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Thursday 2 June 2016

16-174MR ASIC calls on directors to apply realism and clarity to financial reports

ASIC expects companies to adopt realistic valuations for asset values, appropriate accounting policies and better communication of that information in the lead-up to the end of financial year reporting season.

Announcing its focus areas for 30 June 2016 financial reports of listed entities and other entities of public interest with many stakeholders, ASIC highlighted key problem areas to address.

‘Directors and auditors should continue to focus on values of assets and accounting policy choices. We continue to see companies use unrealistic assumptions in testing the value of assets or that have applied inappropriate approaches in areas such as revenue recognition,’ ASIC Commissioner John Price said.

We will select financial reports both looking at risk-based criteria and also from a random selection.

Asset values

ASIC encourages preparers of financial reports and their auditors to carefully consider the need to impair goodwill, inventories and other assets. ASIC continues to find impairment calculations based on unrealistic cash flows and assumptions, as well as material mismatches between the cash flows used and the assets being tested for impairment.

Fair values attributed to financial assets should also be based on appropriate models, assumptions and inputs.

There should be particular focus on assets of companies in extractive industries and mining support services, as well as asset values that may be affected by digital disruption.

Accounting policy choices

Directors and auditors should also consider how the choice of accounting policy can affect reported results. These include the treatment of off-balance sheet arrangements, revenue recognition, expensing of costs that should not be included in asset values, tax accounting, and inventory pricing and rebates.

Material disclosures

ASIC’s surveillance continues to focus on material disclosures of information useful to investors and others using financial reports, such as assumptions supporting accounting estimates, significant accounting policy choices, and the impact of new reporting requirements.

ASIC does not pursue immaterial disclosures that may add unnecessary clutter to financial reports. We encourage efforts to communicate information more clearly in financial reports.

The role of directors

Even though directors do not need to be accounting experts, they should seek explanation and advice supporting the accounting treatments chosen and, where appropriate, challenge the accounting estimates and treatments applied in the financial report. They should particularly seek advice where a treatment does not reflect their understanding of the substance of an arrangement.

Further information can be found in ASIC Information Sheet 183 Directors and financial reporting (INFO 183) and ASIC Information Sheet 203 Impairment of non-financial assets: Materials for directors (INFO 203).

Client monies

Australian financial services licensees should ensure that client monies are appropriately held in separate, designated trust bank accounts, and that monies are applied in accordance with client instructions and the requirements of the Corporations Act. We remind auditors of the importance of audit testing to obtain assurance that monies are dealt with appropriately and that breaches are reported to ASIC in accordance with that Act and ASIC Regulatory Guide 34 Auditors Obligations: Reporting to ASIC.

Other entities

ASIC will continue to review the financial reports of proprietary companies and unlisted public companies, based on complaints and other intelligence. We proactively identify and follow up companies that are required to lodge financial reports with ASIC but have not done so. It is their responsibility to do so and ASIC will take all necessary steps to see this done. 

More information

More detailed information on these issues is provided in the following attachment.

Attachment to 16-174MR MR: ASIC calls on directors to apply realism and clarity to financial reports 

Focuses for 30 June 2016 financial reports

Accounting estimates

1. Impairment testing and asset values

The recoverability of the carrying amounts of assets such as goodwill, other intangibles and property, plant and equipment continues to be an important area of focus.

It is important for directors and auditors to ensure:

  1. Cash flows and assumptions are reasonable having regard to matters such as historical cash flows, economic and market conditions, and funding costs. Where prior period cash flow projections have not been met, careful consideration should be given to whether current assumptions are reasonable and supportable;
  2. Discounted cash flows are not used to determine fair value less costs of disposal where forecasts and assumptions are not reliable.  Fair value less costs to sell should not be viewed as a means to use unreliable estimates that could not be used under a value in use model;
  3. Value in use calculations:
    • use sufficiently reliable cash flow estimates 
    • do not use increasing cash flows after 5 years that exceed long term average growth rates, and without taking into account offsetting impacts on discount rates, and
    • do not include cash flows from restructurings and improving or enhancing asset performance
  4. Cash flows used are matched to carrying values of all assets that generate those cash flows, including inventories, receivables and tax balances;
  5. Different discount rates are used for cash generating units (CGUs) where the risks are different and the CGUs are located in different countries, and that similar discount rates are used where the risks are similar;
  6. CGUs are not identified at too high a level, including where cash inflows for individual assets are not largely independent;
  7. CGUs for testing goodwill are not grouped at a higher level than the operating segments or the level at which goodwill is monitored for internal management purposes;
  8. Corporate costs and assets are allocated to CGUs on an appropriate basis where it is reasonable to allocate them;
  9. The impairment test in AASB 136 Impairment of assets is used for exploration and evaluation assets after technical feasibility and commercial viability have been demonstrated;  and
  10. Appropriate use of fair values for testing exploration and evaluation assets during the exploration and evaluation phase.

Further information can be found in ASIC Information Sheet 203 Impairment of non-financial assets: Materials for directors (INFO 203).

Particular consideration may need to be given to values of assets of companies in the extractive industries or providing support services to extractive industries, as well as values of assets that may be affected by the risk of digital disruption.

Focus should also be given to the pricing, valuation and accounting for inventories, including the net realisable value of inventories, possible technical or commercial obsolescence, and the substance of pricing and rebate arrangements.

Directors and auditors should focus on the valuation of financial instruments, particularly where values are not based on quoted prices or observable market data. This includes the valuation of financial instruments by financial institutions.

Accounting policy choices

2. Off-balance sheet arrangements

Directors and auditors should carefully review the treatment of off-balance sheet arrangements, the accounting for joint arrangements and disclosures relating to structured entities.

3. Revenue recognition

Directors and auditors should review an entity’s revenue recognition policies to ensure that revenue is recognised in accordance with the substance of the underlying transactions. This includes ensuring that:

  1. Services to which the revenue relates have been performed;
  2. Control of relevant goods has passed to the buyer;
  3. Where revenue relates to both the sale of goods and the provision of related services, revenue is appropriately allocated to the components and recognised accordingly;
  4. Assets are properly classified as financial or non-financial assets; and
  5. Revenue is recognised on financial instruments on the basis appropriate for the class of instrument.

The appropriate timing of revenue recognition may also need careful consideration in industries with complex sale and licensing arrangements that may include continuing obligations, such as software providers.

4. Expense deferral

Directors and auditors should ensure that expenses are only deferred where:

  1. There is an asset as defined in the accounting standards;
  2. It is probable that future economic benefits will arise; and
  3. The requirements of the intangibles accounting standard are met, including
    1. expensing start-up, training, relocation and research costs;
    2. ensuring that any amounts deferred meet the requirements concerning reliable measurement; and
    3. development costs meet the six strict tests for deferral.

To assist users of financial reports to understand the results of an entity, items of income and expense should only be included in other comprehensive income rather than profit/loss where specifically permitted by the accounting standards.

5. Tax accounting

Tax effect accounting can be complex and preparers of financial reports should ensure that:

  1. There is a proper understanding of both the tax and accounting treatments, and how differences between the two affect tax assets, liabilities and expenses;
  2. The impact of any recent changes in legislation are considered; and
  3. The recoverability of any deferred tax asset is appropriately reviewed.

Key disclosures

6. Estimates and accounting policy judgements

Disclosures regarding sources of estimation uncertainty and significant judgements in applying accounting policies are important to allow users of the financial report to assess the reported financial position and performance of an entity. Directors and auditors should ensure disclosures are made and are specific to the assets, liabilities, income and expenses of the entity.

Disclosure of key assumptions and a sensitivity analysis are important. These enable users of the financial report to make their own assessments about the carrying values of the entity’s assets and risk of impairment given the estimation uncertainty associated with many asset valuations.

Preparers should be particularly mindful to make these disclosures at 30 June 2016 as this information may be revealed under key audit matter disclosures in the new enhanced audit reports for listed entities from 15 December 2016 year ends.  Preparers should note that the key audit matter disclosures may also refer to matters that should have been discussed in the Operating and Financial Review.

7. Impact of new revenue and financial instrument standards

Directors and auditors should ensure that notes to the financial statements disclose the impact on future financial position and results of new requirements for recognising revenue, for valuing financial instruments, and accounting for leases. These new requirements will apply to future financial reports and may significantly affect how and when revenue can be recognised, the values of financial instrument (including loan provisioning and hedge accounting), and assets and liabilities relating to leases.

Last updated: 02/06/2016 12:00