Financial reporting considerations related to the UK’s vote to leave the EU has been saved
Financial reporting considerations related to the UK’s vote to leave the EU
Financial Reporting Alert 16-1
This Financial Reporting Alert (originally published June 24, 2016, and updated March 31, 2017) discusses considerations related to the United Kingdom’s vote to depart from the European Union (EU). The decision has given rise to a host of questions about the near-term and longer-term effects of Britain’s exit from the EU on an entity’s financial reporting.
On March 29, 2017, the United Kingdom’s (UK’s) ambassador to the European Union (EU) delivered a letter to the president of the European Council that gave formal notice under Article 50 of the Lisbon Treaty of Britain’s withdrawal from the EU (“Brexit”) and has set in motion a two-year period of trade, tax, and other exit-related negotiations between the UK and other EU member countries. As financial markets and economic conditions react to the uncertainty that may accompany the negotiation period, some or all of the considerations outlined in this Financial Reporting Alert continue to remain relevant. We have updated certain of those considerations, however, and added others (and made some minor editorial changes) to reflect information that has come to light since the alert’s original issuance in June 2016:
- Risk factors and Appendix B — Updated to (1) remind registrants to consider establishing a process for monitoring material changes in risk factors and (2) provide additional disclosure considerations.
- Income Tax Considerations section — Updated to discuss broader in-country and cross-border income tax considerations for entities with operations in the UK. See also Deloitte’s separate March 31, 2017, Financial Reporting Alert (17-4), which clarifies that the UK’s notification under Article 50 does not represent an event that would require recognition in the period of notification.
- Other obligations — Added to provide additional considerations regarding obligations that could be affected by changes to laws or regulation.
The UK’s vote in the June 23, 2016, referendum to depart from the EU caught many by surprise and has given rise to a host of questions about the near-term and longer-term effects of Brexit on an entity’s financial reporting.
The referendum and notice of departure will not result in the UK’s immediate exodus from the EU. Parliament must now enact laws to facilitate Brexit, and the UK and European Commission have a two-year window in which to establish its terms.
Although formal separation from the EU will take time, the uncertainty introduced by the vote has already manifested itself in the financial markets. Such uncertainly is likely to affect other areas of the global economy in the short term and is expected to continue at least until the date on which the terms of the UK’s exit have been determined.
The impact on entities will vary significantly by industry sector and by other entity-specific factors. However, given the vote’s shock to global financial markets and their immediate reaction to it, all entities should consider how they are affected and what they may need to communicate to the market. The following are some near-term considerations:
- Typically, sharp rises in economic uncertainty express themselves initially and most forcefully through the liquidation of financial assets, which can significantly affect the value of currencies and drive down the value of equity securities. Flight by entities to safe-haven assets is also common.
- In the UK corporate sector, the vote to leave the EU is likely to fuel perceptions of uncertainty and depress risk appetite. Lower risk appetite is likely, in turn, to lead to a squeeze in business investment and hiring in UK operations as well as a renewed focus on cash and cost control.
- Legal ramifications will take longer to become clear and will depend on the time frames associated with the terms of the EU departure agreement. However, for at least two years, EU regulations and EU-inspired UK laws will continue to apply.
Given the potentially significant and far-reaching effect of the departure negotiations, entities should be aware of the following financial and regulatory reporting considerations as their next reporting cycle approaches:
- Risk factors — The departure process may affect an entity’s risk factors, including new risks or changes to existing risks, that may need to be disclosed. Affected registrants may consider developing a process to monitor material developments related to exit negotiations and consider any necessary updates to their risk factors. In an interim report, an entity’s disclosures may need to include more detail than the usual summary and reference to the risk factors included in the latest annual report.
- Accounting policies — In an uncertain environment, management’s disclosure in MD&A of an entity’s accounting principles and its methods of applying those principles may be especially critical to an investor’s understanding of the entity’s financial statements. Further, entities should carefully consider the disclosure requirements in ASC 235-10-50-1 through 50-3 related to accounting policies disclosed in either their interim or annual financial statements.
- Impact of market volatility on assumptions and forecasts — Since short-term or longer-term volatility is likely to affect key assumptions used in the development of forecasts, entities should identify which judgments and disclosures could be affected by the volatility. A good starting point would be an evaluation of the assumptions underlying the critical accounting policies disclosed in MD&A. Accounts that are most sensitive to financial market volatility may include investment balances, foreign currency denominated assets and liabilities, and other market-sensitive assets and liabilities. (See Appendix A for considerations related to selecting the appropriate exchange rate for translation of foreign currency transactions.)
- Impairment reviews — Market reaction to the vote may have triggered a requirement for entities to consider whether financial or nonfinancial assets (including goodwill and other intangible assets) are impaired. (See Appendix A for impairment-related considerations.)
- Financial instrument considerations — Market reaction to the vote may affect, among other things, impairment assessments, classification of investment securities, hedge accounting, and fair value measurement. (See Appendix A for financial instrument considerations.)
- Income tax considerations — Market reaction to the vote may affect a reporting entity’s ability to use deferred tax assets or its ability to assert whether undistributed earnings of foreign subsidiaries will remain indefinitely invested. (See Appendix A for tax considerations applicable to entities with foreign operations.)
- Inventory valuations — ASC 330 requires inventory to be measured at the lower of its cost or market value. In a volatile economic environment, it may be particularly important for an entity to challenge whether the utility of its inventory on hand has been impaired by changes in price levels or other causes. Entities should apply the guidance in ASC 330-10-35-1 through 35-11, which address adjustments of inventory balances to the lower of cost or market.
- Long-term intra-entity foreign investments — ASC 830 permits gains and losses on certain intra-entity foreign currency transactions “of a long-term investment nature” to be treated like translation adjustments instead of being recognized in net income. For a transaction to qualify as a long-term investment, an entity must be able to assert that “settlement is not planned or anticipated in the foreseeable future.” An entity that has characterized intra-entity transactions with entities in the UK or the EU as part of its net investment may need to reassess whether that designation is still appropriate. That is, the entity should reassess its assertion that settlement of intra-entity transactions is not planned or anticipated in the foreseeable future.
- Other obligations — Entities should take care to identify any obligations that may be affected by a change in law or regulation as a result of the departure process. In theory, such a change could result in the recognition of a new obligation or in the modification or extinguishment of an existing obligation. Although we are not aware of any specific implications, environmental liabilities and asset retirement obligations are examples of liabilities that should be evaluated to determine the effect of changes resulting from the departure process. Entities should consider consultation with legal counsel and accounting advisers to determine the effects of, and timing of accounting recognition for, such changes.
- Going concern — Economic changes, particularly those related to anticipated short-term cash flows in regions affected by the vote, may force entities to consider whether they should continue to prepare their financial statements on a going-concern basis. The flowchart in ASC 205-40-55-1 outlines a decision process for use in assessing whether substantial doubt exists about an entity’s ability to continue as a going concern and applies to both interim and annual financial statements.
- Disclosures — Entities should disclose how and why they have reached certain conclusions, in particular those related to forecasting or financing. SEC registrants should also consider the SEC reporting and disclosure considerations outlined in Appendix B.
Because this massive change in the geopolitical landscape is still in its early days, the implications of the Brexit vote may not become clear until we see its effects on the capital markets and economy and start to understand the political timetable. Practice will no doubt evolve regarding the nature and quantity of disclosures that entities must provide in both interim reporting and annual reports.
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Financial Reporting Alerts are issued as needed to highlight up-to-the-minute accounting, regulatory, or other developments that may require immediate action or that may affect financial reporting and disclosure.