CATERING TO USER DEMANDS

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Multiple-choice questions
There are some significant changes to previous ASB proposals in the standards bodys latest plans to
reshape financial reporting in the UK and Ireland, says Graham Holt
This article was first published in the June 2014 UK edition of Accounting and Business magazine.
For many years, regulators and standard-setters have grappled with the issue of how entities should
best present financial performance and not mislead the user. Many jurisdictions have enforced a
standard format for performance reporting, with no additional analysis permitted on the face of the
income statement. Others have allowed entities to adopt various methods of conveying the nature of
underlying or sustainable earnings.
Although financial statements are prepared in accordance with applicable financial reporting standards,
users are demanding more information and issuers seem willing to give users their understanding of the
financial information. This information varies from the disclosure of additional key performance
indicators of the business to providing more information on individual items within the financial
statements. These additional performance measures (APMs) can assist users in making investment
decisions, but they do have limitations.
COMMON PRACTICE
It is common practice for entities to present APMs, such as normalised profit, earnings before interest and
tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA). These alternative
profit figures can appear in various communications, including company media releases and analyst
briefings. Alternative profit calculations normally exclude particular income and expense items from the
profit figure reported in the financial statements. Also, there could be the exclusion of income or expenses
that are considered irrelevant from the viewpoint of the impact on this years performance or when
considering the expected impact on future performance.
An example of the latter has been gains or losses from changes in the fair value of financial instruments.
The exclusion of interest and tax helps to distinguish between the results of the entitys operations and the
impact of financing and taxation.
These APMs can help enhance users understanding of the companys results and can be important in
assisting users in making investment decisions, as they allow them to gain a better understanding of an
entitys financial statements and evaluate the entity through the eyes of the management. They can also be
an important instrument for easier comparison of entities in the same sector, market or economic area.
However, they can be misleading due to bias in calculation, inconsistency in the basis of calculation from
year to year, inaccurate classification of items and, as a result, a lack of transparency. Often there is little
information provided on how the alternative profit figure has been calculated or how it reconciles with the
profit reported in the financial statements.
The APMs are also often described in terms which are neither defined by issuers nor included in
professional literature and thus cannot be easily recognised by users.
APMs include:
all measures of financial performance not specifically defined by the applicable financial
reporting framework
all measures designed to illustrate the physical performance of the activity of an issuers business
all measures disclosed to fulfil other disclosure requirements included in public documents
containing regulated information.
An example demonstrating the use of APMs is the financial statements of Telecom Italia Group for the
year ended 31 December 2011. These contained a variety of APMs as well as the conventional financial
performance measures laid down by International Financial Reporting Standards. The non-IFRS APMs
used in the Telecom Italia statements were:
EBITDA. Used by Telecom Italia as the financial target in its internal presentations (business plans) and
in its external presentations (to analysts and investors). The entity regarded EBITDA as a useful unit of
measurement for evaluating the operating performance of the group and the parent.
Organic change in revenues, EBITDA and EBIT. These measures express changes in revenues,
EBITDA and EBIT, excluding the effects of the change in the scope of consolidation, exchange
differences and non-organic components constituted by non-recurring items and other non-organic
income and expenses. The organic change in revenues, EBITDA and EBIT is also used in presentations to
analysts and investors.
Net financial debt. Telecom Italia saw net financial debt as an accurate indicator of its ability to meet its
financial obligations. It is represented by gross financial debt less cash and cash equivalents and other
financial assets. The report on operations includes two tables showing the amounts taken from the
statement of financial position and used to calculate the net financial debt of the group and parent.
Adjusted net financial debt. A new measure introduced by Telecom Italia to exclude effects that are
purely accounting in nature resulting from the fair value measurement of derivatives and related financial
assets and liabilities.
EVALUATING APMS
The International Accounting Standards Board (IASB) is undertaking an initiative to explore how
disclosures in IFRS financial reporting can be improved. The project has started to look at possible ways
to address the issues arising from the use of APMs. This initiative is made up of a number of projects. It
will consider such things as adding an explanation in IAS 1 that too much detail can obscure useful
information and adding more explanations, with examples, of how IAS 1 requirements are designed to
shape financial statements instead of specifying precise terms that must be used. This includes whether
subtotals of IFRS numbers such as EBIT and EBITDA should be acknowledged in IAS 1.
In the UK, the Financial Reporting Council supports the inclusion of APMs when users are provided with
additional useful, relevant information. In contrast, the Australian Financial Reporting Council feels that
such measures are outside the scope of the financial statements. In 2012, the Financial Markets Authority
(FMA) in the UK issued a guidance note on disclosing APMs and other types of non-GAAP financial
information, such as underlying profits, EBIT and EBITDA.
APMs appear to be used by some issuers to present a confusing or optimistic picture of their performance
by removing negative aspects. There seems to be a strong demand for guidance in this area, but there
needs to be a balance between providing enough flexibility, while ensuring users have the necessary
information to judge the usefulness of the APMs.
To this end, the European Securities and Markets Authority (ESMA) has launched a consultation on
APMs. The aim is to improve the transparency and comparability of financial information while reducing
information asymmetry among the users of financial statements. ESMA also wishes to improve coherency
in APM use and presentation and restore confidence in the accuracy and usefulness of financial
information.
ESMA has therefore developed draft guidelines that address the concept and description of APMs,
guidance for the presentation of APMs and consistency in using APMs. The main requirements are:
Issuers should define the APM used, the basis of calculation and give it a meaningful label and
context.
APMs should be reconciled to the financial statements.
APMs that are presented outside financial statements should be displayed with less prominence.
An issuer should provide comparatives for APMs and the definition and calculation of the APM
should be consistent over time.
If an APM ceases to be used, the issuer should explain its removal and the reasons for the newly
defined APM.
However, these guidelines may not be practicable when the cost of providing this information outweighs
the benefit obtained or the information provided may not be useful to users. Issuers will most likely incur
both implementation costs and ongoing costs. Most of the information required by the guidelines is
already collected for internal management purposes, but may not be in the format needed to satisfy the
disclosure principles.
ESMA believes that the costs will not be significant because APMs should generally not change over
periods. Therefore, ongoing costs will relate almost exclusively to updating information for every
reporting period. ESMA believes that the application of these guidelines will improve the
understandability, relevance and comparability of APMs.
Application of the guidelines will enable users to understand the adjustments made by management to
figures presented in the financial statements. ESMA believes that this information will help users to make
better-grounded projections and estimates of future cashflows and assist in equity analysis and valuations.
The information provided by issuers in complying with these guidelines will increase the level of
disclosures, but should lead issuers to provide more qualitative information. The national competent
authorities will have to implement these guidelines as part of their supervisory activities and provide a
framework against which they can require issuers to provide information about APMs.
Graham Holt is director of professional studies at the accounting, finance and economics
department at Manchester Metropolitan University Business School
PROFIT, LOSS AND OCI
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Multiple-choice questions
Graham Holt explains what differentiates profit or loss from other comprehensive income and where
items should be presented
The purpose of the statement of profit or loss and other comprehensive income (OCI) is to show an
entity's financial performance in a way that is useful to a wide range of users so they may attempt
to assess the future net cash inflows of an entity. The statement should be classified and aggregated
in a manner that makes it understandable and comparable.
International Financial Reporting Standards (IFRS) currently require that the statement be presented as
either one statement, being a combined statement of profit or loss and other comprehensive income, or
two statements, being the statement of profit or loss and the statement of other comprehensive income. An
entity has to show separately in OCI, those items which would be reclassified (recycled) to profit or loss
and those items which would never be reclassified (recycled) to profit or loss. The related tax effects have
to be allocated to these sections.
Profit or loss includes all items of income or expense (including reclassification adjustments) except those
items of income or expense that are recognised in OCI as required or permitted by IFRS.
Reclassification adjustments are amounts recycled to profit or loss in the current period that were
recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be
reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised
gains or losses on cashflow hedges. Those items that may not be reclassified are changes in a revaluation
surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit
plan under IAS 19, Employee Benefits.
However, there is a general lack of agreement about which items should be presented in profit or loss and
in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification
and when or which OCI items should be reclassified.
A common misunderstanding is that the distinction is based on realised versus unrealised gains. This lack
of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI
in IFRS. It may be difficult to deal with OCI on a conceptual level since the International Accounting
Standards Board (IASB) is finding it difficult to find a sound conceptual basis.
However, there is urgent need for some guidance around this issue.
Opinions vary, but there is a feeling that OCI has become a 'dumping ground' for anything controversial
because of a lack of clear definition of what should be included in the statement. Many users are thought
to ignore OCI as the changes reported are not caused by the operating flows used for predictive purposes.
Financial performance is not defined in the Conceptual Framework, but could be viewed as reflecting the
value the entity has generated in the period and this can be assessed from other elements of the financial
statements and not just the statement of comprehensive income. Examples would be the statement of
cashflows and disclosures relating to operating segments. The presentation in profit or loss and OCI
should allow a user to depict financial performance, including the amount, timing and uncertainty of the
entity's future net cash inflows and how efficiently and effectively the entity's management have
discharged their duties regarding the resources of the entity.
There are several arguments for and against reclassification. If reclassification ceased, there would be no
need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions
can be left to specific IFRSs. It is argued that reclassification protects the integrity of profit or loss and
provides users with relevant information about a transaction that occurred in the period. Additionally, it
can improve comparability where IFRS permits similar items to be recognised in either profit or loss or
OCI.
Those against reclassification argue that the recycled amounts add to the complexity of financial
reporting, may lead to earnings management, and the reclassification adjustments may not meet the
definitions of income or expense in the period as the change in the asset or liability may have occurred in
a previous period.
The original logic for OCI was that it kept income-relevant items that possessed low reliability from
contaminating the earnings number.
Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort
common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss
needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of
net income. The use of OCI as a temporary holding for cashflow hedging instruments and foreign
currency translation is non-controversial.
However, other treatments such as the policy of IFRS 9 to allow value changes in equity investments to
go through OCI, are not accepted universally.
US GAAP will require value changes in all equity investments to go through profit or loss. Accounting
for actuarial gains and losses on defined benefit schemes are presented through OCI and certain large US
corporations have been hit hard with the losses incurred on these schemes. The presentation of these items
in OCI would have made no difference to the ultimate settled liability, but if they had been presented in
profit or loss the problem may have been dealt with earlier. An assumption that an unrealised loss has
little effect on the business is an incorrect one.
The discussion paper on the Conceptual Framework considers three approaches to profit or loss and
reclassification. The first approach prohibits reclassification. The other approaches, the narrow and broad
approaches, require or permit reclassification. The narrow approach allows recognition in OCI for
bridging items or mismatched remeasurements, while the broad approach has an additional category of
'transitory measurements' (for example, remeasurement of a defined benefit obligation), which would
allow the IASB greater flexibility. The narrow approach significantly restricts the types of items that
would be eligible to be presented in OCI and gives the IASB little discretion when developing or
amending IFRSs.
A bridging item arises where the IASB determines that the statement of comprehensive income would
communicate more relevant information about financial performance if profit or loss reflected a different
measurement basis from that reflected in the statement of financial position. For example, if a debt
instrument is measured at fair value in the statement of financial position, but is recognised in profit or
loss using amortised cost, then amounts previously reported in OCI should be reclassified into profit or
loss on impairment or disposal of the debt instrument.
The IASB argues that this is consistent with the amounts that would be recognised in profit or loss if the
debt instrument were to be measured at amortised cost.
A mismatched remeasurement arises where an item of income or expense represents an economic
phenomenon so incompletely that presenting that item in profit or loss would provide information that has
little relevance in assessing the entity's financial performance. An example of this is when a derivative is
used to hedge a forecast transaction; changes in the fair value of the derivative may arise before the
income or expense resulting from the forecast transaction.
The argument is that before the results of the derivative and the hedged item can be matched together, any
gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective
and qualifies for hedge accounting, should be reported in OCI. Subsequently those gains or losses are
reclassified into profit or loss when the forecast transaction affects profit or loss.
This allows users to see the results of the hedging relationship.
The IASB's preliminary view is that any requirement to present a profit or loss total or subtotal could also
result in some items being reclassified. The commonly suggested attributes for differentiation between
profit or loss and OCI (realised/unrealised, frequency of occurrence, operating/non-operating,
measurement certainty/uncertainty, realisation in the short/long-term or outside management control) are
difficult to distil into a set of principles.
Therefore, the IASB is suggesting two broad principles, namely:
1. Profit or loss provides the primary source of information about the return an entity has made on
its economic resources in a period.
2. To support profit or loss, OCI should only be used if it makes profit or loss more relevant.
The IASB feels that changes in cost-based measures and gains or losses resulting from initial recognition
should not be presented in OCI and that the results of transactions, consumption and impairments of
assets and fulfilment of liabilities should be recognised in profit or loss in the period in which they occur.
As a performance measure, profit or loss is more used, although there are a number of other performance
measures derived from the statement of profit or loss and OCI.
Graham Holt is director of professional studies at the accounting, finance and economics
department at Manchester Metropolitan University Business School




VEXED CONCEPT
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Multiple-choice questions
Uncomfortable questions are surfacing about the purpose and the nature of the equity method of
accounting. Graham Holt explains
Equity accounting was originally used as a consolidation technique for subsidiaries at a time when
acquisition accounting was considered inappropriate because it showed assets and liabilities not owned by
the reporting entity.
The equity method evolved as a basis of reporting the performance of subsidiaries partly as it was seen as
more appropriate than cost.
International consensus on the equity method eventually led to an amended EU directive to require the
use of equity accounting for associates of an investor. Some European countries questioned this
amendment on the basis that it did not use acquisition accounting principles to account for subsidiaries.
WHATS THE POINT?
In short, equity accounting has a long history and is currently used to account for associates and joint
ventures. However, IAS 28, Investments in Associates and Joint Ventures, does not state what equity
accounting is trying to portray. Under the equity method, on initial recognition the investment in an
associate or a joint venture is recognised at cost, and the carrying amount increased or decreased to
recognise the investors share of the profit or loss of the investee after the date of acquisition.
Many of the principles applied in the equity method are similar to the consolidation procedures described
in IFRS 10, Consolidated Financial Statements. For example, under equity accounting, profits are
eliminated on intergroup transactions only to the extent of an investors interest. This reflects a
proprietary perspective to consolidation, as opposed to the entity perspective of IFRS 10.
Although IAS 28 does not specifically state that IFRS 3, Business Combinations, should be applied to an
acquisition of an investee, it does refer to the acquisition accounting principles in IFRS 3. For example,
IAS 28 requires that goodwill relating to an associate or a joint venture is included in the carrying amount
of the investment. Amortisation of goodwill is not permitted.
DUAL APPROACH
Equity accounting reflects a measurement approach as well as a consolidation approach. For example,
losses in excess of carrying value are not recognised in most circumstances after the investor or joint
venturers interest is reduced to zero, a liability is recognised only to the extent that the investor or joint
venturer has incurred legal or constructive obligations or made payments on behalf of the investee.
The basis for conclusions in IAS 28 refers to the equity method as a way to measure an investment in an
associate and a joint venture. Thus, questions can be raised as to whether equity accounting is a type of
financial instruments valuation accounting or a one-line consolidation.
There are a number of differences between consolidation and equity accounting that may give a different
result, including acquisition costs and loss-making subsidiaries. In the consolidated financial statements,
acquisition costs on a business combination are expensed in the period they are incurred, but included in
the cost of investment for equity accounting. The consolidated financial statements include full
recognition of losses of a subsidiary, but under equity accounting an entity discontinues recognising
losses once its share of the losses equals or exceeds its interest.
Recent developments have helped preparers understand the thinking behind the equity method. In
December 2012, the International Accounting Standards Board (IASB) published two exposure drafts for
amending IAS 28 IAS 28, Equity Method: Share of Other Net Asset Changes, and IAS 28, Sales or
Contributions of Assets between an Investor and its Associate or Joint Venture. The first dealt with how
an investor should recognise its share of changes in net assets of an investee not recognised in
comprehensive income, while the second dealt with the inconsistency between IFRS 10 and IAS 28
dealing with the sale or contribution of assets between an investor and its investee.
There appears to be significant diversity in the way the equity method is applied in practice mainly
because of the two different concepts of measurement and consolidation underpinning the method. The
proposed amendments did not address this issue and were seen as a short-term measure. Respondents felt
it was important for the IASB to establish a clear conceptual basis for the equity method.
SEPARATE STATEMENTS
Some jurisdictions require equity accounting to be used in the separate financial statements of the parent
company for investments in associates, joint ventures and subsidiaries. IAS 27, Separate Financial
Statements, does not currently permit this as the option was removed for investments in separate financial
statements in 2003. The IASB has been asked to restore this option and issued an exposure draft in
December 2013 entitled Equity Method in Separate Financial Statements (Proposed amendments to IAS
27). The draft also requires the change to be applied retrospectively if the entity elects to use the equity
method.
Retrospective application for associates and joint ventures may not be a problem as the equity accounting
used in an entitys separate financial statements would be consistent with its consolidated financial
statements. However, there may be a problem with investments in subsidiaries in areas such as
impairment testing and foreign exchange.
There is some doubt about the objective of separate financial statements, as they are not required in
International Financial Reporting Standards (IFRS). In general, they are required by local regulations or
other financial statement users. IAS 27 points out that the focus of such statements is on the financial
performance of the assets as investments.
IAS 27 does not mandate which entities must produce separate financial statements for public use. It
applies when an entity prepares separate financial statements that comply with IFRS.
Currently, financial statements in which the equity method is applied are not separate financial
statements. Similarly, the financial statements of an entity that does not have a subsidiary, associate or
joint venturers interest in a joint venture are not separate financial statements.
When an entity prepares separate financial statements, investments in subsidiaries, associates and jointly
controlled entities are accounted for at cost or in accordance with IFRS 9, Financial Instruments.
Investments accounted for at cost and classified as held for sale are accounted for in accordance with
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
If an entity elects, as permitted by IAS 28, to measure its investments in associates or joint ventures at fair
value through profit or loss in accordance with IFRS 9, it has to account for them in the same way in its
separate financial statements. At present, therefore, companies have to elect under IFRS to measure their
investments in associates, joint ventures and subsidiaries either at cost or to treat the investment as a
financial instrument. The proposed third option will lead to diversity in practice but perhaps more
importantly, it raises the question about the nature and purpose of equity accounting.
Respondents to the IASB exposure drafts are generally not in favour of introducing accounting policy
options in IFRS. The proposed change to IAS 27 will align the accounting principles across boundaries
but some respondents feel that the use of the equity method in separate financial statements is
inappropriate because the proposed amendment lacks a conceptual basis.
If the main objective of the proposals is to improve the relevance of information, then the IASB should
first clarify what the equity method purports to achieve. The basis of the argument of respondents
opposing the introduction of the equity method is that it simply reflects information already given in the
consolidated financial statements and the introduction of additional accounting policy options reduces the
comparability of financial information. Further it is felt that the IASB should investigate current practice
in countries with experience in applying the equity method before approving the change.
SOWING CONFUSION
The proposals could be seen as creating confusion about the purpose and nature of the separate financial
statements. Apart from the single-line presentation, consolidation rules would apply, so additional
questions are raised about the purpose and the nature of the equity method.
The IASB feels including this option in IAS 27 would not involve any additional procedures because the
information can be obtained from the consolidated financial statements by applying IFRS 10 and IAS 28.
Under the present proposals in the exposure draft, an entity could account for its investments in
subsidiaries using the equity method, its associates under IFRS 9 and its joint ventures at cost. The
proposed amendment affects IAS 28, which makes it imperative to consider whether any consequential
amendments reflect the intention of the amendment to IAS 27.

Graham Holt is director of professional studies at the accounting, finance and economics
department at Manchester Metropolitan University Business School
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Last updated: 24 Apr 2014


ARE YOU COMPLYING?
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Multiple-choice questions
Following research by ESMA, the regulatory bodies are focusing on key aspects of IAS 36, says Graham
Holt
IAS 36, Impairment of Assets, describes the procedures that an entity should follow to ensure that
it carries its assets at no more than their recoverable amount, which is effectively the higher of the
amount to be realised through using or selling the asset. When the carrying amount of asset exceeds
the recoverable amount, the asset is considered to be impaired and the entity recognises an
impairment loss. Goodwill acquired in a business combination or intangible assets with indefinite
useful lives have to be tested for impairment at least on an annual basis. The standard details the
circumstances when an impairment loss should be reversed, although this is not possible for
goodwill.
For the purposes of impairment testing, goodwill should be allocated to the cash-generating units (CGU)
or groups of CGUs benefiting from goodwill. Such group of units should not be larger than an operating
segment before aggregation. For any asset, an impairment test has to be carried out at each reporting date
if there is any indicator of impairment. IAS 36 gives a list of common indicators of impairment such as
increases in market interest rates, market capitalisation falling below net asset carrying value or the
economic performance of an asset being worse than projected in internal budgets.
Detailed disclosures, including the circumstances that have led to impairment are required in relation to
each CGU with significant amounts of goodwill and other intangible assets. These include the key
assumptions on which management has based cashflow projections, a description of management's
approach to determining the values of each key assumption, terminal growth rates and discount rates as
well as sensitivity analysis where a reasonable change in a key assumption would lead to impairment.
Additionally, the International Accounting Standards Board (IASB) has recently published Recoverable
Amount Disclosures for Non-Financial Assets (Amendments to IAS 36). These narrow amendments to
IAS 36 detail the disclosure of information about the recoverable amount of impaired assets if that
amount is based on fair value less costs of disposal. When developing IFRS 13, Fair Value Measurement,
the IASB decided to change IAS 36 to require disclosures about the recoverable amount of impaired
assets. The recent amendment limits the scope of those disclosures to the recoverable amount of impaired
assets that is based on fair value less costs of disposal. The amendments are to be applied retrospectively
for annual periods beginning on or after 1 January 2014 with earlier application permitted.
In January 2013,the European Securities and Markets Authority (ESMA) issued a report on the
accounting practices relating to impairment testing of goodwill and other intangible assets. ESMA
reviewed the nature of disclosures in the 2011 IFRS financial statements of a sample of 235 companies
with material amounts of goodwill. Similarly, a recent research report by the Centre for Financial
Analysis and Reporting Research (CeFARR) at the Cass Business School entitled Accounting for asset
impairment: a test for IFRS compliance across Europe reviewed the compliance of European listed
companies' as regards IAS 36. The authors, Hami Amiraslani, George E Iatridis and Peter F Pope,
investigated the degree of compliance with IFRS by analysing impairment disclosures during 2010/11,
relating to non-financial assets within a sample of over 4,000 listed companies from the European Union
plus Norway and Switzerland.
The two reports make interesting reading and there is some consistency in their conclusions. The findings
of the CeFARR research contextualise the ESMA report. CeFARR found that compliance with some
impairment disclosure requirements varied quite considerably suggesting inconsistency in the application
of IFRS. Compliance with impairment disclosure requirements that required greater managerial
involvement was less rigorous than those requirements with low effort required. This leads to a tendency
to use boilerplate description, which helps reduce the cost of compliance. There appears to be
considerable variation across European countries in compliance with some impairment disclosure
requirements.
CeFARR found that the quality of impairment reporting is better in companies whose jurisdiction has a
strong regulatory and institutional infrastructure. They placed the UK and Ireland in this category.
However, impairment disclosures seem to be of lower quality in jurisdictions where there is a weaker
regulatory regime. They further conclude that companies operating in a strong regulatory and
enforcement setting appear to recognise impairment losses on a timelier basis. These findings could have
implications for future investment decisions in terms of lower risk in certain jurisdictions.
In the current economic and financial crisis, assets in many industries are likely to generate lower than
expected cashflows with the result that their carrying amount is greater than their recoverable amount
with the result that impairment losses are required. However, ESMA found that the material impairment
losses of goodwill reported in 2011 were limited to a small number of companies, and these were mainly
in the financial services and telecommunication industries. Overall impairment losses on goodwill in
2011 amounted to only 5percent of goodwill recognised in the 2010 IFRS financial statements.
An indication of impairment could be a fall in market capitalisation below the carrying value of equity.
An equity/market capitalisation ratio above 100percent is one of the external sources of information
indicating that assets may be impaired, and should be considered in assessing the realistic values of key
assumptions used in impairment testing. ESMA reported that the average equity/market capitalisation
ratio of its sample rose from 100percent at 2010 year-end to 145percent at 2011 year-end and further, that
as at 31 December 2011, 43percent of the sample showed a market capitalisation below equity compared
to 30percent in 2010. Of these entities, 47percent recognised impairment losses on goodwill in their 2011
IFRS financial statements.
ESMA feels that the increased equity/market capitalisation ratio and relatively limited impairment losses
call into question whether the level of impairment in 2011 appropriately reflects the effects of the
financial and economic crisis. As CeFARR found, in many cases the disclosures relating to impairment
were of a boilerplate nature and not entity-specific due to a failure to comply with the requirements of the
standard and possibly IAS 36 not providing specific enough detail, especially as regards the nature of the
sensitivity analysis.
As a result of the ESMA review, they have identified five problem areas:

1 Key assumptions of management
In the ESMA sample, only 60percent of the entities discussed the key assumptions used for cashflow
forecasts other than the discount rate and growth rate used in the impairment testing and half of these
entities did not provide the relevant entity-specific information.
2 Sensitivity analysis
ESMA has identified different practices with regard to disclosures on sensitivity analysis. Only half of the
entities presented a sensitivity analysis where the book value of their net assets exceeded their market
capitalisation. This is a surprisingly low figure considering that this is an indication of impairment.
3 Determination of recoverable amount
'Value in use' is used by most entities for goodwill impairment testing purposes and 60percent of entities
used discounting to calculate 'fair value less costs to sell'. Thus a significant number of entities estimate
the recoverable amount using discounted cashflows. IAS 36 requires different criteria for cashflows when
using value in use or fair value less costs to sell to determine the recoverable amount. One would expect
that third party information would prevail over entity based assumptions when determining 'fair value less
costs to sell' in this way.
4 Determination of growth rates
IAS 36 states that for periods beyond those covered by the most recent budgets and forecasts, they should
be based on extrapolations using a steady or declining growth rate unless an increasing rate can be
justified. ESMA found that more than 15percent of issuers disclosed a long-term growth rate above
3percent which, given the current economic environment, is optimistic and probably unrealistic.
5 Disclosure of an average discount rate
ESMA found that 25percent of issuers in the sample disclosed an average discount rate, rather than a
specific discount rate on each material cash-generating unit. The applied discount rate has a major impact
on the calculation of value in use. Therefore separate discount rates should be disclosed and used which
fit the risk profile of each CGU. The disclosure of a single average discount rate for all CGUs obscures
relevant information.
As a result of the above, ESMA and the national regulatory authorities are focusing on certain key aspects
of IAS 36. The key areas include the application by entities of the rules re impairment testing of goodwill
and other intangible assets, the reasonableness of cashflow forecasts, the key assumptions used in the
impairment test and the relevance and appropriateness of the sensitivity analysis provided. ESMA expects
issuers and their auditors to consider the findings of their review when preparing and auditing the IFRS
financial statements. ESMA also expects national regulatory authorities to take appropriate enforcement
actions where needed.
Graham Holt is associate dean and head of the accounting, finance and economics department at
Manchester Metropolitan University Business School