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09-115MR ASIC review of 30 June 2009 financial reports

Friday 26 June 2009

ASIC has highlighted a number of areas on which company Boards and those responsible for the preparation of financial reports should focus in the upcoming reporting period.

These issues are informed by ASIC’s recent review of the full-year, and 31 December 2008 half-year, financial reports of over 100 listed entities, and our ongoing monitoring of market conditions.

ASIC also announced that its upcoming review will cover the 30 June 2009 financial reports of about 350 listed entities and unlisted entities with large numbers of users.

‘It is important that directors and auditors continue to focus on specific areas most affected by the current economic conditions, such as going concern and valuation of assets’, ASIC Commissioner, Mr Michael Dwyer, said.

‘Our review of the 31 December 2008 financial reports did not reveal any significant non-compliance with the financial reporting obligations, however, we urge companies to continue focusing on appropriate recognition and measurement of assets and liabilities, and providing appropriate disclosures and explanations in their financial reports’, Mr Dwyer said.

While the main overall focus areas are the same as those highlighted by ASIC for the 31 December 2008 financial reports, we have highlighted some additional issues for the upcoming reporting period, identified in our recent review of those reports.

‘Clear and unambiguous reporting by listed entities is a critical contributor to market and investor confidence. ASIC will continue its regular reviews of financial report, and provide guidance about specific focus areas and results of its reviews, to promote quality financial reporting’, Mr Dwyer said.

The following information summarises the key findings of ASIC’s recent review and provides further guidance for the upcoming reporting period.

1. Going concern

ASX reviews of half-year reports showed that the audit reports with emphasis of matter paragraphs or qualifications on going concern increased from 130 at 31 December 2007 to 407 at 31 December 2008.

Directors should continue to assess the appropriateness of the going concern assumption in preparing financial reports, particularly in regard to reduced liquidity and ability to refinance debt or raise new funds, and compliance with lending covenants.

The market should be kept informed where the ability of a disclosing entity to continue as a going concern is subject to negotiations with financiers.

Recoverability of deferred tax assets should be reviewed when going concern is in doubt. Where an entity is not a going concern, assets should be shown at realisable values less costs to sell.

2. Asset impairment

From the financial reports reviewed, the write down of goodwill and indefinite life intangibles in the six months to 31 December 2008 averaged 5.8 per cent of the total value compared to less than 1 per cent for the 12 months to 30 June 2008.

As further write downs may be expected at 30 June 2009, directors should focus on asset values, particularly for more recently acquired assets.

ASIC’s review found that some entities had not followed methods required by accounting standards for impairment testing, or used cash flow information or discount rates that did not appear reasonable having regard to historical cash flows, market information and future expectations. In view of this, directors should consider whether there is appropriate ‘in-house’ expertise to perform impairment calculations and apply requirements of the standards.

Assets should be allocated to cash generating units at the lowest levels to ensure that cash flows from one group of assets are not used to support the value of other assets. Cash generating units should not be larger than primary or secondary segments used for segment reporting. Further, goodwill should be measured at the lowest level of units or groups of units at which goodwill is monitored internally.

Cash flows or discount rates may need to be adjusted for risks and uncertainties. Discount rates and cash flows should reflect consistent price change assumptions. Value in use and fair value less costs to sell calculations should be compared to those, and only those assets and liabilities supported by the cash flows used.

Disclosure of key assumptions for value in use calculations, such as discount rates and growth rates, explanations of forecast periods beyond five years, and sensitivity analysis, are important for user confidence in reported asset values.

Although not mandatory until 31 December 2009, entities should disclose discount rates, growth rates and forecast periods for a cash flow projection used in determining fair value less costs to sell.

3. Fair value determination

Assets held at fair values include financial assets and investment properties. Fair values less costs to sell may also be relevant in impairment testing of assets held at amortised cost.

Based on financial reports reviewed by ASIC, unrealised losses on investment property carried at fair value was about six per cent of the total asset value over six months. Further write downs may be expected at 30 June 2009 and regard should be given to the higher yields that may be expected from assets to cover risk, as well as impacts on rents, rental incentives and vacancy rates

Careful consideration should also be given to whether assets are traded in active markets. Most ASX-listed securities are actively traded, in which case, quoted prices should be used. Where markets are inactive, any valuation models should make maximum use of market inputs, model changes should be appropriate, and models used for actual transactions should be applied for financial reporting purposes. Key assumptions should be disclosed.

Available-for-sale financial instruments are valued at fair value. Movements in value are taken to a reserve, except that an impairment loss expense is recognised for the difference between cost and fair value where there is a ‘significant or prolonged decline’ in value. This backwards-looking test applies to each security and it is irrelevant whether those losses may reverse in the future. ASIC expects many ASX-listed stocks to have either significant or prolonged declines in value against cost for the year ending 30 June 2009.

Fair values of investment properties must reflect current market conditions - obtaining, or refreshing, external valuations should be considered. The best evidence of fair value is current prices in an active market for property in the same location and condition with similar lease and other contracts. Without an active market, adjusted prices in other active markets, similar recent sales adjusted for changed economic conditions, and discounted cash flows that reflect any uncertainties are used.

Our review showed some property trusts did not disclose key valuation assumptions, included a narrative description, or referred to a separate unaudited document. The full year financial report must contain key assumptions such as capitalisation rates, expected vacancy rates and expected changes in future rentals.

Movements in fair values of assets of sponsored defined benefit superannuation funds can have a material impact on their sponsors and should be reviewed. ASIC reviews showed an average three per cent negative return on plan assets in the 12 months to 31 December 2008.

In regards to both asset impairment calculations and fair value determinations, ASIC reminds auditors to ensure that audit team members have sufficient skills to audit fair values and impairments; if not, they may need to engage their own expert. The scope of an expert’s work must be adequate for audit purposes. The reasonableness of significant assumptions should be evaluated individually and as a whole, as well as the adequacy of evidence obtained and consistency with other audit evidence. Where there is significant uncertainty regarding values, a modified report may need to be considered.

4. Off balance sheet arrangements

Directors should reassess the risks and benefits associated with any off-balance sheet arrangements, particularly in view of changed economic circumstances and possible future adverse conditions. The substance of arrangements involving special purpose vehicles, derecognised financial assets and liabilities, and lease arrangements should be carefully reviewed. The nature and scale of any off balance sheet arrangements should be disclosed, including an explanation of why they aren’t on balance sheet.

Consolidation should be considered where the entity has an ownership interest close to 50 per cent and other interests are diversely held.

5. Financial instrument disclosures

The adequacy of financial instrument disclosures should be reviewed in the upcoming reporting period. User information needs should be considered and meaningful disclosures made that provide a proper understanding of the business and risks faced, including information that is, or should be, used by management.

ASIC’s reviews have identified use of boilerplate disclosures, and disclosures that didn’t properly convey the risks associated with an entity’s instruments and how those risks are managed. The extent of use of instruments was sometimes unclear. In addition, market risk disclosures and sensitivity analysis were sometimes net of the effect of hedging arrangements and there was no information on notional underlying amounts of derivatives. Hedging arrangements were sometimes poorly disclosed.

Disclosures of security for borrowings and debt maturity profiles, which are particularly important given reduced liquidity and debt refinancing opportunities, were sometimes omitted.

Other matters

Further focus areas for those responsible for preparing the financial reports are:

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