- ASIC recently issued some warnings that should be taken into account when preparing upcoming half-year financial reports.
As we move into the half-year reporting season, the market will be taking a close look at how companies account for the global financial crisis. Accordingly, the preparation of half-year financial statements will definitely not be a case of "business as usual".
ASIC recently used its review of 2008 annual reports to issue some warnings that should be taken into account when preparing upcoming half-year financial reports. Having reviewed full-year reports for 2008, it is likely that ASIC will conduct a similar exercise on half-year reports, in order to test compliance with these matters.
As noted below, ASIC is also very mindful of the potential for continuous disclosure issues to arise during the process of preparing periodic financial statements.
AASB 101 requires that financial reports reflect whether or not the company is a going concern - in other words, unless indicated otherwise, financials are prepared and read on the assumption that the company is not going to be wound up in the foreseeable future.
ASIC is reminding directors of the importance of ensuring that this assumption is still appropriate for their company. It highlights a number of relevant factors which are particularly relevant in the current economic climate:
- reduced liquidity
- reduced ability to refinance debt or raise new funds; and
- compliance with lending covenants.
Obviously a review of cash flow forecasts will be very important in the current context. Some companies have been taking steps to shore up the underlying assumptions. For example, a number of companies have approached the market with accelerated equity raisings to shore up their balance sheet in the current climate.
Write-downs of assets
An asset must be carried on the books at no more than its recoverable amount; otherwise it is described as "impaired". AASB 136 requires financial statements to recognise an impairment loss (ie. the difference between the book value and the recoverable amount).
In its review of 2007-2008 financial reports (reportedly covering around 100 entities), ASIC found that these write-downs of intangible assets were less than one percent of the total value. It "expects further writedowns" in the half-year financials that are currently in preparation. Directors are warned to maintain a strong focus on impairment of intangibles and other assets not reported at fair values (including relatively recently acquired assets). In light of market developments one could argue that the one percent figure looked far too low and so it is not surprising ASIC will be looking at this area.
Of course, the reporting of impairment losses depends upon the calculation methodology. ASIC expressed concern about the degree to which investors can have faith in the results of that methodology. In that respect, it reports that its review of 2007-2008 accounts found instances where companies did not disclose:
- discount rates and growth rates used in value-in-use calculations
- explanations for using forecast periods of greater than five years; and
- sensitivity analysis in relation to changes in key assumptions.
Singled out for special mention was the treatment of cash-generating units (CGU). A CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. ASIC cautions that CGUs should be identified "at sufficiently low levels" in entities' businesses for the purposes of impairment testing. This is to ensure that surplus cash flows from one CGU not being used to support the values of assets in other CGU.
Impairment is obviously a significant issue which will need to be rigorously examined, especially where the impairment changes may have consequential impacts on matters such as lending covenants.
Determining fair values
"Fair value" is defined as "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction" (AASB 102).
ASIC has identified a number of specific concerns about fair value calculations by infrastructure and property trusts and in relation to financial instruments and sponsored defined benefit funds. It apparently believes that there is insufficient use of market information and disclosure of methods and assumptions when calculating fair value. In this respect, it pointed particularly to:
- infrastructure and property trusts, which in 2007-2008 reported $53 billion of their $55 billion of assets at fair values using directors' valuations, with $20 billion guided by independent valuations;
- financial instruments, reporting that some entities made greater use of models to value financial instruments in their 2007-2008 financials;
- defined benefit funds, specifically advising directors to focus on exposures to changes in the values of assets held by sponsored defined benefit funds.
Off balance sheet arrangements
Some of the entities whose 2007-2008 financials were reviewed by ASIC had possible off balance sheet arrangements that, in the regulator's view, were not adequately explained in terms of:
- the nature and scale of the arrangements; or
- why assets and liabilities were not on the balance sheet.
ASIC will also be asking some entities why off balance sheet assets and liabilities were equity accounted rather than consolidated where the entity's ownership was close to 50 percent and the balance of ownership was widely-held.
When preparing the forthcoming half-year reports, directors are advised by ASIC to understand the "risks and benefits" of off balance sheet arrangements, particularly given the potentially adverse effect that off balance sheet arrangements could have if the current crisis continues.
Given the importance now attaching to refinancing of debt, ASIC is concerned about disclosure of financial instruments, particularly debt instruments, citing such lapses as:
- lack of information about security provided on borrowings
- poor disclosure of debt maturity profiles
- insufficient disclosure of risks associated with financial instruments; and
- poor disclosure of hedging arrangements.
It also noted instances in which quantitative measures of risk were omitted, risk and hedging disclosures were provided on a net basis, and there was no information on exposures to notional underlying amounts under derivatives.
While the impact of the crisis is expected to be revealed in the next release of half-year accounts, it is important to bear in mind that periodic reporting is not a substitute for continuous disclosure:
Speaking just before Christmas, ASIC Commissioner Gibson noted that the same Guidance Note says that "a variation in excess of 10% to 15% may be considered material". However, ASIC clearly believes that this sets the bar too low in current circumstances, leading Commissioner Gibson to caution that "variations at the lower end of the scale might reasonably be expected to impact price materially and should be disclosed."
Commissioner Gibson was particularly mindful of the importance of revisiting earnings forecasts in the current climate. She sees a need for greater disclosure of the assumptions that are used to generate earnings forecasts:
Statements about future matters are deemed to be misleading unless there is a reasonable basis for the belief. Accordingly, listed companies may need to take particular care with any new guidance or forecasts and to revisit prior guidance in the current year to see whether an update may be required.
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