on the credit rating model for the Dutch corporate clients of ABN AMRO

Rules versus Reality

An investigation into the influences of International Financial Reporting Standards

on the credit rating model for the Dutch corporate clients of ABN AMRO

Ingeborg Schepers

Rules versus Reality

An investigation into the influences of International Financial Reporting Standards

on the credit rating model for the Dutch corporate clients of ABN AMRO

AMSTERDAM, June 2004 Author: I.M.C. Schepers

1229842

Institution: RijksuniversiteitGroningen Faculty: Management & Organisation Supervisors: dr. W. Westerman

dr. T. Marra

‘The author is responsible for the content of the thesis, the copyright rests with the author.’

© 2004

P

PRREEFFAACCEE

The past six months I have been studying the IFRS and investigating the influence they may have on the credit rating model of the ABN AMRO Bank for Dutch corporate clients. It was a difficult process due to continuous changes in the standards, the substance and the complexity of IFRS.

Nevertheless, it has been a very fruitful time in which I learned a lot and participated in interesting discussions on the subject.

I would like to thank Mr. Frank Nivard, for the internship possibility at ABN AMRO’s Credit Portfolio Management ACD department, and all the CPM people, particularly Mr. Jos van de Ven, for their enthusiasm and for showing me around in the world of credits.

Furthermore, I would like to pay my gratitude to Mr. Evert de Vries, an ABN AMRO expert on the credit rating model, for the many “brainstorm sessions” and for guiding me throughout the research.

A special thanks goes out to my RuG supervisors: Mr. W. Westerman, for his patience, kindness en help during the process and Mr. T. Marra, for helping me to come up with a scientific view on the research.

I’m as well thanking my parents & friends for their help during the University period and I’m very grateful for all the support they have given me.

Ingeborg Schepers

Amsterdam, 21 June 2004.

S

SUUMMMMAARRYY

This thesis is the result of a investigation that is executed during an internship at the Amsterdam headquarters of the ABN AMRO Bank between December 2003 and June 2004.

Chapter one describes in general terms the ABN AMRO Bank. The focus is on the Stategic Business Unit Wholesale Clients and, more specifically, on the Business Unit Financial Markets of which Credit Portfolio Management is a part, were the investigation is undertaken. Credit Portfolio Management handles all lending products for ABN AMRO’s Wholesale clients.

In Chapter two the research scope is discussed. It is shown that in the current international business society, the trend is to heavily invest in new systems and standards to promote transparency, comparability, reduce risk and improve operational efficiencies. Two closely related concepts, credit ratings and accounting standards, which play a central role throughout the investigation are set out. And it became clear that there is a need for all listed EU companies, banks and insurance companies to apply International Financial Reporting Standards by 1 January 2005 to their consolidated annual reports.

The methodological core of this research is described in Chapter 3. This Chapter points out that, due to the IFRS conversion, AA might assign a different rating to their corporate clients that themselves actually have not changed. The ‘transparency’ that IFRS intends to bring, can allow the analysts to see things that they could not see before. It is important for AA to keep producing meaningful ratings and therefore it is necessary to know what the impact of the IFRS conversion is and how to deal with it. This thesis focuses on the conversion from Dutch GAAP to IFRS, which can have an influence on the ratings that ABN AMRO gives to their counterparties.

A meaningful rating, implicates that it is a stable and transparent rating, based on ratios that are scarcely affected by IFRS which enables the rating model to perform a trend analysis.

The research goal is: Ensure that the user of the AA credit rating model for corporate clients remains producing meaningful ratings after transition of Dutch GAAP to IFRS.

The research question is: What is the possible influence of IFRS through the changed input of the AA credit rating model for corporate clients on the ratings and how should the user of the rating model deal with this influence?

Chapter 4 presents the structure of the credit rating model of the AA. It shows that the model’s financial analyses require the input of reliable financials, these financials should be based on generally accepted international accounting principles. The calculation of the ratios is model driven and cannot be changed or suppressed. The system in the model calculates 14 historical financial ratios, balanced over the following four categories (see table 6). Given that these ratios have different weightings in the model, certain financial numbers are more important than others. It should be emphasised that when concerning the relative weightings of the ratios EBIT appears to be the most sensitive number.

The gap between Dutch GAAP and IFRS is presented in Chapter 5, for each financial item by taking a close look at the substantial accounting changes caused by the IFRS conversion. The elements that provide the most likely sources of material changes to the input of the rating model are:

Basis of accounting, consolidation principles, tangible fixed assets, Participating interests, hybrid financing forms, goodwill, hedging Instruments and employee Benefits (pensions).

The bringing on balance sheet of instruments previously not recognised, the mark-to-market requirements for hedge accounting to apply could all lead to increased volatility in the balance sheet , income statement and, among other, the EBITDA.

Another difference concerns not so much the content of the rules, but lies mainly in the extreme application of the rules. Under IFRS there is only a very limited possibility for a so-called ‘true and fair override’ because a deviation from the rules is practically never allowed.

Chapter 6 describes whether the material changes described in Chapter 5, influence the rating model. It became clear that substantial changes will occur in the Financial Assessment due to IFRS. Remarkable is the increased volatility that is likely to occur in the Income Statement. It also became clear that in the current rating model, the Balance Sheet and Income Statement do not include line items for two of the most appreciable financial items: the Hedging instruments and the Employee benefits. The influence of IFRS on industries is discussed separately. It appeared that for the industries in which corporates often have large foreign currency exposure, IAS 39 will be of importance both in the recognition and measurement of financial instruments and in the restrictions applying to hedge accounting. Increased balance sheet and net income volatility could result. Corporates in industries where high goodwill is common face an impact on tangible net worth and EBIT.

In the rating analysis, the following elements were examined: Net income, EBITDA, EBIT, Total debt, Tangible net worth and Net operating funds flow. It became clear that Net income, Total debt, EBIT and EBITDA are substantially influenced by IFRS and that the Net operating funds flow on the other hand, is hardly affected by the IFRS rules. In the current rating situation the credit rating is affected due to IFRS.

Ultimately, Chapter 7 will present the conclusions & recommendations. The general conclusion is that although Basel II and IFRS both tend to increase harmonisation (comparability) and transparency, IFRS has a lot of consequences that contrast this purpose. Out of the results of this research it is not expected that the transparency will increase at first time adoption. Maybe in the future, with a new Basel Accord regarding the credit rating methodology for IFRS the transparency is increased.

For the credit analyst, recommendations are made for each important financial item that endures a substantial and, in the scope of this investigation, relevant change.

Recommendations for the credit rating model concern the format of the weighting of the ratios and the model’s spreadsheets.

One of the general recommendations is for the AA management to provide extensive courses before 1 January 2005, in order to prepare, among other, the credit analysts for the IFRS financials.

Due to time limitation and the complexity of the subject, this investigation principally deals with the material effects of IFRS on the annual figures, and therefore on the input and output of the credit rating model. But this issue contains many other interesting elements that could be examined. For example an investigation into whether an increase/decrease of the credit rating, assigned after 1 January 2005, is subject to the IFRS conversion or caused by the actual performance of the corporate.

CCOONNTTEENNTTSS

LLIISTST OOFF FFIIGGUURREESS..................................................................................................................................................................................................................88 LLIISTST OOFF TTAABBLLEESS......................................................................................................................................................................................................................88

11 IINNTTRROODDUUCCTTIIOONN..........................................................................................................................................................................................................99

1.1 ABN AMRO B

N.V. ... 9

1.1.1 History...9

1.1.2 Structure...9

1.1.3 Core values...9

1.2 W

C

... 10

1.2.1 Financial markets... 10

1.2.2 Credit Portfolio Management ... 10

2 2 SSYYSSTTEEMMSS HHAARRMMOONNIISSAATTIIOONN IINN AA WWOORRLLDD OOFF CCHHAANNGGEE........................................................................................1111

2.1 C

... 11

2.1.1 History... 11

2.1.2 Developments ... 11

2.1.3 Basel I & II ... 12

2.2 A

... 12

2.2.1 History... 12

2.2.2 Developments ... 13

2.2.3 IFRS ... 14

2.3 W

B

IFRS ... 15

33 MMEETHTHOODDOOLLOOGGYY........................................................................................................................................................................................................1616

3.1 P

... 16

3.2 R

... 16

3.2.1 Objective... 16

3.2.2 Research goal... 16

3.2.3 Research question... 16

3.2.4 Research typology and the conditions ... 17

3.3 S

-

... 17

3.4 C

... 19

3.5 D

... 20

44 TTHHEE SSTTRRUUCCTTUURREE OOFF TTHHEE AAAA CCRREEDDIITT RRAATTIINNGG MMOODDEELL..........................................................................................2121

4.1 T

... 21

4.2 T

... 21

4.2.1 Financial assessment ... 21

4.2.2 Business Analysis... 24

4.2.3 Qualitative amendments... 24

4.3 D

... 25

4.4 C

... 26

55 TTHHEE GGAAPP BBEETTWWEEEENN DDUTUTCCHH GGAAAAPP AANNDD IIFFRRSS................................................................................................................2727

5.1 I

... 27

5.2 C

D

GAAP

IFRS ... 27

5.2.1 General principles ... 27

5.2.2 Balance sheet items ... 29

5.2.3 Specific Income Statement items... 33

5.3 C

... 34

6

6 IINNFFLLUUEENNCCEE IIFFRRSS OONN TTHHEE RRAATTIINNGG MMOODDELEL............................................................................................................................3535

6.1 I

... 35

6.2 I

F

A

... 35

6.2.1 General principles ... 35

6.2.2 Balance Sheet and Income Statement items ... 36

6.3 I

B

A

... 37

6.3.1 Industry analysis ... 38

6.3.2 MERI... 39

6.4 I

Q

A

... 39

6.5 R

... 40

6.6 C

... 42

77 CCOONNCCLLUUSSIIOONNSS && RREECOCOMMMMEENNDDAATTIIOONNSS....................................................................................................................................4343

7.1 G

... 43

7.2 C

& R

... 43

7.3 C

& R

... 45

7.4 G

... 46

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LLIISTST OOFF FFIIGGUURREESS

Figure 1: The history of the ABN AMRO BANK Figure 2: Organisational chart CPM

Figure 3: The IASC structure canvas

Figure 4: Conceptual model of the research framework Figure 5: Chart of the rating model

Figure 6: The IFRS timeline

Figure 7: Designation of Derivatives as hedges

Figure 8: The classification as equity or debt under IAS 32 Figure 9: The credit rating model financial ratios

LLIISTST OOFF TTAABBLLEESS

Table 1: Three periods of accounting history Table 2: IFRS adoption in selected countries Table 3: Important data in a world of change

Table 4: The Balance sheet as presented in the rating model Table 5: The income statement as presented in the rating model Table 6: The financial ratios

Table 7: The subjective questions for a Financial Assessment

Table 8: The most important differences between Dutch GAAP and IFRS Table 9: The IFRS impact indicator

Table 10: The IFRS effect on the ratings

11 IINNTTRROODDUUCCTTIIOONN

The following information is obtained from ABN AMRO and the aim of this Chapter is to present a short description of the ABN AMRO Bank N.V. in general (1.1), the history (1.1.1), the structure (1.1.2) and the core values (1.1.3). Thereafter, the focus is on the SBU Wholesale Clients (1.2) and in particular on the BU Financial Markets (1.2.1) of which Credit Portfolio Management (1.2.2) is a part.

1.1 ABN AMRO Bank N.V.

ABN AMRO¹ is a prominent international bank. It’s origins go back to 1824. ABN AMRO ranks 11th in Europe and 23rd in the world based on tier 1 capital, with over 3,000 branches in more than 60 countries, a staff of over 110,000 full-time equivalents and total assets of EUR 639.9 billion (as of 31 March 2004).

The goal of ABN AMRO is to create value for its clients. Key in the relationship approach is a constant focus on the financial services needs of their client segments. It is through the professionalism and motivation of their global staff that they realise this value, resulting in maximum economic value for their shareholders.

1.1.1 History

Figure 1: The history of the ABN AMRO BANK

On 29 March 1824, King Willem I issued a royal decree creating the Nederlandsche Handel- Maatschappij (NHM) with the aim of reviving trade between the Netherlands and the Dutch East Indies (see figure 1). In 1964, NHM merged with De Twentsche Bank to form Algemene Bank Nederland (ABN) while Amsterdamsche Bank and Rotterdamsche Bank joined to become Amsterdam-Rotterdam (Amro) Bank. In 1991 these two banks merged as ABN AMRO Bank (AA).

Today, AA is a powerful presence in world markets, building on a tradition of stimulating international trade.

1.1.2 Structure

AA is active in three principal customer segments: Wholesale Clients, Consumer & Commercial Clients and Private Clients & Asset Management. The objective is to maximise the value of each of these businesses as well as the synergies between them. Excellence of service to the clients and leadership in the chosen markets are of paramount importance to their long-term success.

1.1.3 Core values

The Corporate Values of integrity, teamwork, respect and professionalism are the heart of the AA organisation. They are inherent in everything AA does, from how they interact with clients and other stakeholders to how they relate to each other as colleagues.

The Corporate Values, created in 1997, also provide the foundation for the bank's Business Principles. While the Corporate Values define what AA stands for, the Business Principles define

what that means for their stakeholders. They both aim to guide employees in their daily work and shift the horizons beyond short-term profit to long-term value creation through sustainable development.

1.2 Wholesale Clients

The AA wholesale business is one of the largest in Europe, supported by a strong international network. The AA aims to be a leader in cross-border wholesale banking and the European choice for clients seeking global financing solutions.

They focus their resources on selected corporate, institutional and public sector clients, providing them with integrated corporate and investment banking services.

The sector and country coverage teams lead the way in developing relationships, establishing a thorough understanding of business objectives and challenges.

The product expertise is focused into three groups: Financial Markets, Working Capital, and Corporate Finance and Equities. To help their clients do business in local markets, AA maintains an extensive international presence in about 50 countries.

1.2.1 Financial markets

AA has brought together Wholesale debt capital raising, capital management and risk advisory services into the Financial Markets (FM) group. The result is an extensive product range that is seamlessly integrated in pursuit of the best solutions.

AA offers the corporate and institutional clients excellent foreign exchange, money market and derivatives risk management services. Through their specialised capital raising and structured financing teams they structure and issue debt solutions. Backed by research capabilities, 3,000 specialist staff and a presence in over 40 countries, they are well positioned to lead the way to the clients in fund and risk management. It has leading positions in asset securitisation, sovereign, agency and high-grade international bond and bank capital issues, project finance and international loan syndications.

1.2.2 Credit Portfolio Management

Within the FM group, Credit Portfolio Management (CPM) officers handle all lending products for AA’s wholesale clients. The team functions as a global centre of excellence, involved in structuring, advising, offering, executing and monitoring credits. Once the client relationship managers have identified a client’s financing needs, CPM officers provide the product expertise needed for tailor- made solutions. When an account comprises both structured debts and general banking facilities, the credit management responsibility for the structured debts portion will fall under Structured Debt Management whilst that for the general banking facilities portion will fall under CPM. The organisational structure of CPM is shown in figure 2.

Figure 2: Organisational chart CPM

Portfolio Structuring and

Execution

Credit Portfolio Management

Business Support Portfolio

Strategy

Portfolio Management

Reporting &

Analysis Data

Modelling

CLO administration Structuring Markets

Regions/Countries Corporates FIPS

Research/

Developme nts CPM NL

22 SSYYSSTTEEMMSS HHAARRMMOONNIISSAATTIIOONN IINN AA WWORORLLDD OOFF CCHHAANNGGEE

In the current international business society, the trend is to invest heavily in new systems and standards to promote transparency, comparability, reduce risk and improve operational efficiencies.

Two closely related concepts, credit ratings and accounting standards, will play a central role throughout this thesis. In this Chapter, first the background of credit ratings will be sketched (2.1), then the history (2.1.1), the developments (2.1.2) and the impact of “Basel II” (2.1.3). The AA credit rating methodology is explained later (in Chapter 4)

Thereafter, the accounting standards will be discussed (2.2), the history (2.2.1), the developments (2.2.2) and the International Financial Reporting Standards (IFRS) (2.2.3). Finally a linkage is made between the two concepts, the focuses is on where Basel meets IFRS (2.3).

2.1 Credit ratings

Credit ratings are an important tool in monitoring and controlling credit risk. In order to facilitate early identification, a rating system should be responsive to indicators of potential or actual deterioration in credit risk. Credits, especially with deteriorating ratings, should be subject to additional oversight and monitoring (BC, 1999).

2.1.1 History

International granting of credits and the handling of credit risk commenced a long time ago.

Anthony Sampson describes in his book ‘Het internationale bankwezen’, how ‘Florentijnse banken’

already granted credit in the middle ages for merchants and princes. (The money lenders, 1982) Until the nineteenth century financial institutions, under which banks, all had their own way of analysing credit risk and used different criteria to make the granting decisions. Gradually the need rose from the investment community for an independent rating opinion.

John Moody² (1868 – 1958) tried to meet these needs in 1909 by launching a new idea; instead of simply collecting information on the property, capitalization and management of companies, he now offered investors an analysis of security values. He expressed his conclusions using letter rating symbols adopted from the mercantile and credit rating system that had been used by the credit-reporting firms since the late 1800s. He became the first to rate public market securities.

From the very beginning, Moody assigned independent rating opinions to help his investor readers to manage credit risk. Then, as now, Moody’s ratings were based on public information and assigned without the request of issuers.

2.1.2 Developments

Credit risk monitoring has become more and more important since the late 1990s. As globally banks enter new markets, create ever more complex products, and pursue customers near and far, institutions are taking on an increasing amount of credit risk. As credit exposures have multiplied, the need for more sophisticated risk management techniques for credit risk has also increased (JP Morgan, 1997).

In this thesis credit risk is defined (Verschuren, 1999, p.87) as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms, the probability of default (PD). The goal of credit risk management is to maximise a bank’s risk adjusted rate of return by maintaining credit risk exposure within acceptable parameters (BC, 1999). Banks need to manage credit risk inherent to the entire portfolio as well as the risk of individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation.

Until 1988, there was no legal requirements or framework to oblige the bank to efficiently manage and quantify credit risk in a prescribed format. On the back of this, the Basel Committee was founded in 1974 (see 2.1.3)

2.1.3 Basel I & II

In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord³ (Basel I). This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced in virtually all countries with active international banks.

In June 1999, the Committee issued a proposal for a New Capital Adequacy Framework to replace the 1988 Accord. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord;

supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts.

Following extensive interaction with banks and industry groups, a final Consultative Document was issued in April 2003, with a view to introducing the new framework at end 2006, called Basel II.

The new BIS capital requirements for market risk allow banks to use internal models to asses regulatory capital related to both general market risk and credit risk for their trading book. The AA has developed an internal counterparty ratings based (IRB) model for corporate credit risk.

For banks, a credit rating methodology for counterparties⁴ is an indispensable tool for managing and monitoring credit risk, both at individual and portfolio level. In addition, the Basel Committee on Banking Supervision and the European Commission have proposed that counterparty ratings will be a key factor to determine the minimum regulatory capital that a bank has to maintain for credit risk. Therefore it is necessary for AA, to keep the internal counterparty rating model up to date so that it produces meaningful ratings.

According to Basel II, the following areas should be taken into account when evaluating a bank’s credit risk management system: establishing an appropriate credit risk environment, operating under a sound credit granting process, maintaining an appropriate credit administration, measurement and monitoring process and ensuring adequate controls over credit risk⁵.

2.2 Accounting standards

The primary objective of accounting standards is that the accounts published according to these standards, provide financial information which investors find useful when making investment decisions. The currently used accounting standards in the Netherlands are called Dutch GAAP (General Accepted Accounting Principles). The current Dutch system of appreciation and result definition in the annual reports is stated in ‘Het Burgelijk Wetboek’ (BW2 titel 9). A specific description of these rules can be found in ‘the Guidelines of de Raad van de Jaarverslaggeving’.

2.2.1 History

Accounting has a long history. The first complete description of the double entry bookkeeping system appeared in 1494, authored by Luca Paciolo, an Italian monk/mathematician. Following 1494, the double entry system spread throughout Europe (Scott, 2003).

During the seventeenth and eighteenth century, accounting was primarily used internally because for most companies external capital providers/investors did not exist.

In the second part of the nineteenth century, the European economy endured an important transformation, among other things characterised by an increasing large-scale economy and the origination of new industries. The limited company became the most important organisation form as well as for the upcoming industries (for example the textile- and metal industry) as for the strongly extended traditional industries (for example shipping and international trade).

From circa 1870 till now the accounting history of Europe can be divided in three main periods (see table 1).

Table 1: Three periods of accounting history

In 1973, the International Accounting Standards Committee (IASC) was founded in nine countries⁶ including the Netherlands, to draw up International Accounting Standards (IAS).

The conceptual framework of the IASC has the following structure (see figure 3):

Users and their information needs

Underlying assumptions

Figure 3: The IASC structure canvas (Source: Hoogendoorn, Klaasen, Krens, 2001, p.101)

The Goal of IASC is: “to formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements. And to promote their worldwide acceptance and observance to work generally for improvement and harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements”(IASC, 2000).

The International Accounting Standards Board (IASB) replaced the IASC in 2001. Since then the IASB has amended some IAS, has proposed to replace some IAS with new International Financial Reporting Standards (IFRS) and has proposed certain new IFRS on topics for which there was no previous IAS.

2.2.2 Developments

With the development of financial markets, in particular the strong growth of derivatives, and the increased involvement of banks in the trading of financial instruments, the accounting framework has come under increased pressure because it does not adequately reflect economic reality. The growing demand in the investor community for transparency and for the creation of shareholder

Qualitative Characteristics - Understandability - Relevance - Reliability - Comparability - Constraints - True and fair view

Elements

- Definition - Recognition - Measurement - Capital maintenance

Accrual Going concern

Financial statements

Financial position, Notes and Performance schedules (changes)

I 1870-1945 A period, in which the underlying assumptions of the accounting theory were created. The end of this period is marked by the World War II

II 1945-1970 The period in which a rule based structure was completed, and in NL resulted in the ‘Wet op de Jaarrekening’ of 1970.

III 1970-2004 In the period from the mid 1970s. till now internationalisation has been the main influence on the accounting theory.

value requires firms to provide information that better reflects the impact of prevailing economic conditions on their financial position (ECB, 2004, p.69).

In June 2002, the Council of Ministers of the European Union (EU) adopted the anticipated

regulation requiring all listed EU groups to apply IFRS in their financial statements, generally by 1 January 2005. Within the EU, the stimulus for an accounting reform stems mainly from the objective of creating an unambiguous single market.

Even before high-profile accounting tragedies like Enron⁷ and Parmalat⁸ hit the headlines, the need to overcome differences in accounting standards between Member States and to have a harmonised accounting framework, was considered a crucial step towards the integration of financial markets in the euro area and the EU. Indeed, harmonised accounting rules would increase transparency and comparability, thus likely facilitating better capital allocation and potentially reducing the cost of capital (ECB, 2004, p.72). The recent major accounting scandals in the United States and Europe underlined the importance of transparent and high-quality financial reporting.

Just a few years ago, IFRS were only a distant possibility. Today, the reality is far different. The world is in a shift that is fast making IFRS the most widely accepted accounting model in the world⁹ (see table 2 below). The Netherlands is one of the countries were almost all listed companies, banks and insurance companies need to apply IFRS by 1 January 2005 to their consolidated annual reports.

2.2.3 IFRS

As the business environment becomes increasingly global and companies routinely list on stock exchanges in many countries, the need for consistent worldwide reporting standards intensifies.

IFRS, formerly known as International Accounting Standards, clearly addresses this issue.

IFRS intends to (KPMG, 2003, p.20):

- enhance transparency by requiring companies to account for transactions in a more consistent way and to disclose new and different aspects of their businesses;

- enable companies to be compared more easily with their peers;

- promote efficient cross-border investment and access to capital;

- facilitate merger and acquisition transactions.

IFRS – Adoption in selected countries

Adopting or adopted IFRS IFRS permitted Converging with IFRS EU (including new members)

Norway Russia Liechtenstein Australia

Canada Switzerland Hong Kong Singapore

Canada Japan India

New Zealand United States Table 2: IFRS adoption in selected countries

Incorporating IFRS in the European regulation does not implicate that the standards are

interpreted and applied in the entire EU in a consistent way. The IFRS standards are supposed to have a positive implication for organisations and individuals that adopt or analyse them, but there are several obstacles that will make the conversion to IFRS a complex process. Cultural

differences, the human subjectivity that plays a role when interpreting the standards and the necessity of estimations for materials at ‘fair value’ might disturb the intended transparency.

The implementation of IFRS has several consequences for corporates as well as for banks, which will be addressed in Chapter 3.

2.3 Where Basel meets IFRS

According to the new Basel Accord, supervisory review helps to create very direct incentives for banks to evaluate and manage their risks carefully. Transparency can supplement that incentive by leveraging the power of financial markets to encourage prudent risk-taking and, very

important, the third pillar¹⁰ of the New Accord, being market discipline.

The dangers that occur when companies fail to disclose their risks adequately have made the harmonisation of accounting and the disclosure practices worldwide more important.

The New Basel Accord intends to promote greater insight into a bank’s risk profile. IFRS intends among other things, to better reflect economic reality and transparency.

With reference to the New Accord, it became clear that it is useful to align the supervisory framework more closely with the converging accounting practices worldwide.

It is important that the Basel Committee’s view on the financials is in line with the changes in the relevant accounting standards, for example the treatment of provisions and the valuation of financial instruments.

The timetable below summarises the most important movements in the world of IFRS and Basel I

& II.

1930

Establishment BIS

1974 foundation BC

1988 Basel I Accord

End of 2006 Basel II

1973 foundation IASC

2001 replacement IASC by IASB

1 Jan 2005 first time adoption IFRS Table 3: Important data in a world of change

33 MMEETTHHOODDOOLLOOGGYY

In this Chapter the methodological core of this research is described. At first, the problem definition is explored (3.1), then the research design is illustrated (3.2), with the objective (3.2.1), the research goal (3.2.2) and the research question (3.2.3), which have a central place in this thesis. Thereafter, the approach, typology and the conditions of the research are described (3.2.4). Further, the research question is divided into several less encompassing sub-questions (3.3) and the conceptual model (3.4) is presented with an illustration. At last the data-collection for this thesis is given (3.5).

3.1 Problem definition

Within the AA, rating models are used to judge the financials and other important data to explore the default risks of their counterparties. The employees of the CPM Department of the AA therefore use a credit rating model to criticise the financials of the counterparties.

This model contains a dedicated financial spreadsheet to spread the annual figures of corporate clients. When the analyst imports the annual figures into the spreadsheet, the model presents the (defined in Chapter 4) relevant financial ratios. The conversion from Dutch GAAP to IFRS can have an influence on the ratings because it changes the way in which the annual figures are presented and thus part of the financial input of the rating model.

The use of IFRS can have an impact on the credit assessment. Adaptations in the valuation of the balance sheet and income statement, for example the use of ‘fair value’¹¹, can have consequences for the ratios and results of corporates. Another consequence of the adaptations is that the so- called trend analysis will probably be disturbed. A comparison with earlier annual figures and information would then be less useful.

3.2 Research design

After describing the general problem definition, the actual problem needs to pointed out more detailed. De Leeuw (1996) does this by stating the objective of the research, the research question and the related sub-questions. The objective formulates the principal, what the result of the research will be and finally the relevancy (De Leeuw, 1996, p. 85). The sub-questions are meant to structure the process of answering the research question. The typology and the conditions for the research will additionally be outlined.

3.2.1 Objective

Due to the IFRS conversion, AA might assign a different rating to their corporate clients that themselves actually have not changed. The ‘transparency’ that IFRS intends to bring, can allow the analysts to see things that they could not see before. It is important for AA to keep producing meaningful ratings and therefore it is necessary to know what the impact of the IFRS conversion is and how to deal with it.

A meaningful rating, implicates that it is a stable and transparent rating, based on ratios that are scarcely affected by IFRS which enables the rating model to perform a trend analysis.

3.2.2 Research goal

The research goal is: Ensure that the credit analyst of the AA remains producing meaningful ratings after transition of Dutch GAAP to IFRS when using the credit rating model for corporate clients.

3.2.3 Research question

The research question is: What is the possible influence of IFRS through the changed input of the AA credit rating model for corporate clients on the ratings and how should the credit analyst that uses the rating model deal with this influence?

3.2.4 Research typology and the conditions Typology of the research

This research can be qualified as ‘descriptive research’ and as ‘explorative research’ because it first describes the differences of Dutch GAAP and IFRS and then looks at the connection between the input of the rating model and the rating (Baarda, de Goede, 2000).

According to de Leeuw (1996, p.70) this research can also be described as practical research; the outcome of the research, like data, insights, methods, concepts can be used for specific management problems. The purpose is to satisfy the specific customer related need for knowledge, during this thesis how to perform a meaningful rating.

Conditions of the research

Since IFRS is only required for listed companies, this research concentrates on purely on listed corporates.

IFRS is implemented in the entire EU. Currently, all these countries have different local General Accepted Accounting Principles (GAAP). All these countries face different consequences of IFRS when it is implemented. Considering the available time, this thesis only focuses on the corporates that are now reporting under Dutch GAAP.

The comparison between Dutch GAAP and IFRS focuses on the preparation of consolidated financial statements by listed enterprises on a going concern¹²

The credit rating has, among other, a substantial impact on the calculation of the profitability of relationships and transactions. Therefore, the credit rating model is not only important for credit risk but also for commercial reasons. In this thesis the focus will be principally on the credit risk.

The goal of this thesis is, among other, to come up with recommendations concerning IFRS for the credit analysts of CPM NL. This is the Department where the internship is performed.

The AA has several rating models, CPM NL uses the European Probability of Default (PD) counterparty rating model for corporate clients. Only for this model the influence of IFRS is investigated.

An important condition is that any information relating to rating models or to the AA that is not public in nature has to be kept strictly confidential.

Timeliness of the field research period is 6 months.

3.3 Sub-questions

1) How is the rating model of AA structured?

• What is the general outlook on the credit rating model?

• What is the input of the credit rating model?

• How are the ratings determined?

Before determining a possible influence of IFRS on the credit rating, it is necessary to understand how the credit rating model works. Is the output of this model purely based on financial figures or is it the experience of the analyst that plays a central role? An interesting question is, whether the user’s subjectivity contributes to the assignment of the ratings . To see if accounting standards are of any influence on the credit rating, the input is examined.

2) What are the differences between Dutch GAAP and IFRS?

• What are the general principles of Dutch GAAP and IFRS?

• How do the Balance Sheet and the Income Statement differ?

IFRS intends to bring more transparency but also tends to bring more volatility in the annual figures. To understand the possible changes IFRS might cause, it is important to see how IFRS differs from Dutch GAAP. The answer to this question will show if the volatility is increased and which financial items will be affected. Thereby, it is interesting to know whether IFRS will bring more transparency.

3) What is the influence of the IFRS conversion on the rating model?

• The influence on the Financial Assessment?

• What is the influence on the Business Analysis?

• Are the Qualitative Amendments influenced?

• What is the influence on the rating?

If the research points out that there are indeed considerable differences between Dutch GAAP and IFRS, then it becomes important to understand whether or not these differences change the input.

After investigating the rating model, it is possible to see where the possible changes will influence the input and what the consequences will be for the rating.

If the rating is likely to change, it becomes interesting to take a look at the expected changes and wonder whether these changes are meaningful for the ratings assigned to the corporate clients of AA. Therefore, it is examined which changes are meaningful and result in a better reflection of the available information (transparency) and which changes will not contribute to a meaningful rating.

4) What are the conclusions & recommendations?

• Impact of IFRS in general on the credit ratings?

• The recommendations for the analyst of the credit rating model?

• The recommendations for the structure of the credit rating model?

If the IFRS conversion includes changes that will not contribute to a better output of the rating model and a meaningful rating, recommendations will be given to deal with these changes.

What should the CPM analyst do to remain producing meaningful ratings with the rating model.

The purpose is to give the CPM analyst better insight in the upcoming changes and include advice on how to deal with the new situation.

3.4 Conceptual model

The conceptual model below (see figure 4) can, according to De Leeuw (2000, p.137) be seen as an abstract model of a concrete system. The problem (see 3.1) covers several aggregation levels.

A high aggregation level is chosen to present a clear overview. During the investigation certain parts of the model are explained in more detail.

Figure 4: Conceptual model of the research framework

The Research question is “What is the influence of IFRS through the changed input of the AA credit rating model on the ratings and how should the user of the rating model deal with this influence?”

The IASB is trying to create harmonisation in the accounting framework with IFRS. The increasing importance of internationalisation and transparency all influenced the reporting requirements and made the EU adopt IFRS 1 January 2005 for the consolidated statements of listed companies.

Since one of the reporting requirements is transparency, it is expected by the EU that IFRS will better reflect company information in the annual figures than Dutch GAAP and therefore should be used as reporting model.

Currently, Dutch GAAP is used as reporting model. There are many differences between Dutch GAAP and IFRS which may change the annual figures of the listed Dutch corporates when implementing IFRS.

If the input of the credit rating model changes due the IFRS reporting model, it is examined how this changes the rating. When the rating becomes less meaningful, recommendations will be made to increase the meaningfulness.

transparency internationalisation harmonisation

Reporting requirements

Dutch GAAP IFRS

Reporting model

rating

3.5 Data collection

This thesis started with a general description of the AA Bank to give an impression of the company and to clarify the environment in which the research was performed. Then the scope of the research is clarified: the introduction of credit rating models and accounting standards. In this Chapter the research design is introduced and in the coming Chapters the sub questions will be answered. Finally the conclusions and recommendations are presented.

To present the AA credit rating model, internal reports of the AA rating models are available and will be used. Furthermore, literature is used to gather information about the history and relevance of rating models and discussion with credit rating experts within the AA are held to fully understand the structure of the model. (Chapter 4)

To understand the content of the IFRS, external (KPMG, PWC, IASB etc.) reports are used. The danger that comes along when using these reports is that they may contain wrong information.

Careful attention should be paid to the derived information about the standards and internal (AA) accountants are consulted to be sure of the correctness of the research.

Within the AA, interviews will be held with persons that have knowledge about and a view on IFRS, to gather information.

Thereby, IFRS reports will be used along with information from the official web sites. Desk research will be done and interviews with corporate and external accountants will be held to discover the differences between Dutch GAAP and IFRS.

Since IFRS will face a lot of changes from December 2003 until March 2004, a lot of work has to be done to adjust the comparison to the new IFRS requirements, which can result in a time pressure when completing the research. (Chapter 5)

After understanding the working and the input of the rating model, the focus will be on the differences between Dutch GAAP and IFRS and find out which of these differences will change the input of the rating model. A working group is founded with credit Risk and industry risk experts, to brainstorm about the possible consequences for the several industries. Thereby, rating model experts are consulted to consider the weighting of the ratios in the credit rating model that have an substantial impact.

The difficulty faced performing this investigation is that there are hardly any IFRS annual figures available at this moment. To perform a statistical analysis a representative set of data is needed, which was not available during the period of research. A ratio analysis will be made to discover the impact of the changed input on the final rating. (Chapter 6)

The purpose of this research is to make it possible for the user to keep using the rating model in such a way that the ratings remain meaningful. Out of the results, recommendations will be made which can guide the credit analysts when performing a credit rating using IFRS financials.

If appears that the model will not be functioning properly after the IFRS conversion, then recommendations will be presented for alternative adjustments to the rating model.

For the management of the AA recommendations will be made and areas for further research will be pointed out. (Chapter 7)

44 TTHHEE SSTTRRUUCCTTUURREE OOFF TTHHEE AAAA CCRREEDDIITT RRAATTIINNGG MMOODDELEL

This Chapter presents the structure of the credit rating model of the AA (4.1). First it gives insight in the input of the rating model (4.2), by looking at the Financial Assessment (4.2.1), the Business Analysis (4.2.2) and the Qualitative Amendments (4.2.3). Thereafter the determination of the ratings is explained (4.3). The conclusion (4.4) will point out which parts of the credit rating model can be influenced by IFRS.

4.1 The credit rating model

The AA managed to successfully incorporate Basel’s internal ratings based approach in the credit rating model. Which means that the AA bank estimates each borrower’s creditworthiness, and the results are translated into estimates of a potential future loss amount, which form the basis of minimal capital requirements.

The credit rating model is an expert tool, whereby the scoring of the output is (also) based on the knowledge about the client facing CPM analyst or relationship manager. The model serves to clearly distinguish objective elements (for example access to capital and growth of the market) and subjective elements (for example intuition of the CPM analyst), that will clarify and improve the quality of the counterparty rating process of the AA, through meaningful ratings can be produced.

There are several reasons for questioning the quality and meaningfulness of the produced credit ratings. One of these reasons is inconsistency due to human judgement and methodology of the rating model. The CPM department of AA has to assess default risk of many corporates from different industries. This job is done by numerous analysts working in separate teams. Grading the default risk of firms under such circumstances is subject to inconsistencies.

A second reason concerns the intuition and interpretation of the analysts. It appeared that when several analysts produce a rating for the same corporate, it can result in different ratings.

The underlying factors of this inconsistency will be discussed further in this Chapter.

4.2 The input of the credit rating model

The model’s financial analyses require the input of reliable financials, these financials should be based on generally accepted international accounting principles. The input of the credit rating model includes an balance sheet and an income statement, that are dependent on accounting standards. Therefore it is possible that the credit rating model might be influenced by IFRS and that the results of the credit rating model might be less reliable.

4.2.1 Financial assessment

The Financial Assessment contains several inputs. Among other, financials are necessary for the Balance Sheet and the Income Statement. The input for the Balance Sheet and the Income Statement is mostly derived from annual reports.

The Balance Sheet & Income Statement

As said before, the quality of the credit rating model output is dependent upon the accuracy and correctness of the quality of the input. It is therefore strongly emphasised that correct, complete and consistent Balance Sheet (table 3) and Income Statement (table 4) spreading is of the utmost importance. Therefore, interim figures may be used only if these are not seasonal.

Given all the adjustments IFRS is likely to cause in the Income Statement it will be difficult to accommodate them in the current set up of the credit rating model. Filling in the new IFRS figures in the current Income Statement format will impact the accuracy of Income Statement figures.

And therefore influence the Cashflow Statement that is derived from, among other, the Income Statement. In table 4 the Balance Sheet of the credit rating model is presented.

Table 4: The Balance Sheet as presented in the rating model

Table 5 below shows the format of the Income Statement according to the credit rating model.

Table 5: The Income Statement as presented in the rating model Turnover/sales/gross revenues (01)

Cost of goods sold (02) -/-

Gross trading profit/loss (03) Salaries and wages (04) -/-

Other expenses (05) -/- Operating provisions (06) -/-

EBITDA (07) Depreciation and amortisation (08) -/-

EBIT (09) Associates (10) +/-

Interest gross (11) -/-

Other financial income/expenses (12) +/-

Operating profit after finance (13) Extraordinary gains (14) +

Extraordinary losses (15) -/-

Profit/loss before tax & minority interest (16) Taxation (17) -/-

Minority interest (18) -/-

Net profit/loss (19)

Dividends (20)

Assets

Fixed assets

Land and buildings (01) Machinery/equipment (02) Ships/aircraft (03) Other fixed assets (04) +/+

Gross fixed assets (05) Accumulated depreciation (06) -/-

Net fixed assets (07) Long-term loans (08)

Investments in subsidiaries (09) Investments in associates (10) Other financial investments (11) Other non currrent assets (12) +/+

Fixed assets (13) Current assets

Work in progress (01)

Related progress payments (02) -/- Net work in progress (03) Finished goods (04) Raw materials (05) Other inventory (06) +/+

Total inventory (07) Group companies (08)

Accounts receivable (09) Other receivables (10) Other current assets (11) Marketable securities (12) Cash/bank deposits (13) +/+

Current assets (14)

Total assets (15)

Liabilities

Own and associated means Preferred shares (01) Common shares/capital (02) Paid in capital (03) Retained earnings (04) Revaluation reserves (05) Other reserves (06)

Currency translation adjustment (07) Treasury stock (08) +/+

Net worth (09) Net intangibles (10)

Loans to shareholders (11) -/-

Tangible net-worth (12) Subordinated debt (13)

Minority interest (14)

Own and associated means (15) Long term liabilities

Group companies (01) Deferred taxes (02)

Other long-term liabilities/provisions (03) Long-term debt (04)

Long-term bank debt (05) +/+

Long-term liabilities (06) Current liabilities

Group companies (01) Accounts payable (02) Short-term bank debt (03) Other short-term debt (04) Dividends (05)

Current maturities (06) Other current liabilities (07) Accruals (08) +/+

Current liabilities (09)

Total liabilities and own means (10)

Cashflow Statement

Fundamental to the lending decision is an assessment of the borrower's ability to service and repay the debt as scheduled. The Cashflow Statement is calculated from the input of the Balance Sheet and the Income Statement. A careful interpretation enables us to assess the borrower's

"free" operational cash flow, which will be available for debt service.

Ratios

The calculation of the ratios is model driven and cannot be changed or suppressed. Therefore it is very important that the input of Balance Sheet and particularly Income Statement items have been considered carefully.

The system in the model calculates 14 historical financial ratios, balanced over the following four categories (see table 6):

Table 6: The financial ratios

Given that these ratios have different weightings in the model, certain financial numbers are more important than others. It should be emphasised that when concerning the relative weightings of the ratios EBIT appears to be the most sensitive number.

The analysis of these ratios is an important input for the determination of the final rating, further on in the thesis the effect of IFRS on the ratios is examined (see 6.5).

Industry Peer Groups

To each obligor one (or more) industry peer group(s) have to be assigned (maximum five).

AA industry codes assigned to its customers are considered important data. Industry codes are essential for gathering valuable statistical information, e.g. the distribution of the bank’s credit portfolio among industries. The regulators and rating agencies also require

information about credit exposures of specific industries. Therefore, it is mandatory to enter the correct code in the spreadsheet for each customer under consideration.

The completed balance sheet and income statement together with the ratio analysis and the industry peer group are the financial indices.

Financial Subjectives

In addition to the financial index analysis, the system includes several multiple-choice questions that have to be answered by the user of the model (CPM analyst). Though qualitative, if possible, clear references (broker reports, annual reports etc) should be used for answering these questions. The results of several questions are combined for each category, resulting in a score for

Operations

● Total debt/Net operating funds flow

● Net worth/Adjustment total assets

● Tangible net worth/Total assets

● Return on capital employed

Liquidity

● Current ratio

● Quick ratio

● Days inventory

● Days receivable

● Days payable

Cash flow and debt service

● ICR (Interest cover ratio)

● Total debt/EBITDA

● Net operating funds flow /Financing charges

Capital structure

● Gearing (Total debt/Tangible net worth)

● Own + Associated means/Total assets

the so-called financial subjectives. The financial indices and financial subjectives are then combined into an assessment for each category (operations, liquidity, cash flow and debt service and capital structure).

The results of the four categories’ assessments are combined into the Financial Assessment. There are eight subjective questions, these are presented in table 7.

Table 7:The subjective questions for a Financial Assessment 4.2.2 Business Analysis

The second part of the corporate score is the Business Analysis, which is a score, resulting from the combination of the industry analysis and the Macro Economic Risk Indicator (MERI).

For the industry analysis similar industries (in terms of balance and profit and loss account) are bundled into clusters. The AA’s Industrial Research Department rates each cluster based on the judgement of several variables. These are: relevant market conditions (e.g. industry sales growth, profitability and industry stage), industry sensitivity (e.g. business cycle, pricing strength, interest rate sensitivity), production conditions (e.g. capital sensitivity, technology dependence) and structural factors (e.g. competitiveness, regulatory issues, environmental concerns and barriers to entry). These variables cover the most relevant aspects in assessing the risk of industries.

The analysts at CPM work in teams, the corporates are divided in nine industry clusters:

▪ Automotive ▪ Energy ▪ Technology

▪ Consumer ▪ Chemicals ▪ Media

▪ Diversified ▪ Healthcare ▪ Telecom

The MERI takes into account the macro economic issues of countries. The MERI is determined by the institutional environment in which a company operates and by the company’s commercial macro economic exposure. Its two sub-indicators are:

• An indicator for sales market risk

The country (countries) of sales is the country where the obligor sells it products or services.

• An indicator for country of residence risk

The country of residence is the country in which the obligor is located. If the company is established in one country, but the majority of its operations are concentrated in another, a

‘second’ country of residence is taken into account.

4.2.3 Qualitative amendments

To come to a final corporate score input is needed which involves the assessment of some qualitative elements including:

• Quality of management;

The basic assumption the credit rating model model makes is that the company’s management is, in principle, well qualified for running the business. Accordingly, no positive adjustments are to be made because of a positive management assessment.

Operations Trading area Market conditions Supplier risk

Competitive leadership

Liquidity

Customer concentration Stock liquidity

Accounting risk

Capital Structure Access to capital

• Contingencies;

If the company has announced material contingencies such as pending litigation, material off- balance sheet liabilities or other possible future obligations that are not reflected in its financial statements then a downward adjustment of the UCR is appropriate.

• Group support.

If the counterparty is part of a group or has a shareholder that is likely to support the counterparty to fulfil its financial obligations then an upward adjustment can be applied.

It could be argued that shareholder support is often a feature of the structure of the facility and therefore should not be reflected in the obligor rating. However, shareholder’s support, whether it is formal or informal also often influences the likelihood that the counterparty will default. Thus it should be assessed as part of the obligor rating.

• Other;

The ‘other’ category should be used for any relevant elements not included in the remaining

“Qualitative Amendments”. It includes currency mismatch risk, expected changes in the financial conditions of the counterparty. The expected changes in the financial conditions may include announced mergers, acquisitions or large investments. Significant changes in the expected profitability, not already reflected in the last financial statements, should also be taken account of.

Such expected changes must be substantiated in the rating proposal

4.3 Determination of the ratings

In the Chart below is reproduced how the credit rating model is structured and which parts can be affected by IFRS.

Figure 5: Chart of the rating model

Subjective questions + Financial assessment

Industry MERI +

Business Analysis

Initial UCR(= numerical score) Qualitative Amendments +

Proposed UCR

Credit approval authority +

Final UCR Ratio analysis

Industry peer groups + Financial indices Balance sheet

Income statement + MFA

IFRS