Research report 134 Worldwide application of IFRS 3, IAS 38 and IAS 36, related disclosures, and determinants of non-compliance Worldwide application of IFRS 3, IAS 38 and IAS 36, related disclosures, and determinants of non-compliance ACCA RESEARCH REPORT 134 Ioannis Tsalavoutas, Lecturer in Accounting, The University of Stirling Paul André Professor of Accounting, ESSEC Business School, Paris Director ESSEC Financial Reporting Centre Dionysia Dionysiou, Lecturer in Finance, The University of Stirling Certified Accountants Educational Trust (London), 2014 ACCA’s international research programme generates high-profile, high-quality, cutting-edge research. All research reports from this programme are subject to a rigorous peer-review process, and are independently reviewed by two experts of international standing, one academic and one professional in practice. The Council of the Association of Chartered Certified Accountants consider this study to be a worthwhile contribution to discussion but do not necessarily share the views expressed, which are those of the authors alone. No responsibility for loss occasioned to any person acting or refraining from acting as a result of any material in this publication can be accepted by the authors or publisher. Published by Certified Accountants Educational Trust for the Association of Chartered Certified Accountants, 29 Lincoln’s Inn Fields, London WC2A 3EE. ACKNOWLEDGEMENTS This report is the result of a research effort spanning a period of 18 months. The authors are grateful to many people for their support. The project would not have been possible without the financial support and encouragement of ACCA. Yin Wang (Company Reporting Practices Ltd) has contributed greatly during the development of the coding scheme and the data collection process. Michael Mavromatis (Axios Systems) contributed in the early stages of the project in the development of the structure of the database in which the data collected was stored. Richard Martin (ACCA), Barbara Davidson (IASB), Michael Stewart (IASB) and an anonymous referee have provided helpful comments on earlier versions of the present report. Ioannis Tsalavoutas and Dionysia Dionysiou thank the Accounting and Finance Division at the University of Stirling, and Paul André thanks the ESSEC KPMG Financial Reporting Centre for additional financial support. ISBN: 978-1-85908-489-2 © The Association of Chartered Certified Accountants, May 2014 Contents Executive summary 5 1. Introduction 10 2. IFRS 3 Business Combinations 15 3. IAS 38 Intangible Assets 25 4. IAS 36 Impairment of Assets 32 5. Determinants of compliance levels with disclosures mandated by IFRS 3, IAS 38 and IAS 36 41 6. Conclusions 62 Appendix: Screen-shot of the database developed and used for the data collection 65 References 66 WORLDWIDE APPLICATION OF IFRS 3, IAS 36 AND IAS 38, 3 RELATED DISCLOSURES, AND DETERMINANTS OF NON-COMPLIANCE Abbreviations ANC Autorité des Normes Comptables CAS Chinese Accounting Standards for Business Enterprises EC European Commission EFRAG European Financial Reporting Advisory Group ESMA European Securities and Markets Authority FASB Financial Accounting Standards Board FRC Financial Reporting Council FRRP Financial Reporting Review Panel GAAP Generally Accepted Accounting Principles IAS International Accounting Standards IASB International Accounting Standards Board IASC International Accounting Standards Committee ICB Industry classification benchmark ICAEW Institute of Chartered Accountants in England and Wales ICAS Institute of Chartered Accountants of Scotland IFRS International Financial Reporting Standards MASB Malaysian Accounting Standards Board NZICA New Zealand Institute of Chartered Accountants PRC People’s Republic of China SEC Securities and Exchange Commission 4 Executive summary This report investigates the accounting for, and information disclosed under, IFRS 3 Business Combinations, IAS 36 Impairment of Assets, and IAS 38 Intangible Assets, and examines compliance levels with the mandated disclosures and their determinants. The uniform application of IFRS across different jurisdictions on the accounting policies introduced with IFRS 3. Second, has been heavily questioned, since the implementation of this report documents the significance and prevalence of, and high-quality accounting standards (which IFRS claim to ensure) accounting for, intangible assets across countries and may not necessarily lead to high-quality reporting because of industries. Third, the report discusses the frequency and the influences of different socio-economic environments on magnitude of the impairments recognised across countries financial reporting practices (Larson and Street 2004; Ball and industries, while capturing information about the 2006; Nobes 2006; Soderstrom and Sun 2007; Weetman 2006; assumptions companies use for impairment testing. Fourth, it Zeff 2007). This means that equal levels of compliance with shows the level of compliance with the mandated disclosures mandatory disclosure requirements and/or consistent across countries and industries. Fifth, it identifies the firm- measurement and display of similar transactions between and country-level determinants of these compliance levels. different companies may not be achieved. This concern is investigated here, first, by examining the accounting for, and Overall, the report highlights areas on which preparers, the information disclosed under, IAS 36 Impairment of Assets, regulators and enforcement bodies need to focus to improve IAS 38 Intangible Assets and IFRS 3 Business Combinations. the level of disclosure by companies. This should result in Secondly, levels of compliance with these three standards’ more complete provision of information to the users of the mandated disclosures and their determinants are considered. financial reports. Furthermore, it highlights areas that These investigations involved a large sample of companies standard setters may need to improve in order to eliminate from different countries around the world. ambiguity in the interpretation of the standards. This should result in greater comparability of the information provided by Focusing on these three standards is important for users and companies. standard setters. First, several studies, including those from the Financial Reporting Review Panel (FRRP 2006), the SAMPLE SELECTION European Commission (EC 2008), the Institute of Chartered Accountants in England and Wales (ICAEW 2007), the Most EU listed companies adopted IFRS in 2005 for their Securities and Exchange Commission (SEC) (2007) and consolidated financial statements, while a significant number Company Reporting Ltd (2007; 2008) consistently indicate of other countries have now also adopted IFRS or claim that there is an underlying issue of compliance with these significant convergence of their national accounting standards and that certain areas within the standards standards with IFRS. Nonetheless, very little is known about themselves pose problems in terms of comparability. Second, the accounting for, and related disclosures under IAS 36, IAS given the requirements in IFRS 3 that intangible assets be 38 and IFRS 3, not only among companies within the EU but recognised separately on acquisition (FRRP 2006: 4), mergers also those outside it that have recently adopted/converged and acquisitions significantly increase the importance of with IFRS. This report, therefore, draws on a large sample of intangibles in firms’ financial statements. Third, the recently companies in and outside the EU. revised IFRS 3 (effective for financial periods starting on or after 1 July 2009), together with the result of a desired In order to examine the accounting for, and related convergence on the topic of business combinations between disclosures under, the three standards for the first year of the IASB and FASB, introduces a number of significant implementation of IFRS 3 (financial year 2010/11), a sample of changes, the implications of which have yet to be investigated. 544 non-financial companies was selected from the EU, Australia, China, Hong Kong, New Zealand, Brazil, South Major contributions arise from the present research. First, this Africa and Malaysia. The companies were constituents of their report documents the level of mergers and acquisitions countries’ premier stock market indices as at 1 June 2011. For (M&A) activity and its impact on financial statements, the EU, constituents of the S&P Europe 350 index as at 1 June including the types of asset acquired and their significance, 2011 are also used. This allows a focus on the companies that the treatment of non-controlling interests and the level of are the most likely to be followed by a significant number of acquisition-related costs expensed. This leads to a reflection investors (foreign and domestic). WORLDWIDE APPLICATION OF IFRS 3, IAS 36 AND IAS 38, EXECUTIVE SUMMARY 5 RELATED DISCLOSURES, AND DETERMINANTS OF NON-COMPLIANCE SUMMARY OF FINDINGS offers two potential ways of measuring non-controlling interest. Additionally, only 11 companies (14.4%) explicitly Reflecting on the findings, overall, this report documents state that they measure their non-controlling interest at significant disparities in the mandated information provided fair value (full goodwill approach), indicating that the by different companies about business combinations, newly introduced alternative method is not popular intangible assets and impairment testing. among firms. Disclosures about business combinations (IFRS 3) • On average, 38.9% of the total purchase price is allocated • For 280 companies (ie 51.5% of the sample) there is an to ‘Other intangible assets’. Companies are not explicit on indication that at least one business combination took what is recognised in this ‘class’ of assets so there is a place. Of these, 51 (or 18.2%) indicate that they had one or need for supportive disclosures on what these assets more business combinations by disclosing some constitute. information, such as number of businesses acquired, consideration transferred, related costs expensed or • A large number of the sample companies do not disclose method of payment, but do not disclose any further pro forma information about the business combinations. information. It is assumed that these business Does this mean that it is too costly or ‘impracticable’to do combinations are considered immaterial (individually and so in all these cases? collectively) and hence that detailed information is not merited. Nevertheless, the question that arises is why do Reflecting on the above findings, it becomes apparent that, some firms disclose only selected information? without specific guidance on when and how items should be disclosed, companies provide significantly disparate • Similarly, 240 out of the 280 firms report the actual price/ information about business combinations, resulting in a lack consideration transferred for completing the of comparability. From a user’s perspective, it is difficult to combinations conducted and an identical number of firms determine whether this disparity is because firms do not view disclose the method of payment for their combinations. their acquisitions as material, do not understand the As above, it is not clear why some companies do disclose mandated requirements and/or simply do not follow the and some do not. standard to the letter. • Only 101 companies disclose the acquisition-related Application of IAS 38 and related disclosures expenses incurred and expensed in the income • The research showed that ‘other intangibles’ feature as a statement. In an attempt to identify the relative separate class of intangible assets in the statement of importance of such disclosure, the research found that the financial position of 453 of the 517 companies (ie 87.6%) mean (median) ratio of acquisition-related costs over that have at least one type of intangible asset other than profit before tax for the firms disclosing such information goodwill. Additionally, this type of asset represents, on separately is 2% (1%). Two conclusions arise from this. average, 5.28% of companies’ total assets. This would First, the associated acquisitions costs expensed are very make one to expect that companies supply readers with modest relative to the size of the companies in the sample more details about these assets. However, this is not the and the volume of the business combinations conducted. case. As a result, the change introduced by IFRS 3, ie expensing all acquisition-related costs, does not lead to a significant • In countries such as the UK, Belgium, Hong Kong, France, change in companies’ financial performance. Second, why Denmark, the Netherlands and Australia, almost 30% of do other firms not disclose such information or clearly companies’ total assets relate to intangible assets state that it is immaterial? (including goodwill). Additionally, constituents of the consumer services and healthcare industries appear to • Although 258 companies disclose that they recognise make higher investments in intangible assets, including goodwill, only 61 disclose a qualitative description of the goodwill (respectively 36% and 40% of total assets of factors that make up this goodwill. This leads to the these two industries). Thus, intangible assets are one of conclusion that a large number of companies fall short of the most material asset types in a large number of the IFRS 3 requirement for such information. In most companies in the larger stock markets worldwide. cases, even the 61 companies that do provide a description give nothing more than a brief statement • A large proportion of the sample companies do not referring to synergies expected to arise from the disclose whether the useful lives of intangible assets combinations. There appears to be a lack of guidance on (either acquired or internally generated) are indefinite or what is expected from this requirement. Note that the finite and, if finite, the useful lives or the amortisation rates ICAS and NZICA study (2011) recommends deletion of this used. Similarly, a large proportion of the sample firms do requirement. not disclose the line item(s) of the income statement in which any amortisation of intangible assets is included. • Out of the 76 companies for which acquisitions involve Companies in the consumer goods and consumer services between 50% and 99% of the acquiree’s assets, 33 remain industries provide this information more frequently than silent on how the non-controlling interest is measured. firms in the utilities and basic materials industries. Hence, users do not receive full information as IFRS 3 now 6 • There are 151 companies that give an indication of having • IAS 36 requires companies to disclose the growth rate at least one intangible asset with indefinite useful life. used to extrapolate cash flow projections beyond the Only 58% (ie 88) of these companies, however, disclose period covered by the most recent budgets/forecasts. In the reasons supporting the assessment of an indefinite practice, 21% of the 485 companies that disclose some useful life and/or the factor(s) that played a significant role information about the cash flow estimations do not in determining that the asset has an indefinite useful life. disclose this information. • The majority of firms that should disclose a reconciliation • IAS 36 has recently introduced a requirement for of movement of the carrying amount of intangible assets companies to disclose (i) the period over which at the beginning and end of the period, do so (about management has projected cash flows; (ii) the growth rate 94%). used to extrapolate cash flow projections; and (iii) the discount rate(s) applied to the cash flow projections, if fair • No company was identified that measures intangible value less costs of disposal has been used and fair value assets at fair value (this is consistent with earlier studies, less costs of disposal is determined using discounted cash eg Glaum et al. 2007). As a result, there are no effects on flow projections. Of the surveyed companies, 22 fall into the comparability of accounting information with this category and 21 of these do provide the newly companies from China (or the US) where the revaluation introduced mandated disclosures. model is not permitted. The IASB could consider the usefulness of permitting this practice. Given the complexity of the standard and the depth of information it requires, the analysis illustrates the disparities Overall, intangible assets account for a large proportion of between companies in the amounts and types of information companies’ assets and yet relevant mandatory disclosures are actually provided. This reinforces the need for a review of the not provided in full. For the IASB, ensuring that there is disclosures mandated by IAS 36 along with provision of sufficient and comprehensive guidance to promote the best specific guidance on when this information is expected. possible communication of relevant information should be Arguably, this report’s recommendation for specific guidance considered a key priority. on the application of the materiality principle across different disclosure requirements seems pertinent, especially in IAS 36. Application of IAS 36 and related disclosures • Almost all companies reporting recognition of an Additionally, beyond the need for promoting better guidance impairment disclose the amount of the impairment about the disclosures mandated by the standard in general, separately (334 out of 339 companies), as required by the there are two areas related to recognition and measurement standard. The most frequent type of asset to be impaired that also appear to need improvement. The first relates to the is plant and machinery, with land and buildings to follow. It use of post-tax discount rates in the impairment testing is more frequent for companies to recognise an calculations. Although in principle the standard seems to impairment on an intangible asset with finite useful life require pre-tax discount rates, it is worded in a way that than on goodwill. This may not be that surprising if one allows companies to use post-tax rates instead. This considers the standard’s requirement to test these for apparently results in great variation in practice, which hinders impairment at an individual level, whereas goodwill is comparability of the information reported. Further, while one tested against the recoverable amount of an entire would expect companies to use pre- or post-tax cash flows cash-generating unit. when using pre- or post-tax discount rates, respectively, this is not necessarily verifiable given the relevant disclosure • The large majority of companies reporting recognition of requirements in the standard. a reversal of an impairment disclose separately the amount of the reversal (93 out of 101 companies), as is The second area relates to the option companies have in required by IAS 36. Even so, only 37 companies disclose a reversing impairment losses recognised. IAS 36 requires a required justification for the reversal recognised. company to disclose the main events and circumstances that led to recognition of reversals of impairment losses (providing • Of the 495 companies for which paragraphs 134 and 135 that these reversals are material). Only 37% of companies do are potentially relevant, 35 (7.1%) remain silent as to the so while the mean (median) percentage of reversal of methods adopted for measuring the recoverable amounts impairments over operating profit is a non-trivial 7% (1%). of the assets, even though this is required. On a more Given that these reversals appear to be significant and that positive note, although 75 companies disclose that the this practice is not permitted under US GAAP and CAS, it is period of cash flows used in the impairment testing surprising that companies fall short of the standards’ process exceeds five years (which is not recommended by requirements. This is another example where guidance with the standard), they do give a justification for why cash regards to materiality would be useful. flows beyond a five-year period have been used. • Although IAS 36 recommends that the discount rates used during the impairment-testing process be calculated on a pre-tax basis, a large number of the sample companies (92) use post-tax discount rates. WORLDWIDE APPLICATION OF IFRS 3, IAS 36 AND IAS 38, EXECUTIVE SUMMARY 7 RELATED DISCLOSURES, AND DETERMINANTS OF NON-COMPLIANCE Levels of compliance with mandated disclosures1 CONCLUSION AND RECOMMENDATIONS • The mean (median) overall compliance score is 83% (84%). Interestingly, 75% of the sample firms have at least 75% This report documents a high level of disparity of information compliance levels. Firms with the lowest compliance and what appears to be non-compliance, across a broad scores (ie the bottom quartile) report minimum international set of firms, with the mandatory disclosure compliance levels of 33%. At the other end of the requirements in IFRS 3, IAS 36 and IAS 38. Although spectrum, those in the top quartile (25%) of highly materiality thresholds have been imposed by the researchers, compliant firms comply with at least 93% with the access to inside information would be necessary to determine requirements of the three standards. whether 1) companies consider certain transactions (eg a business combination) or items (eg an intangible asset or an • Mean (median) compliance levels of just above 80% are impairment loss) not to be material enough, 2) the standards valid not only for total compliance scores, but also for are misunderstood/not clear enough, or 3) companies individual compliance levels with IFRS 3, IAS 36 and IAS 38. deliberately fail to follow the mandatory disclosure requirements. • For the 23 countries examined, this report documents average compliance scores from 77% to 90%. Specifically, This research is very timely in that it reflects on the current New Zealand is the country with the highest average debate about the need for or usefulness of mandatory compliance of 97%. Ireland is the country with the second disclosures within IFRS. In January 2013, the IASB hosted a highest average disclosure score of 91%. UK follows with public Disclosure Forum to consider the challenging area of 90%. In contrast, some countries report much lower disclosure overload. Participants included some of the compliance levels. Greece is the country with the lowest organisations that have undertaken work in the area of compliance score, at only 67%. Brazil has a disclosure disclosure in financial reporting (see EFRAG 2012; ICAS and score of 75%. Austria, Spain, China, South Africa and NZICA 2011)). In May 2013, the IASB issued a Feedback Portugal are at 76%. Statement about this event and, in July 2013, the chairman of the IASB, Hans Hoogervorst, gave a speech entitled ‘Breaking • Less variability on average compliance levels is seen at the the boilerplate’ outlining ‘10 good proposals to make industry level. Compliance scores by industry ranges from disclosures more effective’. Furthermore, FASB and EFRAG, 80% to 88%. The oil and gas industry is weaker in its among others, have expressed concerns about the potentially overall compliance scores (80%), while the technology excessive quantity of mandated disclosures and the need for sector has the highest compliance score, 87%. a disclosure framework. Finally, in July 2013, the IASB started its post-implementation review of IFRS 3 (2008), part of which Determinants of compliance with mandatory disclosures is the identification of areas in which ‘implementation • Firms reporting impairments comply less with mandatory problems or unexpected costs with IFRS 3 were encountered’ disclosure requirements of IFRS 3, IAS 36 and IAS 38 than (IFRS Foundation 2013b). The recommendations below aim to do firms without impairments. further this debate and discussion. • Cross-listing in the US increases compliance levels, which To facilitate easier application of IFRS by preparers and is consistent with the bonding and signalling hypotheses. enhance clarity and comparability of accounting information for users, this report recommends that the IASB consider • The strongest the enforcement mechanisms in a country, revisiting the disclosure requirements at a standards level. the higher the compliance levels. In fact, it is the auditing Such a review should reflect on the need for and provision of component of the enforcement environment that drives specific materiality thresholds that would trigger the this result. disclosure of particular information. Additionally, in the absence of disclosure, IFRS should require companies to • Compliance levels are lower when a company is from a provide an explicit statement explaining when disclosure is country with a legal system of French origin. not merited or explaining where providing certain disclosures is impractical, which would reduce information asymmetry Earlier evidence indicates that companies did not fully comply and improve comparability across companies. This will with previous national mandatory disclosure requirements. require a broad consultation with preparers, users, auditing The present results indicate that companies continue not to firms, enforcement bodies and academics. do so even after adopting IFRS. Hence, the research findings in this report are in line with concerns that adoption of IFRS does not necessarily lead to high-quality reporting across different jurisdictions. Beyond the quality of the standards, different firm and country-level factors (eg enforcement, audit environment, listings) influence financial reporting practices. 1. Compliance scores are summarised where each item is of equal importance (CK method). Chapter 5 also presents results using a method of measuring compliance where each standard is of equal importance (PC method). Results are qualitatively similar. 8