IFRS KEY RISKS AND MANAGEMENT STRATEGIES

Presentation to the
IPAA CEO breakfast briefing

By Wayne Cameron
Auditor-General of Victoria

25 August 2004

Good morning. It’s nice to be here to discuss the key risks and management strategies necessary to implement the new Australian Equivalents to IFRS.

This briefing on the topic is timely. While there was some debate around the deferral of the application date for the introduction of the new stable platform of accounting standards, we must now accept that the new standards will apply to reporting periods commencing on or from 1 January 2005.

I expect that agencies have already developed, and are implementing, a strategy for the timely transition to the new financial reporting standards commencing on or after 1 January 2005.

The first financial report under the new regime is to be prepared as if the new standards always applied. The need for reporting of comparatives means we all should be addressing IFRS now.

We can look forward to preparing the prior year comparatives.

For some, the implementation timetable is much earlier than their June 2006 accounts.

If you are a university, you will know that the 31 December 2005 year is your target date.

If you prepare interim financial statements in the year of application, you will need to apply the new stable platform.

The only relief (if that’s possible) is that for any standards that are not part of the stable platform with a later application date – early adoption is available. Early adoption is not possible for the stable platform.

All agencies have a responsibility to begin to inform and educate stakeholders, including staff and users of their financial reports, on the impacts of these new standards.

Overview

My presentation will address the following:

• Key risks in implementing the new standards

• Those standards with greatest likely impact

• Other standards under development with AASB

• Implementation strategies.

My Office has been working closely with the Department of Treasury and Finance (DTF) in relation to IFRS, in relation to:

• identification of the major impacts

• planning the content and timing of training

• examining the options available under IFRS and deciding in which situations to limit the choice.

It’s also worth noting that we need leadership from the centre if we are to avoid a shambles.

Before we get started, it’s worth restating what we mean by the new standards:

• The new stable platform

• UIG Abstracts and IFRICs.

Significant issues under Australian Equivalents to IFRS

For-profit/not-for-profit

As was mentioned earlier this morning, the need to classify each entity as either for-profit or not-for-profit is a very significant issue, particularly for the VPS.

What is a “not-for-profit” entity, and what are the implications of being classified “not-for-profit”?

The standards define a not-for-profit entity as an entity “whose principal objective is not the generation of profit”. This criterion for financial reporting purposes does not suggest that not-for-profit entities are in any way less efficient and effective than a for-profit entity. Some Aus clauses permit not-for-profit entities to apply IFRS standards in a different manner than for-profit entities. For example, not-for-profit entities may continue to treat revaluations according to classes of asset, whereas for-profit entities must revalue assets on an individual basis.

What might be the key criteria for determining the classification?

Staff from my Office have being attempting to develop a set of principles that can be applied consistently to determine the classification. This work has been shared with DTF, members of the water sector and commented on by other Auditors-General’s offices around Australia. We understand HOTARAC are doing the same.

Some tentative criteria are:

• Is the intention for the establishment of the entity to generate profits included explicitly in legislation, associated regulations or in its constitution?

• Is the entity funded from the state budget to deliver goods, and/or services for no or nominal cost to the citizen (i.e. the entity is budget dependent)?

• Do the financial targets of the entity reflect profit concepts, or aim to be commercially successful with explicit rates of return etc.?

• Is the entity self-funding in the longer-term, including raising sufficient revenue to meet maintenance expenditures and fund the replacement of the existing service potential of the assets?

• Does the entity pay tax, or is it subject to tax equivalent reporting to the state?

• Does the entity pay dividends and are the dividend targets set at equal to, or greater than, the long-term bond rate when expressed as a rate on equity or contributed capital?

Valuation - fair value or cost?

As many assets in the VPS are not cash-generating, then fair value becomes value in use, which is measured using the written-down replacement cost.

Illustration of special case – Valuation of crown land at highest and best use after consideration of legal restrictions.

The transitional period – the timetable and opportunities

At the date of transition, it will be necessary to prepare an opening balance sheet for the first comparative period. These opening adjustments to the new standards are taken through the equity account, rather than through the income statement. As a consequence, there is an opportunity to clean-up existing issues against equity without impacting on future income statements. For most VPS entities, the transition date will be 1 July 2004. However, entities, which are not June balancers like universities, which close their accounts at 31 December, will have 1 January 2004 as a transition date.

IFRS and the public sector

The basic principle is that the standards are sector neutral. And there are others that contain differing treatments for the public sector (not-for-profit entities) – so be aware.

For example: Inventory standard - Inventory held for distribution: For-profit sector - Lower of cost or NRV; NFP - Lower of cost or current replacement cost.

All standards clearly state the source of the standard. And state the changes to existing standards. One such source is IPSAS. The standards usually incorporate relevant IPSASs into the standard. But in some cases, the existing IPSAS has not been included – where the IPSAS has not previously been exposed in Australia. IFAC PSC is currently rechecking the 20 IPSASs on issue against the IASs to bring them up-to-date. We should become more aware of these IPSASs in the future, since they seek to specifically recognise some of the unique issues of the public sector. For example, the 2 ITCs out for comment are on:

• Revenue from non-exchange transactions

• Accounting for social policies of governments.

Options in standards

One of the problems we in Australia have had in converging with the IASs is the risk that such a step would be regressive. Having travelled so far on the standard-setting path, simple adoption fully could, in some instances, loosen rather than strengthen the value of standards. This is particularly germane for standards such as the Insurance standard when the development of the standard is to be covered in 2 phases – the intermediate phase causing the industry to take a step back in time, but in the knowledge that phase 2 is most likely to reinstate many of the current good practices. This dilemma has caused the AASB to have to, on occasion, make some decisions about whether the options in a standard are really in the best interests of the economy. In some, it has deleted the availability of the other option.

Some argue that this action is not consistent with the harmonisation process. That assertion is not true. A preparer will still have harmonised with the IAS even when the available options are limited.

Aus paragraphs

In a number of cases, the standards include Aus paragraphs. These have been named so as to enable the preparer to understand clearly what has been added from the IAS. They are added to assist in the application of the standard.

Compliance statement

Reporting entities will be required to say that they have applied Australian accounting standards and, where they wish to, comply with IAS.

GBEs are to be treated as for-profit entities – more about who is a for-profit entity later.

Impact of the new standards

Significant issues facing public sector entities

1. The distinction between a for-profit and a not-for-profit entity has been addressed.

2. Employee benefits. The defined benefit plan surplus or deficit will create a new asset or liability on the balance sheet (already a requirement in the Victorian public sector). However, additional volatility may result from using the projected unit credit method of actuarial valuation (if not already used), and in measuring plan assets at fair value.

3. Income taxes will apply to tax-equivalent entities in the public sector. The move from the transaction approach to a balance sheet approach will be challenging both within the private and public sectors.

4. Intangible assets will only be recognised at fair value if there exists an active market to support the use of fair value. Internally-generated intangible assets must not be recognised and research cost must be expensed.

5. Standards that contain an exemption for application to the public sector; e.g.:

• Related parties standard

• Segment reporting

• Remuneration disclosures.

6. Practical implications of consolidating a for-profit entity into a not-for-profit economic entity. For example, with an entity like TCV using fair values, what are the implications for the AFR when it is completed according to adjusted historical cost assumptions?

AASB 101 presentation

• Terminology is different, and at times confusing.

• Statement of changes in equity – local government has always had it.

• Current assets/liabilities definition reinforces use of the operating cycle/or liquidity basis.

• Recycling seems possible in some standards, e.g. financial instruments, increments/decrements through P&L.

• Report by function or nature.

• Extraordinaries now completely out.

Budget impact

• Greater fluctuations.

PP&E standard

• Cost or fair value

• Assets at fair value – standard allows for difficulty in getting fair value – not-for-profits can use discounted replacement cost.

• Increase/decrease can be done by class in the public sector. Private sector has to do it by asset.

• Assets received (donated) – can fair value be assigned (in the absence of historical cost)?

• Disclosure (far value normally requires cost to be shown in the notes) – we don’t need to show this in the public sector.

Impairment

• Not-for-profit dispensation – easier to apply.

• Don’t need to deal with nasties – value in use and cash-generating units.

• For not-for-profits, this is hard to work out – go to value in use + discounted replacement cost.

• Standard has impairment indicators.

Financial instruments

• Much broader scope than what people think, e.g. look at terms of trade.

• No public sector dispensation.

• Classification is important, e.g. hold to maturity portfolios.

• Because “financial instruments” is broadly defined, standards AASB 132 and AASB 139 will have a significant impact on financial reports. It covers cash, debtors, creditors and a broad range of financial contracts, including derivatives. Hence, not only the treasury corporations of the public sector should be interested, but also all departments and agencies will be impacted, even if not dealing in derivatives.

• Presentation and disclosure: Both private and public sector entities will be affected. Principal changes include limiting the valuation of compound instruments with outstanding debt components to valuing the debt component, with equity being the residual difference. The move to AASB 132 will result in more instruments being classified as debt.

• Recognition and measurement: The most significant change will be to bring financial instruments on to the balance sheet at fair value, with changes in the fair value being recognised as income or expense. Financial instruments will be classified into 4 categories, being loans/receivables, held-to-maturity, available for sale, or trading. The classification, in turn, will determine which valuation methodology applies, being either amortised cost or fair value, hedge accounting cannot only be implemented if tight criterion are met, otherwise all gains must be transferred to income or expense.

Inventory

• Use of the lower of cost or replacement value (compared with net realisable value in the private sector.

AASB 119 Employee Benefits
Attention will have to be given to the actuarial method required to calculate any surplus or deficiency on employer-sponsored defined benefit funds. Because AAS 25 Financial Reporting by Superannuation Plans has not been revised, a different actuarial methods may apply, and hence expert advice may be required to meet the reporting requirements under AASB 119.

AASB 112 Income Taxes
This will be relevant to all entities required to report under the tax reporting regime. The move from a transactions approach to a balance sheet approach will involve the production of tax balance sheets necessary to calculate the temporary differences arising. The balance sheet approach requires the determination of both an accounting-based balance sheet and a balance sheet determined according to taxation principles. For each individual asset and liability, the difference between the tax balance and the accounting balance will be a temporary difference. The cumulative total of these differences will be recorded either as a tax asset or a tax liability, which will be classified according to whether they are current or non-current.

AASB 1047 sets out the disclosure requirements of adopting the new standards:

• For 30 June 2004: Disclose the impacts in a note. Likely to be narrative only since many will not be able to quantify these impacts. Our expectation is that many will simply identify the main standards that will impact on measurement, e.g. Treatment of Goodwill, revaluation of Principal, Plant and Equipment, and AASB 139 financial instruments are likely impact on line items.

• For 30 June 2005: Disclose your quantified effects on the reported result and key balance sheet values. You will have done this for the comparatives which will be required for the following reporting year in any case.

AASB 1. First time adoption of Australian Equivalents to International Financial Reporting Standards

The first time adoption/transitional arrangements allow for first time adoption adjustments to be taken directly to equity:

• Opening AIFRP balance sheet

• Recognise all assets and liabilities whose recognition is required

• Not recognise assets and liabilities if not permitted

• Reclassify items previously recognised per new standards

• Apply AIFRP in measuring all assets and liabilities

• Retrospective application

• Targeted exemptions

• Must apply latest version of the standard

• Estimates at the same date

• Transitional provisions not applicable to first time adopter

• Enhanced disclosure.

DTF and my Office will be consulting on the extent of the options available. The general requirement is for retrospective reporting involving the disclosure of comparatives as though the standards applying to your first financial report using Australian Equivalents to IFRS had always applied. AASB 1 has some mandatory and voluntary options to this general rule.

AASB initiatives significant for the public sector

Current AASB initiatives with future significance for the public sector

AAS 27 Financial Reporting by Local Governments – [(ED 125 which includes Accounting for Grants (in the Public Sector)]

• Note that AASB 120 Accounting for Government Grants and Disclosure of Government Assistance only applies to reporting by for-profit entities.

• AASB 1004 Contributions, which has been separated from the revenue standard AASB 118 Revenue, provides the guidance for not-for-profit entities and retains the control criteria for recognition which is part of existing AGAAP.

AAS 29 Financial Reporting by Government Departments

• To be a slimmed-down version of the existing standard, avoiding repetition of issues dealt with in the body of the new standards.

• Re-issue is being delayed because of the GFS/GAAP debate and because of the need to resolve accounting for grants and assistance provided.

AAS 31 Financial Reporting by Governments (GFS/GAAP project and implications for whole-of-government reporting).

Management strategies

Issues to address

• The adoption of Australian Equivalents of IFRS is not just an accounting/financial reporting issue, it should be recognised as potentially having implications across the entity with implications for a broad range of stakeholders, including the governing body of the entity, the CEO, the CFO, finance staff, internal audit staff and the external auditor.

• Appointment of staff to be responsible for implementation and ongoing support.

• Analysis of impacts of adopting Australian Equivalents of IFRS.

• Does the entity have adequate resources to address the issues identified? For example, will further work be needed with the actuaries to cover-off the requirements for accounting for defined benefit plans under the Employee Benefits standard?

• Identify additional information/data to be collected and then check that systems and processes, including software, will be available and capable of collecting, analysing and presenting the information as required by the new standards.

• Appropriate and timely training of all staff, including board members, financial accountants and other staff.

• Communications with stakeholders to be undertaken in a timely and meaningful way.

What to do next

• Familiarise yourself with the breadth of the news standards.

• Develop an implementation timetable.

• Acquire resources to handle the changes.

• Brief audit committee and board, or council, early and frequently on progress with the implementation plan and any impacts, such as budget, expected outturn, performance measures, and resources and advice.

Remember, some of the changes may need accounting systems changes.

Some accounting treatment responses will require guidance from DTF to avoid confusion with quite different treatments being adopted in like industries.

There is no doubt that we have a lot ahead of us. But it’s not that daunting.

We need to prepare now, not next year, but NOW – especially if you have a December balance date, or prepare half-yearly accounts.

To avoid needlessly wasting time on reinventing the wheel on how to respond to the numerous issues, leadership from central agencies is required.

The absence of clear leadership for the public sector runs the risk of spending time on things that won’t matter, and more importantly, risk choosing different paths in like circumstances in the same industry – thus stretching the credibility of the new standards.

A good example of what I mean relates to the decision of whether to remain on historical cost on initial adoption, or embark on the revaluation option. For 2 or more organisations in the same industry – say the water industry – to choose a different option (allowable under the standard) would be hard to explain to the public and to parliament.