A European example of assessing impairment (or not) in a related party situation

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 11^th edition:

• “The issuer’s accounting policies in its 2009 financial statements disclosed that amounts receivable are initially recognized at fair value and subsequently measured at amortized cost, using the effective interest rate method less any impairment loss. The notes to the accounts indicated that carrying amounts are reviewed at each accounting reference date with a view to assessing any impairment. The notes also disclosed that the objective evidence that the financial assets have been impaired would include, for example, the failure by a third party to fulfil its obligations to the company. The impairment loss in respect of financial assets measured at amortized cost is computed as the difference between the net carrying value of the assets and the present value of the future cash flows discounted at the original effective interest rate.
• At December 31, 2009, entity A, a related company, being a subsidiary of the issuer’s principal 95% shareholder, was indebted to the issuer for m.u 10 million. The amount receivable was overdue by 90 days. The debt was still outstanding at March 31, 2010, when the financial statements were drawn up, and was now overdue by 180 days. As at December 31, 2009, the amounts receivable from entity A accounted for 51 % of the issuer’s current assets, and 23 % of its total assets.
• Entity A had suffered losses in the two previous years: m.u. 5 million in 2009 and m.u. 5.8 million in 2008 and its current liabilities materially exceeded its current assets (by m.u. 19.3 million in 2009 and by m.u. 15.1 million in 2008). Entity A’s 2009 financial statements disclosed that as at December 31, it had no possibility of borrowing from any financial institution and that its continuing activities were dependent on the financial support of its sole shareholder. The auditor had qualified its opinion in respect of the accounts for going concern risk.
• On enquiry, the issuer agreed that the amounts due from entity A did show evidence of a possible impairment but that it had not conducted an impairment assessment in respect of the amounts due from its related party on account of the cost involved which it could not sustain given its financial position at that time.”

The enforcer (as ESMA likes to term it) concluded “there was objective evidence of a possible impairment in the amounts receivable from entity A given its failure to settle its obligations to the issuer and in the light of its severe financial difficulties,” and that the issuer wasn’t in compliance with the requirement in IAS 39.63 to recognize an impairment loss. As written, that sounds fair enough. But on reading the above, you might find yourself wondering: what about the parent…?

Many smaller Canadian entities may find themselves in a variation of the same situation, where amounts receivable from related parties clearly aren’t recoverable based on the current financial position and prospects of those parties alone. However, if a common controlling shareholder confirms its intention to fulfil the obligation in the event that the related entity is unable to do, and if there’s no indication that the amount receivable would be impaired if it were receivable directly from the shareholder, I doubt whether most entities would feel it necessary to recognize an impairment loss (or whether they could come up with a rational basis for estimating one). Of course, in saying this, I may be somewhat capitulating to the frequent reality that amounts to or from related parties often seem driven much more by a shareholder’s ability to move things around than by the economic or commercial needs of the entity in question (why did the issuer hand over so much of its resources to this “entity A” in the first place?), and that being a non-controlling shareholder in such an entity is often more than a bit perilous.

It’s difficult to believe that the issuer’s explanation of the matter, as the summary claims, amounted to no more than saying, basically, we know we should have recognized something, but it would have cost too much to figure it out. Firstly, it’s just hard to believe that any issuer (even back in the dark days of 2009!) wouldn’t have known this reasoning just wasn’t enough; secondly, how much could it have cost anyway to have a conversation on the matter with its own shareholder? A truer explanation, one imagines, is that the issuer didn’t think its financial statements could get it into much trouble, impairment loss or not, assuming it appropriately disclosed the related party nature of the amounts and the overall reliance on the shareholder. And the ESMA example would be more valuable if it focused on the circumstances in which that kind of reasoning would or wouldn’t be sufficient for it to have closed the file…

The opinions expressed are solely those of the author