Financial Reporting Reform - implications for charities
||It’s happened! The most significant financial reporting reform for the past 20 years has now been legislated. So what does this mean for charities in New Zealand?
New Zealand financial reporting legislation has been undergoing significant reform in recent times. This comprehensive reform has now largely been legislated via a number of new statutes as well as amendments to existing ones. The most significant amongst this new legislation, at least as far as the charitable sector is concerned, are the Financial Reporting Act 2013 (FRA 2013) and the Financial Reporting (Amendments to Other Enactments) Act 2013. Among other things, the FRA 2013 prescribes the functions of the External Reporting Board (XRB), the Crown Entity that is charged with developing New Zealand’s overall financial reporting strategy. The XRB is also responsible for developing and issuing financial reporting and auditing and assurance standards for application in New Zealand.
The legislation now prescribes “who has to report” – what type of entities are required by law to prepare general purpose financial reports (GPFR). For such entities the XRB then has the role of developing the “what” they have to report, i.e. the applicable accounting standards that will represent GPFR.
The new Accounting Standards Framework
The XRB has now implemented a new “Accounting Standards Framework” for New Zealand. This is quite a radical departure from previous financial reporting directions where we tried as a country to globally harmonise our financial reporting and keep as much as possible to a “one size fits all” form of accounting standards. Both of these aims were intellectually laudable with some sound logic behind them. However, in a country that is essentially made up of what would be considered micro-entities when measured on the world stage, this was akin to using a rather large sledgehammer to crack every nut.
As a result, our new Accounting Standards Framework consists of a two-sector, four-tier structure with different accounting standards applying to each tier. The two sectors are the “For-Profit” sector and the “Public Benefit Entity” (PBE) sector, the latter of which includes public sector entities, not-for-profit entities, and the subset of those: registered charities. This development of accounting standards on a multi-sector, multi-tier basis has allowed a much more “horses for courses” approach, meaning the applicable standards are much more likely to result in a better cost/benefit balance.
While initially some may look with horror at having a multitude of differing accounting standards in place (including many accountants!), there is sound logic in what has been done. International accounting standards are still used as the base unless there are very strong reasons not to do so. Harmonisation with Australia is also seen as important. However, there are different accounting issues faced by PBEs compared to For-Profit entities and accordingly it makes sense for the accounting standards to reflect and accommodate these.
For example, International Financial Reporting Standards (IFRS – the accounting standards used internationally for For-Profit entities) do not have a standard for accounting for non-exchange revenue, such as donations and grants, because that is not something that profit-seeking businesses have to deal with. In contrast this is a big issue in the PBE sector. Another similar example is accounting for heritage assets, such as a cathedral – you cannot usually sell them, they cost money to maintain, they often have dubious income-producing capacity, yet many consider them priceless. Hence trying to apply a commercial asset valuation and accounting approach to a heritage asset is nonsense and IFRS had no reason to have such an accounting standard in its suite.
The XRB has also been very cognisant of the make-up of the various sectors in New Zealand and appreciates that we have a large number of very small entities. Accordingly it has designed some “Simple Format Reporting Standards” for the smaller PBEs to reflect the relative costs and benefits of reporting by entities of this size. In developing these it has taken a “blank piece of paper” approach and determined what needs to be reported, with every decision having been run through a cost/benefit lens. The result is some very simple and pragmatic standards that should be a breath of fresh air for the sector once implemented.
What does this mean for charities?
All registered charities will be required to prepare annual financial statements in accordance with the accounting standards issued by the XRB thanks to the FRA 2013 and amendments to the Charities Act 2005. These are divided into four tiers based on size – three use accrual accounting and the fourth tier (very small entities) is permitted to use cash accounting. This will become mandatory for accounting periods beginning on or after 1 April 2015.
The significance here is that, in the past, the vast majority of registered charities (and there are currently around 27,000 in total in New Zealand) have not been required by law to comply with accounting standards. To see the impact of this one only has to invest a bit of time searching the financial statements of registered charities on the Charities Register (www.charities.govt.nz). While many charities have attempted to comply with existing accounting standards, there are also many cases of very poor quality accounting and financial reporting. This does not serve the sector well.
Requiring charities to follow specified accounting standards by law, as well as requiring the Department of Internal Affairs’ (DIA) Charities Services to be (in effect) the regulator to ensure compliance, should in future help to improve the accountability of charities.
Also proposed (via the Accounting Infrastructure Reform Bill) is a mandatory requirement for independent audit or review engagement assurance over larger charity financial statements.
The impact of changed accounting standard requirements for charities will vary across the sector. For some not much will change, but for many the accounting changes are likely to be significant and will require some education and mind-set changes. For example, the timing of some revenue recognition may change significantly. Effort and resource will need to be applied to understanding the impacts and in achieving the transition from one accounting treatment to another.
Accountability, transparency and comparability
Fundamentally, accounting is about accountability. Charities should be accountable to their stakeholders for the funds they raise and how they use these. Accordingly, if they wish to continue to enjoy the support of their stakeholders, it is in their best interests to account clearly and well.
To charities, “key stakeholders” are donors and taxpayers. Registered charities receive an economically important benefit in being exempt from paying income tax. This effectively means all other tax payers are subsidising charities. Tax exempt status is granted by the Government via registration as a charity with DIA Charities Services.
A quid pro quo is that there needs to be a high level of transparency and accountability in the financial reporting of charities to help maintain public confidence in the sector. However, the general public does not have the power to specify accounting standards or an assurance engagement. Hence it seems appropriate that this should be required by legislation.
The independent assurance requirement is one of the last missing pieces of the new financial reporting reform jigsaw. Audit and assurance requirements for larger charities are being proposed by the Ministry of Business, Innovation and Employment (MBIE) due to the perceived need for higher levels of transparency and accountability from the large charities.
Registered charities are currently required by the Charities Commission to include financial statements in their annual return. The Charities Commission then loads the financial statements lodged with it onto its website to allow public viewing. However, at present there is no requirement either from legislation or from DIA Charities Services for those financial statements to be audited or reviewed. The primary reason for this is that there has been no mandatory requirement in the past to do so. It is only the result of either provisions in the charities’ own constitutions or specific requirements of funding bodies that has led to entities in the sector previously being audited.
There is a lovely quotation from a U.S. Supreme Court Justice Louis Brandeis that “Sunlight is the best disinfectant”. This neatly encapsulates the concept of openness and transparency. People who feel uncomfortable under the bright light of scrutiny and criticism often (usually?) have something to hide. This is where the benefits of professional independent assurance come in.
The proposals are that “large” charities (defined as those with annual operating expenses over $1 million) will require an audit by a qualified auditor. “Medium” charities (defined as those with annual operating expenses over $500,000) must have either a review or an audit by a qualified auditor.
Linked to accountability are the important concepts of transparency and comparability. The standardisation of requirements to help ensure quality reporting, such as common accounting standards that must be followed. A requirement for an independent audit (or other form of independent assurance) will help achieve enhanced transparency and comparability in regard to the financial affairs of charities.
Charities will have to follow accounting standards relative to their size as set by the XRB. Audit and assurance requirements for larger charities are proposed to be legislated to complete the financial reporting reform for charities.
While the changes will take some work to implement, these changes should eventually see a much improved level of financial accountability, transparency and comparability as regards financial reporting in the charitable sector in New Zealand in future. In time, this should lead to better informed governing bodies, funders, business and other key stakeholders, thereby improving decision-making and increasing confidence in the charitable sector.
Craig Fisher FCA is Chairman and Audit Director at Hayes Knight Chartered Accountants, and a specialist regarding NFP and charitable entity issues. Craig can be contacted on 09 367 1654 or email@example.com.
A recent ADLS CPD seminar on charities law at which Craig Fisher spoke will shortly be available as an on demand CPD product. Please check www.adls.org.nz/cpd for further details.