A European example of issues arising in applying IAS 1.85

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 facilitates investments by clients who want to gain exposure to the underlying securities (principally Asian stocks) by issuing structured notes and warrants. The issuer’s ultimate parent and controlling entity is a leading international investment bank. The principal activity of the issuer is issuing structured notes and warrants to clients.
• The proceeds received from the issuance of securities are lent to other group undertakings and are used to purchase prepaid equity securities contracts and other financial instruments from other group undertakings. Furthermore, the issuer enters into derivative contracts with other group undertakings. The fair value of the issuer’s liabilities (i.e. the securities by the issuer) is determined by the fair value of the financial assets. The fair value gains or losses recognized on financial instruments (assets and liabilities) are not presented in the statement of profit or loss and other comprehensive income for the period and this information is not disclosed in the notes to the financial statements. The issuer’s rationale for this presentation is because it believes it has no exposure to market risk. The net outcome of the investment strategy pursued by the issuer is such that any gains and losses on financial assets and financial liabilities will exactly offset each other giving a net nil result for the year. The issuer presented no quantitative data in the statement of profit or loss and other comprehensive income for the period and disclosed no analysis of offsetting in the notes, even though the exactly corresponding net fair value gain from financial assets and the net fair value loss from financial liabilities during the year amounted before offsetting to CU 1.5 billion.

The enforcer (as ESMA likes to term it) disagreed with this analysis, taking the view that the issuer should have disclosed the gross gains or losses from financial assets separately from those on the financial liabilities. It bases this primarily on IAS 1.85: “an entity shall present additional line items, headings and subtotals in the statement of profit or loss and other comprehensive income when such presentation is relevant to an understanding of the entity’s financial performance.” It also cites IAS 1.32: “an entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an IFRS.” The big picture is that “the issuer’s net nil presentation and the absence of disclosure in the notes to the financial statements did not provide sufficient information necessary for users to gain an understanding of the financial performance.”

As in many of these ESMA reports, it would have been helpful to be given a bit more information here. It doesn’t sound like the enforcer had any problem with the presentation of assets and liabilities on the balance sheet, and it also doesn’t cite any deficiencies in what the issuer disclosed about its various financial instruments and the attached risks, or about the overall structure and functioning of the entity. We also don’t know what kind of performance data the issuer presented in a management report or elsewhere. But assuming that was all fine, and that the issuer presented a comparative balance sheet and a cash flow statement (and again we’re not told that it didn’t), readers must have been able to obtain at least a general understanding of the magnitude of the gain and of the loss in question. From a qualitative perspective, you might argue it’s irrelevant whether the amount offset was CU 1.5 billion or half that much or twice that much, as there’s little the reader can practically do with the information in any event, when it comes to forming expectations about future performance. In this regard, the entity under discussion sounds fundamentally different from (say) an industrial entity where the present and past relationship of sales and cost of sales and various expense categories and recurring versus non-recurring items etc. etc. is likely a crucial reference point in making any kind of informed decision.

Indeed, ESMA might as well have argued that IAS 1.85 suggested a need to gross up the gains and losses included within the gross gains or losses from financial assets, as this would be equally relevant in understanding the scope of the entity’s activities. I suppose the broad problem though is that it’s not entirely clear IAS 1.85 is relevant at all – that is, if the gains on investments essentially accrue directly to the accounts of liabilityholders, then you might argue the entity doesn’t really have any financial performance, and so there’s no need to help anyone in understanding it. It follows that the relevance of IAS 1.32 isn’t completely apparent either – if it’s not clear in the first place that an issuer has to present two particular items in its income statement, then there can’t be a problem with offsetting them.

No doubt that sounds reductive, and it probably is – as so often, I’m merely throwing out ideas here. But it’s important to keep in mind that a particular number’s predictive value and importance to investors isn’t dictated merely by its size, and that what truly contributes or doesn’t to “understanding” in a particular situation is often a far from self-evident concept…

The opinions expressed are solely those of the author