Common errors in presentation of financial statements – Part 1

NZ IAS 1 Presentation of Financial Statements for Tier 1 and Tier 2 for-profit entities (or PBE IPSAS 1 Presentation of Financial Statements which is the equivalent standard for Tier 1 and Tier 2 public benefit entities (PBEs)) is perhaps the most overlooked accounting standard.

The standard sets out a number of key principles around disclosure, all of which are intended to assist a user of a set of financial statements in understanding the performance of that entity. Any common error in application of NZ IAS 1 (PBEs - PBE IPSAS 1) is by its nature likely to cause a user to either be misled, or to be provided with insufficient information to make an economic decision, particularly in respect of investing in that entity.

NZ IAS 1 (PBEs - PBE IPSAS 1) sets out amongst other things:

The need to include four primary statements in the financial statements
The layout of those primary statements
The need to include notes to support those primary statements
The need to include comparatives
The need to have the third balance sheet when there is retrospective restatement for Tier 1 for -profit entities
Key guidance as to going concern
Key guidance on disclosing estimates and judgements
Requirement to refer to the accounting framework
Requirement to provide additional disclosures where specific disclosure requirements in accounting standards are insufficient
Offsetting
Classification of assets and liabilities as current and non-current, and
Disclosures relating to the primary statements.

Although NZ IAS 1 (PBEs - PBE IPSAS 1) does not contain any direct guidance on measurement of accounting transactions, many of the potential common errors can lead to users being misled and preparers and auditors opening themselves up to significant criticism and potential litigation.

Due to the number of potential common errors that can occur when applying these ‘easy’ standards, in this article we will focus on common errors occurring in 1. to 10. above, and will follow next month with more common errors arising from applying NZ IAS 1 (PBEs - PBE IPSAS 1).

Common error 1 - Not including all four primary financial statements

NZ IAS 1, paragraph 10 (PBE IPSAS 1, paragraph 21) describes a complete set of financial statements as including all four primary financial statements, being:

NZ IFRS	PBE Standards
The statement of profit or loss and other comprehensive income	The statement of comprehensive revenue and expense;
The statement of financial position (referred to also in this article as ‘balance sheet’)	The statement of financial position;
The statement of cash flows	The cash flow statement
The statement of changes in equity	The statement of changes in net assets/equity

If the entity is claiming compliance with NZ IAS 1 or PBE IPSAS 1, all four primary financial statements must be included.A common error occurs among entities that previously reported under Old GAAP, where many preparers think that including a cash flow statement is optional.

A complete set of financial statements comprises:

(a) a statement of financial position as at the end of the period;

(b) a statement of profit or loss and other comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period;

(e) notes, comprising significant accounting policies and other explanatory information;

(ea) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A; and

(f) a statement of financial position as at the beginning of the preceding period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements in accordance with paragraphs 40A–40D.

An entity may use titles for the statements other than those used in this Standard. For example, an entity may use the title ‘statement of comprehensive income’ instead of ‘statement of profit or loss and other comprehensive income’.

NZ IAS 1, paragraph 10

A complete set of financial statements comprises:

(a) A statement of financial position;

(b) A statement of comprehensive revenue and expense;

(c) A statement of changes in net assets/equity;

(d) A cash flow statement;

(e) When the entity makes publicly available its approved budget, a comparison of budget and actual amounts either as a separate additional financial statement or as a budget column in the financial statements;

(f) Notes, comprising significant accounting policies and other explanatory notes; and

(g) Comparative information in respect of the preceding period as specified in paragraphs 53 and 53A. An entity may use titles for the statements other than those used in this Standard.

PBE IPSAS 1, paragraphs 21 and 22

Common error 2 - Not including comparatives

In a number of situations, an entity may find that it requires an audit for the current financial year, but was not required to produce audited financial statements in the past. For example, the company may exceed the ‘large’ size threshold test in the Financial Reporting Act 2013 for the first time, and may find itself now requiring an audit, or it may be planning an IPO or have new shareholders that require an audit.

If the entity wants to comply with accounting standards, particularly NZ IAS 1 (PBEs - PBE IPSAS 1), it must show comparatives, and include at least:

Two statements of financial position
Two statements of profit loss or other comprehensive income
Two statements of cash flows
Two statements of changes in equity, and
Related notes.

Except when NZ IFRS permits or requires otherwise, an entity shall present comparative information in respect of the preceding period for all amounts reported in the current period’s financial statements. An entity shall include comparative information for narrative and descriptive information if it is relevant to understanding the current period’s financial statements.

NZ IAS 1, paragraph 38

An entity shall present, as a minimum, two statements of financial position, two statements of profit or loss and other comprehensive income, two separate statements of profit or loss (if presented), two statements of cash flows and two statements of changes in equity, and related notes.

NZ IAS 1, paragraph 38A

Except when a PBE Standard permits or requires otherwise, an entity shall present comparative information in respect of the preceding period for all amounts reported in the financial statements. An entity shall include comparative information for narrative and descriptive information if it is relevant to understanding the current period’s financial statements.

PBE IPSAS 1, paragraph 53

An entity shall present, as a minimum, one statement of financial position with comparative information for the preceding period, one statement of comprehensive revenue and expense with comparative information for the preceding period, one cash flow statement with comparative information for the preceding period and one statement of changes in net assets/equity with comparative information for the preceding period, and related notes.

PBE IPSAS 1, paragraph 53A

Common error 3 - Not showing a third balance sheet when there is retrospective restatement for for-profit Tier 1 entities

Another clear requirement in NZ IAS 1, paragraph 10(f) that often results in a common error is forgetting to include the third balance sheet (statement of financial position) when a Tier 1 for-profit entity has made retrospective restatements in its financial statements, either because of a:

Voluntary change in accounting policy,
Prior period error, or

Reclassification of items in the prior year’s statement of financial position.

A complete set of financial statements comprises:

(a) a statement of financial position as at the end of the period;

(b) a statement of profit or loss and other comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period;

(e) notes, comprising significant accounting policies and other explanatory information;

(ea) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A; and

NZ IAS 1, paragraph 10

NZ IAS 1 does provide some relief in these scenarios for Tier 1 entities, which means that:

The third balance sheet need only be disclosed where the retrospective application has a material effect on the information in the third balance sheet (paragraph 40A), and
A three column note format for the balance sheet is not required for all balance sheet items included in the third balance sheet. Only information about the amended items in the third balance sheet need to be disclosed, which can be provided via the relevant NZ IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors disclosures (paragraph 40C)

An entity shall present a third statement of financial position as at the beginning of the preceding period in addition to the minimum comparative financial statements required in paragraph 38A if:

it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial statements or reclassifies items in its financial statements; and
the retrospective application, retrospective restatement or the reclassification has a material effect on the information in the statement of financial position at the beginning of the preceding period.

NZ IAS 1, paragraph 40A

When an entity is required to present an additional statement of financial position in accordance with paragraph 40A, it must disclose the information required by paragraphs 41–44 and NZ IAS 8. However, it need not present the related notes to the opening statement of financial position as at the beginning of the preceding period.

NZ IAS 1, paragraph 40C

Perhaps the easiest way for users to be placed on alert as to the retrospective adoption of a new accounting policy or a retrospective restatement (error) or reclassification in the financial statements is the presentation of a third balance sheet. Therefore failing to show a third balance sheet can easily result in users being misled. Users may perform a flawed analysis of key performance issues, failing to adjust for restatements, and most importantly, failing to recognise the reduction in the entity’s previously reported profits.

Common error 4 - Not disclosing material uncertainty about going concern

Although much of the guidance on going concern is contained within Auditing Standard, ISA (NZ) 570 Going Concern, NZ IAS 1 (PBEs - PBE IPSAS 1) is the accounting standard that requires full disclosure about uncertainties around going concern. Without any disclosure of the existence of uncertainty, a user could reasonably argue that they invested in the entity, or did business with the entity, on the basis that there was no uncertainty as to its ability to continue as a going concern.

Going concern

When preparing financial statements, management shall make an assessment of an entity’s ability to continue as a going concern. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern.

NZ IAS 1, paragraph 25

When preparing financial statements, an assessment of an entity’s ability to continue as a going concern shall be made. This assessment shall be made by those responsible for the preparation of financial statements. Financial statements shall be prepared on a going concern basis unless there is an intention to liquidate the entity or to cease operating, or if there is no realistic alternative but to do so. When those responsible for the preparation of the financial statements are aware, in making their assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, those uncertainties shall be disclosed. When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the financial statements are prepared and the reason why the entity is not regarded as a going concern.

PBE IPSAS 1, paragraph 38

Common error 5 - Not disclosing key judgements where uncertainty regarding going concern was considered but determined that there is no uncertainty

There is usually judgement involved in determining whether there is material uncertainty as to an entity’s ability to continue as a going concern.

If the conclusion from this analysis is that there is no significant uncertainty, and therefore not required to be disclosed under NZ IAS 1, paragraph 25 or PBE IPSAS 1, paragraph 38 (refer common error 4 above), because it was a ‘close call’, and does represent a key judgement, this fact should be disclosed.

If the entity subsequently gets into distress, users may reasonably claim they were misled if it was not bought to their attention that it was a ‘close call’ as to whether material uncertainty existed about the entity’s ability to as a going concern.

Sources of estimation uncertainty

An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:

(a) their nature, and

(b) their carrying amount as at the end of the reporting period.

NZ IAS 1, paragraph 125

An entity shall disclose in the notes information about (a) the key assumptions concerning the future, and (b) other key sources of estimation uncertainty at the reporting date, that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:

(a) Their nature; and

(b) Their carrying amount as at the reporting date.

PBE IPSAS 1, paragraph 140

Common error 6 – Tier 2 entities incorrectly claiming compliance with IFRS and NZ IFRS (or PBE Standards)

Although NZ IAS 1 and PBE IPSAS 1 requires an explicit statement for compliance with IFRS[1] or PBE Standards, such a statement will not be appropriate for Tier 2 Entities who have elected to comply with the Reduced Disclosure Regime (RDR).

An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes. An entity shall not describe financial statements as complying with IFRSs unless they comply with all the requirements of IFRSs.

NZ IAS 1, paragraph 16

An entity whose financial statements comply with Public Benefit Entity Standards (PBE Standards) shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with PBE Standards unless they comply with all the requirements of PBE Standards.

PBE IPSAS 1, paragraph 28

In the case of financial statements prepared by applying RDR, these do not comply with all of the disclosure requirements of IFRS and NZ IFRS and therefore the IFRS and NZ IFRS compliance statement is not appropriate.

Common error 7 - Not providing additional disclosures where specific disclosure requirements are insufficient

The disclosure requirements for specific transactions and events is included in the various accounting standards dealing with specific topics and this is all that most entities would generally include in the notes to their financial statements. However, sometimes this disclosure is not enough, and more information about a particular transaction or balance needs to be disclosed to achieve fair presentation.

In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable NZ IFRSs. A fair presentation also requires an entity:

….

(c) to provide additional disclosures when compliance with the specific requirements in NZ IFRS is insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

Extract of NZ IAS 1, paragraph 17

In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable PBE Standards. A fair presentation also requires an entity:

….

(c) to provide additional disclosures when compliance with the specific requirements in PBE Standards is insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

Extract of PBE IPSAS 1, paragraph 29

Common error 8 - Justify the application of inappropriate accounting policies

Another common error occurs where an entity tries to justify an inappropriate accounting treatment by either merely disclosing a different accounting policy, or by including additional notes in the financial statements showing the impact of the correct policy which has not been recognised and measured in the financial statements.

For example, some entities are still in denial about the need to record all derivative assets and liabilities on their balance sheet in respect of interest rate swaps or forward foreign exchange contracts entered into for non-speculative hedging purposes. Simply disclosing the fact that had NZ IAS 39 Financial Instruments: Recognition and Measurement (or the equivalent PBE IPSAS 29 Financial Instruments: Recognition and Measurement for PBE entities) been complied with, a derivative asset/liability of $xxxx would have been recognised does not mean NZ IAS 1 (PBEs - PBE IPSAS 1) has been complied with.

An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting policies used or by notes or explanatory material.

NZ IAS 1, paragraph 18

Inappropriate accounting policies are not rectified either by disclosure of the accounting policies used, or by notes or explanatory material.

PBE IPSAS 1, paragraph 30

Common error 9 – Not referring to the NZ Framework when no guidance contained in for profit accounting standards

In preparing financial statements that comply with accounting standards, preparers must comply with the NZ Framework. This may result in assets not being recognised where a specific standard is silent on the issue. For example, intangible assets such as (internally generated) customer relationships and employee relationships cannot be recognised as an asset because they fail the ‘control’ test set out in the NZ Framework.

Similarly, this is a key requirement in considering whether the transaction that gave rise to an asset or liability was part of a linked transaction.

When the accrual basis of accounting is used, an entity recognises items as assets, liabilities, equity, income and expenses (the elements of financial statements) when they satisfy the definitions and recognition criteria for those elements in the NZ Framework.

NZ IAS 1, paragraph 28

Common error 10 – Offsetting

A common error occurs where entities incorrectly offset assets and liabilities or income and expenses.

Certain key performance ratios can be significantly impacted by balance sheet or income statement presentation and NZ IAS 1, paragraph 32 (PBE IPSAS 1, paragraph 48) specifically prohibits this offsetting.

An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an NZ IFRS.

NZ IAS 1, paragraph 32

Assets and liabilities, and revenue and expenses, shall not be offset unless required or permitted by a PBE Standard.

PBE IPSAS 1, paragraph 48

Common error 11 – Reporting periods not equal to 12 months

In certain circumstances, a set of financial statements may cover a period that is shorter or longer than a year (12 months). This is typically the case where an entity is newly incorporated or decides to change its year end.

In order to understand trends and performance against the prior period, users need to know the duration of the period covered, i.e. they should be able to ‘compare apples with apples’. If the period covered is shorter or longer than 12 month, NZ IAS 1 (PBEs – PBE IPSAS 1) requires this be clearly disclosed together, with the reason for this.

An entity shall present a complete set of financial statements (including comparative information) at least annually. When an entity changes the end of its reporting period and presents financial statements for a period longer or shorter than one year, an entity shall disclose, in addition to the period covered by the financial statements:

(a) the reason for using a longer or shorter period, and

(b) the fact that amounts presented in the financial statements are not entirely comparable.

NZ IAS 1, paragraph 36

Financial statements shall be presented at least annually. When an entity’s reporting date changes and the annual financial statements are presented for a period longer or shorter than one year, an entity shall disclose, in addition to the period covered by the financial statements:

(a) The reason for using a longer or shorter period; and

(b) The fact that comparative amounts for certain statements such as the statement of comprehensive revenue and expense, statement of changes in net assets/equity, cash flow statement, and related notes are not entirely comparable.

PBE IPSAS 1, paragraph 66

For more on the above, please contact your local BDO representative.

[1] The New Zealand Additional Disclosures Standard – FRS-44, paragraph 5 – also requires a Tier 1 reporter to make an explicit and unreserved statement of compliance with NZ IFRS