How much does it matter when items are wrongly classified and labeled within the income statement?

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 is a savings bank with a long term relationship with entity A, a fish farm, both as lender and shareholder. Prior to 2004, the issuer loaned money to entity B; however, after entity B suffered continuous operating losses, it was acquired by the issuer. In 2004, the issuer sold entity B to entity A (a thinly capitalized, newly founded company). The issuer provided all the financing to entity A for this transaction. It also provided entity A with a credit facility sufficient to cover several years of estimated future operating losses. In the following years, entity A suffered, as expected, significant operating losses. The issuer participated in several efforts to refinance entity A. It provided fresh loans and subsequently exchanged these loans for shares. At the end of 2014, the issuer held shares of entity A classified as AFS, in addition to having a significant loan receivable, which was measured at amortized cost.
• The issuer recognised an impairment loss on the loans to entity A, in 2009. In the course of the efforts to refinance entity A during the period 2010 to 2014, other shareholders made capital contributions in cash. In most of these capital increases, the share price used to calculate the exchange rate for the loans was two to five times higher than the subscription price for shareholders offering contributions in the form of fresh cash. Entity A also made unsuccessful attempts to attract new investors by offering them a lower share subscription price than the one used in the conversion of the issuer’s loans. This indicated that the fair value of the shares received in the conversion was considerably lower than the carrying value of the converted loans.
• However, the exchange of loans for shares of entity A between 2010 and 2014 did not lead to any further impairment losses on the loans. The issuer accounted for the exchange of its loan investments for equity by reducing the carrying amount of the loans, with an offsetting increase in the value of the AFS investment. The AFS investment, however, were impaired in the same year in which they were acquired and the losses were presented in the statement of profit or loss for the period as ‘net change in value of financial instruments’.

The early reference to a “fish farm” will very likely have led many readers to expect a more exciting story than the one that’s actually provided. Regardless, the enforcer (as ESMA likes to term it) disagreed with this treatment, noting that on derecognizing the loans, the difference between their carrying amount and the fair value of the shares received should have been presented as a loss on loans instead of as ‘net change in value of financial instruments’. To make this case, it need only cite IAS 39.26.

It doesn’t seem that ESMA is identifying an overall misstatement of the bottom line here, but rather focusing in on the appropriate sequencing and characterization of the events that generated the loss. The broad question is whether the difference between a loss on loans and a ‘net change in value of financial instruments’ actually matters to any reader of the statements. It’s certainly possible to imagine how it might; for example, just for the sake of argument, the company might place greater emphasis in its reporting on the performance of its loan portfolio as a measure of management’s effectiveness (and of their compensation) than it does on the performance of its investment portfolio. Just from a quantitative perspective, identified misstatements relating to the loan portfolio might be more material than those relating to investments. On the other hand, if those factors don’t apply, it might not matter much either way – it’s hard to say in this case.

Variations on this kind of issue often pop up in other areas of the statements. For example, it’s not uncommon to come across situations, mostly among smaller entities, where (for instance) the assets acquired in a business acquisition or other corporate transaction are very rapidly identified as being impaired, sometimes within the same reporting period. In such cases, suspicions may arise that the values assigned to the assets were overstated in the first place, and that the impairment losses are correspondingly overstated. From one perspective though, it doesn’t matter too much – any reader can see the company made a bad deal and rapidly had to face up to it, and there’s no impact on anything going forward. In such cases, the potential misstatement of the statements may matter less than other aspects of the reporting regime (for example, whether the transaction was mischaracterized at the time in news release or elsewhere). On the other hand, the false characterization of the transaction may so distort the company’s history that it’s appropriate for regulators or others to pursue it despite the absence of any direct prospective implications.

In financial reporting, there’s little point in studying an entity’s past if not as a basis for forming expectations about its future. Looked at that way, potential errors that belong solely to the past don’t much matter. But when one thinks about an error’s qualitative as well as its quantitative implications, it may not always be entirely clear when that’s the case, and when it’s safe merely to throw the fish back in the water…

The opinions expressed are solely those of the author