In FRED 67, the Financial Reporting Council has published its proposals to relax and improve aspects of FRS 102. Fiona Hackett and Terry O'Rourke report. By now, a huge number of Irish companies have prepared one, if not two, sets of annual accounts in accordance with FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. Many of these companies had to change aspects of their accounting to comply with FRS 102, such as accruing holiday pay and recognising foreign exchange contracts at fair value – two areas of accounting where the UK’s Financial Reporting Council (FRC) specifically made FRS 102 more rigorous than old GAAP. As part of its triennial review of FRS 102, the FRC heard concerns from preparers and other stakeholders about aspects of FRS 102 where the case for its degree of rigour was not so compelling. Areas of concern Aspects of FRS 102 that caused particular concern to many commentators included:   The complexity of having to account for loans at fair value, rather than amortised cost, where the loans do not meet the rules-based definition of “basic” as prescribed in FRS 102; The impracticality of small companies having to apply net present values to interest-free loans from director shareholders; The difficulty and questionable usefulness of having to identify, recognise and measure new types of intangible assets in acquisition accounting; The cost of having to obtain a fair value for accounting purposes for property that is rented to another group company, where that property is not included at fair value in the group accounts; and The inconsistent interpretation of the definition of a financial institution under FRS 102, which has caused uncertainty about which companies have to provide enhanced disclosures about their financial instruments. The good news is that the FRC has listened to these concerns and proposes to relax these requirements of FRS 102, just as it reduced the burden of shareholder notification for companies that were qualified to avail of the reduced disclosures under FRS 101 and FRS 102. The FRC’s proposals to change FRS 102 are contained in the financial reporting exposure draft, FRED 67 Draft Amendments to FRS 102, which has just been issued. The proposals would result in fewer loan assets and liabilities having to be fair valued because of the proposed wider definition of what loans qualify as “basic”. The proposed option not to apply a present value to interest-free or non-market rate loans would be available only to small companies and in relation to loans from shareholder directors that are natural persons. The proposals would allow less intangible assets to be recognised in acquisition accounting than under FRS 102, and would provide an option for a group company to avoid the need to fair value a property it has rented out to another company which is not an investment property in the group accounts. FRED 67 proposes that the revised FRS 102 would be effective for reporting periods commencing on or after 1 January 2019, but allowing early adoption once the revised FRS 102 is finalised, which could be before the end of 2017. In this case, many preparers may choose to avail of its proposals in their 2017 accounts. Early adoption would, of course, come with the caveat that the whole of the revised FRS 102 should be adopted, and not all of the proposals of FRED 67 represent relaxation of the existing requirements of FRS 102. FRED 67 emphasises that its proposals are intended to balance improvements in the quality of financial reporting with maintaining stability and improving the usability of FRS 102. In explaining its proposals, the FRC uses the terms “easier”, “simpler” and “cost-effective”, demonstrating its commitment to accounts being based on a financial reporting standard that is proportionate to the size and complexity of the entity and the information needs of users. The subtitle of FRED 67, which is Triennial Review 2017: Incremental Improvements and Clarifications, further reflects the objective of maintaining the stability of financial reporting. Transitional arrangements The usual rule of accounting when accounting policy changes are made is to restate prior year numbers with retrospective effect. In recognition of the effort that having to restate prior year numbers would involve where existing accounting policies are changed as a consequence of applying the new, less onerous accounting, FRED 67 proposes some exemptions from full retrospection. One of these exemptions relates to companies within groups that had to fair value properties rented out to other group companies under FRS 102 and that choose to cease fair valuing under the FRED 67 proposal. The existing fair value under FRS 102 would be permitted to be carried forward as a deemed cost on applying the revised FRS 102. In relation to investment properties generally, FRED 67 proposes to remove the existing exemption where obtaining values would involve undue cost or effort, on the ground that all entities should be able to do so without undue cost or effort. FRED 67 also proposes that, for future acquisitions, companies need not recognise the additional intangible assets required by FRS 102. Any additional intangible assets already recognised under FRS 102 in past acquisitions would be required to continue to be recognised, thus avoiding the need for prior year restatement. There would also be an option for companies to recognise the wider range of intangible assets in future acquisitions, subject to applying this option consistently to classes of intangible assets and explaining in the accounts why this approach has been adopted. Other proposed changes to FRS 102 In addition to its proposals to relax aspects of FRS 102, the FRC also proposes to introduce into FRS 102 certain areas of accounting on which FRS 102 is currently silent or where commentators suggested that its requirements should be clarified. These include macro-hedging (to be addressed by cross reference to IAS 39), debt equity swaps, hyperinflation and transfers of a business in a group restructuring. Other incremental improvements proposed in FRED 67 include additional guidance on how to apply the fair value methodology and a closer alignment of accounting for share-based payment with IFRS. An area where FRED 67 proposes a significant additional disclosure relates to the Cash Flow Statement. FRED 67 proposes the inclusion of a net debt reconciliation, which has continually been requested by investors and, indeed, the old FRS 1 required such a reconciliation. The FRC recognises that additional guidance in FRS 102 is desirable on how to determine whether an entity is acting as a principal or an agent, and FRED 67 proposes to add such guidance based on IAS 18 Revenue. Recent IFRS standards Perhaps equally important to the proposals to change FRS 102 being made by the FRC is the fact that FRED 67 is not proposing to fast-track the more recent new IFRS standards into FRS 102, such as IFRS 15 on revenue, IFRS 16 on leases and the expected loss model of IFRS 9. FRED 67 states that these will be the subject of a later consultation by the FRC and will not be effective before 1 January 2022. The FRC also considered whether to incorporate into FRS 102 the updated rules of IFRS on how to identify when one entity controls another, as set out in IFRS 10 Consolidated Financial Statements. The FRC decided not to propose changing this aspect of FRS 102. However, FRED 67 recognises that this may result in certain structured or special purpose entities not being consolidated under FRS 102 and proposes that additional disclosures about such entities should be included in the accounts. Financial instruments: accounting and disclosure A major feature of FRS 102 is the choice it offers on accounting for financial instruments and the financial institutions it requires to give enhanced disclosures on financial instruments. Under FRS 102, preparers can choose whether to apply Sections 11 and 12 of FRS 102, or IAS 39, or IFRS 9 in accounting for financial instruments. The FRC had to consider how FRS 102 should deal with these choices as the effective date of IFRS 9, as the replacement for IAS 39, draws nearer. FRED 67 proposes that the three options should be retained in FRS 102 and specifies which version of IAS 39 should be used where the IAS 39 option is chosen. As a future-proofing measure, FRED 67 proposes that the version of IAS 39 to be used is the version that is effective at the preparer’s year-end date, and proposes that, when IAS 39 is superseded by IFRS 9, the relevant version of IAS 39 will be the one that was effective at the date it was superseded by IFRS 9. As well as proposing an amendment to the definition of a financial institution under FRS 102, which will reduce the number of such institutions required to provide enhanced disclosures, FRED 67 notes that any entity with risks arising from financial instruments that are “particularly significant” may need to provide additional disclosures to enable users to evaluate the significance of financial instruments to its financial position and performance. FRED 67 also proposes to remove retirement benefit plans from the list of entities defined as financial institutions; retirement benefit plans will still provide the specific disclosures specified for them by FRS 102 Section 34. To make FRS 102 clearer and easier to use, FRED 67 proposes to add a number of examples illustrating which types of financial instruments should be accounted for at amortised cost and which types at fair value. Conclusion Given the very wide variety of companies that use FRS 102, from the largest private companies to much smaller entities, it is not surprising that a mix of views was expressed by stakeholders on the future of FRS 102, from those who asked for a significant relaxation of its requirements to those who considered it should move more quickly to keep pace with changes in IFRS. The FRC considered that requests for amendment in some areas may reflect incorrect application of FRS 102, rather than a lack of clarity in FRS 102. It may provide additional informal guidance on such issues. In finalising the 140 pages of proposals in FRED 67, the FRC has had to consider very carefully which aspects of FRS 102 should be relaxed and which aspects should be retained or improved, while identifying the aspects of accounting that should now be introduced into FRS 102. In accordance with its usual practice, the FRC has invited comments on its proposals with those comments due by 30 June 2017. As many of the proposals represent an easing of FRS 102, it is important to note that they will not be effective until the final revised FRS 102 is issued. While many commentators can be expected to agree with the FRC’s proposals, others may not be as supportive. Now that we have seen how open the FRC is to considering the views expressed by stakeholders, if you have views one way or the other on the proposals of FRED 67 to change our GAAP, why not accept the FRC’s invitation to comment? Fiona Hackett FCA is a Director with PwC and a member of the Accounting Committee of Chartered Accountants Ireland. Terry O’Rourke FCA is a Consultant with PwC and chairs the Accounting Committee of Chartered Accountants Ireland.

Michael Kavanagh summarises the feedback from stakeholders on their experience of applying FRS 102 and the Financial Reporting Council’s overall approach for dealing with issues raised. The vast majority of entities in Ireland use the financial reporting standards issued by the UK Financial Reporting Council (FRC). New UK and Irish GAAP became mandatory for all accounting periods ending on or after 31 December 2015. Subsequent to the first reporting season, the FRC has conducted outreach to obtain feedback on implementation challenges and to identify areas for potential improvements. The FRC invited informal comments on the implementation of FRS 102 in a press notice with a 31 October 2016 deadline and consulted formally on the approach to IFRS in the consultation document, Triennial Review of UK and Ireland Accounting Standards – Approach to Changes in IFRS, with a response deadline of 31 December 2016. General issues arising The focus of this article is on some of the general issues that commentators raised on the implementation challenges and what the FRC’s overall approach is for dealing with such issues. From discussions with Irish practitioners and the FRC, it appears that the transition to New UK and Irish GAAP has been relatively smooth. However, as to be expected, issues have arisen. Many of these are of a technical accounting nature, but the following are some of the more general issues that have been commented upon: Accounting policy choices and perceived lack of guidance: some commentators felt that there is too much room for interpretation in the standards, which leads to inconsistency in the accounting treatment for similar transactions. Clearly, this also leads to challenges for preparers and auditors in determining appropriate accounting policies. In particular, where there is a lack of guidance, those familiar with IFRS will tend to follow the IFRS solution, whereas those not so familiar with IFRS will tend to follow the Old UK and Irish GAAP rules. Given that FRS 102 is almost one-tenth the size of old GAAP or IFRS, it is inevitable that the standard is more principles-based and specific matters are not addressed in detail. Software issues: not unexpectedly, comments have arisen in relation to the accounting software that the preparer is using. These include adverse comments on the quality of the output, the updated software not being available on time, the length of some of the disclosures produced and so forth. While these issues are largely outside the remit of the standard setter, the FRC is acutely aware of the concerns raised. Lack of understanding of FRS 102 financial statements: some commentators have suggested that certain users of FRS 102 financial statements do not understand the financial statements and, in particular, changes brought about by the adoption of FRS 102. This is inevitable with such a seismic change to the standards used to prepare financial statements, and the accountancy bodies have been to the fore in leading education initiatives in this regard. The FRC has conducted extensive outreach in this regard and continues to do so. Given the significant changes that have occurred in financial reporting, a period of stability is important. In that context, I would be surprised if the triennial review were to lead to suggestions for significant changes to FRS 102 at this point in time. UK GAAP Technical Advisory Group: the UK GAAP Technical Advisory Group (UK TAG) provides advice on accounting and related company law issues for all entities applying UK accounting standards. Part of its work includes discussing current implementation issues and determining whether FRS 102 is clear and whether a consensus exists on the most appropriate treatment. Some commentators, including Chartered Accountants Ireland, feel that it would be very helpful if information were published on a regular basis on the FRC website on the nature of issues arising and any decisions made by this grouping to keep preparers, auditors and users of financial statements up-to-date. Proposed FRC plan When FRS 102 was issued in 2013, the FRC indicated that it would be subject to review every three years. Responses to the consultations outlined above will be taken into account in developing formal proposals, which are expected to issue by the end of March 2017. The overall expected approach is to propose incremental improvements and clarifications, which will become effective from 1 January 2019, with more significant changes effective from 1 January 2022, giving adequate time for preparation. Two exposure drafts are proposed. Phase 1 is expected to focus on incremental improvements and clarifications. It will: respond to implementation feedback on how FRS 102 can be improved; make editorial and other amendments to improve the usability and clarity of FRS 102; incorporate relevant improvements from the 2015 Amendments to the IFRS for SMEs; incorporate the control model from IFRS 10 Consolidated Financial Statements; update definitions and the fair value hierarchy for greater consistency with IFRS 13 Fair Value Measurement; and improve the separation of contracts for the purposes of recognising and measuring revenue, so that it is similar in this regard to IFRS 15. Phase 2 is expected to include proposals to update FRS 102, with effect from 1 January 2022, to: incorporate the expected loss model for impairment of financial assets, based on IFRS 9 Financial Instruments; and update lease accounting by lessees for consistency with IFRS 16 Leases. Conclusion The FRC has received in the region of 50 responses to both its informal and formal consultation, which is clearly a very high response rate. All responses will be considered and will feed into the triennial review. The first outcome of this will be proposed amendments published as an Exposure Draft for comment by the end of March 2017. Michael Kavanagh is IAASA’s observer at the Corporate Reporting Council of the Financial Reporting Council.

Lorraine McCann outlines the opportunities associated with the integration of environmental, social and governance factors into annual reporting. A recent study conducted by EY found that there are four key forces disrupting finance leadership: digital innovation and smart technologies; the proliferation of data and advanced analytics; volatile risk environments; and increasing stakeholder scrutiny and regulation. As these forces mature, it is imperative that the role of accounting and finance is redefined to adapt to ever-increasing stakeholder demands and enable organic evolution of the business strategy. In this article, I will focus on one of the four key forces disrupting the finance role – increasing stakeholder scrutiny. Increasing reliance on non-financial data Over the last 30 years, we have seen how the format and content of corporate reporting has changed significantly in response to growing stakeholder demand for increasing amounts of information. Traditional reporting models are being challenged to keep pace with a 21st-century redefinition of value and a growing desire for stakeholders to see beyond conventional financial data. Central to the discussion of value is data on environmental, social and governance (ESG) performance, which is often reported by companies in addition to compulsory financial statements. We wanted to assess the importance of incorporating ESG performance information into corporate reporting, and to better understand the investors’ perspective on ESG performance data, to anticipate what the future of reporting, and the future of auditing, will look like. For the second consecutive year, EY commissioned a study on the views of more than 200 institutional investors around the world regarding non-financial reporting by issuers (publicly traded companies). This follow-up study builds on the inaugural thought leadership report, published in early 2014, which established that investors were progressively incorporating ESG analysis along with other non-financial elements into their decision-making. In this latest study, we have seen even greater evidence of this reliance on non-financial information. With greater emphasis on the incorporation of increasing amounts of non-financial information in corporate reporting, it is imperative that the accounting and finance function is positioned to respond accordingly by developing non-financial skillsets that traditionally have not been present in these roles. Gaining a more complete understanding of performance Amid growing concerns about the effects of non-financial factors on business strategy, the research found that investors are taking a more formal approach to evaluating non-financial information tied to ESG matters. In our 2014 study, less than 20% of respondents said they typically conduct a structured, methodical evaluation of ESG disclosures. However, in 2015 this had almost doubled as 37% reported using such an approach. Similarly, the proportion of respondents saying they conduct little or no review of ESG information had fallen from 36% in 2014 to 21% in 2015. As the analysis of non-financial information plays an increasingly important and integrated role in investors’ decision-making, it may well assume a position similar to that of financial analysis as a core skill and become a structured set of capabilities required by all investment professionals. In the long-term, non-financial data analysis may play a similarly prominent role in the operating and financial decisions made by issuers’ accounting and finance functions as well. Furthermore, as investors and issuers progress in their use of non-financial information, the quality, timeliness and comparability of this information will need to improve. The accounting and finance profession will therefore need to develop processes and procedures that ensure the accuracy of non-financial data and are comparable to the level of rigour traditionally applied to financial data. Increased data and improvements in data quality are only the start, however. As non-financial concerns continue to emerge as material to investment decisions, companies will likely be increasingly expected to provide this information alongside financial information in an integrated report format. Investors are starting to question how they can access the non-financial information they consider to be most useful to their investment decision-making – that is, information tied to companies’ visible, measurable performance. The International Integrated Reporting Council (IIRC) is one organisation helping investors and issuers achieve this goal. In 2013, the IIRC released the Integrated Reporting Framework, which helps companies produce integrated reports that link their financial, ESG and other non-financial disclosures to their expected performance and plans for value creation. As companies and industries continue to adopt the guiding principles incorporated into this reporting framework, it could be a significant step in helping investors access the non-financial information they need. We are now seeing integrated reporting emerge as the newest form of corporate reporting. It’s a concept that has been created to better articulate the broader range of measures that contribute to long-term value and the role organisations play in society. Central to this is the proposition that value is increasingly shaped by factors beyond financial performance such as reliance on the environment, social reputation, human capital skills and others. This value creation concept is the backbone of integrated reporting and, we believe, is the direction of future corporate reporting. It is therefore imperative that the team composition of future accounting functions reflects this trend and can respond accordingly to changing talent needs. Consistent and comparable non-financial information Investors state repeatedly that they do not receive enough accurate, standardised non-financial information relevant to companies’ risk and performance assessment. Specifically, 64% of respondents surveyed by EY said companies do not adequately disclose information about ESG risks that could affect their current business models. There are many reasons for poor and uneven reporting of ESG and other non-financial risks and opportunities by issuers. Issuers often cite cost, or perceived cost, as a reason for their inadequate disclosure of ESG and other non-financial information. In response to the implementation of recent EU regulations, the consistency and accuracy of ESG information is an area that will come under much greater attention in the future, particularly for large public interest entities (PIEs) with securities traded on a regulated market in the EU. Under the EU Non-Financial Reporting Directive, such entities are now required to disclose in the annual management report a non-financial statement containing relevant information on their policies, main risks and outcomes relating to environmental matters, social and employee aspects, respect for human rights, anti-corruption and bribery matters, and diversity in their board of directors. Public disclosure of such information in the management report will require the accounting and finance functions to confirm the accuracy of this data (many through voluntary third party audits) prior to publishing performance against the regulation. This non-financial data has not historically fallen under the same level of scrutiny as financial data, leading to a risk of data inaccuracies and credibility risk. With regulation continuing to move forward in the ESG space, we can only anticipate increased regulation affecting a wider population of companies going forward. Standardised, sector-specific information Investor survey data indicates that investors are eager to measure a company’s non-financial performance against that of its sector peers, and to link a company’s non-financial information to its expected performance. Specifically, 74% respondents consider sector-specific reporting criteria and key performance indicators (KPIs) to be “very beneficial” or “somewhat beneficial” to their investment decision making. Meanwhile, more than 70% see metrics that link non-financial risks to expected performance as equally beneficial. This enthusiasm for sector-specific disclosures is reinforced by respondents’ comparatively low ranking of prescriptive accounting standards with fixed criteria that would seek to apply a level of uniformity across all sectors. When asked to rank a wider range of format types used to communicate non-financial information, investors’ strong enthusiasm for integrated reporting is both clear and on the rise. In the 2015 study, 71% of respondents see integrated reports as essential or important, up from 61% on the previous year. In fact, integrated reports ranked second only to companies’ annual reports (without specification as to whether they are integrated annual reports or not). Of course, this is not to say that separate reporting is not appreciated. Indeed, any reporting of non-financial information is considered a good thing. In 2015, 59% of respondents saw companies’ separate corporate social responsibility (CSR) or sustainability reports as essential or important, up from 35% in 2014. As the trend towards integrated reporting and separate sustainability reporting is increasing, it is indicative of the skillsets that will be required in the accounting and finance function to ensure the accuracy and credibility of non-financial data. Conclusion The results of our research are clear. Non-financial performance reporting is on the rise and demands from stakeholders, investors and regulators will continue to increase. Disruption can indeed be a challenge but if embraced, it can yield great opportunity to tell a wider value-driven performance story through a company’s annual report which encompasses both financial and non-financial information. The future skillset and experience of the accounting and finance profession must adapt so that companies’ business strategies remain relevant and non-financial data disclosure accuracy can be trusted. This disruption will also create significant opportunities for the profession going forward, and must therefore be embraced.   Lorraine McCann is Senior Manager in Climate Change and Sustainability Services at EY Ireland.

IAASA’s ninth annual Observations document details the year’s key financial reporting issues and provides guidance on how they should be addressed, writes Michael Kavanagh. 2016 was another year of change in the world of financial reporting and this is reflected in the ninth annual IAASA 2016 Observations document, which was published recently. The document aims to facilitate the production of high-quality financial reports by highlighting key topics to be considered by those preparing, approving and auditing financial statements. The Irish Auditing and Accounting Supervisory Authority’s (IAASA) remit extends to Irish companies trading on the regulated markets of European stock exchanges (issuers). However, the Observations document is relevant to a wider range of companies when preparing year-end financial statements. While preparers of financial statements are the primary audience for IASSA’s Observations document, it also helps users of financial statements to understand the significant judgements made by directors in preparing such reports and highlights matters they, as users, should be aware of and focus on when reviewing financial statements. Financial reporting in uncertain times 2016 has been a volatile year, with a number of potentially significant economic issues emerging such as unpredictable commodity prices, significant exchange rate fluctuations, country risk (Russia and Venezuela, for example), low economic growth in many economies, low and negative interest rate environments and, more recently, uncertainty arising from the United Kingdom’s (UK) decision to leave the European Union (EU). This uncertain economic backdrop may impact on issuers to a different extent, depending on their geographic areas of operation and their risk exposure. However, it poses challenges for all entities in making assumptions and exercising judgements when preparing their 2016 financial reports. The Observations document serves as a useful guide by detailing the key issues and providing guidance on how they should be addressed. The paragraphs that follow outline the key topics covered in the Observations document. Brexit – the financial reporting challenges Brexit, the hot topic of the moment, poses financial reporting challenges for issuers. Given the significance of the matter for Ireland, IAASA released a comprehensive Information Note in July which set out factors that IAASA feels should be considered by issuers when preparing half-yearly financial reports for the six months ended 30 June 2016. The Observations document outlines issues that should be factored into consideration when preparing the annual report. It also urges directors and audit committees to carefully evaluate the impact of the risks and uncertainties arising from Brexit on the recognition, measurement and disclosure of income, expense, assets and liabilities in the financial statements, together with the risk disclosures in the notes and qualitative information in management reports. The impact of new accounting standards not yet effective Financial reporting standards (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors) require various disclosures regarding the impact a new accounting standard will have on an entity’s financial statements in the period of initial application. A number of new standards fall into this category, namely: IFRS 9 Financial Instruments; IFRS 15 Revenue from Contracts with Customers; and IFRS 16 Leases. It is expected that these new standards will represent a significant change to the recognition, measurement and presentation of assets, liabilities, income, expenses and cash flows for some entities. The Observations document outlines specific disclosures expected with regard to the three new standards mentioned above. Fair value measurement IFRS 13 Fair Value Measurement sets out the framework for measuring the fair values of assets and liabilities, together with the various disclosures required. Based on its examinations during 2016, IAASA’s Observations document recommends that issuers should, in relevant instances:   Provide more entity-specific disclosure that informs users of the measurement bases used in the fair value measurement of intangible assets; Provide clearer disclosure of the key fair value judgements and assumptions that management has made and that have the most significant effect on the amounts of intangible assets recognised in the financial statements; Provide more disclosure of how material liabilities are fair valued; and Provide fair value disclosures by class of assets and liabilities where appropriate. Deferred tax assets Certain companies which have incurred significant losses in recent years have recognised very large amounts of deferred tax assets (DTA) on their balance sheets. The relevant accounting standard, IAS 12 Income Taxes, requires the recognition of such deferred tax assets to the extent that it is probable that future taxable profits will be available against which the unused tax losses may be recovered. This is an area that IAASA continues to engage with issuers on and has held discussions with the European Securities and Markets Authority (ESMA) and the International Accounting Standards Board (IASB). Arising from these discussions, both ESMA and IASB are taking initiatives in this area. The Observations document outlines the factors that IAASA considers when assessing whether there is sufficient “convincing other evidence” for the recognition of DTAs. Classification of financial instruments – debt or equity Some financial instruments, such as convertible bonds or other complex financial instruments, can exhibit characteristics of both equity and liabilities. The entity-specific terms on which these instruments are issued can therefore impact on the accounting treatment that is ultimately applied. IAASA has examined whether certain financial instruments with characteristics of both equity and liabilities have been correctly classified in issuers’ financial statements. When issuing convertible bonds, for example, anti-dilution clauses or “conversion price adjustments” are a feature of convertible instruments. Common conversion price adjustments include takeover-related adjustments, capital distributions by a parent, and increases in share capital by means of the capitalisation of reserves. The Observations document reminds issuers that, when convertible instruments are issued that include conversion price adjustments, they should ensure the fixed-for-fixed rule of IAS 32 Financial Instruments: Presentation has not been breached and the instrument is correctly classified as debt or equity. Issuers should ensure transparency with regard to disclosing the accounting policy adopted and the judgements made by management in relation to the characteristics of these instruments. Presentation of financial performance and the quality of disclosures The reporting of financial performance and the quality of disclosures in financial reports has been a source of debate and criticism over recent years. Disclosures in financial statements may be “boilerplate” in nature, rather than entity-specific, or may not be relevant insofar as they refer to transactions that are not undertaken by the entity or relate to immaterial items. IAASA continues to engage with issuers, and this engagement has led to improvements in their financial reports in this regard. IAASA has also encouraged users of financial statements to critically evaluate reported headline items and the income statement presentation adopted by issuers. Users have been encouraged to consider the related explanatory note disclosures, including the definitions used and the accounting policy adopted in respect of items such as “exceptional items” and “operating result”. The Observations document reiterates a number of these key messages, which have been the subject of previous IAASA publications. Statement of cash flows The Statement of Cash Flows enables users to evaluate an entity’s ability to affect the amounts and timing of cash flows it generates. It also enhances the comparability of the reporting of operating performance by different entities. A divergence in the classification of cash flows as operating, investing and financing by selected debt issuers has been noted during IAASA examinations. Some debt issuers examined by IAASA have classified most cash flows as operating and major classes of cash flows are netted in the Statement of Cash Flows. This practice could impair the ability of users to understand the cash flows of the entity, which could in turn lead to a divergence of practice among similar issuers’ Cash Flow Statements and limit the comparability of issuers’ Statements of Cash Flows. The Observations document outlines a number of key messages for directors and audit committees in this regard. IAASA’s Observations on Selected Financial Reporting Issues – Years Ending On or After 31 December 2016 can be accessed at www.iaasa.ie/publications/frsu. Michael Kavanagh is Head of Financial Reporting Supervision at IAASA.

Derarca Dennis and Alan Seery outline the key components of the “acid test”, which will help you prepare a best-in-class annual report. Investors and analysts often suggest that the annual report and accounts (ARA) have become too complex and no longer meet the needs of the user. This article will take a closer look at EY’s “acid test”, which can be used to simplify financial statements and make sure you present a single story that highlights the key aspects of your business activity. Preparers of Irish financial statements who adopted the 2014 UK Corporate Governance Code (the Code), as well as the additional requirements of the Irish annex (when applicable), will be familiar with many of the challenges this presents. EY’s acid test focuses on the key questions a reader should be able to answer having read the narrative report. Illustration 1 (see right) provides a summary of the key components, which are also considered in the paragraphs that follow. Business model  How does the company make its money? What are the key inputs, processes and outputs in the value chain, and how are the company’s key assets (including its physical assets, IP, people, culture, technology, etc.) engaged in the value chain? How does the company make money? Asking this simple question can help assess if a business model description is informative and useful. Many reports still describe the business model as a set of values or statements of intent rather than a practical explanation of how the business works. Leading practice disclosure includes the use of infographics where companies outline the inputs, processes and outputs of the business coupled with explanations around the competitive advantages of the company’s business model and how it differs from other companies in the industry. Antofagasta plc’s 2014 ARA provides a good example, as the business model explains the inputs, processes and outputs of the business. It also shows which stages in the business model require varying levels of investment and those that create varying levels of income. Strategy  What are the key metrics the board uses to measure progress against its strategic objectives? How has the company performed against these metrics over time and how has this influenced the remuneration of key executives? While the business model should demonstrate how the business creates value, the strategy should explain the approach taken to sustain this value over time. It is important that companies disclose a clear strategy linked to a set of strategic objectives. These are more granular expressions of how the strategy will be achieved and implemented. Well-communicated strategies and clear strategic objectives are most likely to offer better overall reporting in terms of telling a story of the year with clear links from strategy to performance measures, through to risks and remuneration. For example, in Smith & Nephew plc’s 2014 ARA, the “How We Performed” section shows clearly-defined strategic priorities linked to an explanation of the global outlook for the industry. Performance indicators What are the key metrics the board uses to measure progress against its strategic objectives? How has the company performed against these metrics over time and how has this influenced the remuneration of key executives? Key performance indicator (KPI) disclosures should enable users of annual reports to see how the company is progressing towards achieving its strategy and strategic objectives. In Smith & Nephew plc’s 2014 ARA, each of the strategic priorities are linked to the related KPIs. The use of alternative performance measures continues to be an area of interest for the Irish Auditing and Accounting Supervisory Authority (IAASA), which was highlighted in IAASA’s recently-published Observations document (see page 37). An increasing number of reports are now showing KPI trend analysis over a two- to five-year period. Companies should consider disclosing KPI trend data over a period that allows for a meaningful comparison between years, as this significantly enhances shareholders’ ability to contextualise and assess performance during the specific year under review. DS Smith plc’s 2014 ARA provides effective disclosure by defining each KPI with an explanation of why each has been selected as a KPI, along with a related narrative on performance. Risk What are the key risks to the successful delivery of the strategy and operation of the business model? What are the risks that pose the greatest threat to the viability of the company (e.g. solvency and liquidity risks)? How might these risks manifest themselves in the company? Principal risks: having established how the company makes its money, principal risk disclosures should identify the key risks to the successful delivery of the strategy and operation of the business model. Disclosure should further focus on identifying the risks and events that pose the greatest threat to the future survival of the business. Best practice would include risks that are specific to the company, linking them to their strategic objectives; a description of relative impact and likelihood; and an indication of the change in individual risks since the prior year. Risk appetite: a clear articulation of the levels of risk the board is willing to take in pursuit of its strategy and how this is monitored by the board should also be included. A good example of this is Weir Group plc’s 2014 ARA, which provides a full risk appetite statement that includes details of the parameters of the company’s risk appetite in specific areas. Risk management and internal control disclosure: good risk reporting is, more often than not, underpinned by sound risk management processes and systems. Companies tend to explain the process and structures for managing risk, including the frameworks they have in place. ARAs generally include confirmation that the board has conducted a robust assessment of the principal risks. However, this can be enhanced by providing qualitative detail on the process or findings of a review or ongoing monitoring. An example of best practice in this area is the 2015 ARA of John Lewis Partnership, which includes the following key points:   The section on managing risks describes each risk and mitigating action without jargon. A comprehensive overview of the risk management governance structure is also provided; A heat map shows potential impact and likelihood of each risk before and after mitigating actions; and Changes from the previous year are clearly highlighted. Viability statement Over what timeframe has the board considered the viability of the company and why? What process did the board use to assess viability? Does the board understand which, if any, severe but plausible risks (or combination of risks) would threaten the viability of the company and has appropriate disclosure been provided? What assurance did the board obtain over relevant elements (e.g. stress testing)? What assumptions did the board use in reaching its conclusion?  Amendments to the Code in 2014 introduced reporting of a longer-term view of a company’s prospects in a viability statement. This creates its own challenges in terms of sourcing adequate information from various components within the company (risk, internal audit, treasury, finance and others). It is not only for the sake of compliance and good reporting, however; it is more important that boards and management teams use the viability statement requirement as a trigger for identifying potential improvements to their risk processes and, where relevant, new opportunities. Rio Tinto plc’s 2015 ARA provides a good example of disclosure. Their disclosure provided the principal risks with an indication of whether they have a potential impact on viability, health, safety, environmental matters and reputation; and an explanation of potential upside impact (opportunity) associated with each risk. Governance What did the board and its committees actually do in the year to govern the company – what specific governance issues arose and how were they addressed? What, if any, changes were made to governance arrangements during the year and why? What areas for improvement were identified from the board evaluation and what progress was made against actions from the previous evaluation? How is board composition and succession planning being managed, giving due regard to the evolving strategy of the group, skills, experience and diversity? How did the board seek to understand the views of shareholders during the year and what, if any, action was taken as a result of feedback?  The governance of a group or company impacts on several areas of the business. We consider the key areas below. Culture: in recent years, corporate culture has become a key area of focus for regulators, boards and other stakeholders due to its strong link to strategy. Getting the culture right normally goes hand-in-hand with getting the business model to work. This is why it is so vital that companies don’t merely treat culture as a reporting buzzword, but rather see it as an area for action which their reporting appropriately reflects. Adopting a formal values statement is simply not enough. Companies are therefore encouraged to report meaningfully on this topic by explaining how culture relates to the business model and strategy, and how it is monitored. Shire plc’s 2015 ARA provides good disclosure in this regard. Its business model section explains how the culture supports the company’s success while culture is framed as one of the inputs to the business model. The “patient-focused and performance-based” culture is then referred to consistently throughout the report. Stakeholder engagement: this is a key board responsibility. It is important to address how the board engages with stakeholders to understand their views and what, if any, action was taken as a result of feedback. Companies are encouraged to make this section focused and insightful by touching on the areas of discussion, actions and outcomes arising from shareholder engagement. Provident Financial plc’s 2014 ARA provides a good example on how this disclosure could be addressed, with their disclosure focusing on key themes discussed with shareholders during the year and a calendar of investor relations events taking place during the year. Nomination committee report: the nomination committee plays a vital role in determining the board’s composition and leadership of the company. The committee is critical to a company’s future success, yet investors often have little insight into its activities. In Cobham plc’s 2014 ARA, graphs and tables are used effectively to show board composition in terms of skills and experience and the tenure of each director. This allows the reader to see when directors joined the board, which skills and experience they bring with them and, conversely, when skills gaps may emerge that will need to be addressed. Board evaluation: investors normally gain comfort from the knowledge that a company has undertaken an external board evaluation. While investors recognise the sensitivities around disclosing the full conclusions of the evaluation, they see a definite benefit in companies disclosing the highlights along with any resultant actions. In Lonmin plc’s 2014 ARA, significant detail is provided on actions from the previous evaluation; progress against these during the year; and actions from the review. A degree of fairness and balance is shown in reporting areas in which progress was not made as expected, as well as areas in which progress was achieved. Directors’ remuneration reporting: remuneration reports provide a prime opportunity to convey the value of people and culture, and explain how executives are remunerated in a way that drives performance in line with strategy. By clearly articulating the link between KPIs and bonus pay-out metrics, companies will improve readers’ understanding of how their executives are incentivised to deliver the company’s long-term business strategy. In recent years, there has been increased prevalence of post-vesting holding periods as well as non-financial performance metrics, which includes safety and sustainability, balanced scorecard, research and development leadership and project implementation. Companies are pursuing a stronger alignment of executive performance-related pay with long-term company objectives. Accordingly, disclosure should account for these trends. Conclusion As you prepare your annual report and accounts, consider the acid test and the best practices examples highlighted above. In addition, here are five simple key actions for you, as the preparer, to undertake as you work towards preparing your next annual report: start early; start afresh each year but continue the story; get feedback on last year’s report; appoint one owner to coordinate; and put yourself in the place of the reader and focus on outcomes, not processes. Derarca Dennis FCA is Head of Financial Accounting Advisory Services at EY. Alan Seery is a Director in the Financial Reporting Group at EY.

The flexibility that comes with IFRS 9 will allow companies to manage risk more efficiently and effectively, write Derarca Dennis and Emer Keaveny. The unprecedented volatility in financial markets that has been witnessed in recent times has adversely impacted on many entities which have not been able to manage their risk exposures effectively. This has been exacerbated in some cases by the fact that hedge accounting under IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) was at times difficult to achieve in practice, resulting in income statement volatility. IAS 39 has often been criticised as being complex and rules-based, thus ultimately not reflecting an entity’s risk management activities. With the introduction of the new financial instruments accounting standard, IFRS 9 Financial Instruments (IFRS 9), which will replace IAS 39 in its entirety, we now have what is viewed as a more risk management-friendly standard. IFRS 9 has also replaced some of the arbitrary rules in IAS 39 through more principle-based requirements and allows for more hedging instruments and hedged items to qualify for hedge accounting. The high-level aim of the new standard with regard to the hedging model is to provide useful information about risk management activities that use financial instruments, with the effect being that financial reporting will reflect more accurately how entities manage their risks and the extent to which any hedging undertaken mitigates those risks. Ultimately, the goal is to ensure that there is a clearer link between an entity’s risk management strategy, the rationale for hedging and the impact of that hedging on the financial statements. In the past, the use of certain hedging instruments gave rise to potentially adverse accounting (i.e. volatility in the financial statements). The misalignment between optimum economic risk management and the associated accounting has had very real impacts on earnings due to the requirements that had to be met in order to achieve hedge accounting treatment under IAS 39. IFRS 9 eases many of the accounting obstacles, giving corporate treasurers an opportunity to deploy the hedging instruments that best meet their risk management needs and that will achieve hedge accounting treatment. IFRS 9 has a mandatory adoption date of 1 January 2018 with early adoption permitted for financial years beginning on or after 1 January 2017. With the EU endorsement process expected to conclude in Q4 2016, early adoption should be strongly considered by finance and corporate treasury functions as it presents a real opportunity to access the considerable benefits IFRS 9 offers by allowing them to manage their risks in the most efficient and effective manner. The benefits that may be realised through the adoption of the new hedge accounting model include:   Increased transparency for shareholders as a result of better linkages between financial statements and the risk management strategies employed by management; Reduced volatility in the income statement due to an increased ability to achieve hedge accounting treatment; Removal of ‘bright-line’ rules relating to retrospective hedge effectiveness testing; More flexibility in risk management strategies being applied due to eligibility of components, rebalancing and net positions for hedge accounting; Potential to reduce ineffectiveness and costs of hedging as a result of being able to enter into derivatives that manage correlated and net positions more efficiently; and More favourable treatment of unavoidable ‘costs of hedging’ such as time value of options. Qualifying criteria and effectiveness testing One of the biggest changes with the introduction of IFRS 9 has been the removal of the retrospective effectiveness assessment requirement and the 80-125% rule that many have found a frustration in the past. To qualify for hedge accounting under IFRS 9, the following effectiveness requirements must be met:   There must be an ‘economic relationship’ between the hedged item and the hedging instrument; The effect of credit risk must not ‘dominate the value changes’ that result from that economic relationship; and There must be a balance in the ratio between the quantity of the item being hedged and the quantity of the hedging instrument being used. As noted above, IFRS 9 introduces the concept of an economic relationship between a hedged item and a hedging instrument in order for hedge accounting to be applied. The approach adopted by companies to assess effectiveness may, in certain circumstances, be qualitative only. The critical term ‘matching concept’ can be applied to prove that there is an economic relationship between the hedged item and instrument. In practice, this can sometimes be difficult to achieve due to basis risks and timings. Correlation can also be proven through regression analysis and this has already been used by some companies implementing IFRS 9 in demonstrating the economic relationship concept using a quantitative approach. The key point is that there are a number of ways to prove that an economic relationship exists, many of which would already be considered by risk managers before entering into any derivative instrument to hedge an exposure that may result in an increased ability to meet hedge accounting criteria. Hedging components of non-financial items A further change from the world of IAS 39 hedge accounting is the ability to hedge a component of a non-financial item under IFRS 9. Previously, many companies with exposures to commodity price risk struggled with accounting mismatches as a result of basis risk (i.e. a difference in how the hedged item and hedging instrument are priced) being included in the assessment of hedge effectiveness. IFRS 9 now shifts how a risk manager views their exposure. In the past, where risk managers tried to hedge a variable that they had determined to be the predominant driver of price variability in a non-financial item, IAS 39 required them to hedge all the variables in the non-financial item and this sometimes resulted in unfavourable accounting arising from a good risk management decision. IFRS 9 has addressed this by recognising that there are multiple variable price elements (risk components) that risk managers may look at in isolation. A risk component can be hedged once it is separately identifiable and reliably measurable. This creates an opportunity to remove any price basis risks that may have caused ineffectiveness and consequently, profit or loss volatility under IAS 39. By making risk component hedging available under IFRS 9, commodity-based hedging will become more flexible. This change will be welcomed by many sectors and in particular, the transport sector where refined products used for fuel are often priced on more than one variable, such as the biodiesel and diesel fuel oil components making up the fuel price for certain fuel types or jet fuel being made up of various price components. Under IFRS 9, a company can isolate the predominant drivers of volatility, such as the diesel fuel oil in Figure 1, and hedge this in isolation, making for a more effective hedge relationship and strategy. By hedging specific components, companies now have the option of entering into one derivative that sufficiently hedges the dominant component within an identified exposure or designating derivatives as a hedge of each component separately. Both options now give the risk manager more flexibility in how they approach risk management than was previously permitted in an IAS 39 world. Rebalancing Treasury functions managing a company’s risk understand that the conditions on which they based historic decisions can sometimes change and, as a result, the ratio or amounts hedged may need to change in response. Under IAS 39, where a hedge ratio is revised, companies have to discontinue the hedge accounting relationship in its entirety and restart a new hedging relationship, which can lead to ineffectiveness. This was common for companies that hedged transaction risk for either price or foreign exchange where the dates of the transactions were subject to change. This has caused ineffectiveness in the past as the re-designated hedging instrument would likely have a non-zero fair value at the inception of the hedge accounting relationship. IFRS 9 introduces the concept of ‘rebalancing’ a hedge relationship. This means that the hedge relationship continues if the quantity of the hedged item or hedging instrument changes in response to a change in conditions, reducing in turn this source of potential ineffectiveness. IFRS 9 allows for changes to the documentation and hedge ratio for accounting purposes to align with the hedge ratio for risk management purposes on a prospective basis, with all previous deferred gains and losses remaining in equity. IFRS 9 will therefore afford risk managers and finance functions more flexibility in managing their exposures through rebalancing. A consequence of linking discontinuation of a hedge to a change in the risk management objective is that voluntary discontinuation, where there is no change in the risk management objective, is not permitted. Net positions IFRS 9 expands the range of eligible hedged items by including synthetic exposures (i.e. a combination of a derivative and non-derivative) and aggregated exposures (i.e. net positions). Under IAS 39, where a company wanted to manage price exposure on a non-financial item such as jet fuel, they would use a hedging instrument priced in US dollars which leaves the company with a US dollar foreign exchange exposure to hedge. Another derivative and hedge relationship would then be entered into to hedge that risk. The concept of a derivative hedging a position that contained another derivative was not allowable under IAS 39. This meant that an entity had to maintain hedge relationships and documentation separately for each hedging relationship, unless both were designated in a combined hedge relationship which was sometimes not practical. IFRS 9 now allows companies to use a derivative to hedge an exposure that is made up of a derivative and non-derivative instrument and still avail of hedge accounting. This will be a significant benefit to many companies as they can manage their overall risk to both the commodity price and foreign exchange risk on fuel prices, with more flexibility by looking at the total exposure. IFRS 9 also addresses the eligibility of net positions as hedged items. Under IAS 39, some companies have managed their exposures on a one-to-one basis. This means that more derivatives were being entered into in order to manage risk. By looking at exposures on a net basis, a company can now see where they are short and long on certain risks and address this appropriately. Instead of designating gross exposures into IAS 39 hedge relationships and entering into a higher number of derivatives, these companies may now be able to manage exposures on a net basis. This will result in increased efficiency while managing risk effectively. Costs of hedging Currently under IAS 39, entities can designate the intrinsic value of an option or the spot element of a forward contract. When doing so, the changes in fair value of the time value of the option or the forward points of the forward contract are accounted for in profit or loss, resulting in potentially significant profit or loss volatility. In response to these concerns, IFRS 9 introduces a new accounting treatment for changes in the fair value of the time value of an option where only the intrinsic value is designated in the hedge relationship. The cost of hedging, being the time value of the option, is treated separately depending on its relationship to the hedged item. Where the hedge relates to a transaction-based item, such as a hedge of a future purchase of property, plant and equipment in a foreign currency, the costs of hedging would be included within the initially-recognised cost of the property plant and equipment purchased as a basis adjustment. If the hedged item is expected to impact profit and loss over a period of time, such as a floating rate bond, then the costs of hedging should be treated in a systematic manner, being amortised in line with when the hedged risk occurs in profit and loss. IFRS 9 also includes an optional accounting treatment for the forward element of a forward contract. This applies when only the spot element of the forward contract is designated as the hedging instrument. Where this treatment is chosen, the change of fair value of the forward element is recognised in other comprehensive income and the forward element is amortised to profit and loss on a rational basis. A similar treatment is also available for the foreign currency basis spread of a financial instrument if it is excluded from the designation as the hedging instrument. This treatment means that these ‘costs of hedging’ can be recognised in profit or loss at the same time as the hedged transaction, rather than these elements affecting profit or loss like a trading instrument. This will result in the accounting treatment being more aligned with how a risk manager would view these costs. Conclusion The potential conflict between optimum risk management decisions and the associated accounting under IAS 39 has had, at times, an adverse impact on both working capital and earnings. There is now a real opportunity to access the considerable benefits that IFRS 9 offers to those looking to manage their risks in a more efficient and effective manner. Risk managers should therefore consider reviewing current practice to identify opportunities to capitalise on the standard’s changes and fully realise all available benefits – be that a reduction in cost, volatility, risk or complexity. In some companies, risk management has been conducted within the boundaries of what could be achieved from the end accounting result. IFRS 9 now removes many of those barriers and allows risks to be managed more effectively. Instead of looking at risks in isolation, IFRS 9 brings a more flexible and integrated approach to risk management. To gauge the benefits of the new requirements, companies should consider the overall risks they are exposed to; hedging activities to mitigate those risks; existing hedge accounting; and the reasons why hedge accounting may not have been achieved in the past. By identifying the many risk components that a company is exposed to, and managing those risks in a more integrated way, IFRS 9 has introduced the flexibility required to enable companies to manage risk more efficiently and effectively. Derarca Dennis is Head of Financial Accounting Advisory Services at EY Ireland. Emer Keaveny is Director of Financial Accounting Advisory Services at EY Ireland.