Blind Freddy – Common errors in presentation of financial statements – Part 3

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

AASB 101 Presentation of Financial Statements is the standard which sets out key principles around presentation of the four primary financial statements, and is intended to assist users of financial statements in understanding the performance of that entity.

In our April and May Accounting News articles on this topic, we discussed Blind Freddy errors relating to the following aspects of AASB 101:

The need to include four primary statements in a financial report
The layout of those primary reports
The need to include notes to support those primary statements
The need to include comparatives
The need to have the third balance sheet when there is retrospective restatement
Key guidance as to going concern
Key guidance on disclosing estimates and judgements
Requirement to refer to the accounting framework
Requirement to provide additional disclosures where specific disclosure requirements in accounting standards are insufficient
Offsetting
Classifying assets and liabilities as current or non-current.

This month we highlight Blind Freddy errors when complying with the disclosure requirements in AASB 101 regarding the four primary financial statements.

Blind Freddy error 1 – Profit and loss disclosure - Distinguishing different types of revenue and other income items

Interest income

Users get useful information about an entity’s performance if they are able to distinguish between revenue earned from providing goods and services to customers and revenue from earning interest on deposits. Some of this interest income may arise through the Impact of applying the effective interest rate model rather than being paid physical cash for interest income. A material error can occur where interest income is not clearly identified.

In addition to items required by other Australian Accounting Standards, the profit or loss section or the statement of profit or loss shall include line items that present the following amounts for the period:

(a)	revenue, presenting separately interest revenue calculated using the effective interest method;
(aa)	gains and losses arising from the derecognition of financial assets measured at amortised cost;
(b)	finance costs;
(ba)	impairment losses (including reversals of impairment losses or impairment gains) determined in accordance with Section 5.5 of AASB 9;
(c)	share of the profit or loss of associates and joint ventures accounted for using the equity method;
(ca)	if a financial asset is reclassified out of the amortised cost measurement category so that it is measured at fair value through profit or loss, any gain or loss arising from a difference between the previous amortised cost of the financial asset and its fair value at the reclassification date (as defined in AASB 9);
(cb)	if a financial asset is reclassified out of the fair value through other comprehensive income measurement category so that it is measured at fair value through profit or loss, any cumulative gain or loss previously recognised in other comprehensive income that is reclassified to profit or loss;
(d)	tax expense;
(e)	[deleted]
(ea)	a single amount for the total of discontinued operations (see AASB 5).
(f)-(i)	[Deleted]

AASB 101, paragraph 82

Gains and losses from derecognising financial assets measured at amortised cost

On the same theme as interest revenue above, these disclosure requirements, if not correctly applied, will result in users being unable to properly understand the underlying performance of an entity. In this case, users would be unable to distinguish between income from normal operations providing goods and services to customers, and profits made on disposing of a loan book or another financial asset.

Blind Freddy error 2 – Profit and loss disclosure – Distinguishing different types of expenses

Another Blind Freddy error that is often encountered from paragraph 82 above, is failing to disclose the following expense items separately on the face of the statement of profit or loss (if material):

Finance costs
Impairment losses
Reversal of impairment losses, and
Profits/losses of associates /JV using the equity method.

Blind Freddy error 3 - Not distinguishing those items in comprehensive income (OCI) that will subsequently be reclassified to profit and loss from those that will not

The simple example of an item that will not be classified through profit or loss is a revaluation reserve in respect of property, plant and equipment (PPE) under AASB 116 Property, Plant and Equipment. Perhaps the more serious ‘Blind Freddy’ error is where losses on cash flow hedge reserves that are recognised in OCI through a cash flow hedge reserve are not clearly identified as being an item that will be reclassified as a loss through the income statement.

The other comprehensive income section shall present line items for the amounts for the period of:

items of other comprehensive income (excluding amounts in paragraph (b)), classified by nature and grouped into those that, in accordance with other Australian Accounting Standards:

will not be reclassified subsequently to profit or loss; and
will be reclassified subsequently to profit or loss when specific conditions are met.

the share of the other comprehensive income of associates and joint ventures accounted for using the equity method, separated into the share of items that, in accordance with other Australian Accounting Standards:

will not be reclassified subsequently to profit or loss; and
will be reclassified subsequently to profit or loss when specific conditions are met.

AASB 101, paragraph 82A

Blind Freddy error 4 - Not disclosing the income tax relating to each item of other comprehensive income (OCI)

While paragraph 82A specifically requires disclosure of the income tax expense on profit/loss items in the statement of profit or loss, there is no specific requirement to disclose income tax relating to items of OCI in the OCI section of the statement of profit or loss and other comprehensive income. Indeed, paragraph 91(b) merely requires that if OCI items are presented ‘gross’ on the face of the statement of comprehensive income, then one line for the aggregate tax effects is to be shown, split between items that will be reclassified to profit or loss in future, and those that will not.

This could lead to users having difficulty identifying the after tax amount of each item of OCI.

An entity shall disclose the amount of income tax relating to each item of other comprehensive income, including reclassification adjustments, either in the statement of profit or loss and other comprehensive income or in the notes.

AASB 101, paragraph 90

An entity may present items of other comprehensive income either:

net of related tax effects, or
before related tax effects with one amount shown for the aggregate amount of income tax relating to those items.

AASB 101, paragraph 91

Blind Freddy error 5 – Hybrid expense presentation

Another common Blind Freddy error occurs when preparers adopt a mixed format, or hybrid, presentation format for expenses in the income statement.

AASB 101, paragraph 99 expressly requires an entity to present an analysis of expenses using either their:

Nature, or
Function.

An entity shall present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function within the entity, whichever provides information that is reliable and more relevant.

AASB 101, paragraph 99

Expenses by ‘function’ would typically include expenses such as:

Cost of goods sold
Marketing costs
Occupancy costs
Administration costs, and
Costs for other types of functions within the business.

However, expenses by ‘nature’ would typically include more line items in profit or loss. Instead of disclosing ‘cost of goods sold’, by ‘nature’ expenses would instead reflect the changes in inventories and finished goods from the beginning to the end of the reporting period. This format would also include disclosure of employee benefit expenses, and depreciation and amortisation expenses.

Blind Freddy error 6 - Not disclosing depreciation expense, amortisation expense and employee benefit expense separately where a ‘function’ format is used in the income statement

Following on from Blind Freddy error 5 above regarding presentation of expenses as either by nature or by function, where a functional presentation format is used, many preparers omit the specific disclosure of employee benefits and depreciation and amortisation expense required by paragraph 104 (if material).

An entity classifying expenses by function shall disclose additional information on the nature of expenses, including depreciation and amortisation expense and employee benefits expense.

AASB 101, paragraph 104

Blind Freddy error 7 - Not disclosing significant accounting policies

There is some debate as to exactly which accounting policies need to be disclosed in an entity’s financial statements. For example, should an entity disclose:

All possible accounting policies from accounting standards?
All those that could apply to the entity because the entity operates in an industry that could one day come across that particular transaction or balance?
Just those that do apply to the entity because the entity actually has such transactions and balances?

With decluttering of financial statement being required for 30 June 2017 financial statements, (a) and (b) would appear to go against the basic principle of removing superfluous information from the accounts.

Even if applying (c) above, there are probably many accounting policies that can be omitted because the impact of the underlying transactions and balances is not material to the financial statements. However, in applying this decluttering process, preparers should be careful not to omit accounting policies that could have a significant impact on the financial statements.

Disclosure of accounting policies

An entity shall disclose its significant accounting policies comprising:

the measurement basis (or bases) used in preparing the financial statements; and
the other accounting policies used that are relevant to an understanding of the financial statements.

AASB 101, paragraph 117

Blind Freddy error 8 - Not disclosing key judgements involved in applying the entity’s significant accounting policies

Because IFRSs are principles-based, and not rules-based standards, judgement may be required when applying certain accounting policies. For example, entities would need to apply judgement in determining:

Whether the acquisition of a business is a business combination to be accounted for under AASB 3 Business Combinations, or as an asset acquisition
Whether they have control over another entity under AASB 10 Consolidated Financial Statements
Whether they have significant influence under AASB 128 Investments in Associates and Joint Ventures
Whether they are acting as principal or agent to determine the amount of revenue to be recognised under AASB 118 Revenue, etc.

Because different accounting treatments could result in vastly different results, it is vital that details of judgements made are unambiguously disclosed in the notes to the financial statements so that the users can understand the financial implications of having selected one accounting policy over another.

An entity shall disclose, along with its significant accounting policies or other notes, the judgements, apart from those involving estimations (see paragraph 125), that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.

AASB 101, paragraph 122

Blind Freddy error 9 – Not disclosing key estimates
Many items in the financial statements are subject to estimation uncertainty because they rely on various management assumptions, the outcome of which could vary, depending on the outcome of future, uncertain events. These include:

Allowance for doubtful debts on trade receivables, inventory obsolescence and impairment of non-financial assets such as property, plant and equipment and intangibles
Useful lives of assets
Employee leave provisions
Warranty provisions
Recovery of deferred tax assets
Share-based payment valuations
Fair values of financial instruments and non-financial assets.

A common Blind Freddy error is that many entities include a form of ‘boilerplate’ disclosure for all these items which provides little, if any, information to enable users to make informed economic decisions.
Paragraph 125 only requires disclosure where there is a significant risk of a material adjustment to the carrying amount of assets and liabilities in the next financial year.

Sources of estimation uncertainty

An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:

their nature, and
their carrying amount as at the end of the reporting period.

AASB 101, paragraph 125

Blind Freddy error 10 – Not disclosing dividend information

Dividend information is useful to users of financial statements in making economic decisions and should therefore be included in the financial statements.

In many cases, dividends relating to the profits earned in a particular reporting period are only declared after the reporting date, once the profit for the period has been finalised. These dividends are not recognised in the financial statements (even though they relate to profit for the period) because they are only declared after the end of the financial year and at the reporting date, no obligation exists to pay the dividend.

Another common Blind Freddy error occurs where disclosure of these dividends are declared after the reporting date is omitted.

An entity shall disclose in the notes:

the amount of dividends proposed or declared before the financial statements were authorised for issue but not recognised as a distribution to owners during the period, and the related amount per share; and
the amount of any cumulative preference dividends not recognised.