Part 2: Transition to New Zealand equivalents to International Financial Reporting Standards

Central government: Results of the 2006/07 audits.

2.1
In this Part, we:

  • comment on our increasing unease with the appropriateness of New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for the public sector; and
  • report on progress made by the central government sector towards preparing the first set of financial statements in accordance with NZ IFRS.

Summary

2.2
We are becoming increasingly concerned about the credibility of NZ IFRS for the public sector. If appropriate and sensible changes are not made to NZ IFRS in the future, there is an increasing risk that the resulting set of standards will not be of high quality nor ultimately “fit for purpose” for the public sector.

2.3
We have raised our concerns with the chairman of the Accounting Standards Review Board (ASRB) because we consider that continuing with the current approach is not in the best interests of the public sector. We believe that the ASRB understands the nature of our concerns, and that the ASRB is trying to address the causes of the underlying problems within the current standard setting environment.

2.4
A considerable amount of work has been done to prepare for the 2008 Financial Statements of the Government (FSG). In general, good progress has been made with preparing the Government’s provisional NZ IFRS opening balance sheet and the provisional NZ IFRS comparative figures.

2.5
We have substantially completed our audits of these figures, but there are a few outstanding issues. There have been delays in the timetable for these audits because of the challenges of applying NZ IFRS to complex public sector issues, and some entities have not addressed NZ IFRS early enough to meet the Treasury’s timetable.

2.6
Unless the performance of central government entities in providing quality financial information to the Treasury within the agreed timetable improves significantly, we are concerned that the Treasury may not meet the statutory timetable for preparing the 2008 FSG.

2.7
Although many of the complex NZ IFRS issues have been dealt with during the transition process for the FSG, central government entities will also need to ensure that their own annual financial statements comply with the requirements of NZ IFRS.

Background

2.8
In December 2002, the ASRB announced its decision that New Zealand entities producing general purpose financial statements would be required to apply new standards based on International Financial Reporting Standards (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.

2.9
In August 2003, the Government announced that NZ IFRS would be implemented in the FSG as part of Budget 20071 and that the first audited FSG reported under NZ IFRS would be for the year ending 30 June 2008.

2.10
The first set of NZ IFRS financial statements must include comparative figures presented on the same accounting basis. That is, the figures for the year ended 30 June 2007, and an opening balance sheet as at 1 July 2006, which also needs to be stated in accordance with NZ IFRS.

2.11
Government departments, State-owned enterprises (SOEs), and most Crown entities will also first report under NZ IFRS for the year ending 30 June 2008.

2.12
Tertiary education institutions (TEIs) and schools, however, 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 ended 31 December 2007, with their opening balance sheets restated under NZ IFRS as at 1 January 2006.

Increasing unease with NZ IFRS for the public sector

2.13
In our view, irrespective of the approach to setting financial reporting standards, an overriding objective of standard setting should be to set high quality standards that meet the needs of people using the financial statements of those entities that apply the standards.

2.14
The decision toward the end of 2002 to base New Zealand financial reporting standards on IFRS (which are written to be applied by large, profit-oriented entities) was made with the acknowledgement that the needs of the public sector are different to the private sector. They would therefore, in some circumstances, require different treatment. In our view, NZ IFRS will result in high quality standards for the public sector only if they are seen to:

  • specifically consider public sector issues and the needs of people using public sector financial statements;
  • incorporate appropriate changes to IFRS so that the public sector is able to sensibly apply them; and
  • incorporate appropriate guidance to assist the public sector to apply the standards.

2.15
We are becoming increasingly concerned about the credibility of NZ IFRS for the public sector. We believe the above three factors are not happening in all cases. If appropriate and sensible changes are not made in the future, there is an increasing risk that the resulting set of standards will not be of high quality, nor ultimately “fit for purpose” for the public sector.

Concern that public sector issues are inadequately addressed

2.16
We acknowledge that NZ IFRS provides a more complete set of standards than the standards previously applied. For example, under the previous standards there was no recognition and measurement standard dealing with financial instruments. NZ IFRS includes such a standard.

2.17
However, issues raised by public sector constituents about proposed standards do not always appear to be appropriately addressed within the standards. At the extreme, not appropriately addressing concerns can have serious implications for the usefulness of financial statements. For example, widespread concerns were raised throughout the public sector about a requirement to capitalise borrowing costs to certain assets and its implication for depreciated replacement cost valuations of assets, which are common in the public sector. No changes were made to standards or guidance issued as a result of the concerns raised. We fear that the reliability of valuations will be seriously impaired as a result of the requirement to capitalise borrowing costs to certain assets. The scope of some audits, including the audit of the FSG, may be limited, thereby affecting the nature of the audit reports issued. We also have reservations that the costs versus benefits of compulsory capitalisation have not been adequately assessed.

2.18
Also, some types of non-commercial transactions, which are common in the public sector, do not appear to have been addressed in the development of some standards. Examples include:

  • imposing fines in an environment where collection is variable;
  • making “loans” to non-related entities, with no interest and/or no fixed repayment terms or flexible interest options and/or flexible repayment terms; and
  • providing funds documented as a loan, but otherwise exhibiting the characteristics of equity.

2.19
There have been very few disclosure changes made to NZ IFRS, meaning public sector entities are required to provide the same disclosures as large profit-oriented entities. People throughout the public sector have commented that NZ IFRS requires voluminous disclosures, many with questionable relevance to people using the financial statements of public sector entities. In some cases, NZ IFRS do not require disclosures that may be considered more relevant to those users. Once again, we have concerns that the costs versus benefits of NZ IFRS disclosures may not have been adequately assessed for the public sector.

2.20
One of the important implications of standards that do not fully respond to the needs of the public sector is the increasing scope for different interpretations of the requirements in the standards. We are already seeing many cases where the requirements within NZ IFRS are interpreted differently. We are likely to need to produce significantly more interpretations of the requirements than we needed to under the previous standards. Our strong preference is for the standards to be clear so that public sector entities and their auditors consistently interpret the requirements - without us needing to issue numerous interpretations.

2.21
We have concerns with the manner in which standards are currently being developed, and in particular the criteria being applied when changes are made to IFRS for public benefit entities. However, we are also becoming increasingly uneasy about the appropriateness of NZ IFRS for the public sector in the future.

2.22
We are aware of developments in international standard-setting that have us questioning the appropriateness of IFRS as the basis for public sector financial reporting standards in the longer term. The conceptual framework within which IFRS are set is undergoing revision (which could take five years), and early indications are that the revised framework will be heavily focused on cash flows and the information needs of investors, financiers, and creditors typically found in the private sector. Such a framework would be quite inappropriate for most of the public sector. In our view, it is going to become increasingly difficult to try and accommodate the public sector within such a regime.

2.23
Also, other big international projects such as business combinations and liabilities have the potential to significantly change financial reporting in the public sector. Without adequately considering the needs of people using the financial statements prepared for public sector entities (and, as a consequence, appropriate changes to NZ IFRS for public benefit entities), the resulting standards will, in our view, undermine the quality of reporting by the public sector.

Concern that institutional arrangements may no longer be appropriate

2.24
We have now begun to question whether the right institutional arrangements are in place in New Zealand for setting financial reporting standards. In New Zealand, the decision was made to adopt IFRS for profit-oriented entities. Few if any changes have been made to IFRS so that profit-oriented entities in New Zealand can assert compliance with IFRS. In this respect, New Zealand has become a “standard taker”.

2.25
The International Accounting Standards Board is responsible for writing IFRS. New Zealand can therefore be only an influencer at best of standards for profit-oriented entities. However, the ASRB acknowledged in 2004 that, for most public sector entities, which are not profit-oriented, it would be necessary in the case of some IFRS to make changes to measurement and recognition requirements and to add disclosure requirements and/or give disclosure concessions so that those entities could apply the standards.2

2.26
Given that acknowledgement, it seems that New Zealand is now only really “setting standards” for entities other than profit-oriented entities (that is, most of the public sector and other not-for-profit entities such as charities). There needs to be appropriate standards for these entities, even though IFRS provides a base for those standards. Given this reality, the institutional arrangements that have been in place for many years in New Zealand, including the composition of the standard-setting board, need to be reviewed.

Where to from here?

2.27
We have begun to voice our concerns publicly, and we have raised our concerns with the chairman of the ASRB because we consider that continuing with the current approach is not in the best interests of the public sector. We believe that the ASRB understands the nature of our concerns, and that the ASRB is trying to address the causes of the underlying problems within the current standard-setting environment.

2.28
If real changes are not made to the current process soon, New Zealand will need to seriously consider moving to separate financial reporting standards for public benefit entities that better meet the needs of people using those entities’ financial statements.

Central government progress towards NZ IFRS financial statements

2.29
Publication of the Government’s first annual financial statements based on NZ IFRS is only months away. A considerable amount of work has been done to prepare for the 2008 FSG. In general, good progress has been made with preparing the Government’s opening balance sheet and provisional NZ IFRS comparative figures.

2.30
Achieving consolidation of all the entities comprising the FSG has required the Treasury to:

  • establish NZ IFRS-compliant accounting policies;
  • develop an NZ IFRS reporting package to be completed by entities consolidated into the FSG; and
  • remap the Crown Financial Information System and prepare and document new consolidation journals.

2.31
A lot of work has gone into achieving these changes. In our view, the system operates effectively.

2.32
As we reported last year,3 government departments, SOEs, and Crown entities provided the Treasury with provisional NZ IFRS opening balance sheet information as at 1 July 2006. During the last year, those same entities provided the Treasury with provisional NZ IFRS-based numbers that will be reported as 2007 comparative figures in the 2008 FSG.

2.33
The Treasury had expected to complete and have audited both the provisional NZ IFRS opening balance sheet and provisional NZ IFRS comparative figures for inclusion in the 2008 FSG well before now. The audits are now substantially complete. However, because final NZ IFRS-based information on three outstanding issues (accounting for tax debt, the Earthquake Commission’s insurance liabilities, and the financial instruments disclosures) has not been provided, the provisional NZ IFRS opening balance sheet and provisional NZ IFRS comparative figures are not yet finalised.

Outstanding issues

2.34
The outstanding issues with the provisional NZ IFRS opening balance sheet and/ or provisional NZ IFRS comparative figures are outlined below. While there are only three outstanding issues now, there have been various issues that have delayed completion of this work. In our view, there have been two main reasons for delays:

  • the challenge of applying NZ IFRS to complex public sector issues; and
  • entities not addressing the NZ IFRS transition early enough to meet the Treasury timetable.

Meeting deadlines for providing information

2.35
We are concerned that, if the performance of central government entities in providing quality financial information to the Treasury within the agreed timeframes does not improve significantly, the Treasury may not meet the statutory timetable for preparing the 2008 FSG.

Accounting for tax debt

2.36
Accounting for tax debt under NZ IFRS is an issue that has still not been resolved. Under current generally accepted accounting practice (GAAP), tax debt has been accounted for at the principal amount of the debt less any provision for amounts considered uncollectible. Under NZ IFRS, receivables (which include tax debt) are initially recognised at fair value and subsequently measured at amortised cost using an effective interest rate.

2.37
NZ IFRS standards provide no guidance on how to calculate initial fair value for non-commercial debt, like tax debt, which is common in the public sector. The Treasury and the Inland Revenue Department are currently reviewing the approach to accounting for tax debt under NZ IFRS.

Earthquake Commission insurance liabilities

2.38
Accounting for the Earthquake Commission’s insurance liabilities is another issue that has not been fully resolved. The issue is the adequacy of the liabilities and, in particular, consideration of the probability and impact of a major natural disaster within the scope of Earthquake Commission coverage. The Earthquake Commission is working with its advising actuary on this matter.

Financial instruments disclosures

2.39
The Treasury has yet to finalise and present for audit the intended disclosures for financial instruments under NZ IFRS for the 2008 FSG. The Government holds many and diverse financial instruments for which disclosures are required to enable users of the financial statements to:

  • determine the nature and extent of risks arising from the financial instruments and how the risks are managed; and
  • evaluate the significance of financial instruments on financial performance and financial position.

2.40
Producing an appropriate consolidated disclosure that meets the requirements of the standard and the information needs of users is a challenge, given the devolved management of many of the financial instruments included within the FSG.

Significant NZ IFRS transition adjustments

2.41
Last year, we outlined the significant adjustments that arose in producing the provisional NZ IFRS opening balance sheet for the FSG. These same issues also required significant adjustments to be made to the provisional comparative Statement of Financial Position as at 30 June 2007 under NZ IFRS. The more significant adjustments, in terms of size of the adjustment and/or the effort involved in determining the NZ IFRS figures, included:

  • reducing the liability for pension obligations in the Government Superannuation Fund and National Provident Fund;
  • increasing the ACC claims liability;
  • recognising derivative financial instruments, such as forward exchange contracts, interest rate swaps, and electricity and commodity derivatives;
  • writing down non-commercial debts to reflect the time value of money;
  • categorising and valuing other financial instruments;
  • establishing provisions for accumulating sick leave;
  • reclassifying software to intangible assets; and
  • reclassifying certain properties and revaluing them to fair value.

2.42
A number of the adjustments listed above also resulted in adjustments to the Government’s provisional comparative Statement of Financial Performance under NZ IFRS. The more significant adjustments included:

  • the movement in the ACC claims liability;
  • the change in fair value of derivative financial instruments;
  • the effect of the revised accounting for non-commercial debtors; and
  • the reversal of goodwill amortisation.

2.43
A detailed analysis of the effect of the NZ IFRS transition on the FSG, including a reconciliation between the NZ IFRS figures and the previously reported figures, is available in the monthly Financial Statements of the Government available on the Treasury’s website.

The challenges ahead

2.44
Although many of the complex NZ IFRS issues have been dealt with during the transition process, central government entities will also need to ensure that their own annual financial statements comply with the requirements of NZ IFRS.

2.45
The disclosure requirements of NZ IFRS are greater than under the previous Financial Reporting Standards. Entities will need to ensure that they address disclosure requirements at an early stage to ensure that they meet reporting deadlines.

2.46
The 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.

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

2: ASRB Release 8: The Role of the Accounting Standards Review Board and the Nature of Approved Financial Reporting Standards, May 2004.

3: Central government: Results of the 2005/06 audits, parliamentary paper B.29[07a], pages 81-82.

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