Part 7: Transition to New Zealand equivalents to International Financial Reporting Standards
7.1
In this Part, we:
- comment on our increasing unease with New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for the public sector; and
- report on the local government sector’s experience with preparing annual financial statements in accordance with NZ IFRS for the first time in 2007.
Summary
7.2
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.
7.3
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 consider 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.
7.4
The transition to NZ IFRS has been a significant challenge for the local government sector. Many local authorities coped extremely well with these challenges, while other local authorities have struggled. One result of this has been a significant increase in the number of local authorities that did not adopt their annual report within the statutory deadline.
7.5
The transition to NZ IFRS has also come at significant cost to the sector, particularly in terms of staff time. It remains to be seen whether the benefits of NZ IFRS will justify these additional costs.
7.6
Because of the variety of assets, liabilities, revenues, and expenses of local authorities and their controlled organisations, there were many different adjustments made in the transition to NZ IFRS.
Background
7.7
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.
7.8
Nearly all local authorities and many of their subsidiaries and associated entities adopted these standards for their financial statements for the year ended 30 June 2007. To prepare their first NZ IFRS-compliant financial statements, local authorities had to establish an opening balance sheet as at 1 July 2005 and restate the figures for the year ended 30 June 2006 in keeping with NZ IFRS.
Increasing unease with NZ IFRS for the public sector
7.9
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.
7.10
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.
7.11
We are becoming increasingly concerned about the credibility of NZ IFRS for the public sector. We consider that the three factors listed above are not happening in all instances. 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.
Concerns that public sector issues are inadequately addressed
7.12
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.
7.13
However, issues raised by public sector constituents about proposed standards do not always appear to be appropriately addressed. At the extreme, not appropriately addressing concerns can have serious implications for the usefulness of financial statements.
7.14
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, particularly in local government. No changes were made to the 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 may be limited, thereby affecting the nature of the audit reports issued. We also have reservations that the costs and benefits of compulsory capitalisation have not been adequately assessed.
7.15
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:
- 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.
7.16
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 and benefits of NZ IFRS disclosures may not have been adequately assessed for the public sector.
7.17
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.
7.18
We have concerns with the manner in which standards are currently being developed, and in particular the criteria being applied to 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.
7.19
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.
7.20
Also, other big international projects to look at financial reporting in areas 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
7.21
We have now begun to question whether the right institutional arrangements are in place in New Zealand for setting financial reporting standards. Here, 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”.
7.22
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.1
7.23
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). Appropriate standards are needed 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?
7.24
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 consider 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.
7.25
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.
Local government experience with NZ IFRS financial statements
7.26
The transition to NZ IFRS has been a significant challenge for local authorities and council-controlled organisations. Finance teams have had to become familiar with the complex requirements of the NZ IFRS standards, to restate under NZ IFRS their financial information as at 1 July 2005 and 30 June 2006, and to meet the full NZ IFRS disclosure requirements in the 30 June 2007 annual report.
7.27
Many local authorities coped extremely well with these challenges, while other local authorities have struggled. As discussed elsewhere in this report, one consequence has been a significant increase in the number of local authorities that did not adopt their annual report within the statutory deadline. The late adoption of an annual report means that communities do not have timely information on the performance of their local authority. In a number of instances, the 2006/07 annual reports were not yet available to communities that were being consulted about the 2008/09 draft annual plan.
7.28
Although a small number of local authorities received qualifications in the audit report on their financial statements, they were not about issues arising from the adoption of NZ IFRS. This indicates that those local authorities that have completed their annual reports have managed to cope with the NZ IFRS requirements.
7.29
However, the transition to NZ IFRS has come at significant cost to the sector. The most significant cost has been for the time of local authority finance personnel, but there have also been significant external costs, mainly from consultants advising on NZ IFRS transition issues. There have also been additional audit fees incurred in the audit of the restated NZ IFRS-compliant figures for 1 July 2005 and 30 June 2006, as well as the additional NZ IFRS requirements in the 30 June 2007 financial statements. It remains to be seen whether the benefits of the transition to NZ IFRS will justify these additional costs.
7.30
One benefit of NZ IFRS may be increased consistency and comparability of the financial reporting by local authorities. The adoption of NZ IFRS has reduced the options that local authorities had in their accounting policies in areas such as financial instruments, investment properties, and forestry. In theory, this should lead to more consistent reporting. However, the complexity of the financial instruments standards, in particular, and the lack of guidance on how these standards should be applied to non-commercial instruments, increases the risk that the requirements might be interpreted differently.
7.31
Local authorities’ first annual financial statements under NZ IFRS are significantly larger, in terms of the number of pages, than those before NZ IFRS. In part, this is a year one issue, with lengthy reconciliations and disclosures required to explain the transition. However, the disclosure requirements of NZ IFRS generally are significantly greater than under the previous financial reporting regime. It remains to be seen whether the readers of the annual reports will find this additional disclosure useful or even understandable.
What were the most common adjustments arising on transition to NZ IFRS?
7.32
Because of the variety of assets, liabilities, revenues, and expenses of local authorities and their controlled organisations, there were many different adjustments made in the transition to NZ IFRS. In the main, the adjustments that arose were consistent with our expectations of likely adjustments that we have reported in previous years.
7.33
We have summarised the more common NZ IFRS transition adjustments that arose for local authorities for the statement of financial position, the statement of financial performance, and the statement of cash flows.
7.34
The more common NZ IFRS transition adjustments in the statement of financial position were:
- reclassifying computer software from property, plant, and equipment to intangible assets;
- taking the transitional option to use a fair value determined in a previous period as deemed cost for selected property, plant and equipment;
- recognising derivative financial instruments (such as interest rate swaps and forward foreign exchange contracts) in the statement of financial position at fair value;
- recognising an employee entitlement liability for accumulating sick leave;
- writing down loans at less than a commercial interest rate to reflect their initial fair value;
- reclassifications between investments and cash and cash equivalents to meet NZ IFRS definitions;
- adjusting investment property carrying values to fair value from the previous requirement of net current value (by adding back anticipated costs of disposal);
- recalculating deferred tax balances in accordance with NZ IFRS requirements (for those council groups that include tax-paying entities);
- adjusting carrying values of equity investments to reflect NZ IFRS measurement requirements;
- recognising liabilities for financial guarantees provided by local authorities (particularly for not-for-profit organisations); and
- reclassifying assets classified as held-for-sale back into property, plant and equipment, where lengthy public sector disposal processes do not meet NZ IFRS criteria.
7.35
The more common NZ IFRS transition adjustments in the statement of financial performance were:
- accounting for the movements in the fair value of derivative financial instruments (which are now on balance sheet);
- accounting for the movements in the fair value of investment property (which could previously be transferred directly to equity);
- accounting for interest income now recognised on low or no interest loans (as the initial fair value write down is unwound and the loan written back up to face value by repayment date);
- accounting for movements in fair value of forestry assets (which previously were either deferred in equity or not recognised if accounting was based on cost);
- accounting for movements in sick leave liabilities; and
- accounting for movements in fair value of other financial instruments.
7.36
The more common NZ IFRS transition adjustments in the statement of cash flows were:
- reclassifications between investments and cash and cash equivalents to tie in with NZ IFRS criteria; and
- separating out the purchase of intangible assets (primarily computer software) from the purchase of property, plant and equipment.
7.37
As well as these adjustments, the NZ IFRS requirements resulted in some changed line items being presented on the face of the primary financial statements, or revised descriptors being used for certain line items.
7.38
To help the sector with the challenges of preparing the first NZ IFRS-compliant annual report, we produced model sets of NZ IFRS-compliant financial statements specifically for local authorities and for council-controlled organisations. Many local authorities followed the model, or elements of it, in preparing their NZ IFRS financial statements.
7.39
To continue to support the sector to meet its financial reporting obligations under NZ IFRS, we will revise these model financial statements when there are significant changes to the NZ IFRS reporting requirements.
1: Refer to ASRB Release 8 entitled The Role of the Accounting Standards Review Board and the Nature of Approved Financial Reporting Standards issued in May 2004.