3.1 Planning for transition to the New Zealand equivalents to International Financial Reporting Standards

Local government: Results of the 2004-05 audits.

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In this article, we provide an update on the progress made by the local government sector towards the transition to accounting and reporting in accordance with the New Zealand equivalents to International Financial Reporting Standards (IFRS),1 NZ IFRS,2 and highlight some of the implications for the 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, most local authorities are adopting these standards for their reporting period beginning 1 July 2006. This is so local authorities avoid having to present information in their 2006 Long-Term Council Community Plans (LTCCPs)3under 2 different sets of standards. If local authorities delay NZ IFRS adoption until the latest possible date, then the first year of their 2006-16 LTCCP would be under the old standards, with the remaining 9 years under the new standards.

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As local authorities’ first set of NZ IFRS financial statements (for the year ending 30 June 2007) must include comparative figures presented on the same basis of accounting, the comparative figures for the year ending 30 June 2006, and an opening balance sheet at 1 July 2005, will need to be restated in accordance with NZ IFRS.

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Where a local authority has subsidiary (or associate) entities, in most cases these entities are adopting NZ IFRS at the same time as their parent local authority. This is because NZ IFRS require the consolidated financial statements of a group to be prepared using uniform accounting policies.

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If a local authority’s subsidiary (or associate) entities adopt NZ IFRS at a date different from their parent local authority, 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 consolidation purposes).

The new standards and their anticipated effects on the local government sector

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On 24 November 2004, the ASRB approved the initial suite of standards for NZ IFRS. This initial group of approved NZ IFRS was 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 to the IASB’s “stable platform”.

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Some aspects of the “stable platform” have already been amended, and the IASB is continuing its work on the development of IFRS. The IASB’s work programme will lead to further changes to IFRS, and consequently NZ IFRS, before NZ IFRS are adopted by the local government sector. These changes will need to be monitored.

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However, we are expecting the majority of the “stable platform” to stay, in the main, as it is now. There is, in our view, enough certainty to enable the sector to plan for the transition to NZ IFRS, assess the implications for financial reporting, and make the transition.

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Although a number of local authorities have completed preliminary opening NZ IFRS balance sheets, it is still too early to comment definitively on the effects of the transition to NZ IFRS. However, we observe 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 (for example, derivative financial instruments, accrued sick leave);
  • some assets will no longer be recognised (for example, internally generated intangibles, to the extent they exist in the sector); and
  • there will be more disclosures in the notes to the financial statements.

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Probably the most significant change is in accounting for financial instruments, where current generally accepted accounting practice (GAAP) in New Zealand sets out only disclosure requirements. NZ IFRS establish new rules for the recognition and measurement of financial assets and liabilities. Derivative financial instruments will need to be accounted for “on balance sheet” at fair value, and there will also be an increased requirement to account for other financial instruments at fair value. This may increase the volatility of reported financial performance, and, while there are options to reduce this volatility in some circumstances through the use of hedge accounting, the criteria that need to be met for adopting hedge accounting are quite onerous (for example, in terms of assessing hedge effectiveness and in record keeping).

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A number of local authorities do use derivative financial instruments in their treasury operations, particularly interest rate swaps to reduce exposure to interest rate variability on borrowings. The accounting and record-keeping requirements of derivative transactions is proving a challenge for some local authorities.

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Another area of significant effect is in accounting for community loans (loans to entities in the local community, such as sports clubs and sports venues). Community loans often do not earn a market rate of return, and the repayment dates and the ability of the entities to repay such loans can be uncertain. The current accounting policy is to record community loans at amounts ultimately expected to be received in settlement of the loan (excluding interest), whereas under NZ IAS 39 these assets will have a lower value, which takes into account the time value of money.

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Some of the other areas where the requirements of NZ IFRS are significantly different from current GAAP requirements, and which may significantly affect the financial statements of some local authorities or other local government sector entities, are:

  • business combinations (including a prohibition on goodwill amortisation, which is replaced by an annual impairment test);
  • 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 – for example, council-controlled trading organisations);
  • employee entitlements (particularly a requirement to account for accumulating non-vesting sick leave);
  • property, plant, and equipment (particularly a requirement for profit-oriented entities, such as council-controlled trading organisations, to account for asset revaluations on an asset-by-asset basis rather than the current class-of-assets basis);
  • investment property (including changes to the criteria used to identify investment properties, and a requirement for the annual change in fair value to be recognised in the statement of financial performance);
  • biological assets (including assets such as forestry, and a requirement for annual revaluation to fair value, with valuation movements recognised in the statement of financial performance); and
  • related parties (including disclosures of compensation information for “key management personnel”).

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The degree to which individual local authorities are affected will depend on the types of assets and liabilities that they have, and the transactions that they enter into. For large local authorities with multiple subsidiary entities the transition to NZ IFRS is likely to be complex, whereas for some small local authorities with no subsidiaries and no complex financial instruments the transition may be more straightforward.

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In April 2005, the ASRB approved Financial Reporting Standard 41: Disclosing the Impact of Adopting New Zealand Equivalents to International Financial Reporting Standards (FRS-41). FRS-41 requires disclosure in the annual report of issuers4, of information about planning for the transition to NZ IFRS, key differences in accounting policies that are expected to arise, and the estimated effects on the financial report of adopting NZ IFRS. Although most entities within the local government sector are not issuers as defined in section 4 of the Financial Reporting Act 1993, FRS-41 encourages other entities to also provide these disclosures. We support such voluntary disclosure.

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Many entities in the sector provided some disclosures of this nature in their 2005 annual report, although only a few quantified the expected effects. This was to be expected, given the state of progress towards the transition to NZ IFRS at that stage. However, we expect that there will be significantly more information about the effects of the transition to NZ IFRS included in annual reports for the year ending 30 June 2006.

Guidance for public benefit entities

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IFRS 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.5 In order for NZ IFRS to be appropriate for public benefit entities, some adaptation of IFRS has been necessary.

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The ASRB established guidelines6 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)7 or existing New Zealand 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 (as outlined above).
  • 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.8

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We reported last year9 that, 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 have worked closely with the Financial Reporting Standards Board (FRSB) on this issue over the past year, and we will continue to do so.

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We are pleased to report that some of the concerns that we have raised last year in relation to guidance for public benefit entities have now been addressed. In particular the FRSB has now issued useful guidance to assist entities to determine whether they are a profit-oriented entity or a public benefit entity.10 This distinction is important as some of the requirements of NZ IFRS differ depending on the nature of the entity applying the standards.

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The local government sector is made up of some entities that are clearly public benefit entities (such as local authorities) and some entities that are clearly profit-oriented entities (such as council-controlled trading organisations and electricity lines companies). However, there are some entities that have a mix of objectives (such as some airports and some utility providers). The guidance developed by the FRSB provides a framework for these entities to use in determining whether they should account under NZ IFRS as a public benefit entity or as a profit-oriented entity.

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The FRSB has recently established a public benefit entity working group, on which we are represented. The working group is addressing topics that affect public benefit entities and that are not currently adequately addressed in NZ IFRS. We hope to continue our involvement in this working group and we will continue to raise the need for appropriate guidance for public benefit entities with those parties responsible for setting standards in New Zealand. Our strong preference remains for such guidance to form an integral part of the new standards, rather than be seen as an “add-on” for the public sector.

Sector progress towards NZ IFRS transition

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Over the past year, the sector has made good progress towards the transition to NZ IFRS. The Society of Local Government Managers (SOLGM) has played a significant role in providing guidance to the sector (such as through seminars) and providing a forum for the sector to share NZ IFRS information and experiences. We have worked closely with SOLGM over the past year and we will continue to do so.

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Our auditors are also working closely with individual local authorities and other entities in the sector. While many entities in the sector have made significant progress, the progress of others has been more limited.

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The major tasks that entities have been undertaking have included:

  • assessing the effects of NZ IFRS on their financial statements;
  • selecting the accounting policies that they will adopt under NZ IFRS, including assessing the options available under NZ IFRS both on transition and for the ongoing application of NZ IFRS accounting policies; and
  • producing the restated preliminary opening NZ IFRS balance sheet as at 1 July 2005.

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The local government sector is already dealing with the challenge of preparing LTCCPs. One input into the LTCCP financial forecasts is the conversion to NZ IFRS. Project managing the preparation of LTCCPs and the transition to NZ IFRS has been a significant challenge. In practice, we are finding some local authorities have made excellent progress in planning their transition to NZ IFRS, whereas some others, particularly some smaller local authorities, have prioritised other aspects of their LTCCP and made less progress to date.

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The forecast financial statements in the LTCCPs are generally being prepared on a parent entity basis (rather than a fully consolidated basis). Therefore the key information required for the LTCCP in relation to subsidiary and associate entities is about funding flows from the local authority parent to the subsidiaries and associates and about dividends flowing back to the parent. Although full NZ IFRS opening balance sheets of subsidiaries and associates will be required for future financial reporting, they are not required as an input into the LTCCP. This means that there has been little incentive for some smaller local government sector entities to address the transition to NZ IFRS at this stage. For many of the smaller entities, the transition to NZ IFRS will be straightforward, but this will not be so in all cases.

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The transition to NZ IFRS affects both the workload and training requirements of finance teams in some public sector entities. The transition to NZ IFRS is also likely to result in some additional costs through the transition period.

Effect on auditors

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

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There will be additional audit work required in relation to restated opening balance sheets and comparative figures, and in assessing revised accounting 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. Entities within the local government sector will need to ensure that such additional audit fees are incorporated into their budgets.

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Over the past year, we have put all our professional staff through extensive training on NZ IFRS and we are continuing to develop resources for auditors to ensure that they are fully prepared to audit in an NZ IFRS environment. The audits of the restated preliminary opening NZ IFRS balance sheets in the local government sector are currently in progress and are the first real test of the effectiveness of this training and of our audit approaches under NZ IFRS.

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We will continue to work closely within the sector over the transition to IFRS. In particular we will continue to work with the Financial Management Working Party (FMWP) of SOLGM.

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We participated with FMWP during 2005 in their “Jigsaw” and “Booster” workshops for senior managers in the local government sector. The later workshops in particular had a focus on the transition to NZ IFRS. We will continue to support such initiatives where appropriate. We anticipate the main focus will be around significant aspects of local authority accounting under the IFRS regime – such as the most appropriate and pragmatic accounting under NZ IFRS for development contributions.

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As resources allow, we also anticipate that Audit New Zealand’s model annual report, for Te Motu District Council, will be updated. This has been an effective means in the past of assisting the sector.

Summary

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The local government sector has made good progress over the past year towards the implementation of NZ IFRS. However, there remains much to be done.

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Although NZ IFRS will continue to be subject to some change in the period leading up to the adoption of NZ IFRS, there is sufficient stability within NZ IFRS to allow entities to plan for, and manage, the transition.

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Accounting for financial instruments is expected to be the area of greatest challenge for the sector, although the effect on individual entities will vary depending on the nature of their assets, liabilities, and underlying transactions.

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We are pleased with the progress made in providing guidance on NZ IFRS for public benefit entities, and consider that the formation by the FRSB of a public benefit entity working group is a positive step.

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There has also been good progress towards the transition to NZ IFRS by many local authorities and other entities within the local government sector, although the degree of progress is variable, particularly for smaller entities.

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SOLGM has played a significant role in providing guidance to the sector. We have worked closely with SOLGM over the past year and we will continue to do so.

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The transition to NZ IFRS remains a significant challenge for us. There is additional audit work required, particularly in relation to NZ IFRS accounting policies, restated opening balance sheets, and comparative figures. We are confident that we will fully meet these challenges and that we will achieve our overriding objective of supporting the change to NZ IFRS at least cost, and with minimum fuss, in a constructive and co-operative manner.

1: The term IFRS is used to refer to International Accounting Standards Board (IASB) standards. The standards comprise International Accounting Standards (IAS), inherited by the IASB from its predecessor body, the International Accounting Standards Committee (IASC), and the interpretations of those standards; and International Financial Reporting Standards (IFRS) – the new standards being issued by the IASB, and the interpretations of those standards.

2: NZ IFRS will comprise: New Zealand International Accounting Standards (NZ IAS), and the interpretations of those standards; New Zealand International Financial Reporting Standards (NZ IFRS), and the interpretations of those standards; and New Zealand Financial Reporting Standards (FRS), where there is no equivalent IFRS.

3: Councils are required to produce LTCCPs by 30 June 2006, covering a period of 10 years starting 1 July 2006.

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

5: Public benefit entities are entities whose primary objective is to provide goods or services for a community or a 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 holders. They include most public sector entities.

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

7: 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.

8: 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).

9: Local Government: Results of the 2003-04 Audits, parliamentary paper B.29[05b], page 30.

10: NZ IAS 1: Appendix: New Zealand Application Guidance: When is an Entity a Public Benefit Entity?

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