Drawbacks in debt reporting – hopefully not insurmountable

A recent article on CCH Daily summarized a report from Moody’s Investor’s Service on “five critical drawbacks in debt reporting, given an environment with low interest rates and volatile currencies.”

The underlying report doesn’t appear to be easily accessible anymore, so here’s the summary provided by CCH:

  • “The report says the first concern is that the amount reported as debt does not incorporate the hedging of foreign currency risk. Debt denominated in a foreign currency is always translated at the year-end exchange rate. This rule applies even when the year-end exchange rate is of questionable relevance because the currency exposure has been hedged using a derivative instrument.
  • Secondly, Moody’s argues that the amount reported as debt loses its meaning when fair value hedge accounting is used for interest rate swaps. The credit ratings agency argues this means fair value hedge accounting causes debt to be adjusted by an amount that is not actually payable to, or receivable from, the lender.
  • It also highlights that the amount reported as debt may, or may not, include accrued interest payable. Interest owed to lenders but not yet paid at the balance sheet date may, or may not, be included within the amount reported as debt.
  • Moody’s goes on to argue that the amount reported as debt may not represent the sum owed to lenders by an acquired subsidiary. All debt issued by the acquired company must be recorded in the books of the acquirer at its fair value on the date of the acquisition. As a result, the amount reported on the balance sheet is not actually owed to the lenders, and there will be no corresponding cash outflow unless the debt is redeemed ahead of schedule.
  • Finally, the ratings agency says the amount reported as debt is reduced by the cost of borrowing the money. IFRS requires the cost of issuing debt to be deducted from the liability reported on the balance sheet. Although the resulting understatement diminishes systematically over the term of the borrowing, the lower amount is unhelpful because the principal owed to the lender is unaffected by the expenses incurred to borrow the money.”

The sum total of these observations, as expressed by Trevor Pijper, vice president and senior credit officer at Moody’s, is that: “In the current environment, there is a significant risk that the amount reported as debt will fail to represent either the amount owed to the lenders, or the future cash outflow needed to discharge the obligation.” He concludes: “Companies voluntarily disclosing additional information not required under IFRS helps us to identify and address the above distortions, and factor them into our credit metrics where material.”

Plainly, any such thoughtful report issued by a major user of financial information is always useful, helping to counter the risk that preparers of financial statements and MD&A will lose themselves in the mechanics, forgetting to consider the reasons underlying the various aspects of IFRS, or their implications for effective reporting. The reference to these observations as “distortions” may be unhelpful though, if it implies that these are essentially standard-setting errors or oversights. It seems fairer to acknowledge that a balance sheet provides a single summarized representation of an entity’s financial position, and that by its nature, the value assigned to a single asset or liability can’t hope to satisfy all the possible forms of stakeholder interest that might attach to it. To take one of the examples, the IASB could certainly justify why debt of an acquired subsidiary isn’t simply reported at its face value, and why it would often distort the economic portrayal of an acquisition if it were. As a reference point, another kind of common example arises from the carrying values of property, plant and equipment, which of course don’t necessarily provide a measure of their remaining fair value, or their replacement cost, or their ability to contribute to maintaining productive capacity, or in a worst case of anything very prospectively useful…

Hence the importance then of disclosing additional information that responds to identified stakeholder needs. If a company’s reported debt, for any or all of the reasons set out by Moody, leaves some potentially significant matters potentially unclear, and if the IFRS-compliant notes can’t or don’t remedy that (although for several of the points cited above, it wouldn’t be very hard for them to do so), then of course the company should disclose more (a similar point was made not long ago about supplementary tax reporting, as we discussed here). This might bring us to familiar concerns about disclosure overload and so forth, but as I always say, in an age that emphasizes access to information, there ought to be a way for companies to be able to address identified needs of key stakeholders without somehow detracting from the ability of those stakeholders to navigate through to the other information they need. Or does such repeated optimism on my part overstate the capacity and resourcefulness of even our most advanced users…?

The opinions expressed are solely those of the author

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