Asset impairment disclosures: a test for compliance

Posted on May 17, 2013 by admin

by John Hughes

The Cass Business School at City University London has issued an interesting research study Accounting for asset impairment: a test for IFRS compliance across Europe. Even from the title alone, you could probably guess that the report doesn’t conclude the “test” was passed with flying colours. This is how the authors summarize the findings:

  • “There is considerable variation across European countries in compliance with some impairment disclosure requirements, suggesting uneven application of IFRS.
  • Compliance with impairment disclosures requiring greater managerial involvement in making discretionary reporting choices (high effort) is lower than compliance with low effort disclosure requirements, revealing a tendency to use boilerplate language.
  • High-quality impairment reporting is more likely to be found in companies that operate in countries with a stronger regulatory and institutional infrastructure, for example the United Kingdom and Ireland. In contrast, impairment disclosures appear to be of lower quality in countries where regulatory scrutiny is weaker.
  • The timeliness of recognition of bad news in earnings appears to be dependent on the quality of the institutional environment. Companies operating in strong regulatory and enforcement settings appear to recognize economic losses on a more timely basis than those based in jurisdictions where enforcement is anticipated to be weaker.”

I don’t mean to be flippant about these conclusions or the work that went into reaching them, but I’d be very surprised if anyone would have expected anything different. That is to say, just about everyone involved in IFRS (including everyone at the IASB I imagine) knows the quality of disclosure tends towards boilerplate, that different countries exhibit different degrees of compliance, and that one of the key drivers of that is the overall rigour of the prevailing culture and regulatory environment. If your inclinations run a certain way, you could jump on this report as more “proof” that the IFRS project is fatally flawed, because these difficulties will probably never be completely vanquished. If you’re more like me, you see it as a warning against making overblown claims about attaining a “single global accounting language,” but not as seriously prejudicing IFRS’s value as a common reference point. By now, anyone who cares has probably carved out their place on the spectrum of belief pretty firmly.

Perhaps accidentally, the report does provide good fuel for the ongoing debate about disclosure overload, by encompassing “an assessment of overall compliance and reporting behavior in 11 selected disclosure areas.” One might fairly ask: how could this single aspect of IFRS, or any single aspect of IFRS, even include 11 disclosure areas (more, given those they didn’t select!), and isn’t it inevitable that companies would yawn their way through much of it? And I’m saying that as someone who sees more value to the impairment disclosures than to those in many other areas. But that doesn’t mean they’re equally compelling in all instances. To illustrate, suppose a company shuts down one of its operations, and writes down all the related assets. Practically speaking, the disclosures about recoverable amounts, cash flow projections and so forth don’t have much ongoing significance in that situation – what’s done is done. In contrast, take a case where a company recognizes a partial writedown of assets attaching to an ongoing operation, because of volatile economic conditions, and where the impairment loss might potentially be reversed in the future. In this case the disclosures would potentially have much greater predictive value, and their absence might be a larger practical impediment to decision-making. The report doesn’t distinguish between such cases, but hopefully regulators would, in deciding how best to allocate their resources.

It’s a bit ironic that this report appears soon after the IASB issued an exposure draft in which it proposed tinkering further with those copious IAS 36 disclosure requirements. I know that defining the playing field and overseeing what happens on it are two different things, and that the IASB doesn’t have any direct authority over the latter function. But if it were to ask how to best further its goal of attaining high-quality financial reporting, it seems to me it might get more mileage out of doing what it can to promote better regulation of what already exists, for example (and I’m just thinking out loud here) by making its own assessment of perceived strengths and weaknesses in the programs of different jurisdictions, and then putting that out in the open. Of course, national regulators probably wouldn’t welcome the intrusion, but if it carried any chance of embarrassing some of them into action, who cares. There’s a bigger issue though. The report categorizes European countries into three “clusters” based on their degree of investor protection, the stage of development of their stock markets and so forth, and I was surprised that only two nations, Ireland and the United Kingdom, made it into the top cluster; France and Germany, in contrast, were both in the second cluster; Italy was in the third. Not that countries don’t evolve over time, but at this advanced and strained stage in human development, it would be questionable to hope for any quick transformations. So maybe we should think seriously about the problems of holding first-cluster expectations in a mostly second- or third-cluster world…

The opinions expressed are solely those of the author

Posted in Disclosure, IFRS, Impairment | Leave a comment

Going concern disclosures – keeping on the lights

Posted on May 11, 2013 by admin

by John Hughes

The CICA’s IFRS Discussion Group recently discussed going concern assessments for development stage entities, in particular what criteria these entities should use to determine whether going concern uncertainty disclosure is required. For illustration, they focused on a common case – a mining company in the exploration stage that, if it encounters difficulty in raising financing, can either “slow its rate of exploration activity and associated spending to a level that can be sustained for a significant period of time based on its existing financial resources; or defer exploration spending to the level necessary to keep its exploration property and permit rights, and reduce its operational spending to a level that enables it to ‘keep the lights on’ for a significant period of time.”

Some members of the group “supported the view that going concern uncertainty disclosure is necessary because the entity does not have sufficient funds and faces significant uncertainty about its ability to raise funds.” Others thought though this isn’t necessary, for a mixture of reasons: “only contractually required payments should be considered; the entity can scale back and modify its business plan to “keep the lights on” until additional financing is available; and disclosures that are required by other IFRSs, such as IFRS 7 Financial Instruments: Disclosures, are sufficient to inform users of the risks that the entity faces.” Overall: “group members agreed that while it may not be necessary to provide going concern disclosure, disclosure of some sort is required for the fact pattern discussed. Group members noted that to be useful those disclosures should be specific to the entity and avoid being boilerplate. Group members agreed that sufficient disclosure is necessary for a user to have a proper understanding of the nature of the business and the stage of the business cycle. However, Group members expressed different views on the form and content of the disclosures.”

IFRIC has also been considering this issue, and has recommended that the IASB issue an exposure draft to provide more guidance on the area, so we’ll see where that goes. In the meantime, I’d certainly agree with the IDG members who took a more measured view to the matter – I can’t see any point in slapping full-blown going concern uncertainty language on an entity just because, to put it broadly, it doesn’t have much going on. Practically speaking, as some IDG members mentioned, this would only mean the disclosure becomes standardized and meaningless (if it isn’t already, for entities at the smaller end of the scale). The OSC thinks these disclosures “provide warnings about significant risks that the issuer is facing and may help investors avoid or minimize negative consequences when making investment decisions.” But this seems to me an odd statement to say the least, implying that the specific “going concern” label (on financial statements potentially appearing several months after the events they depict) will resonate with investors, saving them from “negative consequences,” in a way that other disclosures about risk and uncertainty (such as those in the MD&A, or news releases) won’t. It’s hard to see why the OSC would even want that to be true.

And anyway, I don’t think going concern disclosures are primarily designed to achieve that. As I wrote at greater length here, their core purpose is less about communicating operating risk than about the integrity of the accounting. The Framework sets out the concept as follows: “The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed” (my emphasis). The point of the italicized passage is that if the entity knows it’s going to (say) liquidate, then some of the values that would otherwise be included in the statements will make no sense – for instance, it will be obviously wrong to show carrying values for property, plant and equipment calculated on assuming an extended useful life. But the “if so” acknowledges that even if a liquidation is pending, the financial statements won’t necessarily have to be prepared on a different basis – for instance, if the statement of financial position consists entirely of financial instruments measured at fair value for which no adjustment would be necessary. In this case, that passage of the Framework, read literally, wouldn’t require any additional disclosure; it would be indifferent in effect to whether a liquidation is pending or not.

IAS 1.25 expands on this: “When management is aware, in making its assessment (of the ability to continue as a going concern), of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties.” But the point here, again, is about the relevance of those uncertainties to assessing the recognition and measurement decisions taken in preparing the statements, not about their implications as a whole. This is logical because any number of reasons might exist why a particular set of financial statements provides a poor guide to the future (changes in economic conditions, enhanced competition, departures in key personnel, and so on), but none of these would typically be disclosed there. That’s the importance of MD&A and other aspects of the continuous disclosure regime.

Against this backdrop, the regulatory focus on going concern disclosures gets to seem a bit illogically neurotic –  if investors don’t realize at the outset that buying into struggling penny stocks generates a risk of losing everything, then they’re not going to be helped by a few more disclosure elaborations. I’m still drawn to the same conclusion I expressed before: “It seems clear to me that rather than trying to cater to investors who need a neon warning sign on top of obvious operating challenges, regulators should be telling them they’re in over their heads. But the OSC doesn’t like to send that kind of message, because I suppose it seems too interventionist (or grim!) Consequently, it ends up catering to a weird and marginal concept of an investor who’s supposedly basically capable of investing in highly risky companies and yet too dumb to understand the danger signals unless they’re laid out in a prescribed, programmatic manner. It’s all done with the best intentions of course. But if you ask me, there’s no point trying to save people from themselves.”

The opinions expressed are solely those of the author

Posted in Going concern, IFRS | Leave a comment

Accounting and long term investment – flying the plane

Posted on May 5, 2013 by admin

by John Hughes

The text of IASB Chairman Hans Hoogervorst’s recent speech, Accounting and long term investment – ‘Buy and hold’ should not mean ‘buy and hope’, makes for an odd, rather disjointed read.  Hoogervorst starts by describing the “perils of short-termism,” asserting that “promoting healthy, long-term investment…is an essential part of (the IASB’s) job.” From here he devotes a couple of paragraphs to the concept of stewardship, then skips over the familiar arguments for and against fair value measurement, before devoting the bulk of his address to the ongoing project on insurance contracts, for which he cites the public debate as “a microcosm of the debate on long term investment versus short-termism.”

It’s expected that the exposure draft will propose a current measurement approach for measuring insurance liabilities, which “will allow investors to gain a much more reliable view on the true performance of the industry. Markets will gain much more insight into how effective insurers are in matching their liabilities with assets.” On the other hand: “Critics say that interest rates and other market fluctuations go all over the place and that our standard will lead to unnecessary short-term volatility.” Hoogervorst claims the exposure draft bridges this gap: “our exposure draft will contain a host of proposals to reduce accounting volatility. But we have rejected proposals that reduce volatility in an artificial way.” He doesn’t clarify the principles whereby various methods of reducing the volatility he’s just been defending might be divided into artificial versus real, or whatever the term might be, but he seems to be referring mainly to recognizing certain elements in other comprehensive income, an artificiality if ever there was one, which the IASB endlessly talks about clarifying even as it becomes more helplessly dependent on the concept as a way of extricating itself from various tight spots.

He ends by stressing “that even long-term investors cannot afford to ignore short-term fluctuations, if only because you never know how short the short-term will be.” To bolster his point, he provides the following comparison: “It is estimated that an airplane flying from London to New York will only spend 10% of the time pointing in the right direction. The direction of the plane is not determined by the pilot alone, but also by external factors such as wind speed and direction. The pilot needs to make continuous short-term corrections in order to achieve the long-term goal – to arrive safely in New York. Business is no different.” The metaphorical arrival point is that “Our standards would not be right if they tell the pilot he is flying to New York, while his plane is actually blown off track. Those who care about the long term, should also know where they stand today.”

But actually, if the comparison counts for anything at all, it seems more helpful to the anti- than to the pro-current measurement forces. Stakeholders who use financial statements in monitoring the value of that stake surely aren’t analogous to the pilot, given their lack of power over the “airplane,” but rather to the passengers, if you assume for this purpose the passengers have the ability to parachute on or off the plane during the flight. If it’s preordained that the plane will seldom seem to be pointing in the right direction, then passengers have little to gain by obsessively monitoring those deviations, and no practical alternative other than to trust in the pilot, as long as the journey seems to be proceeding within the usual parameters, and they have ways of regularly verifying that their trust remains well-founded. So much for the power of poetic evocation.

This peculiar grab-bag might have had a bit more point, it seems to me, if it showed any engagement with how financial reporting might be used in the real world. If the IASB was serious about “promoting healthy long-term investing,” then it ought to be asking what healthy long-term investing actually means (assuming the term has any universally applicable meaning at all), and how it actually comes about in the real world. How much do long-term investing decisions depend on assessing individual entities rather than, say, on building balanced portfolios? And to the extent those decisions are taken in individual entities, how much do they actually depend on financial reporting, as opposed to (to name a few) on interest rates, assessments of particular industries, of corporate governance, of relative competitive strength, of long-term strategy, of MD&A; and to the extent they do depend on financial reporting, what’s the nature of that dependence (surely all aspects of what’s contained in financial statements as they’re currently constituted aren’t of equal importance)? It’s futile to claim to promote a particular behaviour without being able to articulate what that behaviour consists of, and to communicate its relative merits over other kind of behaviour, and to understand what’s empirically relevant to shaping it and what isn’t. That would be a worthy objective for the IASB, but put it this way – if the goal of promoting healthy long-term investing lives in New York, then as far as one can tell from his public statements, Captain Hans might as well be flying to Zimbabwe.

The opinions expressed are solely those of the author

Posted in Fair Value, IFRS | Leave a comment

Site restoration costs and inventories – a visit to my nostalgia file!

Posted on April 29, 2013 by admin

by John Hughes

Here’s a description from Tembec Inc. of a difference between IFRS and old Canadian GAAP:

Sad to say, we’ve nearly seen all of these disclosures that we’re ever going to, given that almost all currently-public Canadian entities have moved by now out of the reconciliation phase of their transitions, and are just living free and clear in the IFRS world: all that remains, unless I’m overlooking something, might be a handful of chronically late filers. So I thought I’d take this last-gasp opportunity to write about this item, one that for me almost has an air of nostalgia about it: it takes me back four years or more to when I was first getting my head around IFRS. Maybe it’s just the company I kept, but it’s a topic that used to come up a lot at that time, although I hadn’t thought about it much recently.

As Tembec describes, IAS 16 specifies that the cost of an item of property, plant or equipment includes “the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when an item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.” The basis for conclusions for the standard clarifies the intention: “An entity applies IAS 2 Inventories to the costs of these obligations that are incurred as a consequence of having used the item during a particular period to produce inventories during that period (because) accounting for these costs initially in accordance with IAS 2 acknowledges their nature.”

Old Canadian GAAP had the same basic concept of recognizing a liability for an asset retirement cost by increasing the related asset’s carrying amount, but didn’t make any link between this and the requirements for measuring inventory costs. It’s a perfectly logical link -  inventory costs encompass “all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition,” and if the act of bringing a batch of inventories to their present location and condition causes (say) incrementally more environmental disturbance, and therefore contributes to the clean-up bill that’ll ultimately be incurred, then that’s just as much a cost of that inventory as anything else, even if more difficult to measure. Some entities might have analyzed it that way for themselves under Canadian GAAP, and allocated a portion of any decommissioning obligation to inventory in the same way they allocated depreciation expense arising from the assets used in production. But there was certainly no consensus on having to do that.

So that’s what Tembec describes, although it looks like they’re highlighting it for completeness more than its materiality in their circumstances. Actually, on several occasions when I recall this item coming up in the early days of IFRS conversion, it wasn’t so much for the item itself as for what it illustrated about the challenges we were all heading into. One might have imagined that the place to look for complete guidance on what constitutes inventory cost would be the relevant section, IAS 2. However, as I mentioned, this particular issue isn’t addressed in IAS 2, but rather in IAS 16 – and the greatest clarity on it doesn’t even come in the body of IAS 16, but rather in the basis for conclusions (which wouldn’t be visible, for instance, if one were reviewing the information provided as a first instance to all members on Knotia.ca). This served as a convenient indication then of some of the practical differences that might arise in researching matters under IFRS, and I used it as such myself in various speeches and suchlike.

This broad problem still comes up fairly often – people sometimes ask me how I knew where to find the answer for a particular matter, after they’d failed to find it themselves. Sometimes, as just noted, they didn’t realize their search excluded many of the accompanying documents. Sometimes, it’s a matter of terminology – to take the same example, someone conducting an electronic search only for “retirement obligation” wouldn’t locate the passage I cited above. Obviously, for all of us, if you pound away at this stuff for long enough, it eventually starts to take hold a bit more effectively. Often though, I find an answer by consulting one of the publications by the big four firms: sometimes because the indexing and organization helps in getting to the right place, sometimes because one publication or another will shine a light on something that isn’t actually addressed in IFRS in so many words. So although it may not always help bolster my own standing as a fount of IFRS knowledge, sometimes when people ask how I found an answer, I just admit I looked in (to cite my own favourite) the E&Y book. Maybe in an ideal world we wouldn’t need these publications to facilitate our own research, but in the world as we find it, many of us are glad they exist…

The opinions expressed are solely those of the author

Posted in IFRS, Inventories, Provisions | Leave a comment

Reducing disclosure, or a cure that’s worse than the disease?

Posted on April 23, 2013 by admin

by John Hughes

Writing recently on the PWC IFRS blog, the firm’s global chief accountant John Hitchins starts off as follows: “There’s a remarkable consensus in the IFRS world that we have a problem with disclosure. There’s a problem with the problem, though, as was very evident from the IASB Disclosure Forum at the end of January: there is no consensus on what the problem is.” He briefly sums up the landscape, and observes the widespread if vaguely developed view that we “should all be braver in applying the materiality concept to disclosures” before going on as follows:

  • I believe the debate needs to be expanded to consider more radical ideas. There has been much talk about establishing a single principle for disclosure but, so far, there has been little research into what that principle might be. Two ideas that come to mind are:
    • to disclose information that has direct predictive value for cash flows; or
    • to disclose information that allows users to have an in-depth understanding of the quality of assets and claims and the expected timing of payments and the ultimate amount of liabilities.
  • Applying either would probably eliminate some disclosures, but equally it could highlight the need to expand other disclosures or introduce new ones. There’s no guarantee that the amount of disclosure would reduce, but at least following a principle should help to present a more coherent set of information rather than a compliance checklist of data.
  • ….I suggested that we establish a principle that every piece of disclosure be accompanied by an explanation of its significance to the business. This could have two benefits: first, where that significance is difficult to find, it could embolden us to leave the disclosure out as not material, thus getting rid of clutter; and, secondly, additional explanation would help the reader to navigate the financial statements – the “story” behind the financial statements would be clearer.

I find this a rather intriguing train of thinking, not so much for the specific ideas, but for what they suggest about Hitchins’ (and I suppose PWC’s) underlying views about financial statements. Putting his ideas into practice, we might (for instance) identify all the disclosures relating to calculating stock option expense as an example of items that could be removed – what they communicate doesn’t have any direct predictive value for cash flows, and doesn’t have any information content about collecting on assets or settling liabilities. And indeed, I doubt anyone much would miss those disclosures. But of course, there is a reason why they’re there – to shine a light on a calculation that can fundamentally change the bottom line of the income statement. If those disclosures disappeared, it would implicitly communicate that no one really needs to care how those amounts are calculated, or needs to know more about them. But that could only be because no one cares about the amounts at all, because they’re not relevant to anyone’s assessment of an entity’s performance or prospects. Which takes us, as so many conversations do, to the behavioural reality by which most users place most (if not all) of their emphasis on cash flow or other adjusted measures, excluding the impact of many of IFRS’ more abstract concepts.

My point here isn’t to argue that users are right or wrong in how they use financial statements, but to observe that PWC seems to have little passion in pretending they do so in a way consistent with standard setters’ notional beliefs, or higher aspirations, or however you’d express it. In this light, you might say the real “problem with the problem” isn’t so much the volume of disclosure in itself, as the fact that no one cares about the underlying mechanism on which the disclosure is built. But should we just give in to that? Of course, there used to be a time when financial statements (and for that matter the underlying accounting standards) were very minimal, and a user for the most part had no practical choice other than to accept them on faith. I suppose it worked well enough at the time…but that time isn’t coming back: that was before the explosion in stock market activity and our collective reliance on it; before leaps in technology, in modern  notions of transparency and so on. It’s contrary to the spirit of the age to say we’ll keep on putting the same numbers together, and yet provide less information on them.

The real problem with the problem might be that all of those advances I mentioned haven’t touched the structure of financial reporting, which still follows the same old-time linear format, compelling the semi-interested reader to choose between cracking open (or the electronic equivalent of cracking open) the full document, or else making do with nothing (aside from whatever else companies’ own analyses of investor needs might lead them to provide, earnings releases being the main example). I don’t doubt at all that disclosure overload is a real problem for many users, but the modern world provides plenty of ways to deal with overloads – filters, sieves, channels. Sure, you can always deal with a limp by amputating the leg, but that’s generally been viewed as a cure that’s worse than the disease…

The opinions expressed are solely those of the author

Posted in Disclosure, IFRS | Leave a comment

Disclosing contingent assets – a major crime?

Posted on April 17, 2013 by admin

by John Hughes

Here’s a disclosure to think about:

The amount that the company hopes to recover is, I think, a contingent asset – a “possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.” I assume that’s the case because it doesn’t seem to be entirely within the company’s control whether or not it’s successful in recovering any or all of the stolen amount. But then the question arises: is this disclosure – even of the broad fact that the company might recognize a recovery in a future period – actually in accordance with IFRS? IAS 37.89 says: “Where an inflow of economic benefits is probable, an entity shall disclose a brief description of the nature of the contingent assets at the end of the reporting period, and, where practicable, an estimate of their financial effect…” The standard doesn’t explicitly prohibit disclosing contingent assets not reaching that threshold, but at least one of the big firms takes the view in its literature that this is what’s intended, presumably on the basis that any possible benefit to investors of knowing about the situation would be outweighed by the risk of them placing too much weight on it (old Canadian GAAP was more specific on this point, saying “it would not be appropriate to disclose the existence of a contingent gain that is unlikely to be realized”).

If we assume for the sake of argument that’s what IAS 37 intends, then in this case (which of course I’m just using as a springboard to muse about the requirement in general – I don’t know anything about these specific facts), it doesn’t seem the existence of the contingent asset is necessarily probable. The company doesn’t say that it is, and based on the little information provided, it doesn’t sound like the outcome of the process can easily be anticipated. It seems to follow then that this disclosure might not be consistent with IAS 37.

I think most people would say this feels a bit different, because the company is just trying to get back what it originally owned. But the disclosure requirements for contingent assets don’t change based on how the issue arose – they’re based on where things stand now. And whether an entity is trying to remedy a black-and-white theft or launching a Quixotic legal action to seize something it never had in the first place, it comes down to the same thing – is the likelihood of obtaining that asset sufficient to justify talking about it? If not, then IFRS requires remaining quiet.

(It’s possible on transition from old Canadian GAAP to IFRS that companies might have found themselves needing to remove something they’d previously disclosed in this area. CICA 3290 said the existence of a contingent gain should be disclosed “when it is likely that a future event will confirm that an asset had been acquired or a liability reduced at the date of the financial statements.” The IFRS threshold of “probable” might be interpreted as being a bit more restrictive than the old threshold of “likely,” in which case items falling in the gap wouldn’t meet the criterion any more. But of course, even if an ongoing situation which used to be disclosed was now eliminated from the statements because of this distinction, the information would remain out there, just as a jury can’t un-hear something it’s already heard, regardless that the judge struck it from the testimony.)

You might say the contingency wouldn’t be adequately described without highlighting these recovery attempts. But there’s another issue, that it doesn’t seem appropriately labeled as a contingency in the first place. The lost money doesn’t represent a possible obligation, or a present obligation that can’t be recognized for the reasons set out in IAS 37 – it’s just a loss, that nothing could justify not recognizing. It doesn’t even seem like a provision, a liability of uncertain timing or amount, because there’s no liability (so IAS 37.85, which says that for each class of provision, disclosure should include “the amount of any expected reimbursement,” isn’t relevant either).

By now you’re probably thinking this whole article is a ridiculous example of taking a sledgehammer to a nut. And indeed it is. It’s not plausible to think this disclosure could possibly have any harmful effect on anyone – what investor would rush to buy the company’s stock based on the vague prospect of its recovery action turning out well? Which to me raises the broader question of whether disclosing a contingent asset not meeting the probability threshold could ever be harmful. I mean, the world in general is full of such “disclosures” – what are those egregious lottery ticket commercials (“Imagine the freedom!”) if not an invitation to muse on the wonderful prospects of monstrously remote contingent assets? And, no question, some people are swayed by such advertising. But it’s contrary to securities law to issue misleading disclosure, regardless of the requirements of IFRS. Disclosing some remotely attainable asset, if it’s sufficiently clear what’s going on, may not ultimately be of much utility, but it’s not necessarily misleading, no more so than whatever the company has to say about its far-off hopes and dreams in other areas of life.

The opinions expressed are solely those of the author

Posted in Contingent assets, IFRS | Leave a comment

The big one: the IASB’s exposure draft on expected credit losses

Posted on April 11, 2013 by admin

by John Hughes

The IASB has issued its long-awaited exposure draft Financial instruments: Expected Credit Losses, open for comment until July 5, 2013. The headline proposal, as has been hotly debated for years now, is to move away from the current model, where an entity recognizes impairment losses on financial assets measured at amortized cost only after identifying a specific “loss event” constituting objective evidence of impairment. Under the proposed new approach, the entity would recognize expected credit losses regardless of whether a specific loss event has taken place, using current estimates of expected shortfalls in cash flows based on past experience, current conditions, and on other “relevant information that is available without undue cost or effort.”

The battlelines on the project are already well-known. The IASB builds the exposure draft on the premise that “delayed recognition of credit losses that are associated with loans and other financial instruments was identified during the financial crisis as a weakness in existing accounting standards.” On the other hand, as reported for example in the Britsh Daily Telegraph: “..critics argue that the changes will do little to improve transparency and will lead to a huge increase in disclosures as well as more volatility in banks’ results. Nigel Sleigh-Johnson, head of financial reporting at the Institute of Chartered Accountants for England Wales, said there was ‘little evidence’ that accounting rules played a ‘signifcant role’ in the financial crisis. ‘It is important to be realistic; this is not going to be a panacea. There are potential pitfalls linked to any model, including expected loss models; the proposals could, for example, increase the potential for profit smoothing,’ he said.”

I don’t feel remotely qualified to comment on the relative costs and benefits of this particular project (in the same article, an Ernst & Young specialist characterizes the proposals as “the single biggest change in accounting the banks have ever had to deal with”). Just on their own terms though, they openly represent a compromise, which you might view either as a Solomonic balancing of concepts and practicalities, or else as the kind of subjective bargaining that can’t possibly yield a stable end result.

In particular, the proposals distinguish between instruments that have and haven’t deteriorated significantly in credit quality since inception. Assuming it has low credit risk at the reporting date, an instrument without such deterioration is treated by recognizing an estimate only for “12-month expected credit losses” (the lifetime cash shortfalls that will result if a default occurs in the twelve months after the reporting date, weighted by the probability of that default occurring), rather than for credit losses expected over its lifetime. Once the instrument exhibits such deterioration, but assuming there’s still no objective evidence of an actual loss event, then the estimate expands to encompass expected lifetime losses. In each of these cases though, interest revenue continues to be calculated on the asset’s gross carrying amount (that is, without being reduced for the estimates of losses). After the instrument becomes subject to objective evidence of impairment, then the entity switches to recognizing interest revenue on the net carrying amount. The IASB has provided the following representation of how credit losses would flow into the financial statements under this model:

IASB

As illustrated, this differs from the way the IASB came at it in its 2009 Exposure Draft, which proposed adjusting the effective interest rate from the outset for initial expectations of lifetime credit losses, so that the carrying amount of a financial asset measured at amortized cost would always equal the present value of the expected future cash flows, discounted at the credit-adjusted effective interest rate.” The IASB doesn’t really seem to have moved away from this original vision, but it’s been persuaded about the extent of the “operational challenges” it represented. As it now puts it, the new approach: “would achieve an appropriate balance between the benefits of a faithful representation of expected credit losses and the operational costs and complexity. The IASB acknowledges that this is an operational simplification, and that there is no conceptual justification for the 12-month time horizon.” In fact, it even acknowledges that the new proposal “would result in an overstatement of expected credit losses for financial instruments, and a resulting understatement of the value of any related financial asset, both at and immediately after initial recognition of those financial instruments.”  On this basis, IASB member Stephen Cooper voted against the exposure draft, unwilling to sign on to something that seems out of step with the IASB’s own conceptual framework, and in any event believing the 2009 proposals wouldn’t actually have created significantly more operational challenges than the new proposals.

Well, there’s no doubt the perfect is the enemy of the good, and while it’s obvious the new proposals aren’t perfect, it’s harder to assess what net benefit they might represent. Given the disagreement cited above on the real-world impact of financial reporting in this area, maybe we’ll never know that. I just wish it felt more like an approach that would stand the test of time…

The opinions expressed are solely those of the author

Posted in Financial Instruments, IFRS, Impairment | Leave a comment

Related party transactions – what does IFRS require again?

Posted on April 5, 2013 by admin

by John Hughes

Here’s a disclosure from Q Investments Ltd.:

I’ve written about this area before, but it strikes me as interesting enough to return to once in a while. To recap briefly, the core principle of old CICA 3840 was to measure related party transactions at the carrying amount, with two exceptions. One of these covered transactions in the normal course of operations, which were measured at the exchange amount (the agreed-to consideration) if they had commercial substance – this covered legal fees provided by directors and suchlike. The second exception covered transactions not in the normal course of operations (such as a transfer of intellectual property). These were also measured at exchange amount if the change in the ownership interests of the item transferred or benefit of the service provided was substantive (usually meaning at least a 20% change in the ownership interests) and the exchange amount was supported by “independent evidence”. This independent evidence might come from independent appraisals, comparable recently quoted market prices, comparable independent bids on the same transaction, or comparable amounts of similar transactions actually undertaken with unrelated parties. If those two conditions weren’t met (and it was somewhat in the company’s power, perhaps, to determine whether it had adequate “independent evidence” or not) then these non-normal course transactions were measured at their previous carrying amount in the financial statements of the entity they came from, with any difference between that and the amount exchanged going to equity, as Q describes. But since IFRS doesn’t address such non-normal course exchanges, most people conclude you should measure them using the same principles you’d apply to any other transactions.

Q’s disclosure says “all related party transactions are required to be recorded at (their) fair value,” but I’m not sure IFRS says that specifically. For example, a company might receive management services from a party with a related party connection, but when it records the amount it paid for those services, it’s not clear it has to ensure that the amount paid represents the exact price that would have been paid in an orderly transaction between unrelated market participants. Indeed, the whole point of IAS 24 Related Party Disclosures is that they might not have been – that standard’s stated objective is to “draw attention to the possibility that (an entity’s) financial position and profit or loss may have been affected by the existence of related parties” and it provides as an example: “an entity that sells goods to its parent at cost might not sell on those terms to another customer. Also, transactions between related parties may not be made at the same amounts as between unrelated parties.” But nothing in IAS 24 or elsewhere seems to require dealing with these matters by adjusting the amounts of the transactions (by the same token, there might be plenty of reasons why transactions between unrelated parties aren’t always at their fair value either, although that only points to the ongoing difficulty of identifying what the term even means in an environment of wheeling and dealing).

Most people would perceive a difference though between such day to day situations and the kind of major one-off transaction Q describes, where the technical requirements of the old Canadian GAAP standard meant recognizing nothing at all in profit or loss, and probably only served in many cases to make a major economic negotiation less clear than it should have been. In this kind of case, it seems clear IFRS would require a more conventional accounting treatment, even if everyone might not express that precisely in terms of being recognized at fair value (see for instance the example I wrote about last time).

Here’s something else to think about. When a transaction clearly encompasses providing or obtaining some benefit to or from a related party, the most obvious way of dealing with that seems to be (as under old Canadian GAAP) to recognize that amount of benefit in equity, analogous to making a distribution or to receiving a contribution into surplus. This clearly seems to be the correct treatment for amounts “resulting from transactions with owners in their capacity as owners,” as IAS 1 puts it. But all related parties don’t fall into that category – for example, those resulting from a transaction between an entity and an individual who’s a member of its key management personnel (but not a shareholder) can’t be regarded as a transaction with an owner. If the fair value of such a transaction were different than the amount that actually changed hands, you might argue the difference should be recognized in profit or loss, but separately from the transaction itself, as you would a windfall gain, or a loss due to an act of God. In other words, because all related party relationships aren’t created equal, maybe the accounting treatment isn’t always equal either…

I wrote last time that “it wouldn’t be a surprise going forward if IFRS occasionally caused preparers or auditors to think more rigorously about the appropriateness of the ‘exchange amount’ than they did under Canadian GAAP,” and that seems to be correct. But until the IASB addresses this subject head-on – which doesn’t seem imminent – I think there’s still going to be some variation in when that more rigorous thinking takes place, and in where it leads people.

The opinions expressed are solely those of the author

Posted in IFRS, Related Party Disclosures | Leave a comment

BAM! A massacre! – Some Easter IFRS tweets

Posted on March 30, 2013 by admin

by John Hughes

It’s time again to put on my public service hat and, as an Easter treat, to unveil another selection of real-life tweets that made mention of IFRS in one way or another, presented here in their original form – typos, oddities, possible tastelessness and all. You know, some people consider these twitter compilations to be my crowning achievement, and maybe that’s right – I guess it’s not for me to judge. Let’s start this time with some photos, IFRS-related photographs being a much underappreciated genre:

Here’s a fine artistic composition. Note the immaculate appearance of the IFRS manual, the blankness of the page, and the horrible-looking coffee http://instagram.com/p/QSTnaCRZoR/

Here’s a licence plate to aspire to https://twitter.com/KabeloPule/status/291227135677448193/photo/1

And here’s a cute kid sitting in a big chair behind an IFRS book (“Starting young”) https://twitter.com/UJAccountancy/status/253403834322415616/photo/1

And now on to our main program:

“Facilitator: Do you love IFRS? .,. ” and there is silence,..haha

two disadvatages of IFRS? I have it can be costly, I can’t think of anything else??

*logs off and opens IFRS standard so that he won’t ever have to worry about bail money*

That awesome feeling of being able to indulge in a novel other than IFRS for once :D

If she doesn’t know what IFRS is, she’s too young for you bro :) #auditors” Hahahahahaha!!

If you understand IFRS9 then you have clearly not read it right!

I need to evaluate what about me isn’t attracting sappy love songs. Maybe I would be married and not struggling through IFRS

I can’t really believe in a book that doesn’t update with the change in times. That’s why IFRS is my bible.

He has to be the most uncharismatic speaker I’ve ever seen. Save maybe for the bloke explaining IFRS 6 yrs ago in Sydney

My mom is retarded. She reads a book finish and then complains she has nothing to read?!? Almost handed her my IFRS.(0_o)

You know you’re at the bottom end of the hierarchy of your department if you’re the one that gets stuck lecturing IFRS 8

I have an old blood stain in my textbook from a June paper cut. Its like “IFRS 5 measurement provisions” and then BAM! A massacre!

Hahaha!!! Two auditors being married: atleast their children will be IFRS compliant from a very young age. The things I have to deal with…

#IFRS should allow depreciating people as some have really reached to Zero value ! Auditors, can we work on it?

Is it just me or is reading about the ‘Arab Spring’ a lot more interesting than revising Consolidation in IFRS?

Accountancy used to be common sense & real world logic. Then came IFRS & now it is all cloud cuckoo designed by people smoking something

IFRS and GAAP can go suck a fatty. I should be getting shwasty faced right now but i’m not because of this damn exam

“Oh awesome, IFRS 38″ – said no accountant ever.

IFRS comes up with fancy names for Financial Statements every year yet Companies still call them Balance Sheets, P/L statements…

so next to me is the SAICA handbook the IFRS guide. and then on my laptop an episode of gossip girl… not hard to figure what won

5% of the time I forget that I’m an accountant and then I spend 7 hours on an IFRS update and it all comes rushing back *shudders*

I like the ladies that work at my woolworths… People are just hating:… Stop reading the news and read your ifrs

It has very high nutritional value lol RT @Nchaupe: I feel like having an IFRS statement for lunch!!

Anyone in need of a trophy wife? I am done finding a comfy spot on my bed then realising I grabbed the wrong IFRS

IFRS was not designed for Twitter. I’ll need 4 tweets just to quote the latest gobbledegook … IFRS 11 unsurprisingly …Am done looking for an IFRS tutor! I’m reading ds thing on my own. It can’t be greek can it?

The plan was to read IFRS 3 in the plane BUT the lady sitting next to me had a baby AND it was her first time flying (>_<)

Colouring inside the line vs Accounting in line with IFRS -___- I wanna go back to pre-school

B-school Donna answering a question on whether or not to act under IFRS: “You don’t do nuthin.” Great analysis Donna.

IFRS training tomorrow and I’m still watching Bad Teacher in HBO. #imsodead

IFRS 7 looks like it was written in hurry at 2 in the morning. Not the stiff-upper-lip english one would expect from the IASB.

All I need in this life of sin is me and my IFRS, me and my IFRS.

IFRS = Incentive For Retiring Soon. Only accountants will get that.

And this is me. That’s it for this time – after all, I too should be getting shwasty faced right now. Have a great weekend!

The opinions expressed are, on this occasion, seldom those of the author

Posted in IFRS, Social media | Leave a comment

Classifying liabilities – some potential fuzziness?

Posted on March 24, 2013 by admin

by John Hughes

The CICA’s IFRS Discussion group recently discussed an interesting issue, set out as follows:

  • An entity may raise funds through a public offering. In the offering document the entity discloses that it expects to use the proceeds from the offering to settle a long-term debt obligation. The long-term debt is not part of the working capital used in the entity’s normal operating cycle and is not otherwise due within twelve months of the reporting date.
  • As the long-term debt is now expected to be settled within twelve months, does paragraph 69(a) of IAS 1 Presentation of Financial Statements require the entity to reclassify the debt as a current liability…or continue classifying the debt as a long-term liability…?

The question comes up because IAS 1.69 says an entity classifies a liability as current when, among other things, it expects to settle the liability in its normal operating cycle (assumed to be twelve months, unless clearly identifiable as something else). The use of “expects” suggests the classification might sometimes be driven by an issuer’s intention, especially perhaps if it’s an intention that’s been publicly expressed. On the other hand, the subsequent paragraphs in IAS 1 seem to indicate that this criterion intends to focus on obtaining a clear picture of working capital, by ensuring that even if (say) a trade payable is due to be settled after more than twelve months after the end of the reporting period, it’s still classified as current if the normal operating cycle is also more than twelve months. IAS 1.71 says specifically: “Financial liabilities that provide financing on a long-term basis (i.e. are not part of the working capital used in the entity’s normal operating cycle) and are not due for settlement within twelve months after the reporting period are non-current liabilities..” (assuming no covenant breaches or suchlike).

Most members of the group put more weight on that second approach, although others said they could accept either view, depending on the facts and circumstances. Some members aptly noted that classifying such a debt as current “may create illogical consequences and result in inappropriate financial reporting outcomes…(such as to) trigger a covenant violation, and this outcome would likely be illogical because the entity is presumably becoming better off rather than worse off.”

Other group members thought it might be difficult to support not classifying the debt as current in some circumstances: “For example, when the financing deal is complete or virtually complete at the reporting date and a few days after the end of the reporting period the entity receives the proceeds and repays the liability.” But as others pointed out, if a liability has become repayable on demand because of a covenant breach, then it’s classified as current even if the lender, after the end of the period, has waived the right to demand payment. If we don’t look to subsequent events to prevent a liability from being classified as current, why would we look to them to force a liability into such classification?

Some pointed out that US GAAP contains an additional clarification which would help here: “The current liability classification is not intended to include debts to be liquidated by funds that have been accumulated in accounts of a type not properly classified as current assets, or long-term obligations incurred to provide increased amounts of working capital for long periods.” This really goes to the key point, that the value of segregating current and non-current assets and liabilities is to communicate something useful (and perhaps even decision-critical) about liquidity and stability. The fact pattern considered by the group, since it relates to an offering after the end of the reporting period, doesn’t provide any information content about the financial position as it existed at that date (except, as noted, that it’s getting better). If one draws on just a piece of that fact pattern, to affect the classification of the obligations to be paid out from the offering proceeds, you can easily argue it only results in a less relevant portrayal of the financial position, and that maybe the notes to the statements should include accompanying pro forma disclosure, to provide a complete picture of how things look after receiving the proceeds. But of course, if financial statements went down that road, there might be all kinds of subsequent events that could be illustrated in a similar way. Better not to open the whole thing up in the first place.

I’d have little difficulty then in signing onto the  group’s second approach, to leave the liability classified as non-current – I think the principles of IAS 1 are clear enough, even if the words are a little fuzzy in part. But then, as people like to point out, if you worry about every little bit of potential fuzziness in the principles, you end up with a big set of rules. Anyway, the group recommended that the AcSB bring this issue to the attention of the IFRS Interpretations Committee, so maybe we’ll see some tweaks to this aspect of IAS 1 in the future.

The opinions expressed are solely those of the author

Posted in Current/non-current classification, IFRS | Leave a comment