Common errors in presentation of financial statements – Part 2

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 the standard which sets out key principles around presentation of the four primary financial statements, and is intended to assist users of financial statements in understanding the performance of that entity.

Any common error in applying NZ IAS 1 is by its nature likely to cause a user to either be misled, or to be provided with insufficient information to make economic decisions, particularly in respect of investing in that entity. Although NZ IAS 1 does not contain any direct guidance on measurement of accounting transactions, many of the potential common errors can lead to users being misled. This in turn results in preparers and auditors opening themselves up to significant criticism and potential litigation.

In our May Accounting Alert article on this topic, we discussed common errors relating to the following aspects of NZ IAS 1:

  1. The need to include four primary statements in a financial report
  2. The layout of those primary reports
  3. The need to include notes to support those primary statements
  4. The need to include comparatives
  5. The need to have the third balance sheet for Tier 1 reporters when there is retrospective restatement
  6. Key guidance as to going concern
  7. Key guidance on disclosing estimates and judgements
  8. Requirement to refer to the accounting framework
  9. Requirement to provide additional disclosures where specific disclosure requirements in accounting standards are insufficient
  10. Offsetting

This month we highlight common errors made when classifying assets and liabilities as current or non-current, and next month we will conclude our  NZ IAS 1 common errors series with a discussion on financial statement disclosures.

Common error 1 – Incorrectly classifying assets as ‘current assets’ when not held for the purpose of trading

In order to present a more favourable financial position to users of financial statements, including to meet bank covenants and other key performance indicators, many entities may be motivated to attempt to include as many assets as possible within current assets when they are NOT primarily held for the purpose of trading.

An entity shall classify an asset as current when:

  1. it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle;
  2. it holds the asset primarily for the purpose of trading;
  3. it expects to realise the asset within twelve months after the reporting period; or
  4. the asset is cash or a cash equivalent (as defined in NZ IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

An entity shall classify all other assets as non-current.

NZ IAS 1, paragraph 66

An asset shall be classified as current when it satisfies any of the following criteria:

  1. It is expected to be realised in, or is held for sale or consumption in, the entity’s normal operating cycle;
  2. It is held primarily for the purpose of being traded;
  3. It is expected to be realised within twelve months after the reporting date; or
  4. It is cash or a cash equivalent (as defined in PBE IPSAS 2 Cash Flow Statements), unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date.

All other assets shall be classified as non-current.

PBE IPSAS 1, paragraph 76

This common error involves entities incorrectly classifying assets such as investments in shares as current assets when they are not held for trading.

Common error 2 - Presenting an asset as current when the entity does NOT intend to sell or consume it within the next 12 months

Again, this common error may include wrongly classifying investments in shares as current assets where it is not intended to sell these items in the next 12 months.

It may also apply to the presentation of inventory, receivables and work-in-progress (being capitalised time costs for professional services firms) where realisation is not likely to occur in the next 12 months.

A further example would be receivables with extended credit terms, including retention amounts invoiced on construction contracts.

Similar misclassification may also occur in respect of prepayments, deposits, rental bonds etc. where these will not be released in the next 12 months.

An entity shall classify an asset as current when:

  1. it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle;
  2. it holds the asset primarily for the purpose of trading;
  3. it expects to realise the asset within twelve months after the reporting period; or
  4. the asset is cash or a cash equivalent (as defined in NZ IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

An entity shall classify all other assets as non-current.

NZ IAS 1, paragraph 66

An asset shall be classified as current when it satisfies any of the following criteria:

  1. It is expected to be realised in, or is held for sale or consumption in, the entity’s normal operating cycle;
  2. It is held primarily for the purpose of being traded;
  3. It is expected to be realised within twelve months after the reporting date; or
  4. It is cash or a cash equivalent (as defined in PBE IPSAS 2 Cash Flow Statements), unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date.

All other assets shall be classified as non-current.

PBE IPSAS 1, paragraph 76

Common error 3 – Presenting restricted ‘cash’ as a current asset

In a number of cases, an entity may be required to place cash on deposit to secure borrowings or some sort of guarantee. If this cash is not accessible for 12 months, it cannot be shown as a current asset.

The presentation of an asset as a current asset when it is non-current can lead to a material misstatement in the financial statements. These common errors are likely to result in users arriving at the wrong conclusion about the entity’s liquidity position and risks associated with the entity becoming insolvent, or having to secure expensive finance, raise dilutive share capital, or to dispose of assets at a discount.

NZ IAS 1 (PBE IPSAS 1 for PBEs) is the standard that sets out very clear rules in respect of which assets are classified as current. If these rules are broken it is likely error accusations will follow – particularly if the entity does subsequently have liquidity issues.

An entity shall classify an asset as current when:
…..

  1. the asset is cash or a cash equivalent (as defined in NZ IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

Extract of NZ IAS 1, paragraph 66

An asset shall be classified as current when it satisfies any of the following criteria:

  1.  It is cash or a cash equivalent (as defined in PBE IPSAS 2 Cash Flow Statements), unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date.

All other assets shall be classified as non-current.

Extract of PBE IPSAS 1, paragraph 76

Common error 4 - Presenting current liabilities as non-current

Back where it all began!

Failure to comply with NZ IAS 1’s (PBE IPSAS 1 for PBEs) clear rules about which liabilities are current can lead to material misstatements.

An entity shall classify a liability as current when:

  1. it expects to settle the liability in its normal operating cycle;
  2. it holds the liability primarily for the purpose of trading;
  3. the liability is due to be settled within twelve months after the reporting period; or
  4. it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period (see paragraph 73). Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification.

An entity shall classify all other liabilities as non-current.

NZ IAS 1, paragraph 69

A liability shall be classified as current when it satisfies any of the following criteria:

  1. It is expected to be settled in the entity’s normal operating cycle;
  2. It is held primarily for the purpose of being traded;
  3. It is due to be settled within twelve months after the reporting date; or
  4. The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date (see paragraph 84). Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification.

All other liabilities shall be classified as non-current.

PBE IPSAS 1, paragraph 80

Common error 5 – Classification of liabilities where the original loan was for a period greater than 12 months but the loan is now repayable within 12 months

A common area when classifying liabilities occurs where the original loan was for a term greater than 12 months but with the passage of time, the loan is now due for repayment within 12 months. At the outset these loans would be correctly classified as non-current, but preparers often forget to reclassify these as current liabilities when settlement is due within 12 months.

An entity classifies its financial liabilities as current when they are due to be settled within twelve months after the reporting period, even if:

  1. the original term was for a period longer than twelve months, and
  2. an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are authorised for issue.

NZ IAS 1, paragraph 72

PBE IPSAS 1, paragraph 83

Common error 6 – Classification of liabilities as non-current when agreement to approve refinancing is only agreed after the reporting date

The decision as to whether a loan is current or non-current is made at the reporting date (end of the reporting period). This means that loans cannot be classified as non-current at reporting date when they are due to be settled within 12 months from reporting date.

The fact that subsequent to the reporting date there is agreement with a financier to refinance the loan, does not impact the classification of the loan at the end of the reporting period.

An entity classifies its financial liabilities as current when they are due to be settled within twelve months after the reporting period, even if:

  1. the original term was for a period longer than twelve months, and
  2. an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are authorised for issue.

NZ IAS 1, paragraph 72

PBE IPSAS 1, paragraph 83

Common error 7 - Presenting a loan as non-current where loan covenants are in breach at reporting date

An entity must present a liability as current if, at the reporting date, it does not have an unconditional right to defer repayment for 12 months. This NZ IAS 1/ IPSAS 1 requirement is particularly relevant where an entity, at the reporting date, has breached a borrowing covenant, allowing the lender to demand repayment.

The liability is current even if the lender has subsequent to the reporting date, agreed to waive the breach.

When an entity breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current, even if the lender agreed, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach. An entity classifies the liability as current because, at the end of the reporting period, it does not have an unconditional right to defer its settlement for at least twelve months after that date.

NZ IAS 1, paragraph 74

When an entity breaches an undertaking under a long-term loan agreement on or before the reporting date, with the effect that the liability becomes payable on demand, the liability is classified as current, even if the lender has agreed, after the reporting date and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach. The liability is classified as current because, at the reporting date, the entity does not have an unconditional right to defer its settlement for at least twelve months after that date.

PBE IPSAS 1, paragraph 85

 

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