The Top 10 Financial Reporting Issues for Directors to Pay Attention to
Among numerous other duties, company directors are responsible for the company’s financial statements. Although directors must ensure that they fully understand the company’s financial statements and are satisfied that they fairly present the company’s financial position, performance and cash flows, there are inevitably some issues that are more complex and/or more significant than others, and these are the areas that will typically require the greatest attention by directors.
The complex and/or significant issues faced by companies depend on a number of factors, including the industry in which the company trades and factors specific to the entity itself, such as its financing structure, its relationships with other entities, the basis on which it carries assets (such as historical cost or fair value) and its revenue sources.
However, some issues tend to be complex and/or significant more commonly than others, with the following being, in no particular order, the ten financial reporting issues that typically require the most attention from directors:
- Unusual events with substantial impacts
- Selection of accounting policies
- Classification of relationships with other entities
- Lease modifications
- Fair value
- Asset impairment
- Revenue recognition
- Business combinations
- Presentation and disclosures.
Issue number 1 – unusual events with substantial impacts
Unusual events with substantial impacts don’t strike very often, but when they do the way in which they are addressed in the financial statements typically requires the application of considerable professional judgement. Unusual events range from the global (think COVID-19) to the company specific (such as the loss of a major customer, or a destructive natural event such as a flood).
In such circumstances, there are typically four questions that need to be considered during the preparation of the financial statements:
- Is the business a going concern?
- What is the impact of the event on the items in the financial statements?
- What has happened subsequent to the reporting date?
- How should the impact of the event be presented in the financial statements?
Is the business a going concern?
Financial statements are prepared on the basis that the entity reporting is a going concern (i.e. that it will continue to operate for at least 12 months from the date of signing the financial statements). When determining whether an entity is a going concern, all available information, including information that arose after the reporting date, must be considered.
From a financial reporting perspective, there are only three possible answers to the question of whether an entity is a going concern. Those possibilities, and the ramifications of each, are:
|The entity is not a going concern
||The financial statements must be prepared on a realisation basis (i.e. assets and liabilities must be recognised as current and assets must be carried at the amount that they are expected to be realised for)
|The entity is a going concern, but there are material associated uncertainties
The financial statements must include a note outlining the material uncertainties associated with the going concern assumption
|The entity is a going concern
||The financial statements do not need a note that specifically addresses going concern issues (although it might still be appropriate to address the issue if the impacts of the unusual event are so substantial that users of the financial statements might have concerns about the ability of the company to continue trading)
Where the going concern assumption remains valid, but there is a material uncertainty about its validity, information about that uncertainty should be disclosed in a note to the financial statements. That note should:
- Adequately disclose the principal events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern
- Adequately disclose management’s plans to deal with those events or conditions
- State that the financial statements are prepared on a going concern basis
- Clearly state that there is a material uncertainty related to events or conditions that may cast significant doubt on the ability of the entity to continue as a going concern
- Clearly state that, if the entity is not a going concern, it may be unable to realise its assets and discharge its liabilities in the normal course of business.
What is the impact of the event on the items in the financial statements?
Unusual events with substantial impacts typically affect several areas of the financial statements. All of these impacts from the event must be identified and quantified, so that the financial statements are fairly presented.
To ensure that all impacted items are identified, a two pronged approach can be useful:
|Brainstorming of impacts
||A brainstorming of impacts will enable identification of the most substantial impacts and will enable connections between impacts to be identified and examined.
|Detailed review of the financial statements
A detailed line by line review of the financial statements will enable all issues to be identified
Alternatively, more granulated information could be obtained by going one step further back and analysing each line item in the trial balance
Typical impacts from unusual events include (but are not limited to) the following:
|Accounts receivable/loans advanced
||Change in impairment due to changed expectations about credit losses
Write offs due to spoilage
Reduced selling price (potentially causing net realisable value to fall below cost)
||Change in fair value
|Property, plant and equipment
Change in fair value (if carried under the revaluation model)
Impairment due to change in business model
||Impairment due to expectations of reduced profitability
|Other intangible assets
||Impairment due to change in business model or changed expectations (for example, about customer retention)
|Deferred tax assets
||Recognition of reduced amount, or derecognition, due to expectations of reduced profitability
Increased returns due to increased online orders
Onerous contracts (such as supply contracts with minimum order quantities)
Recognition of a restructuring provision due to restructuring plans that have been communicated to impacted parties
||Recognition of an increased amount due to expectations of the borrower’s reduced capacity to meet loan repayment
||Reclassification from non-current to current due to covenant breaches
What has happened subsequent to the reporting date?
When examining subsequent events, which are events that occur between the reporting date and the date of signing the financial statements, the issue that must be considered is whether these events impact the primary financial statements. To enable this issue to be resolved, New Zealand equivalents to International Financial Reporting Standards states that there are two types of subsequent events:
- Subsequent events that provide evidence of conditions that existed at the end of the reporting period (these are referred to as adjusting events after the reporting period)
- Subsequent events that are indicative of conditions that arose after the reporting period (these are referred to as non-adjusting events after the reporting period).
The requirements in relation to adjusting events and non-adjusting events are:
|Type of event
|Adjusting events after the reporting period
The financial statements must be adjusted to reflect these events
The event and the adjustments made to the financial statements must be disclosed
|Non-adjusting events after the reporting period
The financial statements must not be adjusted
The event must be disclosed if it is material
The following are examples of adjusting events after the reporting period that would require an entity to adjust the amounts recognised in its financial statements, or to recognise items that were not previously recognised:
- The settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period
- The receipt of information after the reporting period indicating that an asset was impaired at the end of the reporting period, or that the amount of a previously recognised impairment loss for that asset needs to be adjusted – for example, the bankruptcy of a debtor that occurs after the reporting period usually confirms that the receivable was impaired at the end of the reporting period and the sale of inventories after the reporting period may give evidence about their net realisable value at the end of the reporting period
- The determination after the reporting period of the cost of assets purchased, or the proceeds from assets sold, before the end of the reporting period
- The determination after the reporting period of the amount of revenue collected during the reporting period to be shared with another entity under a revenue-sharing agreement in place during the reporting period
- The determination after the reporting period of the amount of profit-sharing or bonus payments due to employees, if the entity had a present legal or constructive obligation at the end of the reporting period to make such payments
- The discovery of fraud or errors that show that the financial statements are incorrect.
The following are examples of non-adjusting events after the reporting period that would ordinarily warrant disclosure:
- A decline in the fair value of listed investments between the end of the reporting period and the date when the financial statements are authorised for issue
- A major business combination after the reporting period
- After the reporting period, announcing a plan to discontinue an operation
- Major purchases of assets subsequent to the reporting period
- The destruction of a major production plant or facility by a fire after the reporting period
- After the reporting period, announcing a major restructuring
- Major share transactions after the reporting period
- Changes in tax rates or tax laws enacted or announced after the reporting period that have a significant effect on current and deferred tax assets and liabilities
- Commencing major litigation arising solely out of events that occurred after the reporting period.
Where events are moving rapidly, it can be particularly challenging to determine which subsequent events are adjusting and which are non-adjusting. In some instances, keeping a timeline of key events can assist the preparers of financial statements to differentiate between those subsequent events that provide evidence of conditions that existed at the end of the reporting period and those subsequent events that are indicative of conditions that arose after the reporting period.
How should the impact of the event be presented in the financial statements?
As unusual events with substantial impacts can affect many areas of the financial statements, locating a summary of impacts in one note will make it easier for users of the financial statements to understand the extent and severity of the impact of the event. Locating a summary of impacts in one note also makes it easier to completely remove the information from the financial statements once the event and its impacts have passed.
The summary note should:
- Be located as close to the beginning of the notes as possible
- For each impact from the event, provide only highly summarised information and cross reference to the note where more detailed information is provided (this will prevent information being unnecessarily repeated and will make it easier for users of the financial statements to understand the totality of the impacts from the event and each impact in detail.
Finally, many of the matters outlined above require the application of considerable professional judgement and/or significant estimates to be made. These judgements and estimates must be disclosed in the normal manner.
In future editions of Accounting Alert, we’ll examine the remaining top ten issues.
For more information on the above, please contact your local BDO representative.
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