strategic shift couldinclude a disposal of a major geograph-ical area or a major line of business.
This higher threshold will lead tofewer disposals qualifying for discon-tinued operations treatment, leavingthe results of more disposed busi-nesses within continuing operations.Therefore, instead of being able torely on the income statement itself,financial statement users will have torely on company management to elec-tively provide additional informationthat may not be disclosed under thenew rules to arrive at their own proforma adjustments.
Expected Effect On Financial StatementsSince adoption of the new require-ments is not required until periodsbeginning after Dec. 15, 2014, and onlyoptional at this point, there are fewexamples of how this new standardmay affect the information received byfinancial-statement users. To date, themajority of companies that have early
adopted are in the real estate sector, asthe old guidance was viewed by someto be too onerous on real estate com-panies. But companies’ disclosuresclearly reflect an expected decrease inthe frequency of disposals reported asdiscontinued operations.
Medical Properties Trust Inc.(BB/Positive/—) disclosed:
“We adopted ASU 2014-08 for thequarter ended March 31, 2014. Theapplication of this guidance is prospec-tive from the date of adoption andshould result in our not generallyhaving to reflect single property dis-posals as discontinued operations inthe future.” (Source: MEDICAL PROP-ERTIES TRUST INC.—First-quarter2014 10-Q, SEC EDGAR)
While Starwood Hotels & ResortsWorldwide Inc. (BBB/Stable/—) disclosed:
“. . .we expect to ear ly adopt thisASU on a prospective basis in thesecond half of 2014. We believe theadoption of this update will reduce thenumber of disposals that are pre-sented as discontinued operations inour financial statements.” (Source:STARWOOD HOTELS & RESORTSWORLDWIDE, INC.—First-quarter2014 10-Q, SEC EDGAR)
The impact on U.S. GAAP reportingcompanies is mostly anecdotal at thispoint; however, because the new U.S.GAAP threshold virtually convergeswith the existing IFRS threshold, wecan look to an IFRS disclosureexample to demonstrate the issue withwhich we are concerned.
Anheuser-Busch InBevIn November 2008, InBev acquiredAnheuser Busch. Postacquisition, thecombined entity sold five individual
businesses in 2009: Oriental Brewery,Busch Entertainment, Central EuropeOperations, Tennant’s Lager Brand,and four metal beverage can and lidplants. However, despite this flurry ofdisposals, the company did not reportany discontinued operations on itsincome statement in 2009.
As part of its ongoing filing reviewprocess, the SEC issued a com mentletter to Anheuser-Busch In Bev(A/Stable/—) questioning why theseoperations were not presented as dis-continued operations.
Anheuser-Busch InBev responded:“The Company advises the (SEC) Staffsupplementally that, during 2009, itmade several disposals, of which thethree largest were the disposals of
Oriental Brewery, Busch Entertainment,and certain operations in CentralEurope. Individually, the disposed netidentifiable assets of Oriental Brewery,Busch Entertainment, and CentralEurope represented 1.1%, 2.0%, and1.0% of total assets as of Dec. 31, 2008,respectively.
“Paragraph 32 of IFRS 5 states thata ‘discontinued operation is a compo-nent of an entity that has been eitherdisposed of... and (a) represents a sep-arate major line of business or geo-graphical area of operations, (b) is partof a single coordinated plan to disposeof a separate major line of business orgeographical area of operations or (c)is a subsidiary acquired exclusivelywith a view to resale.’ The Companyapplied this principle in the context ofi ts operating segment repor t ingformat, which is geographical becausethe risks and rates of return associatedwith the Company’s operations areinfluenced predominantly by the fact
72 www.creditweek.com
SPECIAL REPORTFEATURES
This higher threshold will lead to fewer disposals
qualifying for discontinued operations treatment…
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 73
that the Company operates in differentgeographical areas. Each of theCompany’s geographical segments is adist inguishable component of theCompany that is engaged in providingproducts or services within a partic-ular economic environment, which issubject to risks and returns that aredif ferent from those of other seg-ments. In applying IFRS 5, theCompany believes that only a com-plete geographical segment wouldconstitute ‘a separate major line ofbusiness or geographical area’ withinthe meaning of paragraph 32.Accordingly, when only underlyingbusiness units are sold, the definitionof major line of business or geograph-ical area is not met.” (Source: SECEDGAR; Filing Type: CORRESP FilingDate: 2010-06-10)
Subsequent to this response, there wereno further written comments from theSEC, and no changes made to Anheuser-Busch’s reporting that we found.
So in this case, reported continuingoperat ions contains the results ofthese disposed businesses, and finan-cial statement users are left to scourthe financial statements and manage-ment ’s d iscuss ion and analys is(MD&A) for information about thecontribution of these businesses in2009. While the company disclosedthe sales price for each of these dis-posit ions ( total ing $5.2 bi l l ion onoperating cash flows of $9.1 billion), itonly disclosed in MD&A revenues fortwo (Busch Entertainment and thebeverage can plants) of the five com-ponents, totaling $2.6 billion. Totalreported revenue for 2009 was $36.8billion, so these two disposed busi-nesses alone were 7% of reported rev-enue, and it is unclear what the rev-enue contribution of the remainingthree disposed businesses was.Beyond revenue, the transparencydecreases even further when one triesto arrive at run-rate earnings.
If Anheuser-Busch InBev is a pre-cursor to what we can expect fromcompanies using the new U.S. GAAPthreshold, investors and analysts canexpect to be doing a lot more legwork.
Additional Disclosures Provide Some Insight, But Do Not Outweigh TheReduced TransparencyWhile the new standard also requiresexpanded disclosures, the value of thesedisclosures is questionable. For disposi-tions that qualify as discontinued opera-tions under the higher threshold, compa-nies will be required to disclose, amongother things, one of the following for theperiods in which discontinued opera-tions are reported:● The total operating and investing
cash flows of the discontinued oper-ation; or
● The depreciation, amortization, cap-ital expenditures, and significant oper-ating and investing noncash items ofthe discontinued operation.While these disclosures are more than
currently required and will provide sometransparency around the cash flows ofcontinuing operations, the decreased fre-quency of dispositions qualifying as dis-continued operations, the condensednature of the disclosures, and the optionto provide one disclosure instead of theother limit their usefulness.
Addit ional ly, companies wi l l berequired to disclose only the pretaxprofit or loss of individually significantdispositions that do not qualify for dis-continued operations presentation inthe income statement. The limitedapplicability to only those dispositionsthat are individually significant (ratherthan to all dispositions in the aggre-gate) and the condensed nature of thisdisclosure (only pretax profit or loss)significantly limit its utility and willlikely not allow financial statementusers to arrive at the necessary proforma adjustments. CW
Analytical Contacts:
Mark W. Solak, CPA New York (1) 212-438-7692
Joyce T. Joseph, CPANew York (1) 212-438-1217
Naveen SarmaNew York (1) 212-438-7833
For more articles on this topic search RatingsDirect with keyword:
Discontinued Operations
SPECIAL REPORT
74 www.creditweek.com
FEATURES
Accounting for rate-regulated utilities is unique because
regulators can allow utilities to record costs in a period
different from the one in which an unregulated
company would report the same costs. Standard & Poor’s
Rating Services recognizes that this can lead to different
financial results (see appendix).
Analyzing U.S. Rate-Regulated UtilitiesThe Magic Of Regulatory Assets And Liabilities
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 75
Overview● Accounting for rate-regulated utilities is unique, but follows the economic reality
created by rate regulators. ● Regulatory accounting primarily affects the reporting of postretirement benefits
(PRBs) by altering the amount of PRB expense and shareholders’ equity reported
in the financial statements. ● Rate-regulated accounting for hedges can reduce the complexity of hedge
accounting and reporting. ● Utilities record asset retirement obligations and nuclear decommissioning costs
as regulatory assets until collected in rates. ● International Financial Reporting Standards do not yet allow regulatory accounting.
Regardless of the specific accountingrules used or the financial statementpresentation, our fundamental analysisof the credit quality of the U.S. utilityindustry follows the economic reality,whether created by rate regulation ormarket forces (see “Key Credit Factors For
The Regulated Utilities Industry,” published
Nov. 19, 2013, on RatingsDirect).U.S. rate-regulated electric, natural gas,
and water utilities have the unique abilityto use special accounting rules that allowthem to record regulatory assets and lia-bilities, based on how their regulatorspermit the utilities to recover costs fromcustomers. These rules, established underU.S. generally accepted accounting princi-ples (GAAP), Accounting StandardsCodification 980, Regulated Operations,reflect the economic effects of regulationby matching expenses with their recoveryin rates.(1) Consequently, the financialreporting of U.S. regulated utilities candiffer significantly from unregulated com-panies. Some of the most pronouncedreporting differences when using regula-tory accounting are for PRBs, hedges, and
asset retirement obligations. U.S. GAAP forutilities also differs from InternationalFinancial Reporting Standards (IFRS) thatgenerally do not take into account theeffects of rate regulation.
Credit QualityOne of our primary concerns with U.S. reg-ulatory accounting occurs when a com-pany’s regulatory assets materially growwith uncertain recovery prospects. TheCalifornia energy crisis of 2000 and 2001highlighted this when the regulated utilitiescould only collect a predetermined amountfor electricity but had to purchase elec-tricity at much higher market prices,leading to a material weakening of creditquality. Most companies now have someform of a fuel- or purchased-power adjust-ment clause that allows for timely recoveryof these costs—greatly reducing the risksand enhancing credit quality.
The high credit quality and (mostly)investment-grade ratings for the utilityindustry are predicated on its monopolisticnature, providing an essential service, andcredit-supportive rate regulation. Because a
utility’s ability to effectively manage regula-tory risk is an integral component of creditquality, our assessment of a regulatory juris-diction’s credit supportiveness and a utility’sability to manage regulatory risk within itsregulatory jurisdiction are major factors fordetermining a utility’s credit risk (see “Utility
Regulatory Assessments For U.S. Investor-
Owned Utilities,” published Jan. 7, 2014).Under U.S. GAAP for utility accounting,
the financial presentation generally reflectsthe economic reality created by the utility’sregulators. Regulators must often balanceproviding a fair return to the utility whilelimiting high rates and spikes in customers’bills. Regulators frequently will smooth thevolatility of customer bills through variousmeans, including deferring costs by usingregulatory assets.
Consolidated Edison Inc. has the highestpercentage of net regulatory assets as a per-centage of total equity (see table 1). Whilethis ordinarily could be an indication of ahigher regulatory risk, this is not the case inthis instance because a high percentage ofthe net regulatory assets are from PRBs, thecosts of which historically have been fully
76 www.creditweek.com
SPECIAL REPORTFEATURES
As of Dec. 31, 2013
Net regulatory Net regulatory Net regulatoryassets/(liabilities) assets/(liabilities) assets/(liabilities)
Company reported (mil. $) Total assets (mil. $) Total equity (mil. $) as a % of total assets as a % of total equity
AGL Resources Inc. (802) 14,656 3,676 (5) (22)
Ameren Corp. (525) 21,042 6,686 (2) (8)
American Electric Power Co. Inc. 643 56,414 16,086 1 4
Atmos Energy Corp.* (167) 7,940 2,580 (2) (6)
Berkshire Hathaway Energy Co. 850 70,000 18,816 1 5
Consolidated Edison Inc. 5,354 40,647 12,245 13 44
DTE Energy Co. 1,930 25,935 7,954 7 24
Duke Energy Corp. 3,821 114,779 41,408 3 9
Entergy Corp. 3,619 43,406 9,726 8 37
FirstEnergy Corp. 1,414 50,424 12,695 3 11
NextEra Energy Inc. (3,342) 69,306 18,040 (5) (19)
Northeast Utilities 3,588 27,796 9,612 13 37
Northwestern Corp. (39) 3,715 1,031 (1) (4)
PG&E Corp. (183) 55,605 14,594 0 (1)
SCANA Corp. 394 15,164 4,664 3 8
Southern Co. 2,624 64,546 19,764 4 13
Xcel Energy Inc. 1,593 33,907 9,566 5 17
Note: The table quantifies the amount of net regulatory assets (liabilities) as a percentage of total assets and total equity, and are not core financial measures. *As of Sept. 30, 2013.
Table 1 | Net Regulatory Assets And Liabilities
recovered from ratepayers (see table 2). Thissignificantly reduces the company’s poten-tial regulatory risk for an under-collection,preserving its credit quality.
Pensions And OtherPostemployment BenefitsRegulatory accounting primarily affectsthe reporting of PRBs in two ways:● Regulatory accounting can alter the
amount of PRB expense that a rate-regulated utility recognizes each year,which also affects retained earnings.When a regulator defers recovery ofpension costs to future years, the com-pany records a regulatory asset insteadof expense for the amount deferred.SCANA Corp. explains that regulatoryaccounting “...allowed it to mitigate asignificant portion of...increased pen-sion cost by deferring as a regulatoryasset the amount of pension expenseabove the level that was included inthen-current cost of service rates for itsretail electric and gas distribution regu-lated operations.” Absent regulatory
accounting, SCANA would havereduced net income by these costs.(2)
● PRB accounting standards for unregu-lated companies recognize theunfunded status of employee benefitplans on the balance sheet as a lia-bility. To the extent that PRB under-funding has not been recognized inexpense, unregulated companiesrecord the offset in accumulated OCI,reducing shareholders’ equity.However, regulated utilities generallyrecord the offset to the unfunded lia-bility as a regulatory asset, rather thanaccumulated OCI, resulting in higherreported equity compared to anunregulated company. Similarly,Ameren Corp. “...recognizes theunder-funded status of its pension andpostretirement plans as a liability onits balance sheet, with of fsettingentries to accumulated OCI and regu-latory assets.” In 2012, it included$184 million (or 98%) of the offsettingentry in regulatory assets, rather thanaccumulated OCI.(3)
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 77
As of Dec. 31, 2013
Net pension and OPEBNet pension and Net regulatory regulatory assets as
OPEB regulatory assets/(liabilities) a % of net regulated Company assets (mil. $) reported (mil.$) assets/(liabilities)
AGL Resources Inc. 108 (802) (13)
Ameren Corp. 169 (525) (32)
American Electric Power Co. Inc. 1,197 643 186
Atmos Energy Corp.* 188 (167) (113)
Berkshire Hathaway Energy Co. 515 850 61
Consolidated Edison Inc. 2,967 5,354 55
DTE Energy Co. 1,576 1,930 82
Duke Energy Corp. 1,585 3,821 41
Entergy Corp. 1,723 3,619 48
FirstEnergy Corp. 0 1,414 0
NextEra Energy Inc. 58 (3,342) (2)
Northeast Utilities 1,240 3,588 35
Northwestern Corp. 58 (39) (149)
PG&E Corp. 1,444 (183) (789)
SCANA Corp. 238 394 60
Southern Co. 1,760 2,624 67
Xcel Energy Inc. 1,311 1,593 82
Note: The table quantifies pension and OPEB regulatory assets (liabilities) as a percentage of net regulatory assets (liabilities), and is not a core financial measure. *As of Sept. 30, 2013.
Table 2 | Pension Regulatory Assets And Liabilities
We consider pension liabilities to be debt-like, and make formal adjustments to autility’s debt and cash flows for PRB obliga-tions (see “Corporate Methodology: Ratios And
Adjustments,” Nov. 19, 2013). While utilityaccounting for PRB may result in a higherbook equity that we qualitatively incorporatewithin our overall analysis, we do not make aformal quantitative equity adjustment to ouranalysis. When determining the risk ofdefault, we place greater emphasis on ourcore financial measures of funds from opera-tions (FFO) to debt and debt to EBITDA,reducing our analytical reliance on the bookvalue of equity (see “Key Credit Factors For
The Regulated Utilities Industry,” Nov. 19, 2013).
Hedging Without The HassleWhen using rate-regulated accounting forhedges, regulated utilities have advantagesthat unregulated companies do not have:● Reduced complexity in accounting for
hedges; and● Reporting of cash-flow-hedge gains
and losses in regulatory assets or liabil-ities, rather than stockholders’ equity.Unregulated companies generally report
derivative instruments on the balancesheet at fair value and report changes infair value within income, adding volatilityto a company’s net income. When unregu-lated companies designate qualified deriv-atives as hedges, the unregulated compa-nies can reduce income volatility bymatching derivative gains or losses withlosses or gains on the hedged transactions.However, these hedge accounting rulesare extremely complex, requiring that thederivatives meet various tests.
Regulated utilities can more easilyachieve the same results. When regula-tors permit utilities to recover theirderivative gains and losses in customerrates, regulated utilities can achievesimilar results by deferring derivativelosses and gains in regulatory assets orregulatory liabilities. The use of regula-tory accounting allows the utility toavoid the complex hedge accountingrules and tests.
Xcel Energy Inc. reports derivatives thatare not designated as hedges in currentearnings or as a regulatory asset or liability.“The classification as a regulatory asset orliability is based on commission approved
regulatory recovery mechanisms”;(4) (see “Key Credit Factors For The Regulated
Utilities Industry,” Nov. 19, 2013).Similarly, Ameren explains, “...derivative
contracts that qualify for regulatory deferralare recorded at fair value, with changes infair value recorded as regulatory assets orregulatory liabilities in the period in whichthe change occurs. ...Therefore, gains andlosses on these derivatives have no effecton operating income.”(5)
Because of regulatory accounting,Xcel Energy and Ameren avoided thecomplexities of qualifying and desig-nating derivatives as hedges that arerequired for an unregulated company.
A second distinction between regulatedand unregulated companies whenaccounting for hedges is the reporting ofshareholders’ equity. When using hedgeaccounting, an unregulated companydefers the gain or loss on future cash flowhedges in shareholders’ equity as part ofaccumulated OCI. In contrast, utilityaccounting allows the deferred loss orgain to be recorded as a regulatory asset
or liability, not affecting shareholders’equity (see table 3).
We view the utility-hedge accountingtreatment as a generally accurate depictionof economic reality. While we recognize thediffering accounting treatment for rate-reg-ulated utilities could result in a difference inreported book equity, our emphasis on acompany’s ability to meet it debt obliga-tions through cash flows is not materiallyaffected because of relatively small changesto book equity. For this reason, we do notmake any quantitative analytical adjust-ments for our analysis of utilities for hedgeaccounting (see “Key Credit Factors For The
Regulated Utilities Industry,” Nov. 19, 2013).
Asset Retirement ObligationsAnd Nuclear DecommissioningA regulated utility’s recognition of assetretirement obligation (ARO) expenses alsocould differ from what an unregulated com-pany reports. Duke Energy Corp. says,“Asset retirement obligations are recog-nized for legal obligations associated withthe retirement of property, plant and equip-
78 www.creditweek.com
SPECIAL REPORTFEATURES
As of Dec. 31, 2013
Net derivative regulatoryNet derivative Net regulatory assets/(liabilities) as a
regulatory assets/ assets/(liabilities) % of net regulated Company (liabilities) (mil. $) reported (mil. $) assets/(liabilities)
AGL Resources Inc. 0 (802) 0
Ameren Corp. 148 (525) (28)
American Electric Power Co. Inc. (35) 643 (5)
Atmos Energy Corp.* 0 (167) 0
Berkshire Hathaway Energy Co. 182 850 21
Consolidated Edison Inc. 19 5,354 0
DTE Energy Co. 0 1,930 0
Duke Energy Corp. 450 3,821 12
Entergy Corp. 0 3,619 0
FirstEnergy Corp. 0 1,414 0
NextEra Energy Inc. (81) (3,342) 2
Northeast Utilities 638 3,588 18
Northwestern Corp. 0 (39) 0
PG&E Corp. 106 (183) (58)
SCANA Corp. (57) 394 (14)
Southern Co. 58 2,624 2
Xcel Energy Inc. 0 1,593 0
Note: The table quantifies derivative regulatory assets (liabilities) as a percentage of net regulatory assets(liabilities) and is not a core financial measure. *As of Sept. 30, 2013.
Table 3 | Derivative Regulatory Assets And Liabilities
ment. Substantially all asset retirement obli-gations are related to regulated operations....Duke Energy...receive(s) amounts to fundthe cost of the asset retirement obligationfor regulated operations through a combi-nation of regulated revenues and NDTF(nuclear decommissioning trust funds). As aresult, the net of amounts recovered in reg-ulated revenues, earnings on the NDTF,accretion expense and depreciation of theassociated asset is deferred as a regulatoryasset or liability.”(6)
The regulated utility’s reporting of AROshas no effect on earnings because the AROexpense is recorded as regulatory assetsuntil collected in rates. Conversely, anunregulated company would recognizeARO expenses in the income statement.
Both regulated utilities and unregulatedmerchant power generators that havenuclear generating facilities must funddecommissioning trusts. Unregulated com-panies recognize gains and losses on thetrust investments in the income statementor in OCI. However, regulated utilities wouldnot necessarily have to report gains and
losses on the nuclear trust investments tothe income statement or OCI (see table 4).Ameren records investment trust fundlosses as a regulatory asset, and says“...losses on assets in the trust fund couldresult in higher funding requirements fordecommissioning costs, which AmerenMissouri believes would be recovered inelectric rates paid by its customers.Accordingly, Ameren and Ameren Missourirecognize a regulatory asset on their balancesheets for losses on investments held in thenuclear decommissioning trust fund.”(7)
When evaluating a company’s creditquality, we consider ARO liabilities to bedebt-like and quantitatively adjust debt toinclude AROs. For decommissioning costs,we believe regulatory accounting reflects theeconomic reality created by rate regulation,recognizing decommissioning costs whenrecovered from ratepayers. We will continueto monitor the size of regulatory assetsbecause a disproportionally large regulatoryasset could signal the possibility that a utilitymay not fully recover its costs absent aformal action plan that assures recovery.
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 79
As of Dec. 31, 2013
Net ARO regulatoryNet ARO Net regulatory assets/ (liabilities) as a
regulatory assets/ assets/(liabilities) % of net regulatoryCompany (liabilities) (mil.$) reported (mil. $) assets/(liabilities)
AGL Resources Inc. (1,472) (802) 184
Ameren Corp. (1,579) (525) 301
American Electric Power Co. Inc. (3,178) 643 (494)
Atmos Energy Corp.* (418) (167) 250
Berkshire Hathaway Energy Co. (1,967) 850 (231)
Consolidated Edison Inc. (540) 5,354 (10)
DTE Energy Co. 43 1,930 2
Duke Energy Corp. (3,700) 3,821 (97)
Entergy Corp. 637 3,619 18
FirstEnergy Corp. (1,000) 1,414 (71)
NextEra Energy Inc. (3,921) (3,342) 117
Northeast Utilities (435) 3,588 (12)
Northwestern Corp. (337) (39) 864
PG&E Corp. (4,592) (183) 2,509
SCANA Corp. 341 394 87
Southern Co. (1,283) 2,624 (49)
Xcel Energy Inc. (745) 1,593 (47)
Note: The table quantifies ARO and asset removal regulatory assets (liabilities) as a percentage of net regulatoryassets (liabilities) and is not a core financial measure. *As of Sept. 30, 2013.
Table 4 | ARO Regulatory Assets And Liabilities
The merchant power company’s decommis-sioning trust has the risk of the marketreturns and, therefore, investment gains andlosses are recorded in the income statement.In general, our assessment of credit qualityfor regulated and unregulated merchant gen-eration companies will continue to followtheir economic reality, even if the accountingpresentation differs between industries.
International Financial Reporting StandardsUnlike U.S. GAAP, IFRS generally do notallow rate-regulated utilities to recognizeregulatory assets and liabilities on theirbalance sheets.
However, in January 2014, theInternational Accounting StandardsBoard (IASB) issued an interim standard,IFRS 14 “Regulatory Deferral Accounts,”that temporarily allows regulated utilitiesthat adopt IFRS for the first time to con-tinue recognizing regulatory assets andliabilities following their previous localaccounting standards. This exceptionremoved a barrier to adoption of IFRS forrate-regulated companies in Canada (see
“Implications Of The Canadian Regulated
Utility Sector’s Mixed Bag Of Accounting
Standards,” published Aug. 21, 2012).While adoption of IFRS in the U.S.
remains uncertain, we recognize that, ifcurrent IFRS rules are allowed in the U.S.,financial reporting for U.S. utilities could bematerially affected. Xcel Energy says, if theSEC “...mandate(s) the use of IFRS and thelack of an accounting standard for rate-reg-ulated entities under IFRS could require usto charge certain regulatory assets and reg-ulatory liabilities to net income or OCI.”(8)
Without the use of regulatory assets andliabilities, earnings volatility would increase,although cash flows would remainunchanged. The cumulative effect ofcharging regulatory assets and liabilities toincome may also significantly affect retainedearnings and total equity (see “What May Be
At Stake For U.S. Investor-Owned Utilities When
International Financial Reporting Standards
Arrive,” published Aug. 10, 2010). While therevised financial results using IFRS would bedifferent, we expect the credit quality of U.S.utilities would remain largely unaffected,because credit quality for rate-regulated utili-ties will continue to follow economic reality.To preserve our fundamental analysis, we
will continue to identify key distinguishingdifferences between these accountingmethods. The IASB continues to work on acomprehensive, rate-regulated accountingproject, and expects to issue a discussionpaper in the third quarter of 2014. Weencourage utilities and investors to give theirviews on the paper to the IASB.
There are various accounting differencesbetween regulatory accounting and theaccounting used by an unregulated com-pany. While these distinctions result insome reporting differences, they do notaffect the credit quality of a utility or anunregulated company. Our fundamentalanalysis will continue to incorporate theeconomic reality whether created by rateregulation or market forces. In all situations,we will qualitatively take into account thesereporting differences and in specificinstances, we will quantitatively incorporatefinancial adjustments that better reflect acompany’s obligations and cash flow. CW
NOTES(1) Originally found in Statement of
Financial Accounting Standards No. 71,“Accounting for the Effects of CertainTypes of Regulation”
(2) SCANA Corp., Form 10-K for the yearended Dec. 31, 2012, page 101
(3) Ameren Corp., Form 10-K for the yearended Dec. 31, 2013, page 127
(4) Xcel Energy Inc., Form 10-K for theyear ended Dec. 31, 2013, page 97
(5) Ameren Corp, Form 10-K for the yearended Dec. 31, 2013, page 109
(6) Duke Energy Corp., Form 10-K for theyear ended Dec. 31, 2013, page 116
(7) Ameren Corp., Form 10-K for the yearended Dec. 31, 2013, page 88
(8) Xcel Energy Inc., Form 10-K for theyear ended Dec. 31, 2013, page 69
(9) Xcel Energy Inc., Form 10-K for theyear ended Dec. 31, 2013, page 69
(10) Entergy Corp., Form 10-K for the yearended Dec. 31, 2013, page 63
80 www.creditweek.com
SPECIAL REPORTFEATURES
Regulators can allow utilities to report costs in a period different from the one in
which an unregulated company would report these costs in income or other com-
prehensive income (OCI). For a regulated utility, this creates:● Regulatory assets (future cash inflows); and● Regulatory liabilities (future cash outflows).
Describing its regulatory accounting, Xcel Energy Inc. said, “Regulatory assets gener-
ally represent incurred or accrued costs that have been deferred because they are prob-
able of future recovery from customers. Regulatory liabilities generally represent
amounts that are expected to be refunded to customers in future rates or amounts col-
lected in current rates for future costs.” It adds, “In other businesses or industries, regula-
tory assets and regulatory liabilities would generally be charged to net income or OCI.”(9)
To use regulatory accounting, a U.S. utility must meet the following conditions:● A regulator (i.e., a public utility commission) sets rates that bind customers;● The rates are designed to recover a utility’s specific costs; and● It is probable the utility can charge and collect these rates from customers.
If a utility ceases to meet any of the three conditions, the utility would eliminate
regulatory assets and liabilities from its balance sheet and include them in net income
or in OCI, consistent with the reporting requirements for unregulated companies.
Entergy Corp. explicitly acknowledges that the consequences of not meeting all of
the three conditions would require it to “...report that event in its financial statements...”
and “...eliminate from its balance sheet all regulatory assets and liabilities.”(10)
Appendix: Why Rate-Regulated Utility Accounting Is Different
Analytical Contacts:
Sherman A. Myers, CPANew York (1) 212-438-4229
Gabe GrosbergNew York (1) 212-438-6043
For more articles on this topic search RatingsDirect with keyword:
Rate-Regulated
The analyses, including ratings, of Standard & Poor’s and its affiliates are opinions and not statements of fact or recommendations to purchase, hold, or sell securities. They do not address the suitability of any security, and should not be relied on in making any investment decision. Standard & Poor’s does not act as a fiduciary or an investment advisor except where registered as such.
Copyright © 2013 by Standard & Poor’s Financial Services LLC. All rights reserved.
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82 www.creditweek.com
FEATURES
Tax-driven corporate inversion strategies, in which U.S.
companies seek to acquire entities in countries with lower
tax rates and reincorporate overseas, account for a small
but growing fraction of mergers and acquisitions (M&A) in 2014.
A significant proportion of pending large inversion transactions
will likely hurt credit ratings if completed. Standard & Poor’s
Ratings Services’ view is that the credit positives of these
inversions, including lower taxes and increased access to
offshore cash and investments, is often outweighed by negative
credit consequences, including higher leverage and the initiation
of shareholder-friendly activities, which can undermine liquidity.
Inversions Lower TaxLiabilities, But Also CanImpair Credit Ratings
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 83
Overview● The pace of announcements of merger and acquisition inversions in 2014 has picked
up, led by a growing number of health care companies seeking to lower tax rates,
access overseas cash, and bolster their product portfolios. ● As the pending Medtronic, AbbVie, and Burger King inversions demonstrate, these
types of transactions can negatively affect credit ratings.● In particular, materially higher leverage to fund acquisitions and the use of
overseas cash for aggressive shareholder-friendly actions can lead to downgrades.● Technology firms hold the largest amount of cash trapped abroad, but have
largely stayed away from inversions because of the relative scarcity of
appropriate acquisition targets.● If U.S. corporate tax reform or a tax holiday were to occur, companies may choose
to return significant amounts of cash to shareholders, as occurred in 2004 when
the government allowed corporations to repatriate cash at a 5.25% tax rate.
How Inversions Can Harm RatingsThe impact on ratings of M&A inversiondeals varies markedly, but in a significantproportion of cases, inversions haveraised the following credit risks:● More aggressive financial policies,
including higher leverage to fundacquisitions, spurred by the attractionof tax inversion benefits.
● Easier access to previously “trapped”cash, leading to more aggressive sharebuybacks and dividend payments.This can weaken liquidity and raiseadjusted leverage metrics. Companies’can become distracted by the lure oftax benefits of an inversion instead offocusing on the longer-term strategicand operational risks of the prospec-tive acquisition.
● Large tax-driven acquisitions can con-strain a company’s financial capacity toconduct further strategic acquisitionsneeded to replenish its product portfolio.
● Future legislation limiting tax inver-sions, which could expose re-domi-ciled companies to higher U.S. tax lia-bilities than anticipated, given the U.S.government’s strong desire to put anend to inversions.
● The potential for public, political,media, and customer backlash whenan inversion is announced.In M&A deals, we analyze the degree of
strategic and management fit; the impact onearnings; cash flow and liquidity; product,market, and geographic diversification; exe-cution risk; and the amount and amortiza-
tion schedule of any additional debt. Thislast factor is most likely to lead to down-grades if new borrowings are significant. Aneffective inversion strategy should makesense for business fundamentals and not justfor tax reasons, considering that acquisitionswith robust tax benefits often command ahigher price multiple, which companies mayhave to finance with increased debt.
How Some Major InversionTrends Are Unfolding This YearThis year, the majority of inversion-moti-vated M&A activity has occurred in thehealth care sector. This is predominantlyattributable to health care companies’large overseas cash balances and theample number of attractive acquisition tar-gets compared to other industries.However, Burger King Corp.’s recent bidfor Tim Hortons of Canada shows thatthese types of deals can also be attractivefrom a tax perspective to companies oper-ating outside of the health care space.
The fear of potential backlash frompoliticians and customers has become amaterial risk factor needing considerationwith respect to overseas tax-motivatedM&A activity. In fact, Jack Lew, U.S.Treasury Secretary, stated earlier this weekthat the Obama administration is close totightening ownership and operational resi-dency rules that would significantly limitcompanies’ ability to invert. But even priorto this announcement, some companieshave recognized the potential for inversionstrategies to cause them to be perceived as
unpatriotic. For example, drugstore retailerWalgreen Co. seemed poised to go theinversion route with its recent acquisitionof British drugstore chain Alliance BootsLtd. However, while Walgreen has decidedto proceed with the acquisition, it hasdecided not to invert.
The Potential Credit Impact Of Corporate Tax Reform Or A Tax HolidayWe have analyzed the potential effects onratings if any future U.S. corporate taxreform or tax holiday were significantenough to entice companies to repatriatelarge overseas cash balances. Maintainingcash reserves domestically—or using themfor capital expenditures, growth, or debtreduction—would likely be ratings-neutralto ratings-positive. A company using repa-triated cash for acquisitions could nega-tively affect ratings if a questionablestrategic fit resulted, compromising busi-ness strength, or if the company funded theacquisition with a mix of cash and debtthat materially increased leverage.
Relative softness in global economicgrowth has limited internal growth opportu-nities for many companies. With the cur-rently strong level of capital market liq-uidity and the abundance of investorsseeking yield alternatives, corporate issuersremain less incentivized to reduce debt withsurplus cash. In the event of U.S. corporatetax reform or a tax holiday, companies maychoose to return significant amounts ofcash to shareholders, as occurred in 2004
84 www.creditweek.com
FEATURES
Date U.S. company Acquisition target Initial rating Rating at announcement Current rating* Rating action
Pending AbbVie Shire A/Stable A/CW Negative A/Watch Neg Unfavorable
Pending Mylan Abbott's generics unit BBB-/Stable BBB-/Positive BBB-/Positive Favorable
Pending Medtronic Covidien AA-/Stable AA-/Watch Neg AA-/Watch Neg Unfavorable
Pending Mallinckrodt Questcor BB-/Stable BB-/Stable BB-/Stable Neutral
Pending Allergan Valeant A+/Stable A+/Watch Neg A+/Watch Neg Unfavorable
Feb. 28, 2014 Endo International Paladin Labs BB-/Stable BB-/Stable BB-/Negative Neutral
Nov. 5, 2013 Perrigo Elan BBB/Stable BBB/Negative BBB/Negative Unfavorable
Oct. 7, 2013 Actavis Warner Chilcott BBB/Negative BBB/Negative BBB-/Stable Neutral
May 21, 2012 Jazz Pharmaceuticals Azur Pharma — BB/Stable BB/Stable —
Oct. 7, 2011 Alkermes Elan Drug Technologies — B+/Stable BB/Stable —
Sept. 28, 2010 Valeant Biovail BB-/Stable —
*As of Sept. 2, 2014.
Major Health Care Inversion Deals Since 2010
when the government allowed corporationsto repatriate cash at a 5.25% tax rate. Thiswould increase credit risk.
Heath Care Companies Are TheLeading Practitioners—And TheMajor Credit Quality GaugeThe pharmaceuticals and medicalsupply sectors have seen the most inver-sions in the recent past, as well as in2014 (see table). Some large announcedhealth care inversions in 2014 (e.g.,AbbVie Inc. and Medtronic Inc.) havenegatively af fected credit qualitybecause of the additional leverage nec-essary to finance the transaction.
We believe that pharmaceutical compa-nies will use their trapped cash to fund share-holder-friendly actions, which can provedetrimental to credit quality, especially if itundermines liquidity metrics. During the“one-time” tax holiday created by theAmerican Jobs Creation Act of 2004, theU.S. government allowed companies to bringback offshore cash to the U.S. The industryrepatriated tens of billions of dollars (PfizerInc. alone repatriated $37 billion), only to usethe overwhelming bulk of the cash to con-duct share buybacks and pay dividends.With Big Pharma companies facing a periodof slow growth, we currently projectbranded pharmaceutical companies to growin the low- to mid-single-digit range over thenear term. The need to support earnings pershare and share prices will likely spur agrowing number of newly tax-inverted phar-maceutical companies to embark on majorshare repurchase programs, given theincreased access to overseas cash.
In our view, Big Pharma companiesmay be utilizing their financial capacity toexecute what is essentially a predomi-nantly tax-focused transaction, rather thanone that adds promising new products andprospects to their portfolios. Withincreased potential exposure to legislativeaction against companies consideringinversion tactics, inversions can be a netnegative from a credit perspective.
Tax Driven Or Strategy Driven?Pharmaceutical companies’ rationales forpursing inversions vary. Mylan Inc. hasasserted that the company would have“absolutely” completed its $5.3 billion
acquisition of Abbott Laboratories’ non-U.S.developed generic drugs business evenwithout the tax inversion benefits. ValeantPharmaceuticals International Inc., whichacquired Biovail Corp. in 2010 and bene-fited from Canada’s more lenient corporatetax structure, claims that tax savings were avery limited factor for the deal. Meanwhile,
Endo International PLC’s $1.6 billion acqui-sition of Paladin Labs in 2014 may havebeen based mainly on the promise of lowertaxes, as the transaction did not significantlyimprove Endo’s need for new and growingproducts. Pfizer’s failed bid for AstraZenecaPLC, as well as Medtronic’s pending bid forCovidien plc, included provisions thatwould have allowed termination of the dealif revised U.S. regulations prevented it fromreincorporating. These latter transactionssuggest that the companies’ tax-driveninversion decision overshadowed strategicbusiness considerations.
Technology Companies Miss Out On InversionAmong U.S. industry sectors, technologycompanies, on average, generate thehighest percentage of their cash flow, andhave the largest amount of cash, overseas.These factors suggest that companies inthis sector represent ideal candidates forinversion. Technology companies accountfor over 30% of total cash and short-terminvestments among Standard & Poor’s-rated nonfinancial companies, and manylarge global companies have 80% or even90% of their total cash held abroad (see
“2014 Cash Update: Cheap Debt Fuels Record
Cash Growth,” published April 14, 2014, on
RatingsDirect). What they lack, however, is adeep pool of inversion targets. Unlike phar-maceutical companies, which have a strongpresence domestically and in the EU (manyin low-tax jurisdictions), large technologycompanies tend to be based mostly in the
U.S. and, to some extent, in Asian countries(e.g., China, Taiwan, and Korea). Inversionstargeting these countries are not practicalbecause of corporate tax rates that aregenerally higher than in the EU and, moreimportantly, politically unfeasible given theimportance of these companies to theirnational economies.
If inversions were to occur in the tech-nology industry, they would be less aboutenhancing product revenues. Technologyinversions would generate significant taxsavings on future cash flows, and couldunleash a significant amount of overseascash. If they were able to access thistrapped cash, technology companies would,in our opinion, undertake major shareholderdistributions through both large one-timedividends and higher share repurchases.
M&A activity could also increase as tech-nology companies use the cash to enternew products or end markets. It is also pos-sible, especially among higher-rated issuers,that companies would use the new-foundcash to retire existing debt that was issuedas a form of “synthetic cash repatriation,”or at least ring-fence a like amount to fundfuture debt maturities. Finally, we wouldn’texpect R&D or capital spending to benefitmaterially from inversions. Large tech-nology companies already have access tocapital to fund future product development,either through internally generated cashflow or capital markets.
The Major Differences BetweenU.S. And Other NationalCorporate Tax StructuresU.S. tax rules, which are markedly differentfrom taxation practices in many other largedeveloped countries, may have contributedto growing overseas cash reserves. Mostdeveloped nations take a territorial taxationapproach, taxing their corporations only onprofits earned domestically, with overseas
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 85
Technology inversions would generate significant
tax savings on future cash flows, and could unleash
a significant amount of overseas cash.
86 www.creditweek.com
FEATURES
earnings subject to the tax rates of the for-eign jurisdictions in which the companiesoperate. By contrast, the U.S. taxes world-wide profits brought home to the U.S. at therate of 35%. Subject to certain exceptions,American companies’ foreign profits arenot taxed until they are repatriated. Thetiming of bringing this cash home is left tothe discretion of the company, with manyentities choosing to sit on overseas earn-ings in hope of tax reform or a tax holiday.
By way of comparison, the EU averagetop corporate tax rate in 2013 was approx-imately 23%. According to the TaxFoundation, the U.S. rate, including stateincome tax, is 39.1%, while the simpleaverage of the other 33 OECD countries is25.5%. (We acknowledge that averagetaxes paid by U.S. corporates are meaning-fully lower than this rate due to numeroustax deductions available. However, re-domiciling abroad would still generatemeaningful tax savings and easier accessto cash trapped overseas.)
What’s Driving The CurrentIncrease In Inversions?Factors driving the increase in inversionsinclude:● Lack of comprehensive tax reform, or
a temporary tax holiday, to ease repa-triation to the U.S.
● Concern that new legislation will halt orscale back inversions, which may beaccelerating companies’ decision to invertbefore the window of opportunity closes.
● Surging stock market valuations(growing company currency), whichhave fueled M&A activity.
● Generally favorable credit market con-ditions providing easy debt access tofinance acquisitions.
● The desire to use growing foreign cashreserves more productively, including low-ering taxes on future profits from overseassources that companies can use to bolstershareholder-friendly initiatives (such asbuybacks and dividend increases).
● The view that U.S. corporate tax ratesare a disadvantage for U.S. companies.
Alternatives To InversionsFor companies holding large foreign cashreserves, “synthetic cash repatriation” hasemerged in recent years as the most popular
approach for companies to fund their needson a tax-efficient basis (see 2014 Cash Update:
Cheap Debt Fuels Record Cash Growth, pub-
lished April 14, 2014). Many companies viewtheir overseas cash as effectively trappedbecause of the high tax cost of repatriation.In order to fund domestic needs, such asshareholder-friendly actions or capitalexpenditures, firms have chosen to borrowdomestically. Companies’ ability to issuebonds in the U.S. has been a function of theirgood credit standing, partially due to largeoverseas cash holdings. These types oftransactions have the added benefit of notbeing as controversial as inversions.
Caveat Emptor: Inversions MayBe Negative For CreditworthinessInversions have the potential to improvecredit by enhancing cash flow and liquiditythrough lowering tax rates. However, webelieve that material risk factors can out-weigh tax inversion and can be negative forratings. These negatives include increasedleverage to finance the acquisition, height-ened payouts to shareholders using previ-ously trapped overseas cash (which canundermine liquidity and weaken credit-pro-tection metrics), and an over-focus on theshort-term tax benefits of inversion withoutgiving due consideration to the longer-termstrategic fit and risks of the acquisition. Inaddition, if U.S. corporate tax reforms or atax holiday were to occur, companies maychoose to return significant amounts ofcash to shareholders, as occurred in 2004when the government allowed corporationsto repatriate cash at a 5.25% tax rate. Thiswould also increase credit risk. CW
Analytical Contacts:
David P. WoodNew York (1) 212-438-7409
Arthur C. WongToronto (1) 416-507-2561
Michael G. BerrianBoston (1) 617-530-8307
Andrew ChangSan Francisco (1) 415-371-5043
Leonard A. GrimandoNew York (1) 212-438-3487
David C. TesherNew York (1) 212-438-2618
For more articles on this topic search RatingsDirect with keyword:
Inversions
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 87
The first three pages of this section displaydata compiled by Standard & Poor’s Global
Fixed Income Research, provider of analyticaland timely information on Standard & Poor’srating actions, new issuance activity, andsecondary market yield spreads.
■ Rating actions are tracked and analyzed.Credit trends are followed daily across sevenbroad industry sectors and numeroussubsectors.
■ New-issuance volume and pricing trends in the primary market for both investment gradeand high-yield bonds in the corporate-industrial sector, telecommunication, utility,yankee, banking and financialinstitutions/insurance are analyzed.
■ Secondary market yields and spreads forinvestment-grade and high yield corporatebonds are tracked and analyzed.
For additional information, contact DianeVazza, managing director of Global FixedIncome Research at Standard & Poor’s.
☎ (1) 212-438-2760
—This Week— —YTD 2014—Sector Action No. Mil. $ No. Mil. $
Industrial Upgrade 2 2,075 145 364,945Downgrade 4 2,527 163 318,205
Telecommunications Upgrade 1 12,400 5 36,474Downgrade 0 0 6 30,006
Utility Upgrade 1 2,300 14 45,403Downgrade 0 0 10 73,969
Banking Upgrade 0 0 5 13,340Downgrade 0 0 7 12,981
Financial Institutions/Insurance Upgrade 0 0 11 40,264Downgrade 0 0 3 8,163
Sovereign Upgrade 0 0 10 1,117,604Downgrade 0 0 13 935,342
International Upgrade 1 290 134 588,032Downgrade 2 1,534 164 538,621
Standard & Poor’s Fixed Income Research
Rating Actions
RATINGSTRENDS
Data as of Sept. 10, 2014. The rating action data are for issuer credit ratings. International includes all sectors outside the U.S.Source: Standard & Poor’s Global Fixed Income Research.
05
101520253035404550556065707580859095
100105110115120125130135140
-1
0
1
2
3
4
5
Nov
-201
0
Dec
-201
0
May
-201
1
May
-201
2
Nov
-201
2
May
-201
3
Aug
-201
0
Sep-
2010
Oct
-201
0
Jan-
2011
Feb-
2011
Mar
-201
1
Apr
-201
1
Jun-
2011
Jul-2
011
Aug
-201
1
Sep-
2011
Oct
-201
1
Nov
-201
1
Dec
-201
1
Jan-
2012
Feb-
2012
Mar
-201
2
Apr
-201
2
Jun-
2012
Jul-2
012
Aug
-201
2
Sep-
2012
Oct
-201
2
Dec
-201
2
Jan-
2013
Feb-
2013
Mar
-201
3
Jun-
2013
Apr
-201
3
Aug
-201
3
Sep-
2013
Oct
-201
3
Nov
-201
3
Dec
-201
3
Jan-
2014
Jul-2
013
Feb-
2014
Mar
-201
4
Apr
-201
4
May
-201
4
Jun-
2014
Jul-2
014
Aug
-201
4
Sep-
2014
Investment grade High yield 3-month T-bill 10-year Treasury 30-year Treasury
(Bil. $) (%)
Corporate Issuance Volume And Treasury Yields
Includes all public and Rule 144a issuance of straight debt, convertible debt, floating-rate notes, and medium-term notes by financial and nonfinancial entities into the U.S. market.Sources: Standard & Poor's Global Fixed Income Research, Thomson Financial.
Corporate Issuance Volume And Treasury Yields
0
40
80
120
160
200
240
280
320
360
400
020406080
100120140160180200220240
359
133
7
292
309
161
768
52
400
152
49 116
279
108
11
112 177334
371
722
1312428
194
160
363
By SectorBy Rating Category
Number Of New Issues And Dollar Volume
Includes all public and Rule 144a issuance of straight debt, convertible debt, floating-rate notes, andmedium-term notes by financial and nonfinancial entities into the U.S. market.Sources: Standard & Poor's Global Fixed Income Research, Thomson Financial.
Includes all public and Rule 144a issuance of straight debt, convertible debt, floating-rate notes, andmedium-term notes by financial and nonfinancial entities into the U.S. market.Sources: Standard & Poor's Global Fixed Income Research, Thomson Financial.
YTD 2013 YTD 2014 YTD 2013 YTD 2014
(Bil. $) (Bil. $)
Industrials Telecom Utilities Banks Financial/Insurance
AAA AA A BBB BB B CCC &Below
NR
3/26/2014 4/23/2014 5/21/2014 6/18/2014 7/16/2014 8/13/2014 9/10/2014100
125
150
175
200
3/26/2014 4/23/2014 5/21/2014 6/18/2014 7/16/2014 8/13/2014 9/10/201475
100
125
150
175
200
225
Industrial Telecommunication Electric, Water & Gas Finance Co.
(Bps above Treasuries)
Sector Relative Value Rating Category ‘A’
AAA AA A BBB
U.S. Industrial Credit Trends By Rating Category
(Bps above Treasuries)
Spread To Treasuries By Rating Category
Includes Yankee bond issues. Nine plus years to maturity and minimum $100 million outstanding.Source: Standard & Poor’s Global Fixed Income Research.
Five-plus years to maturity and minimum $100 million outstanding.Source: Standard & Poor’s Global Fixed Income Research.
88 www.creditweek.com
Spread To Treasuries By Rating Category
Number Of New Issues And Dollar Volume
RATINGSTRENDS
2009 2010 2011 2012 2013 YTD 20140
100
200
300
400
500
600
700
800
900
1,000
1,1001,200
1,742 2,1981,955 2,1801,645
64%
28%
$1,084.6
8%
59%
13%
67%
67%
25%
8%
$792.6
20%
1,404
20%
61%
$1,045.78%
28%$740.9
25%
8%
14% $786.8
78%
$973.7
28%
U.S. Corporate Bond Issuance
Includes all public and Rule 144a issuance of convertible debt, straight debt, floating-rate notes,and medium-term notes by financial and nonfinancial entities into the U.S. market.Sources: Standard & Poor's Global Fixed Income Research, Thomson Financial.
Investment grade High yield Not rated
(Bil. $)
Issues Issues Issues Issues Issues Issues
Global Insight is a leading provider of financial and economic information used by industry, government, and financial institutions to assess business condi-tions and monitor emerging trends.
☎ For additional information on Global Insight products and services, call Charles Ferrari (1) 212-884-9518.
5 10 15 20 251.00
2.00
3.00
4.00
5.00
6.00
7.00
U.S. Industrial Bond Yields
Data as of Sept. 10, 2014.Source: Standard & Poor's Global Fixed Income Research.
AAA AA A BBB BB+
Standard & Poor’s Rated U.S. Money Fund Indices
Macroeconomic Data From Global Insight
U.S. Corporate Bond Issuance U.S. Industrial Bond Yields
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 89
Money Fund Indices (Period ended 9/9/2014)
‘AAAm’/Government 0.01 0.01 N.A. N.A. 43 N.A.
‘AAAm’/Taxable 0.01 0.01 N.A. N.A. 42 N.A.
‘AAAm’/Tax-Free 0.01 0.01 N.A. N.A. 31 N.A.
Government Investment Pool (GIP) Indices* (Period ended 9/5/2014)
GIP Index/All 0.05 0.05 0.15 0.15 44 87.7
GIP Index/Government 0.02 0.02 0.09 0.09 43 21.6
GIP Index/General Purpose Taxable 0.05 0.05 0.16 0.16 45 66.1
Data presented as monthly averages.Source: Global Insight.
Data presented as weekly averages. Germany is current yield. Other data are yield to maturity. Source: Global Insight.Data for German and Japanese short-term bond rates have been discontinued.
*Comprised of ‘AAAm’ and ‘AAm’ rated government investment pools. N.A.—Not available. Sources: Standard & Poor’s; Rated Money Fund Report, a service of iMoneyNet, Inc.
Wholesale Price Inflation (% Change-1 Yr.)
Jul-2014 Jun-2014 May-2014
U.S. 2.03 2.03 2.02
U.K. 1.09 1.09 1.09
Germany 1.06 1.06 1.06
Japan 1.04 1.04 1.04
Long-Term Bond Rates (%)
This week One week ago One year ago
U.S. 2.52 2.44 2.92
U.K. 2.49 2.45 2.97
Germany 0.96 0.91 1.99
Japan 0.56 0.53 0.73
Short-Term Interest Rates (%)
This week One week ago One year ago
U.S. 0.20 0.20 0.19
U.K. 0.56 0.56 0.52
90 www.creditweek.com
FIXED INCOMEINDICES
Index Yield 1-W MTD YTD Index Yield 1-W MTD YTD
Corporate Bonds
S&P International Corporate Bond 1.98 (1.80) (2.49) 1.60
S&P U.S. Issued Inv. Grade Corp. 2.84 (0.46) (0.95) 6.03
S&P U.S. Issued High Yield Corporate Bond 5.50 (0.55) (0.59) 5.08
S&P U.S. Covered Bond 1.19 (0.06) (0.15) 1.98
DJ Equal Weight U.S. Issued Corp. 2.88 (0.60) (1.11) 5.58
U.S. Treasury & Agency
S&P/BGCantor U.S. Treasury Bill 0.02 0.00 0.00 0.05
S&P/BGCantor U.S. Treasury Bond 1.14 (0.21) (0.46) 2.24
S&P/BGCantor Current 10-Yr T-Bond 2.50 (0.61) (1.30) 7.02
S&P/Citigroup International Treasury Bond 1.12 (1.58) (2.44) 2.57
S&P U.S. Agency 1.04 (0.09) (0.26) 1.84
S&P 10+ Year U.S. Agency Index 3.29 (0.50) (1.45) 13.54
U.S. Municipal Bonds
S&P National AMT-Free Municipal Bond 2.04 (0.20) (0.29) 7.23
S&P Municipal Bond 2.46 (0.12) (0.18) 7.56
S&P Municipal Bond Investment Grade 2.14 (0.17) (0.24) 7.16
S&P Municipal Bond High Yield 6.27 0.48 0.52 12.91
S&P Municipal Yield 5.50 0.32 0.32 11.93
Money Market
S&P U.S. Commercial Paper 0.15 0.00 0.01 0.13
Credit Default Swaps (Δ in bps)
S&P/ISDA U.S. 150 Credit Spread 1.15 1.06 (7.95)
U.S Homebuilders Select 10 9.83 9.70 9.35
U.S. Consumer Staples Select 10 4.18 3.95 9.04
U.S. Energy Select 10 9.48 8.19 17.79
U.S. Financials Select 10 0.61 0.67 (6.41)
U.S. Health Care Select 10 1.19 0.52 2.11
Leveraged Loans
S&P Global Leveraged Loan 5.02 (0.47) (0.53) 1.35
S&P/LSTA Leveraged Loan 4.86 (0.06) (0.03) 2.70
S&P/LSTA U.S. Leveraged Loan 100 4.52 (0.17) (0.12) 2.33
Equity
S&P U.S. Preferred Stock (0.96) (1.23) 6.55
S&P U.S. Floating Rate Preferred (0.83) (1.04) 11.77
S&P/TSX Preferred Share Laddered (0.19) (0.40) 2.73
S&P South Africa Preference (1.13) (1.34) (3.82)
Regional
S&P Eurozone Sovereign Bond 1.24 (0.05) (0.38) 9.90
S&P/ASX Australian Fixed Interest 3.37 (0.80) (1.02) 5.26
S&P/ASX Bank Bill 2.61 0.05 0.06 1.84
S&P India Bond 8.78 0.32 0.41 8.48
S&P China Bond 4.80 (0.00) (0.04) 6.05
S&P/DB ORBIT (USD) 4.00 0.05 0.05 2.53
S&P Pan Asia Bond 4.74 0.08 (0.05) 5.69
S&P Thailand Bond 2.99 0.03 (0.08) 3.39
S&P South Korea Bond 2.71 0.03 (0.00) 4.08
S&P/Valmer Mex. Gov. CETES 2.91 0.05 0.09 2.57
Inflation-Linked
U.S. TIPS 0-3 Year (0.61) (0.16) (0.26) (1.36)
U.S. TIPS 10 Year 0.39 (1.19) (1.58) 6.97
S&P/ASX Gov. Inflation-Linked 1.19 (1.62) (2.04) 7.67
S&P/Valmer Mex. Gov. Inf. 1+yr 2.04 (0.46) (0.74) 8.70
Sukuk
DJ Sukuk Higher Quality Investment 2.32 (0.04) (0.03) 4.99
DJ Sukuk Total Return Inv. Grade 2.42 (0.04) (0.04) 5.21
Market Attributes®
● Credit default swap spreads of the S&P/ISDA U.S Energy Select 10 Indexwidened (9.93) basis points since last week suggesting lower market confidencein the sector. The sector experienced widening spreads throughout 2014,currently up 17.79 bps YTD.
● The S&P Municipal Bond Yield Index that is up 11.93% YTD, showed 0.32%one week returns.
● The S&P U.S. Preferred Stock Index has returned 6.55% YTD, following a (0.98%)one week drop. U.S. floating preferreds continue to outperform their fixedcounterparts; the U.S. S&P Floating Rate Preferred Index is up 11.77% YTD.
● The S&P U.S. Leveraged Loan 100 Index has remained relatively flat this yearreturning 2.33% YTD, down 0.17% over the last seven days. Yields haveremained between 4-5%.
Summary
Source: S&P Dow Jones Indices LLC and/or its affiliates. Data as of September 10, 2014. Index performance is based on total return, and returns for international indices are in USD. Past performance is not a guarantee offuture results. It is not possible to invest directly in an index. Index returns do not reflect expenses an investor would pay to invest in securities associated with an index. Go to http://us.spindices.com/regulatory-affairs-disclaimers/ for more index performance disclosures.S&P Dow Jones Indices LLC does not make investment recommendations and does not endorse, sponsor, promote or sell any investment product or fund. S&P Dow Jones Indices LLC, BGCantor Market Data L.P. (“BGCantor”), CitigroupIndex LLC (“Citigroup”), and their respective affiliates (together, “S&P Parties”) do not guarantee the accuracy, adequacy, completeness or availability of any data and information and are not responsible for any errors or omissions or forresults obtained from their use. S&P PARTIES GIVE NO EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In noevent shall any of the S&P Parties be liable for any direct, indirect, special or consequential damages in connection with use of data or information provided. None of the financial products based on the S&P/BGCantor U.S. TreasuryIndices are endorsed, sponsored, promoted or sold by BGCantor, and BGCantor makes no representation regarding the advisability of investing in such products. Redistribution, reproduction and/or photocopying in whole or in part areprohibited without the written permission of S&P, or Citigroup in the case of Citigroup information and data.STANDARD & POOR’S and S&P are registered trademarks of Standard & Poor’s Financial Services LLC, a part of McGraw Hill Financial. DOW JONES is a registered trademark of Dow Jones Trademark Holdings LLC. Trademarkshave been licensed to S&P Dow Jones Indices LLC.BGCANTOR and BGCANTOR MARKET DATA are trademarks of BGCantor Market Data L.P. or its affiliates and have been licensed for use by Standard & Poor’s.CITIGROUP is a registered trademark and service mark of Citigroup Inc. or its affiliates and is used under license for certain purposes by Standard & Poor’s.
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 91
SOVEREIGNLIST
Standard & Poor’s Ratings Services currently rates 130 sov-ereign governments and has established transfer and con-vertibility (T&C) assessments for each country with a rated
sovereign, as shown in the table below. A T&C assessment is therating associated with the likelihood of the sovereign restrictingnonsovereign access to foreign exchange needed for debt serv-ice. For most countries, Standard & Poor’s analysis concludesthat this risk is less than the risk of sovereign default on foreign-currency obligations; thus, most T&C assessments exceed thesovereign foreign currency rating. Foreign currency ratings ofnonsovereign entities or transactions generally can be as high asthe T&C assessment if their stress-tested operating and financialcharacteristics support the higher rating. For more information,please see “Corporate And Government Ratings That Exceed The
Sovereign Rating,” published monthly on RatingsDirect.
If a sovereign, through membership in a monetary or curren-cy union, has ceded monetary and exchange rate policy
responsibility to a monetary authority that the sovereign doesnot solely control, the T&C assessment reflects the policies ofthe controlling monetary authority, vis-à-vis the exchange of itscurrency for other currencies in the context of debt service.The same applies if a sovereign uses as its local currency thecurrency of another sovereign. A T&C assessment may changesharply if a sovereign introduces a new local currency, byentering or exiting a monetary/currency union, or throughsome other means. This is because the new local currency, andin some cases the new monetary authority, may operate in verydifferent monetary and exchange regimes. The T&C assess-ment does not normally reflect the likelihood of change in acountry’s local currency.
For historical information on these ratings and assessments,please see “Sovereign Rating And Country T&C Assessment
Histories,” published monthly on RatingsDirect. Ratings as of Aug.21, 2014. CW
Abu Dhabi AA/Stable/A-1+ AA/Stable/A-1+ AA+*
Albania B/Stable/B B/Stable/B BB-
Andorra A-/Negative/A-2 A-/Negative/A-2 AAA*
Angola BB-/Stable/B BB-/Stable/B BB-
Argentina CCC+/Negative/C SD/NM/SD CCC-
Aruba BBB+/Stable/A-2 BBB+/Stable/A-2 BBB+
Australia AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Austria AA+/Stable/A-1+ AA+/Stable/A-1+ AAA*
Azerbaijan BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-
Bahamas BBB/Negative/A-2 BBB/Negative/A-2 BBB+
Bahrain BBB/Stable/A-2 BBB/Stable/A-2 BBB+
Bangladesh BB-/Stable/B BB-/Stable/B BB-
Barbados BB-/Negative/B BB-/Negative/B BB-
Belarus B-/Stable/B B-/Stable/B B-
Belgium AA/Stable/A-1+ AA/Stable/A-1+ AAA*
Belize B-/Stable/B B-/Stable/B B-
Bermuda AA-/Negative/A-1+ AA-/Negative/A-1+ AAA
Bolivia BB/Stable/B BB/Stable/B BB
Bosnia and Herzegovina B/Stable/B B/Stable/B BB-
Botswana A-/Stable/A-2 A-/Stable/A-2 A+
Brazil BBB+/Stable/A-2 BBB-/Stable/A-3 BBB+
Bulgaria BBB-/Stable/A-3 BBB-/Stable/A-3 A-
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
Sovereign Ratings And Country T&C Assessments
92 www.creditweek.com
SOVEREIGNLIST
Burkina Faso B/Stable/B B/Stable/B BBB-*
Cambodia B/Stable/B B/Stable/B B+
Cameroon B/Stable/B B/Stable/B BBB-*
Canada AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Cape Verde B/Stable/B B/Stable/B BB-
Chile AA+/Stable/A-1+ AA-/Stable/A-1+ AA+
China AA-/Stable/A-1+ AA-/Stable/A-1+ AA-
Colombia BBB+/Stable/A-2 BBB/Stable/A-2 A-
Congo-Brazzaville B+/Stable/B B+/Stable/B BBB-*
Congo-Kinshasa B-/Stable/B B-/Stable/B B
Cook Islands B+/Stable/B B+/Stable/B AAA*
Costa Rica BB/Stable/B BB/Stable/B BBB-
Croatia BB/Stable/B BB/Stable/B BBB
Curacao A-/Stable/A-2 A-/Stable/A-2 A-
Cyprus B/Positive/B B/Positive/B AAA*
Czech Republic AA/Stable/A-1+ AA-/Stable/A-1+ AA+
Denmark AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Dominican Republic B+/Stable/B B+/Stable/B BB
Ecuador B+/Stable/B B+/Stable/B B+
Egypt B-/Stable/B B-/Stable/B B-
El Salvador BB-/Negative/B BB-/Negative/B AAA*
Estonia AA-/Stable/A-1+ AA-/Stable/A-1+ AAA*
Ethiopia B/Stable/B B/Stable/B B
Fiji B/Positive/B B/Positive/B B
Finland AAA/Negative/A-1+ AAA/Negative/A-1+ AAA*
France AA/Stable/A-1+ AA/Stable/A-1+ AAA*
Gabon BB-/Stable/B BB-/Stable/B BBB-*
Georgia BB-/Stable/B BB-/Stable/B BB
Germany AAA/Stable/A-1+ AAA/Stable/A-1+ AAA*
Ghana B/Negative/B B/Negative/B B+
Greece B-/Stable/B B-/Stable/B AAA*
Grenada SD/NM/SD SD/NM/SD BBB-*
Guatemala BB+/Stable/B BB/Stable/B BBB-
Honduras B/Stable/B B/Stable/B B+
Hong Kong AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Hungary BB/Stable/B BB/Stable/B BBB-
Iceland BBB-/Positive/A-3 BBB-/Positive/A-3 BBB-
India BBB-/Negative/A-3 BBB-/Negative/A-3 BBB+
Indonesia BB+/Stable/B BB+/Stable/B BBB-
Ireland A-/Positive/A-2 A-/Positive/A-2 AAA*
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
Standard & Poor’s Ratings Services CreditWeek | September 17, 2014 93
Israel A+/Stable/A-1 A+/Stable/A-1 AA
Italy BBB/Negative/A-2 BBB/Negative/A-2 AAA*
Jamaica B-/Stable/B B-/Stable/B B
Japan AA-/Negative/A-1+ AA-/Negative/A-1+ AAA
Jersey AA+/Stable/A-1+ AA+/Stable/A-1+ AAA
Jordan BB-/Negative/B BB-/Negative/B BB+
Kazakhstan BBB+/Negative/A-2 BBB+/Negative/A-2 BBB+
Kenya B+/Stable/B B+/Stable/B BB-
Korea AA-/Stable/A-1+ A+/Stable/A-1 AA
Kuwait AA/Stable/A-1+ AA/Stable/A-1+ AA+
Latvia A-/Stable/A-2 A-/Stable/A-2 AAA*
Lebanon B-/Stable/B B-/Stable/B B+
Liechtenstein AAA/Stable/A-1+ AAA/Stable/A-1+ AAA*
Lithuania A-/Stable/A-2 A-/Stable/A-2 AA-
Luxembourg AAA/Stable/A-1+ AAA/Stable/A-1+ AAA*
Macedonia BB-/Stable/B BB-/Stable/B BB
Malaysia A/Stable/A-1 A-/Stable/A-2 A+
Malta BBB+/Stable/A-2 BBB+/Stable/A-2 AAA*
Mexico A/Stable/A-1 BBB+/Stable/A-2 A+
Mongolia B+/Stable/B B+/Stable/B BB-
Montenegro BB-/Negative/B BB-/Negative/B AAA*
Montserrat BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-*
Morocco BBB-/Stable/A-3 BBB-/Stable/A-3 BBB+
Mozambique B/Stable/B B/Stable/B B
Netherlands AA+/Stable/A-1+ AA+/Stable/A-1+ AAA*
New Zealand AA+/Stable/A-1+ AA/Stable/A-1+ AAA
Nigeria BB-/Negative/B BB-/Negative/B BB-
Norway AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Oman A/Stable/A-1 A/Stable/A-1 A+
Pakistan B-/Stable/B B-/Stable/B B-
Panama BBB/Stable/A-2 BBB/Stable/A-2 AAA*
Papua New Guinea B+/Stable/B B+/Stable/B BB
Paraguay BB/Stable/B BB/Stable/B BB+
Peru A-/Stable/A-2 BBB+/Stable/A-2 A
Philippines BBB/Stable/A-2 BBB/Stable/A-2 BBB+
Poland A/Stable/A-1 A-/Stable/A-2 A+
Portugal BB/Stable/B BB/Stable/B AAA*
Qatar AA/Stable/A-1+ AA/Stable/A-1+ AA+
Ras Al Khaimah A/Negative/A-1 A/Negative/A-1 AA+*
Romania BBB-/Stable/A-3 BBB-/Stable/A-3 A-
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
94 www.creditweek.com
SOVEREIGNLIST
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
Russia BBB/Negative/A-2 BBB-/Negative/A-3 BBB-
Rwanda B/Stable/B B/Stable/B B
Saudi Arabia AA-/Positive/A-1+ AA-/Positive/A-1+ AA
Senegal B+/Stable/B B+/Stable/B BBB-*
Serbia BB-/Negative/B BB-/Negative/B BB-
Sharjah A/Stable/A-1 A/Stable/A-1 AA+
Singapore AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Slovak Republic A/Positive/A-1 A/Positive/A-1 AAA*
Slovenia A-/Negative/A-2 A-/Negative/A-2 AAA*
South Africa BBB+/Stable/A-2 BBB-/Stable/A-3 BBB+
Spain BBB/Stable/A-2 BBB/Stable/A-2 AAA*
Sri Lanka B+/Stable/B B+/Stable/B B+
Suriname BB-/Stable/B BB-/Stable/B BB
Sweden AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Switzerland AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
Taiwan AA-/Stable/A-1+ AA-/Stable/A-1+ AA+
Thailand A-/Stable/A-2 BBB+/Stable/A-2 A
Trinidad and Tobago A/Stable/A-1 A/Stable/A-1 AA
Turkey BBB/Negative/A-2 BB+/Negative/B BBB
Turks and Caicos BBB+/Stable/A-2 BBB+/Stable/A-2 AAA
Uganda B/Stable/B B/Stable/B B
Ukraine B-/Stable/B CCC/Stable/C CCC
United Kingdom AAA/Stable/A-1+ AAA/Stable/A-1+ AAA
United States AA+/Stable/A-1+ AA+/Stable/A-1+ AAA
Uruguay BBB-/Stable/A-3 BBB-/Stable/A-3 BBB+
Venezuela B-/Negative/B B-/Negative/B B-
Vietnam BB-/Stable/B BB-/Stable/B BB-
Zambia B+/Negative/B B+/Negative/B B+
—SOVEREIGN RATINGS (LT/OUTLOOK/ST)— TRANSFER & CONVERTIBILITYCOUNTRY LOCAL CURRENCY FOREIGN CURRENCY ASSESSMENT
*These T&C assessments are for countries that are either members of monetary or currency unions or use as their local currency the currency of another sovereign. Because of this, the assessmentshown is based on Standard & Poor’s analysis of either the monetary authority of the monetary/currency union or the sovereign issuing the currency. Thus, for European Economic and MonetaryUnion (EMU) members (Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, Netherlands, Portugal, Slovak Republic, Slovenia, and Spain), the T&C assessments reflect our view of the likelihood of the European Central Bank restricting nonsovereign access to foreign exchange needed for debt service. Similarly, the T&C assessments forcountries with rated sovereigns in the Eastern Caribbean Currency Union (Grenada and Montserrat) reflect the current and projected policies of the Eastern Caribbean Central Bank. Likewise, the T&Cassessments for countries with rated sovereigns in the West African Economic and Monetary Union (Burkina Faso and Senegal) are based on the policies of the Central Bank of West African States,and the T&C assessments for countries with rated sovereigns in the Central African Economic and Monetary Community (Cameroon, Congo-Brazzaville, and Gabon) are based on the policies of theBank of Central African States. As for countries that use the currency of another, the T&C assessments of El Salvador and Panama are equalized with that of the U.S., while those of Abu Dhabi and Ras Al Khaimah are equalized with that of the United Arab Emirates, Andorra and Montenegro with EMU members, the Cook Islands with New Zealand, and Liechtenstein with Switzerland.
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