Michael Kavanagh considers the key elements of IAASA’s latest Observations document, which focuses on financial reporting in a recovery.
The Irish Auditing and Accounting Supervisory Authority (IAASA), Ireland’s accounting enforcer, has published its annual Observations document highlighting key topics to be considered by those preparing, approving and auditing 2015 financial statements. The document aims to facilitate the preparation of high-quality financial reports by offering comments on selected financial reporting issues to coincide with the preparation of 2015 financial statements.
IAASA’s remit extends to Irish companies trading on the regulated markets of European stock exchanges. However, the Observations document should be of interest to a wider range of companies when preparing their 2015 year-end financial statements. Furthermore, while preparers of financial statements are the primary audience for IAASA’s Observations document, it also helps users of financial statements 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.
Some aspects of the document may also be of interest to media commentators – especially the section on alternative performance measures. These alternative measures, as the name suggests, are not governed by accounting standards and tend to be reported by journalists when analysing the financial reports of companies listed on the stock exchange.
Changing climate
All external indicators suggest that the domestic economy is in recovery mode and the challenges faced by many entities are abating. Previous Observations documents reflected the then economic climate and focused on what could be best described as accounting for a downturn. The focus of this year’s document is that of financial reporting in a recovery and many of the items highlighted reflect issues relevant to this new economic environment. It is certainly a challenging time for those involved in the financial reporting preparation process with a plethora of new accounting standards for those preparing IFRS financial statements and a completely new set of accounting standards for those preparing local GAAP financial reports. Companies Act 2014 also came into force during 2015 and is the most significant change to domestic company legislation in a number of decades. The following is an outline of the key topics covered within the Obervations document.
Business combinations and fair value accounting
A key indicator of the economic recovery is the level of acquisition and merger activity reported or planned in the near future. IFRS 3 Business Combinations is the financial reporting standard applicable when an acquirer obtains control of a business as a result of an acquisition.
IAASA undertook a desktop survey of the 2013 and 2014 annual financial reports of 27 Irish equity issuers to assess the quantum of business acquisition activity and the document outlines the results of that survey. It is noteworthy that €1.8 billion was spent on acquisitions in 2014 and €14 billion of cumulative goodwill was recognised on equity issuers’ balance sheets, which equates to 59 per cent of the total equity of those entities. Given the large percentage of equity issuers’ assets that is made up of goodwill and intangible assets acquired, IAASA has examined – and will continue to examine – the accounting for such transactions.
As the scale of business combinations increases, it is expected that IAASA will examine in more detail issuers’ recognition (or non-recognition) and measurement of intangible assets and, as a consequence, the amount of goodwill and intangibles recognised in financial statements.
Value-in-use calculations of cash generating units
Messages on the recognition, measurement and disclosure of the value-in-use (VIU) calculation of cash generating units (CGUs) contained in IAASA’s 2013 and 2014 Observations documents continue to be of relevance to issuers in preparing future financial statements. The 2015 Observations document outlines some additional matters in relation to the discount rate that should be applied and disclosures required in instances where a reasonably possible change in a key assumption would cause the carrying amount to exceed its recoverable amount.
The Consolidation Suite of Standards
For most Irish issuers using IFRS, their 2014 annual financial statements were the first where the application of the new Consolidation Suite of Standards (IFRS 10, 11 and 12) was required. While it is too early to draw definitive conclusions on the quality of issuers’ application of those new standards, IAASA conducted a preliminary desktop survey of a small sample of issuers to establish the level of compliance and the document outlines the results.
Directors and audit committees should ensure they carefully evaluate the accounting treatment adopted for these transactions, disclose the key judgements made and provide the new disclosure requirements introduced by IFRS 10, 11 and 12 in a meaningful way and tailored to the issuer and its particular circumstances.
Deferred tax assets
Certain companies that have incurred significant losses in recent years have recognised material amounts of deferred tax assets on their balance sheets. The relevant financial reporting standard, IAS 12 Income Taxes, requires the recognition of such assets to the extent that it is probable that future taxable profits will be available against which the unused tax losses may be recovered.
Notwithstanding the economic recovery, it is still relevant to draw attention to the onus on entities (by paragraph 56 of IAS 12 Income Taxes) to reduce the carrying amount of a deferred tax asset to the extent that it is no longer probable that there will be sufficient taxable profits to allow all or part of that deferred tax asset to be utilised.
IAASA continues to engage extensively with issuers on this topic given that some entities – mainly financial institutions – have relied on forecasts of taxable profits over a very prolonged period of time to support the recognition of significant amounts of deferred tax asset. Clearly the longer the forecast period necessary to recover the deferred tax asset is less likely to be in the category of ‘convincing other evidence’ as required by paragraph 35 of IAS 12. As well as continuing to engage with issuers, IAASA has met the International Accounting Standards Board (IASB) and European Securities and Markets Authority (ESMA) to discuss the matter. Such engagement is continuing.
Alternative performance measures
Alternative performance measures (APMs) are best described as financial measures of financial performance, financial position, or cash flows other than a financial measure defined or specified in accounting standards. Common APMs presented by Irish equity issuers include operating profit, underlying earnings, adjusted earnings per share, free cash flow and constant currency performance measures. IAASA continued to engage with issuers throughout 2015 on their use of APMs to ensure they were appropriate and relevant. Various undertakings have been obtained for improvements in future financial reports.
While some issuers adhere to a high standard in reporting APMs, it is unacceptable that others flatter their results by excluding certain items from performance measures.
ESMA published its Guidelines on Alternative Performance Measures in 2015, which are applicable from July 2016. The ESMA’s APM guidelines are consistent with the findings and recommendations contained in IAASA’s surveys on the use of APMs by Irish equity issuers, the results of which have been published in two papers available on IAASA’s website. The coming into force of the ESMA APM guidelines will give added impetus to IAASA’s activity in this area.
Judgements, assumptions, and auditors’ risks of material misstatements
IAS 1 Presentation of Financial Statements requires an entity to disclose the judgements – except those involving estimations – that management has made in the process of applying the entity’s accounting policies and have the most significant effect on the amounts recognised in the financial statements. During 2015, IAASA undertook a desktop survey of 20 equity issuers’ disclosures of assumptions and judgements together with a survey of the risks of material misstatement identified by equity issuers’ auditors. While the principal findings of the survey are included in the Observations document, the more common critical accounting judgments identified by directors were specific aspects of:
- Taxation: identified in 75 per cent of the selected financial statements;
- Retirement benefit obligations: identified in 60 per cent of the selected financial statements;
- Goodwill impairment: identified in 55 per cent of the selected financial statements;
- Provisions: identified in 40 per cent of the selected financial statements.
IAASA notes with interest that a number of topics identified by directors as critical accounting judgements, together with the assessed risks of material misstatements identified by the independent auditors, had already been identified by IAASA in its annual Observations documents from 2008 to 2014. Such topics have been raised with individual issuers though IAASA’s enforcement activity and include, in some instances, undertakings which had been obtained.
Messages for financial institutions
The Observations document also outlines some specific messages for financial institutions regarding the accounting aspects of the:
- Current impairment provisioning regime and the need for changes in impairment charges to be directionally consistent with observable data (IAS 39);
- Impact of the new standard dealing with impairment provisioning and the need for proper disclosure of this impact as soon as the information is available (IFRS 9);
- Deposit guarantee schemes; and
- Work being undertaken in conjunction with our European colleagues.
Avoiding boilerplate and excessive disclosures
There is much commentary about the usefulness of financial reports and the volume of information contained therein. While various initiatives by standard setters and fellow accounting enforcers are ongoing in this regard, it is IAASA’s view – as articulated in previous publications – that the current financial reporting standards are, in many instances, robust enough to deal with this issue. IAASA has in the past enforced where it felt disclosures were too boilerplate, not issuer-specific and provided limited, if any, decision-useful information to users. The document outlines IAASA’s previous messages in this regard in addition to relevant extracts from IFRS, which have been used by IAASA as part of its enforcement activities in the past.
IAASA’s Observations on Selected Financial Reporting Issues –Years Ending On or After 31st December 2015 can be downloaded at www.iaasa.ie.
Michael Kavanagh is Head of Financial Reporting Supervision at IAASA.