Ralph Martin

The global push to simplify financial statements is gathering momentum, and those preparing accounts should take the opportunity to conduct their own “decluttering” process, says Crowe Horwath’s Audit Technical Director Ralph Martin.

He says there is widespread acknowledgement that financial statements have become too lengthy and complex, and those preparing accounts should take advantage of recent changes to accounting standards to make them far more accessible to investors or other readers.

“Financial statements have grown in size every year, with a typical ASX-listed company often preparing more than 100 pages of information. Although listed companies are the most visible example, private companies, charities and government entities often experience similar issues.

“It’s not surprising that some companies revert to preparing two sets of financial reports; those required to comply with the Australian Accounting Standards, which are increasingly regarded as a compliance exercise, and those where the company produces additional, specifically tailored reports for its shareholders.

“While it can be tempting to place blame purely on the accounting standards themselves, ‘disclosure overload’ can also arise from the way that some financial statements are prepared, with over-reliance on generic templates and checklists, without consideration for what investors would like to know, and how best to present information to them.

“We see situations where companies with small market capitalisations are producing lengthy reports for shareholders. You have to ask what the benefit is.”

The International Accounting Standards Board (IASB) launched an initiative to work out how to reduce “disclosure overload”, with a key outcome being a revised version of AASB 101Presentation of Financial Statements.

The revised standard clarifies several key concepts around financial statement preparation, including:

• Changing the structure of the financial statements in order to give more prominence to relevant areas.
• Applying the concept of materiality to ensure that information within the financial statements is relevant to the readers.
• Although each standard contains specific minimum disclosure requirements, a company doesn’t need to provide a specific disclosure required by an Australian Accounting Standard if the information is immaterial.
• Those preparing financial statements should not try to obscure material information by “hiding” it in a large volume of immaterial information.

Martin says these principles are designed to reassure those who prepare financial statements that they have the freedom to apply the concept of materiality and exercise judgment in deciding what should be included in financial statements.

“This includes a greater focus on relevance, removing unnecessary notes and wording, change to the order of the financial statements and to use plain English.

“For example, it’s not necessary to include a note for every material balance. Rather, consider which notes genuinely provide further useful information to the end user.

“Also, using plain English is key. The use of technical language and accounting jargon is a common complaint by readers of financial statements, particularly when describing accounting policies.”

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Ralph Martin

Small business owners such as retailers or distributors who lease their premises could find themselves being forced to renegotiate the terms of their bank loans in the wake of a change in the accounting treatment of most leases according to leading accountancy firm, Crowe Horwath.

The International Accounting Standards Board (IASB) has just issued IFRS 16 Leases that effectively abolish the concept of the operating lease and treat all leases as finance leases. The end result is that almost all leases will be recognised as liabilities on the balance sheet rather than the current distinction between operating and capital leases.

Ralph Martin, Crowe Horwath’s Audit Technical Director, says one of the unintended consequences of the standard could be to force small business owners who lease their premises to renegotiate their loan agreements with their banks if this change in accounting standards puts them in breach of their loan covenants.

“Many loan agreements contain covenants based on ratios such as debt-to-equity or interest cover. The new standard could significantly affect those calculations.

“What was treated in the past as an operating lease will now sit in the balance sheet as a liability. The effect could be to trigger a breach of their loan covenants that could give the bank the right to demand repayment of the loan in full.

“Exceptions to this significant standard will be short-term leases (less than one year) and low-value assets such as office equipment and computers, but clearly won’t exclude long-term property leases.”
The saving grace for small businesses is that the standard doesn’t take effect until 1 January 2019, but Martin says it’s essential they begin to prepare now for this important change in accounting standards.

“It’s easy to think that 2019 is nearly three years away, but our advice to small businesses is to start preparing for the change now.”

“The new requirements can be complex, so it’s important to seek appropriate professional advice. Not all businesses will be affected equally. We expect the sectors to be most affected to include retailers and distributors, agribusiness, and the logistics and haulage industries.”

The decision to issue IFRS 16 Leases reflects a long-standing view among global standard setters of accounting standards that the previous standard, IAS 17 Leases, was too ambiguous.

Martin says: “The previous distinction between finance leases, which were recognised on balance sheets, and operating leases, which were not, was often arbitrary, and resulted in substantial lease obligations being visible to investors only in the notes to the financial statements.

“Under this standard the nature of the expense recognised in the income statement will change.

Instead of being shown as rent, or as leasing costs, it will be recognised as depreciation on the leased asset, and an interest charge on the lease liability. The interest charge will be calculated using the effective interest method, which will result in a gradual reduction of interest cost over the life of the lease.”

“One effect of the new standard is that sale-and-leaseback arrangements can no longer be used as a method to keep debt off the balance sheet.”

Aside from potential breaches of loan covenants, Martin says there are three other possible consequences:

• It may require some entities to adjust their accounting systems in order to capture the data required for implementation.
• Many loan covenants, business acquisition arrangements, and other contracts make use of EBITDA-based metrics. Payments that were previously classified as “rent” may now be treated as a mix of “depreciation” and “interest.” This may particularly impact earn-out arrangements based on EBITDA multiples.
• The replacement of today’s straight-line expense approach of operating leases with the front-loaded recognition of the interest expense may affect the timing of earnings associated with major projects or asset groups.

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