Directors & CEOs – Ten key issues to consider when reviewing your 30 June 2017 financial report

In its media release MR 17-162, the Australian Securities and Investments Commission (ASIC) once again re-iterated its views regarding directors’ responsibilities for the financial report, particularly that:

Directors are responsible for the quality of the financial report, including providing useful and meaningful information for investors and other users of the financial report
Directors are not expected to be accounting experts, but they should seek explanation and advice supporting the accounting treatments chosen and, where appropriate, challenge the accounting estimates and treatments applied in the financial reports, and
Directors should particularly seek advice where a treatment does not reflect their understanding of the substance of an arrangement.

Being in the middle of the listed entity reporting season, this article serves as a reminder to all directors and CEOs about their responsibilities regarding their financial reports, as well as key issues to look out for when reviewing the reports.

Our ‘top 10’ key issues to consider (i.e. areas directors and CEOs commonly overlook), are as follows:

New audit reports - Key audit matters (KAMs) for listed entities
Revenue recognition
Expense deferral
Impairment testing and asset values
New transactions and agreements
Profit or loss and other comprehensive income
Major new accounting standards
Consistency of information between the Operating and Financial Review (OFR) and the financial report
Remuneration reports and materiality
Disclosure initiative ('Decluttering' your financial report).

These are discussed in more detail below.

New audit reports – Key audit matters (KAMs) for listed entities

For 30 June 2017 financial reports, your audit report will look different. In particular, it will include an outline of key audit matters (KAMs), which are the matters, which in the auditor’s judgement, are of most significance in the audit of the financial report for the current period. KAMs may relate to significant accounting estimates, as well as judgements about appropriate accounting policies.

Key issue 1

Ensure that KAMs involving key estimates and judgements have been clearly disclosed in the financial report as required by AASB 101 Presentation of Financial Statements, paragraphs 122 and 125.

In particular, ASIC are looking to see more detailed information disclosed regarding items subject to material estimation.

Revenue recognition

Users of financial statements, and in particular investors and analysts, have indicated that they are particularly interested in the amount and timing of revenue recognised in the financial report.

Key issue 2

Ensure that the accounting policies adequately describe, in Plain English, how revenue is recognised so that it can easily be understood by users of the financial report.

A Plain English, bespoke ‘revenue’ accounting policy will assist you in understanding the policy, and in turn ensures that revenue is recognised in accordance with currently applicable accounting standards, and the substance of the underlying transactions.

To assist you in this process, we recommend you review management’s accounting papers outlining the appropriate accounting treatment for each revenue stream based on authoritative guidance in accounting standards AASB 118 Revenue, AASB 111 Construction Contracts and other relevant interpretations dealing with revenue recognition.

Expense deferral

Other than when an entity prepays for a good or service in advance, AASB 138 Intangible Assets only permits deferral of expenses as assets in very limited circumstances.

Key issue 3

For each new asset type on the balance sheet, enquire which accounting standard governs its recognition (e.g. AASB 102 Inventories, AASB 116 Property, Plant and Equipment, AASB 140 Investment Property and AASB 139 Financial Instruments: Recognition and Measurement).

For all other assets, ensure that they meet the recognition criteria as an intangible asset under AASB 138, noting that the following cannot be capitalised:

Internally generated intangibles such as brands, mastheads and customer lists
The costs of introducing a new product or service
Selling costs
Staff training
Inefficiencies and initial operating losses incurred before the asset achieves optimum performance levels.

Impairment testing and asset values

The diagram below illustrates the appropriate accounting standards dealing with the impairment requirements for financial and non-financial assets:

Type of asset
↓		↓
Non-financial: Goodwill PPE Intangibles		Financial: Receivables AFS investments
↓		↓
Impairment indicators – AASB 136, paragraph 12: External sources - e.g. adverse changes in technology, market & economic factors, changes in interest rates, & NAV > market capitalisation Internal sources – e.g. asset obsolescence, idle assets, poor economic performance, etc.		Objective evidence of impairment - indicators – AASB 139: Receivables (paragraph 59/60) - Significant financial difficulty, breach of contract such as defaults, probable bankruptcy, measurable decrease in estimated future cash flows, disappearance of an active market, etc. AFS investments – (paragraph 61) – adverse changes in technology, market & economic factors, significant or prolonged decline in fair value

Non-financial assets are often significant assets of an entity, with the value attributed to these assets affecting not only the entity’s reported financial position, but also its reported performance. Calculations to determine the recoverable amount often rely on discounted cash flows and can be complex.

The Attachment to ASIC’s media release, MR 17-162 outlines in more detail items for directors to look out for when reviewing impairment models, including ensuring that:

Cash flows and assumptions appear reasonable based on historical cash flows, economic and market conditions and funding costs
Discounted cash flows are not used to determine recoverable amount based on fair value less costs of disposal unless forecasts and assumptions that a market participant would use can be reliably estimated
Value in use calculations should assume declining growth rates in cash flows after year five
Value in use calculations should assume cash flows from the asset in its current condition, and not assume cash flows from restructuring unless the entity is committed, or from improving the asset’s performance
Value in use calculations should match cash flows with the assets in the cash-generating unit (CGU) being tested. For example, if cash flows from collecting receivables and selling inventories are included as cash inflows in the impairment model, receivables and inventories are to be included in the carrying value of CGU assets against which the recoverable amount from the impairment model is compared. Similarly, if cash outflows to settle creditors are included as cash outflows in the impairment model, creditors should be deducted from CGU assets.

Financial assets such as receivables carried at amortised cost, and available-for-sale investments with negative fair value movements recorded in other comprehensive income, also need to be tested for impairment if there are impairment indicators of the type listed in the diagram above. Even though available-for-sale (AFS) investments are recognised at fair value in the balance sheet, any negative balance in the AFS reserve should be reclassified as an impairment loss in profit or loss if there is a ‘significant or prolonged decline in fair value’.

Key issue 4

Ensure that impairment indicators for financial and non-financial assets have been considered under the correct accounting standard (AASB 136 for non-financial assets and AASB 139 for financial assets).

Non-financial assets

Review management’s impairment models for all material non-current assets or cash-generating units requiring an impairment test under AASB 136 Impairment of Assets (including goodwill, intangible assets with an indefinite life, and assets with impairment indicators).

Paying attention to items to consider outlined in the ASIC Media release, you need to review management’s cash flows and assumptions, having regard to your knowledge of the business, the economic environment, the assets and future business prospects, to satisfy yourself that the recoverable amount of these assets exceed their carrying amount.

Financial assets

Ensure that impairment losses have been recognised in profit or loss for all AFS investments with negative balances in the AFS reserve that represent a significant or prolonged decline in fair value.

New transactions and agreements

While you may be familiar with the accounting treatment for last year’s transactions and balances, there is a risk that new transactions and agreements entered into during the current year are incorrectly accounted for in your June 2017 financial report.

As directors and CEOs, you are best placed, based on your knowledge of transactions and agreements, to determine whether these transactions and agreements have been correctly accounted for.

Key issue 5

For each new significant agreement or transaction stream, review management’s accounting papers outlining the appropriate accounting treatment based on authoritative guidance in accounting standards. Examples to consider include:

Off-balance sheet arrangements - have these been appropriately consolidated or disclosed under AASB 12 Disclosure of Interests in Other Entities?
Joint arrangements - have these been appropriately accounted for as joint ventures or joint operations?
Business combinations – have these been appropriately noted as being provisionally accounted if the purchase price allocation has not been finalised?
Share-based payment arrangements – have all options granted been valued and appropriately expensed (including to KMPs, even if these are immaterial – refer to comments under remuneration reports and materiality below)?
Share-based payments – have shares issued under non-recourse or limited recourse loans been appropriately accounted for as de facto options?
Derivatives – have all derivatives been recognised at reporting date with fair value movements recorded in profit or loss (unless the hedge accounting requirements have been met, in which case fair value movements are recognised in other comprehensive income)?
Funding arrangements/capital raisings – have funds received been appropriately classified as debt vs equity?

Profit or loss and other comprehensive income

Users are particularly interested in earnings and therefore the statement of profit or loss and other comprehensive income. In this regard, it is important the entity appropriately calculates and presents statutory profit and earnings per share (EPS).

Key issue 6

Subtotals

Review the presentation of the profit number in the statement of profit or loss and other comprehensive income, ensuring that any profit subtotals such as EBITDA are not presented in bold.

It should be noted that if you present expenses ‘by function’, i.e. including cost of sales (COGS), it is not usually appropriate to present a subtotal EBITDA because some amounts for depreciation and amortisation will be included as part of COGS, meaning that describing a subtotal as EBITDA is not an accurate description of the relevant line item.

Diluted EPS

Also ensure that EPS has been correctly computed, particularly diluted EPS for the effect of dilutive options. Entities with losses do not have diluted EPS as the impact of any dilutive options would be, in fact, antidilutive. Also note that the effect of out-of-the-money options on diluted EPS is also antidilutive and therefore is not disclosed. In-the-money options only impact diluted EPS to the extent of the number of shares that would be issued for no consideration.

Reclassifying items of OCI

Ensure that gains on disposal of items subject to revaluation or fair value adjustments in other comprehensive income (OCI) are correctly accounted for, for example:

Revaluation surpluses on PPE remain in OCI, or are transferred to retained earnings but are not recycled through profit or loss, and
Available-for-sale reserves are recycled and recognised in profit or loss in period of disposal (with the reversal appearing in OCI for the period).

Major new accounting standards

Directors should be mindful of the disclosure requirements when an entity has not applied a new Australian Accounting Standard that has been issued but is not yet effective (AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors, paragraphs 30-31). The entity is required to disclose known or reasonably estimable information relevant to assessing the possible impact that application of the new Australian Accounting Standard will have on the entity’s financial statements in the period of initial application.

As at 30 June 2017, the following five Australian Accounting Standards have been issued but they are not yet effective:

AASB 9 Financial Instruments

The main impacts of AASB 9 are that:

There are strict tests that must be met for financial assets to be measured at amortised cost, so in future some financial assets will be measured at fair value through other comprehensive income (certain debt instruments only) or fair value through profit or loss
The new ‘expected loss’ impairment model is more forward looking and will replace the existing ‘incurred loss’ model where a credit event (or impairment ‘trigger’) needs to occur before credit losses are recognised
Hedge accounting may be easier to achieve for certain entities.

AASB 15 Revenue from Contracts with Customers

The core principle of AASB 15 is to recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. AASB 15 introduces a five-step revenue model to determine when to recognise revenue and at what amount.

AASB 16 Leases

AASB 16 introduces a single lessee accounting model (all leases, finance and operating leases, will be accounted for in the same way) and requires a lessee to recognise assets and liabilities for all leases. A lessee will now be required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

Not-for-profit entities only: AASB 1058 Income of Not-for-Profit Entities and AASB 1059 Service Concession Arrangements: Grantors

AASB 1058 establishes principles and guidance that apply to transactions where the consideration to acquire an asset is significantly less than fair value principally to enable a not-for-profit entity to further its objectives, and the receipt of volunteer services.

AASB 1059 outlines the appropriate accounting treatment for infrastructure projects of public sector entities conducted via public-private partnerships.

AASB 17 Insurance Contracts

AASB 17 will replace AASB 4 and requires all insurance contracts to be accounted for in a consistent manner, making financial statements more comparable for users. Insurance obligations will be accounted for using current values, instead of historical cost.

AASB 17 will generally not apply to normal trading entities that have entered into insurance contracts for assets and other business purposes. It will only apply to insurance companies and entities issuing insurance and reinsurance contracts and holding reinsurance contracts.

Key issue 7

These new Australian Accounting Standards come into effect over the next two to four years. You should therefore ensure that the notes to your June 2017 financial statements disclose the impact on the future financial position and results.

Please note the following when reviewing these disclosures:

Directors should not be making statements to the effect that there will be no impact (or no material impact) for a particular standard unless your transition assessment is complete and your auditors are satisfied with your analysis
If you have completed your assessments for particular standards, companies have continuous disclosure obligations to keep the market informed, and as such, the notes should quantify the impacts if transition date has passed, and
If transition assessments are still ongoing, with particular transaction streams or balances having been identified but the impacts not quantified, ASIC still expects a narrative description of the types of transactions and balances impacted, as well as whether earnings and net assets are likely to increase or decrease.

Interpretation 23 Uncertainty over Income Tax Treatments

It is also worth noting that the AASB recently issued Interpretation 23, which could result in significant increases in current tax liabilities for entities with transfer pricing and other uncertain tax positions. Although its recent release means there is unlikely to be expectation from ASIC or users to quantify the impacts in your June 2017 financial report, you will need to consider whether this interpretation could have a potential impact in future and disclose narrative information accordingly.

Consistency of information between the Operating and Financial Review (OFR) and the financial report

While not technically part of the audited financial statements, directors are nevertheless responsible for preparing the ‘other information’ contained in the Directors’ Report and the Operating and Financial Review (OFR).

This ‘other information’ should be consistent with amounts recognised, measured and disclosed in the financial statements. Audit reports for 30 June 2017 for the first time will include a section on ‘other information’. Any material inconsistencies identified between the ‘other information’ and the financial statements that have not been rectified will be described in the audit report (ASA 720 The Auditor’s Responsibility Relating to Other Information).

Key issue 8

Ensure that all discussion and analysis in the OFR is consistent with the way transactions and balances have been recognised, measured and disclosed in the financial report. For example:

Discussion of a poorly performing asset in the OFR should trigger an impairment test and relevant disclosures in the financial statements regarding assumptions used in determining recoverable amount, or
The number of segments disclosed in the segment note should generally correspond with the number of business units whose results are analysed in the OFR. We would usually only expect to see more business units than segments if they meet the criteria in AASB 8, paragraph 12, for aggregating operating segments into fewer reportable segments, and details of the judgements made in applying the aggregation criteria have been disclosed.

Remuneration reports and materiality

Although forming part of the directors’ report, the remuneration report for listed companies required by s300A of the Corporations Act 2001 is audited and then voted upon by members at the annual general meeting (albeit via a non-binding vote under s250R(3)). It is therefore a key piece of information used by shareholders to assess the reasonableness of director and key management personnel (KMP) compensation.

While ‘materiality’ applies to transactions and balances recognised and measured under Accounting Standards, the Corporations Act 2001 includes no such concept. This means that even though Regulation 2M.3.03(5) refers to definitions in accounting standards to determine how much compensation is disclosed for KMPs, there is no materiality threshold. Therefore, details of all amounts paid or payable to KMPs, shares/options/loans to KMPs, as well as transactions with KMPs must be disclosed.

It should be noted that analysts and shareholder groups are also becoming increasingly vocal regarding disclosure of KMP compensation. In many cases, the remuneration report and KMP long-term incentives may be voted down simply because the performance conditions are not adequately or clearly disclosed. Indeed, the descriptions of performance conditions in some reports is either too high level (e.g. a generic statement that performance conditions are ‘based on personal targets’, without including a description of the targets), or too detailed and complicated that it almost appears as if the disclosure has been constructed so that users are unable to understand the terms.

Key issue 9

Review the remuneration report to ensure that information disclosed for KMPs is complete and accurate, including KMP non-cash compensation.

Ensure that performance conditions for KMP long-term and short-term incentives are clearly explained, in Plain English.

Disclosure initiative (‘decluttering’ your financial report)

In line with ASIC’s expectations that directors are responsible for the quality of the financial report, including providing useful and meaningful information for investors and other users of the financial report, entities are encouraged to ‘declutter’ their financial statements and apply judgement when deciding which mandatory disclosures are relevant to users, and which are not.

Key issue 10

Review all accounting policies and ensure:

All redundant accounting policies are deleted
Accounting policies are written in Plain English and tailored to suit your entity’s circumstances, and
Disclosures carried forward from years gone by are deleted if they do not provide useful information relating to current transactions and balances.

To make the financial report even more user-friendly, you may also want to consider:

Moving accounting policies relating to specific transactions and balances into those respective notes (e.g. revenue into the revenue note, PPE into the PPE note, etc.)
Moving disclosures about key estimates and assumptions into the relevant note, and
Re-ordering and grouping notes.

The above recommendations will not only assist users’ understanding of the financial report, but will enable a more efficient and effective process for your own reviews.