ESMA and the AMF have published their recommendations for 2018 financial reporting on their websites, on 26 and 29 October respectively.
Following a reminder that information presented in financial reporting should be relevant and proportionate, the recommendations unsurprisingly focus on issues relating to the application of IFRS 15 – Revenue from Contracts with Customers and IFRS 9 – Financial Instruments, both of which came into effect for financial periods commencing on or after 1 January 2018. The recommendations also address the required disclosures relating to the implementation of IFRS 16 – Leases for the 2018 financial statements.
They also remind issuers affected by Brexit of the need to present disclosures on the expected impacts. In addition, they note that the classification of Argentina as a hyperinflationary economy under IFRS as of 1 July 2018 means that entities with significant exposure to this country must present disclosures on the resultant accounting and financial impacts. Finally, the AMF observes that the application of the most recent IFRS IC interpretation, IFRIC 23 – Uncertainty over Income Tax Treatments, for financial periods commencing on or after 1 January 2019, will involve significant work for preparers and could potentially have substantial impacts.
It should be noted that, whereas previous years’ recommendations related to “financial statements”, they will henceforth refer to annual financial reporting in general, as both organisations have provided recommendations relating to other aspects of financial reporting, notably non-financial information, including environmental issues, and Alternative Performance Measures.
The two institutions agree on the priorities identified for 2018 financial reporting. To avoid confusion, we will here focus on ESMA’s recommendations, which are consistent with the AMF’s enforcement priorities, with the exception of further detail provided by the AMF and of two topics relating to the implementation of IFRS 16 that are addressed only by the French regulator (marked “AMF only”).
ESMA’s recommendations focus on the following issues:
1. The Importance of relevant and proportionate information
As major new standards are implemented, ESMA highlights the importance of issuers being specific in their disclosures and providing informative description and explanation of the issues that are relevant to the understanding of the entity’s financial performance and financial position.
The AMF reminds preparers, on the other hand, that regulators and standard-setters will be looking at the presentation, readability and relevance of financial statements and the application of the materiality principle.
It welcomes efforts by a growing number of issuers to make improvements in these areas, and encourages entities to continue working on them.
The AMF emphasizes besides the need for consistency when deciding on the level of granularity for each subject, both between the financial statements and other components of financial reporting, and within the financial statements.
For example, detailed disclosures would be required in the notes if the entity reports a major event or a key judgement (within or outside the financial statements), or if a topic related to figures or aggregates from the financial statements is presented as a key audit matter in the auditors’ report.
2. IFRS 15 – Revenue from Contracts with Customers
In light of the changes introduced by IFRS 15 on the main notions and principles of revenue recognition, ESMA emphasizes the importance for entities to understand how all the concepts and principles in the new standard apply to them, whether or not the impact is material at the transition date.
It also draws issuers’ attention to the following specific issues:
ESMA makes the following recommendations for the 2018 year-end financial statements:
- it emphasizes that issuers should disclose the entity-specific impacts of the transition to IFRS 15;
- it reminds issuers of the need to present both qualitative and quantitative disclosures on aspects of the standard that have had a material impact on the entity’s financial statements, presented separately by topic (identification of separate performance obligations, revenue recognition approach, reclassifications in the balance sheet, etc.) and to explain, where necessary, the reasons why the standard has not had an impact on the financial statements when other entities in the sector have experienced significant impacts;
- it underlines the need to provide transparency on the transition method applied and reminds that the use of the modified retrospective method requires additional disclosures for transitional reporting periods, namely the IFRS 15 impact on each financial statement line item as compared to the previously applied requirements and an explanation of the reasons for significant changes.
- Identification of performance obligations (POs) and revenue recognition: ESMA highlights the need for additional transparency on the changes in timing and/or amount of revenue recognition patterns (over time or at a point in time) arising from the new requirements for POs’ identification and transfer of control. In this respect, ESMA encourages issuers to look at the decisions made by the IFRS IC in March 2018 when assessing whether separate performance obligations exist and whether they are fulfilled over time or at a point in time.
- Allocation of the transaction price to multiple performance obligations: in situations where an entity needs to estimate the stand-alone selling price, ESMA emphasizes the need to maximize the use of observable inputs from comparable goods (adapting them as necessary to take account of market conditions, type of customer, etc.) and to apply estimation methods consistently in similar circumstances.
- Agent vs. principal assessment: ESMA reminds issuers that the general principle of IFRS 15 (i.e. whether an entity controls the good or service before it transfers it to the customer) is the key consideration in this assessment, and that the indicators provided in the standard are not an exhaustive list. It also reiterates the importance of the disclosures of significant judgements and assumptions applied for this assessment.
Disclosures in the notes
- Accounting policies, judgements and estimates: irrespective of the significance of the impact, ESMA recommends that entities should update their accounting policies in light of the new provisions of IFRS 15, ensuring that they are entity-specific (revenue streams, contracts) rather than simply describing the general principles of the standard. It also recommends that issuers should disclose significant judgements in the notes, and gives several examples. It also draws issuers’ attention to the disclosure requirements on judgements made in determining the amount of the costs incurred to obtain or fulfil a contract with a customer, the amortization methods and related impacts recognized in the reporting period. The AMF specifies also that it would be a good idea for entities to specify the types of costs taken into account when assessing whether contracts are onerous, while awaiting a final decision on the issue from the standard-setters.
- Contract assets and liabilities: ESMA reminds issuers that if they have significant contract asset and contract liability balances, it is important to present any changes over the period, broken down by type. It shall also present a qualitative explanation of their composition and the most significant changes.
- Disaggregation of revenue: ESMA reminds issuers that disclosures must meet the objective of IFRS 15, and must therefore enable users to understand the main drivers of revenue. Thus, when deciding on the level of disaggregation, issuers should consider (i) the principles and examples set out in the standard; and (ii) information provided about revenue in other components of financial reporting, which could imply that revenue should be disaggregated at a higher level of granularity than required under IFRS 8 and that companies may need to go into more detail than they did in their condensed interim financial statements.
- Allocation of transaction price to remaining POs: ESMA reminds issuers that it is important to provide qualitative as well as quantitative data. The AMF provides illustrations on this matter: (i) any significant amounts of consideration that are not included in the revenue recognition schedule (e.g. amounts of variable consideration in some situations); (ii) changes and significant amounts presented; and (iii) key assumptions (e.g. contracts and time periods) used in the calculation. The AMF also notes that it is useful to explain any major differences from the order book if the entity has presented this information earlier.
3. IFRS 9 – Financial Instruments
- ESMA reminds preparers of the need to update their accounting policies on the recognition of financial instruments. If first-time application of the standard on modification of debt has had significant impacts, these shall be presented separately. ESMA even encourages credit institutions to disclose the IFRS 9 impact on applicable prudential ratios.
- Particularly for credit institutions: ESMA recommends disaggregating the reconciliation between IAS 39 and IFRS 9 impairment allowances by class of financial instruments. Generally speaking, the main changes relating to reconciliations between the two standards (reclassifications, impairment allowances) should be explained in entity-specific rather than generic terms.
Hedge accounting disclosures
ESMA reminds issuers that the new disclosure requirements of IFRS 7 apply to all issuers with significant hedging operations, including those that continue to apply the provisions of IAS 39 and those for which application of IFRS 9 has only a limited impact.
IFRS 9 impairment model
Particularly for credit institutions:
- Significant changes in credit risk: in addition to qualitative criteria, which were provided by nearly all credit institutions in the sample studied at 30 June 2018, ESMA recommends that institutions should also present quantitative criteria (indicators, thresholds) for assessing whether there has been a significant increase in credit risk, as well as any factors taken into account in assessing the reversal of a significant increase in credit risk. It notes that it is also helpful to specify if a portfolio approach has been used.
- Forward-looking information taken into account when determining lifetime expected credit losses: ESMA encourages issuers to specify the macro-economic assumptions used (probability weighting of scenarios, nature and quantification of assumptions).
- Reconciliations between opening and closing balances: ESMA emphasises the need to provide details of significant changes, broken down by class of financial instruments, together with entity-specific qualitative explanations.
- Assessment of expected cash flows from credit impaired loans: ESMA recalls also its 2017 recommendation on this topic. It recommends that credit institutions significantly impacted by IFRS 9 review their estimates and ensure that these expectations, including those from the related collateral, are realistic and unbiased, It also underlines the need to consider a sale of the loan scenario in the measurement of expected credit loss, to the extent that it is one of the methods that the entity reasonably expects to pursue in a default scenario and provided such expectations are clearly evidenced, and supported, by its intention and ability to sell.
Classification and measurement of financial assets
Particularly for credit institutions: when analysing the contractual characteristics of a financial instrument to determine its classification under IFRS 9, issuers should disclose the key judgements made and provide details of the approach used.
Specific considerations relating to insurance activities
ESMA reiterates its recommendations for the 2017 financial statements for entities that have chosen to defer application of IFRS 9: they should provide sufficient information to enable users to understand how they meet the exemption criteria. The AMF also reminds issuers that IFRS 9 requires additional disclosures in the notes on the classification and measurement of certain types of financial assets.
Presentation of interest revenue in the income statement
ESMA reminds preparers that interest revenue calculated using the effective interest method shall be presented as a separate line item in accordance with the IFRS IC’s March 2018 agenda decision. Impairment losses (and reversals of impairment losses) on financial assets shall also be presented as a separate line item.
4. IFRS 16 – Leases
Key points of the standard
ESMA points out that the determination of lease terms and discounts rates are among the main assumptions used in the determination of right of use assets and lease liabilities that should be disclosed thus enabling users to assess the impacts of the changes introduced by IFRS 16. The AMF gives the following additional clarifications in this respect:
- Determining the lease term: the AMF reminds preparers that when determining the period for which a lease contract is enforceable, they should (i) consider all relevant contractual terms and legislation; (ii) ensure that assumptions used are in line with the group’s strategy for use of the assets in question; and (iii) ensure consistency with related estimates (such as the depreciation period for fixtures and fittings).
- Discount rate: if the interest rate implicit in the contract cannot be readily determined, the AMF asks issuers to take especial care in determining the lessee’s incremental borrowing rate, as this requires consideration of a range of factors and data that are specific to the lessee.
Deferred tax and IAS 12 exemption (AMF only)
The AMF encourages entities with significant deferred tax impacts to specify in the financial statements whether or not they have elected to recognize deferred tax. It notes that any change in accounting policy election would be retrospective, including for finance leases covered by IAS 17.
- Information to be disclosed to the market: ESMA reminds issuers that:
- they should provide more details and generally enhance their qualitative disclosures (progress of work towards implementation, types and characteristics of leases, practical expedients and exemptions used, assessments carried out to determine whether contracts are leases as defined in IFRS 16, key assumptions used when measuring lease liabilities and right-of-use assets, etc.);
- the market will expect to see quantitative disclosures on expected impacts, where these are known or reasonably estimable (or failing this, a qualitative indication of the magnitude of the expected impact and the elements that are still being analyzed);
- they should disclose whether lease liabilities to be recognized under IFRS 16 are broadly in line with commitments for future minimum operating lease payments presented in accordance with IAS 17, and explain any major discrepancies.
- The AMF encourages also issuers who will be significantly affected to present (in their financial communication for 2018) the expected impacts on the aggregates used in financial reporting. Before this information is published, all efforts should be made to ensure it is reliable (e.g. it should be reviewed by the entity’s governing bodies, with considerable involvement from the statutory auditors).
- Transition requirements: ESMA reminds issuers that if they use the modified retrospective approach, they may present restated comparative information provided that this is not presented in the primary financial statements or the associated notes. ESMA also recommends that entities should specify the lease term used to calculate the discount rate (i.e. the remaining lease term or the original lease term) if this assumption is significant. It also recalls that this information will fall under the scope of the ESMA Guidelines on APMs.
First interim financial statements published in accordance with IFRS 16 (AMF only)
The AMF recommends that issuers should:
- present sufficiently detailed and entity-specific disclosures on the standard in the first interim financial statements published in accordance with IFRS 16. At a minimum, this should include the significant disclosures on first-time application and the chosen transition approach required by appendix C of the standard.
- update their accounting policies on leases, even if the impact is not material.
5. Topics Related to Other Parts of the Annual Report
ESMA reminds issuers that the requirement in the Accounting Directive to include details of non-financial performance in the management report is effective for financial periods commencing on or after 1 September 2017. ESMA emphasises the importance of presenting non-financial information that is relevant, material and entity-specific and encourages issuers to refer to the (non-obligatory) guidelines on non-financial reporting published by the European Commission (EC). In this respect, the AMF also reminds issuers that they can refer to its recommendations published in November 2016, which are still applicable.
- Environmental matters: ESMA emphasises that in order to comply with reporting requirements, entities must:
- describe their environmental policies and due diligence processes, with a particular focus on climate change;
- include any key performance indicators that are relevant for evaluating the results of these policies;
- address both the actual and potential impacts of their business on the environment, as well as the ways in which these impacts may affect their own development, performance or position;
- consider potential adverse consequences of these impacts at both an operational and a financial level.
- If an entity has no policy on a risk identified as material: ESMA reminds entities that in this case they must justify and explain their decision, and ensure they comply with other reporting requirements.
- Disclosure and selection of key performance indicators (KPIs): ESMA recommends that issuers should apply the principles set out in the EC Guidelines when selecting their KPIs, which should be (i) necessary to understand the development of their performance and the impact of their activity; and (ii) preferably widely used, to improve comparability between entities in the same sector. Qualitative disclosures should also be presented on the methodology used and the scope of activities covered.
Alternative Performance Measures (APMs):
As entities focus on non-financial reporting and the implementation of new accounting standards, ESMA reminds them of the key principles of Guidelines on APMs:
- entities must provide definitions of APMs used (details of their components and assumptions used in calculation);
- labels used should reflect the content of the APM and should avoid conveying misleading messages;
- entities must explain any changes to APMs and present restated comparative figures;
- entities should explain why APMs are deemed to be useful;
- APMs must not be presented with more prominence than measures directly stemming from financial statements.
Issuers are also encouraged to refer to the Questions and Answers document published by ESMA in October 2017, which provides further explanations and useful examples.