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 42 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 eight cases arising in the period from December 2016 to December 2018, 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:

• The issuer is a ship owner and a leading provider of offshore tonnage to the international oil and gas industry. The issuer prepares quarterly accounts in accordance with IAS 34.
• Considering information available on the market generally and given by the issuer through announcements specifically, it was clear that the issuer was facing a challenging market conditions with overcapacity and laid up vessels. This situation had led to liquidity problems and the issuer started negotiations with its financial creditors on suspension and deferral of payments of principal and interest of the issuer’s debt in 2018.
• In the reports for the first three quarters of 2018, no impairments were recorded and there was no information on whether the issuer had performed an impairment test by estimating the recoverable amount of the assets. The issuer explained that it had assessed several indications of whether the assets might be impaired. However, it had concluded that no indication of impairment was present at the time of the third quarter 2018 report and therefore it had not estimated the recoverable amount of the fleet.

The enforcer (as ESMA likes to term it) “was sceptical of the values of the issuer’s vessels and challenged the issuer’s assessment of the potential indications of impairment and pointed out that several indications of impairment existed. The issuer was thus required to perform an impairment test and to estimate the recoverable amount for the vessels as of third quarter 2018.”

Here’s some of the evidence amassed by the enforcer:

• the price to book (P/B) ratio of the issuer. The issuer’s carrying amount of the net assets was significantly higher than the issuer’s market capitalization and the P/B was around 0.4.
• the issuer argued that the indicators did not deviate much from other peer companies in the industry. However, the enforcer highlighted that comparison analysis needs to be specific to the preparer’s assets and – in this case – consider factors such as the vessels type and age, their specification and quality etc. Furthermore, the issuer had not taken into account in its comparison that several companies in this industry actually had written down the value of their vessels during 2018.
• the issuer argued that there had been no material accounting losses from sale of vessels in 2018. However, in the enforcer’s view even if the disposal losses were immaterial compared to the period’s result and carrying value of total assets, there were several cases where the recognized loss per vessel was material in relation to the carrying amount of the vessel. Documentation showed that the sales prices for three of the vessels were half of the carrying amount.
• the issuer mentioned that there was only a slight change in the values estimated by brokers of the fleet in the third quarter, compared to the previous quarter. However, in the enforcer’s view, the lack of change in broker valuations should not be taken as an indicator that there is not an impairment trigger
• the issuer pointed at an increasing oil price and improving demand for offshore service vessels. Nevertheless, the enforcer did not see any increase in the shipping rates and the issue of overcapacity of the vessels remained.

This hardly needs much additional commentary, seeming (at least in ESMA’s telling) to provide a clear case of cherry-picking the evidence to lead toward a desired outcome. As ESMA notes, “Paragraph 9 of IAS 36 requires an entity to assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.” The standard provides a list of indications to be considered at a minimum, observing that this list is not exhaustive. Certainly, the issuer may reasonably anticipate that (say) the asset’s recoverable amount may be unaffected by a particular indicator, for example because of its awareness of other compensating factors, but if so this should be evidenced through the testing than by rationalizing away the need to test at all.

The failings of IAS 36 are a perpetual object of focus, although the current emphasis is primarily on goodwill (we can expect an IASB discussion paper early next year). Impairment testing for property, plant and equipment may certainly raise its own problems, but the resulting losses almost always tell a somewhat meaningful story. As do (less often) the subsequent reversals…

The opinions expressed are solely those of the author