On 28 October, the European Securities and Markets Authority (‘ESMA’) published its recommendations for 2020 financial reporting on its website.
Keywords: Mazars, Thailand, ESMA, Financial reporting, IFRS 16, Leases, Financial statements, COVID-19, IAS, Liquidity risk, working capital, Disclosures
18 December 2020
Unsurprisingly, the recommendations primarily concern issues related to the current public health and economic crisis. The key topics addressed include: the presentation and relevance of financial statements (including going concern issues); measurement of non-financial assets; liquidity risk issues and working capital requirements; and topics specific to credit institutions.
The recommendations for 2020 also include points relating to IFRS 16 – Leases, specifically regarding the application of the amendment recently published by the IASB (the May 2020 amendment on Covid-19-related rent concessions), and disclosures required in the notes under IFRS 16. Furthermore, although it does not make any specific recommendations, the regulator reiterates its call for issuers to clearly communicate the potential impacts of Brexit, where relevant.
Moreover, as issuers prepare to publish their first annual financial reports in XHTML format (under the European Single Electronic Format), ESMA reminds issuers that documentation is available on its website to help them to better understand the requirements, including support materials published by the IFRS Foundation, in particular the Preparer’s Guide.
ESMA also made recommendations focusing specifically on non-financial performance. These recommendations on the non-financial sections of the annual report primarily relate to the impact of the Covid-19 pandemic on non-financial information, and disclosures on social and employee matters.
This study focuses on accounting topics and thus does not address the recommendations relating to non-financial information.
ESMA’s recommendations for 2020 financial reporting are available here.
Presentation and relevance of financial statements
Going concern assumptions
For entities exposed to going concern risks over the twelve months following year-end, ESMA recommends presenting the assumptions used to draw up the financial statements on a going concern basis and the associated uncertainties (e.g. considering reduced market demand for products or services).
If the entity has concluded that there are no material uncertainties, it must provide a detailed and entity-specific description of the judgements made in reaching this conclusion.
Information provided in support of the conclusion could include, for example, the existence of undrawn credit lines or the receipt of government grants or public support measures.
Moreover, the regulator reminds issuers that the information supporting the assessment of going concern should be consistent with other information disclosed in the financial statements regarding in particular liquidity and other financial risks.
Significant judgements and estimation uncertainty
As the current public health and economic crisis is creating a lot of uncertainty, the regulators emphasise the need for issuers to provide specific and detailed information on topics that are useful for understanding the financial statements and the situation of the individual company. Given the increased need for users to be able to understand the assessments carried out by businesses and the risks to which they are exposed, transparency of financial information is essential to bolster market confidence in financial reporting.
Particular attention should be paid to information on key judgements and estimates with high levels of complexity and uncertainty. In this context, ESMA although strongly encourages issuers to disclose information about the sensitivity of carrying amounts to the methods, assumptions and estimates made that underlie calculations. To identify specific issues at 31 December, the regulator recommends taking account of discussions that have taken place with management, auditors and/or the regulator, as well as topics highlighted by the company in its description of risk factors and/or by the auditors in their report of key audit matters.
In addition, assumptions should be consistent across the various estimates presented by the company and the various types of information published in the annual report (notes to the financial statements, management report, risk factors, and other elements of financial reporting).
Presentation of the impacts of the Covid-19 pandemic
In line with its recommendations for the 2020 interim financial statements, ESMA reminds companies of the principle of consistency of presentation of financial statements set out in IAS 1.
Thus, to ensure comparability and to facilitate understanding of the entity’s performance, the regulator still recommends that entities should not change the presentation in the income statement to separately present the impacts of the Covid-19 pandemic. Qualitative and quantitative information should be disclosed on the significant impacts of Covid-19, and the regulator insists on the importance of specifying the methodology used to identify and measure these impacts. Moreover, if such disclosures to explain the Covid-19 impacts are provided in multiple notes, ESMA encourages issuers to clearly cross-reference the relevant notes.
Measurement of non-financial assets
Impairment testing requirements
IAS 36 requires entities to carry out annual impairment testing of cash generating units (CGUs) to which goodwill has been allocated. The test can be carried out at any point in the year, provided that it is the same point every year.
Thus, ESMA reminds companies that even if they carried out impairment tests at the half-yearly closing of accounts as a result of the current crisis, they may still need to carry out their annual impairment testing if this is usually done at year-end. The regulator emphasises that all underlying assumptions used for impairment testing (both financial and operational) need to be updated.
As regards tangible and intangible assets that are to be amortized, ESMA underlines the importance of identifying any indications of impairment at year-end, as there is an increased likelihood that impairment indicators will be triggered by the current crisis. If there are indications of impairment, the entity must carry out the annual impairment test, even if testing was carried out at the half-yearly closing of accounts.
Disclosures on assumptions and sensitivities
ESMA recommends that entities should provide transparency of the estimates and thus include a description of the key assumptions used, particularly operational assumptions, in the notes to the financial statements, along with explanations of any changes in these assumptions since 30 June. For example, it would be useful to present the assumptions regarding if and when the entity considers to be realistic to return to pre-crisis cash-flows levels, and the time horizon considered in relation to post-Covid-19 scenarios.
Moreover, given the current high uncertainty and difficulty of forecasting, ESMA recommends that entities should give greater weight to external evidence when determining the key assumptions used for impairment testing. If there are discrepancies between the assumptions used and external information or past experience, an explanation must be provided.
As regards the sensitivity analyses required under IAS 36, the regulator emphasises the need to select the most relevant variables. For example, it may be useful to provide analyses of the sensitivity to new assumptions that reflect the current health crisis, such as changes in the time horizon for the return to pre-crisis levels of economic activity.
Entities may also need to take account of a potential increase in the scale of reasonably possible changes in assumptions, given the current high levels of uncertainty.
Even if an entity concludes that no reasonably possible change in key assumptions would give rise to impairment, quantitative data on these reasonably possible changes should still be presented considering requirements under IAS 1.129.
Finally, a sensitivity analysis is still useful and relevant even if the asset is already impaired. This allows users to assess the likelihood of any further impairment in the event of changes in key assumptions.
Liquidity risk disclosures and working capital requirements
Liquidity risk disclosures
ESMA emphasises that in the current context of high uncertainty, which has led to increased financing needs coupled with potentially greater difficulty in accessing financing, the liquidity risk disclosures required by IFRS 7 are all the more useful and necessary to the reader to allow them to assess the nature and extent of the entity’s liquidity risk and how the entity manages this risk.
With this in mind, the regulator expects issuers to provide detailed and specific disclosures on debt renegotiations or new significant amounts of financing, as well as banking covenants. Furthermore, ESMA underlines the importance of disclosing a maturity analysis of the financial liabilities and the financial assets, when applicable, used to manage liquidity risk.
Management of working capital requirements
The Covid-19 crisis may lead companies to make increased use of working capital management strategies (such as factoring and/or reverse factoring) in order to maintain liquidity levels. Disclosures on these strategies are particularly useful, as they help readers of the financial statements to assess the entity’s liquidity risk.
ESMA thus recommends that entities that have put in place material arrangements for optimising working capital requirements present transparent, high-quality disclosures including a description of the arrangements, the accounting analysis carried out and the accounting treatment applied, the amounts involved (the total amount involved, the amount of associated receivables and payables, the amount of guarantees if applicable) and the classification in the financial statements (balance sheet, income statement and statement of cash flows).
ESMA recommends that credit institutions should present disclosures in their financial statements on the impacts of the Covid-19 crisis on the identification, management and measurement of credit risk.
It also reminds issuers that the expected credit losses model involves a lot of assumptions and estimates. Given the material uncertainties associated with expected credit losses, the regulator recommends that entities should provide detailed disclosures on the calculation of ECLs, including qualitative and quantitative information on the macroeconomic assumptions used in the scenarios considered.
It also encourages issuers to expand on the disclosures required under IFRS 7 on credit risk exposures and changes in expected credit losses. Thus, it recommends presenting a breakdown of gross amounts and the associated impairment for each stage, broken down by type of credit and by type of customer or counterparty.
IFRS 16 – Leases
Accounting for rent concessions granted by lessors in the context of Covid-19
Readers will remember that on 28 May 2020, the IASB published an amendment to IFRS 16, introducing a practical expedient that allows lessees to immediately recognise Covid-19-related rent concessions in profit or loss. The amendment is applicable for financial periods commencing on or after 1 June 2020. Early application is permitted.
Therefore, the regulator reminds issuers of disclosure requirements of the amendment. Indeed, entities that apply the amendment in their 2020 financial statements should disclose that they have done so, and present the disclosures required by the amendment, i.e. the amounts recognised in profit or loss for the period arising from rent concessions covered by the practical expedient.
Finally, for both lessees and lessors that are materially impacted by rent concessions granted or benefitted from, ESMA recommends that they should provide clear disclosures, including the accounting treatment used for these rent concessions.
Disclosures in the notes and presentation of financial statements
Disclosures relating to profit or loss
ESMA reminds issuers of the requirements of the standard, which stipulates that entities that are materially impacted should disclose the depreciation charges and lease expenses recognised in profit or loss for the period, broken down by type (variable lease payments, short-term leases accounted for by applying the exemption, leases of low-value assets accounted for by applying the exemption, income from subleases).
Lease liabilities and lease payments
IFRS 16 requires entities to disclose enough information to enable users to assess future cash outflows relating to leases and thus to assess their impact on the entity’s liquidity position. ESMA therefore recommends that companies should provide more information on maturity analysis of lease liabilities and future cash outflows relating to leases. This information should include exposures arising from variable lease payments, extension and termination options, residual value guarantees and leases not yet begun to which the lessee is committed.
IFRS 16 specifies that issuers must disclose additional information if this is necessary for users to assess the impact of leases on the financial statements.
As issuers prepare for the second year of applying IFRS 16, the regulator recommends that they should consider the potential utility and relevance of disclosing additional information, such as specific disclosures on variable lease payments. Indeed, especially in the context of the Covid-19 pandemic, such information may complement with relevance disclosures already available to help users of financial statements to understand the impact of the crisis on an issuer’s financial position, performance and cash flows.
Key points to remember
- Unsurprisingly, the recommendations from ESMA for 2020 financial reporting are closely related to the ongoing public health and economic crisis resulting from Covid-19. They are also consistent with the recommendations already published for the interim financial statements.
- The key topics addressed include: the presentation and relevance of financial statements (including going concern issues); measurement of non-financial assets; liquidity risk issues and working capital requirements; and topics specific to credit institutions.
- ESMA reminds entities that separate presentation of impacts of the Covid-19 crisis in the income statement would make it more difficult for users to understand an entity’s financial performance. However, qualitative and quantitative information on the impacts of the Covid-19 is expected, with details on the methodology used to identify and quantify these impacts.
As 2020 is the second year of applying IFRS 16 – Leases, ESMA expects to see more detailed disclosures in the notes to the financial statements.