1.4 Planning for conversion to the New Zealand equivalents of International Financial Reporting Standards

Local government: Results of the 2003-04 audits.

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Last year, we reported on the decision to convert to reporting in accordance with International Financial Reporting Standards (IFRS)28, and the consequent issues emerging for local authorities. In this part, we provide an update on the progress made towards the transition to the New Zealand equivalents of IFRS (NZ IFRS29), and highlight some of the implications for the local government sector.

Background

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In December 2002, the Accounting Standards Review Board (ASRB) announced its decision that New Zealand entities would be required to apply new standards, based on IFRS, for reporting periods beginning on or after 1 January 2007. Entities have the option to apply the new standards from reporting periods beginning on or after 1 January 2005.

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While we expect the majority of public sector entities to adopt the new standards for their first reporting period beginning on or after 1 January 2007, we expect local authorities will adopt these standards for their reporting period beginning 1 July 2006. This is because:

  • Councils are required to produce Long-Term Council Community Plans (LTCCPs) by 30 June 2006, covering a minimum of 10 years starting 1 July 2006. Councils will subsequently be required to report against these plans.
  • Councils will want to try to avoid having to present information under two different sets of standards in the one LTCCP. If councils delay adoption until the latest possible date, then the first year of their 2006 LTCCP will be under the old standards, with the remaining 9 years under the new standards.

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Adopting the new standards from 1 July 2006 will require local authorities to restate their opening statement of financial position as at 1 July 2005. This is necessary because the financial statements for the year ending 30 June 2007 must include comparative information for the 30 June 2006 year using the new standards.

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We understand that some council controlled organisations and other controlled entities (e.g. port companies) are considering adopting NZ IFRS at a date different to their controlling local authority shareholders. If any of these entities choose to adopt NZ IFRS at a date different to their local authority shareholders, they will have to maintain 2 sets of information. One set would be in accordance with the policies adopted for their own reporting, while the other would be in accordance with the reporting requirements of their parent (for reporting to their local authority shareholders for consolidation purposes).

ASRB approval of the NZ IFRS “stable platform”

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On 24 November 2004, the ASRB approved the initial suite of standards for NZ IFRS. The adoption of these standards is the culmination of 2 years of intensive work by standard setters and those few parties (including the Office of the Auditor-General) that have been providing submissions on the exposure drafts of NZ IFRS.

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The initial group of approved NZ IFRS is described as the “stable platform”. This term is used by the International Accounting Standards Board (IASB) to describe the standards to be applied by countries moving to adopt IFRS from 2005. The approved NZ IFRS “stable platform” is the New Zealand equivalent of the IASB’s “stable platform”.

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Some aspects of the “stable platform” are still being developed by the IASB. The IASB has a number of projects in progress that are likely to lead to changes to IFRS and, consequently, to NZ IFRS and the “stable platform” before NZ IFRS are adopted by the local government sector, which we expect to be in the year to 30 June 2007.

One set of standards for all reporting entities

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The current set of standards in New Zealand is “sector-neutral”, in that the standards have been developed for all reporting entities, and the same standards apply to both profit-oriented and public benefit entities30. IFRS, on the other hand, have been developed with a focus on profit-oriented entities. NZ IFRS have preserved the format, language and structure of IFRS but the ASRB has decided that a single set of standards should continue in New Zealand, applying to both profit-oriented and public benefit entities.

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In our view, there are a number of benefits in retaining a single set of standards, including efficiency in applying the standards (preparers and auditors can achieve a better understanding of a single set of standards), and more clarity and cross-sector comparability for readers of financial reports. However, it is important to appreciate that, while the standard setters in New Zealand have been able to preserve one set of standards, those standards can no longer be considered sector-neutral. This is because the adaptions made to IFRS (in accordance with the ASRB’s guidelines – see paragraph 1.411 below) have resulted in differing requirements for public benefit entities and profit-oriented entities in some circumstances.

Guidance for public benefit entities

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In June 2003, we raised concerns with the ASRB that inadequate consideration was being given to the effects of changes to standards on public sector reporting. After discussion, the ASRB established the following guidelines31 to be used in adapting IFRS in New Zealand:

  • The IFRS disclosure requirements cannot be reduced for profit-oriented entities.
  • Additional disclosure requirements can be introduced for all entities.
  • The IFRS recognition and measurement requirements for profit-oriented entities cannot be changed.
  • Recognition and measurement requirements can be amended for public benefit entities, with a rebuttable presumption that amendments are based on existing International Public Sector Accounting Standards (IPSAS)32 or existing New Zealand Financial Reporting Standards (FRS).
  • The introduction of guidance materials for public benefit entities should be based on the same principles as those applying to the amendment of recognition and measurement requirements (see previous bullet point).
  • The elimination of options in IFRS is permitted for all entities, on a case-by-case basis. Where an IFRS permits options that are not allowed in an existing FRS, a strong argument would need to be made in order for the ASRB to agree to the retention of such options in the NZ IFRS. In reaching a view on this issue, the ASRB will be mindful of the approach adopted by the Australian Accounting Standards Board.33

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In our view, the provision of additional guidance on the application of NZ IFRS to public benefit entities is crucial to ensure that NZ IFRS are relevant and appropriate for the New Zealand public sector environment. We are concerned that valuable guidance, built up over a decade and based on our experience as the first country to apply accrual accounting in the public sector, could disappear. We will continue to work closely with standard setters to try and ensure that this does not happen.

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A number of the recently approved NZ IFRS include some additional requirements that apply to public benefit entities. However, we believe that further guidance is required, and that this needs to be addressed as a priority. In our view, the main areas where additional guidance should be provided are:

  • How to distinguish a public benefit entity from a profit-oriented entity – A number of public sector entities exist both for the benefit of the public and to make a profit, and it is debatable whether they fall within the definition of a public benefit entity. In addition, we note that most public sector entities are ultimately controlled by a public benefit entity (primarily the Crown or a local authority). This creates issues where consolidated groups contain a mix of public benefit entities and profit-oriented entities (e.g. a local authority parent with a council controlled trading organisation as its subsidiary). In such circumstances, there will be a temptation for all subsidiary entities to be treated as public benefit entities, which may not be appropriate. We acknowledge that the Financial Reporting Standards Board of the Institute of Chartered Accountants of New Zealand has issued an Exposure Draft providing some guidance on this aspect.
  • The application of NZ IAS 16: Property, Plant and Equipment to public benefit entities, particularly in relation to infrastructural assets – Much of the guidance needed is already contained in the current standard on property, plant and equipment (FRS-3), and could be supplemented by the knowledge gained in the public sector from applying that standard. The guidance should address such issues as componentisation, component accounting, classification of assets into classes, and calculating depreciated replacement cost (e.g. guidance on optimisation).
  • How to determine whether a public benefit entity controls another entity – The current consolidation standard (FRS-37) includes extensive guidance that has been built up, through the experience of applying consolidation principles in the public sector, over the last decade. The nature of relationships and arrangements between entities frequently differs markedly between the public sector and the private sector, meaning that FRS-37 can be difficult to apply in the public sector where ownership interests are less well defined. Notwithstanding this, the guidance in FRS-37 has proven to be very useful in seeking to apply the standards.
  • The application of non-financial performance reporting – NZ IFRS appear to have carried forward most of the guidance in terms of reporting non- financial performance information. In our view, however, NZ IFRS have not gone far enough regarding non-financial performance reporting. It is debatable whether any of the carried-forward material has any standing, given that NZ IFRS state that they are developed for application to financial statements, and acknowledge that statements of service performance are not financial statements but rather part of a financial report. There are statutory requirements for local authorities to report non-financial performance, and that information is required to be prepared in accordance with generally accepted accounting practice (GAAP). Reporting of non- financial performance is important to the local government sector because of these requirements. To ensure that non-financial performance reporting remains at a level consistent with current New Zealand FRS, it is essential, in our view, that changes be made to NZ IFRS to remove room for debate about the authority of non-financial reporting requirements in New Zealand FRS.

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We will continue to raise the issue of guidance for public benefit entities with those parties responsible for setting standards in New Zealand. Our strong preference is for such guidance to form an integral part of the new standards, rather than be seen as an “add on” for the public sector.

Impact of the new standards

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The approval of the “stable platform” of NZ IFRS provides a degree of certainty, enabling entities to plan for the transition and assess the implications for their financial reporting. We are currently analysing the changes between the approved NZ IFRS and current NZ GAAP. We have been working closely with the Society of Local Government Managers (SOLGM), which has been assisting the local government sector in terms of providing training in relation to the adoption of NZ IFRS.

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In general terms, we expect that:

  • there will be changes to the values at which some assets and liabilities are measured;
  • there will be some assets and liabilities recognised for the first time (e.g. derivative financial instruments); and
  • there may be some assets no longer recognised (e.g. internally generated intangibles).

There will also be increased disclosures in the notes to the financial statements.

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One area of significant change is in the accounting for financial instruments, an area where there is no current New Zealand FRS. The new NZ IFRS 19 December, 2006 financial assets and liabilities. There will be an increased requirement to account for financial instruments at fair value, including derivative financial instruments. This is likely to increase the volatility of reported financial performance. While there are options to reduce this volatility through the adoption of hedge accounting, the criteria that need to be met for adopting hedge accounting are onerous (e.g. in terms of hedge effectiveness, and in record keeping). As a result, such options will not be worthwhile for some entities.

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Other areas where the requirements of NZ IFRS are significantly different from current FRS requirements, and which may significantly affect local authorities and local authority controlled entities, include:

  • deferred tax (the whole approach to accounting for deferred tax is changing, and will result in more deferred tax assets and liabilities being recognised by those local government entities that pay tax – e.g. council-controlled trading organisations);
  • business combinations (including a prohibition of goodwill amortisation, which is replaced by an annual impairment test);
  • redeemable preference shares (under NZ IFRS many preference shares will be reclassified as debt rather than equity; this will affect financial ratios, and may require careful communication with lender institutions and credit agencies);
  • property, plant and equipment (including increased disclosures, and a requirement for profit-oriented entities to account for asset revaluations on an asset-by-asset basis rather than the current class basis);
  • related parties (including disclosures of compensation for “key management personnel”); and
  • biological assets (including assets such as forestry, and a requirement to account for changes in annual asset revaluations through the statement of financial performance.)

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The degree to which individual entities are affected will depend on the types of assets and liabilities that they have, and the transactions that they enter into. For some local authorities, the impact is likely to be limited, and managing the transition to NZ IFRS is therefore likely to be uncomplicated. However, this will not be the case for all local authorities.

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The Financial Reporting Standards Board has issued Financial Reporting Standard – 41: Disclosing the Impact of Adopting New Zealand Equivalents to International Financial Reporting Standards. FRS-41 proposes mandatory disclosure in the annual report of issuers34 of information about the implications of adopting NZ IFRS, and planning for the transition to NZ IFRS. Although most entities within the local government sector are not issuers, FRS-41 encourages other entities to also provide the disclosures. In our view, such disclosures are helpful. They demonstrate that entities are planning for the transition to NZ IFRS, and provide an early indication to stakeholders of the likely impact of the transition.

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We agree that appropriate communication with stakeholders on the transition to NZ IFRS is important. This will include bankers and lenders, in relation to loan covenants and the financial measures used to assess credit worthiness and credit ratings. Other stakeholders include the users of financial statements, including ratepayers, community groups, employees (possibly with elements of remuneration linked to reported financial performance), and Parliament.

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We have outlined above some of the implications for accounting and financial reporting (to the extent they are known at this stage). The workload and training requirements for finance teams in some local authorities may need to increase, if the transition to NZ IFRS is to progress smoothly. New policies and procedures will need to be determined in some areas, and systems may need adapting (e.g. in entities with complex financial instrument transactions, to meet fair value and hedge accounting requirements). The transition to NZ IFRS is likely to result in additional costs through the transition period.

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In general, we would expect local government entities, with appropriate assistance from SOLGM, to have the capability and resources to cope with the challenges of the transition to NZ IFRS. However, the local government sector does include some smaller councils that have limited resources to apply to the transition of NZ IFRS. We will continue to work with the local government sector to ensure that all councils properly assess the impact of the transition to NZ IFRS.

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The local government sector is planning to adopt NZ IFRS a year earlier than central government. We expect the lessons from the local government transition experience to be extremely helpful for the central government transition.

Effect on auditors

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The transition to NZ IFRS is also a significant challenge for the Office of the Auditor-General, and the auditors appointed to audit entities on behalf of the Auditor-General.

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Auditors need to be trained in the requirements of the new standards, and audit approaches will have to be reviewed and adapted to meet the revised reporting requirements. There will be additional audit work required, in relation to restated opening balance sheets and comparative figures, and in assessing revised policies and processes (such as those required for hedge accounting). This additional work will need to be included within an already tight work programme, and will have some implications for audit fees.

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We fully expect to be able to meet these challenges, and we have established a major project in the Office of the Auditor-General to ensure that our auditors are ready to audit in an NZ IFRS environment.

Summary

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Significant progress has been made over the past year towards the implementation of NZ IFRS, but much work remains to be done. A major achievement has been the ASRB’s approval of the “stable platform” of NZ IFRS.

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We have some concerns that, to date, insufficient priority has been given to guidance on applying NZ IFRS to public benefit entities. We will continue to liaise with standard setters over the matters identified in paragraph 1.413.

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The approval of the “stable platform” means that there is now some certainty from which to assess the impact of the transition to NZ IFRS. However, all the implications of the transition are not yet fully clear. As well as affecting financial reporting, the transition may require amendments to processes and systems. The changes will be significant for some local authorities, but less so for others.

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The conversion to NZ IFRS will affect the workload and training requirements of finance teams in some local authorities. We will continue to work closely with SOLGM as it continues to provide assistance to the local government sector.

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The Office of the Auditor-General has a significant project under way, to ensure that our auditors are ready to audit in an NZ IFRS environment.

28: The term IFRS is used to refer to International Accounting Standards Board (IASB) standards. The standards comprise:

  • International Accounting Standards (IASs), inherited by the IASB from its predecessor body, the International Accounting Standards Committee (IASC), and the interpretations of those standards.

  • International Financial Reporting Standards (IFRS) – the new standards being issued by the IASB, and the interpretations of those standards.

29: NZ IFRS will comprise:

  • New Zealand equivalents of International Accounting Standards (NZ IASs), and the interpretations of those standards.

  • New Zealand equivalents of International Financial Reporting Standards (NZ IFRSs), and the interpretations of those standards.

30: Public benefit entities are reporting entities whose primary objective is to provide goods or services for community or social benefit, and where any equity has been provided with a view to supporting that primary objective rather than for a financial return to equity shareholders. They include most public sector entities.

31: Accounting Standards Review Board Release 8, paragraph 27.

32: IPSAS are developed and issued by the International Public Sector Accounting Standards Board of the International Federation of Accountants, for application to public sector entities.

33: One of the functions of the ASRB is to liaise with the Australian Accounting Standards Board, with a view to harmonising New Zealand and Australian financial reporting standards (section 24, Financial Reporting Act 1993).

34: FRS-41 uses the concept of an “issuer” as defined in section 4 of the Financial Reporting Act 1993.

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