Graham Holt explores the ESMA’s common enforcement priorities for 2014 financial statements
First published in the January 2015 UK edition of Accounting and Business magazine.
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
The European Securities and Markets Authority (ESMA) has published the European common enforcement priorities 2014 that represent the key focus for examinations of the financial statements of listed companies by ESMA and European national enforcers.
The common enforcement priorities for 2014 financial statements are:
- preparation and presentation of consolidated financial statements and related disclosures
- financial reporting by entities with joint arrangements and related disclosures
- recognition and measurement of deferred tax assets.
These topics have been highlighted because of significant changes to accounting practices as a result of new standards, such as IFRS 10,Consolidated Financial Statements, IFRS 11, Joint Arrangements, and IFRS 12, Disclosure of Interests in Other Entities, and the challenges faced by issuers as a result of the current economic environment.
The latter refers to the difficulty of forecasting future taxable profits for the purpose of determining deferred tax assets when there is a period of low economic growth. The priorities were identified after discussions with European national enforcers with a view to further increasing transparency in financial reports.
National enforcers might also set additional enforcement priorities. ESMA will report on its priorities in 2015 and will review priorities identified in previous years. These include requirements related to:
- the impairment of financial and non-financial assets
- fair value measurement
- disclosures on risks arising from financial instruments.
In particular, ESMA reminds issuers of the specific requirements related to using cashflow projections and the disclosure of key assumptions when performing impairment tests of non-financial assets.
ESMA pointed out that its 2013 report on comparability of institutions’ financial statements remains relevant to the 2014 financial statements. This report found that the required disclosures under International Financial Reporting Standards (IFRS) were generally observed, but also identified broad variations in the quality of the information provided. ESMA defines the European common enforcement priorities in order to promote consistent application of IFRS.
ESMA still feels that financial statements are cluttered with excessive disclosure due to their general rather than entity-specific nature, or because they refer to transactions that are not relevant for the issuer. Its aim is not necessarily a decrease in the number of items disclosed, but rather clear and complete disclosures which are specific to an entity and necessary to understand its financial position. Entities should avoid too much aggregation and allow users to understand the consequences of economic events that affect the entity.
The requirements of IFRS 10, IFRS 11, IFRS 12, amended IAS 27, Separate Financial Statements, and IAS 28, Investments in Associates and Joint Ventures, became mandatory in the EU for periods starting on or after 1 January 2014.
IFRS 10 Consolidated Financial Statements
IFRS 10 defines control as the situation ‘when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee’. The principles relating to control are set out in IFRS 10 and the application guidance. ESMA feels both the standard and the application guidance should be considered when determining if control exists. This may require significant judgment to be made and issuers should carefully explain the judgments made in complex situations as required by IFRS 12.
IFRS 12 Disclosure of Interests in Other Entities
IFRS 12 requires disclosures to enable users to understand the nature of the non-controlling interests (NCI) in the group’s activities and cashflows. Disclosures are expected to be ‘sufficient’ which includes disclosure of the operating segments material NCIs have been allocated to.
ESMA stresses the importance of the materiality assessment as well as the issuer’s judgment in determining the presentation of information. When a group presents a significant amount of NCIs, none of which are individually significant, ESMA encourages issuers to disclose and explain this. Issuers should disclose the nature and extent of any significant restrictions on their ability to access assets and settle liabilities. The amount of significant cash and cash equivalent balances held by the entity but not available for use by the group should also be disclosed.
ESMA draws issuers’ attention to specific disclosure requirements with respect to the nature of, and changes in, the risks associated with their interests in consolidated and unconsolidated structured entities. IFRS 12 defines a structured entity as having been set up so that any voting or similar rights are not the dominant factor in deciding who controls the entity. For example, when voting rights relate only to administrative tasks and the relevant activities are directed by contractual arrangements. A structured entity often has some or all of the following features:
- restricted activities
- a narrow and well-defined objective
- insufficient equity to permit the entity to finance its activities without subordinated financial support
- financing in the form of multiple contractually linked instruments to investors that create concentrations of credit or other risks (tranches).
The principal uses of structured entities are to provide clients with access to specific portfolios of assets and to provide market liquidity for clients through securitising financial assets. Structured entities may be established as corporations, trusts or partnerships. They generally finance the purchase of assets by issuing debt and equity securities that are collateralised by and/or indexed to the assets held by the structured entities.
The debt and equity securities issued by structured entities may include varying levels of subordination. Structured entities are consolidated when the substance of the relationship between a group and the structured entities indicate that the entities are controlled by the group. The disclosures for these entities are wider and deeper than for unstructured ones.
IFRS 11 Joint Arrangements
IFRS 11 sets out criteria which determines the classification of joint arrangements as either joint operations or joint ventures. The basis of the classification is the rights and obligations of the parties to the arrangement, rather than, as previously, the legal form. This requires consideration of the structure, terms, conditions and the legal form of the arrangement, and ‘other facts and circumstances’.
When assessing ‘other facts and circumstances’, the focus should be on whether they create rights to the assets and obligations for the liabilities. It is possible for two joint arrangements with similar characteristics to be classified differently depending on their structure.
The IFRS Interpretations Committee has considered various issues arising from the implementation of IFRS 11, and ESMA has recommended that issuers review the findings of these discussions when preparing their 2014 financial statements. ESMA expects issuers to provide disclosures about significant judgments and assumptions regarding the joint arrangement and information relating to the nature, extent and financial effects of its interests in joint arrangements.
The first-time adoption of IFRS 10 and IFRS 11 might change the assessment as to whether to consolidate an investee. This could be the case where a different conclusion is reached over whether control is achieved by an investor holding less than a majority of voting rights in an investee. If this is the case, the factors that led to the change should be disclosed and the changes dealt with in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.
IAS 31 allowed the use of proportionate consolidation, outlawed by IFRS 11. A change of accounting policy may occur as a result of joint ventures now being accounted for using the equity method. IFRS 10 introduces an exception to the consolidation requirement for investment entities. Issuers are expected to be very specific about how they arrived at any judgment not to consolidate.
Deferred tax assets
The current economic climate could result in the recognition of tax losses or the existence of deductible temporary differences where perhaps impairments are not yet deductible for tax purposes. The recognition of deferred tax assets requires detailed consideration of the carry forward of unused tax losses, whether future taxable profits exist, and the need for disclosing judgments made in these circumstances.
IAS 12, Income Taxes, limits the recognition of a deferred tax asset to the extent that future taxable profits will probably be available against which the deductible temporary difference can be utilised. IAS 12 says the existence of unused tax losses is strong evidence that future taxable profit might not be available. Therefore, recent losses make the recognition of deferred tax assets conditional on the existence of convincing other evidence.
The probability that future taxable profit will be available to utilise the unused tax losses will need to be reviewed and if convincing evidence is available, there should be disclosure of the amount of a deferred tax asset and the nature of the evidence. ESMA feels it is particularly relevant to disclose the period used for the assessment of the recovery of a deferred tax asset as well as the judgments made. ESMA also expects issuers to disclose their accounting policy relating to material uncertain tax positions.
As well as ESMA, national enforcers will continue to focus on material issues in the financial statements and will take corrective actions if material misstatements are identified.
"As well as ESMA, national enforcers will... take corrective actions if material misstatements are identified."
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School