Video transcript: Financial reporting update
Title: Financial reporting update, Brett Story, Associate Director, Audit New Zealand
Brett Story
What I’m going to take you through for the next half an hour or so, just talking through improving communication in financial reports, which is an ongoing, interesting topic. And also just talk through, at a reasonably high level, on some of the accounting standard changes that are on the horizon. So those are the two sort of broad areas I’ll be talking about. And I’ll sort of take any questions at the end as well. And I’ll be hanging around for lunch, too, if you want to ask me any questions at that time.
So just starting off with improving communications in financial reports. In this part of the session what I’m going to discuss with you are some of the improvements we are seeing in financial reports in New Zealand, some of the drivers for that change, and also try and encourage you or motivate you to see how you can improve the communication of your financial information and the value of that to your users, if you haven’t thought about that already – I know there’s some in the room that have already embarked on this. On your tables there’s a couple sets of financial statements, there’s not enough for everyone – I think there’s two copies of our Crown entity model financial statements, and there’s one copy of Meridian Energy Financial statements, they are sitting there, I will refer to those throughout the course of the presentation, but you may want to flick through those now if you want to.
So it’s just helpful to start off with, I guess what we’re trying to achieve through presenting of financial statements – is it just a compliance exercise, or is it about communicating to an audience? And hopefully you are thinking it is the latter. Whilst it does need to be done, the importance is around the communication of the right information to your audience. It’s useful to just to refer to the PBE conceptual framework. Now this just discusses the objective of financial reporting, which is to provide information to users for accountability and decision-making purposes. The framework also discusses the primary users in relation to financial statements, which is the service recipients, which are the entities and individuals that receive the services delivered by entities and also the resource providers. So when financial statements are being prepared, it is important to keep in mind who are the users of the financial reports. And that can differ from entity to entity, but typically these are the general public, could be tax payers, rate payers for councils, users of the entities’ services, for some entities it can be MPs and select committees, and it can also be the providers of finance, such as banks. So can be quite a broad range of users there for some entities.
Now there has been some concerns raised around the information and extent of information that is being disclosed in financial statements, so there has been a lot of work by various groups over the last five years or so that have been traversing this area, and many reports have been issued in this space, including the Auditor-General’s report issued in early 2016 titled Improving financial reporting in the public sector. Now some of the themes from these reports are: financial statements are too long; there’s too much immaterial disclosure, which leads to obscuring or hiding important and relevant information; there’s too much complexity in relation to disclosures, because of the complex disclosure requirements as setting the standards; there can be duplication of information between the notes and the accounting policies. Some of the disclosures are rather boiler-plate, such as around key estimates and judgements, accounting policy and judgements, rather than disclosing information that’s specific to the entity, often that can just be boiler-plate and just sort of standard-type wording that may just be copied from a model set of financial statements. So those are just some of those themes that have come out of those reports.
Now the standard-setters have been hearing the messages that have been coming out of that report, out of these reports, and they have been embarking on some disclosure initiative projects so we are starting to see some changes coming through the standards and some messaging from those changes around how communication of financial statements could be improved. It is a bit of a journey, it’s fair to say, but it has started. So, whilst there has been a lot of work going on, the first one I want to focus on really is the disclosure initiative amendments to the presentation standard IAS 1 for full profits or PBE IPSAS 1 for public benefit entities.
So these are mainly clarification amendments, rather than creating new requirements, but it is helpful that that guidance has been added. It does create some more flexibility and does help remind you what the focus is in preparing disclosures. So some of the things that the amendments do say: entities shall not reduce the understandability of its financial statements by obscuring material information with immaterial information, and usually not need provide a specific disclosure required by standard if that information is not material. It also has some additional guidance around including subtotals in the primary financial statements, which some entities like to do to try to improve the communication in financial statements, particularly in statements of financial performance. It does clarify its flexibility around note ordering, and also flexibility around placement of accounting policies. So accounting policies don’t necessarily need to sit in, all in statement of accounting policies, they can be moved into notes, for example. But there’s still ongoing work being done around disclosure initiatives there, so that’s the first array of amendments, but there’s some more work that’s been happening internationally around there, which will crystallise over the next few years I hope.
Not often when we think about disclosures in financial statements we often come to the concept: is a disclosure material or not. Whilst we have definitions and we do have some guidance around materiality, it is quite difficult in practice to apply this to disclosures, it does require professional judgement, and that comes back to considering the needs of users for decision-making and accountability purposes. For disclosures, it’s not always based on the size – that’s often a consideration for disclosures but not always. The nature of transactions or disclosures also need to be considered, examples of there like related-party transactions and remuneration-related disclosures, or other legislative-like disclosures. Often those sorts of things are material because of the nature, even though the numbers themselves may be immaterial. So it is an ongoing challenge for both preparers and auditors around this materiality concept as to whether something should be disclosed or not.
So what are we seeing in terms of evolving good practice? What we are seeing out there is in the accounting policy space, entities are moving the accounting policies wording that relate to specific items in the notes, that wording has been moved into the notes to be presented together with the underlying numbers. Some entities have been looking at rewriting their accounting policy wording to make it a bit more plain language, although that is a challenge. Some entities are also looking at what policies are being disclosed, potentially removing immaterial notes and also disclosing accounting policies in relation to those immaterial notes as well. We’re seeing some entities putting indexes for their financial statements or indexes to the notes, seeing changes in headings, symbols being used for accounting policies or key estimate judgements, we’re seeing some entities focused on trying to make their disclosures around key estimates, and assumptions being tailored to their specific circumstances and actually explaining some of those judgements that are being used, particularly around evaluations. Considering the order of notes is another one. The traditional presentation is to have the P&L notes first then the balance sheet notes, then usually sort of the other notes. So some entities are reordering their notes, which is permissible, putting the more important areas first. So if it’s an asset-intensive entity it may have a property, plant and equipment disclosures first, or if it’s an entity with lots of borrowings maybe it has a borrowing disclosure first. So there is flexibility around the presentation of notes in the financial statements. Some entities have also put some sort of management commentary within the financials as well, around key summaries of significant matters for the year, or key development notes. So that’s some of the good practice we’ve seen.
What entities are doing this sort of stuff – this is not an exhaustive list, these are the ones that we are aware of, so apologies if you think you’ve done a lot of work in this space and you’re not on that list. So there’s a number of entities here that are PBEs and also for-profits in the public sector that have looked at their disclosure and presentation and have made quite substantial changes to their financial statements. So, PBEs we have here are Auckland Council, FMA, and the Fire Service Commission. I do have the Meridian Energy accounts printed, because they weren’t too long, they have done quite a lot of good things in that evolving good practice slide I just had previously, so if you want to have a look at those they are quite a good example to look at in terms of how they’ve integrated the accounting policies into the notes, and they’ve got symbols, for example, and they’ve got some indexes, and some management commentary and summaries of key issues for the year.
So Audit New Zealand’s response around this area: we are accepting of new approaches. In terms of our model financial statements, we have updated the crown entity model financial statements of June 2016 last year. We also updated the tertiary education model December 16, where we have followed some of these evolving good practices in preparing those models, so what we’ve done – we have spread accounting policies through the notes. We’ve tried to improve some of the wording around those accounting policies, but it is hard to do that, to try and write them a bit easier, they still can be complex, we have expanded some of our disclosures around re-evaluations, for example, explaining the assumptions and judgements used in those evaluations but those areas really need to be tailored specific to entities. What we haven’t done is we haven’t removed potentially immaterial disclosures, which is a criticism we sometimes get for our models that they’re too long, we’re trying to give a broader range of disclosures there, because some of those items may be material for clients, at the end of the day it is up to clients and auditors to have those discussions around what items should be included based on materiality. So just because we’ve got it in the model doesn’t necessarily mean you need to have it. And there’s a copy of the crown entity model there if you want to have a look at the change in presentation that we’ve adopted for that one. And we will be putting this sort of thinking into our future models as we update those, we’re currently working on the local government model.
Putting it into practice – so if you are embarking on this process of looking at your financial statements and how can you improve them – it does require planning, time, and resource, and it will need to be a significant focus of a finance team with buy-in from the top, so you also need to consider the timing of when that work is done, it probably needs to be done earlier rather than at the reporting cycle at the end, when the accounts are actually being prepared, you’re going to have to consider consultation, such with the audit committee, getting feedback from them, getting feedback from the auditor as well. The best approach is not to just give the updated accounts at the end of the final audit, who are at final audit with a completely different presentation, that might get the auditor a bit worried, so it’s best to engage early with those particularly through the pro forma process or even earlier if you’re looking at recasting your financials and changing them significantly. The other approach is, consideration is: do you take a big bang approach, like try and do this all in one big hit, like reintegrate or rewrite significantly, so that’s what some entities do. Some entities one year may just reintegrate the accounting policies into the notes and the following year they may look at the wording, try and enhance the wording further. So there’s different ways of doing this, either doing it one big approach or spreading it out over some time, doing incremental changes.
Just some concluding comments. I guess the key thing is focusing around what information should be disclosed and the needs of users and accountability, shifting from compliance to better communication, more relevant and useful communication in the financial statements. Transparency is still key, if you’re unsure if something should be disclosed, if you think it could be useful to a particular user, then maybe you should err on the side and disclose. Probably a message here is the overall objective shouldn’t just be ‘I want to reduce the size of my financial statements’, it may be a by-product, but what the objective is is trying to improve the communication of what is in your financial statement, so a by-product of that could be it does reduce, but typically it doesn’t reduce the size of your annual report. CANZ, who are the Chartered Accountants of New Zealand, they have done some research of entities that have done these changes, and they found on average that those entities only reduce their financial statement size by 2%. But the general consensus was that those entities had significantly improved the communication of their financial statements.
Right. So that’s the first part of the session. The second part is talking about accounting standards updates, so just a couple things to keep in mind with this. I’m going to keep this reasonably broad and not get into too much detail, because I don’t have time to do that today. I’m just going to talk about some of the more relevant changes, so there is a lot more change that’s out there but I just want to focus on the key stuff that is worth communicating with you today. So I’m just going to do the more imminent stuff, and some stuff that’s more into the horizon, some stuff that’s on the horizon is quite substantive so it’s useful to highlight that now.
So the good news first is there’s no new standards to worry about for June 17 year ends. There has, however, been a number of minor amendments to some of the standards. Most of you here today are PBEs, I’m aware there a couple of for-profits, I’ve just got some stuff there in brackets in that table. Probably just the things that are worth mentioning on this slide is around treatment of accumulated depreciation on revalued assets. Most entities in the public sector just eliminate accumulated depreciation to zero against the gross carrying value. That treatment’s still permissible. What this clarification is really dealing with those entities that do something different, so if you do do something different then you need to look at that clarification to see whether what you’re doing is still permissible. It’s not very common that sort of treatment in New Zealand, to do another treatment.
The other one worth mentioning is where an entity is providing key personnel services to an entity, it’s been clarified that that entity is a related party, and also that the remuneration to that entity would need to be separately disclosed, so it doesn’t form part of the KMP remuneration itself, but it’s just a separate disclosure about the remuneration to that particular entity that’s providing KMP services. Donated goods, so PBEs do need to recognise donated goods such as donated inventories, and this has been a real issue for like not-for-profits, such as food banks and the second-hand shops, so there’s been a practical expedient added in here now that entities where it’s not practical to measure the fair value of those donated items if they’re not measured at fair value at initial recognition. That’s typically things that are low-value, high-quantity type items, and maybe relevant for some local councils that have second-hand stores that receive stuff donated at the dump, that sort of stuff now doesn’t need to be accounted for at initial recognition, it will just be revenue recognised upon sale.
So there’s really little change here for the June 17 reporting round. For June 18, there are just a couple minor amendments worth flagging here. Some entities may have biological assets that are called bearer plants, these are things like fruit trees that grow fruit on them, or grapevines, for example. These have been accounted for at fair value with fair-value movements through profit and loss. These are now going to be classified as property, plant and equipment, either accounted for at cost or at fair value with movements going through reserves. We do have a few entities with service concession assets, or PPE-type assets. There has been some uncertainty around how those should be presented in the property, plant and equipment note. It’s now been clarified that they are not separate asset classes within themselves, they can be in effect presented as part of other assets or similar-type assets, so they don’t need to be a separate asset class. So that could be a change for some entities.
This is one that’s reasonably hot off the press: revalued property, plant, and equipment. Technically, if you’re going to impair a revalued item of PBE, you know you’ve had to impair the whole asset class to do that, with the way the standards are currently written. Audit New Zealand has been taking a pragmatic approach around that and allowing those assets that have been revalued to be individually impaired without requiring a revaluation for the entire class. That change has now in effect come through for standards, or our view has been coming through the standards now as a particular change because New Zealand raised concerns around this. What was happening was you could have damage to one particular asset and the only way you could impair it was revaluing everything, which didn’t seem sensible, so this has been a sensible change that’s come through and sort of supports the interpretation that we have been applying for the last couple of years.
Right so that’s sort of the more imminent stuff, so what I’m going to talk about are three areas that are more future-focused, around financial instruments, leases, and revenue. So financial instruments – you may not be aware but new financial instrument standard was issued, I think around January, as a New Year’s present for those interested in this area, PBE IFRS 9. Now the reason that this was issued is for-profits need to apply a new financial instrument standard IFRS 9 for December 18 year-ends onwards and this standard is quite different to the existing financial instruments standard, so there’s been concerns, particularly in New Zealand, around for-profits applying quite a different accounting standard to PBEs and when PBEs groups consolidate for-profit entities, it’s going to give rise to quite significant, complex consolidation adjustments. So what New Zealand has done is develop this PBE IFRS 9, based on IFRS 9 for-profits will be applying, and it gives PBEs the option to early adopt that PBE IFRS 9 so you can, in effect, have substantially the same accounting standard of financial instruments within the group both for-profits and PBEs. So whilst there’s a mandatory effective date of 30 June 2021, that’s a long way out, for-profits need to apply IFRS 9 to June 19, so some PBE groups are going to have to think about should we early adopt PBE IFRS 9 for June 19. I’ll get on to FSG in a moment, which is relevant for some of you here today.
The new standard does have new classification measure requirements, financial assets, it could mean some financial instruments will move from fair value to amortised cost, some may move from amortised cost to fair value depending on how the rules are applied. The impairment model for financial assets and amortised cost has changed, from an incurred model to a more forward-looking expected-loss model, and hedge-accounting requirements have also changed, which may make hedge-accounting a little bit more attractive to some entities as their requirements are a little bit easier and less onerous in some respects.
We’ll just scratch into a little bit more detail. Some of the key changes under IFRS 9, particularly around share investments – a lot of these might be classified as available for sale now fair-value movements are going through reserves and when you sell them you realise gains and losses, if they are impaired you recognise losses, under the new standard those fair value movements never get recycled to profit and loss so when they’re sold there’s no gain or loss being recognised and there’s no impairment considerations to think through. So if value falls below cost you don’t need to recognise impairment expenses it just stays as a negative reserve. So that’s quite a big change around sheer investment accounting.
There is a fish-hook around loans and receivables. They can only be classified as amortised cost if they are solely payments of principle and interest. That is a challenge for some public sector loans where repayment may be contingent on particular events, there are good examples like student loans where the student or the person only pays their loan back subject to meeting thresholds of income generation. So there are issues there around whether it meets the solely payment of principal and interest test. If not, it means that those instruments are revalued at fair value at each reporting date, which means revised discount rates, expected losses, and a bit more volatility in profit and loss. So that will be a big issue for some entities that don’t have straightforward loan arrangements or borrowings that they’ve given out.
Impairment for loans and receivables – the current models being impaired when you’ve got evidence of impairment, so usually it’s known there is an issue, you book a loss. Under the IFRS 9 it’s a forward-looking model based on expected losses, as credit risk increases and then you start booking more losses, greater losses. So it’s more forward-looking and losses will largely be booked earlier compared to the previous standards. So it is more complex, how significant could these adjustments could be, and potentially systems and processes around this. It’s really a big issue for banks; it’s probably could be an issue for some other clients that are not banks, it will just depend. Now Financial Statements of Government, so that’s relevant for entities consolidated into the government, which is obviously not councils, so those components of the Financial Statements of Government – Treasury hasn’t made a formal decision around if they’re going to adopt IRFS 9, but it seems likely that they will. What that means is when the information is coming through for consolidation, we expect that it’s going to have to be a on an IFRS 9 compliant basis, so it’s looking like they’ll probably do it for June 19 to line up with IFRS 9 with all the big for-profits in that group have to adopt. But there’ll be more communication from Treasury once they’ve made that formal decision, and really what the process and expectations are, so we’re not yet clear what those processes and expectations are, it’s too early.
Leases. So lease accounting has been an ongoing issue for a long time, I think as long as I’ve been involved in accounting, lease accounting has been an issue. The ISB eventually has issued a new lease standard on NZ IFRS 16 and this is a big game-changer, so this standard does require basically for lessees to recognise an asset and a liability for most leases, so for lessees basically those leases will come onto the balance sheet, and end up with accounting similar to finance lease accounting. So that’s for for-profits, this change hasn’t come through yet into PBEs. The New Zealand standard-setter has not yet decided to introduce a PBE equivalent to IFRS 16, it’s just keeping a watch on what’s happening internationally. What’s happening internationally is that the public sector accounting standards board, the IPSASB, it is looking to develop an exposure draft which is largely similar to IFRS 16, so they’re proposing that public benefit entities would bring leases onto the balance sheet, for lessees anyway, that’s the current thinking but they’re still developing an exposure draft which will be out later this year. That project is also looking at accounting for concessionary leases, which is an area of challenge at the moment, there’s lots of nominal or peppercorn-type rental agreements out there, which are accounted for in different ways, so they’re looking at trying to address that to try and get consistency around those sorts of leases. It’s really a matter of wait-and-see around what leases – how that change will affect public benefit entities in the future but I expect there will be change but we just don’t know what it will look like yet.
And finally, on revenue, non-exchange expenses. There’s been a new revenue standard for for-profits, NZ IFRS 15, to apply from December 18 year-end onwards. It’s a five-step revenue recognition model, you need look at revenue contracts with a bit more granularity, and recognise revenue with a bit more granularity, based on performance obligations. That standard hasn’t been brought into the PBE suite of standards, and is not likely to, but again what’s happening internationally is the IPSASB is looking at revenue accounting, and it’s not just looking at exchange revenue, it’s looking at non-exchange revenue and how that should be accounted for and what sort of models should be applied to it, because we’re all aware there’s some issues in trying to account for the current accounting we have using the current standards, IPSAS 23 in particular. And there’s also change expenses in relation to grant accounting for which we don’t have any standards at present and as a result we do have some variability in practice. So again that’s a forward-looking one, but it will be relevant to quite a lot of you in the room. They’re working on a consultation paper – if you have a strong interest in this area than I would encourage you to look at that consultation paper when it does come out, which will probably be in the second half of this year, I’m picking.
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