Is corporate New Zealand ready for the ‘Big 3’?

February 2018

pwc.co.nz

New Zealand companies are facing the most significant changes to accounting standards since the introduction of IFRS in New Zealand in 2007. These changes affect some of the most prevalent transactions in the financial statements – financial instruments, revenue and leases. Although the new requirements will not change cash flows, they could potentially have a significant impact on earnings profiles, financial ratios and financial analysis.

With this in mind, we looked at the NZX 50’s financial statements two years out from their first reporting date under the new financial instruments and revenue standards to see if companies are prepared for the changes.

By now, companies should have commenced their assessment of the potential impact of these standards and should have had a clear plan for implementation and transition.

The findings from our review however, appear to show that companies have more work to do. Almost 50% of the companies we reviewed had not started their assessment or did not indicate the status of their implementation plan, only a handful provided quantitative information on the expected impact of the new standards and most did not reveal their proposed adoption method.

It’s possible that many companies were further ahead than they’ve disclosed, but it’s also likely that many have underestimated what’s required to adopt the ‘Big 3’. Our experience on numerous transition projects is that even companies with straightforward business models have discovered that the issues can be complex, their reported results will be affected and they’ll need to make significant changes to their systems and processes. We’ve also seen examples where the standards will not have a material impact, but considerable work has been required to become comfortable that this is the case.

In November 2017, the FMA published its second update on its expectations for FMC reporting entities regarding their readiness for the new standards. They expressed concerns that many entities had not started their assessment of the potential impact.

The next reporting season provides corporate New Zealand with a final opportunity to better communicate the impact of the new standards to stakeholders. For Boards and Audit Committees, now is the time to ensure a plan is in place, that companies have the right expertise and resources, and that they will be able to quantify the impact on reported results. If not, investors and the regulator will be asking why.

This is more than a compliance exercise. It’s an opportunity for companies to gain a deeper understanding of some of the most important elements of their business: their revenue and customer engagement process; and the impact of financial risks and the volatility this creates. The question is whether New Zealand companies are ready for this change, and are using this opportunity to enhance communication and transparency, and create shareholder value.

If you’d like to have a chat about your financial reporting and/or how to get your transition plan on track, please contact us or your usual PwC contact.

Is corporate New Zealand on track with implementing the new accounting standards?

Lyn Hunt Partner T: +64 9 355 8863 M: +64 21 318 547 E: lyn.c.hunt@nz.pwc.com

Richard Day Partner, AucklandT: +64 9 355 8824 M: + 64 21 870 572 E: richard.m.day@nz.pwc.com

‘In February, we stressed the importance of adequate plans and processes, and the full, accurate and timely disclosure of any possible impact of adopting the new standards. However, our reviews and recent industry engagement show many entities still haven’t started a proper assessment of the potential impact, or considered an implementation process yet. We are concerned about this, and urge directors and management of FMC reporting entities to actively engage with each other - and their auditors - to ensure readiness for the new standards from 1 January 2018.’ Financial Markets Authority Update, 23 November 2017

What’s changing?

The ‘Big 3’ are effective for reporting periods beginning on or after the following dates:

• NZ IFRS 9 Financial Instruments 1 January 2018

• NZ IFRS 15 Revenue from Contracts with Customers 1 January 2018

• NZ IFRS 16 Leases 1 January 2019

And it’s not just New Zealand companies that will have to apply these standards for the first time. Their equivalent versions will be applied in the world’s largest economies, most of which have adopted International Financial Reporting Standards (IFRS).

Why does it matter?

Some might argue that accounting does not affect cash flows, and therefore changes in the accounting requirements don’t really matter. However, the ‘Big 3’ will affect the financial position and future profits of many New Zealand companies.

A key metric for most companies and a key component of investor analysis is earnings (earnings multiples, or forecast future cash flows). The new accounting standards can make earnings less predictable, creating additional challenges for analysists in understanding past performance and future sustainable earnings.

Typical ratios such as Net debt/EBITDA, interest cover and gearing may be affected by the implementation of the new standards. Although a company’s cash flows will not change, perceptions of risk may change when new accounting standards cause a significant change in those ratios.

Understanding these changes plays a significant role in assessing a company’s value and the impact on financial condition requirements.

Already globally, and in New Zealand, we have seen a number of companies highlight just how pervasive the impact of these standards can be. For example, UK manufacturer Rolls Royce reported that if they had applied the new revenue model to their 2015 aerospace business, revenue would have decreased by nearly £1 billion, while their net assets would have decreased by £3.5 billion. There are other examples closer to home. When Trustpower early adopted NZ IFRS 15, this resulted in a $10 million increase in profit after tax and $40 million increase to net assets.

The new standards and why they matter

Understanding these changes plays a significant role in assessing a company’s value and the impact on financial condition requirements.

What makes good disclosure?

Accounting standards require, and regulators expect, that when a new accounting standard is issued, companies must, in the periods before adoption of the new standard, disclose any known or possible impacts of adoption.

The key elements of good disclosure include the following, many of which ASIC has explicitly communicated but are just as relevant to New Zealand companies:

• Information about the entity’s preparedness for adoption, including a description of its plans for implementation and its proposed transition method.

• Known or reasonably estimable information relevant to assessing the possible impact that application of the new standards will have on the entity’s financial statements.

• Quantitative information for the reporting date that coincides with either the start of the first comparative period, or the start of the year of initial application, depending on which will be affected in the first financial report under the new standards. Information that there will be no material impact will also be important information for the market.

• Impact on other public disclosure documents (e.g. documents prepared for public offerings of securities).

• Expected changes in business practices due to the new standards (e.g. ability to pay dividends, lease versus buy decisions that may impact liquidity metrics).

What about interim accounts?

Listed entities will also need to consider disclosures regarding the impact of adopting the new standards in their interim financial statements. The extent of these disclosures will depend upon the entity’s specific circumstances.

Companies with December year ends only have four months remaining to complete their transition projects and report under these standards for the half year ending 30 June 2018.

Regulators’ expectations

In February 2017, the FMA issued its first update to highlight the importance of the implementation process and the full, accurate and timely disclosures of the possible impact of adopting the new standards.

In November 2017, the FMA further stressed their concerns about the (lack of) readiness of FMC reporting entities for the implementation of the new standards from 1 January 2018. They warned that they will continue to review relevant disclosures and, where necessary, engage with entities about their assessment and implementation processes.

And it’s not just the FMA raising concerns. Regulators world-wide have raised expectations regarding appropriate disclosures, including the Australian regulator, the Australian Securities and Investments Commission (ASIC).

What are the questions Boards and Audit Committees should be asking?

Boards and Audit Committees will need to ask some tough questions to make sure the business is on track for the adoption of the ‘Big 3’. There is no time to waste. If directors are unsure how the implementation process is going, here are some questions to ask management that will reveal where things are at:

• What is the timeline to assess and implement the new accounting standards?

• Who is responsible for executing the implementation plan?

• Where is the implementation up to?

• What is the impact on the way we conduct our business?

• What is the impact on our financial reporting?

• Have we discussed the changes with our auditors?

• What business insights has the process revealed?

One of the most important questions that directors can ask is: how are we going to communicate the impact of the new standards to stakeholders? Investors and analysts will want to know if your company’s reporting profile is likely to change or stay the same, while regulators will want to know that the standards are being appropriately applied.

Boards and Audit Committees will need to ask some tough questions to make sure the business is on track for the adoption of the ‘Big 3’. There is no time to waste.

New standards implementation disclosures by the NZX 50

The research

We performed a review of the financial statement disclosures of the NZX50 for reporting periods ending between December 2016 and September 2017. We looked at how many entities had early adopted one or more of the new standards. For those that were yet to adopt, we focused on their disclosure of the expected impact of adoption, their plans for implementation and their proposed adoption methods. While we were rigorous in ensuring we took a consistent approach to each company’s disclosures, judgement was required when interpreting certain disclosures.

Early adopters

How many companies had early adopted?

Of those yet to adopt how many companies indicated that they will early adopt?

Disclosures by those yet to adopt

Did companies provide more than just boilerplate disclosures?

Less than half of the companies provided more than just boilerplate information as depicted.

The rest simply provided a generic summary of the changes under the new standards, the effective date and that the company is still in the process of assessing the impact of adopting the new standards.

What was the status of the implementation?

Very few companies indicated that they had completed their impact assessment, with only 9 (21%) indicating this for NZ IFRS 9, and 6 (12%) for NZ IFRS 15 and NZ IFRS 16.

NZ IFRS 9

45%NZ IFRS 15

39%NZ IFRS 16

34%

NZ IFRS 9

21%

5%

29%21%

24% CompleteIn progressDid not indicateInitial assessment completeYet to assess

NZ IFRS 9*

16%NZ IFRS 9

7%NZ IFRS 15

2%NZ IFRS 15

4%NZ IFRS 16**

0%NZ IFRS 16

8%

* Adopted at least part of or all of NZ IFRS 9** No companies have early adopted NZ IFRS 16

39%

22%

16%

10%

12%

NZ IFRS 15

NZ IFRS 16

18%

32%26%

12%

12%

6

31

30

20

26

26

Was the potential impact indicated?

More than half of the companies commented on the possible impact of adoption; however, only a portion of these companies indicated that they had completed at least a preliminary assessment.

These results raise the question of whether companies had made sufficient progress in their transition projects to confidently make these disclosures. It is possible that companies had made more progress than their disclosures reveal, but there is the potential that as they complete their assessments, more unexpected outcomes could take companies and the market by surprise. Companies should ensure that the market is fully informed of any changes in expected outcomes as they arise.

Was qualitative information provided?

A number of companies provided qualitative information about the impacts of adoption including disclosure about whether the company expects the impact to be material.

However, the majority of companies provided very little tailored information on how the standards might affect future financial statements. They tended to provide generic information about the standards rather than specific details of how the new requirements apply to the company’s individual circumstances. The lack of specific detail indicates that those companies may have considerable work to do, or at least need to make improvements in what they communicate to the market.

Nevertheless, we have found some specific information about the issues that are likely to have an impact on transition.

10

Provided disclosure of the possible impactProvided disclosure that do not expect material impactsIndicated they had completed their assessment or preliminary assessment

Disclosed impacts of adoption

NZ IFRS 9

• Changes to classification and measurement

• Reduced volatility in the income statement as a result of increased ability to hedge account and changes in the requirements when using options and forwards as hedging instruments

• Amended hedge documentation

• Earlier recognition of impairment losses

• Additional disclosures

NZ IFRS 15

• Delayed recognition of revenue

• Allocation of incentives and discounts

• Capitalisation of customer acquisition costs

• Additional disclosures

NZ IFRS 16

• Recognition of lease assets and lease liabilities

• Front loaded expense pattern for current operating leases due to higher interest recognised on the liability in the early part of the lease

• Changes to key ratios

NZ IFRS 9

42%NZ IFRS 15

32%NZ IFRS 16

34%

NZ IFRS 9

8NZ IFRS 15

2NZ IFRS 16

Was quantitative information provided?

A very small percentage of companies provided quantitative information on the expected impact.

As entities move forward with their implementation plans the expectation is that the level of disclosure should increase, with quantitative information being provided in the reporting period prior to adoption. The 2018 reporting period will be the last chance for companies to provide this disclosure for NZ IFRS 9 and NZ IFRS 15.

Was the plan for the implementation described?

Across the three standards, less than 3% of companies provided any detail about their transition projects, whether a project team has been established, on what areas of the standards the company has focused on and the main activities the entity is planning to do as it moves towards implementation.

Although not specifically required to be disclosed, it is considered best practice to do so and ASIC has explicitly stated that this is expected of Australian listed companies.

Was the transition method described?

By now, companies should be deciding on the adoption method for the new standards, so they are ready to restate comparatives, if required. There are transition options for all three standards as set out below.

We found that across the three standards, less than 5% of the companies gave an indication of which adoption method they will use for the new standards.

This is perhaps not surprising if implementation plans are not well progressed as it is important to understand the impacts of adoption before deciding whether or not to retrospectively apply the new standards.

NZ IFRS 9

2%NZ IFRS 15

7%NZ IFRS 16

12%

Transition methods

NZ IFRS 9

• Companies can choose to restate comparatives

NZ IFRS 15 Choice between:

• Full retrospective approach (comparatives restated)

• Modified retrospective approach (comparatives not restated and any adjustments recognised in the opening balance of retained earnings at the date of initial application)

NZ IFRS 16 Choice between:

• Full retrospective approach (comparatives restated)

• Simplified approach (comparatives not restated and any adjustments recognised in the opening balance of retained earnings at the date of initial application)

© 2018 PricewaterhouseCoopers New Zealand. All rights reserved. PwC refers to the New Zealand member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.