The Bruce Column — Focusing on year-end priorities

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19 Dec 2012

ESMA, the European investor protection authority, has made clear the areas which it expects companies and auditors to look upon as priorities in the current round of year-end financial reporting. Our regular columnist Robert Bruce takes a look at how it is laying down the enforcement law.

Stephen Maijoor’s warning was blunt. On the day the European Securities and Markets Authority, (ESMA)—the European investor protection authority which he chairs—issued the details of the enforcement priorities which it would be pursuing in 2013 it also issued a blunt reminder. Maijoor made it clear that ESMA had ‘deliberately issued the European common enforcement priorities before the year-end so that companies and their auditors could – and should – take due consideration of them when preparing and auditing the IFRS financial statements for the year ending December 2012’. And these priorities are just as relevant all around the world.

‘Auditors’, he said, ‘ have an important role to play in assuring investors about a company’s financial position and performance, which is more important than ever for all companies, and especially financial institutions’.

He made it clear he was connecting two important strands. Strong credible financial reporting provides investor protection. But to provide proper comparability around the world you have to have strong and effective enforcement.

‘We strongly believe that financial reporting with strong measurement principles along with entity-specific and relevant disclosures reflecting economic substance are important in underpinning market discipline’ he said. This contributed toward proper investor protection and stability. ‘Market discipline can only be achieved through the development and application of high quality accounting standards’, he said.

Worldwide adoption of IFRS was necessary but was not enough, on its own, to provide global comparability. In order to achieve true global comparability the standards had to be enforced. Research showed that adoption of IFRS resulted in reduced capital costs in the immediate mandatory adoption period and that, in turn, reflected increased disclosure and enhanced information comparability. But, said Maijoor: ‘This is only really the case in countries with strong legal enforcement frameworks’, hence the importance of consistent application across the EU, and ESMA’s efforts to enforce this.

He highlighted several areas of concern. ‘Since the beginning of the financial crisis transparency related to financial instruments is a top priority’, he said. ‘Issuers should provide disaggregated and expanded disclosures on material exposures  to all financial instruments – not only sovereign debt exposures – that are exposed to risk’.

And he emphasised other areas where greater disclosure would be expected.

‘A significant or prolonged decline in fair value triggers the recognition of an impairment loss for equity instruments held in the available-for-sale portfolio’, he pointed out. ‘EU enforcers have observed diverging practices in the application of the relevant criteria and think investors would benefit from more transparency’.  His advice? ‘Please tell them and us what is considered to be a significant or prolonged decline in value’.

He turned to the impairment of non-financial assets. ‘The current economic situation increases the likelihood that the carrying amounts of assets might be higher than their recoverable amounts’, he said. ‘The market value of many listed companies has fallen below their book value, a situation potentially indicating impairment and thus the need for an impairment test. ESMA considers that particular attention has to be paid to the valuation of goodwill and intangible assets with indefinite life spans, whenever significant amounts are recognised in the financial statements’.

He warned on defined benefit obligations. ‘In some countries there is no, or no longer, a deep market in high quality corporate bonds whilst discounted post-employment benefit obligations should be determined with reference to such market’, he said. ‘The crisis and economic downturn resulted in significant swings in market yields for some sovereign and corporate debt. The question could arise whether entities should change their approach when determining discount rates for their post-employment benefit obligations. ESMA would expect issuers to disclose the yields used and provide a description of how they determined them’. ESMA are not just looking at the disclosure. They are looking at how an appropriate discount rate is determined. ESMA’s statement on enforcement priorities makes clear that they do not expect to see companies changing their approach to this determination.

And finally Maijoor looked at provisions within the scope of IAS 37. ‘The measurement of provisions involves significant management judgement and could in the current market circumstances be subject to more uncertainty’, he warned. ‘The strong link between provisions and the risks an issuer is subject to, makes a case for high-quality disclosures’. But he voiced his disappointment at the effectiveness of current disclosure practices. ‘European enforcers often find that only aggregated and boilerplate information is provided. Issuers should disclose for each class of provision the nature of the obligation, the expected timing of the outflows of economic benefits, uncertainties related to the amount and timing of those outflows as well as, if relevant, major assumptions regarding future events’. And that too is relevant all around the world, as observations by the US regulator, the SEC, show.

All of these are well-trodden enforcement priorities. But they have a double importance. They are important as areas which need to be focussed on. But at the same time it provides an example of how global enforcement could develop.

As Maijoor made clear a few days later: ‘A principles-based environment can only survive if clear and entity-specific disclosures, re-assessed at the end of each reporting period, bring useful decision-making information to investors’, he said. ‘If not, detailed prescriptive requirements would need to be developed and we all know that what is important today will not necessarily be so in the next financial year. The only way to avoid this is for issuers to stop providing boilerplate information directly mimicking the standards’.

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