Lessons from UK FRC publications on regulatory environment

Financial Reporting Brief November 2019

This article 'Regulatory Environment – Lessons for All' focuses primarily on substantial publications from the UK Financial Reporting Council, where they belong in the broader regulatory context, and the lessons to be learned.

In recent weeks, the UK Financial Reporting Council (FRC) has issued two significant publications, with many of the principles equally of relevance to Irish companies.

In September, the FRC published a letter to Audit Committee Chairs and Finance Directors setting out some of the actions companies should consider in advance of the UK’s exit from the European Union.

In October, the FRC published the findings of its thematic reviews in the areas of:

IFRS 9: Financial Instruments
IFRS 15: Revenue from Contracts with Customers
Impairment of non-Financial Assets

There are clear connections between the two publications, particularly in relation to impairment given the heightened macro-economic uncertainty brought about by Brexit.

It is that time of year when the Regulators and Enforcers go public with their common enforcement priorities and observations for 2019 financial reporting, with the European Securities and Markets Authority (ESMA), the FRC and the Irish Accounting and Auditing Supervisory Authority (IAASA) all going to press.

Annual Report Insights, the Deloitte publication, reporting on our yearly survey of the annual reports of 100 listed companies has just been released, to provide insight and inspiration for the next reporting season.

We shall return to these in articles to come.

Letter from FRC

In its letter, the FRC is encouraging companies to provide disclosure which distinguishes between the specific and direct challenges to their business model from the broader economic uncertainties which may be a consequence of the UK’s exit from the EU. The FRC expects companies to identify any particular challenges and to describe any actions being taken, with detailed sensitivity analysis on cash flow projections.

Companies will need to decide whether exiting the EU impacts their statements on viability, including consideration of their ability to continue as a going concern.

Not all companies will require extensive disclosure, but where sensitivity or scenario testing indicates significant issues, relevant information should be reflected in the appropriate parts of the annual report and accounts.

Some of the other headline areas addressed in the letter may appear specifically UK-related but more lateral thinking will identify that the issues raised, or equivalent, may be of broader application. They include:

Ask your employees to check if they need to apply to the EU Settlement Scheme
Check whether your business may face additional legal, regulatory and/or administrative barriers as a result of the UK becoming a ‘third country’ in the event of a ‘no deal’ EU exit
Ensure your suppliers and customers have considered the impact of and are prepared for the UK’s exit from the EU
Engage with your local chambers of commerce or business advisor and attend a Brexit Business Readiness event.

Thematic Review – Impairment

The FRC has carried out a review of 20 companies that had recognized either material impairment charges or reversals. In scoping their work, the FRC met with investors to understand what they find helpful in impairment disclosures and what they would like to see more of. These include:

Clear and consistent information in describing the business model and principal risks and uncertainties
More comparative information – trends in key assumptions, discount rates, growth rates and the amount of headroom
Specific explanations and values for assumptions
More granular assessment of CGUs

Some of the key findings arising from the thematic review are that some companies:

omitted the recoverable amount of the assets and CGUs subject to an impairment loss (or reversal)
omitted ‘base case’ values for key assumptions for which sensitivity is given
omitted the disclosure of the excess of the recoverable amount over the carrying amount (headroom) of a CGU
did not provide detail of the specific changes in assumptions that would erode headroom to nil
Some companies need to more clearly address impairment losses and the recoverability of non-financial assets as part of the fair, balanced and comprehensive review of the business.

There are many other findings outlined in the review report. Specifically, the FRC encourages the companies to pay greater attention to:

Providing relevant information around significant judgements and key assumptions made in estimating the recoverable amount of assets and cash generating units
Explaining the sensitivity to changes in key assumptions, where reasonably possible changes could give rise to impairment of goodwill or material further adjustments to already-impaired assets.

Thematic Review – Revenue

The FRC performed a desktop review of a sample of 25 companies – mainly in telecommunications, construction, aerospace/defence and software industries – in their application of IFRS 15 for the first time. The review focused on:

Disclosures explaining the transition to IFRS 15
Accounting policy descriptions
Judgements in determining the amount and timing of revenue to be recognized
Revenue disaggregation
The impact on the balance sheet

There was room for improvement in a range of areas, including:

Accounting policies – better explanation of e.g. specific nature of performance obligations and when satisfied, principal/agent relationship
Significant judgements – information needs to be clearer, and quantitative disclosure such as sensitivities where there is estimation uncertainty could be improved – this was particularly notable in areas such as contract modifications, variable consideration, recognition of revenue over time
Some companies did not provide a quantitative breakdown of the transition adjustment
Some companies made no reference to costs to obtain or fulfil a contract which in some cases could be expected to be significant.

Thematic Review – Financial Instruments

The FRC carried out a limited scope desktop review of the annual reports and accounts of twenty entities, mainly banks and financial institutions, applying IFRS 9 for the first time – taking into consideration IFRS 9, IFRS 7 and certain requirements of IAS 1.

There was room for improvement identified in a wide range of areas, including the following:

Analysis of the credit risk profile of financial assets by credit risk ratings grade – this was not done well by non-banking entities and some banking entities
Disclosure could be improved with regard to the qualitative and quantitative factors used to determine whether there has been a significant increase in credit risk
More clarity needed in the explanation of how the simplified approach has been applied to trade receivables, lease receivables and contract assets
Discussion of the business model in assessing the classification of financial assets, which tended to be boilerplate by most banks and not provided by non-banking entities.

The report looks separately at banks and non-banking entities with the quality of disclosure being somewhat less robust with the latter grouping, including inadequate explanation of the business model and hence asset classification; accounting policies not sufficiently clear, concise and relevant; and, occasionally old IAS 39 terminology not being updated for the new standard.

IFRS 9 - Monitor

In July, Deloitte published a report ‘After the first year of IFRS 9 – Analysis of the initial impact on the large UK banks’ which discusses key themes that have emerged in the UK banking industry since the end of the first full reporting period under IFRS 9. IFRS 9 has resulted in an increase in provisioning levels but has not significantly impacted financial results. The longer term consequences are not yet known. The report analyses the impact on the 6 largest UK banking groups, and also highlights some of the initial challenges experienced by the investor community in coming to terms with the new disclosures required by IFRS 9.

ESMA – Common Enforcement Priorities

The Public Statement recently published by ESMA outlines the common enforcement priorities that European enforcers will consider when examining the 2019 annual financial reports of listed companies. These are:

Specific issues related to IFRS 16 Leases (June – Lease Accounting: IFRS 16 – A New Age)
Improvement of information provided under IFRS 9 ‘Financial Institutions’ and IFRS 15 ‘Revenue’
The application of IAS 12 ‘Income Tax’ regarding deferred tax assets arising from unused tax losses (October – Taxation – A Financial Reporting Challenge)

Previous articles in the Financial Reporting Brief series, in June and October, commented on Leases and Taxation, with this article commenting on IFRS 9 and IFRS 15.

Conclusion

Change and uncertainty are the new norm in business. Uncertainty in political, economic, environmental and regulatory conditions and circumstances have heightened investors’ and society’s expectations for clear and transparent reporting.

Those charged with governance and those involved directly in the reporting process need to focus on areas where requirements have changed, where regulators are focusing and where innovative practices are emerging.