Auditors - Credit risk recognition

Last updated: 14 August 2007

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Auditors are preparing for particularly careful scrutiny of companies' assumptions about valuation and the risks posed to their businesses in the light of current market volatility. Two of the Big Four UK accountancy groups have issued internal memos advising their audit teams on the issues that the current market storm could throw up. Concerns range from appropriately valuing illiquid and complex financial instruments to the much larger, though as yet apparently remote, danger that the potential balance sheet impact of recent events poses a material risk to a company's survival. The immediate focus will be on asset values but auditors have been warned to question carefully "going concern" assumptions – in other words, a company's ability to service its debt and stay afloat, particularly if borrowing costs rise. "Auditors would be careful anyway but now we will think more deeply about the possibility of contagion effects. This means what may have been a straightforward assumption last year may be more problematic this time," said Martyn Jones, national audit technical partner at Deloitte. Mr Jones has warned staff to be sceptical about valuation and going concern assumptions, and consider any potential impact on companies' compliance with debt covenants. Accounting experts face the same problems that have dogged the financial world – accurately valuing complex derivatives. Some will have been booked at their market price while others, such as debt products with a fixed lifetime, which can include collateralised debt obligations (CDOs), are accounted for over their lifetime. "Valuing mortgage-backed securities and CDOs has always been challenging, " said Paul Sater, financial services partner at Ernst & Young. "In stable markets a fair value can be estimated using models. In turbulent times valuations become highly judgmental." A senior auditor said: "We have to ensure we consider all the risk of a business. If we're auditing a pension fund, we're concerned about how to value instruments such as CDOs. If it's a bank, we're concerned about the contractual obligations of the loans they've made. If it's the investment bank that bought those loans, then we're concerned about reputational risk should something go wrong." The bigger concern is that the liquidity squeeze turns into a wider credit crunch, with banks and investors less willing to lend money, driving interest rates higher. "In a world of contagion, it could be we get a situation where the possibility of material uncertainty [a real risk to the business] for some companies increases," said Mr Jones.

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