The European Securities and Markets Authority (ESMA) has recently published its annual statement defining the European common enforcement priorities for 2013 financial statements. The aim is to try to foster transparency and the consistent application of IFRS (International Financial Reporting Standards) to help the financial markets function.
With the help of European national enforcers, ESMA has identified several financial reporting topics that should be considered in the preparation of the financial statements of listed companies for the year ending 31 December 2013. Those topics are:
- impairment of non-financial assets
- measurement and disclosure of post-employment benefit obligations
- fair value measurement and disclosure
- disclosures related to significant accounting policies, judgments and estimates
- measurement of financial instruments and disclosure of related risk with relevance to financial institutions.
Not surprisingly, ESMA says that national regulators may also focus on additional relevant topics. It issued a similar statement a year ago and post-employment benefit obligations appears on both listings. ESMA builds on its 2012 statement by emphasising the need for transparency and the importance of appropriate and consistent application of recognition, measurement and disclosure principles. ESMA and the European national enforcers will monitor and assess the application of IFRS requirements relating to the items in this statement.
These European common enforcement priorities will be incorporated into the reviews performed by national enforcers. The guidelines are not statutory, but ESMA hopes that awareness campaigns will lead national regulators to take account of the new priorities. The watchdog will also monitor national regulators' application of the priorities and will publish progress reviews to encourage national regulators to comply.
Users of financial statement have expressed concerns over the use of 'boilerplate' disclosures for transactions that are not relevant or are immaterial to the entity. The view is that entities should disclose only applicable accounting policies and focus on entity-specific information rather than quoting extensively from IFRS.
Impairment of non-financial assets
Continued slow economic growth in Europe could indicate that non-financial assets will continue to generate lower than expected cashflows especially in those industries experiencing a downturn in fortunes. In 2012, ESMA suggested paying particular attention to the valuation of goodwill and intangible assets with indefinite life spans.
This year, it has again included the impairment of non-financial assets in the common enforcement priorities with a focus on certain specific areas. These areas are cashflow projections, disclosure of key assumptions and judgments, and appropriate disclosure of sensitivity analysis for material goodwill and intangible assets with indefinite useful lives.
In measuring value-in-use, cashflow projections should be based on reasonable and supportable assumptions that represent the best estimate of the range of future economic conditions. IAS 36, Impairment of Assets, points out that greater weight should be given to external evidence when determining the best estimate of cashflow projections. IAS 36 says entities should assess the reasonableness of the assumptions on which cashflow projections are based. Each key assumption should be consistent with external sources of information, or how these assumptions differ from experience or external sources of information should be disclosed.
ESMA considers that disclosures made by entities are often uninformative because they are only provided at an aggregate level and not at the level of the cash-generating unit. Financial statements generally are not providing disclosures that are entity-specific or appropriately disaggregated.
ESMA has reviewed 2012 financial statements, and the disclosures relating to the sensitivity analysis of goodwill or other intangible assets with indefinite useful lives are poor. IAS 36 requires disclosures on the sensitivity of the key assumptions to change when determining the recoverable amount.
Entities have regularly used the assertion that 'no reasonable possible change in a key assumption would result in an impairment loss'. ESMA believes that this disclosure does not give users sufficient detail to allow them to assess sensitivity properly.
Measurement of post-employment benefit obligations
IAS 19, Employee Benefits, requires the discount rate applied to post-employment benefit obligations to be determined using market yields based on high-quality corporate bonds. 'High quality' reflects absolute credit quality and not that of a given collection of corporate bonds.
The policy for determining the discount rate should be applied consistently over time and a reduction in the number of high-quality corporate bonds should not normally result in a change to this policy.
The International Accounting Standards Board (IASB) has tentatively decided to amend IAS 19 to clarify that the depth of the bond market should be assessed and this should be at the currency level and not at the country level.
In jurisdictions where there is no deep market in these bonds, the standard requires that market yields on government bonds should be used. ESMA expects issuers to use an approach consistent with this amendment.
There is an additional reminder by ESMA regarding the importance of disclosing the significant actuarial assumptions used in determining the present value of the defined benefit obligation and the related sensitivity analysis. The discount rate is a significant actuarial assumption, the details of which should be disclosed together with any disaggregation information on plans and the fair value of the plan assets where the level of risk of those plans is different.
ESMA has indicated that entities should assess the impact of the requirements of IFRS 13, Fair Value Measurement. In particular, the effect of non-performance risk should be reflected in the value of a liability. As an example, the fair value of a derivative liability should incorporate the entity's own credit risk. ESMA emphasises the need for proper recognition of counterparty credit risk when determining the fair value of financial instruments and providing relevant disclosure.
IFRS 13 requires all valuation techniques to maximise the use of relevant observable inputs, which should be consistent with the asset or liability's characteristics. In some cases, a premium or discount to the market value may be applied but it should be consistent with the nature of the asset or liability.
ESMA stresses the need to provide disclosures related to fair value, particularly when the measurement is based on significant unobservable inputs (level 3). The more unobservable the data, the more important that uncertainties are clearly identified. Further, IFRS 13 (and ESMA) requires entities to categorise measurements into each level of the fair value hierarchy.
Significant accounting policies, judgments and estimates
ESMA expects issuers to focus on the quality and completeness of disclosures relevant to the entity's financial statements. These should be entity-specific and not boilerplate. ESMA believes that disclosures could be improved in the following areas: significant accounting policies, judgments made by management, sources of estimation uncertainty, going concern, sensitivities, and new standards issued but not yet effective.
Significant accounting policies and management judgments could be included in the financial statements in order of materiality and significance. IAS 1, Presentation of Financial Statements, requires disclosure of estimation uncertainties with a significant risk of being adjusted in the next year.
ESMA reiterates that disclosure of new standards that have been issued but are not yet effective (IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors) is relevant where the new standard could have a material impact on the financial statements.
Topics related to financial instruments
Transparency and comparability of financial reporting of financial institutions is in the interest of market participants. ESMA states that issuers should ensure that they meet the requirements of IFRS 7, Financial Instruments: Disclosures, for qualitative and quantitative disclosures and assess whether there is objective evidence of impairment while disclosing sufficient detail to provide a comprehensive picture of the liquidity risk and funding needs of the entity.
Disclosures should enable users to evaluate the nature and extent of risks, and the elements related to the valuation of financial instruments, the latter reflecting economic reality.
Experience during the financial crisis showed diverging accounting treatments in relation to forbearance practices. Forbaearance occurs where the terms of the loan are modified due to the borrower's financial difficulties. ESMA expects issuers to provide quantitative information on the effects of forbearance, enabling investors to assess the level of impairment of financial assets.
ESMA also expects disclosure of the accounting policies applied to financial assets that have been assessed individually for impairment but for which no objective evidence of impairment was available. The purpose of this disclosure is to allow users to assess credit risk.
Entities should also disclose the time bands in the maturity analysis and include maturity analysis of financial assets held for managing liquidity risk.
ESMA is attempting to foster consistent application of accounting standards while ensuring the transparency and accuracy of financial information. As noted above, ESMA and the national regulators will monitor the application of the IFRS requirements outlined in the priorities, with national regulators incorporating them into their reviews and taking corrective actions where appropriate. Auditors and issuers ignore the guidance at their peril.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School