Directors and CEOs - Key issues to consider when reviewing your financial statements this reporting season

As we are well into the June 2017 year end reporting season, it is worth reminding ourselves of the Financial Market Authority’s (FMA) and Companies Office’s views regarding directors’ responsibilities for the financial statements, particularly that:

Directors are responsible for the quality of the financial statements, including providing useful and meaningful information for investors and other users of the financial statements and annual report.
Directors are not expected to be accounting experts, but they should seek explanation and advice supporting the accounting treatments chosen and, where appropriate, challenge the accounting estimates and treatments applied in the financial statements, and
Directors should particularly seek advice where a treatment does not reflect their understanding of the substance of an arrangement.

Being in the middle of the reporting season, this article serves as a reminder to all directors and CEOs about their responsibilities regarding their financial statements, as well as key issues to look out for when reviewing the financial statements. Although this article is aimed at directors and CEOs of Tier 1 for-profit entities, it is equally applicable to directors and CEOs of other types of entities.

Our ‘top’ key issues to consider (i.e. areas directors and CEOs commonly overlook), are as follows:

New audit reports - Key audit matters (KAMs) for listed entities
Revenue recognition
Expense deferral
Impairment testing and asset values
New transactions and agreements
Profit or loss and other comprehensive income
Major new accounting standards
Consistency of information between the Directors’ and/or Chairman’s Reports and the financial statements
Disclosure initiative (‘Decluttering’ your financial report).

These are discussed in more detail below.

New audit reports- Key audit matters (KAM) for listed entitites

For 30 June 2017 financial statements, your audit report will look different. In particular, it will include an outline of key audit matters (KAMs), which are the matters, which in the auditor’s judgement, are of most significance in the audit of the financial report for the current period. KAMs may relate to significant accounting estimates, as well as judgements about appropriate accounting policies.

Key issue 1

Ensure that KAMs involving key estimates and judgements have been clearly disclosed in the financial statements as required by NZ IAS 1 Presentation of Financial Statements, paragraphs 122 and 125. In particular, it is expected to see more detailed information disclosed regarding items subject to material estimation.

Revenue Recognition

Users of financial statements, and in particular investors and analysts, have indicated that they are particularly interested in the amount and timing of revenue recognised in the financial report.

Key issue 2

Ensure that the accounting policies adequately describe, in Plain English, how revenue is recognised so that it can easily be understood by users of the financial report. A Plain English, bespoke ‘revenue’ accounting policy will assist you in understanding the policy, and in turn ensures that revenue is recognised in accordance with currently applicable accounting standards, and the substance of the underlying transactions. To assist you in this process, we recommend you review management’s accounting papers outlining the appropriate accounting treatment for each revenue stream based on authoritative guidance in accounting standards NZ IAS 18 Revenue, NZ IAS 11 Construction Contracts and other relevant interpretations dealing with revenue recognition.

Expense Deferral

Other than when an entity prepays for a good or service in advance, NZ IAS 38 Intangible Assets only permits deferral of expenses as assets in very limited circumstances.

Key issue 3

For each new asset type on the statement of financial position, enquire which accounting standard governs its recognition (e.g. NZ IAS 2 Inventories, NZ IAS 16 Property, Plant and Equipment, NZ IAS 40 Investment Property and NZ IAS 39 Financial Instruments: Recognition and Measurement). For all other assets, ensure that they meet the recognition criteria as an intangible asset under NZ IAS 38, noting that the following cannot be capitalised:

Internally generated intangibles such as brands, mastheads and customer lists
The costs of introducing a new product or service
Selling costs
Staff training
Inefficiencies and initial operating losses incurred before the asset achieves optimum performance levels.

Impairment testing and asset values

The diagram below illustrates the appropriate accounting standards dealing with the impairment requirements for financial and non-financial assets:

Non-financial assets are often significant assets of an entity, with the value attributed to these assets affecting not only the entity’s reported financial position, but also its reported performance. Calculations to determine the recoverable amount often rely on discounted cash flows and can be complex.

Items for directors to look out for when reviewing impairment models, include ensuring that:

Cash flows and assumptions appear reasonable based on historical cash flows, economic and market conditions and funding costs
Discounted cash flows are not used to determine recoverable amount based on fair value less costs of disposal unless forecasts and assumptions that a market participant would use can be reliably estimated
Value in use calculations should assume declining growth rates in cash flows after year five
Value in use calculations should assume cash flows from the asset in its current condition, and not assume cash flows from restructuring unless the entity is committed, or from improving the asset’s performance
Value in use calculations should match cash flows with the assets in the cash-generating unit (CGU) being tested. For example, if cash flows from collecting receivables and selling inventories are included as cash inflows in the impairment model, receivables and inventories are to be included in the carrying value of CGU assets against which the recoverable amount from the impairment model is compared. Similarly, if cash outflows to settle creditors are included as cash outflows in the impairment model, creditors should be deducted from CGU assets.

Financial assets such as receivables carried at amortised cost, and available-for-sale investments with negative fair value movements recorded in other comprehensive income, also need to be tested for impairment if there are impairment indicators of the type listed in the diagram above. Even though available-for-sale (AFS) investments are recognised at fair value in the statement of financial position, any negative balance in the AFS reserve should be reclassified as an impairment loss in profit or loss if there is a ‘significant or prolonged decline in fair value’.

Key issue 4

Ensure that impairment indicators for financial and non-financial assets have been considered under the correct accounting standard (NZ IAS 36 for non-financial assets and NZ IAS 39 for financial assets).

Non-financial assets

Review management’s impairment models for all material non-current assets or cash-generating units requiring an impairment test under NZ IAS 36 Impairment of Assets (including goodwill, intangible assets with an indefinite life, and assets with impairment indicators).

You need to review management’s cash flows and assumptions, having regard to your knowledge of the business, the economic environment, the assets and future business prospects, to satisfy yourself that the recoverable amount of these assets exceed their carrying amount.

Financial assets

Ensure that impairment losses have been recognised in profit or loss for all AFS investments with negative balances in the AFS reserve that represent a significant or prolonged decline in fair value.

New transaction and agreements

While you may be familiar with the accounting treatment for last year’s transactions and balances, there is a risk that new transactions and agreements entered into during the current year are incorrectly accounted for in your June 2017 financial statements.

As directors and CEOs, you are best placed, based on your knowledge of transactions and agreements, to determine whether these transactions and agreements have been correctly accounted for.

Key issue 5

For each new significant agreement or transaction stream, review management’s accounting papers outlining the appropriate accounting treatment based on authoritative guidance in accounting standards. Examples to consider include:

Off-balance sheet arrangements - have these been appropriately consolidated or disclosed under NZ IFRS 12 Disclosure of Interests in Other Entities?
Joint arrangements - have these been appropriately accounted for as joint ventures or joint operations?
Business combinations - have these been appropriately noted as being provisionally accounted if the purchase price allocation has not been finalised?
Share-based payment arrangements - have all options granted been valued and appropriately expensed (including to KMPs, even if these are immaterial)?
Share-based payments - have shares issued under non-recourse or limited recourse loans been appropriately accounted for as de facto options?
Derivatives - have all derivatives been recognised at reporting date with fair value movements recorded in profit or loss (unless the hedge accounting requirements have been met, in which case fair value movements are recognised in other comprehensive income)?
Funding arrangements/capital raisings - have funds received been appropriately classified as debt vs equity?

Profit or loss and other comprehensive income

Users are particularly interested in earnings and therefore the statement of profit or loss and other comprehensive income. In this regard, it is important the entity appropriately calculates and presents statutory profit and (for listed entities) earnings per share (EPS).

Key issue 6

Subtotals

Review the presentation of the profit number in the statement of profit or loss and other comprehensive income, ensuring that any profit subtotals such as EBITDA are not presented in bold. It should be noted that if you present expenses ‘by function’, i.e. including cost of sales (COGS), it is not usually appropriate to present a subtotal EBITDA because some amounts for depreciation and amortisation will be included as part of COGS, meaning that describing a subtotal as EBITDA is not an accurate description of the relevant line item.

Diluted EPS (listed entities)

Also ensure that EPS has been correctly computed, particularly diluted EPS for the effect of dilutive options. Entities with losses do not have diluted EPS as the impact of any dilutive options would be, in fact, antidilutive. Also note that the effect of out-of-the-money options on diluted EPS is also antidilutive and therefore is not disclosed. In-the-money options only impact diluted EPS to the extent of the number of shares that would be issued for no consideration.

Reclassifying items of OCI

Ensure that gains on disposal of items subject to revaluation or fair value adjustments in other comprehensive income (OCI) are correctly accounted for, for example:

Revaluation surpluses on PPE remain in OCI, or are transferred to retained earnings but are not recycled through profit or loss, and
Available-for-sale reserves are recycled and recognised in profit or loss in period of disposal (with the reversal appearing in OCI for the period).

Major new accounting standards

Directors of Tier 1 entities should be mindful of the disclosure requirements when an entity has not applied a new NZ IFRS standard that has been issued but is not yet effective (NZ IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, paragraphs 30-31). The entity is required to disclose known or reasonably estimable information relevant to assessing the possible impact that application of the new NZ IFRS will have on the entity’s financial statements in the period of initial application.

As at 30 June 2017, the following are the major NZ IFRS that have been issued but are not yet effective:

NZ IFRS 9 Financial Instruments

The main impacts of NZ IFRS 9 are that:

There are strict tests that must be met for financial assets to be measured at amortised cost, so in future some financial assets will be measured at fair value through other comprehensive income (certain debt instruments only) or fair value through profit or loss
The new ‘expected loss’ impairment model is more forward looking and will replace the existing ‘incurred loss’ model where a credit event (or impairment ‘trigger’) needs to occur before credit losses are recognised
Hedge accounting may be easier to achieve for certain entities.

NZ IFRS 15 Revenue from Contracts with Customers

The core principle of NZ IFRS 15 is to recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. NZ IFRS 15 introduces a five-step revenue model to determine when to recognise revenue and at what amount.

NZ IFRS 16 Leases

NZ IFRS 16 introduces a single lessee accounting model (all leases, finance and operating leases, will be accounted for in the same way) and requires a lessee to recognise assets and liabilities for all leases. A lessee will now be required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

NZ IFRS 17 Insurance Contracts

NZ IFRS 17 will replace NZ IFRS 4 Insurance Contracts and requires all insurance contracts to be accounted for in a consistent manner, making financial statements more comparable for users. Insurance obligations will be accounted for using current values, instead of historical cost.

NZ IFRS 17 will generally not apply to normal trading entities that have entered into insurance contracts for assets and other business purposes. It will only apply to insurance companies and entities issuing insurance and reinsurance contracts and holding reinsurance contracts.

Key issue 7

These new NZ IFRSs come into effect over the next two to four years. You should therefore ensure that the notes to your June 2017 financial statements disclose the impact on the future financial position and results. Please note the following when reviewing these disclosures:

Directors should not be making statements to the effect that there will be no impact (or no material impact) for a particular standard unless your transition assessment is complete and your auditors are satisfied with your analysis
If you have completed your assessments for particular standards, listed companies have continuous disclosure obligations to keep the market informed, and as such, the notes should quantify the impacts if transition date has passed, and
If transition assessments are still ongoing, with particular transaction streams or balances having been identified but the impacts not quantified, a narrative description is still expected of the types of transactions and balances impacted, as well as whether earnings and net assets are likely to increase or decrease.

NZ IFRIC 23 Uncertainty over Income Tax Treatments

It is also worth noting that the New Zealand Accounting Standards Board recently issued NZ IFRIC 23, which could result in significant increases in current tax liabilities for entities with transfer pricing and other uncertain tax positions. Although its recent release means there is unlikely to be expectation from regulators or users to quantify the impacts in your June 2017 financial report, you will need to consider whether this interpretation could have a potential impact in future and disclose narrative information accordingly.

Consistency of information between the directors' and/or chairman's reports and the financial report

While not technically part of the audited financial statements, directors are nevertheless responsible for preparing the ‘other information’ contained in the Directors’ Report and/or Chairman’s report.

This ‘other information’ should be consistent with amounts recognised, measured and disclosed in the financial statements. Audit reports for 30 June 2017 for the first time will include a section on ‘other information’. Any material inconsistencies identified between the ‘other information’ and the financial statements that have not been rectified will be described in the audit report (ISA (NZ) 720 The Auditor’s Responsibility Relating to Other Information).

Key issue 8

Ensure that all discussion and analysis in the Directors’ and/or Chairman’s Reports is consistent with the way transactions and balances have been recognised, measured and disclosed in the financial statements. For example

Discussion of a poorly performing asset in the Directors’ and/or Chairman’s Reports should trigger an impairment test and relevant disclosures in the financial statements regarding assumptions used in determining recoverable amount, or
The number of segments disclosed in the segment note should generally correspond with the number of business units whose results are analysed in the Directors’ and/or Chairman’s Reports. We would usually only expect to see more business units than segments if they meet the criteria in NZ IFRS 8, paragraph 12, for aggregating operating segments into fewer reportable segments, and details of the judgements made in applying the aggregation criteria have been disclosed.

Disclosure Initiative ('Decluttering' your financial report)

In line with the FMA’s expectations that directors are responsible for the quality of the financial report, including providing useful and meaningful information for investors and other users of the financial report, entities are encouraged to ‘declutter’ their financial statements and apply judgement when deciding which mandatory disclosures are relevant to users, and which are not.

Key issue 9

Review all accounting policies and ensure:

All redundant accounting policies are deleted
Accounting policies are written in Plain English and tailored to suit your entity’s circumstances, and
Disclosures carried forward from years gone by are deleted if they do not provide useful information relating to current transactions and balances.

To make the financial report even more user-friendly, you may also want to consider:

Moving accounting policies relating to specific transactions and balances into those respective notes (e.g. revenue into the revenue note, PPE into the PPE note, etc.)
Moving disclosures about key estimates and assumptions into the relevant note, and
Re-ordering and grouping notes.

The above recommendations will not only assist users’ understanding of the financial report, but will enable a more efficient and effective process for your own reviews.

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