Video transcript: Financial reporting update 2019
Title: Financial reporting update (2019)
Robert Cox
What I’m going to do is cover some of the key accounting standard changes for this year, but also some of the more substantial ones over the next few years, and I’m covering off both public benefit entities within the public sector – which I think is probably most of you in the room – but also the for-profit entities in the public sector, and there are a few here today as well. OK, so in the for-profit world we have what we are calling the big three accounting standards which are just about to hit. So we’ve got the Financial Instrument Standard and the Revenue Standard, which are being applied at 30 June 2019 this year, and we’ve got the Leases Standard, which is the following year. So for-profits, you’re going to be applying these standards right now, so that’s your state-owned enterprises, your council-controlled trading organisations, your port companies, your electricity line companies, and a few Crown entity subsidiaries.
In the PBE world, these standards are generally coming along a little bit later, and we will go through that over the course of the presentation. There is the challenge of mixed groups, which are PBE groups, a public benefit entity group, and for-profit subsidiaries. So on a group basis, a group needs to use consistent accounting policies across the group. So where the for-profit entities and the public benefit entities are applying new standards at different dates, that causes a problem, and the for-profit entities’ results may need restating on consolidation using the PBE Standards. So, to avoid that issue, some mixed groups are early adopting some of the standards, particularly the IFRS 9 and the PBE version of IFRS 9. And it is IFRS 9 that I’ll probably spend the most time on today.
So the mixed group issue means that many of you in this room will be early adopting PBE IFRS 9, a new financial instrument standard. So the Treasury has decided the financial statements of government will early-adopt PBE IFRS 9, so if you’re a government department or a Crown entity, you will be using this standard this year. If you are a council or local authority, you have a choice as to whether to early-adopt or not, and that will depend on how complex your group is. So the Auckland Council Group, for example, with some complex for-profit subsidiaries, is also early-adopting the standard. We expect some other councils with complex groups, including for-profits, to also think about early-adopting the standard.
If you’re not part of the central government group and you’re a council that doesn’t want to early-adopt, then you’ve now got until 2022 or 2023 to adopt the new Financial Instrument Standards. There’s an exposure draft out at the moment which is deferring that date. But, for many of you, you’re going to be driven by the Treasury timetable, which means PBE IFRS 9 this year. So the first thing you need to think about in relation to financial instruments, particularly your financial assets, is whether you are within the scope of this standard. So the financial instrument is defined as, “Being based on the contractual relationship that establishes the financial asset on one side, and a financial liability or an equity interest on the other side.”
So the word ‘contract’ is key there, and the way Treasury has interpreted the standard is that, “Certain receivables which do not have a contract are outside the scope of this standard.” These are things that we’re calling sovereign receivables. The biggest one is probably tax receivables. So your tax receivables, there’s no contract between the IRD and the taxpayer. That receivable is a creature of statue. Fines receivables will be similar. Other levy receivables may well be outside the scope of this standard. So first thing: reflect on whether your receivables are within the scope of the standard. If they are, then the next few slides will apply to you.
OK, so for financial assets this slide sets out the categories of financial assets under IFRS 9. So we’ve got four categories; IAS 39 we’ve got four categories. So how do we decide which category we are going to be in? So the standard, like all financial instrument standard, is very complicated. We have tried to summarise it through some flowcharts to make it easy for you. So the model is first driven whether your asset is an equity instrument or a debt instrument; most of the time it is reasonably clear which one you are. If you are a hybrid instrument you usually will use the debt model.
So under this flowchart, your first question is: is the investment held for trading? So the ‘held for trading’ definition is the same as we have under the current standard, which is, “An instrument acquired principally for the purpose of selling in the near term, part of a portfolio of instruments that are managed together for which there is evidence of a recent actual pattern of short-term profit-taking.” So if you meet that definition, you’re held for trading, you must be measured at fair value through P&L. Your derivatives are also going to be fair value through P&L unless you are hedge accounting. If you don’t meet that definition, then you can designate at fair value through other comprehensive income. Otherwise you’re going to be a fair value through P&L.
So you can only meet that designation on initial recognition; you can’t change your mind once you’ve designated. You can’t say, “OK, those fair value movements are now starting to go against me or in my favour, and I’d like to move those gains into the income statements.” So once you’ve made that designation, you’re stuck with it until you derecognise the instrument. So if you designate fair value through other comprehensive income, all your fair value movements go through OCI. You don’t transfer them across into the income statement on derecognition. There is no impairment transfers into the income statement. So that is quite different to the model we have under the current standard, and this is where we’ll start to get mixed group issues unless the whole group is doing the same accounting.
Note on the flowchart: there is no cost option for equity instruments. So under the current standard you can account at cost if fair value cannot be reliably measured. You no longer have that option. So what does that mean in practice with some of those unusual equity instruments we have in the public sector where there is no market-based evidence of value? You’ve got to find a proxy to fair value. And, in some circumstances, you may be able to justify cost is still your best proxy to fair value, so you may be able to retain that cost accounting. But more likely there will be a better proxy to fair value, and, in some cases, that, for example, might be the net assets. So that is the equity model.
For debt instruments we have a different model, and perhaps a slightly more complicated model. Remember that first check is whether or not you are a financial instrument or a sovereign receivable. But if you’re a financial instrument, this is where you go for your debt. This is based on the characteristics of the cashflows from the instrument and the entity’s business model. So first box, you can designate a fair value through P&L. This is generally where you have an accounting mismatch, so the liabilities and derivatives that fund this asset may have their fair value movements going through the income statement. You’re going to want to put the fair value movements of the debt instrument in the income statement as well to offset. So in that case you can designate a fair value through P&L.
Moving down the model, the next box is to consider the characteristics of the cashflows. So this is the SPPI model, or the SPPI test: solely payments of principal and interest on specified dates. Consistent with the basic lending arrangement. So if you pass that test, you then think about the business model, which is done on a portfolio of instruments basis. So are you holding these instruments to collect the cashflows? In which case, it’s amortised cost, which will be your basic trade receivables; generally, your whole trade receivables to collect the cash. If you’re selling your trade receivables to a debt factor, you will fail this test and, in fact your business model will be to hold-to-collect contractual cashflows in this cell, and you’ll be fair value through other comprehensive income.
If you’ve got a portfolio of bonds for liquidity purposes, at certain times of year you’ll have excess cash. You buy some bonds. Later in the year, you need that cash for your business operations and you sell those bonds. They’ll be held-to-collect contractual cashflows and sell. You’ll be fair value through other comprehensive income. If your business model is neither of those, you’re going to be fair value through P&L. Now, for debt instruments accounted for fair value through other comprehensive income, we do have recycling of those fair value movements from OCI to the income statement on disposal, and also impairment is recognised in the income statement. So that is the opposite of what we had for the equity model. I’m not sure why they chose to do the opposite for debt and equity. It really demonstrates that this is a very rules-based standard, and you need to know the rules which are relevant to the instruments that you have.
One area of concern, when the standard was being developed to public-benefit entities, was the treatment of concessionary loans. We have a lot of concessionary loans in the public sector. These are loans to NGOs or individuals where repayment is dependent on the future financial circumstances of the recipient – the most obvious example of these being student loans, student loans being repayable dependent on the future earnings of the ex-student. Is currently accounted for at amortised cost. The issue is whether or not these pass the SPPI test. Solely payments of principal and interest on specified dates. And the view that we’ve taken, along with Treasury, is that they failed at the test because the payments are not on specified dates that can be determined at the start of the arrangement.
So student loans and similar concessionary loans are probably unlikely to be accounted for on amortised cost; they’ll move across to a fair value model. You’ll get increased income statement volatility based on market changes and discount rates. For student loans, an adjustment has been calculated, so the student loan’s carrying value at the opening position June 2018 has increased by 600-odd million on a carrying value of about $10 billion. So that’s about a 6% adjustment. OK, we’ll move across to the liabilities model. The liabilities model is a lot simpler, and broadly similar to where we are today in our financial liabilities accounting.
So you can irrevocably designate a fair value through P&L if it eliminates or significantly reduces an accounting mismatch – same as for assets – or it’s part of a group of financial instruments measured on a fair-value basis. If it’s held for trading, this is of course going to be fair value through P&L, the ‘held for trading’ definition the same as for assets. One change of note is the box on the left-hand side of the slide. So fair value movements attributable to your own credit risk are parked in OCI. So that’s really to stop the slightly counterintuitive accounting we have under the current standard. If a business is struggling, its credit rating is deteriorating, the fair value of its liabilities will reduce. Currently that gives it a credit into the income statement. So instead of that credit going into the income statement when the fair value of liabilities decreases, that credit is now parked in OCI.
OK, the other significant change in this standard is the impairment model. So currently we are in an incurred loss model, and this new standard will move us across to an expected loss model. So after the global financial crisis there was a fair bit of criticism of accounting standards, particularly in relation to impairment of financial assets. And this was looking at the collateralised debt obligations, CDOs backed by mortgage securities, particularly in the States. People knew that those mortgaged securities were of poor credit quality, but because they hadn’t yet gone bad, no accounting was required for future losses, even though losses on those securities was expected at some stage in the future.
So under the expected loss model, we have what we refer to as three buckets of assets: your performing, your underperforming and your non-performing. So normally when an asset originates, you’re going to presume it’s performing. So initial recognition, in the performing asset bucket, you need to account for 12 months expected future credit losses on those assets. If credit risk significantly increases, you then move across to the second bucket, and you need to think about lifetime-expected credit losses of those assets. So this is when credit risk increases significantly. What do we mean by that? Well, there’s a fair bit of guidance in the standard. So this talks about a significant reduction in credit rating – which is not AA- to AA; this is AA to B- – quite significant changes.
You’re also expected to reflect on the financial results of the entities you are investing in. The standard talks about reasonably and supportable information that is available without undue cost or effort. So if you’ve got bonds in a stock-exchange-listed entity, you’d be expected to know about the financial performance of their entity based on its stock exchange releases. You’re not expected to get on the phone and phone up the financial controller and ask how they are doing. So it’s information that is readily available. The standard has some rebuttable presumptions. If your debt is 30 days past due, it’s going to be underperforming unless you can rebut that. If it’s 90 days past due, it’s going to go into the non-performing bucket.
The underperforming and non-performing buckets are both lifetime-expected credit losses. The difference is how you account for the interest. So underperforming: you account for interest income on the gross carrying value, but you do need to reflect on impairment of any interest receivables. Non-performing: you account for interest income on the net carrying value after impairment. So under this new impairment model, some of your previously unimpaired financial assets may require some impairment to be calculated against them. How are you going to do that? For basic things like receivables, you’re going to look at past practice. So what is my past practice of collections? You can do it on tranches of debt for debt that is current. What is my past practice of collection for debt that is 30 days overdue? What is my past practice of collection for debt that’s 90 or 120? So you can do some fairly basic calculations.
You are meant to adjust these for current conditions and expectations about the future. So that is a bit of crystal-ball gazing, and maybe insights from Treasury about the future economic situation will help us in that. But if we are expecting an imminent economic downturn, then maybe we might expect our collection rates to decrease over what they have been recently. There’s also a probability-based approach which is commonly going to be used for bonds, which is your probability of default multiplied by loss given default for different credit ratings of bonds. And that sort of information is generally available from the credit rating agencies; it’s not usually New Zealand-specific information, but it can be quite useful.
Hedge accounting. The IFRS 9 Hedge Account Model is not yet finished. They’ve been working on this standard for 10 years and they haven’t yet cracked the answer for hedge accounting. So basic instrument-by-instrument hedge accounting they’ve done, but the macro hedging chapter is not yet finished. Macro hedging is really for those entities that hedge on a portfolio basis: mainly financial institutions, banks, insurance companies. In the public sector – this is probably The Reserve Bank, the debt management of an office in New Zealand – probably do their hedging on a macro basis, so we don’t have a macro hedging model as yet.
And because this hedge accounting standard is not finished, you have some options. So, even when you are early-adopting IFRS 9, you have an option of whether or not to do the hedge accounting under IFRS 9. Treasury has chosen that, even though it is early-adopting IFRS 9, it is not early-adopting the Hedge Accounting Model. So you’ll do IFRS 9 except hedge accounting, which stays under IAS 39. So many of you are not going to be doing this hedge accounting yet. Arguably, the Hedge Accounting Model under IFRS 9, to the extent that it’s completed, is better than the existing Hedge Accounting Model. It is a little bit more flexible, and some entities in the public sector that are not driven by the Treasury timetable have chosen to early-adopt this standard, or the hedge accounting chapter of this standard.
It gets rid of the bright line test for hedging. So currently a hedging instrument needs to 80% to 125% effective for you to do any hedging. No, it’s not unusual to have an instrument that’s only 75% effective. In the current situation, you cannot hedge-account for that at all. Under the new standard, you’re allowed to account for that 75% effectiveness and park that 75% of the fair value movements in equity. So, if you have the option of early-adopting the hedge accounting chapter of the standard, I encourage you to look at it. If you’re happy with the hedge accounting you’re doing, or you’re driven by the Treasury timetable, well, you’ll stick with what you’ve done.
Transition for IFRS 9 as a whole is pretty complicated. Treasury has chosen the simpler options available. The key one of those is not to restate the comparatives. So, if you’re driven by Treasury’s instructions, you’re not going to restate your comparatives. Any movements you’ve got are going to be put through opening equity. There is a fair amount of disclosure, as you might expect, around the transition to the standard, really setting out all the changes that you’ve made and the decisions that you’ve made. The standard as a whole has a lot more disclosure in it than the existing Financial Instrument Standard. The thing you need to be aware of, as with all disclosure requirements in standards, you only need to provide those disclosures if the information is material in the circumstances of your entity.
A few other standards I’ll go through a little bit more quickly. So IFRS 15, Revenue, is being applied now by for-profit entities in the public sector. What this requires you to do is go through your contracts, your revenue contracts, identify all the separate performance obligations in those contracts, identify the transaction price for that contract and allocate the transaction price across all the performance obligations, and then you either recognise revenue at the point of time, or over a period of time. There is a lot more guidance in this standard than we have nowadays. It is a much bigger standard. For many entities, the answer is going to be the same. Some entities with more complex contracts, there could be some change. So what for-profit entities are needing to do is go through contract-by-contract.
You can do this on a portfolio basis if all your contracts are much the same, but what we’re finding is, for some contracting companies in the public sector, many of their contracts are individually negotiated and individual contracts are quite different, so it does make going through your contracts to comply with the standard quite onerous. Some of the impacts of the standards include how consideration is allocated across different performance obligations. So if you’re a telecommunications company that is selling a telephone, or giving away a telephone together with a call plan, data and calls, under current accounting you might account for all the revenue as being allocated to the call plan and then giving away a free handset or discounted handset. Under the new standard, that discount will be spread across all the performance obligations equally based on their standalone selling prices, which can give you quite a different revenue recognition pattern and also profit recognition pattern.
There will be some changes from the Standard at the margins, in whether revenue is recognised at a point of time or over time, for construction contracts. Will you recognise revenue on a percentage completion basis during construction, or not recognise any revenue until construction is completed? So the rules in the Standard are quite different to the existing Construction Contract Standard. This Revenue Standard does replace the existing Construction Contract Standard. If you’re applying this standard, I think the key message, as with the financial instrument one, is engage with your auditor at an early stage.
For PBEs, we don’t have a new revenue standard yet. We did have a consultation paper from the IPSAS Board about their thoughts on where revenue might go. It’s fair to say they’re looking at moving away from the distinction between exchange and non-exchange revenue, because that has been really very difficult to work out which revenue streams are exchanged and which are non-exchanged. So they’re focusing on enforceable public sector performance obligations. So, where there is an enforceable performance obligation, chances are the accounting will go pretty similar to what we’ve just talked about in IFRS 15. If there is not an enforceable performance obligation, then that will move into an amended IPSAS 23, which will focus less on exchange and non-exchange. Finalised standards for PBEs on revenue are still some time away.
At the same time as their non-exchange revenue project, they’ve also had a non-exchange expenses project, which has moved along reasonably quickly. We’ve got some exposure drafts out at the moment. To a large extent, these new standards for non-exchange expenses will just codify the accounting we are doing now, so I’m not expecting a great deal of change in this space. The one area where we have inconsistent practice in central government agencies, and the public sector generally, is in grant expenditure, so we’re pretty keen to get this grant expenditure standard. Unfortunately, it is the slowest part of this project and hasn’t made great progress yet, so it is still some years away.
Leases. So some people think this leases standard is quite controversial and some don’t like the answer. There was an article in the NBR, I think last week, where they were quite critical of the accounting that will arise from this new standard. So at the current point in time, we only have a for-profit leases standard. So if you’re an SOE, a CCTO, a port company, you’ll be applying this standard next year. If you’re a government department or a Crown entity, or a DHB, it’s still a little way away. So what does this standard do? So rather than a lease commitment, you’re going to have a lease liability. You’re going to have a liability for the future payments under this lease, which is going to be pretty similar to borrowings, and you’re going to have a right-of-use asset. So you’ve got a lease for a floor of a building, you’ll have a lease obligation liability for the annual rental multiplied by the number of years of your lease, and you’ll have a corresponding asset.
And, at least at the start of the lease, those two numbers will be fairly similar. Once you’ve recognised your right-of-use asset, you depreciate like any other physical property, plant and equipment. And you’ll have interest expense on your lease liability. So this is very different to where we are now. There are two exemptions to that: short-term leases less than 12 months, you don’t do that accounting; also for low-value leases. The standard doesn’t tell us what low-value is, so that is an interpretation for you, and for us as auditors. But it’s going to be things like laptops, photocopiers will be exempt from that model and you can continue your current accounting. But for your office, building leases and large leases, it’s going to be very different.
So what are the consequences of applying this new standard? So I was going to do this as a quiz, but there are far too many of you so I’ll just run through it. OK, so you’re a state-owned enterprise; you’re applying this leases standard next year. What are the consequences? Your assets are obviously going to increase. You’ve got right-of-use assets for your building leases. Your liabilities are going to increase. You’ve got a matching lease obligation liability instead of a lease commitment. Your gearing is going to increase. The rating agencies are going to treat lease obligation liabilities as borrowings. Your operating expenses will decrease, so you no longer have an operating lease expense sitting in operating expenses. Instead, you have depreciation and an interest charge. EBIT and EBITDA, they’re going to increase it as well, because the operating lease expense has disappeared and been replaced by depreciation and interest which are outside EBITDA.
Your total expense over the lease term is, of course, unchanged; the total cashflows will be unchanged. Total expense in the early years of the lease will in fact be higher, so you don’t get this straight-line expenditure pattern that you do under the current leases standard. So your expenses are higher at the start of the lease because you have a lease liability which you’ve got an interest charge on. Obviously, at the start of the lease, the lease liability’s really big, and you’ve got a correspondingly large interest expense. Your total expense in the later years is less because, to a large extent, that lease liability is being paid off, and the interest charged towards the end is low. You get similar effects on your cashflows, so your operating cash outflows will be less because you haven’t got an operating lease outflow there. And your financing cash outflows increase because you now have a new interest charge. So some quite significant consequences if you’ve got a lot of leases.
What’s happening in the PBE world? So we have had an exposure draft of a leases standard from the IPSAS Board. They are proposing much the same lessee accounting model, so they do believe that leases going on balance sheets makes sense for the public sector, so it is likely to happen. They proposed a different lessor accounting model to the IASB, which was maybe conceptually purer but more complicated, and they also gave some guidance on concessionary loans, which are the sort of things we have quite a lot in the public sector, a lease at less than market rate – peppercorn leases, for example.
So the feedback to the IPSAS Board: most people thought that the idea of bringing leases on the balance sheet was a good idea. The lessor accounting approach: people didn’t like that, mainly because it’s just different from the IASB and we don’t want to understand two different models for lessor accounting. The concessionary lease approach in the exposure draft: no one really liked it; it was too complicated. So hopefully they will rethink and find something simpler. So, because people didn’t like everything they proposed, the timing is really a little unclear at this point in time.
The last group of standards I wanted to focus on are the new standards for accounting for groups. Which will apply if you’re a December balance date. If you’re a university/polytech, this will be December this year; the rest of you will be June next year. But is worth just getting yourself ready for these new standards. When they’re implemented in the for-profit world, they were reasonably straightforward, so the for-profits are already applying these standards. Just highlight a few things in here. IPSAS 35, we have a new control test, which is how you determine whether something is a subsidiary and something needs to go into your group accounts. I’ll touch on that in the next slide.
Joint ventures: accounting for joint ventures and the categorisation of joint ventures is a little bit different. We go from three types of joint ventures to two types of joint ventures. Probably the most substantive change is that you will no longer be able to do proportional accounting, proportional consolidation for your joint venture entities. Because that’s an option that’s been around for a very long time but it has finally been closed off, so if you currently proportionally consolidate joint venture entities, you will have to do equity accounting going forward. There is a disclosure standard which requires a lot more disclosure, but, again, subject to materiality. And my last slide is the control test.
So for some of you the control test is quite important. For many of you it is pretty obvious whether your subsidiaries are controlled or not; you own more than 50% of the shares. But in some circumstances in the public sector, determining whether an entity is controlled, is a subsidiary, needs to go into the group accounts, it’s quite difficult. So the words of those two control tests are sitting in those slides on the slide there. Broadly, fairly similar; you need both power and benefits. But the new standard provides a lot more guidance and is a bit more helpful to the public sector, I think, in working out the answer. So IPSAS 35 focuses more on looking at the purpose and design of the entity. It does give some good guidance around predetermination of rights, which is what we call the ‘autopilot test’ at the moment, where all the power is established from the mechanism by which the entity was established, perhaps through drafting its trust deeds.
The standard talks about power being established through a special relationship, which is a new part of the control test not in the current standard. So it talks about a range of indicators for special relationships, which can be quite useful. For example, “The entity provides critical services, technologies, supplies, to the other entity and the other entity depends on this.” And, “The entity provides key management personnel to the other entity.” So those sorts of concepts now come in to assessing control. There’s also more guidance on benefits, and the benefits is, I think, substantially broader than the current benefits test. So the guidance now talks about exposure to benefits or involvement in an entity. The old benefits test talked about an entitlement to benefits, which was really quite a restrictive term and picked up on lawyers as being a very precise entitlement. So now we just need exposure.
What does this mean in practice? If you’ve got an entity – could be a trust – that is associated with you, that was marginally assessed as not controlled under the current standard, you will need to reassess that under the new standard, and I think some of those entities which were marginally assessed as not controlled will become controlled under this standard. And we’ve already, if you like, earlier applied this to some entities in the university sector, and we have found some trusts are coming in to control that weren’t controlled before. If you’ve got entities which were marginally assessed as controlled previously, I don’t think that’s going to change; so it’s more entities are come into the group rather than entities dropping out. So if you have entities, particularly trusts, marginally assessed as not controlled, I think you should look carefully at that standard.
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