United States

Audit and Enterprise Risk Services

Accounting Considerations Related to Holdings of Greek and Other Eurozone Sovereign Debt

Financial Reporting Alert 11-4

July 29, 2011

This alert applies to all audits of entities with holdings of Greek and other Eurozone sovereign debt (reporting under either U.S. GAAP or IFRSs). Specifically, the accounting described in this alert applies to holdings of debt (or other loans) issued by the sovereign states subject to a current rescue plan (i.e., Greece, Portugal, and Ireland); however, it may also be relevant to holdings of debt (or other loans) of other sovereign states in which doubts have been raised about the credit quality of such holdings as a result of recent market sentiment. While this issue may pertain more to entities applying IFRSs, it can also affect those applying U.S. GAAP.

Background

In the second quarter of 2011, Greece's difficulty in meeting its debt obligations became increasingly apparent. Evidence and consequences of such difficulty included (1) Greece's failure in May to meet fiscal targets under the 2010 EU/IMF rescue plan, (2) the subsequent severe downgrading of its credit by rating agencies, and (3) the need for a restructuring or additional rescue package (or both) for it to meet its obligations beyond the immediate term to avoid default. Further, trading volumes and prices in Greek government bonds (GGBs) are at historical lows. The deterioration in credit quality is also apparent from the depressed GGB prices (below 60c per €1) and a historically high cost of buying credit protection against a Greek default, as evidenced in the credit-default swap market.

On July 21, 2011, European Union member states and private bondholders (represented by the Institute of International Finance Inc. (IIF)) agreed to a proposed restructuring of GGBs. Most of the GGBs held by private investors are held by banks and insurance companies in the Eurozone. The proposed restructuring is for GGBs that mature before and including 2020 and involves an exchange for new bonds (with a maturity of either 15 or 30 years) or a rollover to new bonds (with a maturity of 30 years). As part of this restructuring, the IIF estimated that private bondholders will suffer an economic loss of 21 percent of par. The plan requires 90 percent of private bondholders to participate for the plan to succeed and many of the existing holders of GGBs have agreed to the restructuring as of July 21, 2011.

Impairment Assessment — Holdings of Greek Debt

IFRSs

Our assessment is that GGBs and other loans issued by the Greek state held by IFRS-applying entities are impaired as of June 30, 2011. Paragraph 59 of IAS 39¹ includes indicators of impairment of which three are relevant in this instance (significant financial difficulty of the obligor, the lender granting a concession to the borrower, and the disappearance of an active market for the asset because of financial difficulties). If there is evidence of impairment, IAS 39 requires an impairment loss to be recognized in profit or loss. The measurement will depend on how the impaired asset is classified:

· Available-for-sale (AFS) investments — the cumulative fair value loss at period-end is recognized in earnings. This applies to assets currently classified as AFS as well as those assets reclassified from AFS in previous periods in which an amount continues to be recognized in other comprehensive income.

· Loans and receivables and held-to-maturity investments — the difference between the carrying value and the sum of the best estimate of the recoverable cash flows discounted by the effective interest rate will be recognized as an impairment loss in earnings.

While we believe that all GGBs and loans issued by the Greek state are impaired, there is significant uncertainty about how the restructuring affects the recoverability of GGBs and other loans that mature after 2020 since macroeconomic data on this is not currently available. We recommend that you consult with a professional adviser when you believe such assets are not impaired.

U.S. GAAP

Our assessment of the application of U.S. GAAP impairment indicators² is that GGBs and other loans issued by the Greek state held by U.S. GAAP-applying entities are impaired (other-than-temporarily impaired in the case of GGBs) as of June 30, 2011.

The measurement of the impairment loss depends on the type of investment:

· Available-for-sale and held-to-maturity debt securities — ASC 320-10-35-34C and 35-34D³ indicate that "[i]f an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss,^[4] the other-than-temporary impairment shall be separated into both of the following:

a.     The amount representing the credit loss^[5]

b.     The amount related to all other factors.

The amount of the total other-than-temporary impairment related to the credit loss shall be recognized in earnings. The amount of the total other-than-temporary impairment related to other factors shall be recognized in other comprehensive income, net of applicable taxes."

· Loans — ASC 310-10-35-22 states that "a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is a collateral-dependent loan."

Impairment Assessment — Holdings of Other Eurozone Debt

Generally, loans extended to other Eurozone member states are not considered impaired as of June 30, 2011, under both IFRSs and U.S. GAAP. Under U.S. GAAP (but not IFRSs), holdings of sovereign debt securities issued by such member states are impaired as of June 30, 2011, if their fair value is less than their amortized cost basis. In determining whether such impairment should be recognized as an other-than-temporary impairment loss, an entity would assess whether it (1) has the intent to sell the debt security or (2) more likely than not will be required to sell the debt security before its anticipated recovery. If an entity determines that it does not intend to sell an impaired debt security and that it is not more likely than not that it will be required to sell such a security before recovery of the security's amortized cost basis, the entity must assess whether it expects to recover the entire amortized cost basis of the security (i.e., whether a "credit" loss exists as described in ASC 320-10-35-33D).

Disclosures

Transparent disclosures are critical in helping investors understand the financial position and performance of entities that have material Eurozone sovereign debt exposures. Consideration should also be given to indirect exposures (e.g., guarantees and other financial instruments).

Disclosure is not restricted to exposures to GGBs or other loans issued by the Greek state. Disclosures will be relevant if an entity has a material exposure to another member state subject to a current rescue package (e.g., Portugal, Ireland). In addition, consideration will also need to be given to material exposures to other jurisdictions in which recent market sentiment has raised doubt about the credit quality of such jurisdiction's holdings.

In addition to providing the disclosures for debt securities and loans under U.S. GAAP (ASC 320 and ASC 310) and IFRSs (IFRS 7⁶ and IAS 34⁷), entities that have a material exposure to a relevant sovereign state should consider providing the disclosures described below. The amount and detail of disclosures should be proportional to the level of exposure the entities have to relevant sovereign states.

Exposures Arising From Debt Instruments

Disclosures of the nature and exposure by sovereign state and financial asset classification category (i.e., available-for-sale and held-to-maturity investments, and loans and receivables) should include:

· The carrying value, the gross amount before any cumulative impairment provision, and the net amount after any cumulative impairment provision.

· The fair value.

· The impact in profit or loss and other comprehensive income (showing impairment losses separately from other gains or losses and interest income for those exposures that are not measured at fair value through profit or loss).

Credit Risk Mitigants, Guarantees, and Other Similar Contracts

To the extent that credit risk is mitigated through holdings of credit default swaps or purchased financial guarantee contracts over direct sovereign exposures, the nominal amount of the credit protection by sovereign and by maturity should be disclosed along with the carrying value of those instruments that mitigate credit risk. Consideration should be given to disclosing the counterparty of arrangements in which such counterparty has significant exposures as a result of a concentration in writing credit protection over sovereign debt.

The same disclosures should apply if the entity has written credit protection over exposures to sovereign states (i.e., has issued credit default swaps and therefore has a financial liability).

Key Judgments

Disclosure should include the key judgments used:

· In determining whether the holding in sovereign debt is impaired.

· In estimating the impairment loss for holdings measured at amortized cost, including the impact of any events after the period (e.g., debt restructuring).

· In performing the fair value measurement of debt instruments, derivatives, or other similar instruments.

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1   IAS 39, Financial Instruments: Recognition and Measurement.

2   ASC 310-10 and ASC 320-10 provide impairment indicators for loans and debt securities, respectively.

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

4   ASC 320-10-35-34B states, in part, "If an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date."

5   ASC 320-10-35-33D states that "[i]n determining whether a credit loss exists, an entity shall use its best estimate of the present value of cash flows expected to be collected from the debt security. One way of estimating that amount would be to consider the methodology described in Section 310-10-35 for measuring an impairment on the basis of the present value of expected future cash flows. That Section provides guidance on this calculation. Briefly, the entity would discount the expected cash flows at the effective interest rate implicit in the security at the date of acquisition."

6   IFRS 7, Financial Instruments: Disclosures.

7   IAS 34, Interim Financial Reporting.