Appendix 2: Other concerns about the suitability of NZ IFRS for the public sector

A2.1
This Appendix includes some specific implementation issues with NZ IFRS affecting public benefit entities, other than those reported in Part 4. These issues, in conjunction with the issues identified in Part 4, are not intended to represent a full list of implementation issues. Rather, they are included to show that there are many issues with NZ IFRS for public benefit entities. In my view, issues with implementing NZ IFRS are likely to continue emerging.

Unnecessary disclosures about standards that do not yet apply

A2.2
NZ IFRS include a standard on accounting policies (NZ IAS 8).

A2.3
One of the requirements of NZ IAS 8 is to disclose information about new standards that have yet to be applied by the entity. Also, information that allows an assessment of the possible effect of new standards, when they are first applied, must be disclosed.

A2.4
Such disclosures are likely to benefit people using the financial statements of listed companies. Those people are more likely to be interested in comparing entities to help them with decisions about where to allocate resources.

A2.5
However, in my view, such disclosures are of little benefit to people using financial statements of most public sector entities. People using those entities' financial statements are more likely to be interested in accountability of the entities concerned. When it comes to comparability, comparing entities' results to forecasts is usually more important than any significant comparison with other entities.

A2.6
This unnecessary disclosure also adds costs. In my view, the people using the financial statements of most public sector entities do not need such information, therefore the requirement should be removed for public benefit entities.

No guidance about ownership transactions without equity instruments

A2.7
In the private sector, transactions between entities and their owners are usually well defined. For example, a company normally issues shares to its owners when those owners invest in the company. From time to time, dividends are paid by the company to its owners, based on the number of shares the owners have.

A2.8
NZ IFRS have been based almost entirely on the above notions of ownership transactions. These notions are not relevant for most public benefit entities. Share certificates or other forms of equity instruments are not generally issued by public benefit entities in the public sector, and most of those entities do not pay dividends.

A2.9
Throughout the public sector, there are many transfers of resources to and from "parent" entities and "subsidiary" entities. Because of the way the public sector is structured, many of these transactions occur through intermediaries. Therefore, it is not always clear whether the transfer of resources between parent entities and subsidiary entities are revenues or expenses, or contributions from, or distributions to, owners.

A2.10
Given the nature of public benefit entities, I consider that NZ IFRS should include guidance to help identify ownership-type transactions in the public sector. I acknowledge that under previous standards similar issues existed. However, the previous Statement of Concepts for General Purpose Financial Reporting better dealt with the matter. I think it is reasonable to expect more guidance in this area, both in the NZ Framework and, where relevant, in standards.

No guidance about significantly influencing an entity without equity instruments

A2.11
NZ IAS 28 addresses the accounting for investments in associates. Associates are entities in which an investor has significant influence, but are not subsidiaries or joint ventures. Significant influence is defined as the power of an investor to participate in the financial and operating policy decisions of an entity, but without control or joint control over those policies.

A2.12
NZ IAS 28 assumes the investor has a defined ownership interest in the associate. The interest is often defined by the number of shares the investor has in the associate. Alternatively, there may be an agreement that establishes an investor's equity contribution and share of profit or loss of the associate, such as in a partnership agreement.

A2.13
In the public sector, there are some public benefit entities that have together established an associate entity without defined ownership interests. Such associate entities typically carry out activities that are consistent with the objectives of the public benefit entities that established them. In my view, the establishing public benefit entities typically have an ownership interest in the associate entity, as that term is explained in NZ IFRS.

A2.14
Usually each of the public benefit entities will be able to appoint people to the body that governs the associate entity. In this way, the public benefit entities can participate in the financial and operating policy decisions and, therefore, have significant influence over the associate entity.

A2.15
I am concerned that NZ IAS 28 provides no guidance to public benefit entities about how to account for an associate entity in the situation described above. Deficiencies in accounting lead to deficiencies in information for people who use the financial statements. I acknowledge that the point I raise existed in the previous standard. However, I believe it is reasonable that matters such as this one are dealt with by appropriate changes being made to NZ IAS 28.

Unclear whether price indices can be used for certain public sector asset revaluations

A2.16
NZ IAS 16 allows plant and equipment to be valued on the basis of readily available price indices that establish a reliable fair value. The paragraph in NZ IAS 16 that allows use of price indices is very similar to a paragraph in the previous standard, FRS-3. However, FRS-3 also contained further commentary that provided context for the use of price indices. The commentary made it clear that price indices could not be used where depreciated replacement cost was the basis for determining the fair value of plant and equipment.

A2.17
Depreciated replacement cost is often used to arrive at the fair value of assets in the public sector. I am concerned that NZ IAS 16 does not provide context for the use of price indices, particularly where fair value is based on depreciated replacement cost.

A2.18
I am aware that some entities in the public sector are interpreting NZ IAS 16 to mean that price indices can be used for depreciated replacement cost valuations. Those entities note that if the Financial Reporting Standards Board had intended NZ IAS 16 to result in the same treatment as FRS-3, the contextual commentary would have been added to NZ IAS 16.

A2.19
I am not particularly comfortable with price indices being used for depreciated replacement cost valuations, because it means fair value is being derived without the appropriate involvement of an independent valuer. I suspect the exclusion of contextual commentary about the use of prices indices from NZ IAS 16 was an oversight. In my view, NZ IAS 16 needs to be clarified to avoid unintended consequences either way, and to ensure that reliable information is included in financial statements for those people using them.

No guidance about how public benefit entities account for public private partnerships

A2.20
NZ IFRIC 12 is an interpretation that sets out the accounting for public private partnership arrangements by the private sector partner that operates an asset (subject to a service concession arrangement). The interpretation specifically notes that it does not apply to the public sector partner. The reason the interpretation is limited to the private sector is because the interpretation on which NZ IFRIC 12 is based relates only to the operator of the service concession.

A2.21
I am concerned that the scope of NZ IFRIC 12 does not address the accounting requirements for public private partnership arrangements by the public sector partner. By not addressing this possibility, different accounting treatments of such arrangements are more likely to occur, including that neither partner accounts for the assets underlying the partnership. Differences in accounting do not help people using financial statements to understand the public private partnership arrangements.

A2.22
I am aware that the International Public Sector Accounting Standards Board is creating a standard to address accounting by the public sector partner in such arrangements. In my view, when the International Public Sector Accounting Standards Board has created such a standard, it should be used to create a New Zealand standard that sets out the accounting treatment for the public sector partner to these arrangements.

Difficulties assessing the fair value of non-commercial equity investments

A2.23
NZ IAS 39 requires equity investments to be recorded at fair value just like all other financial instruments. Where fair value is not readily attainable, valuation techniques can be used. When fair value cannot be reliably worked out using valuation techniques, the standard allows cost to be used.

A2.24
Fair value for non-commercial equity investments is usually difficult to work out. These difficulties compound when equity investments are in public sector entities that are not traded and not intended to generate net cashflows. In these situations, commercial valuation techniques are likely to be meaningless.

A2.25
I am concerned that NZ IAS 39 does not take into account typical non-commercial equity investments in the public sector. In my view, public benefit entities should not have to default to recording such investments at cost (which is less useful information to most people) simply because a commercial fair value as envisaged by the standard cannot be worked out.

A2.26
I am sure there are other approaches for determining a fair value for such investments. For example, allowing the net assets of the equity investment to be used as a proxy for its fair value. Such a value would be better than cost, particularly where the assets and liabilities of the entity approximate fair value.

Inconsistent accounting for investments received without paying for them

A2.27
In the public sector, it is common for different types of assets to be received by public benefit entities without those entities paying for the assets (or only paying a nominal amount).

A2.28
NZ IAS 16, the standard on property, plant, and equipment, requires property, plant, and equipment received for nil or a nominal amount to be initially recorded at fair value. That requirement relates only to public benefit entities. Standards related to investment assets such as subsidiaries (NZ IAS 27), associates (NZ IAS 28), and joint ventures (NZ IAS 31) do not contain that requirement.

A2.29
Those standards require such investments to be accounted for, either at cost or fair value. Therefore, where there has been nil or a nominal payment, entities are allowed to account for the investment at cost (that is, nil or the nominal amount). In my view, nil or the nominal amount is not particularly relevant for those people using the resulting financial statements.

A2.30
I consider NZ IFRS should be amended for public benefit entities to ensure that accounting for such investments is relevant to people using those entities' financial statements. The amendments should align the accounting for investments received for nil or a nominal amount with the accounting requirements for property, plant, and equipment received for nil or a nominal amount.

Difficulties determining when an entity's investment in a public benefit entity deteriorates

A2.31
NZ IFRS include a standard on impairment (or deterioration in value) of assets (NZ IAS 36). The scope of NZ IAS 36 includes financial assets, such as investments in subsidiaries, associates, and joint ventures.

A2.32
Impairment of investments in subsidiaries, associates, and joint ventures is an important matter for the separate financial statements of a parent entity. Sometimes it can be difficult to work out if there has been impairment. Such difficulties arise where a public benefit entity has investments in subsidiaries, associates, and/or joint ventures that are also public benefit entities.

A2.33
To find out if there has been impairment, the standard requires the recoverable amount of the investment to be worked out. Where an investment is not cash generating, such as investments in public benefit entities, the depreciated replacement cost of the investment is often a proxy for the recoverable amount.

A2.34
A difficulty arises when applying the notion of depreciated replacement cost to investments in public benefit entities. This is because depreciated replacement cost is designed primarily to be used for property, plant, and equipment assets, not all types of assets.

A2.35
I am concerned that the standard is difficult to apply to these types of investments. In my view, the standard should be amended to clarify how depreciated replacement cost can apply to these investments. Alternatively, the standard should use a basis other than depreciated replacement cost for calculating the recoverable amount of these investments.

Unclear whether group financial statements are required when an entity influences but does not control other entities

A2.36
Occasionally in the public sector, an entity will not have any subsidiaries but will have an associate entity or entities. The legislation under which most public sector entities prepare financial statements requires both parent and, where applicable, group financial statements.

A2.37
I find NZ IFRS unclear about whether an entity with no subsidiaries (but with an associate entity) is both a parent entity and, when combined with its associate entity, a group entity. In other words, it is unclear whether the entity needs to prepare both parent and group financial statements. I acknowledge that the point I raise is not limited to the public sector.

A2.38
FRS-38, a previous standard, included helpful guidance for entities with no subsidiaries but with associate entities. That guidance noted that the entity could choose to account for its associate entities in its parent financial statements using the equity method, or it could prepare a separate set of financial statements that used the equity method to account for the associate entities.

A2.39
I do not know why this helpful guidance was not included in NZ IFRS, at least for public benefit entities.

No guidance about how to account for a public sector capital charge

A2.40
NZ IAS 32 requires interest, dividends received, losses, and gains relating to financial instruments to be recognised as income or expense. The standard also requires distributions (such as dividends paid) to holders of an equity instrument to be recognised as a reduction in equity. This means that the classification of a financial instrument as an asset, liability, or equity determines where interest, dividends, losses, and gains are recognised.

A2.41
Capital charges are a cost imposed on many public benefit entities to:

• make transparent the full costs of the goods and services they produce (in particular, costs associated with financing capital); and
• provide information and incentives for efficient management of the Government's investment in public sector entities.

A2.42
Typically, a capital charge is based on an assumed debt-to-equity ratio. However, public sector entities tend not to have either debt instruments or equity instruments, which means the guidance in NZ IAS 32 is not directly helpful.

A2.43
I am concerned that NZ IAS 32 could be interpreted to mean that the capital charge is not an expense of the entity. In my view, reporting the capital charge other than as an expense would thwart the purpose for the charge (that is, to ensure that the costs of capital are included "in the costs of services"), and adversely affect the relevance of financial statements to people using them.

A2.44
I consider NZ IAS 32 needs to explicitly recognise capital charges and provide guidance about how such charges are to be accounted for.

No guidance about accounting for use of Crown-owned property

A2.45
It is reasonably common for a public sector entity to have a right to use or occupy property owned by another entity. For example, state schools have a right to occupy land and buildings owned by the Crown. The arrangements in place between such entities typically are not leases as defined in NZ IAS 17. Also, the standard on intangible assets, NZ IAS 38, is not helpful about how to sensibly account for such arrangements.

A2.46
I am concerned that accounting for these types of arrangements is not adequately addressed in NZ IFRS. In my view, the lack of guidance for these common types of public sector arrangements can lead to inconsistencies in accounting treatment. To remove such inconsistencies throughout the public sector requires effort from my Office. There would not be the need for that effort if NZ IFRS adequately addressed the issue.

A2.47
FRS-3, a previous standard, included helpful guidance about accounting for arrangements where an entity had a right to use or occupy property. The guidance related to such arrangements where the benefits from the right to use or occupy property were substantially the same as if the property were owned. FRS-3 noted that the principles relating to accounting for physical assets, such as property, could be applied to the accounting for these rights.

A2.48
I do not know why this helpful guidance was not included in NZ IFRS for public benefit entities.

Unclear how the Government should account for intangible assets it creates

A2.49
The adoption of NZ IFRS resulted in New Zealand getting a financial reporting standard (NZ IAS 38) that addressed intangible assets. Previously there was not a standard that broadly addressed intangible assets, therefore entities referred to the Statement of Concepts for General Purpose Financial Reporting. NZ IAS 38 includes few changes from IAS 38 for public benefit entities.

A2.50
I am concerned that NZ IAS 38 does not include changes to deal with the type of issues encountered by governments when accounting for intangible assets. Governments establish rights such as fishing quota, radio spectrum licences, and emission trading units. These rights are intangible assets. However, NZ IAS 38 does not address how the Government should account for such rights, including any of those rights that the Government retains and uses.

A2.51
In my view, NZ IAS 38 needs to include requirements and/or guidance to clarify how the Government should account for intangible assets that it establishes, so as to provide relevant information to people using the financial statements of the Government.

Inappropriate accounting for intangible assets received without paying for them

A2.52
Public benefit entities in the public sector commonly receive assets without paying for them (or paying only a nominal amount). Property, plant, and equipment assets received without paying for them, or paying a nominal amount, must be initially recorded at fair value. Intangible assets are another type of asset that can be received for nil or a nominal payment.

A2.53
However, NZ IAS 38 requires all intangible assets to be initially accounted for at cost. Further, it limits the circumstances in which intangible assets can be revalued to such an extent that nearly all such assets cannot be revalued. Where an intangible asset has been received for nil or a nominal payment, I am concerned about the asset being recorded at nil or a nominal amount. In my view, nil or a nominal amount is not particularly relevant information for people using the financial statements.

A2.54
I consider amendments should be made to NZ IAS 38 for public benefit entities to ensure that accounting for intangible assets is relevant to people using financial statements. The amendments should align the accounting of intangible assets received for nil or a nominal amount with the accounting requirements for property, plant, and equipment received for nil or a nominal amount.

Unclear which internally generated intangible assets public benefit entities can recognise

A2.55
NZ IAS 38 outlines the criteria that must be demonstrated before an intangible asset arising from development expenditure can be recognised. Those criteria are also relevant to assessing whether or not website costs can be capitalised, because the criteria are cross-referred to a specific interpretation about website costs (NZ SIC 32).

A2.56
One criteria is that it must be probable the intangible asset will generate future economic benefits. That probability can be demonstrated by the existence of a market for the output of the intangible asset or the intangible asset itself. If the intangible asset is to be used internally, the probability that it will be useful needs to be demonstrated.

A2.57
Although the NZ Framework equates future economic benefits with service potential for public benefit entities, it is open to interpretation whether service potential should be applied to the criteria in NZ IAS 38, and if so, how. In noting this lack of clarity, I am aware that the NZ Framework does not override any specific standard.

A2.58
In my view, changes are needed to NZ IAS 38 for public benefit entities to ensure that accounting for intangible assets is relevant to people using financial statements. The changes need to clarify the application of the notion of service potential as part of the criteria for recognising an intangible asset that arises from development expenditure.

No guidance about common public sector issues with property disposals

A2.59
NZ IFRS 5 has particular accounting requirements for property assets that are for sale. The standard is clear that sales should be expected to be completed within one year, except where delays are beyond the seller's control.

A2.60
In the public sector, property may be disposed of through the Treaty of Waitangi settlements process rather than a sale transaction. That process often takes a long time, so the property may not be disposed of within one year. It is not clear how such property should be dealt with, or indeed whether NZ IFRS 5 is applicable, given disposal of the property is not through sale.

A2.61
NZ IFRS 5 is also prescriptive about the properties that can be considered "for sale". The active marketing of the property is one of the criteria that must be fulfilled for a property to be considered "for sale".

A2.62
In the public sector, it is common for property to be subject to a "disposal of Crown land process" before it can be sold. That process means the property cannot be actively marketed. The process can take a long time, and sometimes more than one year.

A2.63
I am concerned that the processes for both Treaty of Waitangi settlements and disposal of Crown land have not been taken into account in establishing NZ IFRS 5. That standard needs to be amended, or guidance added, to clarify how these common public sector issues are dealt with. In this way, the standard could be clear to those in the public sector who apply it, and lead to relevant information in financial statements for people using them.

Information about managing capital is irrelevant to most public benefit entities

A2.64
NZ IAS 1 requires an entity to disclose information that enables people that use its financial statements to evaluate the entity's objectives, policies, and processes for managing capital.

A2.65
Such disclosures make sense for profit-oriented entities. Those entities typically have share capital, and some are subject to capital requirements such as prudential capital adequacy provisions, or banking covenants.

A2.66
However, I question the value of such disclosures by public benefit entities. As the requirement is currently written, it makes little sense both for those preparing and for those using the financial statements of public benefit entities.

A2.67
Public benefit entities typically do not have equity instruments, or a notion of "capital". A look at some disclosures made by public benefit entities as a result of this requirement generally shows information of no value. I am not surprised, because the requirement has little relevance to public benefit entities.

A2.68
In my view, public benefit entities should be exempted from the disclosure requirement.