2.1 The transition to New Zealand equivalents to International Financial Reporting Standards
2.101
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
Background
2.102
In December 2002, the Accounting Standards Review Board (ASRB) announced
its decision that New Zealand entities producing general purpose financial
statements would be required to apply new standards, based on IFRS, for
reporting periods beginning on or after 1 January 2007. Entities were given the
option to apply the new standards from reporting periods beginning on or after 1
January 2005.
2.103
We expect that all local authorities will adopt these standards for their reporting
period beginning 1 July 2006. Our expectation is based on the fact that all local
authorities, in their 2006-16 Long-Term Council Community Plans (LTCCPs),
included prospective financial information prepared in accordance with NZ IFRS
for the 1 July 2006 to 30 June 2007 financial year. It is also based on the fact that
prospective financial information was required to be prepared in accordance
with the accounting policies the local authorities expect to apply to their actual
financial statements for that period.
2.104
Local authorities’ first set of NZ IFRS-compliant financial statements (for the year
ending 30 June 2007) are required to include comparative figures presented on
the same basis of accounting. Accordingly, the comparative figures for the year
ended 30 June 2006 and an opening balance sheet at 1 July 2005 need to be
restated in accordance with NZ IFRS.
2.105
Where a local authority has subsidiary (or associate) entities, we expect that most,
if not all, of these entities will adopt NZ IFRS at the same time as their parent
local authority. This expectation arises because NZ IFRS requires the consolidated
financial statements of a group to be prepared using uniform accounting policies.
2.106
If a local authority’s subsidiary (or associate) entities adopt NZ IFRS at a date
different from their parent local authority, those entities will have to maintain two
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 expected effects on the local government sector
2.107
NZ IFRS, since first being approved by the ASRB on 24 November 2004, have been
undergoing changes. These changes are largely driven by the work programme
of the International Accounting Standards Board. Such changes will continue to
be made in the foreseeable future. When changes are made, there is normally a
reasonable lead time before the changes must be applied. However, entities can
apply the changes before they become mandatory.
2.108
We therefore expect that NZ IFRS as approved at 31 December 2006 will not
undergo changes that are mandatory for local authorities to apply to their
financial statements for the year ending 30 June 2007. This means that there is
enough certainty to enable the sector to carry out much of the work in the first
half of 2007 that needs to be done to successfully make the transition to NZ IFRS.
2.109
Some local authorities have completed preliminary NZ IFRS opening balance
sheets, but we are concerned that there are many more that may not have carried
out much work toward the transition.
2.110
Of those local authorities that have engaged us to audit their preliminary NZ
IFRS opening balance sheets, the most significant change, as we anticipated, is
accounting for financial instruments. The types of financial instruments having
the greatest effect on preliminary NZ IFRS opening balance sheets are:
- derivative financial instruments, such as interest rate swaps;
- community loans at below market interest rates and/or where there is uncertainty regarding repayment; and
- financial guarantees of community-based entities.
2.111
Interest rate swaps are used by a number of local authorities to reduce exposure
to interest rate variability on borrowings. These derivative financial instruments
are required to be accounted for and recorded “on balance sheet” under NZ IFRS. Under current generally accepted accounting practice (GAAP), these items have
not been recorded “on balance sheet”. Rather, information about the items has
been disclosed in notes to the financial statements. The accounting treatment
under NZ IFRS will therefore recognise these as either assets or liabilities
(depending on the difference between the swapped interest rate and the
underlying interest rate) for the first time.
2.112
Community loans (such as loans to sports clubs and sports venues) are often
provided to entities at below market interest rates or interest free, and sometimes
the repayment dates and the ability of the entities to repay such loans can
be uncertain. Under NZ IFRS, such loans are required to be accounted for and
recorded at their fair value, which takes into account when loans are likely to be
repaid and the time value of money. Under current GAAP, community loans are
recorded at the amounts ultimately expected to be received in settlement of
the loan (excluding interest), which is normally the amount that was lent to the
entity, and takes no account of the time value of money. The accounting treatment
under NZ IFRS will mean lower asset values for community loans because they are
recorded at fair value.
2.113
Financial guarantees are usually provided by local authorities to communitybased
entities so that those entities can obtain the funding they require to
operate. Under NZ IFRS, such guarantees are required to be accounted for at fair
value. Under current GAAP, financial guarantees have not been recorded “on
balance sheet”. Rather, they are disclosed as contingent liabilities in the notes to
the financial statements. The accounting treatment under NZ IFRS will therefore
recognise liabilities for financial guarantees for the first time.
2.114
Issues such as community loans at below market interest rates (or interest free)
and guarantees of community-based entities by local authorities have not been
specifically considered by international standard-setters when developing and
approving financial reporting standards relating to financial instruments. Given
the significance of such financial instruments, particularly in the local government
sector, it would have been helpful if the standard-setter3 in New Zealand had
considered these issues and provided guidance material for public benefit
entities.4 Such guidance material could have assisted local authorities determine
the fair value of such financial instruments, given they are not commercial
arrangements.
2.115
We consider it essential for the credibility of financial reporting standards
applying to the public sector that standard-setters:
- specifically consider such public sector issues;
- make appropriate changes to the international standards (which are written to be applied by large profit-oriented entities) so that the public sector is able to apply them; and
- develop guidance to assist the public sector to apply the standards.
2.116
Other areas where NZ IFRS is resulting in changes to preliminary NZ IFRS opening
balance sheets include:
- the amounts at which deferred tax is recorded;
- the amounts at which some physical assets – such as investment properties and biological assets – are recorded; and
- the first-time recognition of accumulating, non-vesting employee benefits – such as sick leave.
2.117
The new standards distinguish two different types of entities: profit-oriented
entities and public benefit entities. The standards contain some different
accounting requirements for each type of entity. This means that determining
whether an entity is a profit-oriented entity or a public benefit entity is
very important. A wrong judgement about the type of entity may result in
inappropriate accounting requirements being applied.
2.118
In the local government sector, there are a number of sub-sectors that may
comprise entities that are both profit-oriented and for public benefit. It is such
sub-sectors where making the appropriate determination about the type of
entity requires careful judgement. Examples of such sub-sectors include regional
airports and entities set up to operate stadiums. We understand that a number of
these entities have yet to make this determination, which is of concern at this late
stage of the transition to NZ IFRS.
The sector’s response to the transition to the New Zealand equivalents to International Financial Reporting Standards
2.119
The Society of Local Government Managers (SOLGM) has provided guidance to
the sector (such as through seminars) and a forum for the sector to share NZ IFRS
information and experiences.
2.120
During 2006/07, the sector has been heavily geared toward publishing audited
LTCCPs and, more recently, audited amendments to those plans. This has generally
meant that resources that may otherwise have been available to work on the
transition to NZ IFRS have not been available, particularly in the smaller local
authorities.
2.121
Of those local authorities that have carried out the work to set up a preliminary
NZ IFRS opening balance sheet, the general consensus is that there is a significant
cost to the local government sector in making the transition to what is perceived
as providing no benefit to the users of the financial statements.
2.122
We expected most local authorities to provide a reasonable level of detail about
the effects of the transition to NZ IFRS in their annual reports for the year ended 30 June 2006, even though such disclosure is largely voluntary.5 We were
disappointed that only a few provided the level of detail we envisaged about the
expected effects. The limited information disclosed reinforces our concerns about
the lack of progress towards the transition made by many local authorities.
The practical application of new reporting standards to 2006-16 Long-Term Council Community Plans
2.123
In addition to considering recommended disclosures in their annual report, local
authorities also needed to consider the effect of NZ IFRS within their LTCCPs. This
section outlines our findings from the audit of these LTCCPs.
Background
2.124
To avoid the need to present financial information in their 2006 LTCCPs under two
different sets of accounting standards, local authorities were expected to adopt
NZ IFRS for the period beginning 1 July 2006, enabling all 10 years of the LTCCP to
be prepared on the same basis.
2.125
As an organisation’s first set of NZ IFRS financial statements for the year ending
30 June 2007 must include comparative figures prepared on the same basis,
comparative financial information is required for the year ended 30 June 2006. This meant that local authorities had to prepare an opening NZ IFRS-compliant
balance sheet as at 1 July 2005.
Implications for Long-Term Council Community Plans
2.126
All local authorities prepared their 2006-16 LTCCP with parent entity information
only, and did not provide group information incorporating any subsidiary
organisations. Consequently, many of the complexities likely to arise from
applying the new standards did not affect the financial information in the
LTCCP. Moreover, LTCCPs were prepared in accordance with Financial Reporting
Standard 42: Prospective Financial Statements, which requires only the core
financial statements (comprising balance sheet, income statement, and cash flow
statement) to be included. The extensive additional disclosure requirements for
annual reports were therefore not applicable.
2.127
To prepare the forecast financial statements for the LTCCP to comply with NZ IFRS,
local authorities should ideally have considered and documented the changes
arising from NZ IFRS and the effects of those changes on the local authority’s
financial information. The local authority should have prepared NZ IFRS-compliant accounting policies and implemented those policies when preparing the 1 July
2005 balance sheet. Using the opening balance sheet, local authorities needed
to forecast the income statement for the year ended, and balance sheet as at, 30
June 2006. Local authorities should have considered the effects of any accounting
policy changes in the financial projections for each of the 10 years covered by the
LTCCP, starting with the financial year ended 30 June 2006.
2.128
In practice, the majority of medium- and small-sized local authorities had carried
out limited or no formal work on considering the effects of NZ IFRS on the
LTCCP. In contrast, a minority of local authorities, typically larger authorities, had
completed substantial preparatory work on the transition to NZ IFRS. The relative
lack of preparedness was not unexpected, because:
- The focus was on preparing the LTCCP, of which NZ IFRS was a reasonably small element.
- For many local authorities, a cursory assessment indicated that the changes to the core financial statements resulting from NZ IFRS were not significant.
- Some of the accounting implications of NZ IFRS were negated by assumptions about the future (such as the level of interest rates).
- The changes arising from NZ IFRS, such as increased use of fair values, are accrual accounting issues. Although the changes may affect a local authority’s revenue and expenditure and therefore surpluses, the adjustments are non-cash. Local authorities typically prepare their budgets on the basis of the funding required for their activities.
2.129
Giving due consideration to these reasons, we took a reasonably high-level
approach to assessing whether the LTCCPs were NZ IFRS-compliant. We focused
on material rather than absolute compliance. In particular, we considered whether
the accounting policies materially complied with NZ IFRS and whether those
policies had been materially fairly applied in the preparation of the financial
information.
2.130
For example, NZ IFRS prescribes how the financial information is to be presented
and described. Generally, the presentation of information did not follow the
formats required by NZ IFRS. However, as we considered that this did not
disadvantage the reader of the LTCCP, we did not request changes to be made.
2.131
In considering whether the financial forecasts were materially accurate, we
considered the size of the difference between the appropriate approach under NZ
IFRS and the approach actually taken. We also considered whether the appropriate
approach would have potentially changed the local authority’s funding decisions,
meaning that it would change the levels of rating, borrowing, or other financing. As an example, there were instances where the local authority did not include
an estimate for the change in value of its forestry assets. Under NZ IFRS, the
change in fair value of these assets needs to be included in the income statement. However, because it is a non-cash adjustment for most local authorities, this
would not change any of the funding included in the LTCCP.
2.132
Eighty-four of the 85 local authorities amended their accounting policies so that
they complied materially with NZ IFRS. One local authority did not amend its
accounting policies, preparing all information under current GAAP.
2.133
Even where the policies were amended, they were not always applied in the
financial forecasts. For example, changes in the value of investment properties or
forestry were not always included.
2.134
In our view, because of the lack of preparation and formal consideration of NZ
IFRS, local authorities relied heavily on our auditors to review and advise on NZ
IFRS compliance as part of the LTCCP audit. In these cases, the auditor needed to
evaluate the work that the local authority had completed, along with their own
knowledge of the client, the local government sector, and the new standards to
consider whether the application of NZ IFRS would result in materially different
financial information in the LTCCP. In nearly all instances, the auditors considered
that the information would be materially the same under NZ IFRS and current
GAAP.
2.135
However, this was less than ideal and shifted the onus for compliance from the
local authority, where it should have remained, to the auditor.
2.136
Although the LTCCP includes an audit opinion covering NZ IFRS compliance, the
high threshold used in assessing the information means that further adjustments
may be required to the opening balance sheet used as a basis for the forecasts. Consequently, a separate formal review of the opening balance sheet as at 1 July
2005 may still be required. Accounting policies may also need to be reassessed to
ensure that they are more than the bare minimum.
The auditors’ response to the transition to the New Zealand equivalents to International Financial Reporting Standards
2.137
The transition to NZ IFRS is a significant challenge for us and the auditors
appointed on behalf of the Auditor-General.
2.138
We have carried out some of the audit work required for restated opening balance
sheets and hope to do more of these audits as well as audits of comparative
figures before 30 June 2007. We are concerned that there will be a significant number of local authorities that will not have restated opening balance sheets
and comparative figures available for us to audit before 30 June 2007. If that
happens, it will increase the pressure on auditors to be able to sign audit opinions
on the 2007 financial statements of all local authorities by 31 October 2007. Given
that the period 1 July to 31 October is one of the busiest for auditors, some local
authorities may not meet their statutory deadline for having audited financial
statements if they have not considered NZ IFRS transition issues on a timely basis.
2.139
During 2006/07, we have put all our professional staff through “refresher”
training on NZ IFRS (having carried out full training the year before), and we
continue to develop resources for auditors to ensure that they are fully prepared
to audit in an NZ IFRS environment. One such resource for both local authorities
and auditors is the Audit New Zealand model financial statements under NZ IFRS,
for Te Motu District Council, which is available at www.auditnz.govt.nz.
2.140
We continue to work with the sector to make the transition to NZ IFRS – for
example, we participated in the SOLGM financial management seminar held
toward the end of 2006, where we led a session about NZ IFRS. We will continue
to support such initiatives where our resources allow.
Summary
2.141
The local government sector has made further progress during 2006/07 towards
the implementation of NZ IFRS. However, we are concerned that many local
authorities and other entities within the local government sector, particularly
smaller entities, have not yet been able to give this matter much attention.
2.142
We expect that none of the changes to NZ IFRS as approved at 31 December 2006
will be mandatory for local authorities to apply to their financial statements for
the year ending 30 June 2007. Therefore, there is enough certainty to enable the
sector to carry out much of the work in the first half of 2007 that needs to be
done to make the transition to NZ IFRS.
2.143
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. We will continue to encourage the standard-setter in New Zealand to provide
appropriate guidance to assist entities such as local authorities to implement
standards that were not designed for them.
2.144
SOLGM has assisted the sector by providing a seminar for financial managers
that included a session on NZ IFRS. However, the sector has mainly been focused
during 2006/07 on preparing the 2006-16 LTCCPs. We will continue to support the
sector with the transition to NZ IFRS as our resources allow.
2.145
There is an emerging perception in the local government sector that the transition
to NZ IFRS results in reasonably significant costs with no corresponding benefits.
2.146
The transition remains a significant challenge for us. There is additional audit
work required, particularly for restated opening balance sheets and comparative
figures, and it is increasingly being pushed into shorter time frames. We are
becoming increasingly concerned that there will be some local authorities that
may not meet the statutory deadline of 31 October 2007 for having audited
financial statements for the year ending 30 June 2007 prepared in accordance
with NZ IFRS.
2.147
We will continue to work towards our primary objective of supporting the change
to NZ IFRS at least cost, and with minimum fuss, in a constructive, 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. IFRS are written for application by large profit-oriented entities.
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: The Financial Reporting Standards Board of the Institute of Chartered Accountants.
4: Public benefit entities are entities whose primary objective is to provide goods or services for a 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 holders. They include most public sector entities.
5: 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 issuers (as defined in section 4 of the Financial Reporting Act 1993) 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.
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