Part 4: The financial reporting environment

Local government: Results of the 2010/11 audits.

In this Part, we comment on:

Changes in the financial reporting environment

We have expressed concerns in the past about the ongoing suitability of New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) for many entities in the local government sector. Our concerns were prompted, in part, by expected changes to NZ IFRS (because of proposed changes to the underlying International Financial Reporting Standards IFRS) that would make it more difficult for many local government entities to apply them. Some of those changes are happening although at a slower pace than we expected and more changes are envisaged.

At the end of 2008, our concerns led to the then Auditor-General withdrawing staff from the standard-setting process, and, in June 2009, publishing a discussion paper entitled The Auditor-General's views on setting financial reporting standards for the public sector. Since that paper was published, we have seen meaningful debate about how financial reporting standards are set. Change is under way.

We hope that, by raising concerns, we have helped to influence changes to the Financial Reporting Act 1993 concerning the External Reporting Board (XRB), previously the Accounting Standards Review Board (ASRB). Since 1 July 2011, those changes have led to the XRB getting responsibility for preparing and issuing financial reporting standards, among other responsibilities. The XRB has set up two sub-boards. One of these, the New Zealand Accounting Standards Board (NZASB), is tasked with preparing and issuing financial reporting standards.

These changes are a positive step. They position the XRB to make changes to the financial reporting standards to be applied by different types of reporting entities, including all local government entities. As a result of these changes, the Auditor-General has made staff available to the new standard-setting process, and a staff member has been appointed to the NZASB.

The legislative changes require the XRB to draft a strategy for establishing different tiers of financial reporting for different classes of entities, and to submit the strategy for Ministerial approval by 31 March 2012. The purpose of this requirement is to ensure that the financial reporting requirements that apply to different classes of entities are appropriate.

The XRB began consulting on proposals for its draft strategy in September 2011, when it published three papers:22

  • Accounting Standards Framework: A Multi-Standards Approach, a position paper;
  • Accounting Standards Framework for General Purpose Financial Reporting by Public Benefit Entities, a consultation paper; and
  • Accounting Standards Framework for General Purpose Financial Reporting by For-Profit Entities, a further consultation paper.

The position paper sets out the XRB's view that the country should adopt a multi-standards approach to financial reporting because such an approach is likely to best meet the information needs of those who use financial statements. We fully support an approach that focuses on users' information needs.

The position paper explains how the XRB formed the view that there should be a multi-standards approach. The view is based on feedback about a discussion document that the ASRB issued in September 2009 about a proposed new accounting and assurance standards framework for general purpose financial reporting.

The multi-standards approach sets a broad strategic shape to the new accounting standards framework. However, the NZASB needs to establish at a detailed level what that means to different categories of reporting entity, to ensure that all entities report appropriately. The XRB's two consultation papers set out proposals for different tiers of reporting entities and the broad proposals for the financial reporting requirements for those different tiers. We comment below on the proposals as they relate to local government entities.

Implications for entities in the local government sector

The consultation paper about accounting by public benefit entities proposes three tiers. Public benefit entities in the local government sector would be allocated to tiers depending on their operating expenditure and the nature of their accountability. The operating expenditure thresholds would be:

  • for tier 1, more than $30 million;
  • for tier 2, between $2 million and $30 million; and
  • for tier 3, less than $2 million.

Tier 1 would include some public benefit entities based on the nature of their accountability, regardless of their operating expenditure. Those entities include leviers of coercive revenue (such as small local authorities) and issuers (which include a few local authorities).

The financial reporting requirements for public benefit entities would depend on the tier to which an entity was allocated:

  • tier 1 entities would be required to apply New Zealand public benefit entity (NZ PBE) standards based on International Public Sector Accounting Standards (IPSAS), together with relevant domestic standards where there is no equivalent IPSAS;
  • tier 2 entities would apply the NZ PBE standards but with reduced disclosure requirements; and
  • tier 3 entities would have a more simple form of reporting.

We expect that all three tiers should measure and recognise transactions consistently. However, there may be differences in how tier 3 entities measure and recognise transactions.

The proposed approach is likely to be more suitable than standards based on IFRS. However, IPSAS - comprehensive, complex standards with significant disclosure requirements - will significantly influence the proposed requirements. Therefore, although NZ PBE standards will be more appropriate - and some modifications can be made to IPSAS in creating those standards - they will not be a "silver bullet" that will immediately resolve all concerns that we have previously raised.

The consultation paper about accounting by for-profit entities proposes only two tiers. Large for-profit entities in the local government sector would be in tier 1 and all other for-profit entities in the local government sector would be in tier 2. To qualify as large, a for-profit entity in the local government sector would need to have revenue of more than $30 million or assets of more than $60 million.

The financial reporting requirements for those tier 1 entities would be NZ IFRS, which basically consists of IFRS supplemented by relevant domestic standards. Tier 2 entities would apply NZ IFRS but with reduced disclosure requirements.

We support the long-term strategy to separate the reporting requirements of public benefit entities and for-profit entities. Although IFRS and IPSAS are in line, they are likely to diverge. This is because IFRS focus more on the needs of a few users (mainly investors in international capital markets), whereas IPSAS focus on the needs of those who provide resources (such as ratepayers) and those who use public goods and services (such as water, sewerage, public parks, swimming pools, and libraries).

Financial reporting challenges

Although the changes in the financial reporting environment are a positive step, there are some significant financial reporting challenges facing the XRB and NZASB.

Reducing complexity

Since the introduction of NZ IFRS, most public sector entities' financial statements have become larger and more complex, with more disclosures. We continue to question whether the volume of information contained in financial statements properly meets the needs of those who typically read the financial statements. There remains a risk that readers are being presented with too much information, which makes it more difficult to "see the wood for the trees".

The tier structure will go some way to addressing the complexity of information, particularly for smaller entities, given the NZASB can determine the disclosure requirements for tiers 2 and 3. However, tier 1 entities will still have extensive disclosures, as required by IFRS and IPSAS.

In October 2010, the International Accounting Standards Board (IASB) invited the New Zealand Institute of Chartered Accountants and the Institute of Chartered Accountants of Scotland to carry out a project to review the levels of disclosure requirements in IFRS and to recommend changes to the disclosure requirements. Those institutes issued a report in July 2011 entitled Losing the excess baggage – reducing the disclosures in financial statements to what's important.23 The report recommended deleting specific requirements and enhancing the use of materiality in financial reporting disclosures.

If disclosure requirements were reduced in line with the recommendations in the July 2011 report, financial statements prepared in keeping with IFRS could be reduced by up to 30% without losing important information for users. In our view, that would be a positive step. We consider that, if the disclosure requirements in IFRS were reduced, it would be difficult for the International Public Sector Accounting Standards Board (IPSASB) not to similarly reduce the disclosure requirements of IPSAS. Any changes to IFRS and IPSAS should, in time, be reflected in New Zealand standards.

Conceptual frameworks for financial reporting in the public sector

There are conceptual frameworks for both for-profit entities and public benefit entities. However, the framework that the IASB drew up for for-profit entities is more than 20 years old. The framework for public benefit entities is based on the IASB private sector framework and includes only a few changes that focus on the public sector.

Conceptual frameworks are important because they provide a high-level "roadmap" to standard setters, and reference for preparers and auditors of financial statements for transactions that a particular standard does not address.

The IASB is working on changing its conceptual framework to one that is more narrowly focused on the needs of those people accessing international capital markets. This is a long-term project that has been under way for years.

During the last few years, the IPSASB has been working on its first conceptual framework for public benefit entities in the public sector. The IPSASB is considering the work that the IASB is doing but is not constrained by it. That work looks to be focused on the needs of both resource providers (such as ratepayers) and those who receive public goods and (community) services.

In our view, both of these conceptual framework projects are important. The NZASB has a role in appropriately influencing the work being done internationally. While changes are made to conceptual frameworks, it will be important to the public sector that the NZASB considers the interaction between the conceptual frameworks, given that the public sector includes for-profit and public benefit entities.

Standards for reporting non-financial performance information

Often, we have commented on how crucial non-financial performance information is to the accountability of many local government entities. We have noted that such information must work with financial information to provide a coherent and understandable picture about entities' performance.

Few paragraphs in NZ IFRS deal with statements of service performance - a particular form of reporting on non-financial performance information. Supplementing those paragraphs is a document entitled Technical Practice Aid No. 9: Service Performance Reporting (TPA-9). TPA-9 contains application guidance based on practice at the time the material was first published in 2002. However, arguably, it is too detailed and not focused enough on the main principles of what constitutes good reporting of non-financial performance information.

In our view, it is important that the NZASB create an appropriate standard for preparing non-financial performance information, because of the need for that information to integrate with financial information and present a complete performance picture.

Determining which entities combine to form a group

Which local government entities combine to form a group is important. Group financial statements affect the transparency of reporting and accountability, because they show the combined resources, and use of resources, by a "parent" entity.

"Control" is the accounting concept used to determine which entities are combined to form a group. Financial reporting standards provide a lot of guidance about what "control" is in a financial reporting sense. This guidance focuses on the substance of arrangements, not on the meaning of the word "control".

Even with the guidance provided in financial reporting standards, assessing whether or not an entity controls another in the local government sector can be difficult. This is particularly so for entities such as trusts, which have no formal ownership instruments. Working out whether entities such as trusts are "controlled" for financial reporting purposes remains challenging. The standards need to be clearer.

In our view, the NZASB needs to clarify what "control" means for entities with no formal ownership instruments. We consider that it is important that the entities that are combined to form a group keep focusing on the substance of arrangements and present useful information.

22: See "Accounting Standards Framework Documents Released" on the XRB's website,

23: Available on the website of the New Zealand Institute of Chartered Accountants,

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