Extractive industries – what to expect?

Posted on March 17, 2012 by admin

by John Hughes

Chinook Energy Inc. provides an example of an item you find in many IFRS reconciliations of Canadian entities:

The choice allowed by IFRS 6 in this area is well-known to those working with entities in the extractive industries: I wrote a bit about it here. Like Chinook, many Canadian entities used the transition to IFRS to move (in oil and gas terminology) from a “full cost” to a “successful” efforts basis of accounting, or more broadly to a policy of expensing exploration and evaluation expenses they previously capitalized (I only saw one company move in the opposite direction, to start capitalizing costs they previously expensed, but I expect there are others – they’re a distinct minority though). Different entities would no doubt explain the motivation for this in different ways, but one common explanation would perhaps be that the accumulated asset balances just weren’t very relevant to assessing the ultimate value of the economic opportunity, serving mainly to clutter up the balance sheet. Others might argue a policy of capitalizing virtually everything as incurred doesn’t really lend itself to the best internal practice: expensing early-stage costs may provide a better focus on monitoring and controlling them.

Although IFRS 6 inherently promotes inconsistency, I don’t know if it’s a significant impediment to decision-making in practice. Still, the IASB never meant this as a permanent approach – it based IFRS 6 on a “temporary exemption” from the usual requirements of IAS 8. The April 2010 Extractive Industries discussion paper proposed removing this exemption and imposing a single approach in this area – the approach of capitalizing all exploration and evaluation costs. It says: “The information gained from these activities generates a better understanding of whether a minerals or oil and gas deposit exists and, if so, the characteristics of that deposit and the prospects for economically extracting minerals or oil and gas from the deposit. Over time, exploration and evaluation will provide more information, thereby reducing geological and economic uncertainty. Information that is generated during development and production will reduce this uncertainty further. Thus, the information attribute of the legal rights asset will continue to be modified.” The paper takes the view that this “information” satisfies the asset recognition criteria (although I’m not sure it really explains why), and acknowledges “Recognizing information as part of the minerals or oil and gas property— particularly during the exploration and evaluation phases—would lead to a change in existing accounting policies for many minerals entities that recognize all exploration costs as expenses when incurred and for those oil and gas entities that use successful efforts accounting.”

Such a change would be especially irritating, one imagines, for Canadian companies that only recently moved in the opposite direction to adopt their current policy. Still, there’s no particular reason to start anticipating this change. The project is currently “paused,” and it’s hard to predict whether or when the IASB might pick it up again. Even if they do, there’s no reason to think the project would come to the same conclusion as the discussion paper. The staff summary of responses to the discussion paper says this: “a significant majority disagreed with the project team’s view that the subsequent exploration and evaluation activities undertaken would always represent an enhancement of the property (at least at the time that information is obtained).” Many of the respondents “suggested that the project team’s analysis of the treatment of those exploration and evaluation activities was inconsistent with the asset recognition criteria in the Framework because the information obtained may not have any probable future economic benefit.”

It’s rather amusing that the discussion paper consistently refers to the cost of exploration and evaluation activities as “information” – given how little relevance those costs have to the prospects for future success, you might as well label them “misinformation.” Of course, a rational investment decision – particularly for early-stage entities – should be unaffected by whether the costs are capitalized or not. But that being the case, I’d agree with commentators who argued the discussion paper “does not adequately make the case for changing existing accounting policies that are being consistently applied and that are well understood by user of financial statements.” I suspect the IASB will agree with that too.

The Discussion Paper, by the way, is over 180 pages long (I’m not claiming I’ve read all, or even most of those pages), so there’s obviously much more to it than the one item I’ve focused on. For example, it also proposed disclosing information on proved reserves and on proved and probable reserves within the notes to the financial statements. Unsurprisingly, many users and consultants argued that “auditing reserve disclosures would impose a significant cost, be time intensive and would divert geological and engineering expertise away from business functions and towards compliance functions. Furthermore, most users consulted by the project team agreed that the costs of auditing reserves disclosure would outweigh the benefits they would obtain from that assurance process.” I suspect the IASB will agree with that too. On the whole, despite the Board’s presumed reluctance to let a “temporary” exemption become effectively permanent, it wouldn’t surprise me at all if they decide to write off the exploration costs on this project, and to never proceed to the development stage.

The opinions expressed are solely those of the author.

Posted in Exploration and evaluation costs, IFRS | Leave a comment

Common control combinations – gaps and other issues

Posted on March 11, 2012 by admin

by John Hughes

I’ve spent the last two updates to this blog on items arising from the recent notice issued by the OSC’s Office of the Chief Accountant, OSC Staff Notice 52-720 Office of the Chief Accountant Financial Reporting Bulletin, and I’ll go back to the well one last time. The notice has a section on common control business combinations, noting IFRS doesn’t specifically address these; it describes the following accounting approaches noted in practice by OSC staff: “(i) Book value (carry-over basis) accounting of the assets and liabilities acquired for current and comparative years – the financial statements of both entities are combined together at book value for the current and comparative years to account for the entities as though they had always been combined together as one entity, (ii) Book value (carry-over basis) accounting of the assets and liabilities acquired from the date of acquisition – the financial statements of both entities are combined together at book value only from the date of acquisition without restatement of comparative years; or (iii) Purchase accounting analogous to IFRS 3 on the basis that the acquirer is a separate entity in its own right.”

The OSC’s main concern seems to be that the second and third approach might result in omitting historical information about the acquiree: “Staff are of the view that it is important for investors to have financial information about the acquiree that relates to periods both before and after the common control transaction, without gaps in the periods being presented.” Beyond that, the notice doesn’t comment on circumstances in which those three approaches might or might not be appropriate; however, it encourages issuers and advisors to consult with the staff on the proposed method before they file financial information.

The most frequent scenario in this category is also the simplest – the combining entities share exactly the same economic ownership, and it’s just a matter of the owners moving pieces around. In this case not much of substance has happened, and the OSC’s first approach makes sense, to present the history of the combined entity as the combined history of its predecessors. But it doesn’t necessarily follow that this makes sense for all the other scenarios, because some common control combinations may have significant third party involvement, and real economic substance (unlike IFRS, Canadian GAAP did address some of these scenarios, drawing on the guidance for related party transactions in CICA 3840 to define when fair value measurement might be appropriate).

To use an extreme example that nevertheless illustrates the point, the new IFRS 10 envisages that one entity may control another with less than a majority of voting rights, for example if it’s the largest shareholder and the other interests are dispersed and unorganized. Suppose a parent controls two entities on the basis of 45% holdings, and then combines those entities. Obviously that’s not going to happen without substantive negotiation with the parties who hold the majority of the economic benefits. Whether those other parties are bought out or take an interest in the new combined entity, it’s much harder to say that new entity is accurately represented as a simple addition of its predecessors. And in any event, where the combination involves substantive changes of any kind, it seems problematic to present those as if they happened at an earlier date (the province of pro forma rather than historical financial statements).

That example may raise other interpretation issues. IFRS 3 defines a common control combination, for purposes of excluding such transactions from its scope, as one where all the combining entities “are ultimately controlled by the same party or parties both before and after” the combination. In a situation where control is held by a number of individuals or entities, rather than just one, and the make-up of that group changes in the course of the rearrangement, it might be argued control isn’t actually held by “the same party or parties,” and so the exemption doesn’t apply.

Anyway, the more the combination pushes in this kind of direction, to clearly represent more than a shuffling of the cards, the more you might argue gaps in the historical information don’t matter: the past isn’t necessarily as relevant to understanding future prospects.  It’s not really plausible such gaps would frequently result in denying “complete financial information that is important for the investment decision-making needs of users” – more often, I expect, the “missing” information would merely confirm the (perhaps not very exciting) history depicted in the periods that are presented. I tend to think such prescriptions contain an element of trying to save investors from themselves (if the gaps trouble them that much, then they can put their money elsewhere). Still, this is interesting as a rare area where Canadian regulators are asking for more than IFRS itself requires (just as they required providing the transition date balance sheet on the face of the statements for instance). Will there be others?

The opinions expressed are solely those of the author.

Posted in Common control combinations, IFRS, Securities Regulation | Leave a comment

Disclosures about business combinations – not all equally helpful

Posted on March 5, 2012 by admin

by John Hughes

Let’s return to the recent notice issued by the OSC’s Office of the Chief Accountant,  OSC Staff Notice 52-720 Office of the Chief Accountant Financial Reporting Bulletin. I’ve already written about the section on disclosures of critical judgments and sources of estimation uncertainty; today, some observations about the material on business combinations, which addresses both recognition/measurement and disclosure. On the recognition and measurement front, the Notice refers to a few issues “that had not been fully reflected in financial statements in all instances,” such as “the requirement to remeasure previously-held interests at fair value at the date of acquisition, and recognize the resulting gain/loss.” It’s a bit difficult to know what it’s getting at with the reference to not “fully reflected,” since things like this don’t seem to lend themselves to being partly reflected (the OSC’s refilings and errors list doesn’t appear to cite any issuers having amended their statements because of deficiencies in this area, suggesting the problems observed haven’t been material). Still, it doesn’t really matter – the point is, this area will be scrutinized.

IFRS 3 seems to me to be one standard where the disclosures can get to be a bit excessive, and the Notice talks about some of these items: for example, some issuers overlooked the requirement to disclose “the primary reasons for the business combination.” Maybe that information would be useful in reporting jurisdictions with no MD&A requirements or timely disclosure regimes, where the financial statements might constitute the only communication about a particular acquisition. But in Canada, it’s highly unlikely the reasons for a material business combination wouldn’t have been disclosed elsewhere, long before the statements appear. After all, companies have no rational motive to hide the rationale beneath such major corporate transactions; and if they do want to hide the rationale, then they’ll just make some bland disclosure of the “primary reasons” that doesn’t help anyway. Maybe you’d say it’s useful to have the primary reasons disclosed in the statements to alleviate the need for investors to look at any other disclosure documents, but investors should be encouraged to read statements in the context of other disclosures, not duped into thinking they can profitably do the opposite. So sure, it might be nice if financial statements said a few words about this subject, but if they don’t (for example, because it can’t be done succinctly without over-simplifying things, and the statements are too long already) then it’s truly hard, applying any kind of behavioural logic, to see how that could influence the decisions made by users.

That’s a longer discussion than the item deserves, but it illustrates my broader point, that it seems to me the long list of IFRS 3 disclosure requirements should be assessed in the light of their relative materiality, and confidently omitted if they plainly don’t have any. Another of the OSC’s noted items is the requirement to provide “a qualitative description of the factors that make up the goodwill recognized, such as expected synergies from combining operations of the acquiree and the acquirer, intangible assets that do not qualify for separate recognition or other factors.” Sometimes you do get some interesting disclosures under this heading – I’ll discuss an illustration in a couple of weeks’ time. But it’s also awfully easy just to grab the IASB’s lead and say, like a random example I just looked at, that “the goodwill is attributable to the synergies expected to be achieved from integrating the acquired company into the Company’s existing business,” regardless of whether that’s really true. It’s hard to imagine anyone disclosing that the goodwill number only reflects how easy it is to issue shares compared to paying cash, and that the amount they ended up with on the balance sheet doesn’t at all reflect the way they actually think about the transaction, but wouldn’t that be the most truthful thing to say about it in some cases?

The Notice also cites the requirements to disclose revenue and profit or loss of the acquiree subsequent to the acquisition date, and pro-forma revenue and profit or loss for the combined entity. It’s easier to see how this information might provide a perspective that wouldn’t be obtained from anywhere else. But the perspective could be misleading – for example, the numbers might reflect non-recurring transactions of the acquiree, so that the information generated by complying with IFRS 3 wouldn’t provide a meaningful basis for forming expectations about the acquiree’s future contribution (which presumably is the only point of all this). Of course, this could be addressed in the MD&A or elsewhere, but the point is that the statements, and the OSC Notice, don’t tell you to do that.

No question, business combinations are often hugely material and complex events, with the capacity to change dramatically the investment opportunity represented by the acquirer. But because of that very complexity, a checklist approach to disclosure can obscure as much as it illuminates. The disclosure requirements in IFRS 3 certainly provide a potential springboard to clarity about these transactions, but it remains to be seen how often investors will find themselves substantially better informed about the major strategies, judgments and risks than they would have been in the past.

The opinions expressed are solely those of the author.

Posted in Business combinations, Disclosure, IFRS, Securities Regulation | Leave a comment

Disclosing judgments and uncertainties: cutting away the fat

Posted on February 28, 2012 by admin

by John Hughes

The OSC’s Office of the Chief Accountant has issued OSC Staff Notice 52-720 Office of the Chief Accountant Financial Reporting Bulletin, highlighting various financial reporting areas of interest and “(identifying) topics that we are interested in examining more closely during 2012.” Most (although not all) of the items in the Notice relate to disclosure rather than to recognition and measurement, including a section on the IAS 1 requirement to disclose critical judgments and sources of estimation uncertainty. The Notice observes that this information is often either omitted or else consists of boilerplate, and emphasizes that disclosing immaterial information only obscures the items of real importance: it cites the comment in the Basis of Conclusions to IAS 1 that the disclosures “relate to estimates that require management’s most difficult, subjective or complex judgments (and should therefore) be made in respect of relatively few assets or liabilities (or classes of them).”

It’s a very valid observation. Take this random but highly typical example from an exploration-stage mining company:

This is just a mishmash of observations, incapable of providing any real insight or perspective. Everyone knows calculating depreciation involves some subjective allocation, but when the assets currently being depreciated consist only of vehicles and furniture and equipment, as they do here, it’s highly unlikely this calculation has “a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year.” And although calculating stock-based compensation expense is also a somewhat arbitrary process, it’s hard to see how that fits in here; given that the accounting model for equity-settled awards doesn’t require revisiting the valuations of awards in subsequent periods, and also doesn’t involve recognizing assets and liabilities, it doesn’t seem to hold much risk of a material adjustment to the carrying values in the balance sheet. Giving these items the same prominence as the others only sends the message that the entire paragraph is just a bland legalism rather than a meaningful communication.

A material warrant liability recognized on the balance sheet, and measured at fair value at the end of each reporting period, clearly fits the bill better. But then you hit the OSC’s second problem – simply citing the use of the Black-Scholes model and its inputs (something addressed elsewhere in the statements in any event) doesn’t actually tell an investor how his or her perception of the item should be affected. As the Notice references, IAS 1 actually requires disclosing information about the assumptions, which might include “the sensitivity of carrying amounts to the methods, assumptions and estimates underlying their calculation, including the reasons for the sensitivity.” To make this meaningful for something like a warrant liability, an issuer would likely have to address to some degree how the valuation model actually works, to describe the kinds of events that might affect the key inputs over the coming year, and to provide some quantification of how much the carrying amount might change as a result. No doubt this would seem onerous, but it would get to the core purpose: to alert users about what degree of flexibility or skepticism to apply to particular balance sheet items.

The Notice provides a couple of examples of “improved” disclosure in this area, but even these arguably don’t go far enough (not that the OSC claims the examples are complete). Its illustrative disclosure for decommissioning liabilities ends like this: “If the estimated pre-tax discount rate used in the calculation had been 10% higher than management’s estimate, the carrying amount of the provision would have been $75,000 lower.” But the value and utility of this disclosure would depend entirely on the likelihood that such a change in rate might happen. If there’s little or no chance of the discount rate changing more than incidentally over the coming year, then it’s unhelpful to highlight some arbitrary rate movement that isn’t going to occur. On the other hand, if the rate could change by 20%, then the warning light isn’t flashing strongly enough. The point is that the example should likely address the relevance of that theoretical 10% change in the context of the actual economic environment that applies.

The remaining item in the example above is the balance of exploration and evaluation assets, which of course for an exploration-stage mining company choosing to capitalize those costs, like this one, really embodies the entire company’s ultimate success or failure. Again though, for an enterprise at this stage, the disclosure arguably doesn’t fit very well here. The recoverability of those carrying amounts isn’t a function of inherently subjective assumptions and estimates in the same way as a Black-Scholes calculation; it’s more a function of the real-world management actions and intentions relating to the unrelated properties, something amply highlighted elsewhere in the statements.

The way I see it then, you could take issue with every item cited in that paragraph, in one way or another; the same would apply to many similar disclosures by many other issuers. Others will no doubt see it differently though, and although it’s good the OSC has highlighted this area, I don’t think the Notice contains enough detail to resolve all the potential arguments. But then, no one’s saying it’s their last word on the matter…

The opinions expressed are solely those of the author.

Posted in Disclosure, IFRS, Securities Regulation | Leave a comment

Non-IFRS measures – the Australian approach

Posted on February 22, 2012 by admin

by John Hughes

A recent interesting article from Australia talks about the Australian Securities and Investment Commission’s (ASIC’s) view on “non-IFRS profit information” in financial statements. Here’s the summary:

ASIC says that financial information which is prepared other than in accordance with the accounting standards should not be included in financial statements. It is prepared to make an exception for:

  • information required by law;
  • details of a breach of a lending covenant that is determined by reference to a non-IFRS financial ratio;
  • an explanation of director and executive remuneration that is determined by reference to something other than IFRS profit figures.

Non-IFRS financials can also be included in the notes to the financial statements, but only in what ASIC describes as the “rare circumstances” where the non-IFRS information would be necessary to give a true and fair view of the company’s financial position.

In addition, non-IFRS profit figures may not be included as line items or subtotals in the income statement, or presented in additional columns of financial statements.

I’ve written several times (here for instance) about the Canadian approach to what we call “non-GAAP financial measures,” which has continued to evolve as IFRS takes greater hold. It sounds like this has been a problem area in Australia, with many companies supplementing their IFRS-compliant numbers by providing “underlying profit” numbers, calculated on a variety of bases, and serving in most cases of course to increase profits or to turn a loss into a profit. ASIC will still allow these outside the financial statements it seems, within a disclosure structure similar to that long-required by Canadian regulators.

Insofar as it relates to financial statements, the Australian prohibition seems broader than that in Canada. Our CSA Staff Notice 52-306 defines a non-GAAP financial measure as “a numerical measure of an issuer’s historical or future financial performance, financial position or cash flow, that does not meet one or more of the criteria of an issuer’s GAAP for presentation in financial statements, and that either (i) excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or (ii) includes amounts that are excluded from the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP.” This doesn’t seem to encompass, say, a number computed with reference to a covenant compliance calculation and presented as such in the notes, because that kind of number doesn’t seem to be a measure of financial performance, financial position or cash flow. But as cited above, this would fall within the broader Australian prohibition, absent the specific exemption they provide for it.

Would the Australian approach have any impact if introduced into Canada? For some companies, perhaps. Financial statement notes do occasionally include other numerical information which might trip over the ASIC definition (frankly, I imagine auditors would be happy to see most of this information go, thus removing any pressure on them to audit it). For instance, some companies reporting revenue on a net basis might also disclose a number for “gross” or “system-wide” sales, without actually representing that (or perhaps even knowing whether) this broader number is calculated in compliance with IFRS. In other ways, ASIC’s definition might just open up a bunch of interpretation issues. For example, IFRS 8 requires disclosing segment information on the basis of the measures reported internally, even if these don’t conform with IFRS; any such differences are disclosed and then dealt with in reconciling the total numbers. Presumably because IFRS in this case requires disclosing “non-IFRS” information, disclosing the non-IFRS information is consistent with IFRS. Likewise, an entity might define and monitor its “capital” in a way that reflects, say, economic value added concepts rather than IFRS concepts. Because IAS 1 requires disclosing summary quantitative data about what an entity manages as capital, disclosing such non-IFRS information would presumably again be consistent with IFRS.

ASIC’s third exception, for “an explanation of director and executive remuneration that is determined by reference to something other than IFRS profit figures,” seems to reflect their local statutory requirements rather than those of IFRS. IAS 24 requires disclosing summary information about compensation paid to key management personnel, but doesn’t require explaining them. That job falls into the realm of the information circular, and I imagine accountants and auditors generally try to stay as far away from it as possible.

For better or worse, it seems plain investors don’t always view IFRS profit or loss as the most relevant (or in the worst case, even as a relevant) measure of performance – they also focus heavily on cash flow and EBITDA and various adjusted numbers. It’s futile to argue they shouldn’t do this – I tend to put it in terms of the hopelessness of trying to save people from themselves – but there’s no question that an investor’s desire for greater simplicity can play right into an entity’s desire to distract him or her from various problem areas. You can’t blame regulators for flashing a big amber light over all this, even if it starts seeming a bit neurotic, and even if they know people mostly drive straight through regardless.

The opinions expressed are solely those of the author

Posted in Australia, IFRS, Non-GAAP financial measures | Leave a comment

Operating lease revenue – systematically representative?

Posted on February 16, 2012 by admin

by John Hughes

In August last year I wrote about two of the three separate differences reported by Easyhome Ltd. in the area of revenue recognition, and said I’d return to the other item another day. Then I forgot all about it until now. Here it is:

CICA 3065 required including rental income from an operating lease “in the determination of net income over the lease term on a straight-line basis unless another systematic and rational basis is more representative of the time pattern of the user’s benefit.” It defined the lease term as “the fixed non-cancellable period of the lease,” extended by (among other things) periods covered by bargain purchase options, or by extensions at the lessor’s option, or for which not renewing the lease would impose a sufficiently large penalty to make renewal seemingly assured. In a situation where the lease term was entirely cancellable, this would seem to push companies toward considering what other “systematic and rational basis” would make most sense for recognizing income. But it’s no surprise if the lease term would still have ended up in many cases as the main determinant of the recognition period. Using the lease term would keep things systematic at least; whether it would also be rational and most representative of the time pattern of the user’s benefit would depend on actual cancellation experience.

IAS 17 has a similar basic requirement - to recognize income from operating leases on a straight-line basis over the lease term, unless another systematic basis is more representative (IFRS doesn’t mention the criterion of being “rational” – I suppose that word ought to be redundant in the overall context). One difference: IAS 17 refers to “lease income from operating assets” whereas CICA 3465 referred to “rental revenue from an operating lease.” It’s at least possible that under Canadian GAAP, some might have regarded income characterized as “processing fees” as being different from the core rental revenue from the lease, and subject to a different accounting analysis (although I don’t know how often this would ultimately lead to a different conclusion about the appropriate recognition pattern): that is, the IFRS concept of “lease income” might seem broader and more likely to capture all such increments and add-ons (other than receipts for services provided such as insurance and maintenance, which IAS 17 specifically excludes from the definition). Easyhome’s disclosure doesn’t seem to be emphasizing that point though.

Anyway, IAS 17 defines the lease term as “the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.” This appears to capture a broader range of situations than Canadian GAAP did – for instance, a lessee might be “reasonably certain” of going beyond the lease term just because of the attractiveness of the asset, the lack of reasonable alternatives, and suchlike. Under IFRS this might in theory be sufficient to base the lease term on that longer period; under Canadian GAAP, in the absence of bargain purchases, lessor options or other such identifiable factors, it wouldn’t ever be.

But that difference isn’t relevant to Easyhome, because its leases don’t seem to have any non-cancellable period. As in all cases like this, I’m just using the published disclosure as a springboard to muse out loud: I don’t know of course the specific analysis that drove the company to make this change. But it wouldn’t be surprising if it mainly reflects a sense of IFRS as bringing greater analytical rigour to this kind of estimation process. Using the lease term might be systematic, but if it’s systematically inaccurate, the spirit of IFRS (so to speak) pushes you toward using the best available estimates and then prospectively amending them as necessary. To take a random example from a different standard, IAS 16 has a more active concept of the depreciation calculation than CICA 3061 did, placing a sharper focus on whether the method used reflects the consumption of the asset’s future economic benefits, and on changing the method when that pattern of consumption changes.

So that’s that. Now of course, the IASB’s ongoing leasing project would shake all of this up considerably, with a different approach to lessor accounting and a revised definition of the lease term as well. I’ll return to all of that in the future, no doubt more than once. But I suppose a lot of companies like Easyhome will be hoping the IASB retains its plan of allowing short-term leases an exemption from the proposed model for lessor accounting, so that they continue to recognize lease income over the lease term on a systematic basis. Well, actually, I think a lot of companies are wishing the IASB would just forget about the project altogether, but that’s probably too optimistic…

The opinions expressed are solely those of the author.

Posted in IFRS, Leasing, Revenue | Leave a comment

IFRS 10 – is it a subsidiary, or are they just friends?

Posted on February 10, 2012 by admin

by John Hughes

Over a year ago, I wrote about the role of potential voting rights (embodied within convertible debt, warrants and so forth) in assessing whether one entity controls another, noting the Exposure Draft of the proposed amendments to IAS 27, as it was at the time, would change things considerably. Well, that project’s been finalized now, as IFRS 10, and that’s how things turned out: it’ll certainly generate a different conclusion in some situations where this issue applies. But that’s just one piece of it, because IFRS 10 (effective for annual periods beginning on or after January 1, 2013) is a gift basket of greyness. That’s not a criticism – the core question of whether one entity controls another is no doubt often inherently grey. But it’s not hard to anticipate some practitioners, once they apply the new standard to their marginal situations, pining for some old-time bright lines and arbitrary decision trees.

I’ve already signalled some of the issues here, but I thought it was worth returning to the well at least one more time (you can also access some CICA resources on the new standard here). Here’s a quick overview. An investor controls an investee if and only if these three criteria apply: (a) it has power over the investee; (b) it has exposure, or rights, to variable returns from its involvement with the investee; and (c) it has the ability to use its power over the investee to affect the amount of those returns. The key criterion for most of the potential problems I think (leaving aside problems arising from specifically structuring something to achieve a specific outcome), will be the first – whether an investor has power over an investee. Re the second criterion: an investor may have power over an investee without being exposed to variable returns if, for example, it’s limited to a fixed fee, with the gains or losses flowing elsewhere, a situation presumably most commonly applying for fund managers or similar entities. Re the third criterion: an investor may have power over an investee without being able to use that power to affect its returns if, for example, the investee’s activities and returns are predetermined, changing only if particular circumstances arise; as far as I know, this could only apply to a special purpose entity of some kind.

So on that first criterion, an investor has power over an investee when it has existing rights, giving it the current ability to direct the so-called “relevant activities” that significantly affect the investee’s returns (it may take a while for all of us to get used to the new terminology of “power” and “rights” and “relevant activities”). It won’t often change the existing answer where an investor holds more than half the investee’s voting shares, unless some specific restriction applies or, perhaps, someone else has potential rights they could exercise to snatch the investor’s power away. However, IFRS 10 says an investor with less than a majority of the voting rights in another entity still has sufficient rights to give it power over that entity, when it has the practical ability to direct unilaterally the relevant activities. The more voting rights the investor holds compared to anyone else, and the greater the number of other vote-holders needing to act together to outvote it, the more likely it has that practical ability. This might be supported by looking at voting patterns at past shareholder meetings, or other applicable information.

IFRS 10 goes on: “In some circumstances it may be difficult to determine whether an investor’s rights are sufficient to give it power over an investee. In such cases, to enable the assessment of power to be made, the investor shall consider evidence of whether it has the practical ability to direct the relevant activities unilaterally.” It provides a list of factors to which “consideration is given,” which in combination with other rights and indicators may provide relevant evidence. This includes fairly obvious items such as holding veto power, or the ability to appoint key management. But the list also includes more ambiguous situations, for instance where the investee’s key management personnel, or a majority of members of its board or other governing body, are related parties of the investor. IFRS 10 then provides “indications that the investor has a special relationship with the investee, which suggests that the investor has more than a passive interest in the investee,” and which in turn might tip the conclusion. These indications include situations where “the investee depends on the investor for critical services, technology, supplies or raw materials” or where “a significant portion of the investee’s activities either involve or are conducted on behalf of the investor.” But of course, plenty of unrelated companies have relationships evidencing one or more of these indicators, just as a matter of arm’s length negotiation, commercial necessity, past history and so forth.

The standard does make it clear that in the absence of any other rights, the fact of an investee being economically dependent on an investor doesn’t by itself lead to the investor having power over the investee. But in situations where one entity has a non-controlling equity interest of any magnitude in another, and there’s a lot of operational interactivity between the two, IFRS 10 may require quite a taxing analysis of why things exist as they do. Is it a sign of control, or just business?

The opinions expressed are solely those of the author.

Posted in Consolidation, IFRS | Leave a comment

Quiz time!

Posted on February 4, 2012 by admin

by John Hughes

I was looking at a website “designed to make learning International GAAP a lot easier and cater towards your own learning style.” The author is anonymous, but provides the following background: “When I was studying for my accounting exams I found it quite difficult to study the different International Accounting Standards that are out there. Most notes were too detailed and didn’t lend well to quick glances. I also had nowhere to practice what I had learned once I had studied the information.” The site includes notes, “mind maps” and quizzes on various standards.

It’s a nice-looking website and obviously well-intentioned; I don’t mean in any way to criticize the execution of it. But I took one of the quizzes, and it tended to reinforce my sense that there’s a problem in the premise: IFRS can’t really be made “a lot easier” to learn, and in fact, I’d argue, shouldn’t be. It’s a specialized, nuanced field of practice, necssarily “hard” to learn, at least with any degree of depth, which is the only reason so many people can make good money from it. If that sounds like mere knee-jerk protectionism, I’ll illustrate further. The quiz I took was on IAS 8, Accounting Policies, Change in Accounting Estimates and Errors, consisting of sixteen multiple choice questions. By my assessment, at least six of the answers are…not wrong exactly, but let’s say incomplete. That is to say, the quiz tests an ability to memorize the exact words of the standard rather than to grasp what they actually mean, or ignores potential complexities that could make other answers equally or more valid. It might be helpful in “learning” IAS 8, but not in promoting a vibrant, practical sense of why it matters, or what to do about it in what we accountants amusingly think of as “real life.”

Here’s an example: An accounting policy can be changed only if:

  • a) It results in showing more profit for the entity
  • b) There is a change in the Top Management
  • c) The reporting period is twelve months
  • d) It is required by an IFRS
  • e) None of the above

The designated answer is (d). But this implies accounting policies can only be changed if required by an IFRS, and ignores the broader acceptability of changing an accounting policy if the change results in the financial statements providing reliable and more relevant information. A more technically correct answer would have been (e), indicating that even (d) doesn’t convey a complete sense of the issue.

Here’s another one:  When a change in accounting policy is applied retrospectively then the change shall be:

  • a)      Effected in the income statement of the current reporting period
  • b)      Adjusted in the equity
  • c)      Effected in the income statement of the previous reporting period
  • d)      Disclosed in the notes to the financial statements without making adjustments in the financial statements
  • e)      Any of the above

The designated answer is (b). But that doesn’t completely capture the issue; in fact, you could almost argue (e) would again be better. A retrospectively applied change in accounting policy would typically affect opening equity (b) and the comparative income statement (c). But it also entails that the current income statement differs from what it would have been under the previous policy (a), unless that is the change in policy – although sufficiently material to be disclosed (for instance because of its anticipated impact on future periods) – doesn’t materially affect any of the previously-reported numbers (d).

Another question posits: “a company provides for bad debts at the rate of 2% of the sales of that period. With effect from 2012, it has decided to change it to 3% of sales. The sales for 2011 – $100000 and sales for 2012 – $200000. In the financial statements of the year 2012, which of the following treatments is appropriate.” The designated answer is to apply the change prospectively from 2012, reflecting that a change in the estimate for bad debts is typically a change in accounting estimate. But it seems reductive to leave it there, without acknowledging that not all estimates are created equal. The 2% used in previous years could theoretically reflect an error – an estimate made in willful disregard of the circumstances – or the proposed 3% rate might be intended to create a cookie jar for future periods rather than responding to the economic facts.

Another answer directs that “if an error is noticed in a financial statement, then such error shall be….corrected prospectively from the financial statements authorized for issue after their discovery.” This seems to misapply the meaning of “prospectively,” but also misses an opportunity to flag how the IFRS requirements aren’t the whole story here – a practitioner would also need to consider regulatory requirements, audit implications and so forth. And yet another states that “Accounting policies across various reporting periods…shall not be consistent,” which on the face of it seems incorrect, or at least would require much more explanation of whatever subtle sense in which it might be correct.

Again, it’s not that the website is “bad,” relative to its intended purpose: I’m sure many will find it helpful in studying for their exams. But by its nature, it seems to embody a grim and bothersome gap between the data required to pass exams and the knowledge required to do the job even semi-competently…

The opinions expressed are solely those of the author.

Posted in Accounting policies, IFRS | Leave a comment

Cash-generating units – the start of the conversation

Posted on January 29, 2012 by admin

by John Hughes

Winpak Ltd. is just one of numerous Canadian companies reporting the following kind of adjustment within their transition disclosures:

In applying the IAS 36 concept of cash-generating units, I’ve found it’s easy to become swept up in the technicalities, and to forget the underlying purpose of the exercise. The definition seems plain enough: a cash-generating unit is “the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.” The standard provides a few examples to flesh this out, such as a bus company providing services under a contract with a municipality, under which it’s compelled to maintain five designated routes. Although the assets relating to and cash flows derived from each of the routes can be identified separately, they nevertheless form a single CGU “because the entity does not have the option to curtail any one bus route.” So if one of the routes operates at a significant loss, the entity doesn’t recognize an impairment loss for the assets attaching to that route.

It’s worth mulling over this example a bit. What would be the harm, you might say, of recognizing a loss on that unprofitable route, if by not doing that, some of your assets are recorded at a knowingly irrecoverable amount? Well, in that individual case, it’s hard to say there’d be any harm to it actually. But the example’s clarity rather undermines its usefulness. A more challenging situation would be a factory, encompassing a building and an array of machines and equipment and other assets. Some of those assets plainly don’t generate a cent – the meeting room table for instance, or the window frames, or the roof. But if you took all those away, eliminating the necessary elements of a functioning work space, the assets that do generate the dollars couldn’t function. It’s the equivalent of needing a village to raise a child: if the village works as a whole, you don’t worry about the unproductive contribution of a few individual buildings.

It follows from the bus company example that if the entity did have the option to curtail the loss-making route, then it would recognize the impairment loss on that route. Of course, it’s easy to make up circumstances in which the entity would never exercise that curtailment option, even if it existed. For example, the loss-making route might serve a high-visibility part of town, and curtailing the route might destroy the bus company’s standing with the municipality when the contract came up for renewal. If the other four routes were sufficiently profitable, then maintaining the loss-making route might be a strategic investment, as valuable to the company’s overall direction as the assets specifically attached to the money-making routes. Some Canadian companies have certainly recognized additional impairment losses under IFRS on assets that they looked at in a similar way.

Of course, it would be hard for the standard to make room for such potentially subjective considerations. But there’s always materiality. One of the accounting firm texts says this about retailers: “For the majority of modern multi-site retailers, some level of aggregation of sites is normally appropriate. A larger grouping can be treated as a cash-generating unit or each site can be taken to be a cash-generating unit, though in the latter case a pragmatic view of aggregation may be taken on grounds of materiality…In some circumstances, it may be impractical (or at least costly) to prepare detailed cash flow forecasts for each individual site. Furthermore, forecasts may, to some extent, be based on macro-assumptions about factors that affect larger groupings in a similar way.” Although no doubt intended to be helpful, this seems to me to cloud the issue considerably, by suggesting a generous degree of pragmatism and practicality that preparers (or at least their auditors, including auditors from that same firm) might not be as willing to apply in practice.

It’s certainly an advance, I think, that IFRS reduces the ability to avoid recognizing the consequences of loss-making assets by applying some fuzzy claim about (say) management regarding those assets as belonging with other (profitable, but entirely unrelated) assets within a single operating division. But at the same time that IFRS brings such losses out into the open, it may also force out other write-downs that don’t represent losses at all, within management’s way of looking at things. Of course, many entities choose to focus the attention of their users on key performance indicators that exclude these impairment write-downs (among other things), and they can explain the surrounding circumstances in their MD&A. And the best way to do that is to talk in real-world terms about what the losses actually mean, and what they don’t mean, taking the concept of a CGU as just the starting point for the conversation.

The opinions expressed are solely those of the author.

Posted in IFRS, Impairment | Leave a comment

The SEC’s analysis of IFRS in practice: something for everyone

Posted on January 23, 2012 by admin

by John Hughes

I’ve already made some comments about the SEC’s staff paper, An Analysis of IFRS in Practice, generated after examining the most recent annual financial statements of 183 companies domiciled in 22 countries, and setting out an array of apparent deficiencies, ambiguities and opportunities for improvement. But I think it’s worth returning to the subject one more time. After all, regulators don’t tell us that often how they look at things, and the SEC paper could be used as a kind of supplementary checklist, nudging preparers and auditors to tread particularly carefully in the areas it mentions, if they want to avoid receiving a comment letter on those issues. Of course, Canadian regulators don’t look at things in exactly the same way as the SEC, but presumably there’s enough overlap that the paper is useful for our domestic purposes too (not least, of course, because Canadian regulators have no doubt gone through it in detail and extracted some lessons).

An immediate problem in what I just said though is that it’s the kind of attitude that prioritizes petty compliance over materiality: you might be confident a particular disclosure isn’t material, but because its absence could be questioned by regulators, you make the disclosure anyway, rather than take the chance of having to explain it later. I must admit I succumb to this caution myself all the time. It’s entirely misplaced – why worry if regulators raise a comment, as long as you’re comfortable you have the right response to it? – but I think many people tend to regard any kind of communication from the OSC or others as an implicit adverse judgment, and one they want at all costs to avoid, regardless that it means cluttering up the statements.

The SEC is clearly aware of this problem: “The Staff does not intend to suggest that disclosures in these instances (i.e. the instances where they had unresolved questions about the statements) were necessarily deficient or that the disclosures should have been prepared with the purpose of communicating to a regulator the manner in which a company complies with a set of accounting standards. The Staff recognizes that financial statements are intended to facilitate investor decision-making, and additional information that would have benefited the Staff in this analysis may be of less incremental value to an investor.” It’s an important point, but one potentially overshadowed by the many detailed issues listed. For example, on the subject of inventories,, the report observes: “Some companies did not disclose the amount of reversals of write downs during the period and the circumstances that led to the reversal, as required by IFRS.” This seems like an obvious area in which one ought to be able to assume that an absence of disclosure simply means there’s nothing to say. But since the SEC mentions the issue, it’ll just encourage more companies to ploddingly specify that the amount of reversals of write-downs recognized during period was nil (comparative period – nil). The paper has many things along these lines.

It also muddies the waters in various places by seeming to comment on how disclosures might improve on what IFRS requires. For instance, in the context of property, plant and equipment, it says: “Some companies indicated that costs incurred during a start-up period were capitalized but did not describe the nature of costs capitalized or the time span of the start-up period. Such disclosures could help facilitate investor comparisons of financial statements, as the details of cost capitalization may vary across companies.” Well, I suppose they could, although it’s hard to see how an investment decision could ever turn, even marginally, on such trivia. But regardless, IFRS doesn’t require providing such information, so it seems like an arbitrary observation at best. Even geekier is the complaint that only two companies “provided additional disclosure regarding their application of the initial recognition requirements of IAS 12 to finance leases and the provision for asset closure and restoration costs.” I can see how that would ruin someone’s day…

In a somewhat more relevant vein, the paper makes a number of observations about the use of sub-totals on the income statement (they counted up eighteen different kinds). Here again, these observations don’t all necessarily seem to be getting at deficiencies in how entities applied IFRS, but it’s plainly an area the SEC staff doesn’t like and won’t be able to resist asking questions about (not that we didn’t know this already). Canadian regulators have spent some time on this aspect of things too.

Many of the other issues are long-established weak spots under Canadian GAAP. Over the last decade, I think Canadian regulators may have commented just about annually on the weakness of accounting policy disclosures about revenue, but it never really gets much better. No surprise to see this in the SEC report as well. Anyway, despite any reservations, there’s probably enough material in there to jog every practitioner’s thought processes in some respect at least.

The opinions expressed are solely those of the author

Posted in IFRS, Securities Regulation, United States | Leave a comment