21 January 2013

ESMA: Call for improvements in disclosures related to goodwill impairment

The report evaluates the appropriateness of the related disclosures in the 2011 IFRS financial statements of a sample of 235 issuers with significant amounts of goodwill.

As a result of the financial and economic crisis, and the resulting poor economic outlook, assets in many industries may generate lower cash flows than expected when these assets were acquired. This has increased the likelihood that the carrying amount of the non-financial assets is greater than their recoverable amount and that impairment losses are required.

Although the major disclosures related to goodwill impairment testing were generally included, in many cases these were of a boilerplate nature and not entity-specific. This stems from a combination of a failure to comply with the requirements of the standard by issuers, as well as, arguably, a lack of specificity in the standard, especially in the area of sensitivity analysis. This also means that, in many cases, the user of the financial statements is not able to evaluate the reliability of the assumptions used from the disclosures given, which is the primary purpose of those disclosures.

As a result of the review five areas of concern emerged:

1. Key assumptions of the management: In the sample selected, only 60% of the issuers discussed the key assumptions used for cash flow forecasts other than discount rate and growth rate used in the impairment testing. Out of these issuers approximately 50 per cent did not include details, required by the standard, that provide the users with the relevant entity-specific information. The result of the review indicates that approximately 70% of issuers focus insufficiently on disclosing the key assumptions in detail and in a way useful to investors.

ESMA urges issuers to disclose all key assumptions and discuss the approach management has adopted in determining them for impairment testing.

2. Sensitivity analysis: ESMA has identified different practices with regard to disclosures on sensitivity analysis. Sometimes, these disclosures were formulated in a way that did make clear to investors how imminent the impairment loss could be. The lack of consistency of sensitivity analysis provided by issuers might suggest unclear requirements in the standard in this area, especially with respect to the requirement to provide sensitivity analyses only in certain circumstances.

For issuers where the book value of their net assets exceeded their market capitalisation, only half presented a sensitivity analysis. In ESMA’s view this figure appears low since this is an indication that impairment might have occurred. ESMA would expect those issuers to be more transparent and disclose the sensitivity of the impairment calculation to changes in key assumptions.

ESMA urges issuers to make realistic estimates in determining possible changes in key estimates that would cause the carrying amount of the cash generating unit to exceed its recoverable amount.

3. Determination of recoverable amount: Most issuers apply value in use for goodwill impairment testing purposes. As 60 per cent of issuers who used fair value less costs to sell based the calculation on discounted cash flows, vast majority of issuers estimate the recoverable amount based on discounted cash flows. IAS 36 requires different criteria for cash flows when using value in use or fair value less costs to sell to determine the recoverable amount.

ESMA would expect more weight to be given to external sources of information rather than entity specific assumptions when determining fair value less costs to sell using discounted cash flows.

4. Determination of growth rates: More than 15 per cent of issuers disclosed a terminal growth rate in excess of 3 per cent. IAS 36 requires issuers to estimate terminal growth rate by extrapolating the projections based on the budgets and forecasts using a steady or declining growth rate for subsequent years that should not exceed long-term average growth rate for the products, industries or countries in which the issuer operates. In the current economic environment, using a long-term rate exceeding 3 per cent appears ambitious and optimistic and may lead to an overstated long-term growth rate.

ESMA urges issuers to provide realistic estimates of future growth rates that correspond to forecasts of economic development.

5. Disclosure of an average discount rate: Approximately 25 per cent of issuers in the sample disclosed an average discount rate, rather than a specific discount rate on each material cash-generating unit.

Because of the impact of the applied discount rate on determining value in use and fair value less costs to sell if a discounted cash-flows model has been used, ESMA urges issuers to use, and disclose, separate discount rates for each cash-generating unit for which the carrying amount of goodwill or intangible assets with indefinite useful lives allocated to that unit, is significant when the risk profile of the identified cash-generating units differs. By disclosing single average discount rate, issuers potentially obscure information that may be relevant to financial statement users.

On the basis of this review’s findings, and as already announced as part of the European common enforcement priorities, ESMA together with the national competent authorities will focus on:

• improving the rigour issuers apply in the impairment test of goodwill and other intangible assets;
• monitoring the application and compliance with IAS 36 requirements, in particular with regard to:
  • the reasonableness of cash flows forecasts;
  • key assumptions used in the impairment test;
  • the relevance and appropriateness of the sensitivity analysis provided (e.g. in circumstances when market capitalisation fall below the book value of net assets; and
• considering whether issuers have provided sufficient and relevant disclosures in this area.

ESMA expects issuers and their auditors to consider findings of this review when preparing and auditing the IFRS financial statements. ESMA expects national competent authorities will take or have already taken appropriate enforcement actions whenever material misstatements are identified and will actively monitor the progress of those actions. As indicated in the European common enforcement priorities, ESMA will collect data on how European listed entities have applied IFRS requirements in this area and will further report on its findings.

Press release

Report

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