Review of financial reporting by issuers - Cycle 1 [2005] NZSecCom 6 (4 August 2005)

	Home \| Databases \| WorldLII \| Search \| Feedback New Zealand Securities Commission

Report on Statement by ABN AMRO Capital (Belgium) N.V. in Freightways Limited's Prospectus

The Commission has established a financial reporting surveillance programme to review financial reporting practices of issuers. The aim is to encourage New Zealand issuers to improve the quality of their financial reporting.

In Cycle 1 of the programme the Commission reviewed the financial reports of 40 issuers. This report on the Cycle 1 Review provides market participants with the Commission's findings from this review, and gives some guidance on the Commission's expectations of disclosure by issuers.

The purpose of the Cycle 1 review was to identify the level of compliance with Financial Reporting Standards and other elements of Generally Accepted Accounting Practice and to assess the overall quality of financial reporting.

Few serious problems were identified. However, a number of issuers need to raise the standard of their financial reporting. Reports of two issuers of the 40 reviewed had serious problems and were already subject to scrutiny by other agencies. Reports of 16 issuers had some shortcomings that need to be addressed. One of these reports was referred to the Commission's enforcement staff. We wrote to the other issuers.

The Commission has been pleased with the cooperation from issuers and their willingness to improve the quality of their financial reporting.

The review also identified some inconsistencies in substantial security holder disclosures and some potential gaps or delays in continuous disclosure notices. Instances of lack of compliance with the continuous disclosure requirements of the NZX Listing Rules were also found. These matters have been referred to the NZX.

The Commission will continue its Financial Reporting Surveillance Programme and is likely to broaden its scope. Later review cycles will include reviews of disclosures and adjustments made by issuers as they move to New Zealand equivalents of International Financial Reporting Standards.

The Securities Commission is required under section 10(c) of the Securities Act 1978, "to keep under review practices relating to securities, and to comment thereon to any appropriate body".
2.

As part of its work to carry out this function the Commission has established a financial reporting surveillance programme to review financial reporting practices of public issuers.
3.

The aim of the programme is to encourage New Zealand issuers to improve the quality of their financial reporting so that:

investors can have confidence in the credibility of financial information provided by issuers; and

high quality financial reporting will contribute to the integrity of New Zealand's securities markets.

In the first cycle of the programme the Commission reviewed the financial reports of 40 issuers with balance dates from 31 March to 31 July 2004.
5.

The reports were reviewed against New Zealand Generally Accepted Accounting Practice (NZ GAAP). Financial statements comply with NZ GAAP only if they comply with:

applicable Financial Reporting Standards (FRS) approved by the New Zealand Accounting Standards Review Board; and

have authoritative support within the accounting profession in New Zealand. This includes Statements of Standard Accounting Practice (SSAP).
6.

the level of compliance with NZ GAAP by issuers in their financial statements prepared under the Financial Reporting Act 1993;

whether any breaches of GAAP identified in those financial statements were likely to cause the financial statements to not show a true and fair view, or were likely to be materially misleading to users in the context of information disclosure (for investment decision making) as envisaged under the Securities Act 1978 and therefore require enforcement action; and

Although the main focus of the review was the financial statements, other sections of the annual report and continuous disclosure notices for the period were also considered. These were not comprehensively reviewed, however any obvious issue related to continuous disclosure, substantial security holder disclosure, or auditors, was followed up.
8.

Financial reporting requires the exercise of professional judgment. The Commission took this into account when reviewing the financial reports and determining which matters to follow up.

The Commission reviewed the audited full-year financial reports of 40 companies with balance dates from 31 March to 31 July 2004. To gain a complete view of financial reporting practices we also reviewed:

The review of the wider information was to identify any inconsistencies between the various documents, which in turn helped assess the adequacy of GAAP compliance.
11.

We made further enquiries of some issuers. In some instances this was because it was not possible to assess whether FRS had been fully complied with from the information provided in the financial statements and other documents.

This report on Cycle 1 of the Commission's Review of Financial Reporting by Issuers aims to provide market participants with the Commission's findings from this review. It also provides some guidance on the Commission's expectations of disclosure by issuers.

Few serious problems were identified in the Cycle 1 review. However, the review indicates that a number of issuers need to raise the standard of their financial reporting.

Reports of two of the 40 issuers reviewed had serious problems and were already subject to scrutiny by other agencies. One issuer had received an audit report with multiple audit opinion qualifications. The other issuer had received an audit report with two fundamental uncertainty paragraphs. The Commission will monitor these entities as part of future surveillance reviews.

Reports of 16 issuers were found to have some shortcomings that need to be addressed. One of these was referred to the Commission's enforcement staff. We wrote to the other 15 issuers asking them for clarification of some matters, and/or asking them to address specific shortcomings when preparing their next financial reports.
17.

We wrote to issuers whose reporting raised at least one matter of significance. In these letters any minor matters were also drawn to their attention. We did not write to issuers whose reports raised only minor matters.
18.

A copy of the letter was sent to the issuer's auditor. Auditors have an important role in encouraging companies to comply not only with the essential requirements but also with best practice. The Commission encourages auditors to be vigilant in the audit of financial statements. High quality external auditing is critical to integrity in financial reporting. Investors rely heavily on the external assurance of an issuer's financial reporting.

Fifty-two percent of the matters raised in letters to issuers were viewed by the Commission as significant.
20.

Table 1: Outcome of matters raised in letters to issuers

Notes	Outcome	"Significant"	%	Other	%	Total	%

(1)	Resolved	3		3		6
(2)	Point taken/change agreed	13		16		29
	*Agreement reached*	16	73%	19	95%	35	83%

(3)	Second letter sent	4		1		5
(4)	Other follow-up action	2		0		2
	*Further follow-up action taken*	6	27%	1	5%	7	17%

	Total matters raised	22		20		42
	%'s	52%		48%		100%

Resolved: a satisfactory explanation was provided by the issuer on the matters raised.
(2)

Point taken / change agreed: the issuer has acknowledged the point made / agreed to make changes in the 2005 financial statements.
(3)

Second letter sent: a second letter closed the matter but reiterated the points made.
(4)

Other follow-up action: more action required, e.g. as a result of the response the matter has been referred to the NZX.
21.

Satisfactory agreement was reached with issuers on 73% of significant matters raised. Four of the remaining significant matters were reiterated in a second letter and will be monitored on an on-going basis One matter has been referred to the NZX, and one matter is still under review.

The nature of many of the matters raised with issuers suggests that issuers should consider:

whether they could pay greater attention to detail in complying with some of the ancillary financial reporting disclosures (e.g. disclosures in respect of financial instruments and related party disclosures); and

whether they could better manage some of the year end processes for finalising the annual report.
23.

In some cases the disclosures provided raised further questions prompting us to write seeking further explanation. Some of the responses explained the situation, indicating that more clarity or transparency by the issuer would have meant that we would not have had to ask the questions.
24.

One matter relating to large differences between actual and prospective information was referred to the Commission's enforcement staff. The Commission's interest is whether the original prospectus is misleading, and whether prospective financial information is correctly labelled as a forecast or a projection.
25.

an audit report which did not provide an opinion over the issuer's group financial statements; and

The intangible asset had been recognised on acquisition and we queried whether all the residual balance on acquisition should have been allocated to the intangible asset as opposed to some of it being allocated to goodwill. The Commission will continue to monitor this issuer's financial report to see whether the life and value of the intangible is being reassessed on a regular basis to determine if any provision for impairment is necessary.
27.

The issue relating to the valuation of property, plant and equipment concerned the basis of valuation used to determine fair value for a major class of assets. The issuer's disclosures suggested non-compliance with FRS-3 Property, Plant and Equipment.
28.

Section 16 of the Financial Reporting Act 1993 requires an audit report to give an opinion on the parent and group financial statements. In this instance the checking processes surrounding the production of the annual report failed to identify that the audit opinion included in the financial report covered the parent only. These processes would normally include checks of the printer's proofs and website postings by management and the auditor.
29.

The explanation for a prior period adjustment was difficult to understand. Such adjustments are rare and therefore warrant very clear explanation.

One issuer had entered into a share-based arrangement with a distributor of its product.
31.

The arrangement involved a distributor being issued share options if certain targets on product order quantities were met. Although this arrangement had been mentioned in a Continuous Disclosure Notice there was no mention of the arrangement in the issuer's financial report.
32.

When the issuer prepared its financial report there were no New Zealand FRS or SSAP that dealt directly with share-based arrangements. However, other standards would have provided authoritative support for disclosure requirements.
33.

We now have NZ IFRS 2 Share-based Payment, issued November 2004, that deals with the subject of share-based payment. Paragraph 44 says that:

"An entity shall disclose information that enables users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the period."
34.

Information about share options is relevant to investors and should have been disclosed in the issuer's next statutory financial statements.

The Commission considers that the actual versus prospective financial information (PFI) comparison disclosure requirement is important so that investors are given feedback on the relative reliability of prospective financial information, including audited reasons for variances.
36.

We found a number of instances where the financial statements included a comparison of actual and PFI. However, no explanations of major variations between PFI and actual results were disclosed as required by FRS-9 Information to be Disclosed in Financial Statements paragraph 5.4. There were also instances of errors in the labelling of columns of figures.
37.

Where an entity has published prospective financial information other than prospective financial information expressed solely in general terms, for the period of the financial report, the entity shall present a comparison of the prospective financial information previously published with the actual financial results being reported. Explanations for major variations shall be given.

The format of the Statement of Movements in Equity (SoME) in many financial reports did not appear to be compliant with NZ GAAP in that they did not disclose a total recognised revenues and expenses (TRRE) line.
39.

The SoME is a primary financial statement. FRS-2 Presentation of Financial Reports paragraph 7.1 indicates that one of the objectives of the SoME is as a measure of comprehensive income. To this end FRS-2 paragraph 7.3(a) requires disclosure of a TRRE line in the SoME. Therefore we would expect this line to be disclosed in a SoME.
40.

Although all of the components making up TRRE are disclosed in the SoME, meaning that a knowledgeable reader could calculate the figure, we believe that it is important that the TRRE figure is also disclosed.
41.

We wrote to issuers where there were multiple figures making up TRRE. However, even for other issuers where TRRE only comprises Net Surplus, best practice would be to disclose a TRRE line in the SoME.

The Commission encourages issuers to actively manage the final stages of their year end reporting process for finalising the annual report. Some reports indicate that some issuers are not well organised through the final stages of the reporting process. However, most companies do appear to successfully manage this process.
43.

The annual report, comprising the financial report and other statutory disclosures, should be reviewed before being dated and signed by the directors. Auditor sign-off should follow signing of the financial report.
44.

differences between dates for signing of the financial statements and/or annual report and the date of the security holder information; and

one unusual difference between the date of the accounts and the audit report where the latter preceded the former.
45.

Although signed by the directors a number of accounts were not dated. Both FRS-5 Events After Balance Date and relevant legislation require the financial statements and annual report be dated and signed by those authorised to do so.
46.

The differences in dates suggest that the sequence of events may need to be better managed by issuers to ensure that directors and auditors are properly reviewing the annual report in terms of their responsibilities.

Various other matters were identified which, although of lesser significance, warrant greater attention by those who prepare annual reports.

FRS-5 Events After Balance Date requires disclosure of material events that occur after balance date.
49.

In a few instances there were significant subsequent events which, in the Commission's view, should have been disclosed. Examples of these are:

non-disclosure of dividends proposed after balance date. Disclosure is required by FRS-5;

Disclosure of these events elsewhere in the annual report, such as the chairman's report, is not sufficient.

FRS-9 Information to be Disclosed in Financial Statements paragraph 6.6 requires total operating revenue to be disclosed separately.
52.

In some instances interest income had been offset against interest expense and not included in total operating revenue. The net figure had then been included as part of expenses. Therefore, the complete total operating revenue had not been disclosed as required by FRS-9.
53.

In the Commission's view, disclosure of the various components contributing to total operating revenue does not meet the FRS-9 requirement.

Entities shall disclose information from which it is possible to identify and evaluate exceptional risks of operating.

Exceptional risks can include ... dependence on a small number of suppliers or customers.
55.

This is an often overlooked accounting requirement that can provide very important information that is useful to investors. The Commission encourages issuers to more actively consider whether to include a note to their financial report covering this information.
56.

In a number of instances there should have been an exceptional risks of operating note.
57.

In some cases this type of information may be in the chairman's report or in other notes to the accounts. However, having information elsewhere in the annual report does not fulfil the FRS requirement. Information scattered throughout the notes does not assist readers to readily grasp an understanding of the exceptional risks of operating.

GAAP requires present value discounting to be used to calculate the amount of a provision - more so when the settlement of an amount is going to occur well into the future. It also requires a present value discount (passage of time) unwind when a provision has been present valued. This unwind amount is viewed as interest expense.
59.

FRS-15 Provisions, Contingent Liabilities and Contingent Assets paragraph 11.1(e) requires separate disclosure of this interest expense.
60.

In many cases where there were longer term provisions there was no separate interest disclosure. Lack of this disclosure may indicate that these entities are not calculating their longer term provisions on a present value basis, and/or not updating them over time to reflect the present value discount unwind.

There were some instances relating to accounting for independent foreign operations for which the disclosures appeared unusual or inadequate.
62.

FRS-21 Accounting for the Effects of Changes in Foreign Currency Exchange Rates outlines the accounting requirements for such operations.
63.

the relevant accounting policy for an issuer indicated that exchange differences were taken to a foreign currency translation reserve but no foreign currency translation reserve appeared in the accounts; and

no movement in the foreign currency translation reserve for the year despite there still being an independent foreign currency operation. We would have expected some movement.

Employee share ownership plan (ESOP) disclosures should include all matters required by FRS-30 Reporting Share Ownership Arrangements Including Employee Share Ownership Plans.
65.

We identified areas where disclosure of ESOP did not fully comply with the requirements of FRS-30. The areas of non-compliance were:

non-disclosure of the ESOP itself. Some companies did not disclose such information even though it is apparent from the continuous disclosure notices that such a plan existed; and

some companies provided a description of the ESOP but did not provide disclosures on matters such as the number and percentage of shares held by ESOP, classified by class of shares, the number of shares held by ESOP which has been allocated to employee(s) and the number of shares which remain unallocated.
66.

Overall, the review found that disclosure of ESOP would be more complete if all the relevant sections of FRS-30 are followed.

FRS-31 Disclosure of Information About Financial Instruments requires disclosures to be made in respect of financial instruments.
68.

The review indicated that improvements could be made in the general quality of disclosures required by this standard. Some disclosures appeared to be fairly generic and sometimes incomplete. In many instances financial instrument disclosures for the issuers reviewed appeared to not comply with some of the detailed requirements of FRS-31.
69.

the accounting policy disclosure on financial instruments did not cover the basic types of financial instruments;

a lack of interest rate sensitivity information disclosure in respect of, e.g. short-term deposits, term deposits, bank overdraft and convertible notes; and

inconsistencies between figures in the Statement of Financial Position and those in the financial instruments note.

SSAP-22 Related Party Disclosures requires disclosure of the relationships between the reporting entity and its related parties and of transactions with those parties.
71.

The adequacy and quality of disclosure by issuers could be improved. The identification and disclosure of related party transactions are material matters for investors.
72.

Disclosures made by these entities in respect of the requirements of SSAP-22 paragraph 5.1 generally require improvement. Some examples were:

a total was given for related parties as a group rather than for each related party;

a lack of detail about the identity of the related parties for which there have been transactions; and

the outstanding balance of transactions at balance date was given but no financial information was given in respect of all transactions undertaken during the year.
73.

In some cases a positive statement e.g. There are no outstanding balances with related parties would clarify a situation which is unclear from the financial report.

Mention of a matter in sections of an annual report other than the financial report is not sufficient if an FRS requires it to be disclosed in the financial report.

In the process of the review we identified some inconsistencies in the substantial security holder disclosures and some potential gaps or delays in continuous disclosure notices. The Commission expects compliance with these requirements.
76.

Section 26(1) of the Securities Markets Act 1988 requires every public issuer to publish a list of all substantial security holders recorded in the company's file kept under section 25 of the Act. The disclosure under section 26 of the Securities Markets Act must include the total number of voting securities of the public issuer as at the date of the record.
77.

Issuers should take care to ensure that they comply with the various substantial security holder information disclosure requirements.

The Commission and the NZX are co-regulators of the NZX's markets. NZX is the primary regulator concerned with compliance with the Listing Rules, and the Commission, as the statutory regulator, is concerned with the law. These co-regulatory responsibilities are set out in a published Memorandum of Understanding between the NZX and the Commission.
79.

Rule 10 of the Listing Rules defines "material" and requires immediate release of "material" information to the market.
80.

The Listing Rules are supported by the Securities Markets Act 1988 requirements relating to continuous disclosure by public issuers.
81.

A number of instances were found where there has been either a delay in notification of what appeared to be material information, or else a failure to do so. The cases related to a lack of, or late, notification of acquisitions and maiden dividends.
82.

One instance was found of non-disclosure in an annual report of an NZX waiver.
84.

The issuer had obtained a waiver from the NZX in respect of NZAX Listing Rule B4.1. The condition associated with granting of the waiver was that the issuer disclose the waiver in its annual report.
85.

The waiver that was not disclosed in the annual report concerned relief from an NZX requirement regarding a related party transaction.
86.

There are risks associated with the period prior to and during the implementation of NZ IFRS because issuers and auditors face a significant learning curve, and issuers have to manage system and process changes. Issuers will have to take account of current NZ GAAP as well as the differences that will impact their financial report under NZ IFRS GAAP.
88.

Issuers have three years within which they will be able to choose to make the switch to NZ IFRS. During this period, current NZ GAAP will co-exist with NZ IFRS.
89.

Disclosures about the impact of adopting NZ IFRS must be made by issuers prior to adopting NZ IFRS as required by FRS-41 Disclosing the Impact of Adopting New Zealand Equivalents to International Financial Reporting Standards.

The Commission will continue to review issuers' financial reporting as part of the Financial Reporting Surveillance Programme but will broaden its scope.
91.

The next review cycles will include a review of disclosures and adjustments made by issuers as they move to New Zealand Equivalents of International Financial Reporting Standards. These will include impact disclosures made prior to transition, then adjustments made to the balance sheets at the point of transition, and any other significant changes in accounting policies during this transition.
92.

The Commission will raise any identified breaches of the law with individual issuers, and take enforcement action as appropriate. This could include referral of matters to agencies such as the Ministry of Economic Development, the Accounting Standards Review Board, and the Institute of Chartered Accountants of New Zealand.

New Zealand Securities Commission

Review of financial reporting by issuers - Cycle 1 [2005] NZSecCom 6 (4 August 2005)