Maurice Barrett highlights some noteworthy aspects of ESMA’s common enforcement priorities statement for preparers, management and directors.
The European Securities and Markets Authority (ESMA) is the Europe-wide body responsible for safeguarding the stability of the EU’s financial system. ESMA achieves this through the protection of investors and promoting stable and orderly financial markets. Co-ordination of accounting enforcement across the EU is part of ESMA’s activity.
As part of this accounting enforcement role, ESMA publishes an annual Public Statement setting out the common enforcement priorities (CEPs) for the annual financial reports of listed companies. Together with EU national accounting enforcers – including the Irish Auditing and Accounting Supervisory Authority (IAASA) – ESMA pays particular attention to these CEPs when examining entities’ financial statements. In addition to these Europe-wide CEPs, national accounting enforcers may set additional national priorities. IAASA does this in its annual Observations paper, which is available at www.iaasa.ie.
The 2021 ESMA CEPs statement, which is available at www.esma.europa.eu, sets out the enforcement priorities under three headings:
Several aspects of the 2021 CEPs statement are noteworthy:
- The pervasive nature of the impact of COVID-19 across each of the three headings;
- The identification of climate change as an area of concern for accounting enforcers and the recognition that climate-related matters are something about which investors and other users of financial reports require information; and
- The focus attached by ESMA – and, therefore, EU national accounting enforcers – to areas other than IFRS financial statements. Of the seven areas included in ESMA’s CEPs statement, only three refer to IFRS financial statements. This is considered significant and is indicative of the direction of travel of corporate reporting and accounting enforcement at the European level. It reflects a trend to consider corporate reporting from a more holistic point of view and a much broader perspective than the more traditional approach of considering only the monetary amounts and disclosures in the IFRS financial statements.
Impact of COVID-19
The CEPs statement notes that the impact of COVID-19 has been severe and the path to recovery may be prolonged. The statement repeats the messages included in last year’s CEPs statement regarding the need for a careful assessment of the longer-term impacts of COVID-19 on an entity’s activities, financial performance, financial position and cash flows (such as going concern assumptions, significant judgements, estimation uncertainty, presentation of financial statements, and impairment of assets).
Bearing in mind the impact COVID-19 is having on trade and supply chains, the CEPs statement reminds entities to provide transparent disclosures of arrangements that take the form of supply chain financing.
The CEPs statement calls for transparency on the criteria and assumptions used in the recognition of deferred tax assets arising from the carry forward of unused tax losses and unused tax credits due to the COVID-19 pandemic.
IAS 20 Accounting for Government Grants and Disclosures of Government Assistance requires disclosure of information related to government assistance, including the accounting policy adopted and the methods of presentation adopted in the financial statements. The CEPs statement reminds entities to provide a description of the nature and extent of any significant public support measure received by category (for example, loans, tax relief, and compensation schemes).
COVID-19 may impair entities’ ability to meet any pre-determined sustainability-related goals in the short- and medium-term. Accordingly, the CEPs statement recommends that entities provide disclosure as to how the pandemic is affecting their plans to meet such targets and whether any new or adjusted goals have been determined.
The ESMA CEPs statement also urges caution if entities adjust APMs used or develop new APMs with the sole objective of depicting the impact that COVID-19 has on financial performance. ESMA contends that, in most instances, the COVID-19 impact should not be presented separately in APMs.
Climate-related matters
Entities and auditors must consider climate risks when preparing and auditing IFRS financial statements. The identification and assessment of climate-related risks may require a longer-term horizon than that considered for financial risks. Entities should consider climate-related matters by ensuring consistency in the information disclosed across the management report, the non-financial statements, and the financial statements.
The CEPs statement reminds entities that, in addition to the information required by individual IFRSs, paragraph 112(c) of IAS 1 Presentation of Financial Statements requires that information on climate-related matters be provided in the notes if not presented elsewhere in the financial statements when such information is relevant.
Paragraphs 122 to 124 of IAS 1 require disclosure of the significant judgements management has made in the process of applying an entity’s accounting policies. In this regard, entities need to consider disclosure of management judgements related to climate risks. Entities are also required to disclose information in accordance with paragraphs 125 to 133 of IAS 1 regarding major sources of estimation uncertainty. Entities are expected to disclose in the financial statements how forward-looking assumptions, estimates and judgements applied in preparing the financial statements are consistent with the information included in the management report and the non-financial statement.
The CEPs statement notes that ESMA – and, by extension, EU national accounting enforcers – expects entities to consider climate change when assessing whether the expected useful lives of non-current assets and the estimated residual values in IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets should be revised. In addition, under IAS 36 Impairment of Assets, entities should:
- Assess whether indications exist that non-financial assets are impaired as a result of climate risk or Paris Agreement implementation measures;
- Use assumptions reflecting climate risks; and
- Adapt the sensitivity analysis disclosed to consider climate risks and commitments in the assumptions used.
Entities should carefully consider the requirements in IAS 37 Provisions, Contingent Liabilities and Contingent Assets regarding, for example, contingent liabilities for potential litigation, regulatory requirements to remediate environmental damage, additional levies or penalties related to environmental requirements, contracts that may become onerous, or restructurings to achieve climate-related targets.
Articles 19a and 29a of the Accounting Directive require the management report of certain entities to include a non-financial statement containing information regarding environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters. Such a non-financial statement must include a description of the entity’s business model and the policies pursued in relation to those matters, the outcome of those policies, the principal risks, and non-financial key performance indicators. In addition, the CEPs statement suggests that entities might apply the European Commission’s non-binding guidelines on reporting climate-related information (available at www.ec.europa.eu).
It is ESMA’s view that to provide useful information for investors and other stakeholders in assessing the entity’s performance and position in relation to climate-related matters, the disclosures should not be limited to providing backwards-looking information. Instead, this information should be contextualised in the entity’s broader strategic orientation and the related implementation plans, indicating the expected progress to meet pre-defined targets.
Expected credit losses disclosures
The CEPs statement sets out ESMA’s expectations on aspects of expected credit losses (ECL) disclosures, including:
Management overlays
When material adjustments are used in ECL measurement, entities should provide transparency to fulfil the overarching objectives and principles of paragraph 35B of IFRS 7 Financial Instruments: Disclosures. Such adjustments either take the form of ECL model revisions or are applied outside the primary models (“post-model adjustments”). In complying with the requirements of paragraphs 35G, 35D and 35E of IFRS 7, ESMA expects entities to disclose entity-specific information on its impact on the ECL estimate, the rationale, and the methodology applied.
Changes in credit risk (stage transfers)
ESMA highlights paragraphs 35F and 35G of IFRS 7 and reminds entities to disclose the basis for the inputs and assumptions and the estimation techniques used to determine whether there is a significant increase in credit risk (SICR) of financial instruments since initial recognition, or whether a financial asset is credit-impaired.
Forward-looking information
When explaining how forward-looking information (FLI) has been incorporated into the determination of ECL as required by paragraph 35G(b) of IFRS 7, ESMA encourages entities to provide specific disclosures on the main judgements and estimations related to uncertainties that have been taken into account when defining the scenarios and their weight. ESMA recommends that entities disclose quantitative information on the macro-economic variables considered.
Effect of climate-related risk on the ECL measurement
ESMA expects entities to disclose whether material climate-related and environmental risks are taken into account in credit risk management, including information about the significant judgements and estimation uncertainties. Specifically, to meet the objectives of paragraph 35B of IFRS 7, entities should explain how these risks are incorporated in the calculation of ECL, and any credit risk concentrations related to environmental risks and how those risks affect the amounts recognised in the financial statements.
Environmentally sustainable activities
The ESMA CEPs statement reminds entities of the disclosure obligations set out in Article 8 of the Taxonomy Regulation (available at www.eur-lex.europa.eu). Article 8 requires non-financial undertakings to disclose:
- The proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable; and
- The proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with economic activities that qualify as environmentally sustainable.
The European requirements in this area continue to evolve
ESMA encourages entities to plan and prepare for the timely and correct application of the relevant requirements, as the information to be disclosed may require the collection of data that may not be readily available.
Conclusion
The topics set out in the ESMA CEPs statement, along with those set out in IAASA’s Observations paper, will be used by IAASA as its reviews financial statements in 2022.
ESMA and IAASA emphasise the importance of preparers, management, and directors taking these CEPs into account when preparing and approving their 2021 annual reports and financial statements and discussing them with their auditors at the planning, execution, and completion phases.
The messages in the ESMA CEPs statement are directed at entities preparing IFRS financial statements and falling under the remit of national accounting enforcement. However, the topics raised could usefully be adopted by a broader population of entities.
Maurice Barrett FCA is Senior Financial Reporting Manager at the Irish Auditing & Accounting Supervisory Authority.
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