by Joelle Moughanni, Technical Consultant, RSM - taken from RSM Reporting - Issue 29.

This article is of particular interest to preparers and auditors of 2016 financial statements in accordance with IFRS. It highlights some of the most common focus areas that appear to be many regulators’ priorities for 2016 IFRS financial statements. The article aims at identifying 10 financial reporting topics that companies and their auditors should particularly consider when preparing and auditing respectively the IFRS financial statements for the year ended 31 December 2016. Besides these most common priorities, national regulators might set additional enforcement priorities focusing on other relevant topics.

 1. Disclosures on the impact of new Standards

Not surprisingly, disclosures of the impact of the new Standards are one of regulators’ key priorities. In particular, with the effective dates of the new financial instruments, revenue, and leases Standards (IFRS 9, IFRS 15 and IFRS 16 respectively) fast approaching (at the start of 2018 and 2019), regulators expect entities to disclose, in accordance with IAS 8, information about Standards that have been issued but are not yet effective and their potential impacts in the entity’s year-end financial statements. Relevant entity-specific information about the impact of these new Standards should be given and more detailed information about the status or progress of their implementation provided rather than simply stating they are still assessing the impact. As a few aspects of these new Standards represent a significant change to the current ones, they may affect the recognition, measurement and presentation of assets, liabilities, income, expenses and cash flows. Consequently, entities should start preparing for these new Standards now, and some regulators, e.g. the European Securities and Markets Authority (ESMA), have urged entities to push their implementation projects forward.

Some of the specific points to consider for 2016 annual financial statements include the following:

• A detailed description and explanation of how the key concepts included in the new Standards will be implemented and, where relevant, how this differs from the entity’s current accounting policies.
• An explanation of the timeline for implementing the new Standards, and including which transitional provisions the entity expects to use.
• If known or reasonably estimable, a quantification of the possible impact of the new Standards. If the quantitative effect is not reasonably estimable, additional qualitative information to provide an understanding of the magnitude of the expected impact on the financial statements. ƒƒ Disclosures of lease commitments already required under IAS 17 are even more relevant as they may assist users in understanding the impact of IFRS 16.

2. Reporting financial performance

Regulators continuously stress the importance of providing investors with clear and high quality information on financial performance. Entities are expected to present performance transparently and consistently in the primary financial statements, notes and documents accompanying financial statements.

Some of the specific points to consider for 2016 annual financial statements include the following:

• Where non-GAAP measures have been presented in the financial statements or accompanying documents, whether they have been presented in a transparent and unbiased way.
• Compliance with the newly effective amendments to IAS 1 relating to presenting additional line items, headings and subtotals in the statement of financial position and in the statement(s) of profit or loss and other comprehensive income.
• Presentation of segment information ‘through the eyes of management’ in accordance with IFRS 8: segment identification, disclosure of judgements made in aggregating operating segments, reconciliation of total segmental figures to corresponding entity amounts, etc.
• Presentation of items of other comprehensive income (OCI ): distinction between items that may subsequently be reclassified to profit or loss and those that will not, and level of disaggregation of the items to provide relevant information to users.
• Calculation and presentation of earning per share (EP S) and related disclosures in accordance with IAS 33: beware in particular of relatively complex computations (e.g. share options and convertible bonds), and reconciling the weighted average number of shares used to calculate basic and diluted EP S.

3. Distinction between equity instruments and financial liabilities

The distinction between debt and equity has long been one of the most complex aspects of IFRS financial reporting. For the several cases where the debt v/s equity assessment requires significant judgement, entities should focus on the general principle in IAS 32: whether the entity has an unconditional right to avoid delivering cash or another financial asset to settle the contractual obligation. However, depending on the terms of the issued instrument, assessing against this criterion may not be straightforward.

Some of the specific points to consider for 2016 annual financial statements include the following:

• Focus on the general principles in IAS 32 on the distinction between liability and equity
• Consistent application and disclosure of accounting policies
• Transparent disclosure of judgements and characteristics of instruments
• Presentation of additional line items – if material in the statement of financial position or in the statement of OCI – and disaggregation of all related cash flows in the statement of cash flows.

4. Impairment reviews

Impairment is an ongoing area of concern for many entities, and regulators remain focused on it and continue to push for increased transparency in disclosures. Entities holding significant amounts of goodwill and intangibles are at greater risk of a regulatory challenge to their impairment assessments and in particular the related disclosures.

Some of the specific points to consider for 2016 annual financial statements include the following:

• For the value-in-use (VI U) model, key assumptions should stand up against external market data, and cash flow growth assumptions should be comparable with upto- date economic forecasts.
• While IAS 36 requires that the VI U model uses pre-tax cash flows discounted using a pre-tax discount rate, post-tax discount rates and cash flows are often used in practice. If theoretically the end result is the same, the need to consider deferred taxes makes this very complicated to achieve, so that when a post-tax VI U model results in a near miss (1) the entity should then determine fair value less costs of disposal.
• The fair value model must use market participant assumptions (in accordance with IFRS 13), rather than those of management.
• Disclosure of the key assumptions (those that the recoverable amount is most sensitive to) and related sensitivity analysis (as per IAS 36), as well as disclosure of critical accounting judgements and of key sources of estimation uncertainty (as per IAS 1).

5. Fair value measurement and related disclosures

One of the regulators’ recurring areas of interest is entities’ fair value measurement and related disclosures covered by IFRS 13. Some of the specific points to consider for 2016 annual financial statements include the following:

• The use of observable inputs should be maximised and the use of unobservable inputs minimised.
• When available, entities should use quoted prices in an active market without any adjustment (i.e. a Level 1 input).
• Entities should provide relevant information to meet IFRS 13’s objective, including when the fair value is determined by third parties.
• Entities should provide extensive disclosures as required by IFRS 13: description of the valuation techniques applied, any changes in the valuation techniques and reasons, levels of fair value hierarchy, the inputs used for Levels 2 and 3, the sensitivity to changes in unobservable inputs, whether current use differs from highest and best use, etc.

6. Reporting the effects of taxation

Tax may be a complex area, especially for larger, multinational and more complex groups, and reporting of income tax often involves the exercise of significant judgement and estimations. These factors, combined with increased regulatory and media scrutiny of companies’ tax affairs, mean that there is evergrowing demand for transparency in annual reports about a company’s approach to tax, its tax strategy and policies, significant risks arising from tax and the accounting for, and disclosure of, tax. Investors have a heightened interest in wanting to understand the policy decisions made by companies and the impact these have on their current and future accounts. A recent thematic review into tax disclosures by the Financial Reporting Council (FRC), the UK regulator, highlighted that no FTSE 100 company reviewed stood out as a role model for their tax reporting. Thus, there remains scope for companies to improve (i) on articulating how they account for tax uncertainties, (ii) disclosure of the amounts subject to risk of material change in the following year, (iii) the quality of their effective tax rate reconciliations, and (iv) the transparency in relation to significant judgements and estimations of uncertain tax positions.

Some of the specific points to consider for 2016 annual financial statements include the following:

• Accounting policies related to tax should be clear, specific to the entity’s circumstances and should address all key issues including the recognition and measurement of uncertain tax positions, if relevant. ƒ
• Income tax is a common source of estimation uncertainty, particularly in respect of uncertain tax positions. The disclosure requirements of IAS 1 in this respect, particularly if there is a significant risk of material adjustment in the next financial year, should be applied carefully and should include quantitative information, such as sensitivities or ranges of possible outcomes.
• IAS 12 requires an entity to disclose an effective taxrate reconciliation to explain the relationship between the total tax expense and profit before tax for the year. This reconciliation should provide clear information about the key factors affecting the effective tax rate and its sustainability in the future, including the nature of reconciling items and why they have arisen, distinguishing clearly between significant one-off or unusual items and those that are expected to recur.
• Entities are required to disclose the judgements made and evidence that supports the recognition of deferred tax assets derived from deductible temporary tax differences and unused tax losses. In many cases, the assessment as to whether the entity will generate future taxable income involves the use of significant judgement, for example the time period considered (which should be based on the facts and circumstances of the entity rather than an arbitrary limit), tax-planning strategies, impact of future contracts, etc.

7. Debt restructurings

Restructuring of issued debt instruments is a complex area of accounting which can require significant judgement. Some of the specific points to remember for 2016 annual financial statements include the following:

• Determining whether the new and old debt have substantially different terms. Under IAS 39, where a financial liability is exchanged or its terms are modified but the liability remains between the same borrower and the same lender, it is necessary to assess if the terms are substantially different. If they are substantially different, the transaction should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.
• Treatment of gain or loss on modification/ extinguishment.
• Treatment of fees incurred as part of the renegotiation – whether the fees should be recognised immediately or whether they can be capitalised.

8. Disclosing the effect of judgements, risks and uncertainties

Regulators and users of annual reports expect more and more entities to provide them with appropriate insight into the risks and uncertainties they are facing and the judgements that have been made in preparing financial information. In particular, the disclosure of accounting policies should be sufficiently specific and granular to enable users to understand the choices and judgements made by the entity and the financial information provided in an annual report overall. The completeness of accounting policy disclosures should also be considered, particularly when dealing with a significant ‘one-off’ transaction such as the transfer of a business to an associate or an issue that has arisen for the first time (for example, a pension surplus in a scheme previously always in deficit). It is easy, while focusing on developing a proper accounting treatment, to overlook the need to properly disclose that new accounting policy. 12

In addition, the disclosures required by IAS 1 on critical judgements and sources of estimation uncertainty should be clear and entity specific. In particular, the quantitative elements of disclosures on estimation uncertainty should not be overlooked, as IAS 1 requires disclosure of the nature and carrying amount of assets and liabilities for which estimation uncertainty gives rise to a significant risk of material adjustment in the next financial year. The following disclosures might, alone or in combination, fulfil these requirements: (i) the nature of the assumption or other estimation uncertainty, (ii) the sensitivity of the carrying amounts of assets and liabilities to the methods, assumptions and estimates used in calculating those amounts, (iii) if resolution of an uncertainty is expected in the next financial year, that fact and the range of reasonably possible outcomes, and (iv) if an uncertainty remains unresolved, an explanation of any changes made to past assumptions.

IFRS also include specific requirements for disclosure on assumptions used and uncertainties arising in specific areas, such as for fair value measurement, recoverable amounts of assets or cash-generating units for impairment testing, sensitivity analyses, etc.

9. The impact of market volatility

The current pervading political and economic uncertainty has translated to volatility in international markets and can have a number of direct and indirect effects on financial statements.

• Currency exchange rates - The most striking effect of the Brexit vote on the markets has been a significant fall in the value of Sterling (GBP) against other major currencies. This has significant direct effects in terms of the level of gains and losses on the translation of GBP balances into other currencies or, for entities with a GBP functional currency, of balances denominated in other currencies into GBP, and the translation of foreign operations. Also, it is important to consider whether the use of an average rate for translation of either foreign currency transactions or the income and expenses of a foreign operation remains appropriate given the level of volatility in exchange rates, or whether such an average needs to be adjusted to reflect the timing of transactions within the reporting period. Given the potential significant increase in the size of foreign currency movements, it should also be considered whether that effect should be given additional prominence in reporting the results for the year. In addition, items which may previously have been small (such as the effect of exchange rate changes in cash and cash equivalents reported at the bottom of a statement of cash flows) could now be much larger and thus subject to additional focus. Besides other effects, foreign currency movements could have an effect on financial instrument risk disclosures (e.g. it may be necessary to reassess the level of exchange rate movement that is considered ‘reasonably possible’ for the purposes of the sensitivity analysis required by IFRS 7), and on cash flow forecasts for impairment or going concern review purposes.
   
• Interest rates - Prevailing interest rates in many jurisdictions are low (even negative in some cases). As well as affecting the income or expense generated by lending or borrowing activities, market interest rates underpin the discounting applied across a variety of balances, such as defined benefit obligations (IAS 19), valuation of share-based payments (IFRS 2), long-term provisions (IAS 37), a value in use calculation (IAS 36), etc. Here again, sensitivity disclosures may be needed where a change in interest rates could have a significant effect.
   
• Commodity prices – Low commodity prices throughout 2016 had an impact in many industries, the most direct being in the extractive industry (particularly in respect of impairment of assets including exploration and evaluation costs capitalised under IFRS 6), but also on other entities such as airlines with oil being a key part of their costs.

10. Entities potentially affected by Brexit

Taking into consideration the relevance of the UK’s referendum to leave the EU for many entities in Europe and also outside Europe (in particular the many multinationals doing business with the UK), entities potentially affected by the result are expected to assess and disclose the accounting implications of UK’s Brexit decision, the associated risks, and the expected impacts and uncertainties on their business activities.

The biggest immediate accounting impact for 2016 reporting should be disclosure to explain judgements and risks. Valuations, measurements and impairment calculations that use market inputs should also be updated. Some of the specific points to consider include:

• Critical judgements, sensitivities and risk exposures might have been significantly impacted by the potential economic consequences of Brexit.
• The extent of disclosures regarding estimation uncertainty might need to be increased. For example, more items would now be subject to a significant risk that the carrying amount might change materially within the next year.
• The disclosures regarding risks and uncertainties should include commentary on the potential impact of Brexit, although the full impact might not yet be clear.
• Management should assess the entity’s ability to continue as a going concern. Cash flow forecasts might need to be updated to reflect the potential impact of the referendum, and uncertainties over going concern should be disclosed.
• Review of specific contract terms (potentially) impacted by Brexit, including possible termination clauses.
• Assessment of covenants’ terms to identify any breaches as a result of changes in the value of assets and liabilities.
• Effect of increased volatility post-referendum on financial risks disclosure in accordance with IFRS 7: credit risk, liquidity risk, currency risk, and other price risks.
• Impairment assessments - For example, entities should assess if relevant triggers for the recognition of impairment losses in financial assets related to the significant or prolonged criteria in IAS 39 are met and/or if the recoverable amounts determined in accordance with IAS 36 decrease significantly.
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1 Editor’s note: A near miss occurs when the VI U is not significantly higher than the CV of the cash generating unit