Classifying cash flows – it’s an additional investment, but not an investing cash flow!

A European example of misclassified cash flows

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 long-term investment company whose stated objective is to create value by developing assets over the long term, favouring organic growth of its investments. The issuer does not meet the definition of an investment entity in IFRS 10 and, therefore, consolidates its subsidiaries rather than accounting for them at fair value through profit and loss.
  • During 2016, the issuer acquired additional shares in one of its subsidiaries. The cash flow relating to this 2016 acquisition was presented as ‘cash flows from investing activities’ in its statements of cash flows even though the change in the ownership interests in the subsidiary did not result in a change of control. The issuer considered that the presentation of acquisitions and/or disposals of shares, irrespective whether it leads to a change of control, as cash flows from investing activities in the statement of cash flows provides more relevant information for users given the issuer’s activity, as such transactions are part of its investment strategy.

The enforcer (as ESMA likes to term it) disagreed, requiring the issuer to present these as cash flows from financing activities. Here’s some of the reasoning:

  • Paragraph 42A of IAS 7 requires cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control to be classified as cash flows from financing activities, unless the subsidiary is held by an investment entity as defined in IFRS 10.
  • Furthermore, paragraph 42B of IAS 7 clarifies that as changes in ownership interests in a subsidiary that do not result in a loss of control, such as the subsequent purchase or sale by a parent of a subsidiary’s equity instruments, are accounted for as equity transactions, unless the subsidiary is held by an investment entity as defined in IFRS 10. Accordingly, the resulting cash flows are classified in the same way as other transactions with owners, i.e. as cash flows from financing activities.

Fair enough, but many readers may intuitively think the investing activity classification still makes more sense when cash is being expended to increase one’s holding in an investment. I suppose that when a subsidiary is fully consolidated though, then all the economic interests in the entity are already reflected in the financial statements in one way or another, taking into account non-controlling interests. Looked at that way, transactions between controlling and non-controlling interests don’t do anything to increase the reported amount of the investment, and so shouldn’t be seen as investing activities. You might argue that cash flows paid to such non-controlling interests also don’t do anything to change the financing structure of the investee or of the reporting entity itself, and so the classification as financing is also flawed. However, if only because of the shift between controlling and non-controlling interests, they do “result in changes in the size and composition of the contributed equity” of the entity, and so they fall within the concept in that regard.

This issue links back to whether one agrees in the first place that acquisitions of non-controlling interests in a subsidiary should be treated as equity transactions. Those who have trouble with the concept may take comfort from the fact that four IASB members dissented at the time. Among other things, they argued that even if control has already been obtained, a higher ownership interest might provide additional benefits to the parent, for example by increasing synergies; these additional benefits are reflected in the purchase price of the additional interest, which the four members therefore argued should give rise to recognizing goodwill. Under this kind of approach, the related cash flows presumably would have been regarded as investing activities, and ESMA wouldn’t have had anything to write about.

As in many of the ESMA cases, it’s hard to know how harmful this issue was, regardless of the error. That is, it sounds like a non-recurring transaction of a kind that would be specifically disclosed (and, one hopes, discussed in the MD&A). If so, the mischaracterization as an investing activity wouldn’t likely mislead an even semi-attentive reader regarding the nature of the item or its ongoing relevance, and might be viewed as something an enforcer could leave alone. But maybe this only tells us I’m too pragmatic to be an enforcer, let alone an Enforcer.

The opinions expressed are solely those of the author

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