Corporate America is deeply anxious these days over the economic outlook, and financial reporting departments within those corporations are no different as new waves of uncertainty pound against previously well-understood accounting assumptions and reporting obligations.

When Standard & Poor's downgraded U.S. government debt in August from AAA to AA+, it stunned global markets and sparked significant volatility that raises big concerns about economic growth and unemployment, says Robert Royall, a senior partner in Ernst & Young's financial accounting advisory practice. “We've seen economic downturns before, and you could debate whether we ever completely climbed out of the downturn of 2007 and 2008,” Royall says. “The new twist now is the downgrade in U.S. debt.”

The downgrade has several implications for financial reporting, including forecasts that feature prominently in various accounting estimates, he says. It also affects the many instances where accounting rules require use of a “risk-free interest rate” to calculate any number of measures that feed into financial statements. U.S. Generally Accepted Accounting Principles don't explicitly say that the “risk-free interest rate” is the same as the U.S. Treasury yields, but that's become the common practice, Royall says. The question now: “Are we supposed to somehow now not think of the U.S. Treasury yields as the risk-free rate anymore?”

That's an unsettling thought, because accounting literature brims with directives to base measurements or assumptions on the risk-free or credit-adjusted interest rate. It's a component of measuring fair value, for example, which now feeds into many line items on the balance sheet and income statement. It's also an important factor in asset retirement obligations, environmental liabilities, and financial guarantee liabilities for insurers, Royall says. 

For now, at least, accounting and valuation experts seem to agree that companies do not need to adjust their assumptions about a risk-free interest rate based solely on S&P's downgrade. But that could change, they say, as market conditions evolve.

Greg McGahan, a partner with PwC, said during a recent Webcast that the downgrade did not result in any significant decline in the demand for U.S. treasuries, an important consideration in assessing risk. “Current yields continue to reflect investor confidence,” he said. Also significant, said McGahan: Only one of the three leading credit rating agencies downgraded U.S. debt. Moody's and Fitch Ratings have both assigned negative outlooks, he said, but that's less drastic than a downgrade. Still, preparers and auditors need to keep a close eye on the situation, he said. “A subsequent downgrade by any of the other rating agencies may no longer result in U.S. treasuries being regarded as risk-free,” he said.

Paul Barnes, global leader of the valuations practice at financial advisory firm Duff & Phelps, says the key is market reaction. “Would investors demand a higher return for an arguably riskier investment?” he asks. The downgrade occurred at the same time as the European debt crisis escalated, he said, leading to a somewhat surprising investor reaction to the U.S. downgrade. “In the grand scheme of things, U.S. treasuries are still seen as a relatively safe investment,” he says. “Yields actually dropped. Investors are now basically looking for the preservation of principal almost to the point of sacrificing yield and return. So it is still looked at as the risk-free rate.”

“A subsequent downgrade by any of the other rating agencies may no longer result in U.S. treasuries being regarded as risk free.”

—Greg McGahan,

Partner,

PwC

Some situations, however, call for adjustments to the current U.S. treasury rate to be used as a benchmark. Because markets have been so volatile in recent months, Barnes is advising companies to look at a more “normalized” rate as the best metric for a risk-free rate. While U.S. treasuries are moving around 2.6 to 2.7 percent right now, Barnes looks more at a 12-month average rate of about 4 percent and relies on that as a fair benchmark for a risk-free rate. “We don't think where treasuries are now is the best metric to use over 20 years,” he says, when companies are using a risk-free rate as part of discounting projected cash flows over a longer term.

While the debt downgrade doesn't create an immediate need for a new risk-free rate assumption, it raises reasonable questions about numerous other assumptions that flow into financial statements, experts say. Where companies make forecasts about customer demand, cost of capital, price increases, and numerous other metrics, those forecasts are more difficult amid market volatility and duress, Barnes says.

Under such conditions, companies need to reconsider the assumptions used to calculate impairments, valuations, receivables, loan modifications, and a host of other issues, says Jim Schnurr, senior national professional practice director at Deloitte. The good news, he says, is that balance sheets are generally stronger in the latter part of 2011 than they were in 2008, making the period of economic uncertainty a little easier to weather.

S&P's ACTIONS

Below, Standard & Poor's explains its reasoning behind downgrading the U.S. government:

We have lowered our long-term sovereign credit rating on the United States of America to ‘AA+' from ‘AAA' and affirmed the ‘A-1+' short-term rating.

We have also removed both the short- and long-term ratings from CreditWatch negative.

The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.

The outlook on the long-term rating is negative. We could lower the long-term rating to ‘AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

Source: Standard & Poor's Action on U.S. Debt.

One particular area of concern, says Chris Wright, managing director at consulting firm Protiviti, is exposure to economic turmoil in other countries. To the extent companies are invested in those countries, the valuation of those investments is questionable, and the risk of foreign exchange rates must be weighed. Companies also need to take a look at their hedges, he says, to see if reality has proven different from their forecasts. “It could have accounting implications for an ineffective hedge, or there could have been transaction costs for a hedge you didn't need,” he says.

PwC's McGahan is advising companies to scrutinize their risk of loan modifications being classified as trouble debt restructurings. Borrowers might be drawn to restructure existing debt agreements in search of lower interest rates or extended maturities, but it could be classified as a trouble debt restructuring under some relatively new guidance in GAAP, he says, creating accounting consequences companies will want to assess.

Companies might also be thinking about repurchasing stock if they believe their stock price is depressed or undervalued, McGahan said. “These transactions make a lot of economic sense, but the accounting and financial reporting could be complicated,” he said.

Lease agreements are also susceptible to declining economic conditions. According to McGahan, companies should be careful if they are pursuing restructuring plans that include terminating lease agreements. “Depending on the terms of the lease agreement, the lessee may still be responsible for any remaining lease obligation,” he said. “If you're going down that path, take a hard and close look at those lease agreements to figure out what can be terminated and what can't.”

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