2010 Annual Meeting and Conference

Asian Academic Accounting Association (AAAA)

November 28 – December 1, 2010
The Shangri-la Hotel, Bangkok, Thailand
Hosted By Thammasat Business School

CONFERENCE PROCEEDINGS

PAPER 5.3-3

Impairment Losses after Financial Crises: Impact on Financial

Sector Earnings Fundamentals in Pakistan

Muhammad Asif,
Institute of Business Administration, Karachi, PAKISTAN
Muhammad Nishat,
Institute of Business Administration, Karachi, PAKISTAN
 Impairment Losses After Financial Crises:

Impact on Financial Sector Earnings Fundamentals in

Pakistan

Muhammad Asif Jaffer

FCMA, ACCA, MA (Economics)
Faculty Member, Accounting & Law
Institute of Business Administration, Karachi

Dr. Muhammad Nishat

Professor, Economics & Finance
Institute of Business Administration, Karachi
 Impairment Losses After Financial Crises:

Impact on Financial Sector Earnings Fundamentals in

Pakistan

Muhammad Asif Jaffer

FCMA, ACCA, MA (Economics)
Faculty Member, Accounting & Law
Institute of Business Administration, Karachi

Dr. Muhammad Nishat

Professor, Economics & Finance
Institute of Business Administration, Karachi
Abstract

Financial crises hit the economies of the world and the companies in varying ways. This paper

examines the impact of impairment losses resulting from financial downturn on financial sector

earnings fundamentals in Pakistan. Due to huge expected impairment losses and their possible

impact on the earnings fundamentals, a supplementary regulation of the Securities and

Exchange Commission of Pakistan (SECP, 2009) allowed that companies having investments

classified as ‘Available for Sale’ (AFS) can opt not to recognize impairment losses in income

statement and take the fair value adjustments to equity directly. We have analyzed financial

statements of 36 financial sector companies that include commercial banks, investment banks

and mutual funds. This constitutes almost all of the affected financial sector companies where

impairment losses were more than Rs.100,000. The study reveals that the recognition of

impairment losses in the income statement as per IAS 39, for investments classified as AFS,

does have huge impacts on key financial ratios like Return on Equity (ROE), Return on Assets

(ROA) and Earnings per Share (EPS), when compared to the same ratios if the fair value

adjustments (otherwise impairment losses) are taken to equity directly. We observed

empirically a net average difference of 7% in ROA with standard deviation of 14%. This

corresponds to relative impact of 71% in ROA. The difference in ROE is much higher i.e. 17%

with standard deviation of 26%, the relative size of which is 62%. In 11% of the cases, the

bottom line net income was converted into net loss when the impairment loss is taken in the

income statement. We have observed an average difference of Rs.2.90 per share in EPS with

standard deviation of Rs5.20, corresponding to relative increase of 100% in EPS.

Introduction

Financial Crises hit the economies of the world and individual businesses. Financial Institutions

were among the most suffered because of their exposure to capital markets. Many studies have

been conducted mainly in United States and European countries on various aspects of financial

crises. In Pakistan, as a consequence of post financial crises stock market losses (year 2008),
financial companies were badly hit because of their exposure to capital markets. Huge

impairment losses were there to result on the income statements of these financial companies.

The regulatory authorities (SECP) in Pakistan, just as in the other parts of the world, came up

with supplementary regulation to rescue these financial companies. One of such regulations

(SECP, 2009) allowed the financial companies to not show their relevant impairment losses in

the income statement and take the same as equity reserve. This changed the outlook of income

statements of many financial companies and resultantly their performance ratios. This study is

to measure the impact of this supplementary regulation (that allowed the impairment losses not

to be taken in the income statement) on the financial sector earnings fundamentals in Pakistan.

As for relevant prior research in this area, though we could not find published research

specifically targeting our research objective, yet research has been done in some of the

encompassing areas. In a study which was based in Finland (Anna-Maija, 2009), the

researchers tried to find out whether the adoption of IFRS changes the magnitude of key

financial ratios. The research concludes that it does. This is comprehensive research

encompassing impact of various accounting standards. European Union adopted IFRS vide EU

Regulation # 1606/2002. The research data was collected from published annual reports of

listed companies in the transitional period. Barth (Mary E. Barth, 2008) observed that firms

applying IAS from 21 countries generally evidence less earnings management, more timely loss

recognition, and more value relevance of accounting amounts than do a matched sample of

firms applying non-US domestic standards. As a consequence to shift to IFRS by the European

Union, Susana (Susana Callao, 2007) focused on the accounting relevance and financial ratios

of companies in Spain. It is the study of IBEX-35 companies that focuses on the impact of the

standards on comparability and the relevance of financial reporting. The study revealed that

local comparability was adversely affected if both IFRS and local accounting standards are

applied in the same country at the same time. Though the subject matter and finding of the

study are not directly related with our research, yet it can be inferred that IFRS do affect the
financial ratios when compared to the local standards as the impact of its adoption was

worsening the comparison.

To mitigate the negative impacts of financial crises worldwide, regulatory bodies around the

world came up with supplementary regulations in various countries allowing the flexibility to the

affecting companies in accounting for these financial instruments. IASB itself adopted

amendments of IAS39 and IFRS7 on 13th October 2008. These amendments introduced the

possibility of reclassification of investments for companies applying IFRS. Such reclassification

was already permitted under US GAAP. European Union adopted these amendments

(European Union, 2008) on 15th October 2008 to ensure that EU companies have the same

flexibility as their American competitors to reclassify assets held for trading as held to maturity

category. Karen K. Nelson (Nelson, 1996) suggests that the reported fair values of investment

securities have incremental explanatory power relative to book value. This supports the implied

hypothesis of our research that the adoption of strict version of IAS39, when compared to the

relaxed treatment under the said SECP pronouncement, does have its impacts on key financial

ratios. Richard Schroeder (Richard Schroeder, 2009) while focusing their research in the United

States observed that fair value accounting did result in heavy losses for many banking

companies who complied the fair value accounting.

We observed that no study has been made in Pakistan to measure the impact of these

impairment losses on the income statement and the resultant ratios of financial companies. This

study is therefore targeted towards measuring the impact of not taking the heavy impairment

losses in the income statement (as per the supplementary regulation) on financial companies’

profits and performance ratios namely ROE, ROA and EPS. The main objective of this study is

to empirically determine that to what extent are the key financial ratios of financial companies in

Pakistan affected when impairment losses on investments classified as AFS are not taken in the

income statement under IAS 39 but are rather recognized directly in equity (SECP, 2009). The
rest of the paper is organized as follows: Section 2 discusses the historical background of the

financial downturn in equity markets in Pakistan and the scope of the research in terms of IAS

39. The research methodology and data sources are described in Section 3 followed by

discussion of results in Section 4. The summery and conclusions are given in Section 5.

Historical Background and Scope of the Research

Followed by attaining its highest ever peak of 15000 points in April 2008, the Karachi Stock

Exchange (KSE) 100 index eventually started falling in May / June 2008. Having lost more than

one third points, the KSE introduced fixed floor mechanism on 28th August 2008 to protect the

market from further fall (Wikipedia, 2009). The floor was removed on 15th December 2008.

During this period, the prices of many otherwise liquid securities remained fixed at their lowest

fixed floor. Though the floor was technically removed on 15th December 2008, active trading

was not recorded until mid January because of the price lock mechanism which didn’t allow fall

in price of any single security below 5% on a single day. As such, the rates prevailing on the

exchange on 31st December (the period closing date for almost all of the listed companies) were

not reflective of their fair market value.

Heavy impairment losses were expected to be shown in the financial sector companies as a

consequence of fall in value of securities in stock exchange. The price fluctuations in securities

held as available for sale (the subject matter of this research), generally, are taken to equity as

fair value reserve under paragraph 55 of IAS 39. However, IAS 39 provides that any significant

or prolonged fall in value of securities classified as available for sale is to be treated as

impairment loss (hereinafter referred as relevant impairment loss) and is to be taken to the

Income Statement in the period in which such fall occurs. Generally, regulators take fall beyond

20% or one that prevails for more than 6 months (IFRIC, 2009) as significant or prolonged, and

therefore recognize the resultant fall as impairment loss. As a consequence, there were two

major issues facing affected companies for financial reporting. One, that the value prevailing on
the year closure date (i.e.31st December 2008) on the stock exchange was itself doubtful to be

taken as Fair Market Value (FMV) of such securities because there were no active trades in the

market as mentioned earlier. The second issue was the treatment of resulting impairment loss.

If this loss was exactly to be treated as per IAS 39, almost all affecting companies would have

shown heavy net losses which would have affected their financial standing, debt covenants and

consequently the stock market as a whole very adversely. The SECP took up both these issues

by issuing two different notifications. In an earlier pronouncement (SECP, 2009 (1)) SECP

clarified that the market price as quoted on stock exchange on 31st December 2008 can be

taken as fair market values for the purpose of IAS 39. It resolved the first issue described

above. In another notification, (SECP, 2009), SECP relaxed the compliance with strict version of

IAS 39 by giving the affected companies an option to take the resultant relevant impairment loss

to equity rather than to the Income Statement. If availed, the affected companies were then

asked to take the said impairment loss to the Income Statement in four installments in the next

four quarters of the year 2009, after adjusting any recovery or further decline in value, if any, up

to that date.

Many companies opted for the relaxed treatment under the SECP notification and disclosed the

effects on the profits and reserves had the IAS 39 was complied and impairment loss was taken

to the Income Statement. As such, we had both the data available in source reports of the

companies concerned, that is, the profits and reserves when the relaxed treatment was adopted

and when it is not. Even the companies which complied with IAS 39 by not adopting the

relaxation did have the value of the relevant impairment losses in their Income Statements. As

such we had the liberty to evaluate the effects of relaxed treatment in those companies too, had

those also had adopted the relaxed treatment.

As a result, we had two sets of data for each company we have evaluated, for the same period

i.e. period ended 31st December 2008. One set showing the Income Statement and Balance

Sheet positions had the IAS 39 was relaxed and impairment losses were taken to equity, and

the other set representing the same companies data for the same period had the strict version

of IAS 39 was complied in respect of the relevant impairment losses.

The subject matter of this paper is therefore the evaluation of these two sets of data and

evaluating the key financial performance ratios derived there from.

IAS 39 provisions relating to valuation of available for sale securities and impairment

Losses

Paragraph 43 to 46 of IAS 39 contains the provisions in respect of measurement of financial

assets. It says that the financial assets (equity securities in our case) shall be initially recognized

at cost. For subsequent measurement, the IAS divides the financial assets in four categories i.e.

(1) fair value through profit and loss account,, (2) held to maturity, (3) loans and receivables and

(4)available for sale financial assets. It further provides that except for the middle two and

unquoted securities in the other two (if any), the financial assets shall be valued at fair value.

The available for sale securities therefore are to be valued at their fair market value as per the

provisions of these paragraphs of IAS. Paragraph 55 further states that any gain or loss arising

as a result of fair valuation of available for sale securities shall be recognized directly in equity.

However, paragraph 67 to 70 (read with paragraph 59 and 61) of IAS39 deals with the

recognition and treatment of impairment loss in respect of assets held as available for sale. It

says that a significant or prolonged decline (IFRIC, 2009) in the fair market value of equity

securities shall be taken as objective evidence for the purpose of recognition of impairment loss.

Paragraph 67 further states that the relevant impairment losses cannot be reversed back

through Profit and Loss account.

Research Methodology and Data Sources

We have worked 36 financial companies that include 18 commercial banks, 10 investment

banks and 8 mutual funds. The total population of listed companies in these three sectors on

Karachi stock exchange is around 110 but not all of them were relevant for our analysis. We

have gone thorough financial reports of almost all of them and all the relevant reports where

there were relevant impairment losses were selected for analysis. Some were not relevant

because the companies had no ‘available for sale’. However, a few non financial sector

companies might also be relevant if they had investments classified as ‘available for sale’, but

the same are not selected because the magnitude of such investments in non financial sector

companies is likely to be very small relative to other balance sheet items and therefore its

meaningful analysis was hardly possible.

Out of the total of 36 companies as above, 24 companies were adopting the relaxation under

SECP pronouncement stated earlier. These companies took their impairment loss for the period

ended 31st December 2008 directly to equity and did not report the same in the income

statement. However, as per the requirements of IAS 39 and IAS 1, these companies did

disclose the impact of such deviation on their profits and reserves. As such, we had two sets of

data for the profits and reserves and assets of these companies; one, when they adopt the

relaxed treatment under the local pronouncement taking impairment loss directly to reserves (as

they did) and other if they had not done so and taken it through income statement. Eight of the

36 companies did not opted the relaxation under local pronouncement and complied the strictly

version of IAS39 as above. Since the relevant impairment losses figures were available in their

income statements / notes, we had the liberty to work out their incomes, reserves and assets

had they also opted for the relaxed treatment under the said SECP pronouncement. As such the

same two sets of data were made available for such companies also. Four companies did opted

the relaxed treatment partly, i.e., they took some impairment loss to income statement and
some to equity directly. From the same techniques as above, we arrived at two sets of data for

these companies also. As a final outcome, we had two sets of data for the whole sample of 36

companies as to their incomes, reserves and assets etc. in both the scenarios. From these two

sets of data, we worked out ROA, ROE and EPS. In the denominator of ROE and ROA, we

have taken average values of equity and assets, that is, opening plus closing divided by two.

For ROE and EPS, pre-tax income is taken because tax rates vary from company to company

and also vary for difference in the holding period of investments. Taking before tax net income

will therefore eliminate the impacts due to change in tax rates and deferred tax calculations. In

EPS, we did not take weighted average number of shares because this information is

sometimes not available in the annual reports. Further, since our concern is to study the

difference in ratios under the two sets of data, not the ratios itself, taking simple average should

not falsify our analysis as the net impact of the difference of the two is nil. Twenty one of the

selected companies had year closure on December 31st, the reference date for our study. Their

annual accounts were therefore available. However, 15 companies had their year closure on

30th June and as such the reports used for their analysis were showing six monthly incomes. In

order to take these two types of companies on the same period, the ratios of the companies

whose data is annual are deduced to half to enable comparison at Par.

Discussion of Results

Overall impact on profits (losses) of the selected companies was Rs.39.674 billion. Highest

relevant impairment loss was Rs.4.894 billion which was in a bank. As shown in the tables,

overall impact (defined as difference in the ratios under the two options) on ROA was around

7% with standard deviation of 14%. This corresponds to relative impact of 71%. Maximum

impact is observed in mutual funds where relative impact is as much as 104%. In banks relative

impact was minimum i.e. less than 16% with almost consistency. This is so because banks have
wide portfolio compared to mutual funds and investment banks thus making the relevant

impairment loss only a very small part of the earnings before interest and tax.

In ROE, However, overall net impact (calculated as difference in ROE under the two options) is

more prominent and is around 17% with standard deviation of 26%. This corresponds to overall

relative impact of 62% in ROE, The difference in ROE is more prominent in investment banks

that is around 42%. Impact in banks is also minimal here (4%) but its relative size is much

higher. Investment banks remained more vulnerable to the change impact simply because they

had major exposure to equity securities classified as available for sale.

In EPS also, the ROE trend is reflected where maximum impact is observed in investment

banks where it stood at Rs.7 per share. Overall net impact in EPS is of Rs.3 per share with

standard deviation of Rs.5, corresponding to relative impact of 100%

Return on Assets

ROA = Earnings before income and tax x 100 / Average total assets

ROA1= Average of ROA when impairment loss @ income statement

ROA2= Average of ROA when impairment loss @ equity in balance sheet

∆ROA =Net difference in ROA= ROA2 – ROA1

∆ROA% =Net difference in ROA as a percentage of ROA1= (ROA2 – ROA1) x 100 / ROA1

σ (∆ROA) = Standard deviation in ∆ROA

Table 1

Category ROA1 ROA2 ∆ROA ∆ROA% σ (∆ROA)

Overall -9.83% -2.86% 6.96% 70.80% 13.86%

Banks 3.18% 3.68% 0.50% 15.72% 0.49%

Mutual Funds -38.14% -21.81% 16.34% 42.84% 23.16%

 Investment -10.59% 0.51% 11.09% 104.72 12.17%

Banks %

Return on Equity

ROE = Net income before tax x 100 / Average total equity

ROE1= Average of ROE when impairment loss @ income statement

ROE2= Average of ROE when impairment loss @ equity in balance sheet

∆ROE =Net Impact = ROE2 – ROE1

∆ROE% =Net difference in ROE as a percentage of ROE1= (ROE2 – ROE1) x 100 / ROE1

σ (∆ROE) = Standard deviation in ∆ROE

Table 2

Category ROE1 ROE2 ∆ROE ∆ROE% σ (∆ROE)

Overall -27.62% -10.38% 17.24% 62.42% 25.76%

Banks -0.30% 3.34% 3.64% 1213% 2.65%

Mutual Funds -38.50% -21.64% 16.86% 43.80% 24.13%

Investment -68.09% -26.06% 42.03% 61.73% 32.6%

Banks

Earnings Per Share

EPS = Net Income before tax / average outstanding shares

EPS1= Average of EPS when impairment loss @ income statement

EPS2= Average of EPS when impairment loss @ equity in balance sheet

∆EPS =Net Impact = ROE2 – ROE1

∆EPS% =Net difference in EPS as a percentage of EPS1 (EPS2 – EPS1) x 100 / EPS1

σ (∆EPS) = Standard deviation in EPS

 Table 3

Category EPS1 EPS2 ∆EPS ∆EPS% σ (∆EPS)

Overall -2.90 0.00 2.90 100.00 5.19

Banks 2.25 3.17 0.92 40.89% 1.01

Mutual Funds -6.7 -4.38 2.32 34.63% 2.62

Investment -9.13 -2.19 6.94 76.01% 8.45

Banks

Conclusion

This research concludes that not taking the impairment losses to income statement, in respect

of available for sale investments, arising as a result of financial downturn in equity markets in

Pakistan, does have huge impact on financial sector earnings fundamentals like ROA, ROE and

EPS. A net average difference of 7% in ROA corresponding to relative impact of 71% is noted.

The difference in ROE is much higher i.e. 17% the relative size of which is 62%. An average

difference of Rs.2.90 per share in EPS corresponding to relative increase of 100% is observed.

Separate study can be conducted to show that this variant treatment which is against the strict

version of IAS 39 might also have resulted in protecting the share value of the concerned firms

from further decreasing in the times of crises. Also studies can be conducted to see the counter

side of the variant treatment, that is, in the year 2009 when the said impairment losses were

released to income statement with subsequent adjustments

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