2020 will be remembered as the beginning of the 21st century’s most extreme economic crisis. The crisis was, of course, caused by the covid-19 pandemic. For most entities, already operating in a challenging economic environment, it has heightened uncertainty and added to the complexities of financial reporting. Indeed, many auditors and investors have faced unique challenges in auditing information and in making decisions based on reported information.
What steps has the Board taken in 2020 to address the extra challenges that covid-19 has brought about in relation to financial reporting? This article discusses the following questions that are likely to be on the minds of many investors.
In May 2020 the Board issued Covid-19-Related Rent Concessions, which amended IFRS 16 Leases.
The amendment permits lessees, as a practical expedient, not to assess whether particular rent concessions occurring as a direct consequence of the covid-19 pandemic are lease modifications and instead to account for those rent concessions as if they were not lease modifications. The amendment does not affect lessors.
IASB staff published a spotlight article on the amendment and what it means for investors in September’s edition of the Investor Update.
In a recent article, Mary Tokar, a member of the Board, and Sid Kumar, of the technical staff, provided an overview of the key financial reporting considerations that may be on the minds of preparers, auditors, investors and regulators as they tackle the complexities associated with covid-19. (The article draws on views shared during a panel discussion at the IFRS Foundation Virtual Conference on 28 September 2020.)
When applying IFRS 9 Financial Instruments, estimation of expected credit losses (ECL) requires an entity to develop forecasts and to use significant judgement. The attendees of the panel discussion identified the estimation of ECL as one of the most challenging financial reporting issues that they had to deal with during the pandemic. This was not surprising—the Board has received questions about the application of IFRS 9 during the pandemic. In response to these questions, in March 2020, the Board published educational material to reiterate the requirements in IFRS 9 for determining the amount of ECL that should be recognised (see IFRS 9 and covid-19—accounting for expected credit losses). The educational material emphasised that an entity applying IFRS 9 should make use of all reasonable and supportable information that is available to it without undue cost or effort. It should not rely as an alternative on some mechanistic criterion to determine movements in ECL (for example, by treating payment holidays as automatic evidence of a significant increase in credit risk).
The panel discussed the importance of better information about significant assumptions in ECL in IFRS 9. An ECL approach requires lenders such as banks to use forward-looking macroeconomic assumptions (like GDP growth, unemployment rates and housing price changes) as inputs in models. These assumptions may be classified as general assumptions by some stakeholders because they may relate to factors outside the bank’s control. In contrast, entity-specific assumptions relate to an entity’s actions (for example, the decision to lend to a vulnerable sector or borrower) and characteristics (for example, its customer base). When two similar banks use similar general assumptions (for example, about the path of economic recovery) and arrive at different ECL balances relative to their gross loan books (a ratio commonly referred to as a coverage ratio), users want additional information so they can assess the differences in the coverage ratios. For each bank, users want information that helps them understand the extent to which each ECL balance is driven by general assumptions or by entity-specific assumptions that may reflect differences in customer characteristics (for example, retail versus commercial), loan products, collateral, or other loan terms. Without this information, investors find it challenging to make meaningful comparisons. The requirements in IFRS 7 Financial Instruments: Disclosures were developed after the Board had considered the needs of users and the Standard requires an entity to explain the factors that affect the measurement of its ECL.
Throughout most of 2020 regular meetings with investors were replaced with virtual meetings where possible. On 13 November 2020 it was agreed that all meetings with advisory and consultative groups such as the Capital Markets Advisory Committee will be held remotely until 31 March 2021.
The Investor Engagement Team thanks the many investors who provided feedback on the Board’s current projects; in particular, its project on Primary Financial Statements and its project on Goodwill and Impairment.
Florian: My team and I are responsible for equity investments at a bank that has a strong asset management business; for the past thirty years our focus has been on sustainability. We hold portfolios that are highly concentrated, and we are very fundamentally driven, therefore we prepare financial models incorporating financial and non-financial information. When we examine the financial statements of a company, we look for confirmation of what company management tell us in their management discussion and analysis section of reports as well as in meetings.
Florian: Over the past years of analysing financial statements, I feel that the balance sheet has become less important over time. On the other hand, the reliance on non-financial reports has increased, and for this reason I am excited about the IASB’s Management Commentary project. Non-financial reports are not without their challenges, however. While the information in the management discussion may have been sense checked by auditors, we find that often it lacks consistency in the way certain metrics are calculated or presented. For example, when we look at CO2 (carbon dioxide) measures across companies, there is some standardisation in this measure, but when you get into some metrics on the Social or "S" of the ESG, it gets a little tricky. An example of this issue is training: training may be defined differently from one company to the other, and therefore a common definition and metrics are needed.
Florian: The problem we face with sustainability reports is that they are too long and the things that matter to the business are scattered all over the report. It would be more useful if only the issues material to the business were covered in sustainability reports, or if these issues were covered in the management discussion so that they had more prominence. What is currently missing is the focus on investor needs, and to make matters more challenging there is confusion over the different reporting frameworks such as GRI, TCFD, SASB etc. As a result of this confusion, bodies like the European Financial Reporting Advisory Group (EFRAG) are looking to harmonise the requirements by creating recommendations on possible non-financial reporting standards. Despite all these efforts, a key issue with these different frameworks is that they have different objectives and not all are focussed on investors’ needs. For example, I do not think that the principles in the EU Taxonomy for Sustainable Finance are geared towards providing investor relevant information; instead, they are geared towards achieving certain policy objectives. We believe that like IFRS Standards, ESG reporting frameworks need to address investor needs.
Florian: On ESG data we are currently facing issues that are probably more basic. For example, most institutional investors that are focussed on ESG rely on third party providers for the data. We often find that the data provided even by the large providers are of poor quality, which is not quite the issue with financial data. Secondly, there is sometimes a lag between the availability of financial reports and sustainability reports, as well as a lag in the availability of ESG information in the sustainability reports and the ESG databases. Again, if we look at financial databases, this lag is almost non-existent.
As for the second part of the question, I do not think there is an easy solution for establishing a common set of principles for ESG reporting which could ultimately improve the quality and comparability of ESG disclosures. The key issues which arise in drafting accounting standards come to the fore here as well. For us, the key conflict is always the trade-off between comparability and materiality or specificity.
Florian: For starters, we are driven by objectives that we try to achieve. These could be to reduce risk, to enhance return, or to scope externalities, for example to reduce carbon intensities in our portfolios. In our analysis, we look at issues that may be material across companies in a sector as well as at issues that are material to a specific company. Over time we have developed tools, screens, and indicators that we can use to identify companies across our universe. To share examples, we have developed a tail risk reduction tool to reduce the risk of large drawdowns. We have developed indicators that we use in our corporate bonds portfolio that help us reduce the risk of default. We have tools that help us identify companies that we expect to have a higher return on invested capital or margins in the future. A final example is a tool that helps us apply learnings or insights from our research on issues that affect one company to other companies in the same sector. So, if we have identified employee turnover as a key issue for say a postal and delivery company, we can quickly screen for performance across this metric across similar companies. A final point on material ESG issues is that we use this analysis to help us identify leading indicators that will ultimately point to a financial impact that will be reported in the financial statements.
Florian: We use ESG information to identify companies that we want to put in our investment funnel. Next, we develop financial models and assess the impact of ESG information on value drivers such as margins and discount rates. We typically back-test the indicators we use to identify companies and determine the impact on value drivers. For example, how much of an adjustment is made to margins or discount rates is based on back-tested data. However, looking at past data, we have also found that there has not been as much of an impact on value drivers as was expected based on our judgements and beliefs.
I view the financial statements and accounts as the anchor that everything will eventually end up in. In each of our investment cases we have four to five key performance indicators (KPI’s), which include ESG data, non-financial KPI’s, and financial KPI’s. Financial KPI’s are often a minority in this mix.
Florian: I think that information on material ESG factors should be included in financial reports. If a company is monitoring this information internally and believes it is important to the business, then this information should be included in the financial statements. This will add rigour to the information because of the validation through the audit process.
Florian: We find that the discussion around sustainability is very geographically driven. For instance, when I visit the US companies want to talk about governance, but when I visit France companies want to talk about their carbon footprint, and in Germany its mostly about stewardship and ethics. In other words, there is a wide range of issues that people want to talk about under the heading of sustainability. The one thing we have been focussing on more recently is the management incentive system. We pay attention to how the management incentives are determined and how management is guiding investors. We look for alignment in the long-term guidance and long-term equity-based incentives given to management. It is not always easy to find this information, but we find the proxy statements in the US quite useful for this analysis.
Florian: I hope that standard-setters will be more rigid with KPI’s. So, if there is an important KPI for a company that is monitored internally and shared in reports, there needs to be more rigour around how it is presented over time. I believe that for the non-material or longer material issues (stranded assets for example), regulators will force these disclosures on companies. This is quite evident in the EU with the EU Taxonomy, and under this impending legislation if companies want to be part of a sustainability index, they will have to report all the required information. I think this will potentially address the issue of dealing with too many frameworks, and could potentially result in more comparable information.
I expect that companies will also realise the importance of human capital management, especially as they transform from being asset-heavy to asset-light, services-oriented businesses. Many companies today make bold statements in the annual reports about their employees being their greatest resource, but very few of them articulate a clear human capital management strategy, and therefore there is little information available on this area. Hopefully in the future there may be more reporting of things like human capital management strategy, governance, risks, and performance.
We thank Florian for taking the time to share his views with us and our readers.
More information about Florian’s background can be found on the CMAC members’ page here.
The Board is gathering evidence to help decide whether it should develop proposals to replace or amend IFRS 6 Exploration for and Evaluation of Mineral Resources. (IFRS 6 specifies the financial reporting for the exploration for and evaluation of mineral resources.)
To help the Board determine whether there is a problem that needs to be resolved, we are asking for investor views on the importance and availability of information about exploration and evaluation expenditure and reserves and resources.
We have prepared a short online survey for investors on this topic. If you would like to participate in the survey (which takes only around 5–10 minutes to complete), please contact the Investor Engagement team at email@example.com.
IFRS Standards do not specify how to account for mergers and acquisitions involving companies within the same group. As a result, companies account for such transactions in different ways. In some cases, they use the so-called acquisition method that measures assets and liabilities received at fair value, and recognises goodwill. In other cases, companies use a book-value method that measures assets and liabilities received at their existing book values. In addition, a variety of book-value methods are used in practice. Furthermore, companies often provide little information about these transactions. That makes it difficult for investors to understand the effects of these transactions on the companies that undertake them and to compare companies that undertake similar transactions.
In November 2020 the Board published Discussion Paper Business Combinations under Common Control. The Discussion Paper sets out the Board’s preliminary views on how to fill this gap in IFRS Standards. The Board’s aim is to reduce diversity in practice and to improve transparency and comparability in reporting these common transactions. These combinations are seen in many countries around the world, particularly in emerging economies.
In this short video, Board Member Françoise Flores introduces the Board’s preliminary views set out in the Discussion Paper; you can also watch the video here. For an overview you can access a fact sheet about the project. We have also published a Snapshot, which provides a more detailed summary of the Discussion Paper. In the next few weeks, the Board expects to publish an Investor Perspective article on this project. The full text of the Discussion Paper is available on the comment letter page. Please contact firstname.lastname@example.org if you wish to discuss the Board’s preliminary views and provide your comments. The Board is asking for stakeholder comments by 1 September 2021.
The Board published a Request for Information on 9 December 2020 as part of its Post-implementation Review of IFRS 10, IFRS 11 and IFRS 12.
IFRS 10 Consolidated Financial Statements identifies control as the single basis for consolidation and establishes principles for preparing consolidated financial statements. IFRS 11 Joint Arrangements establishes principles to report interests in joint arrangements and uses rights and obligations as the basis for determining the type of joint arrangement to which an entity is a party. IFRS 12 Disclosure of Interests in Other Entities combines, enhances and replaces the disclosure requirements for subsidiaries, joint arrangements, associates and unconsolidated structured entities. All three IFRS Standards have been effective since 1 January 2013.
The Board published an Exposure Draft in November 2020 to seek feedback on the accounting for sale and leaseback transactions—transactions for which a company sells an asset and leases that same asset back from the new owner. The proposal improves the sale and leaseback requirements already in IFRS 16 by specifying how a company measures the lease liability both at the date of the transaction and subsequently. This would improve consistency in application of IFRS 16 to sale and leaseback transactions.
The proposal in the Exposure Draft would not change the accounting for leases other than those arising in a sale and leaseback transaction.
The Board is asking for stakeholder comments by 29 March 2021.
The IFRS Foundation Trustees recently announced the appointment of Andreas Barckow to serve as Chair of the Board, effective July 2021. Andreas currently leads the Accounting Standards Committee of Germany. He will succeed Hans Hoogervorst, who completes his second five-year term in June 2021.
Colette Bowe, Teresa Ko, Larry Leva, Michel Madelain, Ross McInnes, Vinod Rai and Lucrezia Reichlin have all been re-appointed for a second three-year term, effective 1 January 2021.
The Trustees also confirmed the appointment and reappointment of several organisations and individuals to the IFRS Advisory Council, effective 1 January 2021.
In the context of their strategy review, the Trustees have published the Consultation Paper on Sustainability Reporting to determine:
To learn more about this consultation, you can listen to a recording of one of the webinars we hosted on 17 November 2020 by visiting the IFRS Foundation YouTube channel. Materials from the webinar can be found here.
The IFRS Foundation has been engaging with stakeholders since the publication of the consultation paper, and staff and Trustees will analyse the feedback and share updates in future editions of the Investor Update.
Board member Mary Tokar and Sid Kumar, of the technical staff, provide an overview of the key financial reporting considerations that may be on the minds of preparers, auditors, investors and regulators as they tackle the complexities associated with covid-19.
Darrel Scott, who has just completed his second term as a member of the Board, discusses his experience with the man who has replaced him in the Africa seat: Bruce Mackenzie.
The IFRS Foundation recently published educational material to highlight how existing requirements in IFRS Standards require companies to consider climate-related matters when their effect is material to the financial statements.
The educational material complements an article that Board member Nick Anderson wrote on this topic in November 2019. The educational material has been developed in response to requests from stakeholders for further information.
The material contains a non-exhaustive list of examples of when companies may need to consider climate-related matters in their reporting and its aim is to support the consistent application of IFRS Standards. It does not add to or change the requirements in the Standards.
Webinars were recently held for various CFA Societies around the world on the Board’s Discussion Paper Business Combinations—Disclosures, Goodwill and Impairment. A recording of the webinar hosted with CFA France is now available and can be accessed here.
In this blog, Larry Leva calls on investment professionals to share their views on global sustainability reporting.