Developing a better financial reporting framework for Australia

Intro:
Hello and welcome to the CPA Australia Podcast, your source for business, leadership and public practice accounting information.

Ram Subramanian:
Hello and welcome. I'm Ram Subramanian, Policy Adviser in Reporting at CPA Australia. Joining us today is David Hardidge, Technical Director at the Queensland Audit Office. David is a financial reporting expert who has spent much of his professional career dealing with practical implementation issues when preparing IFRS based financial statements. David's experience in financial reporting issues spans the listed and nonlisted corporate sector, the public sector, and the private not-for-profit sector. David's here to talk about a major project being undertaken by Australian Accounting Standards Board that proposes to, amongst other things, remove the ability for entities to prepare special purpose financial statements, when they are fulfilling their statutory financial reporting obligations. Welcome David.

David Hardidge:
Hey Ram.

Ram Subramanian:
David, could you perhaps give us a brief introduction to what the Australian Accounting Standards Board, the AASB, is proposing?

David Hardidge:
Yes. Well, broadly the proposals are an update or a revision of what they proposed about 10 years ago back in 2010. And that's essentially to remove the ability of entities to prepare special purpose financial statements, and claim compliance with Australian accounting standards. They're also proposing a revision to the differential reporting framework, and that framework needs a little bit more research for the for-profit, notfor-profit and public sector entities.

Ram Subramanian:
A number of stakeholders see the proposed removal of the ability to prepare special purpose financial statements as very controversial. What are special purpose financial statements?

David Hardidge:
Well, special purpose financial statements was the way that Australia originally introduced the concept of differential reporting. Differential reporting is an acknowledgement that the accounting standards, which are essentially written for listed companies, aren't suitable for all entities such as smaller medium sized entities. So, they introduced differential reporting frameworks, differential requirements, and often simpler measurement requirements and disclosure requirements for smaller entities.

Ram Subramanian:
So, what was the aim of introducing this as an option? So, what was the aim of introducing special purpose financial statements as an option within the differential reporting framework that you just mentioned?

David Hardidge:
Well, the aim was to align the needs of the users with the preparers, and the cost to them. So, essentially the rules were if you had users dependent upon general purpose financial statements, which are sort of widely used financial statements, then you were a reporting entity and you prepared general purpose financial statements for a wide variety of users. If you didn't have those users then you are a non-reporting entity, and that gave you the choice of preparing general purpose financial statements, or special purpose financial statements.

And those special purpose financial statements you had a discussion, and you looked at your users, and you worked out, well, what did you need to comply with? So, you could pick and choose your measurement standards, and pick and choose your disclosure standards. Although some regulators laid out some minimum requirements such as ASIC for companies.

Ram Subramanian:
So, what was the background and history behind the development of special purpose financial statements as part of the Australian Financial Reporting framework?

David Hardidge:
Well, it goes back about 30 years, and we used the concept of disclosure overload. So, we sort of really haven't moved very far given we're using the same sort of terminology now. But broadly, it was before IFRS financial statements where it got a lot more complicated, and it was when each country sort of had their own financial statements. So, it was trying to work out, well, how do we simplify things for businesses? So, it was before the large and small proprietary tests came through.

It was before the concepts of focused finance reporting, streamline finance reporting, and cutting the clutter that we have now. It was before IFRS for SMEs. It was before the reduced disclosure requirements, and it was before some of the more complicated accounting standards we have now. But broadly, it was to try and simplify things for smaller businesses.

Ram Subramanian:
So, that's the background to why special purpose financial statements have a place in financial reporting here in Australia. And how does this work in practice? What happened in practice?

David Hardidge:
Well, in practice I differentiate between companies that prepare financial statements on a voluntary basis and those that have to prepare them and launch them publicly. So, for those who prepare them on a voluntary basis, I think the systems work well. You essentially prepare financial statements in accordance with the needs of the users. And indeed, under the AASB proposals that will still be able to continue, will still be able to continue with special purpose financial statements as long as you don't state that they comply with Australian accounting standards. But for publicly lodged financial statements, it really hasn't gone that well. So, despite the linking of the needs of the users, and cost of preparers, and that sort of has an innate appeal, Australia is unique in the world in allowing this sort of framework.

Allowing companies that have to lodge their financial statements on a public register, allowing them to determine what their reporting requirements are. So, and I thought, well, after 30 years if this was such a great idea, then you would have thought some other countries would have adopted it, and they haven't. And it's widely seen as the system has been abused, although that's not the actual word. They tend to use the terminology of not working as intended.

Ram Subramanian:
Right? So just to explore that issue a bit more, AASB has clearly stated in its consultation that this area is not working as it's supposed to. So, why is the AASB saying that this area is not working as it is intended?

David Hardidge:
Well, they've done quite a bit of research after the proposals 10 years ago, and that was sort of based on anecdotal evidence. But broadly what they're hearing is that directors are choosing where those companies have to lodge their financial statements publicly. Is that they're choosing special purpose financial statements to avoid complying with accounting standards. For example, consolidation leases or avoid disclosures, like related party disclosures. And based on the AASB research is that you can have two entities that are economically the same, same size, same number of users, same sort of borrowings, and you can end up with two very, very different financial statements.

One prepared based on general purpose and a robust framework, and the other prepared on special purpose with the entity self-selecting whatever they want to comply with. So the research, the AASB has concluded that the concept is not well understood. It's not applied consistently in Practice, and it's too subjective for the regulators to enforce. And so that means that there's not a level playing field between companies preparing financial statements. So, there's a lot of companies that prepare these and lodge special purpose financial statements. So the AASB research has about 60% of unlisted disclosure entities prepare special purpose financial statements, and that actually rise up to about 80% of large proprietary companies. And when this whole small and large test came in, I really don't think that there was an expectation that 80% of large proprietaries would be doing special purpose financial statements.

Ram Subramanian:
So, looking at what the AASB is actually proposing, could you perhaps tell us a little bit about what the AASB is proposing for special purpose financial statements, and for the differential reporting framework?

David Hardidge:
Well, the proposing this official purpose financial statements can remain if you're voluntarily producing financial statements, and they're not going on the public register, and you don't say that they complied with Australian accounting standards. So, that's sort of still going to remain the same. So, on the differential reporting, they're going to ... or they're proposing that we continue with a two tier approach. We call it tier one and tier two. So, tier one is that you follow all the recognition and measurement requirements of accounting standards, and all the disclosures, and you can state that you're complying with IFRS. Tier two is that you have to follow all the measurement requirements of the accounting standards, including consolidations, tax effect accounting, payment leases, but you'll be able to have reduced disclosures.

Now, we already have a tier two and the AASB is suggesting or proposing that that tier two continue as is, which is called the reduced disclosure regime, or RDR framework, likely with less disclosures. Or what I call a minimalist approach, which they have labelled specify disclosure requirements. Which is basically the five minimum accounting standards that people need to comply with now, and full disclosures for four specific areas such as revenue, impairment, income tax, and related parties.

Ram Subramanian:
Okay. So just to clarify, tier one remains as is, so full IFRS compliance. Tier two, there are two alternatives, one will be the reduced disclosure requirements framework, or the RDR framework that we already are used to. And the other one will be a minimalist approach, which is the specified disclosure requirements framework, which is the new proposal that they've come up with.

David Hardidge:
That's right. And they're really wanting one of those tier two alternatives. They don't want a third disclosure alternative in there.

Ram Subramanian:
Yeah. You mentioned the term differential reporting framework and IFRS standards that have been developed for listed companies not always being appropriate for all entities. Is the AASB proposing any measurement simplification for it's second tier?

David Hardidge:
No. They're proposing to continue with the tier two as we know it at the moment, which is falling in the recognition and measurement rules as for tier one. But we're finding that a lot of special purpose financial statements aren't necessarily following all the measurement requirements. So, earlier I mentioned that about distinguishing between financial statements that are voluntarily prepared and those lodged on the public record. So, I think if we're looking at simplifications, we have to look at the consequences of that. So, simplification means differences. So, if you're having financial statements lodged on the public record, now do we really want two different sets of profits? One prepared under one framework and one prepared on another framework.

Ram Subramanian:
So what simplifications do special purpose financial statements usually make by choosing not to follow certain accounting standards?

David Hardidge:
Well, we really don’t know, because there's actually no requirement if you're preparing special purpose financial statements to actually state the individual accounting standards that you followed. So, we often find that some say that they're following all the recognition and measurement. Well that's good, but the AASB research is that about 40% who are preparing special purpose financial statements aren't making that statement. So, they may not be following all of them, or they're sort of saying that we follow sort of most but not necessarily all.

So it's a little bit confusing, but there's broadly 40% that aren't clear and categorical in saying that they're compliant with all the measurement rules. So, for disclosures, special purpose financial statements often drop related parties, but we could be really any disclosures because the minimum isn't really very much. For measurement anecdotally we think it's consolidation, income tax and leases.

Ram Subramanian:
So just to clarify on that 40% number, this is 40% of all entities, corporates that are lodging their financials with ASIC?

David Hardidge:
It's 40% of those preparing special purpose. So it's 60% roughly, are preparing special purpose, 40% of that we're not sure. So that's about 24%-25% that possibly aren't following the recognition criteria.

Ram Subramanian:
Okay. Thanks for clarifying that. I thought you said that ASIC issued requirements that companies should follow all the measurement standards, and why are so many not following the requirements? And what has ASIC done about this?

David Hardidge:
Yes. Well, there's quite a few who look as though they are. That's the 40% that I mentioned. 40%, 60%, such, 24%, and that's about 24,000-25,000 companies, so that's about 6,000. So, there's a lot. And why hasn't ASIC done anything? Well, that's one of the problems in the failings of the special purpose financial statement system. It's a very subjective definition. It's very difficult to enforce. ASIC's announcement is technically guidance, so people say, "Well, it's guidance. It's not mandatory." So essentially, make me. So, for ASIC to do anything, they've got a lot of practical difficulties. They basically have to take the company to court, that costs money. It's not a certain outcome.

So, now ASIC do take companies to court when they fail to lodge financial statements, but I haven't really heard of any where they've actually taken it to court and said, "I don't think that you're a non reporting entity, and you should prepare general purpose financial statements." I've heard of ASIC, what we call jawboning, and having some chats and writing letters to companies, but I'm not too sure that's led to a lot of change.

Ram Subramanian:
Okay. Earlier you mentioned that common standard and common accounting standard not adopted is to do with the related party disclosures. That means not disclosing transactions with directors or other entities in the group, in the corporate group. Don't you think that these would be important disclosures?

David Hardidge:
Yes, and they're very sensitive, which is probably why a lot of special purpose financial statement preparers aren't disclosing them. And so yes, I think that they are important, and the AASB is in their proposals are proposing that the related party standard be one of the minimum standards.

Ram Subramanian:
Okay. And you mentioned that the AASB is not proposing any recognition and measurement simplifications, so that's not on the table. What sort of a simplified framework do you think would be suitable if it were to be considered by the AASB?

David Hardidge:
Well, I'd start with IFRS for SMEs. Now, that's essentially it for is for small to medium size enterprises. So, it's used in over 80% around the world, but it's got a bit of a bad reputation for some people. So, the background to IFRS for SMEs is to prepare a single document or single publication of about 200, 300 pages that summarized and simplified IFRSs as they were back in 2005. It will be self-contained, so you only had to look at that publication. You wouldn't have to go to IFRSs, and there was one exception for financial instruments if you really, really wanted to. So, originally it was going to have the simplified requirements. It was going to have the options in an appendix, but that didn't eventuate.

So, when it was issued, the AASB considered its adoption but rejected it for a whole heap of reasons. But mainly it was to do with it didn't allow options that we commonly use in Australia, like asset revaluation. It had different tax effect accounting, it amortised goodwill over 10 years. So we had a few measurement differences. It wasn't going to be kept up to date on a timely basis, and it didn't cater for not-for-profit, which we have to deal with in Australia. So, since then the ASB's fixed up and put back in, or put in reevaluations, it's fixed up the income tax, but it still has an updated the standard for those new IFRSs has over the last 10 years or so.

Ram Subramanian:
And what about the new standard on financial instruments, revenue and leases? Have they been incorporated?

David Hardidge:
No, no. They haven't even updated for, what was it? Business combinations, back in 2008, 2010. So, they're a long way off updating it. Financial Instruments, the rules are fairly close but it only lasts two measurement rather than the sort of the four that the new financial instruments allows. And no, it hasn't been updated for revenue or leases.

Ram Subramanian:
Okay. Has the AASB considered, or rather reconsidered the use of IFRS for SMEs. And if so, has the AASB changed their mind on this?

David Hardidge:
Well, they've had another look at it and really come back to the same conclusion. And what they've done is they've sort of gone further and said that by introducing IFRS for SMEs, it would increase costs, because you've got different reporting requirements. Different recognition requirements, different measurement requirements, and so they're looking at when you work through the statistics, they're saying that of the companies lodging financial statements around 75% are complying with the recognition and measurement requirements. So if we change that, that means all those companies will have an increased burden.

Ram Subramanian:
Personally speaking, what are your thoughts on using IFRS for SMEs in Australia?

David Hardidge:
Well, I think it would be a really good idea to consider. It had a really innate appeal to me. So I started looking at this project over 10 years ago when the ISB started developing their discussion paper of where they should go. And it had an appeal to me that here is something that we're familiar with, IFRS, and it was reduced to something about 200, 300 odd pages. So, it's something you could look at and you could actually read and understand, and yes, say that you've complied with it. And directors could say that they've complied with it, rather than directors signing off on, yes we've complied with accounting standards in 2000 pages of material that they haven't sort of read.

When we're looking at it in Australia, there's sort of two ways. So, the AASB is sort of looking at it from the side of, well, here are the companies required to lodge financial statements. Almost all of them are already following IFRSs. So, if we introduce this it's going to be increased costs. I look at it from a wider perspective, it's not just the 20 odd thousand companies lodging with ASIC, but the wider small businesses and small to medium size enterprises in Australia. And to me that gets into the tens of thousands, and I think that there's a need for it, where we could have a simplified set of accounting standards that people could refer to. And for an example impairment. Problem one, it's 100-page standard in IFRS. IFRS for SMEs, it's eight pages. I mean, you could just go through it quickly. Yes, yes, yes. I've complied with it. You could use the material in the big IFRS, but you didn't have to go back to it. So, I think it would have a lot of benefits.

Ram Subramanian:
Okay. And what would you do about the issues that the AASB has identified with the IFRS for SMEs standard?

David Hardidge:
Well, I think we need to cater for not-for-profits based on our sector-neutral requirements. And I think that having a simpler set for not-for-profits and public sector entities outside whole-of-government, they would also benefit from it. Personally, I don't agree with some of the measurement requirements put in IFRS for SMEs, such as the amortisation of goodwill over 10 years. I was around when we had the reverse sum of the digits method that people sort of used to muck about and reduce their amortisation expense. And so it was great when they introduced an accounting standard, and said that the arbitrary amortisation of goodwill did not provide useful information.

But some people like amortisation of goodwill because they think that it's going to avoid large impairments down the track. So I think we also need to look at, well, what's happened to the accounting standards over the last 10 years, and whether we want to introduce those? Which I think we should consider. Simplifications, as I mentioned, means differences. So what differences are we going to be happy with? So, I'd potentially look at what accounting standards aren't being followed by those preparing special purpose financial statements, and that could be leases. And while putting finance leases on balance sheet was sometimes an issue, we've now got a new accounting standard for IFRS that puts operating leases on balance sheet.

Like office building rentals, and retail shops, and do small and medium size enterprises really want that? And do users really want that? And potentially we could change that and not have it. But I do think that if we went the IFRS for SMEs approach, we would have to create our own version, which is what the UK have done.

Ram Subramanian:
So, we have an example of a country that may have adopted or adapted the IFRS for SMEs in a particular way. So just looking at the UK, the United Kingdom, what did they do? Can you explain a bit about that?

David Hardidge:
Yes. So quite a few ... Well, not a few countries. Quite a few, but a few countries have tweaked IFRS for SMEs, but the UK I think have done the most extensive changes. So, what they did was they added in some requirements for not-for-profits on revenue. They added in revaluations, which the ASB has now done. They made a number of small tweaks to some of the measurement requirements, such as allowing borrowing costs to be capitalised, or expensed. Because IFRS for SMEs requires them to be expensed. But they're small things, but they're all differences, and they've also made some changes to be consistent with their companies act. But they have kept leases as it was, and I'm also with tax effect accounting.

Ram Subramanian:
And did the AASB consider this particular approach taken by the UK?

David Hardidge:
Well, they've considered the UK standard, but not specifically that approach. So the AASB did some research and they looked at what was being done with various tiers of finance reporting in seven countries. So, they looked at New Zealand, UK, Canada, US, South Africa, Singapore, and Hong Kong. So, it's a wide spread of countries and ones that we often refer to, and they've produced a research report and staff paper. But those documents aren't really referred to a lot in the AASB proposals, and the AASB actually doesn't make any recommendations. They just sort of ask for comments and feedback.

Ram Subramanian:
And that particular research that you just mentioned, what did the AASB find in their research?

David Hardidge:
Well, a lot of different frameworks. So, I think that just about every country sort of did it a slightly different way. But they did find that three countries had simplified reporting based on IFRS for SMEs. So that was the UK, Singapore and South Africa. They also found that of the other three countries, that there was only one reporting framework. But that was because the AASB was looking at who lodges financial statements, and in those other countries only sort of the public companies lodge financial statements, and they have to comply with all accounting standards. But when I dug a bit further, each of those three countries have a simplified framework essentially for small and medium sized enterprises.

So, Hong Kong has IFRS for SMEs. Canada stayed with their old Canada GAAP before they moved to IFRS, and the US, the AICPA has introduced a framework for private entities. So, the exception was New Zealand, which has a similar system of tier two reduced disclosures. They have got another tier for what I call micro entities, and then even on further digging with that, one of the other accounting bodies in New Zealand have produced their own simplified framework. So, it sort of seems that all of them have a simplified framework, and we've got 80 odd countries in the world adopting some form of IFRS for SMEs.

Ram Subramanian:
So, what do you basically saying I think is that there is some facilitation, some catering for financial reporting for voluntary purposes. So, not just for lodging but for voluntary purposes as well in some of the countries that you've just looked at. And also what is your take on the research? What's your own take on the research that the AASB undertook in this area?

David Hardidge:
Well, it's as you've said. Essentially a lot of countries have a simplified framework. Often it's on IFRS for SMEs, the 80 odd countries that we mentioned, and even digging through it a bit more for those countries that don't adopt IFRS for SMEs, for example, some European countries I had a quick look at. For example, France and Germany they've got a simplified system. So, that's the old France and German GAAP that they have. Netherlands have a simplified system. So Australia seems to be an exception of not having a simplified framework for small to medium sized enterprises.

Ram Subramanian:
Okay. Looking at the proposals from the AASB, David, when are these changes proposed to come in?

David Hardidge:
Well, they have introducing it in two phases. The first phase is essentially to allow our tier one entities to early adopt, and then mandatorily adopt the revised conceptual framework from 1st of January, 2020. Tier two, a bit confusing on the timing, that seems to be the same timing. The special purpose financial statements are going to stay in the immediate future until the phase two comes in. But it is a little bit confusing for those entities what happens with the revised conceptual framework, because that's got a terminology clash of what the reporting entity means. But broadly the key phase is phase two. What do we want this new reporting framework to be? So the AASB is sort of pushing some urgency because of some clashes with the revised conceptual framework terminology. But I think we've got a little bit of time up our sleeves, and I think we need to take the time and get things right as to what framework do we want?

What framework do we want that will last another 30 years? And personally, I’d like to see a simplified framework considered in a lot more detail. Not just for those lodging, but for small to medium sized enterprises around the country. But there's a number of questions. When we looked at a simplified framework some years ago, people were asking, well, should a privatised Qantas be allowed to adopt it?

And so there's some very, very large companies and should they be allowed to adopt a simplified framework? That's one to look at. We've got to look at what measurement differences do we want. And I think we need to also look at not-for-profit, and also the public sector, particularly those bodies outside whole-of-government. I think they would benefit from a simplified framework as well.

Ram Subramanian:
David, thank you very much for your thoughts today on what's a very important project that will affect financial reporting in Australia significantly in the coming years. So, thank you for your thoughts today.

David Hardidge:
Thank you.

Ram Subramanian:
For listeners interested in learning a bit more about this topic, various resources are being made available on the webpage where this podcast is hosted.

Outro:
Thank you for listening to the CPA Australia podcast.