The sub-prime meltdown has far reaching accounting effects

Implications: The article shows why the recent problems in global credit markets can have accounting effects that go far beyond the banks and other players directly touched by the crisis.  It also highlights the areas that financial statement readers should be wary of when accessing the possible effects of the crisis on companies of interest.  For example, recent market turmoil could lead to significant asset impairment charges, even for companies with no direct involvement in subprime loans.

Analysis: The recent crisis in subprime loans is having huge effects on corporate financial reporting, far exceeding what most analysts expected.  Of particular interest is the fact that market turmoil is creating havoc with an extensive range of credit instruments. 

First, with markets being less liquid and more volatile, determining fair values is a more complicated and controversial process.  The complications arise from greater volatility, less liquidity, and greater uncertainty over the appropriate discount rate to use for valuation. 

Second, the contagious effects of the crisis will lead to impaired value for a wide variety of assets.  Analysts should expect significant write-downs for any target companies with significant exposure in credit markets. 

And third, certain market conditions can lead to instruments no longer satisfying hedge effectiveness rules.  The result is that any changes in fair value--putting aside issues of whether fair value can be reasonably estimated--will be sent straight to earnings. Previously, changes in fair value were probably sent to other comprehensive income or some other shareholders' equity account.

Analysts should be especially careful in these times to determine what exposure subject companies might have to credit markets, and what impact the crisis is having on fair value estimates, asset impairment charges, and hedge effectiveness.