Financial Reporting - the supervisors' priorities

Published December 2012

In our November article we focused on how companies may have the breathing space in 2012 to focus on improving the quality of their annual report, with particular regard to the increased focus on achieving the appropriate balance of disclosure.

In this month's article we continue in that vein and look at what supervisory authorities are focusing their attention on.

Of particular interest is the Public Statement issued in November by the European Securities and Markets Authority (ESMA). ESMA, together with the national competent authorities will monitor the application of IFRS requirements relating to the items mentioned in the Public Statement and will assess how they are achieved.

The competent authority under the regulations in Ireland is the Irish Auditing and Accounting Supervisory Authority (IAASA). IAASA has published in November its report 'Observations on Selected Financial Reporting Issues'.

ESMA - Public Statement
ESMA is charged with responsibility to act in the field of financial reporting to ensure the effective and consistent application of European Securities and Markets Legislation.

ESMA stresses the need for transparency and the importance of appropriate and consistent application of the recognition, measurement and disclosure principles provided for in IFRS in order to ensure the proper functioning of financial markets. In pursuance of this and recognising the difficult economic and market conditions, ESMA identifies in its Public Statement common financial reporting topics which they believe are particularly significant for European listed companies at this time.

The common financial reporting topics refer to specific aspects of IFRS application in relation to:

• Financial assets
• Impairment of non-financial assets
• Defined benefit pension scheme obligations, and
• Provisions that fall within the scope of IAS 37

These common enforcement priorities will be incorporated into the reviews performed and corrective actions taken by national competent authorities. ESMA will collect data on how European listed entities have applied IFRS requirements in relation to these topics and will report the results of this survey to the market. This does not preclude national competent authorities from publishing additional statements on other priorities in their jurisdiction.

The Common Enforcement Priorities

Key messages within the common enforcement priorities are as follows:

Financial Instruments

Firstly, where an issuer identifies material exposure to financial instruments subject to risk, ESMA expects financial statements to include relevant quantitative and qualitative disclosures reflecting the nature of the risk exposures as well as key elements related to the valuation of such financial instruments. Additionally, disclosures should include an analysis of concentrations of exposure to risk, a description of the shared characteristics that identify each concentration and the amount of risk exposure associated with all financial instruments sharing that characteristic.

Secondly, the assessment of whether there is any objective evidence that a financial asset is impaired, with the identification of a loss event and its impact on future estimated cash flows. Given the current economic environment, two issues of particular focus have been identified:

• Application of the 'sufficient or prolonged' criteria for assessment of impairment for equity instruments - where there is a decline in the fair value of an investment below cost
• Accounting for loans modified for economic or legal reasons relating to financial difficulties of borrowers

ESMA believes that there is a need for improved disclosure related to the assessment of the triggering event for impairment and changes in such assessment, as well as the impact of such changes.

Thirdly, ESMA encourages issuers to further enhance transparency on:

• Quality of country-by country disclosures, more specifically with respect to the granularity of information provided on significant sovereign debt exposures
• Non-sovereign exposure by type of exposures, including qualitative and quantitative information on credit risk
• Impact of credit derivatives, specifically with respect to disaggregation of information

This follows the publication by ESMA during 2012 of a number of statements on providing an enhanced level of transparency in financial statements with regard to material sovereign exposures.

Impairment

ESMA emphasises the need for

• The use of assumptions that represent realistic future expectations, with particular regard to significant goodwill and intangible assets with indefinite lives
• Enhancement of CGU-specific qualitative and quantitative disclosures
• More granular disclosures with a particular focus on key assumptions used, the periods over which cash flows are forecast, growth rates and discount rates applied as well as the consistency of the assumption with past experience
• Additional disclosure on the sensitivity of recoverable amounts to reasonably possible changes in key assumptions
• Improvement of disclosure on assumptions about the future and other major sources of estimation uncertainty

Defined Benefit Obligations

ESMA emphasises the expectation that entities disclose a description of how they determine yields from high-quality corporate bonds, including significant judgements, in arriving at the rate used to discount post-employment benefit obligations.

ESMA also expects that quantitative information on the effects of adoption of the revised IAS 19, mandatory from 2013 onwards, will be provided in the 2012 financial statements. These include the revised basis of calculation of net interest charges and credits, which may have a significant impact on reported earnings in future years.

Provisions

ESMA emphasises the need that the descriptions of provisions should be adapted to reflect the risks attached to the issuer's activities regarding the nature of obligations, the expected timing of outflows and uncertainties related to the amount and timing of those outflows. It also stresses that the granularity of disclosures should be such that the financial consequences of risks that are dissimilar in nature should lead to separate classes of provisions being presented.

The Irish Perspective
The Observations document published by IAASA seeks to assist issuers' management and those charged with governance in the preparation of high quality financial statements.

Many of the IAASA Observations are similar to the matters addressed in the ESMA Common Enforcement Priorities and therefore benefit from the added weight given to them by the ESMA Public Statement. As stated in the ESMA document, national authorities may have additional matters to which they wish to draw issuers' attention. In that vein, IAASA observations include:

• Cash flow statements - the need to avoid instances of non-compliance with the disclosure requirements of IAS 7
• Off balance sheet items: quantative disclosures - in such areas as financing arrangements and commitments, guarantees and warranties or rebates, leveraged nature of certain derivatives and loan covenants
• Alternative performance measures - where presented, disclosure should define the measure, explain the reason for inclusion together with other relevant information
• Presentation of 'exceptional items' - the manner of presentation, the accounting policy and their treatment in subsequent periods if recurring
• Restatement and reclassification of amounts - that the required disclosures are provided where there is a change to presentation or classification, and where errors are corrected in subsequent periods
• Operating segments - disclosure of non-current assets by geography - disclosures should include intangible assets and goodwill
• Reassessment of the reasonableness of significant judgements - the use of reasonable estimates and the assessment of the outcome in areas subject to those estimates
• Accounting pronouncement not yet effective - issuers should provide disclosure of IFRSs issued but not yet applied, irrespective of whether they have been endorsed by the EU

The IAASA Observations are derived from the outcome of IAASA's examinations and surveys conducted in 2012 together with IAASA's expectations of issuers for 2012 reporting. An appendix to the document lists the topics addressed in equivalent documents published over the past four years, the majority of which are of continuing relevance.

IAASA has recently published a survey on the use of alternative performance measures by Irish equity issuers.

Conclusion
There is no doubt that both the ESMA Public Statement and similar documents from IAASA and others will assist in providing direction on improved transparency and the importance of appropriate and consistent application of IFRS principles.

In a year when there is very little in terms of new requirements for companies, there is a major opportunity for them to commit time and resources to the enhancement of the overall presentation and disclosure content of their annual reports.

Cards have been marked! The response will be awaited with interest.

First published in Finance Dublin Online.