A European example of misapplied standards…
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 21st edition:
- The issuer is an IT company which pursued in court another company, Entity X, for the infringement of the issuer’s patents. Following an arbitration procedure in front of a third country court, Entity X agreed to pay damages to the issuer. There is no ability to appeal this ruling and the issuer expected to receive the full payment by the end of the year. The issuer provided disclosure about the successful arbitration procedure in the interim financial statements, but did not recognize any income. Shortly after the end of the interim period the issuer received a first tranche of the payment by Entity X which is disclosed but not recognized, in its interim financial statements. In the notes to the interim financial statements, the issuer also disclosed that it expected the remaining receivable to be settled within the following 12 months.
- Despite the fact that Entity X had agreed to pay the damages for the patent infringement, the issuer argued that, at the end of the reporting period, there were still be uncertainties as to whether the amount agreed would be received, because the court decision was taken in a third country that was neither the country of the issuer, nor the country of Entity X. The issuer argued that Entity X may not comply with the decision taken by the third country court and that the decision may not be enforced by the authorities in the issuer’s home country.
- In addition, the issuer had doubts whether Entity X had the financial means to pay this amount.
- Finally, the issuer argued that according to IAS 18 the conditions for the recognition of income associated with the winning case were not met.
- Consequently the issuer considered the proceeds from winning the court case against Entity X to be a contingent asset in accordance with IAS 37.
The enforcer (as ESMA likes to term it) disagreed with the issuer that the awarded damages should be considered a contingent asset, taking the view that: “the receivable that the issuer was entitled to, as a result of the successful arbitration procedure, qualified as an asset and the related gain should have been recognized in the period during which the court decision was taken.”
Needless to say, only a small minority of enforcement decisions revolve around a failure to recognize assets and/or gains. In the old days, the issuer might have justified its approach almost entirely by wheeling out a single term – conservatism or prudence. As you may recall, the IASB’s recently-revised conceptual framework reintroduced the latter term, although limited to reflecting “the exercise of caution when making judgements under conditions of uncertainty.” In the case set out above, the enforcer’s key point is that the item is a financial asset, as it represents a contractual right to receive cash from another entity; therefore, like any other financial asset, it should have been initially recognized at its fair value, then subsequently classified as a receivable and measured at amortized cost. The various risks identified by the issuer would be taken into account in measuring that fair value, if they constitute characteristics of the asset that would be taken into account by market participants for pricing purposes, as set out in IFRS 13 (the report expresses skepticism though that any of the issuer’s doubts constituted objective evidence).
That all seems fair enough, but some readers might wonder whether this is the kind of issue that’s worth spending enforcement time on. The amount doesn’t arise from the issuer’s ongoing revenue-generating activities – the report emphasizes that the reference to IAS 18 isn’t applicable. As such, it wouldn’t be relevant to evaluating the issuer’s future prospects, and would be excluded from its net income and cash flow for purposes of making any kind of projection, applying any kind of multiple, and so forth. In theory, users should put the same weight on information in the notes as they do on what’s reflected in the primary statements, but if in this case they failed to do that, they’d presumably be better off by overlooking this item altogether than by failing to grasp its non-recurring nature. In other words, you might conclude that even if the issuer’s approach wasn’t technically correct, its approach wouldn’t be likely to influence decisions made by users, and if it did influence them, it might only be for their own good.
You might say such a perspective would be an inappropriate injection of subjectivity, and that quantitatively material non-compliance with IFRS should be pursued regardless of how the cards fall. But there’s no such thing as perfect objectivity in enforcement, any more than in any activity that involves making choices on how to allocate resources; or on what to worry about, or not…
The opinions expressed are solely those of the author