Audit and Enterprise Risk Services

Financial Reporting Considerations Related to S&P´s Downgraded Credit Rating for U.S. Long-Term Sovereign Debt

Financial Reporting Alert 11-5

August 16, 2011

This Financial Reporting Alert discusses several considerations related to Standard & Poor's (S&P´s) recent downgrade of long-term U.S. sovereign debt. At this time, the financial reporting effects of the S&P´s downgrade are primarily disclosure-related, though entities may also experience some volatility in the fair value of U.S. sovereign debt.¹

This alert highlights that the S&P´s downgrade does not cause, in and of itself, an other-than-temporary impairment of U.S. sovereign debt (i.e., this downgrade does not indicate, for accounting purposes, that there has been a credit loss for an investment in U.S. sovereign debt). In addition, U.S. Treasury rates are still considered "risk-free" rates; thus, if previously used as an input in measurements under U.S. GAAP or IFRSs, these rates may continue to be used as such an input. In addition, U.S. Treasury rates continue to be a hedgeable benchmark interest rate.

The alert also reminds accounting professionals that the recent volatility in the financial markets could trigger additional impairment analysis of an entity´s investments (e.g., available-for-sale (AFS) equity securities) and other assets (e.g., goodwill and indefinite-lived intangible assets).

This alert will be updated in the future to reflect new developments as warranted.

Background

For the first time since 1941, S&P is no longer rating long-term U.S. sovereign debt as AAA. On August 5, 2011, this nationally recognized statistical rating organization (NRSRO or "the ratings agency") announced the unprecedented move of reducing its long-term assessment of U.S. sovereign debt to AA+, with a negative outlook. However, the news was not entirely negative since S&P affirmed the U.S. Treasury´s short-term credit rating of A-1+, indicating that the short-term capacity of the United States to meet its financial commitment on its outstanding obligations is strong. The two other major rating agencies, Moody´s and Fitch, continue to have U.S. sovereign debt on their watch lists but have yet to downgrade U.S. sovereign debt from their highest credit rating classifications as of the date of this Financial Reporting Alert. In addition, recent market activity indicates that market participants still view the U.S. Treasury as an AAA debtor.

Risk-Free Interest Rate

Because of S&P´s downgrade of long-term U.S. sovereign debt, some accounting professionals may question whether it is appropriate to continue to use U.S. Treasury rates when the use of a risk-free interest rate is called for by U.S. GAAP. Risk-free interest rates are used in many measurements under U.S. GAAP, such as asset retirement obligations, environmental liabilities, and components of fair value measurements when an income approach is used. The U.S. Treasury yield curve has historically been used as the basis for risk-free borrowing.

Observation: In our view, the U.S. Treasury yield curve continues to be risk-free for purposes of applying U.S. GAAP and IFRSs. This view is supported by the following:

· ASC 715-20-S99-1,² an SEC staff announcement concerning the selection of discount rates used for measuring defined benefit pension and postretirement benefit plan obligations, gives insight into what the SEC staff considers "high quality." This announcement states, in part, "[F]ixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency [shall] be considered high quality (for example, a fixed-income security that receives a rating of Aa or higher from Moody´s Investors Service, Inc.)."

· In a 2003 speech regarding the EITF Issue 99-20³ scope exclusion for beneficial interests in securitized financial assets, John M. James, a professional accounting fellow in the SEC´s Office of the Chief Accountant, noted that "[b]ased on reference to the rating definitions used by the rating agencies, the staff noted that an AA rating[, the second highest,] is defined as ‘the obligor's capacity to meet its financial commitment on the obligation is very strong´ which appears to be consistent with the intent of the Task Force when using the ‘high credit quality´ terminology."

· Two of the three major rating agencies continue to give the U.S. Treasury the highest possible rating.

· Recent market activity for U.S. treasuries has resulted in yields that are lower than those just before the downgrade by S&P.

On the basis of informal discussions with both the FASB and SEC staff, our conclusion that U.S. Treasury yield curves remain an appropriate basis for risk-free rates is consistent with their expectations.

Impairment Considerations

Observation: In our view, the S&P´s downgrade of long-term U.S. sovereign debt does not indicate that there are credit losses on these securities. AA+ is a significantly high credit quality and many market participants still view the U.S. Treasury as a consensus AAA debtor. However, if, in limited circumstances, management determines that it intends to sell U.S. treasuries or other debt securities, or there is evidence that it is more likely than not that the entity will be required to sell such securities (before recovery of its amortized cost basis), and that the fair value of these securities is less than the amortized cost basis, an other-than-temporary impairment has occurred.

On the basis of informal discussions, our conclusion that U.S. treasuries are not other-than-temporarily impaired (except in the limited circumstances noted above) is consistent with the expectations of both the FASB and the SEC staff.

The S&P´s downgrade of U.S. sovereign debt has triggered significant volatility in prices for a variety of investment classes. This market volatility may lead to circumstances in which entities need to evaluate investments other than U.S. sovereign debt for other-than-temporary impairment. In addition, market declines may warrant an assessment of whether other assets (e.g., goodwill and indefinite-lived intangible assets) are impaired.

Portfolio Rebalancing

The FED, FDIC, Office of the Comptroller of the Currency, and National Credit Union Administration all retained the highest-quality risk weighting for U.S. treasuries; thus, capital requirements will not be directly affected by this credit downgrade. Nonetheless, entities may be considering (or currently engaging in) a rebalancing of investment portfolios.

The sale of debt securities to rebalance a portfolio´s risk weighting or for other similar reasons may call into question ("taint") a held-to-maturity (HTM) classification and require a reclassification of other HTM debt securities to the AFS category. In such a reclassification, the unrealized holding gain or loss, equal to the difference between the carrying amount and fair value at transfer, would be recognized in other comprehensive income. ASC 320 provides for limited exceptions, when sales of HTM securities would not taint other HTM securities. Applicable guidance and related facts and circumstances should be carefully considered, and consultation with appropriate accounting professionals is encouraged.

Disclosure

Entities should provide adequate disclosures about the financial statement effects and business risks related to the S&P´s downgrade of long-term U.S. sovereign debt and recent market volatility. Public registrants should provide MD&A disclosures⁴ regarding management´s monitoring and response to these dynamic events, as well as a disclosure of risks that may arise. Other disclosures may also be required; for example, entities may need to disclose the potential for impairments.

Risk Factors

In disclosing risk factors,⁵ an entity could consider the following elements from recent SEC filings:

· The downgrade could materially affect global and domestic financial markets and economic conditions, which may affect an entity´s business, financial condition, and liquidity.

· There could be future changes in capital requirements or a rebalancing of investment portfolios in response to management´s assessment of the related risk weightings.

· Although a downgrade of long-term sovereign credit ratings is not unprecedented, a downgrade of the U.S. credit rating is, and the potential impact is uncertain.

· U.S. treasuries continue to trade in active markets, and the yield curve on U.S. treasuries remains an appropriate basis for determining risk-free rates.

Other Disclosures

An entity should also consider:

· Applicable risks and uncertainty disclosure requirements in ASC 275.

· The disclosure requirements for investments in an unrealized loss position for which other-than temporary impairments have not been recognized in earnings under ASC 320-10-50-6 through 50-8.

· The disclosure requirements for any sales of HTM securities under ASC 320-10-50-10.

· Subsequent-event disclosures, capturing type 2 events such as a significant decline in investment values or an entity´s market capitalization, which may be an indicator of a decline in the fair value attributable to a reporting unit with related goodwill. Subsequent-event disclosures are required under ASC 855.

Entities should continue to monitor market activity and other events and consult with appropriate accounting professionals and, if necessary, the SEC staff when evaluating the financial reporting implications of these events.

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1 For the purpose of this alert, U.S. sovereign debt also includes debt backed by the U.S. Treasury (e.g., the debt of government-sponsored agencies such as Fannie Mae and Freddie Mac).

2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte´s "Titles of Topics and Subtopics in the FASB Accounting Standards Codification."

3 EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets."

4 Registrants should (1) include MD&A disclosures that are tailored to the material trends and uncertainties affecting the registrant and (2) consider guidance in Regulation S-K, Item 303, and Topic 9 of the Division of Corporation Finance´s Financial Reporting Manual.

5 When evaluating and describing risk factors in filings with the SEC, a registrant should follow guidance in Staff Legal Bulletin No. 7 and Regulation S-K, Item 5-03. The SEC staff frequently cites this guidance in comments to registrants when it believes that a registrant (1) uses boilerplate language or (2) includes generic conclusions rather than tailoring its risk factors and disclosure to the potential impacts on the registrant´s results of operations, financial condition, and business.