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Financial reporting surveillance programme Cycle 2 [2006] NZSecCom 1 (20 February 2006)

Last Updated: 10 November 2014

Financial Reporting Surveillance Programme

REVIEW OF FINANCIAL REPORTING BY ISSUERS
CYCLE 2

20 February 2006

TABLE OF CONTENTS

• EXECUTIVE SUMMARY
• INTRODUCTION
• RESULTS OF THE REVIEW
• FOLLOW-UP FROM CYCLE 1
• INTERNATIONAL FINANCIAL REPORTING STANDARDS
• ONGOING REVIEW AND ENFORCEMENT

EXECUTIVE SUMMARY

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 with balance dates from 31 March to 31 July 2004. The Commission published a report on Cycle 1 in August 2005.

In Cycle 2 the Commission reviewed the financial reports of 46 issuers with balance dates from 31 December 2004 to 31 March 2005. The purpose of the Cycle 2 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.

This report on the Cycle 2 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.

Cycle 2 findings were similar to Cycle 1 results in that few serious problems were identified, but a number of issuers need to raise the standard of their financial reporting. Reports of 19 issuers of the 46 reviewed had matters that need to be addressed. We wrote to these issuers.

Some of the matters found were:

• large differences between actual and prospective information in one instance;
• inadequate actual versus prospective financial information comparisons and explanation;
• lack of a total recognised revenues and expenses line in the Statement of Movements in Equity;
• failure to date and/or sign the financial statements;
• apparent overstatement of value of a property intended for sale; and
• disclosure of an intangible under a separate heading in addition to current and non-current assets.

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 directors' and officers' relevant interests and substantial security holder disclosures that required us to write to issuers and security holders. Some non-disclosure of NZX waivers were identified and referred to the NZX.

The Commission will continue its Financial Reporting Surveillance Programme. The financial reports of early adopters of New Zealand equivalents of International Financial Reporting Standards with a 31 December 2005 balance date will be reviewed early in 2006. This will be part of the Commission's plan to review disclosures and adjustments made by issuers as they move to NZ IFRS.

INTRODUCTION

Financial Reporting Surveillance Programme

1. 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 Financial Reporting Act 1993 requires issuers to prepare financial statements that comply with New Zealand Generally Accepted Accounting Practice (NZ GAAP) and give a true and fair view of the matters to which they relate.
4. The aim of the Commission's programme is to encourage New Zealand issuers to improve the quality of their financial reporting so that:
   1. issuers' financial report disclosures are clear and comprehensive;
   2. investors can have confidence in the credibility of financial information provided by issuers; and
   100. high quality financial reporting will contribute to the integrity of New Zealand's securities markets.

Cycle 2 Review of Financial Reporting by Issuers

5. In the second cycle of the programme the Commission reviewed the financial reports of 46 issuers with balance dates from 31 December 2004 to 31 March 2005.
6. The reports were reviewed against NZ GAAP. Financial statements comply with NZ GAAP only if they comply with:
   1. applicable Financial Reporting Standards (FRS) approved by the New Zealand Accounting Standards Review Board; and
   2. where there are no such standards, accounting policies that:
      1. are appropriate to the circumstances of the reporting entity; and
      2. have authoritative support within the accounting profession in New Zealand. This includes Statements of Standard Accounting Practice (SSAP).
7. The purpose of the review was to form a view on:
   1. the level of compliance with NZ GAAP by issuers in their financial statements prepared under the Financial Reporting Act 1993;
   2. 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
   100. the overall quality of financial reporting practices by issuers.
8. 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, although any obvious issue related to continuous disclosure, directors' and officers' relevant interests disclosure or substantial security holder disclosure was followed up.
9. 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.

Background and Work Undertaken

10. The Commission reviewed the audited full-year financial reports of 46 companies with balance dates from 31 December 2004 to 31 March 2005. To gain a complete view of financial reporting practices we also reviewed:
    1. financial information in any current prospectuses;
    2. substantial security holder information;
    100. continuous disclosure notices; and
    4. sections of the annual reports (e.g. the chairman's report).
11. 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.
12. The selection of 46 issuers was made up of:
    1. 35 issuers listed on the NZX;
    2. 5 issuers listed on the NZAX;
    100. 1 issuer whose shares are traded on Unlisted, and
    4. 5 other non-listed issuers.
13. We made further enquiries of some issuers. In some instances this was because it was not possible to assess whether NZ GAAP had been fully complied with from the information provided in the financial statements and other documents.

Purpose of this Report

14. This report on Cycle 2 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.

RESULTS OF THE REVIEW

15. Few serious problems were identified in the Cycle 2 review as was the case with Cycle 1. However, the review indicates that a number of issuers need to raise the standard of their financial reporting.
16. Most of the identified issues can be remedied by greater attention to detail in respect of the requirements of NZ GAAP.

Follow-up Action

17. Reports of 19 issuers were found to have matters that the Commission considers should be addressed. Letters were sent to these 19 issuers asking them to clarify some matters, and/or to address specific shortcomings when preparing their next financial reports.
18. The Commission's approach is to write to those issuers whose reporting raises matters of significance. In these letters any minor matters were also drawn to their attention. We view a matter as "significant" if further clarification or information is needed.
19. 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 statutory 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.

Outcome of Matters Raised

20. Thirty-six percent of the matters raised in letters to issuers were viewed by the Commission as significant. This compares with fifty-two percent for Cycle 1.
21. Table 1 on page 8 outlines the outcome of matters raised with issuers.

Notes to the Table
(1)

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 or 2006 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. the need for subsequent correspondence to seek answers to follow-up questions.

22. The significant matters that came up several times in Cycle 2 related to:
    1. the format of the Statement of Movements in Equity - lack of a total recognised revenues and expenses line (6 instances);
    2. failure to date and/or sign the financial report (4 instances); and
    100. inadequate actual versus prospective financial information comparison (3 instances).

These matters are explained further below.

23. Satisfactory agreement was reached with issuers on 83% of significant matters raised. Three of the remaining four significant matters were reiterated in a second letter and will be monitored on an on-going basis. One matter is still under review.
24. There was a reasonable degree of similarity between matters found in Cycle 1 and Cycle 2.
25. It is acknowledged that Cycle 2 issuers did not have the benefit of being able to read the Cycle 1 report before preparing their financial statements. The Cycle 1 report is expected to provide a guide for issuers with balance dates after its publication.

Significant Findings

Financial reporting disclosures

26. The nature of many of the matters raised with issuers suggests that issuers should 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).
27. In some cases the disclosures provided raised questions which prompted the Commission to seek further explanation. Some of the responses explained the situation, indicating that the questions would not have been raised if there had been more clarity or transparency by the issuer in the original disclosure.
28. One issuer reported large differences between actual and prospective financial information. The Commission's interest is in:
    1. the basis for the projections;
    2. the basis for the prospective financial information included as a comparison in the year end financial report; and
    100. inconsistencies in labelling of prospective financial information between the prospectus and the annual report.

Debt versus equity classification

29. One issuer was asked why a financial instrument had been classified as equity.
30. There is debate within the accounting profession about whether certain financial instruments, e.g. preference shares and convertible notes are debt or equity.
31. The debate has been refocused because of available overseas GAAP in this area, and the move towards adoption of NZ IFRS.
32. The Commission believes that best practice, in accordance with NZ GAAP, is for many of these instruments to be re-classified as debt.
33. The Commission expects issuers to be guided by GAAP when issuing new instruments, and to review any pre-existing arrangements and their current accounting treatment for such instruments in the light of any new GAAP.

Format of the Statement of Movements in Equity

34. The format of the Statement of Movements in Equity (SoME) in many financial reports did not comply with NZ GAAP in that they did not disclose a total recognised revenues and expenses (TRRE) line.
35. 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 this line should be disclosed in a SoME.
36. Although all of the components making up TRRE are disclosed in the SoME, meaning that a knowledgeable reader could calculate the figure, the Commission believes that it is important that the TRRE figure is also disclosed.
37. Six issuers had multiple figures making up TRRE. However, even for other issuers where TRRE only comprises Net Surplus, best practice is to disclose a TRRE line in the SoME.
38. This issue is easy to remedy and issuers will be able to adjust the format of the SoME in future financial reports where this is necessary.

Actual versus Prospective Financial Information comparison

39. The Commission considers that the actual versus prospective financial information (PFI) comparison disclosure requirement is important to give investors feedback on the relative reliability of prospective financial information, including reasons for variances which are subject to audit. This disclosure is not optional.
40. In a number of instances either the financial statements did not include a comparison of actual or PFI when this would be required, or no explanations of major variations between PFI and actual results were disclosed. Inclusion of a comparison and explanations is required by FRS-9 Information to be Disclosed in Financial Statements paragraph 5.4.
41. FRS-9 says:

5.4

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.

Dating and signing of financial statements and annual reports

42. During both this and the previous Cycle reviews the Commission observed that many financial statements and/or annual reports do not meet the Financial Reporting Act and Companies Act 1993 sign-off and dating requirements. These sign-offs are important because they indicate that the directors have reviewed all the material in those documents, and inform investors of the date on which the parts of the document were signed.
43. The Commission encourages issuers, as a matter of best practice, to date the various components of the annual report (the financial statements, the Chairman's report, the Chief Executive's report, and any substantial security holder information) as well as dating the report as a whole.
44. The date of the annual report might be later than the date and signing of the financial statements because of the need to assemble and include other annual report material. For example, substantial security holder information must be recorded as at a date not earlier than 3 months before the annual report is sent out (under section 26(1) of the Securities Markets Act 1988).
45. Auditors have a responsibility to ensure that there is no other information in the annual report that conflicts materially with the financial statements (paragraph 14 of Auditing Standard AS-518 as issued by the New Zealand Institute of Chartered Accountants). As required by paragraph 15 of AS-518, either the auditor arranges to see other material before they sign the audit report or else the guidance in paragraphs 28-33 is followed where the other annual report material is produced after the auditor signs the audit report.

Other significant matters followed up with issuers

46. Other significant matters followed up with issuers were:
    1. an apparent overstatement of value of a property intended for sale.
       
       Despite the existence of a sale agreement and price the carrying value of a property intended for sale was being maintained at a higher figure. An explanation for the lack of a write-down in the value of the asset was sought from this issuer.
    2. disclosure of an intangible under a separate heading in addition to current and non-current assets.
       
       The intangible asset had been disclosed under a separate heading in the Statement of Financial Position of an issuer and not under current assets or non-current assets. FRS-2 (para. 8.5) states that the Statement of Financial Position shall separately disclose Current Assets and Non-current Assets, it does not anticipate any other asset groupings.

Other Matters

47. Various other matters were identified which, although of lesser significance, warrant greater attention by those who prepare annual reports. Most of the matters are similar to those matters identified during Cycle 1. More details on these matters are available in the Cycle 1 Report of August 2005.

FRS-3

48. A range of matters relating to revalued property, plant and equipment were identified. Examples of these are:
    1. non-disclosure of the name of the valuer;
    2. misleading disclosure regarding the transfer of revaluation deficits to retained earnings upon disposal; and
    100. incorrect inclusion of a revaluation movement as part of the unrealised net change in the value of investment properties line item.

Employee share ownership plans

49. Employee share ownership plan (ESOP) disclosures should include all matters required by FRS-30 Reporting Share Ownership Arrangements Including Employee Share Ownership Plans.
50. As in the Cycle 1 review, areas where disclosure of ESOP did not fully comply with the requirements of FRS-30 were identified in this review.
51. Where issuers have an ESOP they need to ensure that their financial statements fully comply with the requirements of FRS-30.

Financial instruments

52. FRS-31 Disclosure of Information About Financial Instruments requires disclosures to be made in respect of financial instruments.
53. The findings were largely similar to results from Cycle 1. 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.
54. Examples of findings in respect of financial instrument disclosures were:
    1. the accounting policy disclosure on financial instruments did not cover the basic types of financial instruments;
    2. a lack of interest rate sensitivity information disclosure in respect of, e.g. short-term deposits, term deposits, bank overdraft and convertible notes; and
    100. disclosures not being given in the parent accounts for financial transactions between the parent and its subsidiaries.

Disclosure about related parties

55. SSAP-22 Related Party Disclosures requires disclosure of the relationships between the reporting entity and its related parties and of transactions with those parties.
56. Similar to Cycle 1 the adequacy and quality of disclosure by issuers could be improved. The identification and disclosure of related party transactions are material matters for investors.
57. Most of the matters identified in this area related to the inadequacy of disclosures in respect of transactions between the parent entity and its subsidiaries and associates. For example:
    1. a lack of detail about the identity of the related parties for which there have been transactions
    2. a total was given for related parties as a group rather than for each related party; and
    100. the outstanding balance of transactions at balance date were not given.
58. SSAP-22 requires full disclosure of such transactions in the parent company accounts even though it acknowledges that eliminated group transactions are not required to be disclosed in the group accounts (SSAP-22, para. 4.17).

Miscellaneous

59. Other comments raised for issuers to consider as part of the preparation of their future financial statements were:
    1. the need to provide reasons for an accounting policy change (FRS-1, para. 5.11);
    2. disclosure of a total operating revenue figure (FRS-9, para. 6.6);
    100. consideration be given to disclosing exceptional risks of operating (FRS-9, para. 8.14);
    4. appropriate inclusion and clarity of disclosure for cash flows from investing;
    5. further disclosure in respect of contingent rental payments; and
    6. calculation and disclosure of the interest unwind on a longer term provision (FRS-15, para. 8.2). The interest unwind occurs where discounting has been used and the carrying amount of a provision increases each period to reflect the passage of time. The increase is an interest expense.

Market Matters

60. The Commission raised several matters relating to disclosures in respect of directors and officers relevant interests, substantial security holder information, and waivers.
61. Most matters in respect of directors' and officers' interests and substantial security information disclosures have been resolved.

Directors' and officers' relevant interests disclosures

62. Section 19T of the Securities Markets Act 1988 requires directors and officers of a public issuer who have a relevant interest in a security of the issuer to disclose that interest to the NZX and in the interests register of the public issuer.
63. Details of new entries in a public issuer's interest register are then required to be disclosed in the issuer's annual report.

Substantial security holder information

64. The review identified some inconsistencies in the substantial security holder disclosures. The Commission expects compliance with these requirements.
65. 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.
66. Issuers and substantial security holders should take care to ensure that they comply with the various substantial security holder information disclosure requirements.

NXZ waivers

67. During Cycle 2 two instances were found of non-disclosure in an annual report of an NZX waiver.
68. The issuers had obtained waivers from the NZX in respect of NZX Listing Rules. The condition associated with the granting of these waivers was that the issuers disclose the waiver in their annual report.
69. These matters have been referred to the NZX.
70. The non-disclosure of a waiver identified during Cycle 1 was considered by the NZX Regulation (NZXR) who decided that the matter was not sufficiently serious to put to NZX Discipline. However, the NZXR decided not to provide relief in the form of a retrospective waiver to correct previous mistakes, and has required that the issuer seek shareholder ratification of the matter at the issuer's next annual meeting.
71. The NZXR has reminded issuers that waivers subject to conditions will be void if the conditions are not adhered to.

FOLLOW-UP FROM CYCLE 1

72. The Commission continues to monitor the reports of two issuers reviewed in Cycle 1 that had serious problems.
73. Matters identified in Cycle 1 relating to two other issuers are still being investigated.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

74. Issuers have three years within which they will be able to choose to make the switch to NZ IFRS.
75. As part of its surveillance programme the Commission will review NZ IFRS financial statements of a selection of issuers during this period. The first reviews will be of NZ IFRS financial statements relating to the reporting period ended 31 December 2005.
76. The aim of these early reviews is to provide feedback to the Commission on the early implementation of NZ IFRS and enable the Commission, where appropriate, to be able to provide feedback to later appliers of NZ IFRS. The Commission will seek to maintain an appropriate balance between education and enforcement during the initial adoption of NZ IFRS.
77. 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. These disclosures will be reviewed as part of the programme.

ONGOING REVIEW AND ENFORCEMENT

78. The Commission will continue to review issuers' financial reporting as part of the Financial Reporting Surveillance Programme and to take any appropriate steps to encourage compliance with Financial Reporting Standards and other elements of GAAP.

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