The IAASB's exposure draft proposes changes to several International Standards on Auditing (ISAs), with the most significant being: 

• Clarifying the meaning of the term "financial statements" to include all disclosures subject to audit, noting such disclosures may be found on the face of financial statements, included in related notes, and where permitted by the financial reporting framework, incorporated by cross-reference
• New application material to assist in the establishment of an appropriate focus on disclosures in the audit, and to bring forward consideration of disclosure to earlier in the audit process
• Enhancements to encourage a more robust risk assessment around disclosures, e.g. considering assertions for related disclosures when considering classes of transactions, events and account balances, considerations about the source of information for disclosures, and clarifying the nature of potential misstatements in disclosures (including non-quantitative disclosures)
• New application material to clarify and explain the expectations of an auditor when evaluating misstatements and forming an opinion, highlighting the types misstatements that might be identified, explaining that disclosure misstatements need to be accumulated, providing examples of disclosure misstatements that may impact the understandability of the financial statements, and how misstatement disclosures impact the evaluation of the presentation of the financial statements.

The FRC is strongly supportive of the proposed changes to ISAs. However, one area where they do not agree with the IAASB is in relation to the need for a new requirement in ISA 320 requiring auditors to make a preliminary determination of materiality for non-quantitative disclosures. Although the IAASB debated introducing such a requirement, they decided it was not necessary, something with which the FRC disagrees. They believe that in the absence of such a requirement, the ISA would remain largely focussed on the quantitative aspects of materiality when it is the non-quantitative aspects that can give rise to the most challenging issues. The FRC proposes in its comment letter a new requirement that could be introduced.

In addition to their responses to the detailed questions raised by the IAASB, the FRC also notes that many of the challenges in relation to the quality of financial statement disclosures and their audit cannot be solved by amendments to the ISAs alone. An example of this is the lack of a disclosure framework to guide preparers in determining the nature and extent of disclosure that is appropriate. In the light of this, the FRC strongly support the ongoing collaboration between the IAASB and the International Accounting Standards Board (IASB) on the IASB's Disclosure initiative.

The full comment letter can be downloaded from the FRC website.

In its Exposure Draft, the IASB proposed three changes to IAS 28 and IFRS 10:

• Exemption from preparing consolidated financial statements. The suggested amendments confirm that an entity can apply the consolidation exemption even if its parent entity measures its subsidiaries at fair value in accordance with IFRS 10.
• A subsidiary providing services that relate to the parent's investment activities. A subsidiary that provides services related to the parent's investment activities should not be consolidated if the subsidiary itself is an investment entity.
• Application of the equity method by a non-investment entity investor to an investment entity investee. When applying the equity method, a non-investment entity investor in an investment entity retains the fair value measurement applied by the associate to its interests in subsidiaries, unless the non-investment entity investor is a joint venturer where the joint venture is an investment entity.

The FRC supports the proposed amendment regarding exemption from preparing consolidated financial statements.

Consolidation of a subsidiary providing services that relate to the parent's investment activities

The FRC disagrees with this proposed amendment. They are concerned that the limitation proposed will lead to important information being lost and result in economically identical group structures being reported in different ways based on legal form. They also note that evidence from constituents indicates that the IASB proposal would reduce the transparency of information in respect of investments, leverage and operational efficiency in investment entity groups, which is not consistent with the expressed needs of investors.

The FRC proposes instead that consolidation of all investment entity subsidiaries, regardless of whether they provide investment services or not, should be required, which in its view would ensure that fair value measurement is applied where it is most useful (i.e. to underlying investments) whilst retaining detailed information on the performance of investment services.

Application of the equity method by a non-investment entity investor to an investment entity investee

In relation to these amendments, the FRC partly supports the IASB's proposals but partly disagrees. It believes that a non-investment entity investor should, when applying the equity method, retain the fair value measurements used for investments in subsidiaries by an investment entity associate or joint venture. This is different to the IASB's position which would mandate this treatment for investments in subsidiaries held by associates but forbid it for joint ventures.

The FRC's position is based on its view, expressed to the IASB when responding to the original consultation on the investment entities amendments, that a non-investment entity parent should not be required to consolidate the subsidiaries of its own investment entity subsidiary. Consistent with that view, they consider that the fair value of an investment entity’s subsidiaries provides the most useful information irrespective of whether the reporting entity’s interest in the investment entity is that of an associate or a joint venture.

The full comment letter can be accessed from the FRC website.

It has taken a longer time than we all expected but the Financial Reporting Council has finally, at the third time of asking, come to a conclusion on where the issues of going concern and the longer term viability of companies should stand in the UK Corporate Governance Code. It seems a long time since Lord Sharman took on the task of making the whole concept of going concern more robust after criticisms following the financial crisis. It might have been expected to be a relatively straightforward process. But agreement was hard to achieve.

Yet, with the new revised Code now issued by the FRC, the arguments should quieten. There are now two different lines of action. The idea of going concern remains a relatively simple accounting test. The broadening out of the whole idea of the security of a company’s future that Sharman wanted is now what is to be called a longer term viability statement.

Boards need to provide two statements. The first says simply that the directors have considered, and disclosed and identified any material uncertainties, and so it is appropriate to adopt a going concern basis for the year from the point that they approved the accounts.

The second is the new viability statement. Here directors need to say that they have assessed the prospects of the company, state how long a period ahead this covers, and why they have chosen this particular period. And they also have to say whether they think they have a reasonable expectation that the company will be able to continue to operate over that period. They need to base this on a robust assessment of the risks ahead, ‘including its resilience to the threats to its viability posed by those risks in severe but plausible scenarios’.

That widens out the thinking of boards of directors. ‘Directors,’ says the guidance, ‘are encouraged to think broadly as to relevant matters which may threaten the company’s future performance and so its ability to continue in operations and remain viable’.  And all of this, while not being open-ended, takes the period being reported about far beyond what previously might have been thought a comfort zone. The guidance says that: ‘Except in rare circumstance it should be significantly longer than 12 months from the approval of the financial statements’. And it is up to companies themselves to decide what length of time they want to comment on. And will a competitor, you wonder, seek to gain an advantage by lengthening the period, which might as the months go by become a disadvantage? There will be a lot of judgement involved here. But it will create a clearer picture for users of accounts.

As the FRC’s CEO Stephen Haddrill made clear in his comments at the annual FRC open meeting, held the day the Code was released, all this was in response to the criticism that during the financial crisis there was little reported which clearly suggested that there were problems ahead.

And the guidance also makes it clear that no one expects the simple existence of a viability statement to make things definite and perfect over the longer term. ‘Reasonable expectation’, it says, ‘does not mean certainty. It does mean that the assessment can be justified. The longer the period considered, the greater the degree of certainty can be expected to reduce’.

Over time this will allow for greater flexibility and thought around these statements. But their very existence puts UK reporting ahead of the game internationally. And the FRC deserves praise for that.

Best practice, as it emerges, will enhance the whole process.

The new requirements since 1 July 2013 include:

• IFRS 14 and IFRS 15;
• the new hedge accounting chapter in IFRS 9;
• amendments to IFRS 1, IFRS 2, IFRS 3, IFRS 8, IFRS 11, IFRS 13, IAS 16, IAS 19, IAS 24, IAS 38, IAS 40 and IAS 41; and
• consequential amendments to other Standards and Interpretations.

The Green Book can be purchased for £94 plus shipping for the two book set (academic, developing country, and volume discounts apply). Click for more information and ordering details.

This update is the final part of the FRC’s two year review of the Code and response to the Sharman report. It follows earlier consultations on directors’ remuneration and risk management, internal control and the going concern basis of accounting. The key changes to the Code cover three principal areas:

• Going concern, risk management and internal control;
• Remuneration; and
• Shareholder engagement.

The updates also include some changes to the Preface to the Code, highlighting the importance of diversity on the board and setting the correct 'tone from the top' regarding standards of behaviour. In particular the Preface notes that, in addition to gender and race:

Diversity is as much about differences of approach and experience, and it is very important to ensure effective engagement with key stakeholders in order to deliver the business strategy.

As well as the updated Code itself, the FRC has also published two guidance documents:

• Guidance on Risk Management, Internal Control and Related Financial and Business Reporting, which revises, integrates and replaces the current documents Internal Control: Revised Guidance for Directors on the Combined Code and Going Concern and Liquidity Risk: Guidance for Directors of UK Companies (the "Guidance"); and
• Guidance for Directors of Banks on Solvency and Liquidity Risk Management and the Going Concern Basis of Accounting, which addresses supplementary considerations for the banking sector and should be read in conjunction with the above.

Furthermore, revised versions of ISA 260 Communication with those charged with governance, ISA 570 Going concern and ISA 700 The independent auditor’s report on financial statements (all links to FRC website) have been published. These reflect consequential amendments to the responsibilities of auditors as a result of the changes to the Code, in particular the fact that the auditors will now have a responsibility to state in their report whether they have anything material to add or draw attention to in relation to the directors' assessment of principal risks, the going concern statement and the statement about the prospects of the entity. 

Going concern

As set out in the proposals in the consultation paper issued in April 2014, going forward boards will need to provide two statements as follows:

1)     In annual and half-yearly financial statements, the directors should state whether they considered it appropriate to adopt the going concern basis of accounting in preparing them, and identify any material uncertainties to the company’s ability to continue to do so over a period of at least twelve months from the date of approval of the financial statements (Code Provision C.1.3); and

2)     The directors should state whether, taking account of the company’s current position and principal risks, they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due over the period of their assessment, drawing attention to any qualifications or assumptions as necessary (Code Provision C.2.2). 

Risk management and internal control

There has continued to be broad support for the FRC’s proposals on principal risks and monitoring the risk management system and, as such, there are no amendments to the April 2014 proposals.  The Code has been amended to include a new provision C.2.1 requiring the directors to:

confirm in the annual report that they have carried out a robust assessment of the principal risks facing the company, including those that would threaten its business model, future performance, solvency or liquidity.

It also requires them to describe those risks and explain how they are being managed or mitigated.

As well as this, provision C.2.3 has been amended to refer to specifically refer to a responsibility for the board to monitor the company’s risk management and internal control systems.

Although concerns were raised during the consultation process about the recommendation in the draft Guidance that the board should explain actions that have been or are being taken to remedy any significant failings or weaknesses in risk management or internal controls, this has been retained in the final Guidance document as the FRC believes that it is of legitimate stewardship interest to shareholders. However supplementary guidance has been included to make it clear that the board

would not be expected to disclose information which, in its opinion, would be prejudicial to its interests. 

Remuneration

Section D of the Code now emphasises that the overall objective of the remuneration policy should be to deliver long-term benefit to the company. Principle D.1 now states that

Executive directors’ remuneration should be designed to promote the long-term success of the company. Performance-related elements should be transparent, stretching and rigorously applied.

This is supported by a requirement to avoid paying more than necessary and changes to Schedule A in relation to the design of performance-related remuneration schemes. The supporting principle also emphasises the need to be cautious about using comparisons with other companies and the danger of upward ratcheting with no corresponding improvement in performance.

Provision D.1.1 has been amended to include a specific reference to recovering or withholding performance-related payments, also know as 'clawback', including the circumstances in which this is considered appropriate.

The supporting principle in provision D.2 has also been amended to remove any potential ambiguity in relation to conflicts of interest when the remuneration consults the chief executive about the remuneration of other executive directors. 

Shareholder engagement

Section E of the Code now includes a new provision requiring companies to explain what action they intend to take in response to situations where a significant proportion of votes have been cast against a resolution at any general meeting. This is likely to be particularly relevant to resolutions on directors' remuneration.

Click here to view:

• The FRC's press release (link to FRC website).
• The updated Code (link to FRC website).
• The Guidance on Risk Management, Internal Control and Related Financial and Business Reporting (link to FRC website).
• The supplementary guidance for directors of banks (link to FRC website).
• Extracts from the revised ISAs (link to FRC website).
• Our Governance in brief publication discussing these changes
• Our previous UK Accounting Plus news item on the April consultation

In recent discussions, one of the factors often mentioned in connection with long-term finance has been accounting and especially fair value accounting. A Green Paper consultation on the long-term financing of the European economy published by the European Commission (EC) in March 2013 had suggested that the fair value might lead to short-termism in investor behaviour. This had solicited, among others reactions, a statement by the IASB that "the IASB does not believe that fair value accounting principles have of themselves led to short-termism in investment behaviour". In an earlier speech the IASB Chairman had noted that even long-term investors require shorter-term, reliable and unbiased performance measures to keep track of their investments and to hold management to account. Nevertheless, the EC later adopted a package of measures on long-term financing that included considering whether the use of fair value in especially in IFRS 9 Financial instruments "is appropriate, in particular regarding long term investing business models".

The FSB report reflects some of the concerns regarding fair value accounting that were voiced in the member survey (the EC is a member of the FSB). The two main concerns voiced were that:

• the use of fair value accounting for financial instruments increases volatility in measures of income and capital and so could provoke adverse reactions from investors and
• fair value does not reflect the business model of long-term investors, as it can mean that short term changes in value of instruments are given undue weight.

The second concern was especially raised for insurers, whose business model involves matching assets and liabilities, and for holders of strategic equity investments. Nevertheless, the members also noted that the insurance contract project is still under development, and that the introduction of expected loss accounting for loan provisions through the impairment project will greatly enhance transparency.

All in all, the FSB finds that it is too early to fully assess whether the concerns are justified and what the impact of the changes on the provision of long-term finance or changes in market behaviour in response to these changes might be, but promises that the regulatory community "will remain vigilant to avoid material unintended consequences and to analyse potential impacts as implementation proceeds". For the time being, however, the FSB concludes:

The FSB's monitoring continues to find little tangible evidence or data to suggest that global financial regulatory reforms have had adverse consequences on the provision of long-term finance. The reforms are intended to be proportionate to risks and to support financial stability. They are not designed to encourage or discourage particular types of finance.

Please click for access to the full report on the FSB's website.

After the report was released, the FSB held a plenary meeting in Cairns, Australia, that looked at vulnerabilities affecting the global financial system and reviewed work plans for completing core financial reforms. Among other topics, the plenary discussed work by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) on new standards for the financial sector that take account of the lessons of the financial crisis and introduce forward-looking expected loss provisions for loan losses. Members welcomed this work and reaffirmed the continuing relevance of the objective of achieving a single set of high-quality global accounting standards. The FSB also encouraged the IASB and FASB to monitor the consistent implementation of their respective standards and to continue to seek opportunities for further convergence.

Please click for the press release on the FSB's website.

The future of audit and assurance is an important corollary of the wider debate on corporate reporting of financial and non-financial matters. In the medium and long term, we support the development of a holistic, forward-looking and strategy oriented approach to corporate reporting. This will help provide users with a longer-term and broader perspective, complementing the financial statements. It is important that the development of this reporting and associated assurance models are driven by users' legitimate and reasonable needs, taking into consideration both the costs and benefits.

The discussion paper itself is available from the FEE website and the full comment letter can be downloaded from our publications pages.

Background

In developing IFRS 13 Fair Value Measurement, the IASB intended to prioritise Level 1 inputs into the fair value hierarchy but did not expressly state that Level 1 inputs should be prioritised even when those inputs to not correspond to the unit of account of the asset measured (the investment as a whole). Therefore, questions arose on the unit of account for investments in subsidiaries, joint ventures and associates and on their fair value measurement when those investments are quoted in an active market. Similarly, the IASB also received questions on the measurement of the recoverable amount of cash-generating units (CGUs) on the basis of fair value less costs of disposal when they correspond to entities that are quoted in an active market.

Therefore, the IASB has now published proposed amendments that would confirm that the unit of account for investments in subsidiaries, joint ventures and associates is the investment as a whole, but that the fair value measurement of quoted investments in subsidiaries, joint ventures and associates should be the product of the quoted price multiplied by the quantity of financial instruments held, without adjustments. The IASB also proposes to align the fair value measurement of a quoted CGU to the fair value measurement of a quoted investment. Lastly, the proposed amendments also include an addition to the Illustrative Examples for IFRS 13 to illustrate the application of paragraph 48 of that standard to a net risk exposure of Level 1 financial assets and financial liabilities.

Suggested changes

The IASB proposes amendments to six standards in ED/2014/4 Measuring Quoted Investments in Subsidiaries, Joint Ventures and Associates at Fair Value (Proposed amendments to IFRS 10, IFRS 12, IAS 27, IAS 28 and IAS 36 and Illustrative Examples for IFRS 13):

Dissenting opinion

One IASB member voted against the publication of the ED. This member believes that using the product of the quoted price multiplied by the quantity of the financial instruments is neither appropriate for the fair value measurement of investments nor for determining the recoverable amount of CGUs. If the IASB concludes conclusion that the unit of account is the investment as a whole instead of the individual financial instruments that make up the investment, this board member believes that the unit of account used for the fair value measurement should also be the investment as a whole and not the underlying financial instruments. According to this board member, the investment's fair value should either be measured using another valuation technique or by adjusting the Level 1 input to reflect the price differences between the investment as a whole and the underlying individual financial instruments.

Effective date and transition requirements

The ED does not contain a proposed effective date. For the proposed amendments related to quoted investments the IASB suggests mandatory application from the beginning of the year the amendment is first applied; for the proposed amendments related to the measurement of CGUs the IASB suggests prospective application.

Additional information

Please click for:

• IASB press release (link to IASB website)
• Access to the exposure draft on the IASB website
• Deloitte's Need to Know newsletter explaining the proposed amendments
• Our UK Accounting Plus project page on IFRS 13 — Unit of account