A limited European Union review of compliance with accounting rules regarding business combinations in financial statements raised several red flags, the European Securities and Markets Authority (ESMA) revealed this week.

ESMA reviewed the 2012 annual International Financial Reporting Standards (IFRS) financial statements of 56 listed entities in 11 European countries, and looked at how consistent the issuers were in applying key requirements of the IFRS 3 rules on business combinations. There were 66 business combinations represented in the statements, worth a combined €76 billion. The regulator said while there were some good disclosures provided, there were several areas where it felt issuers fell short of the mark.

Specifically, while 86 percent of the combinations reviewed included recognized goodwill, more than half of the issuers used “boiler plate” or insubstantial descriptions of factors comprising the goodwill, the report found.

ESMA said most issuers – 92 percent -- did provide summaries of fair values of the major assets and liabilities acquired. However, the disclosures were muddied by a high level of aggregation of assets and liabilities, and some issuers aggregated assets and liabilities of a different nature, the review showed. ESMA also faulted some issuers for only referring to external valuations, and added that “very few” disclosed information on how they determined fair values.

Additionally, almost one-fourth of the reports reviewed did not recognize any intangibles separately from goodwill, ESMA said. It also found bargain purchases happening more frequently than IASB anticipated. About 11 percent of the business combinations included the report of a bargain purchase gain. However, a third of those provided no explanation as to why the transaction resulted in a gain.

Only 11 percent of those reviewed recognized contingent liabilities stemming from business combinations, and even fewer provided the necessary IFRS 3 disclosures, the report said.

The agency said it would present recommendations to both issuers and the International Accounting Standards Board (IASB) regarding areas where it feels the quality of financial reporting can be improved. IASB already is undertaking a post-implementation review of IFRS 3.

The exercise was not merely an academic one. ESMA said it expects the relevant national authorities to take “appropriate enforcement actions” regarding cases in which the report uncovered material breaches of IFRS rules and follow up on the issuers' responses. The names of issuers reviewed were not disclosed in the report.

“Transparency of financial information is of paramount importance for investment decisions,” ESMA Chairman Steven Maijoor said in a statement. “Therefore, given the impact of business combinations on financial statements, ESMA believes that enhanced information by issuers would contribute to investor protection and increase market confidence.”

“Today's report will also assist the IASB in identifying those areas where the IFRS requirements lead to divergence in practice and where clarification or additional guidance is necessary to increase consistency in application by issuers,” Maijoor added.

ESMA is recommending issuers tailor their disclosures to the specifics of a transaction. The authority gave four particular recommendations to issuers:

·        Provide relevant information regarding how the amount of goodwill was determined and information explaining reasons for bargain purchases.

·        Provide more “granular” disclosures regarding the assets and liabilities recognized by issuers.

·        Apply consistent assumptions both at the initial recognition of assets and liabilities and at their subsequent measurement.

·        Improve information provided on the techniques and assumptions used to determine fair-market value of assets and liabilities.

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