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REVIEW OF FINANCIAL REPORTING BY ISSUERS
CYCLE 7

CYCLE 7: FINDINGS

Scope and issuer selection

30. In Cycle 7 the Commission reviewed the financial statements of 44 issuers with balance dates from 31 December 2006 to 30 September 2007.
31. The 44 issuers were made up of:
    1. 16 issuers listed on the New Zealand Stock Market (NZSX) (including 1 overseas listed issuer);
    2. 2 issuers listed on both the NZSX and the New Zealand Debt Market (NZDX);
    3. 8 issuers listed on the NZDX, the New Zealand Alternative Market (NZAX) or both (including 2 dual-listed issuers);
    4. 17 issuers whose shares are not listed on any exchange; and
    5. 1 issuer listed on the ASX.
32. In this Cycle, 21 issuers prepared their financial statements in accordance with NZ IFRS, one in accordance with UK GAAP, and two in accordance with Australian IFRS. The 20 issuers who prepared their financial statement in accordance with previous NZ GAAP will be required to produce NZ IFRS financial statements in their next financial year.
33. The findings of Cycle 7, including those relating to previous NZ GAAP, are discussed in the context of NZ IFRS to provide feedback to issuers who have just adopted NZ IFRS and those yet to adopt NZ IFRS.
34. Eighteen finance companies were selected for review in Cycle 7. All the finance companies but one had prepared their financial statements in accordance with previous NZ GAAP. Three of these companies were listed on the NZDX or NZAX; the rest were not listed companies.
35. In addition to the review of the annual financial statements of the issuers under the FRSP, the Commission selected and reviewed the interim financial statements of five of the finance companies that were prepared for the first time in accordance with NZ IFRS to assess their compliance, in particular, with NZ IFRS 7 Financial Instruments: Disclosures. The findings relating to these interim financial statements are reported separately in paragraphs 114 to 121.

Overall comments on Cycle 7

36. Generally, issuers' compliance with NZ GAAP is good. The Commission did not write to 27 of the 44 issuers reviewed. The Commission did find other matters in relation to some of these issuers. However, they did not warrant the Commission writing to the issuers. Matters common among the issuers are discussed later in this report.
37. In relation to the 18 finance companies reviewed, the Commission did not write to those issuers that went into receivership, or reached a moratorium with its investors, during the period of the Cycle 7 review. Matters raised in relation to two finance companies are being considered as part of the Commission's enforcement work on finance companies.
38. Seventeen of the 44 issuers reviewed in Cycle 7 had matters that prompted the Commission to write to them. The 29 matters raised included 10 matters relating to substantial security holders, directors' interests and directors' share dealings. In writing to the issuers on these matters raised, the Commission also drew the attention of those issuers to 54 other matters. In most cases, issuers agreed to make the necessary changes in their next financial statements.
39. In Cycle 7, the Commission wrote to two auditors to draw their attention to the non-disclosure in their audit reports of services, other than audit services, that they had provided to the issuers (see paragraphs 122 to 126).
40. The Commission also wrote to two substantial security holders of an issuer to draw their attention to their obligations under the Securities Markets Act 1988 to disclose their substantial security holdings to the issuer and NZX (see paragraphs 136 to 138).
41. The Commission referred an audit firm to NZICA in relation to the audit of the financial statements of two related issuers in respect of the question whether fee dependency might have affected the audit firm's independence (see paragraphs 127 to 128).
42. The Commission is encouraged by the commitment of issuers and their auditors to comply with NZ GAAP and to improve the quality of their financial reporting. The Commission is particularly gratified by the many positive comments that it has received from issuers and audit firms on our Cycle reviews.

Outcome of matters raised

43. Table 1 shows the outcome of matters raised in Cycle 7.

44. As in previous Cycles the Commission notes that the responses from issuers explained and clarified many of the matters raised.
45. The high percentage (83%) of agreement reached with issuers based on just the initial letter from the Commission is pleasing.
46. It is important to note that the Commission considers that, in many cases, writing to the issuers may well have been unnecessary had the issuers' disclosures been adequate and more transparent. The Commission continues to encourage issuers to ensure that all disclosures are sufficiently clear to adequately explain matters included in their financial statements.
47. In cases where a second or subsequent letter is sent, those matters are closed off through the Commission reiterating its comments. When the Commission reviews the issuers' financial statements in the next round the Commission intends to assess whether the issuer applied the correct accounting treatment or disclosure in accordance with the appropriate standards with regards to the matters raised.

Specific comments on Cycle 7 findings

48. In discussing the Cycle 7 findings the Commission's focus is on providing feedback and information to issuers who have already adopted and those yet to adopt NZ IFRS. In this regard references to standards and legislation in this report refer to the most recent equivalent paragraph or section, notwithstanding that an earlier version of the standard or legislation may have been applicable at the time of writing to the issuers.

Related party information

49. Related party transactions are a normal feature of commerce and business. However, their nature necessitates financial reporting standards to prescribe certain disclosures to draw attention to the possibility that the financial performance, financial position and the cash flows of an entity have been affected or influenced by related party relationships.
50. In Cycle 7 the Commission wrote to seven issuers relating to nine instances of inadequate disclosure or possible non-disclosure of related party information. These matters included the non-disclosure or possible non-disclosure and inadequate disclosure of:
    1. the ultimate holding company of the issuer (NZ IAS 1 Presentation of Financial Statements, paragraph 138(c));
    2. the nature of the relationship between related companies (NZ IAS 24 Related Party Disclosures, paragraph 12);
    3. key management personnel information (NZ IAS 24, paragraphs 16 and 17);
    4. the identity of related entities (SSAP-22 Related Party Disclosures, paragraph 5.1);
    5. the types of transactions between related parties (SSAP-22, paragraph 5.1);
    6. related party transactions (SSAP-22, paragraph 5.1); and
    7. terms of settlement of outstanding balances (SSAP-22, paragraph 5.1).
51. Issuers committed to make better disclosures in their next financial statements in relation to six related party matters raised and the Commission's queries on two matters were resolved through additional information from issuers. The Commission reiterated its view for better disclosure through a second letter to one issuer.
52. The Commission wrote to an issuer about the non-disclosure of key management personnel information as required by NZ IAS 24 (paragraph 16). In this case the issuer clarified that it had no key management personnel: the issuer was managed under a contract by an entity related to a director of the issuer. The entity related to the director also provides management services to entities other than the issuer.
53. The issuer considered that the remuneration of the key management personnel of the management company was not directly attributable to the services it provided to the issuer. However, the issuer committed to more comprehensively disclose the nature of this transaction in its future financial statements. The Commission accepted the clarification and change proposed by the issuer to its next financial statements.
54. Issuers should note the extensive related party information requirements of NZ IAS 24, particularly the requirement to also disclose certain information relating to key management personnel.
55. In relation to issuers that have no staff or key management personnel, the Commission draws the attention of issuers to the definition of "key management personnel" in NZ IAS 24. It refers to "those persons having the authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity" (paragraph 9). As such, "key management personnel" is not limited to a person directly in the employ of the reporting entity.
56. Moreover, the definition of "compensation" (NZ IAS 24, paragraph 9) includes all forms of consideration paid in exchange for services rendered to the entity.
57. The Commission considers these requirements, taken together, would require the disclosure of key management personnel information where a related party compensates key management personnel on behalf of the reporting entity. Where the reporting entity contracts out its key management functions or has those functions performed on its behalf by another entity the reporting entity's key management personnel compensation is paid, in substance, on its behalf (whether or not the reporting entity pays management fees to the other entity).
58. As these services are usually rendered on the issuer's behalf by the directors and officers of the other entity, the Commission considers that the key management personnel of the other entity are also the key management personnel of the reporting entity. As such, the relevant remuneration of the other entity's directors and officers should be disclosed by the reporting entity. This is particularly so if the other entity only manages or renders services to the reporting entity and to no other entities.
59. In Cycle 7 the Commission noted that entities within a group of finance companies entered into a large number of inter-company transactions involving significant amounts in many instances. While the material related party transactions were usually identified and disclosed, four finance companies failed to disclose all information required to be disclosed by NZ IAS 24 about these transactions.
60. The Commission considers that adequate and transparent disclosure of related party transactions is important, particularly for finance companies where securitisations or mortgage sales take place between related parties and, as a result, financial assets are derecognised in the transferring company. It is not always clear from the financial statements whether the transfers should have been derecognised.
61. The Commission considers the high incidence of inadequate or possible non-disclosure of related party information by issuers unsatisfactory, given the effect related party relationships can have on an entity's financial performance and financial position. The importance of related party disclosures is heightened in the current climate of tight liquidity and finance company collapses as users look to the information to determine the extent to which related party transactions, and possibly any preferential terms, have affected the financial position, performance and cash flows of the finance company.
62. The Commission considers that the disclosure of material related party information is necessary for an understanding of the potential effect of the relationship and/or the amounts involved on the financial statements. Materiality should be considered in the context of the nature of the relationship and not just quantitatively.
63. The Commission considers that transactions with related parties should be clearly disclosed in financial statements. Such disclosures should contain sufficient information and be meaningful to enable users to gain an understanding of the potential effect of those transactions and whether they are at carried out at arm's length.
64. Issuers should note that non-compliance with NZ IAS 24 subjects the issuer to the penalty provisions of the Financial Reporting Act (section 36(2)) for non-compliance with an approved standard. This is in contrast to previous NZ GAAP where there were no specific penalties provided in the Financial Reporting Act for Statements of Standard Accounting Practice (SSAP) and SSAP-22 was not legally enforceable in that regard. Issuers can no longer be complacent when complying with NZ IFRS.

Financial institutions and financial instruments information

65. The review of finance companies raised many disclosure matters, particularly in relation to their financial instruments. Of the 18 finance companies reviewed, the Commission raised a total of twenty-five matters with six finance companies. These matters included 12 matters raised and 13 other matters. The financial statements of these six finance companies were prepared in accordance with previous NZ GAAP.
66. The majority of the matters related to FRS-33: Disclosure of Information by Financial Institutions. In some instances, the matters were raised with more than one finance company. The following matters relating to inadequate and possible non-disclosure of information were raised with the finance companies:
    1. concentrations of funding (paragraph 14.1);
    2. management of liquidity and liquidity profiles (paragraphs 11.1 and 12.2);
    3. contractual re-pricing or expected maturity periods for each class of financial asset and financial liability (paragraph 12.2);
    4. interest revenue from impaired assets (paragraph 6.3);
    5. interest expense separately for each classification of funding presented in the Statement of Financial Position (paragraph 6.3);
    6. lending and credit fee related revenue separately from other fee revenue (paragraph 6.3);
    7. fair value of exchange rate swaps (paragraphs 9.1 to 9.3);
    8. unrecognised financial assets (paragraph 8.1); and
    9. each class of financial liability based on the priority of creditors' claims over the entity's assets in a winding up (paragraph 6.3).
67. Agreement was reached on 23 of the matters with finance companies committing to make the necessary changes in their next set of financial statements. The Commission closed off the last two matters through a second letter to an issuer reiterating the Commission's comments on those matters. For one of the issuers we highlighted to the issuer in our second letter that quantitative, not just qualitative, information was also required to be disclosed by NZ IFRS 7.
68. The Commission took no enforcement action in relation to these matters as they did not render the financial statements misleading. However, the Commission considers it unsatisfactory that these finance companies did not comply fully with all the disclosures requirements of FRS-33, a Standard that is designed specifically to capture information about the transactions and activities of a financial institution that is relevant to a user.
69. While the finance companies that the Commission wrote to in Cycle 7 had financial statements prepared in accordance with previous NZ GAAP, the Commission draws the attention of finance companies (and issuers generally) to the more extensive requirements relating to financial instruments required under NZ IFRS. These requirements are set out in NZ IAS 32 Financial instruments: Presentation, NZ IAS 39 Financial Instruments: Recognition and Measurement and NZ IFRS 7. These are additional new standards and deal not just with disclosures but also with the recognition and measurement of financial instruments. Moreover, these standards apply not only to financial institutions but to all entities with financial instruments.
70. The impact of the above standards on finance companies (and other financial institutions) will be much greater than on other entities generally: the requirements of these standards directly affect the accounting for financial instruments that are core business activities of a finance company. Compliance with these standards by finance companies is essential to ensure that their financial statements contain the necessary information to enable users to understand their operations.
71. It should be noted that NZ IFRS 7 also contains additional New Zealand-specific disclosures applicable to financial institutions (in Appendix E to NZ IFRS 7).
72. More importantly, NZ IFRS 7 puts onus on issuers and management to disclose more information about the various types of risks (credit, liquidity and market risks) facing an entity. Besides qualitative and quantitative information about the risks, entities are now also required to identify and disclose objectives, policies and processes for managing, and methods used to measure, those risks. This information needs to be presented from the perspective of management and in the form provided internally to management.
73. To meet the requirements of NZ IFRS 7 will require management to disclose information that is specific to the issuer to ensure that the operations and transactions of the entity are recognised, measured and disclosed to users in a relevant and understandable manner. "Boiler-plate" and "standardised" accounting policies and notes copied from the standards themselves or from audit firm templates are not acceptable as they may include material that is not applicable to the entity or may not fully or accurately reflect the issuer's transactions and activities.

Essential disclosures

74. The Commission considers that the following are essential disclosures that an issuer is required to make regardless of the industry it is in and the transactions it enters into. In the preparation of financial statements the Commission considers it important that issuers get these "basics" right.
75. For financial statements prepared in accordance with previous NZ GAAP this means providing all the disclosures required by FRS-1: Disclosure of Accounting Policies, FRS-2: Presentation of Financial Reports and FRS-9: Information to be Disclosed in Financial Statements.
76. In transitioning to NZ IFRS, financial statements prepared in accordance with NZ IFRS should provide all the disclosures required by NZ IFRS 1 First-time Adoption of New Zealand Equivalents to International Financial Reporting Standards, NZ IAS 1 and NZ IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
77. It should be noted that many of these matters were also raised in previous Cycles. The matters are reiterated here as the Commission considers that they are essential disclosures.

Accounting Policies

78. Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting its financial statements (NZ IAS 8, paragraph 5). For a set of financial statements to be understandable to its users it is fundamental that all significant accounting policies are disclosed.
79. The Commission is concerned that in eight instances, accounting policies relating to various aspects that the Commission considers material to the issuers' business were not disclosed. These related to non-disclosure of accounting policies for:
    1. the basis of preparation of the cash flow statement in relation to an issuer that is a retailer;
    2. revenue recognition (trading, mortgage fee revenue, leased assets) in relation to an issuer that is a finance company with a retailing segment, and in relation to other issuers that are finance companies;
    3. determining the carrying value of impaired assets in relation to an issuer that is a finance company;
    4. securitisations, mortgage sales and/or derecognition of financial assets in relation to issuers that are finance companies; and
    5. distributions to its members in relation to an issuer that is a cooperative.
80. In one instance, the Commission wrote to an issuer querying an accounting policy that appeared incorrect even though the amount involved for that year was immaterial. Given the nature of the issuer's operations the Commission considered that there was a potential that the item might become material in future. In this instance the issuer agreed to amend the incorrect accounting policy. However, given the small amount that was left to be amortised, the issuer considered that the item would likely be eliminated by the following year.
81. The Commission is committed to ensure that the correct policy is adopted by an issuer where it considers that the policy is significant due to the nature of the issuer's operations. This is notwithstanding that the amounts involved may not have been material in the current and previous years.
82. The Commission considers it unacceptable for companies to fail to adequately disclose accounting policies that are core to their operations and which are critical for an understanding by users of the information presented. For example, the following core accounting policies should have been disclosed but were not, or were inadequately, disclosed by some finance companies:
    1. the recognition of revenue from trading, mortgages and leased assets;
    2. determining the carrying value of impaired assets; and
    3. securitisations, mortgage sales and/or the derecognition of financial assets.
83. Issuers committed in seven instances to make the necessary changes to their accounting policies or other disclosures in their next financial statements. In one instance, the matter was resolved after further clarification from the issuer.
84. Under previous NZ GAAP, FRS-1 requires general purpose financial statements to include a clear and concise statement of all the accounting policies adopted by an entity in the preparation of its financial statements where such accounting policies are material to those financial statements.
85. Under NZ IFRS, NZ IAS 8 (paragraph 7) requires that when an NZ IFRS specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item shall be determined by applying the NZ IFRS, including consideration of any relevant Implementation Guidance approved by the ASRB for the NZ IFRS.

Judgements and estimations

86. NZ IAS 1 (paragraph 122) requires an entity to disclose, in the summary of significant accounting policies or other notes, the key sources of the judgements apart from those involving estimations that management has made in the process of applying the entity's accounting policies that have the most significant effect on the amounts recognised in the financial statements.
87. Closely related to paragraph 122 is the requirement under NZ IAS 1 (paragraph 125) to disclose information about the assumptions an entity makes about the future and other major sources of estimation uncertainty at the end of the accounting period that have a significant risk of resulting in material adjustment to the carrying amounts of assets and liabilities including their nature and their carrying amounts as at the end of the reporting period.
88. The Commission wrote to two issuers in relation to three instances of non-disclosure or inadequate disclosure of the requirements of NZ IAS 1, paragraphs 122 and 125. The issuers committed to make these disclosures in future.
89. The disclosure of key sources of judgements and information about assumptions and sources of estimation uncertainty are important new requirements. They were not explicitly required under previous NZ GAAP. While, as stated in NZ IAS 1 (paragraph 124), some of this information is required under specific NZ IFRS, not all standards require information about estimation uncertainty.
90. The Commission considers the information required under paragraphs 122 and 125 of NZ IAS 1 to be critical. The information complements the significant accounting policies of the issuer. The paragraphs require disclosure of management's judgements in applying the entity's accounting policies that can have a significant effect on the amounts recognised in the financial statements, for example, judgements about the classification of financial assets and whether, in substance, significant risks and rewards of ownership of financial assets have been transferred to other entities. The paragraphs also require information about assumptions made about the future in determining the carrying amounts of assets and liabilities, for example, any future-oriented estimates used to measure the recoverable amount of property, plant and equipment and pension obligations.
91. The Commission discourages issuers from using "boiler-plate" type disclosures in complying with paragraphs 122 and 125 of NZ IAS 1. The Commission expects the disclosures to vary in nature and be specific to entities to meaningfully represent the nature of the issuers' activities and business.

Materiality - "Other expenses"

92. The Commission is concerned to find in some financial statements an item "other expenses" (or similar) that represented a significant percentage of total expenses and "adjusted expenses" (total expenses excluding cost of sales), with no further information in the notes to explain the composition of the item. In many cases the amount of other expenses exceeded the amounts of other separately disclosed expense items.
93. As a result the Commission conducted a separate analysis of this item for all the 21 issuers reporting under NZ IFRS to determine the incidence and percentage figures involved. The results of the separate review prompted the Commission to include a discussion of the disclosure of other expenses in this report.
94. The Commission is concerned with the materiality of the percentages involved. In sixteen⁶ cases where the issuer disclosed other expenses, only nine were other expenses 10% or less of total expenses. In all the other cases, other expenses represented between 14% and 62%⁷ of total expenses.
95. This pattern is similar when other expenses are compared to adjusted expenses. In four cases, other expenses were 10% or less of adjusted expenses. In all other cases, other expenses represented between 11% and 62% of adjusted expenses.
96. The Commission considered it unsatisfactory that such a material item in financial statements remained unexplained.
97. In the two cases where the Commission wrote to issuers on this matter, one issuer agreed to make further disclosures in its next financial statements. The Commission wrote to another issuer to close off the matter by reiterating the need for separate disclosure of all material items of expenses.
98. Under previous NZ GAAP, a statement about materiality is included in each Financial Reporting Standard. NZ IFRS do not contain such a statement about materiality in each NZ IFRS. However, materiality is no less important under NZ IFRS.
99. The concept of materiality is discussed in the New Zealand Equivalent to the IASB Framework for the Preparation and Presentation of Financial Statements (NZ Framework (paragraphs 29-30)) as part of the discussion on the qualitative characteristics of financial statements. In addition, NZ IAS 1 defines "materiality" (paragraph 7) and, under the section Materiality and Aggregation (paragraph 29), requires an entity to present separately each material class of similar items. An entity is also required to present separately items of a dissimilar nature or function unless they are immaterial. An item that is not sufficiently material to warrant separate presentation in the statements may warrant separate disclosure in the notes (paragraph 30). The Commission encourages issuers to bear in mind the materiality of items and their separate disclosure when preparing financial statements.

Statement of Compliance with IFRS

100. In New Zealand all issuers (other than dual and overseas listed issuers) are required to apply NZ IFRS in the preparation of their financial statements for periods commencing on or after 1 January 2007. Cycle 7 included 21 issuers that had prepared their financial statements under NZ IFRS.
101. The Commission is pleased with the quality of the issuers' financial statements that were prepared under NZ IFRS, given the significant effort required to implement and adopt NZ IFRS. However, the Commission considers that the NZ IFRS issuers can still improve their financial statements by ensuring their accounting policies relate to their activities and their financial statements include full and clear disclosures and other information where necessary. The Commission hopes that this will improve over time as issuers gain more experience and become more familiar with the detailed requirements of NZ IFRS. The Commission considers that issuers should aim for transparency in their financial reporting.
102. In relation to the NZ IFRS financial statements, the Commission drew the attention of six issuers to the requirement in NZ IAS 1 (paragraph 16) which requires an explicit and unreserved statement of compliance with IFRS. The Commission is highlighting this matter in an effort to stamp out at this early stage an unsatisfactory practice that appears to have become common practice.
103. The Commission noted that in many cases issuers attempted to make a statement of compliance but such statements are usually along the lines that the financial statements comply with NZ IFRS "which ensures compliance with IFRS". While compliance with NZ IFRS will generally ensure compliance with IFRS, such a statement does not represent an explicit and unreserved statement of compliance by the entity in respect of its financial statements as required by NZ IAS 1. An issuer should make an explicit and unreserved statement of compliance with IFRS where the issuer's financial statements do comply.
104. In Cycle 7 the Commission noted one audit report where the auditor stated that the issuer's "financial statements also comply with IFRS" even though such a statement was not made in the financial statements by the issuer itself. In another case the issuer made the explicit and unreserved statement that its parent entity's financial statements "comply with IFRS", but included only compliance with NZ IFRS "which ensured compliance with IFRS" in respect of its group financial statements.
105. It should be noted that New Zealand is a jurisdiction that has adopted IFRS and compliance by a profit-oriented entity, including an issuer, with NZ IFRS will generally mean that the issuer's financial statements also comply with IFRS. However, in the absence of an explicit and unreserved statement of compliance, it is not immediately clear to users whether the issuer's financial statements do comply with IFRS.
106. A recent Working Paper⁸ by the European Commission calls on entities in countries like New Zealand which are already applying IFRS equivalents to make an explicit and unreserved statement of such compliance. Similarly, the International Organisation of Securities Commissions (IOSCO), of which New Zealand is a member, has also issued a statement⁹ where it has recommended that annual and interim financial statements prepared in compliance with IFRS as issued by the IASB should clearly state that this is the case.
107. The Commission considers compliance with the requirements of NZ IAS 1 in this respect to be important, as an explicit and unreserved statement of compliance with IFRS allows users, including those from outside New Zealand, to differentiate those financial statements prepared under NZ IFRS that also comply with IFRS from those that only comply with NZ IFRS.

Standards and Interpretations not yet effective

108. NZ IAS 8 (paragraph 30) requires entities to disclose certain information relating to the standards and interpretations that have been issued but are not yet effective.
109. The Commission wrote to six issuers on this matter. The Commission draws to the attention of issuers this requirement and also to the need to include interpretations that have been issued but are not yet effective.
110. The Commission considers this disclosure important because of the number of new standards and interpretations that are continually being issued. These usually have delayed adoption periods. It is therefore important for issuers to disclose not only those standards and interpretations that they have adopted early but also those that they have not, as well as the possible impact that those pronouncements may have on the issuer on their adoption when they become effective.