IN PRACTICE
IAASA Highlights Matters For Management by Maurice Barrett
IAASA Highlights Matters for Management, Audit Committees and Auditors to Consider for the 2023 Reporting Screen
by Maurice Barrett
Each year, the Irish Auditing and Accounting Supervisory Authority (IAASA), Ireland’s accounting enforcer, publishes its Observations paper setting out key areas that warrant scrutiny by those preparing, approving and auditing financial statements.
The Observations paper is primarily addressed towards preparers, Audit Committee members and auditors of listed entities preparing IFRS financial statements. However, the messages in the paper have a broader application extending to non-listed entities and to entities applying UK-Irish GAAP and could usefully be applied by all entities.
Continued uncertainty in the economic outlook
Entities will prepare their 2023 financial statements against an uncertain economic backdrop with regional conflicts, increased interest rates and inflationary pressures all contributing to that uncertainty.

The following business headlines from the rte.ie website for a single day in November 2023 illustrate the level of uncertainty:

  • Consumers see inflation above ECB target for years
  • IMF cuts growth forecast for China and euro area
  • ECB’s De Guindos sees inflation slowing down
  • ECB’s Schnabel can’t rule out more hikes
  • Euro zone retail sales see bigger than expected drop
  • ESRI forecasts slowdown in Irish economy this year
Macro-economic impacts
Wars, inflation, high interest rates and energy prices, and weak consumer sentiment present challenges for many entities. These macro-economic impacts should be considered when preparing 2023 financial reports.

Re-financing and other financial risks

Increased interest rates and the possibility of further hikes mean entities may face increased borrowing and re-financing costs, adding to the risk that they may encounter difficulties in meeting their financial obligations.

Entities may need to provide transparency about interest rate risks and liquidity risks on their financial position, performance and cash flows. While the impact of interest rate increases on the financial statements may be particularly pronounced for entities dependent on borrowings subject to variable interest rates, fixed interest debt may present re-financing risks. Entities exposed to interest rate risk are required to provide a sensitivity analysis showing how profit or loss and equity would have been affected by the reasonable possible changes in interest rates. Different classes of financial instruments may require different types of sensitivity analysis.

Cash flow challenges due to inflationary and interest rate pressures may prompt entities to seek additional financing or to amend the terms of existing facilities. Entities (both borrowers and lenders) should provide transparency on financing re-negotiated during the year, disclosing the main changes in the terms and their financial impact.

Substantial modification of financial instruments results in their de-recognition followed by recognition of a new financial instrument.

IFRS 9 Financial Instruments provides guidance on determining whether a modification of a financial liability is substantial. The accounting requirements in IFRS 9.B5.4.5 and B5.4.6 and the disclosure requirements in paragraph 35J of IFRS 7 Financial Instruments: Disclosures should be considered.

Covenants

Macro-economic factors may impact an entity’s ability to meet the covenant requirements. Entities are reminded that a liability shall be classified as current when the entity no longer has an unconditional right to defer settlement for at least twelve months after the reporting period [paragraphs 69 and 73 of IAS 1 Presentation of Financial Statements].

Cash and cash equivalents (C&CE)

IAS 7.45 and 46 require disclosure of the components of C&CE, including the policy adopted for determining their composition. Moreover, it is expected that, if relevant, entities will disclose any significant C&CE held that are not available for use by the entity. The reasons for the cash restrictions should be explained.

Going concern

Increased vulnerability of some entities in the current macro-economic environment may raise questions about their ability to continue as going concerns.

In assessing the appropriateness of the going concern assumption, management, directors, Audit Committees and auditors should consider all the available information about the future [IAS 1.25 and 26]. Entities may need to consider a range of factors relating to current and expected profitability, debt repayment schedules and potential sources of alternative financing (including factors outlined in IFRS 7.B11F).

In the current macro-economic environment, when assessing the going concern assumption, management, directors, Audit Committees and auditors may need to:

  1. consider a greater number of factors than in the past, and
  2. reflect the impact of those factors evolving more quickly than may have traditionally been the case.

Entities aware of material uncertainties related to events or conditions that may cast significant doubts about going concern need to provide entity-specific disclosures about the risks, including how the entity is responding to them.

Fair-value measurement and disclosures
An increased level of uncertainty may exist regarding the fair values of investment properties. Commercial real estate markets in many jurisdictions are characterised by declining prices and weakening investor demand accompanied by decreased market activity.

Residential real estate markets are facing supply shortages, construction cost inflation, high demand and an increasingly costly financing landscape. Similar considerations apply when estimating the recoverable amount of assets measured at cost for the purpose of impairment testing in accordance with the requirements of IAS 36 Impairment of Assets.

Entities are expected to reflect changes in factors such as interest rates and or investor demand in the fair value measurement of investment property. The impact of increasing overall costs due to inflation and potentially decreasing vacancy expectations should be considered when forecasting future cash flows.

Entities are expected to:

  1. explain their methodological assumptions (e.g., how has the capitalisation rate or the rate of return been determined?),
  2. explain any significant changes to the previous year and the reasons for those changes,
  3. consider whether, in cases when the fair value measurement of investment property is based on prices in comparable transactions (‘market approach’) any decline in real estate market activity, the limited information of comparable transactions in recent periods really reflects the current macro-economic environment, and
  4. explain how the impact of climate change and other environmental factors have been considered in the fair value measurement.
Fair values of financial instruments measured at amortised cost
IFRS 7.25 requires the disclosure of the fair value for each class of financial asset and financial liability, including those that are measured at amortised cost. This enables the users of the financial statements to assess financial risk by comparing these values with the carrying amounts. Such disclosures are of particular importance as entities, and especially those which might be experiencing difficulty in meeting their financial obligations, may need to sell some financial investments to generate additional liquidity.
coworkers gathered together studying graphs and materials
IAS 36 Impairment of Assets
Against the background of macro-economic uncertainties and changes in operational environments due to climate risks, the recognition and measurement of impairments under IAS 36 will likely be a key consideration in 2023 financial statements. Preparers and auditors need to ensure that assumptions used for impairment testing are reasonable and supportable [IAS 36.33(a) refers].

Market capitalisation

IAS 36.12(d) states that where the carrying amount of the net assets of an entity is more than its market capitalisation, this is an impairment indicator.

If no impairment is recognised, then preparers, Audit Committee members and auditors of impacted entities need to understand why variances between the market capitalisation and the carrying amount of net assets did not result in an impairment charge.

Climate risks in value in use (VIU) calculations

Entities are reminded that climate risks may be an indicator that an asset is impaired; if so, the entity must factor this risk into its VIU calculations. Entities must update the key assumptions used to reflect the impact of climate risks on the VIU calculations.

Entities are reminded that where there are impairments, or indications of impairment, the consistency between judgements and estimates and related uncertainties disclosed in the financial statements must be considered against information disclosed in the notes, the management report and in any non-financial statements (e.g., is there clear linkage between the various elements where the entity has assessed the impact of climate risk as minor yet the entity has invested in decarbonisation and nature-based projects to achieve climate targets?)

Financial instruments – IFRS 7 Financial Instruments: Disclosures & IFRS 9 Financial Instruments
Where changes in financial instruments have occurred in the reporting period, entities are reminded to consider disclosures in compliance with paragraphs 33 and 34 of IFRS 7, which list the qualitative and quantitative disclosures required for each type of risk arising from financial instruments.

Entities are reminded that accounting for expected credit losses under IFRS 9 and the related disclosures in IFRS 7 remains an area of focus. Entities, in particular, financial institutions, should consider paragraphs B5.5.1 and B5.5.4 of IFRS 9 for risks associated with specific sectors when considering collective or individual assessments.

For entities exposed to increasing interest rates and borrowing costs, IAASA reminds them of the importance of disclosures to enable users of the financial statements to evaluate the nature and extent of their exposure to such risks, and any changes to that exposure, in accordance with IFRS 7.31.

IFRS 8 Operating Segments
The identification of operating segments has implications for the recognition and measurement of impairments as operating segments are used to determine the level at which impairment testing is performed.

Correctly identifying the person or group who carry out the function of Chief Operating Decision Maker (CODM) is essential to identifying operating segments.

Geo-political disruptions, and acquisitions and disposals of businesses may impact the composition of internal structures or geographical markets in which an entity operates. Entities should consider the impact of such changes in the context of IFRS 8 reporting requirements.

Alternative performance measures (APMs)
In 2016, the European Securities and Markets Authority (ESMA) issued its Guidelines on Alternative Performance Measures aimed at improving the comparability, reliability and/or comprehensibility of APMs in financial statements.

The ESMA Guidelines set out requirements surrounding the definition of and disclosure principles for APMs. They also address the presentation, reconciliation, explanation on use, prominence, comparability and consistency of APMs.

The Observations paper highlights instances of incorrect labelling of APMs, APMs not being defined, adjustments not being adequately explained, and missing linkage between the APM and its definition.

Other matters
The Observations paper also references some areas of perhaps more limited application – the European single electronic format (ESEF), amendments to IAS 12 Income Taxes: International Tax Reform – Pillar Two Model Rules, and Amendments to IAS 1 Presentation of Financial Statements and IFRS Practice Statement 2: Disclosure of Accounting Policies – and these impacts should refer to the Observations paper itself for more detail on these topics.

For entities listed on a regulated market, the Transparency Directive requires that ‘the management report includes a fair review of the development and performance of the business and the position of the entity … together with a description of the principal risks and uncertainties that they face’. IAASA calls for the practical difficulties in implementing climate reduction targets, and decarbonisation initiatives to be adequately discussed and explained in the management report.

IAASA’s 2023 Observations paper is available at https://iaasa.ie/wp-content/uploads/2023/10/2023-Observations-1.pdf.

The views expressed here are those of the author and do not necessarily reflect IAASA’s official positions.

Maurice Barrett headshot
Maurice Barrett
Senior Financial Reporting Manager, IAASA
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