A European example of issues arising in applying IAS 36
As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 30 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering fourteen cases arising in the period from March 2014 to June 2016, with the aim of “strengthening supervisory convergence and providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one (a rather cumbersome read I’m afraid, but it’ll all become clear):
- The issuer is active in the extractive industry. In the first decade of the 21st century, the issuer purchased one long-term LNG sales contract and two long term take-or-pay capacity contracts at a LNG import facility in the US. The acquisition cost was allocated to the acquired LNG sales contract, which was recognized as an intangible asset. The issuer included these three contracts, as well as certain trading contracts for piped gas in the US related to the re-gasified imported LNG volumes, in a single CGU.
- The take-or-pay contract requires the issuer to make payments irrespective of actual usage. When fundamental changes in gas markets indicated a lower expected usage of the take-or-pay contracts in the following years, the issuer recognized in 2010 an impairment loss on the carrying amount of the CGU and recognised an IAS 37 onerous contract provision for the capacity contracts.
- In the following year, further changes in prices made the issuer sell the volumes under the LNG gas contract to other markets than the US. Valued with the higher market reference price for these alternative markets, the value of the LNG contract surpassed that of the onerous import capacity contracts, and by mid-2011 all previous impairments and provisions relating to the CGU were therefore reversed. This was despite the fact that the issuer revised in parallel its expected usage percentage of the capacity contracts in the US for their remaining duration to virtually nil. At that time the issuer evaluated whether to split the capacity contracts from their original CGU and record separate onerous contract provisions under IAS 37, but concluded against it.
- The issuer considered that the terminal capacity contracts were still integral to the CGU, central to the business case and dedicated to the LNG contract in accordance with paragraph 69 of IAS 37. CGUs shall be defined consistently over time and paragraph 72 of IAS 36 states that subsequent changes to a CGU must be justified. The issuer regarded changes to the internally established price assumptions to be the most significant change in factual circumstances from the time of the initial identification of the CGU, and that this was not sufficient to justify a change in the CGU.
- The issuer concluded that to redefine the CGU and recognize a separate onerous contract provision, management must either have made a decision not to use the terminal capacity, involving permanent and/or irreversible non-usage, or, alternatively, that expectations of no utilization had to be sustained and evidenced over an extended period of time.
- In the first quarter of 2013, the issuer renegotiated its remaining take-or-pay commitments with the owner of the import terminal, involving an early termination for parts of the contract volumes in 2017. In its 2013 first quarter interim financial statements the issuer split the take-or-pay US import terminal capacity contracts from the CGU and recognized a separate onerous contract provision equal to the net present value of all remaining capacity payment obligations.
The enforcer (as ESMA likes to term it) disagreed with this treatment, taking the view that “the identification of the CGU should have been changed, separating and recognizing material onerous contract provisions for the take-or-pay import capacity contracts, in a financial reporting period prior to the first quarter of 2013.” As in so many of these cases, the point seems to be about the importance of stepping back and bearing in mind the reasons why the standards say what they do. If there were few or no restrictions on changing the composition of CGUs from one period to the next, then it would all too easy to avoid identifying impairment losses by moving things around. But at the same time, the requirements for CGUs are merely a means to an end – the end of ensuring that assets are measured at no more than their recoverable amount. The CGU concept recognizes the inherent interdependency of many assets, and the impossibility of trying to assess their recoverability in isolation.
But when an asset plainly isn’t interdependent with others, and when it’s clear its carrying amount can’t be recovered, there’s no good reason to rely on technicalities to avoid dealing with that. So, as ESMA puts it: “With an expected usage of the LNG import capacity for its remaining duration of virtually nil, the enforcer found that these contracts can no longer be regarded as an integral part of the process flow or contributing to the cash inflows generated by other contracts in the CGU.”
IAS 36 seems particularly susceptible to the problem of preparers seeing only the woods and losing track of the forest. The board is actively discussing the practicality of simplifying the standard, so we’ll see where that goes (we recently cited some suggestions it might consider). But in the meantime, issuers can at least avoid some of the worst potential pitfalls by focusing on the principles…
The opinions expressed are solely those of the author