Part 2: Financial reporting implications of the Canterbury earthquakes

Central government: Results of the 2010/11 audits (Volume 1).

The Canterbury earthquakes have changed the public sector's operating environment, whether temporarily or permanently, giving rise to challenging financial reporting implications for some public entities. Some of those implications have been significant and will continue to be so in the foreseeable future as the recovery continues. See Part 3 (paragraphs 3.9–3.22) and Part 5 for more information about effects of the earthquakes.

In this Part, we comment on the main financial reporting implications that we have seen, along with the associated audit implications. The financial reporting implications relate to:

Damage and repair of physical assets

There was significant damage to physical assets, such as land, buildings, infrastructure, plant, and equipment, in and around Christchurch from two major earthquakes in September 2010 and February 2011. Physical assets are often the asset with the greatest value in the statement of financial position. Accurately reporting the damage to those assets required a great deal of time and a lot of judgement.

For financial reporting purposes, the first issue for public entities to consider after the earthquakes was whether it was possible to assess the extent of the damage to their assets. Where it was possible to make reasonable estimates of the damage, public entities needed to assess the extent to which the damage affected the service potential of those assets. Some damaged assets were still able to be used, but others were not.

Having assessed the extent of damage to assets, and the effect of the damage on their ability to use the assets, public entities then needed to determine whether the assets were repairable or beyond repair.

Reporting about the earthquake damage to physical assets in financial reports was generally complicated and challenging because:

  • the damage to some assets was hidden;
  • some public entities had large numbers of assets that needed a damage assessment;
  • some assets could not be accessed to properly assess their condition;
  • the future use of some assets was uncertain;
  • the repair estimates for some damaged assets varied widely, reflecting the uncertainty of the amount of damage; and
  • public entities had differing interpretations of the financial reporting standards in some circumstances, and lacked relevant guidance on when and how to write-down the carrying amount of damaged assets.

We had to carefully consider the entities' judgements, the robustness and reliability of the processes that the entities had applied in accounting for the damage to physical assets, and the reliability of the information provided by public entities (including information from their experts and insurers). We faced challenges in assessing the quality of information when there was a lack of formal documentation supporting damage estimates.

We have debated with some public entities whether repair costs should be accounted for as an operating expense or capital expenditure. The treatment of repair costs requires public entities to make careful judgements. In our view, the accounting treatment that best complies with financial reporting standards requires:

  • minor damage that does not affect the service potential of an asset to be expensed;
  • damage that affects the service potential of an asset, but is repairable, to be offset against any available asset revaluation reserve (and, if that is exhausted, the residual amount to be expensed);
  • damage that is so extensive it leads to an asset being written off to be expensed; and
  • the cost of repairs or reinstatement of an asset, apart from minor repairs, to be capitalised to the cost of the asset.

Insurance recoveries

The reporting of earthquake-related insurance recoveries often required careful judgement by public entities because of the complexities and uncertainties of the insurance claims process. We had to carefully consider the reasonableness of the judgements that public entities made and the evidence provided to support those judgements.

Often, the main judgement in reporting insurance recoveries was whether the amount of insurance proceeds could be determined, and whether a receivable and revenue should be recognised in the current year's financial statements. Public entities had to consider what stage claims were at, such as claims not yet completed and submitted to insurers, claims accepted by insurers but not yet quantified, and claims submitted and quantified but not yet approved by insurers.

Public entities needed good evidence to support any decisions to recognise insurance recoveries for claims part way through the insurance claims process. Where insurance recoveries were not recorded in the financial statements, public entities disclosed in the notes to the financial statements the likelihood of insurance proceeds being received in future.

The complexities and uncertainties of the insurance claims' process meant that a lot of possible insurance recoveries could not be recognised as a receivable and revenue in the same financial year as the damage to the assets was recognised. This resulted in a lot of volatility in the reported financial performance of public entities affected by the earthquakes.

For example, the carrying amount of a building might have been written off and recorded as an expense in the current financial year because it had sustained severe earthquake damage and required demolition. However, because of significant uncertainties about the amount of the insurance claim, no insurance receivable and revenue might have been recorded in that year. Therefore, an expense for the damage to the building would be recorded in the current year's financial statements and the insurance recovery revenue for the repair or reinstatement of the building would be recorded in a future financial year.

There have been some different views expressed within the New Zealand accounting profession about how insurance recoveries should be presented in financial statements. That is, whether they should be included as part of income (gross presentation) or netted off against the loss they compensate (net presentation). The different views were because of different interpretations of financial reporting standards.

In our view, presenting insurance recoveries gross in the financial statements is the treatment that best complies with the financial reporting standards. Also, a gross presentation provides transparent information to readers of financial statements about losses and related insurance recoveries arising from the earthquakes.

Valuation of physical assets

Some entities that revalue assets experienced difficulties determining the fair value of those assets because of the damage they sustained, the location of the assets, or the lack of a local property market meaning there was limited or no market evidence of fair value. In some instances, valuers were unable to estimate the fair value of earthquake-damaged buildings. In others, valuers were able to estimate the fair value of earthquake-damaged buildings, but only on an undamaged basis. Such valuations were of no use for financial reporting purposes because they did not take into account the damage sustained.

Also, where asset values were determined on a depreciated replacement cost basis, valuers had difficulties determining asset replacement costs for use in valuations because of the possibility of increased contractor demand affecting the replacement costs.

Financial statement disclosures

Public entities were generally good at communicating the financial effects of the earthquakes in their financial statements. Given the significance of the earthquakes, a certain level of disclosure was needed for those public entities to comply with financial reporting standards. The challenge was getting the right balance of information about the earthquakes to comply with standards and to give readers understandable and meaningful information.

Those public entities most severely affected by the earthquakes usually included a separate note that contained all the information about the financial implications of the earthquakes. That note included information about:

  • the damage sustained to assets (or a note that assessments had not been able to be carried out);
  • the assumptions and estimates made in accounting for damage; and
  • the insurance proceeds received or expected to be received.

Public entities with a December 2010 year-end that completed financial statements after 22 February 2011 had two separate issues to contend with. They had to reflect the effects of the 4 September 2010 earthquake and include appropriate disclosures about it and also disclose information about the nature and estimated financial effect of the 22 February 2011 earthquake. This was particularly challenging for those entities.

Timeliness of external reporting

Completing annual financial reports within statutory reporting time frames was not a priority for public entities significantly affected by the earthquakes. Some public entities, such as schools in the Christchurch City, Selwyn District, and Waimakariri District areas, were given extensions to the normal statutory reporting time frames. Where extensions were not granted, statutory time frames were sometimes missed – understandably so.

The Canterbury Earthquake Recovery Authority (CERA) was another public entity that was not required to prepare financial statements in the usual time frames. CERA was established after the 22 February 2011 earthquake (in March 2011) to support the earthquake recovery. It received approval under section 45I of the Public Finance Act 1989 to not prepare an annual report for the 30 June 2011 financial year.

Although not required to prepare financial statements for the period ended 30 June 2011, CERA will be required to report on the period from when CERA was established to 30 June 2012. Therefore, the effect of the exemption under the Public Finance Act has been to delay reporting.

In our view, although the accountability of public sector entities is important, clearly the safety and well-being of people and the re-establishment of operations are paramount.

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