Financial reporting surveillance programme. Review of financial reporting by issues cycle 13 [2011] NZSecCom 1 (1 March 2011)

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

EXECUTIVE SUMMARY ............................................................................................................ 1

INTRODUCTION .......................................................................................................................... 3

CYCLE 13 FINDINGS................................................................................................................... 4

Scope and issuer selection ............................................................................................. 4

Overall comments on Cycle 13...................................................................................... 4

Specific comments on Cycle 13 findings ...................................................................... 7

Segment reporting ................................................................................................................... 7

Financial instruments............................................................................................................. 9

Investment property valuation assumptions ........................................................................ 10

Goodwill impairment disclosures ......................................................................................... 10

Description of non-audit services provided.......................................................................... 11

Market matters............................................................................................................. 11

Directors’ interests and share dealings ................................................................................ 11

Substantial security holders.................................................................................................. 12

Auditors’ reports ................................................................................................................... 12

CONCLUSION ............................................................................................................................. 13

LOOKING AHEAD ..................................................................................................................... 13

APPENDIX 1: BACKGROUND TO THE SECURITIES COMMISSION’S FINANCIAL REPORTING SURVEILLANCE PROGRAMME................................................................... 14

The Commission’s Financial Reporting Surveillance Programme ......................... 14

New Zealand Generally Accepted Accounting Practice ........................................... 15

Selecting issuers............................................................................................................ 15

Identifying matters and taking action ........................................................................ 16

The Financial Reporting Surveillance Programme (FRSP) encourages high-quality financial reporting that will enhance the credibility of issuers’ financial information and thus strengthen investor confidence.

Our FRSP report informs directors, chief financial officers, other financial statement preparers, auditors and financial analysts on what the New Zealand Securities Commission considers could, and should, be improved. The Commission’s Cycle 13 finds improved compliance in some areas of NZ IFRS. However, there remain areas for issuers to focus on in preparing their financial reports.

These include a continuing need for greater transparency. Ensuring stakeholders and investors are fully informed about all areas of their investment is vital. Issuers must ensure they provide clear, concise and transparent financial reports, which are easily understood.

We wrote to 16 of the 20 issuers whose reports were reviewed, mainly about segment reporting and financial instrument disclosures.

None of the matters dealt with warranted Commission enforcement action or referral to any other body.

Issuers should provide a level of disclosure consistent with the core principle of NZ IFRS 8

Operating Segments. This enables financial statement users to evaluate the nature and financial effects of business activities and the economic environment in which they operate.

Issuers need to be aware of what segment information conveys about the structure of their organisation’s activities and segment performance. They should take the opportunity NZ IFRS 8 offers them to communicate how various components of their entity operate, particularly where the business is complex.

A good set of financial instrument disclosures is essential for user understanding of the issuer’s exposure to, and risk associated with, its financial instruments. Recent amendments to reporting standards require disclosure about re-valued financial assets and liabilities. Issuers must include a breakdown showing the extent to which valuations are linked to market prices. They must also reveal the underlying assumptions for valuations not directly based on market prices.

The Commission will continue to monitor compliance with segment reporting and the fair- value hierarchy disclosures NZ IFRS 7 Financial Instruments: Disclosures requires.

The Commission also proposes to focus on disclosures relating to alternative performance measures.

1. This report sets out findings from Cycle 13 of the Commission’s ongoing Financial Reporting Surveillance Programme (FRSP). It covers 20 issuers with a balance date of 31 March 2010.

2. Appendix 1 sets out the programme’s background, including how the Commission selects issuers for review and deals with issues it identifies.

3. The report informs directors, chief financial officers and other financial statement preparers, auditors and financial analysts on financial reporting areas the Commission considers could and should be improved.

4. Although it primarily encourages improvements in financial reporting, the FRSP can result in enforcement action. If we identify a matter warranting enforcement, it is removed from the FRSP and treated as an enforcement matter. That was unnecessary in this cycle.

(a) segment reporting disclosures – in particular, whether all appropriate business segments had been disclosed;

(b) financial instruments – in particular, on inadequate disclosure of concentrations of credit risk by security type and fair-value assumptions.

Notes	Table 1: Outcome of matters raised Outcome	Matters raised ¹	%
(1)	Resolved	13
(2)	Point taken/change agreed	17
	*Agreement reached*	30	97%
(3)	Second letter sent	1
(4)	Other follow-up action	0
		1	3%
	Total matters raised	31	100%

(2) Point taken/change agreed: the issuer acknowledged the point made and/or agreed to make changes in subsequent financial statements.

(3) Second letter sent: a second letter reiterated the points made and closed the matter.

(4) Other follow-up action: more action required eg a written request for answers to further questions; or referral to another body, such as the National Enforcement Unit of the Companies Office, for consideration of enforcement action.

¹Matters raised exclude instances where the Commission wrote directly to audit firms and/or directors of issuers.

9. Table 2 compares statistics from previous FRSP cycles with Cycle 13 results. Under NZ IFRS, the Commission has written to more issuers and raised, on average, more issues per issuer than under previous NZ GAAP². We would like to see this situation improve.

Cycle #	NZ GAAP	Number of issuers reviewed	Number of issuers we wrote to	Issuers written to %	Matters raised	Matters per issuer written to
1	Previous NZ GAAP	40	15	38%	22	1.5
2	Previous NZ GAAP	46	19	41%	24	1.3
3	Previous NZ GAAP	45	19	42%	27	1.4
4	Previous NZ GAAP	40	17	43%	27	1.6
5	Previous NZ GAAP	40	16	40%	19	1.2
6	Previous NZ GAAP	30	20	67%	37	1.9
7	Previous NZ GAAP/NZ IFRS	44	17	39%	29	1.7
8	NZ IFRS	40	35	88%	97	2.8
9	NZ IFRS	24	17	71%	31	1.8
10	NZ IFRS	20	17	85%	50	2.5
11	NZ IFRS	24	20	83%	34	1.7
12	NZ IFRS	21	17	81%	39	2.3
13	NZ IFRS	20	16	80%	31	1.9

²Previous NZ GAAP is the financial reporting regime existing in NZ prior to the implementation of NZ IFRS.

11. NZ IFRS 8 Operating Segments became applicable for issuers whose equity and debt securities are traded (or to be traded) in a public market for periods beginning on or after 1 January 2009. Cycle 13 focused on the application of NZ IFRS 8.³The Commission believes issuers should provide a level of disclosure consistent with the core principle of NZ IFRS 8:

An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates.

12. Consistent with its FRSP policy, the Commission makes enquiries when it is unclear if the reportable and/or operating segments and related disclosed information are appropriate. This is more likely to occur when:

• the titles and responsibilities of the management or executive management team imply an organisational structure that is not reflected in the operating segments;

• the board of directors is identified as the chief operating decision-maker (CODM) when the directors are non-executive and said to be responsible for strategy rather than operating decisions;

* The majority of Matters Raised in relation to segment reporting and financial instruments disclosures relate to recent changes in the corresponding standards.

³Also see article “What are you communicating” by Lay Wee Ng in The Chartered Accountants’ Journal

• financial statements fail to disclose factors used to identify reportable segments, including the basis on which the entity is organised;

• it is unclear whether the aggregation and/or quantitative criteria set out in the accounting policies or in NZ IFRS 8 were met in determining the reportable segments;

• only one reportable segment is reported, but the issuer seems diverse, with various businesses or products/services, or significant operations in various places;

• the disclosures in other parts of the annual report or in prospectuses show business segments not disclosed in the financial statements; or

• the commentary in the narrative report focuses on non-NZ IFRS measures but the segment disclosures are based on NZ IFRS amounts.

13. In Cycle 13, the Commission wrote to five issuers for clarification or information about their segment disclosures, particularly :

• the factors used to identify reportable segments, including the basis on which the entity is organised, the basis for identifying its CODM and the information the CODM was receiving and reviewing internally;

• whether the aggregation and/or quantitative criteria set out in the accounting policies or in NZ IFRS 8 were met in determining the reportable segments;

• whether further segmentation would have let financial statements users better evaluate the nature and financial effects of the entity’s business activities and the economic environment it operates in;

• when the board of directors was identified as the CODM and they were non- executive and said to be responsible for strategy rather than operating decisions, as emphasised by NZ IFRS 8;

• when a financial institution’s impairment losses were not allocated to identified segments; and

• when only one segment was reported, notwithstanding that the issuer appeared to be diverse with various businesses or products/services, or significant operations in various places.

(a) one revised its operating-segment information, identifying another segment and explaining that the CODM is made up of the board’s executive members;

(b) one agreed to review its reporting as its business evolved to the next stage;

15. It is important for issuers to keep reviewing and revising their segment information as the nature of their business activities and their operational structure change.

16. Issuers need to be cognisant of the message segment information conveys about how the business is structured by management for allocating resources and assessing performance. The Commission urges issuers to take the opportunity NZ IFRS 8 offers to communicate this information, particularly where the business is complex.

17. Financial instruments include financial assets and financial liabilities. Financial assets include cash, shares in other entities, trade receivables and derivatives that are “in the money”. Financial liabilities include trade payables, loans received and derivatives that are “out of the money”. NZ IFRS 7 Financial Instruments: Disclosures and NZ IAS 32 Financial Instruments: Presentation sets out the disclosure and presentation requirements for financial instruments.

18. These disclosures are important because they allow users to assess the impact and various risks of an entity’s financial instruments.

19. Matters raised in this area seldom relate to just one aspect of financial instruments.

Our view is that the absence of, or errors in, disclosures related to aspects of an entity’s financial instruments usually mean the disclosures, taken as a whole, are inadequate. A good set of disclosures in this area can provide a “high-definition” picture of an issuer’s involvement with financial instruments.

20. Our Cycle 11 and 12 reports highlighted the need for issuers in financial institutions providing mezzanine finance to consider providing quantitative information on concentrations of loans by security type. In Cycle 13, we wrote to one finance company about this. The company prospectus had provided such an analysis but not its financial statements. The issuer agreed to provide the analysis in future financial statements.

21. All issuers should consider whether financial information presented in prospectuses should be updated or commented on in ongoing financial reporting. If the information was considered important enough to be in the prospectus, it is probably important enough to include in ongoing financial reporting.

22. In response to the global financial crisis, the International Accounting Standards Board (IASB) amended IFRS 7. The amendments include requiring entities with financial instruments that have been measured at fair value to classify and disclose them based on a fair-value hierarchy.

23. The hierarchy gives users more information about the relative reliability of inputs to fair-value measurements, and has the following levels:

(a) Level 1: fair values have been based on quoted prices (unadjusted) in an active market for identical assets or liabilities;

(b) Level 2: fair values have been based on inputs, other than quoted prices included in Level 1, which are observable for the asset or liability, either directly (ie as prices) or indirectly (ie derived from prices); and

(c) Level 3: fair values have been based on inputs for the asset or liability that are not based on observable market data (unobservable inputs).

24. The hierarchy complements disclosures that NZ IFRS 7 requires in paragraph 27:

... the methods and, when a valuation technique is used, the assumptions applied in determining fair values of each class of financial assets or financial liabilities. For example, if applicable, an entity discloses information about the assumptions relating to prepayment rates, rates of estimated credit losses, and interest rates or discount rates.

25. Assets or liabilities falling under Level 2 or Level 3 are valued using a valuation technique. Therefore, where entities hold material balances of such assets or liabilities they must disclose the actual underlying inputs and assumptions used in the valuation techniques.

26. In Cycle 13, we wrote to an issuer with material financial assets and liabilities in Level 3 of the hierarchy. The issuer disclosed information on the valuation technique used but not details of actual underlying assumptions. The issuer agreed that in its next set of financial statements it would disclose key variables used, including information on interest rates, commodity-forward rates and volatility assumptions.

27. Often issuers will engage third parties to value their Level 2 and Level 3 financial instruments. In this case, issuers need to ensure they have enough information on the techniques used and assumptions applied to meet their financial reporting requirements.

28. The Commission will continue to monitor disclosures in this area. So it is in issuers’

interests to ensure they meet the greater transparency NZ IFRS 7 requires. Investment property valuation assumptions

29. NZ IAS 16 Property, plant and equipment (paragraph 77(c)) requires that, where items of property, plant and equipment are stated at revalued amounts, entities must disclose “the methods and significant assumptions applied in estimating the items’ fair values”.

30. In this cycle, we wrote to one issuer asking that it enhance disclosure of significant assumptions for investment property revaluations in its next financial statements.

31. In previous cycles we have raised the issue of greater disclosure of significant assumptions for investment property revaluations. We see a noticeable improvement in the level and type of disclosures by many issuers. We will continue to raise this with issuers where disclosures are inadequate.

32. Under NZ IFRS 3 Business Combinations, goodwill from a business combination is calculated as the excess of the consideration paid over the identifiable net assets

⁴See article in the December 2009 issue of the New Zealand Institute of Chartered Accountants’ Journal by Lay

33. Under NZ IAS 36 Impairment of Assets, CGUs to which goodwill is allocated must be tested for impairment at least annually, and when there is an indicator of impairment.⁵

This involves calculating the recoverable amount of the CGU, usually using a discounted cash-flow model, based on the future profitability of the CGU.

34. We remind issuers that growth rates used in a value-in-use calculation cannot reflect any estimated cash inflows and outflows expected to arise from future restructurings or from improving or enhancing the asset’s performance for a particular division.

35. NZ IAS 36 (paragraph 33(b)) states that, in measuring value-in-use, an entity shall:

...base cash flow projections on the most recent financial budgets/forecasts approved by management, but shall exclude any estimated future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing the asset’s performance. [emphasis added]

36. We wrote to three entities about their disclosure of non-audit services from their auditors. We note that, while entities usually disclose fees paid to auditors by the prescribed categories, some do not describe the nature of those services as NZ IAS 1

37. These disclosures are important as they increase the transparency of the auditor-issuer relationship, enabling annual report readers to judge the degree of independence between auditors and issuers.

38. The Companies Act 1993 (section 148(1)) requires directors with a relevant interest in any shares the company issues to disclose the number and class of these shares, and the nature of the relevant interest, and ensure the information is entered in the interests register. If a director acquires or disposes of an interest in such shares, he/she must disclose certain information to the board and ensure it is entered in the interests register (section 148(2)).

39. In Cycle 13, the Commission wrote to three issuers about this. In one case, failure to file the required notices was due to issuer oversight. In another, we reiterated that we would expect the issuer’s corporate governance policies on directors’ and officers’ disclosures, and on the trading of units by directors and officers, to cover directors’ and officers’ obligations under the Securities Markets Act. The third issuer agreed to make required disclosures in its next annual report.

40. None of the matters in relation to directors’ interests and share dealings were material or required enforcement action.

41. The Securities Markets Act 1988 (section 35F) requires public issuers that are also companies to send certain information on their substantial security holders (SSH) to every shareholder. This may be sent with or in the annual report or by notice under the Companies Act 1993 (section 209). Issuers are required to disclose only information based on the SSH notices they have received.

42. In Cycle 13, the Commission wrote to three issuers about their disclosures in this area:

43. None of the matters raised with these three issuers about SSH disclosures were material or required enforcement action.

44. The Commission wrote to two auditors about disclosure in their respective audit reports that they had no relationship with the issuers or any of their subsidiaries other than in their capacity as auditor. In both cases, the issuers’ financial statements made the necessary disclosures about the nature of the relationship and the amounts involved. However, the audit reports omitted the disclosures.

45. The Financial Reporting Act (section 17) and the New Zealand Institute of Chartered Accountants Auditing Standard AS-702 The Audit Report on an Attest Audit (paragraphs 25(e) and 30) require auditors to identify in their audit report the existence and nature of any other relationship between them and the entity.

46. In one case, it was unclear from the financial statements whether work carried out by the auditor constituted “other assurance services”; the auditor confirmed that it was. Another case was resolved by the auditor agreeing to provide better disclosures in future.

47. The Commission considers it important for auditors and issuers to ensure clear disclosure of all fees paid to their auditor. There must be transparency in the types of services (other than audit services) and related fees paid to an issuer’s auditor. The provision of other services, particularly when the amounts involved are large in relation to an auditor’s total fees, could compromise an auditor’s independence in carrying out audit work.

48. Cycle 13 indicates improved compliance in some areas of NZ IFRS. However, this report highlights segment reporting and financial instruments disclosures as areas needing improvement.

49. The Commission will continue to monitor compliance with NZ IFRS 8 and the NZ IFRS 7 fair-value hierarchy disclosures.

50. The Commission also proposes to focus on disclosures about alternative performance measures.

APPENDIX 1: BACKGROUND TO THE SECURITIES COMMISSION’S FINANCIAL REPORTING SURVEILLANCE PROGRAMME

1. The Securities Commission is the main regulator of the New Zealand securities market. Our purpose is to strengthen investor confidence and foster capital investment in New Zealand by promoting the efficiency, integrity and cost-effective regulation of our securities markets.

2. The Commission regards quality financial reporting by issuers⁶to be fundamental to the fairness, efficiency and transparency of New Zealand’s securities markets.

3. Section 10(c) of the Securities Act 1978 requires the Securities Commission “to keep under review practices relating to securities, and to comment thereon to any appropriate body”.

4. As part of this function, the Commission established an ongoing Financial Reporting

Surveillance Programme (FRSP) in 2004, its first cycle review taking place in 2005.

5. The FRSP aims to encourage New Zealand issuers to improve the quality of their financial reporting so that:

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

6. The FRSP involves reviewing selected issuers’ financial statements. At the end of each cycle the Commission publicly reports on this surveillance work by providing market participants with a summary of its findings. Copies of reports for all cycles are available on the Commission’s website www.seccom.govt.nz

(a) In relation to an equity security or debt security, or to an advertisement, investment statement, prospectus, or registered prospectus that relates to an equity security or a debt security, or to a trust deed that relates to a debt security, the person on whose behalf any money paid in consideration of the allotment of the security is received:

(b) In relation to a participatory security, or to an advertisement, investment statement, prospectus, or registered prospectus, or to a deed of participation that relates to a participatory security, the manager:

advertisement that relates to such an interest, the contributory mortgage broker:

(d) In relation to a unit in a unit trust, or to an advertisement, investment statement, prospectus or registered prospectus that relates to such a unit, the manager:

(e) In relation to a life insurance policy, or to an advertisement, investment statement, prospectus, or registered

prospectus that relates to a life insurance policy, the life insurance company that is liable under the policy:

(f) In relation to an interest in a superannuation scheme, or to an advertisement, investment statement, prospectus, or registered prospectus that relates to such an interest, the superannuation trustee of the scheme.

7. The Financial Reporting Act 1993 requires issuers to prepare financial statements that comply with New Zealand Generally Accepted Accounting Practice (NZ GAAP) and provide a true and fair view of the matters to which they relate⁷.

8. The Commission reviews issuers’ financial statements against NZ GAAP. For the purpose of the Financial Reporting Act, financial statements and group financial statements comply with NZ GAAP only if those statements comply with:

(b) in relation to matters for which no provision is made in applicable financial reporting standards and that are not subject to any applicable rule of law, accounting policies that:

9. The Financial Reporting Act defines “applicable financial reporting standard” to mean an approved financial reporting standard that applies to a reporting entity (or group) and to an accounting period (or interim accounting period) in accordance with a determination of the Accounting Standards Review Board (ASRB) for the time being in force or any election made under section 27 of the Financial Reporting Act. All issuers are required to apply NZ IFRS in the preparation of their financial statements for annual accounting periods commencing on or after 1 January 2007.

(a) the level of issuer compliance with NZ GAAP in financial statements prepared under the Financial Reporting Act;

(b) whether any breach of NZ GAAP identified in those financial statements is likely to cause the financial statements to not show a true and fair view, or be materially misleading to users in the context of information disclosed for investment decision-making under the Securities Act, and therefore require enforcement action; and

11. The FRSP aims to review all issuers listed on NZX Limited (NZX) at least once during a three-to-four-year period.

⁷Part II of the Financial Reporting Act 1993 (section 11) requires every ‘reporting entity’ to prepare financial statements that comply with generally accepted accounting practice and to provide any additional information required to ensure those statements are a true and fair view of the matters to which they relate.

Part I, Section 2 of the Financial Reporting Act 1993 defines a reporting entity as : (a) An issuer; or

12. Dual and overseas-listed issuers may also be selected. Overseas-listed issuers are issuers domiciled or incorporated outside New Zealand that have a recognised stock exchange as the home exchange and are also listed on NZX.

13. Dual-listed issuers are issuers incorporated in Australia that are on the Australian

14. When dual- and overseas-listed issuers are selected, the Commission first writes to the regulator in the overseas jurisdiction to determine whether a review of the issuer’s financial reporting has already been undertaken locally. If it has, the Commission does not review it. When the issuer has not been reviewed by the overseas regulator, the Commission reviews the annual report, NZX announcements and, if applicable, the current prospectus. Where appropriate, findings are communicated to the overseas regulator. If the Commission communicates a significant matter about an issuer to an appropriate overseas regulator and the overseas regulator proposes to take no action, the Commission will write directly to the overseas or dual-listed issuer about the matter.

15. Issuers trading on the Unlisted⁸exchange and issuers not listed on any exchange may be also included in cycle reviews.

16. Issuers may be selected on the basis of criteria determined by the Commission: on areas of particular risk affecting the issuer; the sector the issuer is in at the time of selection; and/or their balance dates. Issuers can also be reselected for a later review when the issues identified in an earlier cycle raised concerns.

17. The Commission reviews an issuer’s annual report when reviewing its financial statements and, in the case of listed issuers, this includes a review of any NZX announcements for the period and any relevant prospectuses. While NZX announcements are not comprehensively reviewed, any market matters relating to continuous disclosure, disclosure of relevant interests by directors and officers, and substantial security holder disclosure are followed up where necessary.

18. Matters identified in the review are referred to as matters raised⁹or other matters.

19. Matters raised are those that are important or where further clarification or information is needed. The Commission is likely, for example, to write to an issuer where a matter:

⁸Unlisted is an unregistered securities trading facility; it is not a registered stock exchange or authorised securities exchange under the Securities Markets Act 1988. Unlisted provides a facility for trading previously allotted securities.

⁹Prior to Cycle 6, the Commission referred to matters raised as significant matters.

20. Financial reporting requires the exercise of professional judgement. The Commission takes this into account when reviewing financial statements and determining which matters to follow up.

21. The Commission writes to an issuer requesting additional information, and in some cases asks the issuer to revise or enhance disclosures in future financial statements.

22. When writing to an issuer about matters raised, the Commission includes other matters the review raises in relation to that issuer. Other matters are miscellaneous matters the Commission considers could be better disclosed.

23. The Commission’s policy is to not write to an issuer whose financial statements raise only other matters unless these are so numerous that it is useful to give the issuer feedback. In this respect, the Commission is mindful of the FRSP’s educative role.

24. When the Commission writes to an issuer, a copy of the letter is also sent to the issuer’s auditor. This practice acknowledges the role of auditors in maintaining and improving the standard of financial reporting. It also alerts an auditor to the particular aspects of its client’s financial statements that concerns the Commission.

25. 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 when auditing financial statements. High-quality external auditing is critical to the integrity of financial reporting, and to the efficiency and integrity of the securities markets.

26. Where a matter may have significant market impact, it is removed from the FRSP and considered separately as an enforcement matter.

27. Referrals are also made to appropriate bodies when the FRSP identifies matters as a breach of: