Europe - are standards being enforced?

With European affairs so much to the fore in all aspects of Irish business and life in general, it is of interest to consider how financial reporting is monitored throughout the European Economic Area.

National enforcement authorities serve a single and common objective - to promote market confidence and protect investors by contributing to the transparency of financial information relevant to investors' decision making processes. A key focus of enforcers' work is the application of International Financial Reporting Standards in financial statements.

The activities of the national enforcement authorities are under the oversight of the European Securities and Markets Authority (ESMA) and co-ordinated by way of European Enforcers Co-ordination Sessions (EECS). ESMA fosters supervisory convergence both amongst securities regulators and across financial sectors. In Ireland, two authorities are involved - (1) the Irish Auditing and Accounting Supervisory Authority (IAASA) which deals with periodic financial reports, and (2) the Central Bank, supported by the Irish Stock Exchange, which deals with financial information in prospectuses.

Enforcement activity in Europe is based on two principles based standards published by the Committee of European Securities Regulators, the forerunner to ESMA - (1) Enforcement of standards on financial information in Europe, and (2) Co-ordination of enforcement activities, accompanied by guidance for implementation of co-ordination of enforcement of financial information. EECS aim to contribute to the harmonisation of the application of IFRS in Europe.

When potential infringements of the reporting framework are identified on review, they are brought to the attention of the issuer. A process then ensues, including correspondence, meetings at which the enforcer may ask for additional information or explanation and, possibly, discussion at the EECS. Corrective action will be taken if infringements are identified, with the market being informed if it is material.

Enforcement in 2010
ESMA has reported that European enforcers maintained a similar level of review in 2010 as in previous years, with around 20% of the approximately 700 reviews carried out in Europe giving rise to matters brought forward to EECS level. Action arose in a wide range of areas covered by IFRS, and frequently related to:

• Recognition, measurement and disclosure of financial instruments
• Application of new requirements for operating segments
• Disclosure of impairment of non-financial assets
• Measurement and presentation of non-current assets held for sale and discontinued operations
• Aspects of share-based payments
• Long-term /short-term classification of financial liabilities
• Disclosure of information related to breach of banking covenants
• Treatment of foreign exchange differences in statements of cash flow
• Use of alternative performance indicators
• Capital management disclosures
• Revenue recognition - accounting policy disclosures

The majority of the matters covered in the ESMA Activity Report on IFRS Enforcement in 2010 are similar, as one would expect, to matters raised in the report of both IAASA and the Financial Reporting Review Panel in the U.K..

In addition to the specific matters referred to above, ESMA expressed concern in its report that the disclosure of the possible impact of risks and uncertainties faced by issuers regarding judgements and estimates used in the preparation of financial information falls well short in many cases. In the current economic environment this takes on even greater importance.

While there remain many areas where these is considerable scope for improvement, ESMA has commented that issuers have developed significant experience in IFRS accounting since its first application in 2005 and this is reflected in the quality of financial reporting. Generally, European enforcers have found reporting has improved from year to year.

Summaries of enforcement decisions dealt with by EECS are regularly published. A range of topics has also been discussed with representatives of the IFRS Interpretations Committee (IFRS IC) as part of the regular feedback process to the International Accounting Standards Board (IASB), with an objective of contributing to the harmonisation of application of IFRS in Europe.

The Global Dimension
In its efforts to contribute to the quality of future financial reporting under IFRS on a global basis, ESMA has maintained its regular dialogue with third country authorities including the US Securities and Exchange Commission (US SEC) and the Japanese Financial Services Authority (JFSA).

In 2006 the European enforcer and the US SEC signed a work plan aimed at promoting high quality and consistent application of reporting standards. As part of a continuing dialogue on enforcement, the following areas were identified as some of the areas causing problems in the application of both sets of standards:

• Application of the management approach and of the aggregation criteria in disclosures relating to operating segments
• Parameters used as part of the determination of impairment on non-financial assets
• Identification of components of multiple element arrangements
• Recognition of deferred tax assets

Both ESMA and the SEC have a particular focus on developments under the IASB/FASB Memorandum of Understanding. Many European countries have signed individual protocols with the SEC relating to the exchange of confidential information regarding dual listed issuers.

Operating Segments - In Focus
In November, ESMA published its report 'Review of European Enforcers on the Implementation of IFRS 8 - Operating Segments'. The report is based on the experience gained by European national enforcement authorities as part of their review activities. This report is in response to the European Parliament request when endorsing the standard in 2007 that a review should be carried out of its implementation, with the IASB intending to carry out a similar review on a worldwide basis.

On the basis of review activity, the overall conclusion is that

(i) The implementation of IFRS 8 resulted in a fairly similar level of information compared to its predecessor IAS 14, and

(ii) There is homogeneity in the issues faced by European enforcers when enforcing the standard.

Four main issues emerged as a result of the review:

• Identification of the chief operating decision maker (CODM) - 41% of issuers identified the Board of Directors as the CODM although this body often includes non-executive members, who would not be expected to be involved in the operations of a company
• Aggregation of operating segments into reportable segments - disclosures were provided by only 29% of investors, although the standard refers to such disclosure as contributing to helping investors understand the entity's basis of organisation. The level of subjectivity in deciding how aggregation should be applied may lead to diversity in practice and ESMA recommends more disclosure of judgements being exercised in the allocation process
• Measurement basis for information presented under IFRS 8 - in many instances, information about allocation policies of profit or loss, assets and liabilities to reporting segments, definition of non-GAAP measures and the reconciliation between segment information and amount reported in financial statements were not disclosed properly
• Analysis of entity wide disclosures - although 58% of issuers provided information on a geographic basis, ESMA noted that notes to the financial statements rarely present fully compliant information and there is some evidence that the quality of information is lower than what was reported under the previous standard, IAS 14.

An underlying theme of these findings, which is particularly emphasised in ESMA's discussions with analysts, is that there would appear to be many situations in which there are significant differences between what is communicated to the Board and what goes further to the shareholders. The investor community is generally of the view that the information provided does not give meaningful information as it is not reported at a sufficiently low level of granularity. This directly conflicts with the core objective of IFRS 8 which is to disclose information 'as seen through the eyes of management'.

Application of IFRS on a consistent basis by all adopters is a must if the concept of a global financial reporting language is to hold true. ESMA as a coordinating body for European national enforcement authorities has a hugely important role to play.

First published in Finance Dublin Online.