Part 9: Transition to New Zealand equivalents to International Financial Reporting Standards

Central government: Results of the 2005/06 audits.

9.101
In this Part, we provide an update on the progress made by the central government sector towards the transition to accounting and reporting in accordance with the New Zealand equivalents to International Financial Reporting Standards (NZ IFRS).

Background

9.102
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.

9.103
In August 2003, the Government announced that NZ IFRS would be implemented in the financial statements of the Government as part of Budget 20071 and that the first set of audited financial statements of the Government reported under NZ IFRS would be for the year ending 30 June 2008.

9.104
The first set of NZ IFRS financial statements must include comparative figures presented on the same accounting basis. Therefore, the comparative figures for the year ending 30 June 2007 and an opening balance sheet at 1 July 2006 need to be restated in accordance with NZ IFRS.

9.105
Government departments, State-owned enterprises (SOEs), and most Crown entities will also first report under NZ IFRS for the year ending 30 June 2008. Tertiary education institutions (TEIs) and schools have 31 December balance dates, so their transition to NZ IFRS is six months earlier. This means that their first set of audited financial statements under NZ IFRS will be for the year ending 31 December 2007 and that their opening balance sheets need to be restated under NZ IFRS at 1 January 2006.

Preparation of preliminary NZ IFRS opening balance sheets

9.106
The opening balance sheet date has now passed for all entities within the central government sector, and many entities have now completed preliminary NZ IFRS opening balance sheets.

9.107
Government departments, SOEs, and Crown entities (except TEIs and schools) were required to provide their preliminary NZ IFRS opening balance sheets to the Treasury2 within two weeks of their 2006 statutory reporting deadline. This was mid-October 2006 for government departments and SOEs, and mid-November for Crown entities. For other than the smaller of these entities, the preliminary NZ IFRS opening balance sheet then needed to be audited and resubmitted to the Treasury in late December 2006.

9.108
For TEIs, the timetable was slightly different, with their audited 1 January 2006 preliminary NZ IFRS opening balance sheets being due at the Ministry of Education by 30 November 2006. The Ministry of Education was then required to consolidate the TEI preliminary NZ IFRS opening balance sheets and return the consolidated position to the Treasury.

9.109
The Treasury is working towards consolidating all the entity-level preliminary NZ IFRS opening balance sheets into a preliminary NZ IFRS opening balance sheet of the Government reporting entity.3 Achieving this consolidation has required remapping the Treasury’s Crown Financial Information Systems (CFIS) consolidation system, and preparing consolidation journals to work with the new NZ IFRS reporting pack and accounting policies. This has been a significant piece of work for the Treasury.

9.110
In general, we are pleased with the progress that the sector has made on their preliminary NZ IFRS opening balance sheets. However, a significant minority of entities did not meet the Treasury’s timetable for completion of their preliminary NZ IFRS opening balance sheets, so the production and the audit of the consolidated preliminary NZ IFRS opening balance sheet of the Government reporting entity is some weeks behind schedule.

9.111
The main reasons for the delays in entities completing their preliminary NZ IFRS opening balance sheets appear to be a combination of the challenges of applying NZ IFRS to the public sector, and entities not addressing the NZ IFRS transition early enough to be able to meet the Treasury timetable. Some of the issues that entities have been dealing with have been very complex, and some of these are described in more detail later in this Part.

9.112
The Treasury also has a role in facilitating implementation of NZ IFRS throughout the central government sector, although individual entities are responsible for ensuring their own preparedness for reporting under NZ IFRS. In carrying out its role, the Treasury’s approach has been to provide the sector with the Government’s NZ IFRS accounting policies and to provide guidance on some sector-wide issues, such as accumulating sick leave and the treatment of the capital charge. The Treasury has supplemented this with individual discussions and advice to entities on particular issues with effects material to the Government financial statements. In providing this advice, the Treasury has consulted regularly with our Office.

9.113
The Treasury has told us that its approach to the provision of guidance to the sector is that where implementation issues are considered unlikely to have a material effect on the Government financial statements or where there is not likely to be significant saving from taking a centralised approach, the Treasury has refrained from providing guidance, believing that these issues are best handled by the organisation responsible for its own financial management.

9.114
While the guidance that the Treasury has provided has been very useful, in our view there are other challenging aspects of NZ IFRS applicable to multiple central government agencies, and for which the sector would have benefited from more guidance (for example, valuation of debt portfolios and how to determine appropriate discount rates).

9.115
Many entities have had to obtain professional advice on NZ IFRS transition matters. In some cases, the engagement of professional advice occurred too late to meet the Treasury timetable.

9.116
A number of the entities that were significantly late in providing an audited preliminary NZ IFRS opening balance sheet for consolidation are in the TEI sector. This could be a reflection of the complex relationship between the Crown and the TEI sector.

The significant changes to central government sector preliminary NZ IFRS opening balance sheets

9.117
Entities within the Government reporting entity are involved in a wide range of activities, and the accounting issues in the sector are diverse. For some entities, the production of the preliminary NZ IFRS opening balance sheet was reasonably straightforward, but for other entities the NZ IFRS transition process has been very complex. Some of these complex issues are still not fully resolved.

9.118
One of the most significant challenges has been accounting for the Government’s non-commercial debtors. A number of Government agencies have significant amounts of non-commercial debt owed to them. This debt includes:4

  • taxes receivable;
  • unpaid fines;
  • benefit recovery debt;
  • child support debt;
  • legal aid debt; and
  • residential care loans.

9.119
Under current generally accepted accounting practice (GAAP), these debtors have been accounted for at the principal amount of the debt less any provision for amounts considered uncollectable. Under NZ IFRS, all debts need to be initially recognised at fair value, which, in the absence of a market price for these types of debt, needs to be determined using discounted cash flow techniques.

9.120
In most cases, the interest, if any, charged on the these debts is less than a commercial interest level, and determination of the initial fair value has resulted in a write-down in the carrying value of the debt. The write-down primarily reflects the time value of money.

9.121
The determination of the initial fair values of these debt portfolios has in some cases proved very complex, with the major challenges being forecasting the future cash flows and determining an appropriate discount rate to apply to these cash flows.

9.122
Forecasting the future cash flows for these debts requires the use of complex models, which use a number of assumptions and estimates about the timing and amount of future payments and in some cases about the population of debtors (for example, mortality rates and income levels).

9.123
Under NZ IFRS, the discount rate applied to the forecast future cash flows must be a prevailing market rate for similar instruments with similar credit risk. As there is no market for debt of this type, determining an appropriate discount rate has also proved a challenge. Most of the agencies involved have needed to engage professional advisors to assist them in valuing these debt portfolios in accordance with the requirements of NZ IFRS.

9.124
Issues such as non-commercial debt portfolios of government agencies have not been specifically considered by standard-setters when developing and approving financial reporting standards relating to financial instruments. Given the significance of such financial instruments, particularly in the central government sector, it would have been helpful if the standard-setter in New Zealand had considered this issue and provided guidance material for public benefit entities. Such guidance material could have assisted Government agencies with how to determine the fair value of such debt portfolios, including guidance around how to determine appropriate discount rates.

9.125
Looking forward, we consider that it is essential for the credibility of financial reporting standards applying to the public sector that:

  • specific consideration is given to such public sector issues;
  • appropriate changes are made to the international standards (which are written for application by large profit-oriented entities) so that the public sector is able to apply them; and
  • guidance is prepared to assist the public sector with application of the standards.

9.126
Other areas that have been challenges to entities within the Government reporting entity, or that have led to significant preliminary NZ IFRS opening balance sheet adjustments, are:

  • determining how to account for the pension liabilities of the Government Superannuation Fund and the National Provident Fund;
  • determining how to account for the Accident Compensation Corporation claims liability, including the increase to the provision necessary to meet the requirement in NZ IFRS 4: Insurance Contracts to add an appropriate risk margin to the estimate of the claims liability;
  • determining whether land and buildings should be accounted for as property, plant, and equipment or investment property or land intended for sale. NZ IFRS transition work to date indicates that there will be significant reclassifications from property intended for sale to property, plant, and equipment, as the criteria under NZ IFRS for use of the intended for sale classification will not be met.5 This will generally result in increases to the carrying value of these assets as they will need to be revalued to fair value;
  • valuing and accounting for derivative financial instruments, such as forward exchange contracts, interest rate swaps, and electricity and commodity derivatives. In most cases, these derivative financial instruments were previously off balance sheet;
  • categorising other financial instruments (such as investments and borrowings) in accordance with the requirements of NZ IAS 39: Financial Instruments: Recognition and Measurement and, dependant on this categorisation, then valuing the instruments in accordance with the complex rules in the standard;
  • establishing provisions for accumulating sick leave; and
  • calculating deferred tax balances. The whole approach to accounting for deferred tax is changing, and will result in more deferred tax assets and liabilities being recognised by those central government entities that pay tax – for example, SOEs. However these deferred tax assets and liabilities are eliminated in producing the consolidated financial statements of the Government.

9.127
As we have stated above, the audit of the consolidated preliminary NZ IFRS opening balance sheet of the Government reporting entity is currently in progress. A number of the issues discussed above have yet to be fully resolved, and the financial effect on the preliminary NZ IFRS opening balance sheet of the Government reporting entity and some individual entities is not yet finalised.

9.128
There is no specific requirement for entities to publish their preliminary NZ IFRS opening balance sheets. However, we are aware that some entities are considering publishing them and an explanation of the major adjustments in their 30 June 2007 annual report. This is one way of an entity meeting the requirements of Financial Reporting Standard 41: Disclosing the Impact of Adopting New Zealand Equivalents to International Financial Reporting Standards (FRS-41).6 We support this approach.

Effect on auditors

9.129
The transition to NZ IFRS has continued to be a significant challenge for us and the auditors appointed to audit entities on behalf of the Auditor-General.

9.130
During the past year, 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 the resources and support tools for auditors to ensure that they are fully prepared to audit in an NZ IFRS environment.

9.131
The audit of the preliminary NZ IFRS opening balance sheets has been additional to our normal work programme, and has required careful management of our staff resources.

9.132
The responsibility for production of the preliminary NZ IFRS opening balance sheets lies with the entities that we audit. In many cases, these entities have done an excellent job in dealing with challenging issues and preparing a well-supported preliminary NZ IFRS opening balance sheet within agreed timeframes. For these entities, the audit of the preliminary NZ IFRS opening balance sheet will generally have been efficient and trouble-free.

9.133
However, some entities have struggled to meet the expectations of them in relation to the preliminary NZ IFRS opening balance sheet, and a number of them have not yet resolved all of the issues more than two months after the agreed date for completion of their audit. For these entities, the audit process will not have been efficient, and in some cases this will have implications for the audit fee charged.

9.134
In our view, the factors that have led to some entities not meeting our expectations include inadequate prioritisation or resourcing of the task, or underestimating the complexity of the issues to be addressed. Some entities have looked to us to advise them on how to carry out aspects of the NZ IFRS transition, and to assist them in determining their preliminary NZ IFRS opening balance sheet adjustments. However, our primary role is that of auditor, and we have had to carefully balance our willingness to work with the sector to achieve the transition to NZ IFRS as smoothly as possible with the need to maintain our independence as auditors.

9.135
A number of entities have stated to us that they would have appreciated further guidance from the Treasury on the transition to NZ IFRS. In our view, there would be merit in the Treasury providing guidance to entities on some of the key areas of difficulty that apply to multiple central government agencies (for example, valuation of debt portfolios and determining discount rates).

The challenges ahead

9.136
In the coming year, there will be further challenges for central government entities and their auditors as the transition to NZ IFRS continues.

9.137
The Treasury will produce Budget 2007 as its first Budget under NZ IFRS. This will require entities to provide NZ IFRS-compliant 2007/08 budget figures to the Treasury.

9.138
All central government entities will need to report under both current GAAP and NZ IFRS for the year to 30 June 2007. The existing standards will apply to annual reports for the year ending 30 June 2007. However, entities will also need to restate their results in accordance with the requirements of NZ IFRS. These restated results will form the comparative figures for the first annual financial statements under NZ IFRS. Some entities may need to maintain accounting records under two different accounting bases to meet these requirements.

9.139
The restated NZ IFRS-compliant financial information for the year ending 30 June 2007 will also need to be audited. This will again create challenges for us as auditors, in terms of resourcing and scheduling this work.

9.140
Similarly, the ongoing transition to NZ IFRS will continue to be a challenge for some central government entities, in terms of workloads of finance teams, transition-related costs (such as professional advice and audit fees), and complexity of the issues to be addressed.

9.141
Although many of the complex NZ IFRS transition issues have been dealt with in the creation of the preliminary NZ IFRS opening balance sheets, some of these issues will require significant further work to determine the effect on the statement of financial performance. In addition, we are expecting the amount and complexity of financial statement note disclosures to increase under NZ IFRS, and entities will need to produce these note disclosures for the first time to support the restated NZ IFRS-compliant 30 June 2007 financial information.

Summary

9.142
The preliminary NZ IFRS opening balance sheets of most central government entities have now been completed and audited.

9.143
A minority of entities did not meet the deadline for completion of their preliminary NZ IFRS opening balance sheets, and this has delayed the completion and audit of the consolidated preliminary NZ IFRS opening balance sheet of the Government reporting entity.

9.144
The reasons for the delay are a combination of the complexity of the issues to be addressed and some entities not adequately planning and resourcing the transition.

9.145
We will continue to encourage the standard-setter in New Zealand to provide appropriate guidance to public benefit entities to assist entities such as Government agencies to implement standards that were not designed for them.

9.146
There have been many complex issues to address when applying NZ IFRS to the central government sector for the first time. One of the most challenging issues has been valuing the Government’s non-commercial debt portfolios using discounted cash flow techniques.

9.147
In our view, there would be merit in the Treasury providing more guidance to entities on some of the particularly challenging NZ IFRS issues that apply to multiple central government agencies.

9.148
We have trained our professional staff and provided support tools to enable them to audit in an NZ IFRS environment. We have balanced the desire to work co-operatively with the sector to achieve the transition to NZ IFRS as smoothly as possible with the need to maintain our independence as auditors.

9.149
During the coming year, there will be further challenges for the sector and for us as auditors, particularly arising from the need to be able to report the financial results for the year ending 30 June 2007 under both the current financial reporting standards and NZ IFRS.

9.150
We are confident that we will fully meet the challenges for us as auditors, and we will continue working towards our overriding objective of supporting the change to NZ IFRS at least cost, with minimum fuss, and in a constructive, co-operative manner.

1: Budget 2007 will set out the Estimates of Appropriations for the Government for the year ending 30 June 2008.

2: District Health Boards (DHBs) were required to provide their opening NZ IFRS balance sheets to the Ministry of Health, where a subconsolidation was performed to enable the Ministry to submit the consolidated DHBs’ NZ IFRS opening balance sheet to the Treasury.

3: From 1 July 2005, the Public Finance Amendment Act 2004 changed the reporting entity from “the Crown” to the “Government reporting entity”. The Government reporting entity is defined to include the Sovereign and the legislative, executive, and judicial branches of the Government. The revised definition clarifies that all three branches of government are to be included within the Government financial statements. Section 27(3) of the amended Public Finance Act 1989 requires the annual financial statements of the Government to include the Government reporting entity’s interests in various entities, including Offices of Parliament.

4: Another example of the Government’s non-commercial debt is student loans. The Government decided to account for student loans using NZ IFRS principles in the financial statements of the Government for the year ended 30 June 2006 because of the significant effect on the fair value of student loans from the introduction of the Government’s interest-free policy.

5: NZ IFRS 5: Non-current Assets Held for Sale and Discontinued Operations establishes the requirements for a property to be classified as held for sale.

6: FRS-41 requires the annual report of issuers to disclose information about planning for, and the effects of, the transition to NZ IFRS. Although most entities within the central 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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