25 January 2013

CeFARR research report: 'Accounting for asset impairment: a test for IFRS compliance across Europe'

CeFARR's study is motivated by the heightened importance of impairments in light of recent turbulence in financial markets and the ongoing economic downturn resulting from the credit crisis. Although economic instabilities are not, prima facie, an impairment indicator, the individual economic events that collectively led to, or stemmed from, the crisis appear to have been relevant in triggering impairment decisions by many European companies. As a recent report by the ESMA reveals, impairment testing and reporting remain to be of high importance because current economic circumstances generally mean that many IFRS preparers will continue to face potentially impaired assets.

CeFARR's study pursues two main objectives. Initially, CeFARR provides some broad evidence on the incidence and timeliness of impairments for a sample of 4,474 European companies during the post-IFRS adoption era (2006-11). Given the discretion that reporting standards offer in terms of managing the amount and timing of impairments, CeFARR believes that it is relevant to assess the speed at which economic losses are recognised in accounting earnings. CeFARR also examines the role of country-level institutions in explaining differences in the timeliness of impairments across European countries.

For a sample comprising 324 companies, CeFARR then assesses the quality of impairment disclosures in 2010-11 for three classes of non-current non-financial assets: PP&E, intangible assets and goodwill.

CeFARR's evaluation is based on the extent to which impairment disclosures conform to the requirements of IFRS. CeFARR examines those areas where compliance is lacking or weak and seek to provide explanations for such observations. Based on CeFARR's findings on actual compliance, CeFARR establishes a model that includes country-level institutional factors as well as firm-specific attributes that could explain disclosure behavior. Finally, CeFARR analyses reporting attitudes through the lens of a novel classification of accounting requirements. CeFARR's analysis rests on identifying two sets of reporting requirements: high-effort versus low-effort requirements. CeFARR's sconjecture is that there are meaningful differences in disclosure quality between these two sets of requirements.

To assess the timeliness of impairments, CeFARR uses two constructs. First, CeFARR relies on the notion of asymmetric timeliness and adopt a measure that is based on the explanatory power of a reverse regression model of earnings on stock returns. Next, CeFARR examines variations in the speed of impairment recognition in earnings across European countries with different institutional features. CeFARR captures such differences by adopting a classification that groups countries into three clusters: cluster 1 includes countries with outsider economies and strong enforcement; cluster 2 constitutes countries with insider economies and stronger enforcement; and cluster 3 includes countries with insider economies and weaker enforcement.

To evaluate IFRS disclosures, CeFARR conducts a survey of European companies’ impairment reporting practices. CeFARR's emphasis is on evaluating disclosures in eleven distinct areas and the degree of their congruence with the requirements of IFRS. To do so, CeFARR develops a compliance survey instrument and relies on unweighted and partial indices to summarise CeFARR´s findings. CeFARR studies differences in compliance across countries and industries and identifies country- and firm-level forces that explain observed disclosure attitudes. Evidence from CeFARR's survey of reporting practices contributes to proposals for improved impairment reporting in Europe.

The results CeFARR finds on the timeliness of impairments are highly consistent with predictions of asymmetric timeliness. CeFARR also finds evidence that confirms CeFARR´s expectations on the role of institutional factors in shaping the outcomes of financial reporting. The findings generally indicate that asymmetric timeliness is lowest in cluster 3 countries where the effectiveness of institutions and enforcement regimes is predicted to be relatively weaker compared with the other two country-clusters.

This is consistent with enforcement differences across countries leading to variations in the speed of recognition of economic losses as well as disparities in the level of disclosure quality.

Findings from CeFARR's survey of impairment disclosures reveal variations in overall compliance levels across European countries and different industries for the three asset classes. Detailed examination of different disclosures indicates that a majority of companies appear to be box-ticking their way through the compliance process. This observation is more pronounced in those areas where compliance is satisfied through the use of boilerplate language.

Consistent with CeFARR's conjectures, CeFARR documents that companies domiciled in stronger institutional settings exhibit higher reporting quality. More specifically, compliance is generally higher in cluster 1 countries compared with the other two country-clusters. No meaningful difference in compliance levels is found between companies classified in cluster 2 and cluster 3. This result is consistent with the important role that complementary institutional forces play in ensuring the adequacy of IFRS implementation.

Using an automatic econometric model selection algorithm, CeFARR identifies the determinants of compliance for CeFARR's sample companies. The selected significant variables include audit quality, type of industry, leverage, intensity of goodwill impairments, firm size and being domiciled in a cluster 1 country. The results highlight the influence of large audit firms and strong institutions in encouraging IFRS compliance.

They also reveal the importance of firm-specific features in explaining how actual reporting practices are shaped. CeFARR's examination of the impact of judgment and effort on IFRS compliance also indicates that, in gauging overall disclosure quality, low compliance with high-effort requirements are generally masked by high compliance with low-effort disclosures across the three asset classes.

Full research report

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