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REVIEW OF FINANCIAL REPORTING BY ISSUERS
CYCLE 8

Valuation and fair values

21. Financial reporting of transactions and events is increasingly moving away from a historical cost basis to a fair value basis, through recognition and by way of increased fair value disclosures. In many cases, this affects not just financial instruments but also the valuation of non-financial assets, for example, intangible assets, investment properties and agricultural assets.
22. Fair values reflect the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties at an arm's length transaction. Fair values provide users with relevant, up-to-date information about the carrying values of assets and liabilities.
23. The use of fair values has its own challenges, particularly in the current market conditions. During stressed market conditions the valuation of transactions and events becomes more challenging even though it is the time when fair values are most needed to reflect the changed or changing market conditions. Market turmoil emphasises the importance of the reliability of fair value measures.
24. The Commission's 2008 News Releases referred to the challenges in valuation practices in the current tight credit and illiquid markets and to the need for issuers to disclose valuation methodologies, processes, key assumptions, risks and uncertainties underlying their valuations. In a changing market, it is important that issuers communicate the inputs and assumptions that they have used for their valuations to better explain the numbers in the financial statements.
25. The Commission considers that as a set of financial statements may not always reflect the most up-to-date values for a user at the time the report is read, particularly in a rapidly changing market, it is imperative that financial statements disclose all the necessary information surrounding any valuation. For example, as required by NZ IAS 40 Investment Property, whether the valuations are carried out by an independent valuer, whether fair values are supported by market evidence or other factors (which must be disclosed) and the methods and significant assumptions underlying the valuations. In general, in relation to the valuation of both financial⁶ and non-financial assets, entities are required under NZ IFRS to ensure, as far as possible, that market inputs are used.
26. Information about fair value methods and the underlying significant assumptions ensures that users are aware of the basis (and any associated limitations) for the fair value measures. It enables users to make any appropriate adjustments when making their investment decisions. The disclosure of such information is also necessary to meet the general legal requirement for financial statements to show a true and fair view.
27. The following fair value and valuation issues were raised with issuers in relation to investment properties under NZ IAS 40:
    1. the possible non-compliance with the fair value hierarchy in NZ IAS 40 (paragraphs 45 and 46); and
    2. the non-disclosure of significant assumptions underlying the valuation of investment property (paragraph 75(d)).
28. NZ IAS 40 contains a hierarchy for determining the fair value of investment properties. In particular, paragraph 45 states that the best evidence of fair value of a property is current prices in an active market for property that is similar in all material respects. It is only in the absence of current prices in an active market that alternative means of determining fair value such as discounted cash flows should be used (paragraph 46).
29. The Commission wrote to 3 issuers about the fair value hierarchy. In the financial statements of these issuers, the disclosures were unclear. For example:
    1. the accounting policy of 1 issuer stated that the fair values of its investment properties were based on market values but the notes to the financial statements indicated that primary reliance was placed on the capitalisation and discounted cash flow approaches;
    2. the accounting policy of 1 issuer indicated that valuation was based on "expected net cash flows discounted at a market determined risk adjusted rate" but the notes to the financial statements indicated that the fair values of its investment properties were based on market values; and
    3. different notes in 1 issuer's financial statements gave conflicting information on whether the fair value was market-based or based on the capitalisation/discounted cash flow method.
30. All 3 issuers confirmed that the valuations were in compliance with the requirements of NZ IAS 40. Market-based inputs were used as far as possible by their independent valuers and the capitalisation/discounted cash flow methods were used because of an absence of an active market for similar property in the same location. In all 3 cases, the issuers agreed to clarify their disclosures in future.
31. NZ IAS 40 (paragraph 75(d))⁷ requires an entity to disclose the following:

"the methods and significant assumptions applied in determining the fair value of investment property, including a statement whether the determination of fair value was supported by market evidence or was more heavily based on other factors (which the entity shall disclose) because of the nature of the property and lack of comparable market data."

32. The Commission wrote to 5 issuers on this matter. All 5 issuers disclosed some relevant information outside the financial statements in other parts of the annual report. Notwithstanding this, the Commission considered that information required by NZ IFRS should be included within the financial statements. In this way the information is also subject to audit requirements. Three issuers agreed to include the necessary disclosures in their future financial statements. Discussion on this matter is continuing with 2 issuers.
33. It is important in the current economic climate to ensure that information about the valuation methods and their underlying significant assumptions is appropriately disclosed. In 2 instances, the Commission requested copies of valuation reports from the issuers to establish the manner in which the fair values of their respective investments properties were determined.
34. The Commission also wrote to 2 other issuers about the following:
    1. whether certain properties leased to subsidiary companies should be classified as investment properties in the parent company's financial statements or as property, plant and equipment; and
    2. whether adjustments to the independent valuation of investment properties complied with the requirement in NZ IAS 40 for such valuations to be independent.
35. The two matters were resolved after further information from the issuers.

Intangible assets

36. NZ IAS 38 Intangible Assets prescribes the accounting treatment for intangible assets. The Standard allows an asset to be separately recognised as an intangible asset only if it meets the identifiability criterion. This requires the asset to:
    1. be separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or
    2. arise from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations (paragraph 12).
37. NZ IAS 38 (paragraph 21) allows an intangible asset to be recognised if, and only if:
    1. it is probable that the future economic benefits that are attributable to the asset will flow to the entity; and
    2. the cost of the asset can be measured reliably.
38. The Commission's 2008 News Releases highlighted the need for disclosures relating to the recoverable amounts of each significant cash-generating unit containing goodwill or intangible assets with indefinite useful lives, impairment of goodwill and factors to support the value of intangible assets.
39. The Commission wrote to 4 issuers about matters relating to recognition, valuation and disclosure of intangible assets and/or goodwill.
40. The Commission wrote to 1 issuer to query the inclusion of certain intangible assets as part of goodwill on the acquisition of a subsidiary in a previous year. The intangible assets were separately identified as part of goodwill in the financial statements. It was unclear from the financial statements why the issuer considered that the intangible assets did not meet the requirements of NZ IAS 38 for separate recognition from goodwill on acquisition. It was also not clear if those intangible assets should have been separately recognised under NZ IFRS 1 First-time Adoption of New Zealand Equivalents to International Financial Reporting Standards on the issuer's transition to NZ IFRS.
41. The matter was resolved through the issuer providing additional information confirming that the intangible asset did not meet the identifiability criteria in NZ IAS 38 to warrant its separate recognition: its fair value could not be reliably estimated, it was not capable of being separated from the other business assets and should not have been separately identified within goodwill in the financial statements.
42. The Commission also queried 1 issuer on whether certain costs incurred in the development of the issuer's product met the general recognition criteria in NZ IAS 38 for capitalisation as an intangible asset in particular, the recognition criteria in NZ IAS 38 (paragraph 57) for internally generated intangible assets arising from development.
43. NZ IAS 38 (paragraph 57) states:

"An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following:

1. the technical feasibility of completing the intangible asset so that it will be available for use or sale.
2. its intention to complete the intangible asset and use or sell it.
3. its ability to use or sell the intangible asset.
4. how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
5. the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
6. its ability to measure reliably the expenditure attributable to the intangible asset during its development."

44. The matter was resolved with the issuer providing information to support and demonstrate that all the recognition criteria and factors listed under paragraphs 12 and 57 were met.
45. Other matters raised under NZ IAS 38 included:
    1. the disclosure, for each class of intangible assets, whether useful lives are indefinite or finite and, if finite, the useful lives or the amortisation rates used - paragraph 118 requires such disclosures;
    2. whether research costs had been capitalised - paragraph 54 prohibits such recognition;
    3. whether the capitalised overhead expenditure is directly attributable to preparing the asset for use - paragraph 67 does not allow other general overhead expenditure to be included as a component of the cost of an internally generated intangible asset unless the expenditure can be directly attributable to preparing the asset for use; and
    4. whether patents, trademarks and licences and intellectual property that were internally generated were correctly accounted for - paragraphs 37 and 63 prohibit the recognition of internally generated brands and similar items unless they constitute trademarks and meet the recognition criteria under NZ IAS 38.
46. In the above cases the issuers were in compliance with the respective requirements of NZ IAS 38 and agreed to clarify their disclosures in future financial statements or agreed to make the necessary disclosures in future (change agreed).

Impairment of assets

47. NZ IAS 36 Impairment of Assets sets out the requirements for entities to recognise an impairment loss where assets are carried at more than their recoverable amount. It also prescribes the procedures that an entity must apply to ensure that its assets are carried at no more than their recoverable amount.
48. The Commission was interested in determining issuers' understanding, documentation and disclosure of the triggers for impairment of their assets.
49. The Commission wrote to 4 issuers about the matters relating to the possible impairment of their assets.
50. In relation to 1 issuer the Commission noted that several market events had occurred that could have a possible impact on the issuer and the carrying value of its property, plant and equipment. The Commission wrote to the issuer to query whether the issuer had considered those events as indicators of possible impairment of the issuer's assets, whether impairment testing of its assets was performed and the specific factors supporting the carrying value of those assets.
51. The matter was resolved through the issuer providing information about the processes and the factors that it had taken into account in carrying out impairment testing, including the engagement of independent valuers for the purpose of valuing the property, plant and equipment.
52. In another case, the Commission queried 1 issuer about the possible impairment of goodwill in the group financial statements given the continuing losses of a subsidiary company. The matter was resolved through the issuer providing independent third party information to support the carrying value of the goodwill.
53. Other queries included:
    1. the possible impairment of goodwill/intangible assets as a result of current market turmoil; and
    2. the basis for determining the recoverable amount of the cash generating unit containing goodwill.
54. In both cases, the issuers provided the necessary information for the matters to be resolved.
55. The indicators for impairment are many and varied, with different issuers being affected by different indicators. Issuers' attention is drawn to the detailed disclosure requirements in NZ IAS 36 (paragraphs 126 to 137). Issuers need to ensure that the necessary impairment indicators, and their underlying assumptions and estimates, are disclosed, particularly where they are sensitive to changes.

Definition and classification of cash flows

56. The Statement of Cash Flows, one of the core financial statements in the financial report of every issuer, helps users assess the ability of the entity to generate cash flows and the needs of the entity to utilise those cash flows. When used in conjunction with the rest of the financial statements, the Statement of Cash Flows enables users to evaluate an issuer's changes in net assets, its financial structure (including its liquidity and solvency) and its ability to adapt to changing circumstances and opportunities.
57. The Commission's 2008 News Releases referred to its interest in the definition and classification of cash flows.
58. The Commission wrote to 3 issuers in relation to matters under NZ IAS 7 Statement of Cash Flows. These included:
    1. the possible incorrect classification of cash flows as operating rather than financing; and
    2. issues relating to the definition of cash and cash equivalents which were inconsistent with the definition in NZ IAS 7.
59. NZ IAS 7 requires an entity to present a Statement of Cash Flows which reports cash flows during the period classified by operating, investing and financing activities.
60. NZ IAS 7 (paragraph 6) includes the following definitions for each of those activities:

"Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity."

61. NZ IAS 7 (paragraph 11) states that an entity presents its cash flows from operating, investing and financing activities in a manner which is most appropriate to its business.
62. Paragraph 12 states that a single transaction may include cash flows that are classified differently. For example, when the cash repayment of a loan includes both interest and capital, the interest element may be classified as an operating activity and the capital element is classified as a financing activity.
63. Paragraph 13 states that the amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash flows to repay loans, maintain the operating capability of the entity, pay dividends and make new investments without recourse to external sources of financing.
64. Paragraph 14 states that cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity. Therefore, they generally result from the transactions and other events that enter into the determination of profit or loss. It states that some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities.
65. The Commission wrote to 2 issuers querying whether amounts received from their customers, but which are repayable to the customers, should have been classified as financing cash flows rather than as operating cash flows in the issuers' Statement of Cash Flows. Both considered the cash flows to be part of their "principal revenue-producing activities" (NZ IAS 7, paragraph 6). The amounts repayable are not recognised as revenue in the issuers' Statement of Financial Performance but as liabilities in their Statement of Financial Position.
66. The Commission considers that such cash flows should be disclosed as part of an entity's financing activities. Notwithstanding that paragraph 11 states that an entity presents its cash flows from operating, investing and financing activities in a manner which is most appropriate to its business, in this case, the Commission considers that the classification is not appropriate for the following reasons:
    • the cash flows are in the nature of an interest-free loan from the entity's customers and are repayable to the customers;
    • the cash flows are recognised as liabilities in the Statement of Financial Position and result in changes in the size and composition of the borrowings of the entity; and
    • the cash flows are not recognised as revenue in the Statement of Financial Performance as they do not meet the definition of revenue in NZ IAS 18 Revenue.
67. While operating activities are defined and relate to the principal revenue-producing activities of the entity, NZ IAS 7 (paragraph 14), in explaining cash flows from operating activities, focuses on cash flows "derived" from the principal revenue-producing activities of the entity. The examples in paragraph 14 differentiate cash flows "derived" from those activities from the total cash flows generated by those activities. As paragraph 14 goes on to illustrate, some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities. The Commission's view is that this illustration is analogous in that, while the cash flows from customers may form a close part of the entity's principal revenue-generating activity, what is derived from those cash flows (and recognised as revenue) are the fees derived from providing services to its customers, not the total gross cash flows from its customers.
68. The Commission wrote to 1 issuer that had included in its Statement of Cash Flows cash and cash equivalents that appeared to be inconsistent with the definition of those terms in NZ IAS 7. NZ IAS 7 (paragraph 6) defines the term "cash and cash equivalents" and paragraph 7 states that an investment normally qualifies as cash equivalent if it has a short maturity of, say, three months or less from the date of acquisition. In this case the issuer included under cash and cash equivalents term deposits with maturities that were longer than three months.
69. The issuer agreed that the investments were misclassified and committed to amend and clarify their disclosures in future financial statements.

Footnotes

6. In relation to financial instruments, issuers' attention is drawn to the IASB's Staff Summary on Using judgement to measure the fair value of financial instruments when markets are no longer active (published in October 2008).
7. Issuers should take note that similar requirements are contained in NZ IAS 16 Property, Plant and Equipment (paragraph 77(c)).