A European example of a disagreement in applying IFRS 12

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 20^th edition:

• The issuer holds more than 20% of the voting rights in entity X but no representation on entity X’s Management or Supervisory Boards. A controlling shareholder holds over 60% of the voting rights in entity X. Resolutions at the general meeting, including the election and removal of shareholders’ representatives in the Supervisory Board and the distribution of profits are adopted by a simple majority. No material transactions between the issuer and entity X have occurred or are expected to occur and there was no interchange of managerial personnel. The issuer has no possibility of participating in the policy-making processes of entity X apart from exercising its voting right in the general meetings, which are however dominated by the controlling shareholder.
• Based on this fact pattern, the issuer concluded that it could be clearly demonstrated that it does not have significant influence over entity X. Yet, the issuer did not disclose, in its financial statements the significant judgements and assumptions on which this was based.

The enforcer (as ESMA likes to term it) asked the issuer to disclose the considerations that led to the conclusion that it didn’t exercise significant influence over entity X. It sets out the analysis in fairly black and white terms:

• Paragraph 7 of IFRS 12 requires an entity to disclose information about significant judgments and assumptions it has made to determine whether it has significant influence over another entity. According to paragraph 9 of IFRS 12, to comply with the requirement in paragraph 7, an entity has to disclose the considerations that led it to conclude that it does not have significant influence even though it holds 20% or more of the voting rights of another company.

Although that sounds fairly obvious, it skips over the core question of whether a judgment and/or assumption is actually “significant” in a particular situation. I don’t believe IFRS sets out an entirely clear basis for making this determination. IAS 1.122 refers to “the judgments, apart from those involving estimations, that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognized in the financial statements.” Although it doesn’t spell it out, there seems to be an implied other piece there – that a significant risk exists of these judgments needing to be revisited in the future, with a corresponding risk of material adjustment (to interpret it in this way would somewhat track the language in IAS 1.125 relating to disclosing information about sources of estimation uncertainty).

Looked at this way, the issuer might have concluded that it would be pointless to belabour a determination that seems to it to be largely obvious and is unlikely to be revisited in the future (you might argue that the disclosure would be useful in alerting investors to the fact that equity accounting could have been provided if the facts were somewhat different, but it’s hard to know what an investor could practically do with such esoteric information). A limitation of ESMA’s description of the issue is that we don’t know how much of the fact pattern provided to us was also available to the company’s investors. If any reasonably engaged reader could readily locate the basic situation as set out above, then you might conclude he or she would be adequately equipped to understand the nature of the asset, regardless that the issuer didn’t join all the accounting dots together.

The more pressing question, you might think, wouldn’t be about the failure to apply equity accounting (leaving aside for today the debate about whether that’s worth doing anyway), but rather about the reasons for investing in entity X at all, given the lack of apparent cooperation from the significant shareholder (a possible practical reason for the issuer not wanting to apply equity accounting to the 20% holding is that management of entity X might be unwilling even to provide the information necessary to implement such accounting). Of course, there’s nothing unusual about an investor choosing to put trust in boards and management over which he or she has no influence. But IFRS normally presumes that where an investor’s stake constitutes 20% or more of the voting power, then he or she won’t put up with such stonewalling.

But of course, any number of reasons exist why the investor might live with it – for example, to make up a fact pattern, the investee might constitute a stable, predictable cash-generating machine with limited capacity for the controlling shareholder to screw things up (perhaps, say, because of regulatory oversight, or inherent controls or constraints applying to the business model). These types of considerations don’t seem to be exactly what IAS 1.122 requires disclosing – they probably belong more to the MD&A or elsewhere. But if that’s all available to the reader, then ESMA’s issue would be a mountain made from a molehill. And I don’t think that conclusion required a significant amount of judgment on my part…

The opinions expressed are solely those of the author