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The European Securities and Markets Authority (ESMA) was formed to ensure the effective and consistent application in financial statements of European securities and markets legislation and more specifically that of International Financial Reporting Standards (IFRS). ESMA has highlighted the areas of focus for European national regulators when they come to review December 2012 financial statements.
It is the first time EU enforcers have agreed common enforcement priorities. Given the global economic and market environment, enforcers around the world are likely to take note and pay particular attention to the same areas.
The financial reporting topics ESMA has identified are:
- financial instruments;
- impairment of non-financial assets;
- defined benefit obligations;
- provisions that fall within the scope of IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
ESMA is to monitor the application of IFRS requirements relating to these items. These common enforcement priorities will be incorporated into the reviews performed by national competent authorities – the Financial Services Authority in the UK, for example – which will take corrective action where necessary. ESMA will also collect data on how European listed entities have applied IFRS requirements in relation to these topics and will report the results to the market.
Common enforcement policies
As a result of the financial crisis, transparency of information relating to financial instruments has become a top priority for investors, issuers and regulators. The provision of disaggregated and expanded disclosures about material exposures to all financial instruments that become subject to risk and the explanation of the nature and extent of that risk help protect investors.
IFRS 7, Financial Instruments: Disclosures, requires entities to disclose information that enable users to evaluate:
- the significance of financial instruments for the entity’s financial position and performance;
- the nature and risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks.
An entity should provide disclosures by class of financial instruments that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments.
ESMA expects financial statements to follow the requirements in IFRS 7 and include relevant quantitative and qualitative disclosures that reflect the nature of the risk exposure, elements related to the valuation of such financial instruments as well as an analysis of concentration of exposure to relevant risks.
Investors’ focus has been on how the sovereign debt crisis has affected the financial performance and financial position of listed financial institutions. ESMA is encouraging disclosure of the following:
- country-by-country disclosures, including quantitative disclosures on gross and net exposures to sovereign debt;
- non-sovereign exposures by type (corporate, banks, for example), including qualitative and quantitative information about credit risk;
- the impact of credit derivatives used in managing material exposures to financial instruments.
In July 2012, ESMA published a review of the accounting treatment of Greek sovereign debt in the 2011 annual financial statements of a sample of European financial institutions.
Impairment of financial assets
IAS 39, Financial Instruments: Recognition and Measurement, requires entities to assess whether there is any objective evidence that a financial asset is impaired. An impairment loss is recognised if and only if such evidence exists. IAS 39 provides guidance as to when such objective evidence exists:
- as a result of an event that occurred after the initial recognition of the asset (loss event);
- when that loss event has an impact on the estimated cashflows of the financial asset that can be reliably estimated.
The two issues in IAS 39 that have been identified are the application of the ‘significant or prolonged’ criteria for assessing the impairment of equity instruments, and the accounting for loans modified for economic or legal reasons relating to the borrower’s financial difficulty.
IAS 39 states that a significant or prolonged decline in the fair value of the investment below its cost is additional objective evidence of impairment. However, IAS 39 does not provide further guidance for determining what constitutes a significant or prolonged decline in fair value. Divergent practices in the application of the significant or prolonged criteria have created varying degrees of transparency in the disclosure of judgments made.
A higher level of transparency in the assessment of the trigger event for impairment is recommended by ESMA. Such transparency should be based on the provisions in IAS 1, Presentation of Financial Statements, which requires management to disclose the significant judgments made in applying the entity’s accounting policies.
Bank leverage is still high and thin equity buffers make banks vulnerable to shocks in performance and the economy. Many holders of bank loans are affected by the difficult economic situation and are struggling to meet their obligations.
As a result a practice of forbearance has developed: where a borrower is in financial difficulties and does not pay on time, the lender decides to wait and see, perhaps even renegotiating the arrangement on more favourable terms. There are currently different practices in judgments made on the level of provisioning and disclosures for renegotiated loans. IAS 39 states that where a loan is renegotiated on substantially different terms, it should be accounted for as an extinguishment of the original financial liability and the recognition of a new one. ESMA requires transparent qualitative and quantitative disclosures in this regard.
Impairment of non-financial assets
The current economic situation increases the likelihood that the carrying amounts of assets might be higher than their recoverable amounts. The market value of many listed companies has fallen below their book value, which potentially indicates impairment and thus the need for an impairment test. Due to the widespread economic slowdown, assessing future cashflows requires considerable judgment to be exercised by management and is subject to high levels of uncertainty.
ESMA considers that particular attention has to be paid to the valuation of goodwill and intangible assets with indefinite life spans whenever significant amounts are recognised in the financial statements. IAS 36 requires detailed disclosures on the estimates used to measure the recoverable amount of cash-generating units to which significant goodwill or intangible assets with indefinite lives is allocated.
ESMA emphasises the need to use assumptions that represent realistic future expectations and would expect issuers to provide entity-specific information related to assumptions used when preparing discounted cashflows (such as growth rates, discount rate and consistency of such rates with past experience) and sensitivity analyses. IAS 1 requires similar disclosures on the assumptions made about the future, and other major sources of estimation that have a significant risk of resulting in a material adjustment to the carrying amounts of assets within the next financial year.
Defined benefit obligations
Discounted post-employment benefit obligations should be determined with reference to the market in high-quality corporate bonds. However, where a country no longer has a deep market in such bonds, the market yields on government bonds should be used. With the crisis and economic downturn resulting in significant swings in market yields for some sovereign and corporate debt, the question could arise as to whether entities should change their approach when determining discount rates for their post-employment benefit obligations.
The International Financial Reporting Interpretations Committee (IFRIC) is currently discussing the notion of high-quality corporate bonds. ESMA believes that entities should wait for an IFRIC clarification and not change their approach to determining discount rates. In the meantime, ESMA emphasises there is a particular need for transparency in this area and expects issuers to disclose the yields used and provide a description of how they determined them.
Provisions within the scope of IAS 37
The measurement of provisions involves significant management judgment and could in the current market circumstances be subject to more uncertainty. The strong link between provisions and the risks an issuer is subject to makes a case for high-quality disclosures. Nevertheless, European enforcers often find that only aggregated and boilerplate information is provided.
IAS 37 provides clear guidance that the aim of disclosures on provisions is to inform users about changes in amounts of provisions. It requires entities to disclose, for each class of provision, descriptions of the nature of the obligations concerned, the expected timing of outflows of economic benefits, uncertainties related to the amount and timing of those outflows as well as, if relevant, major assumptions made concerning future events. The wording used is a strong indication that these disclosures should be adapted to reflect the risks attached to the entity’s activities.
Disclosures allow entities to provide investors with high-quality information within a principles-based environment. However, a principles-based environment can survive only if clear and entity-specific disclosures, re-assessed at the end of each reporting period, bring useful decision-making information to investors.
Graham Holt is an ACCA examiner, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School