A European example of insufficient disclosure in interim financial statements
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA); this is from their 24th edition:
- The issuer is a biotech company. The issuer’s half-yearly condensed income statement only consisted of the following lines and subtotals:
- gross profit/loss;
- profit/loss before financial items;
- profit/loss before tax; and
- profit/loss for the period.
- The amount of revenue of the issuer for the period was limited as many of the expected products were not being sold or distributed yet.
- Furthermore, in addition to limited information in the interim income statement, there were no additional notes to the lines or sub-totals, providing disclosures about the line items that were included. This meant that no lines of costs were presented, nor information specified in the notes.
- In the (June 30, 2017) annual financial statements, the following costs were presented in the statement of profit or loss:
- production costs;
- sales and marketing costs;
- research and development costs;
- administrative expenses;
- financial expenses; and
- total income taxes.
- While production costs and total income taxes could be calculated by users of the interim financial statements, for sales and marketing, research and development and administrative costs, only the aggregate amount for these three types of costs can be calculated. The interim financial report included disclosures regarding the increase in total overheads due to clinical studies in one jurisdiction giving some information on the costs in the period.
The enforcer (as ESMA likes to term it) required the issuer to provide additional lines in the interim condensed income statement, in particular for research and development costs. It cited various portions of IAS 34 to justify this view: the requirement in IAS 34.10 to include additional line items (over and above the headings and subtotals included in the most recent annual statements) if their omission would make the interim financial statements misleading; the requirement in IAS 34.15 to include in an interim financial report an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period; the observation in IAS 34.25 that the overriding goal is to ensure that an interim financial report includes all information that is relevant to understanding of an entity’s financial position and performance during the interim period. The enforcer also made much of a 2014 IFRIC agenda decision indicating that a three-line interim statement of cash flows showing only a total for each of operating, investing and financing cash flow activities wouldn’t meet the requirements of IAS 34. Here’s some of the specific thinking on the research and development item:
- The future prospects of the issuer largely depend on the research and development activity. However, as the condensed income statement did not include the line item regarding research and development costs, the enforcer considered that the interim income statement was too condensed. Furthermore, during 2017 research and development costs increased by almost 120% compared to the year before, while other costs and revenue showed a significantly lower growth. While this increase in research and development costs amounted to almost the total difference in the result for the year compared to the previous year (the loss did increase by almost 50%), it was not disclosed in the notes to the interim financial statements.
Just in my own possibly unrepresentative experience, I probably more commonly encounter the opposing situation, in which the interim statements slavishly repeat everything in the annual statements, obscuring one’s sense of what’s materially changed, often exacerbated by an unfocused MD&A. It would be good to know in this instance whether the issuer disclosed the research and development expense in other documents, albeit that it wouldn’t change the financial statement analysis. Just on the terms provided, the non-disclosure seems rather weird, as it’s hard to see what the issuer had to gain. Maybe the sales and marketing people went crazy and spent too much money on useless junkets and suchlike, or administrative costs ballooned due to poor facilities management (or insert your own imaginary alternative explanation) and the motive was more to hide those embarrassing facts than to obscure the research and development outlay. It’s not the first time that these ESMA summaries are almost as interesting for what’s omitted as for the fact pattern presented (the comment that “the research and development costs are probably the most important line item for the investors” may well be true, but one can devise fact patterns where, for instance, sales and marketing activity would be equally or more crucial, especially if not being wasted on useless junkets).
Anyway, all of that said, it’s hard to argue with the enforcer’s conclusion. Hopefully there won’t be too many cases where regulators will need to point to it as a precedent…
The opinions expressed are solely those of the author