Future developments in financial reporting

The initial focus is inevitably on the wave of significant new accounting standards due over the next few years, which will affect virtually every entity which prepares financial statements. However, Mr Hoogervorst noted that the key challenges extend beyond just the technical requirements of new accounting standards, and went to the heart of the purpose and usefulness of financial statements as a relevant source of information for investors and other stakeholders.

With this in mind, this article highlights the trends in financial reporting that are likely to be of greatest impact over the next few years.

The initial challenge

The next three years will see significant changes to accounting standards, in particular to the big three areas of revenue, leases, and financial instruments. All three areas were recognised as being problematical under the previous standards due to diversity in practice, over-complexity, or standards resulting in outcomes not in keeping with the underlying transactions. The new standards were also part of an attempt to converge IFRS with US GAAP, and thereby create a truly global set of financial reporting standards, although significant differences remain between the two frameworks, and there appears to be little appetite by either party for achieving full convergence in the near future.

Revenue

AASB 15 Revenue for Contracts with Customers is applicable for periods beginning on or after 1 January 2018. It replaces a 20-year-old standard which contained minimal guidance. The new standard sets out a five-step process for revenue recognition:

-Identify the contract(s) with a customer;

-Identify the performance obligations in the contract;

-Determine the transaction price;

-Allocate the transaction price to the performance obligations in the contract;

-and Recognise revenue when (or as) the entity satisfies a performance obligation.

This will likely result in revenue recognition outcomes closer to the commercial substance of transactions. Put simply, the new standard requires preparers to work out what they have promised to their customers, and recognise revenue when those promises are met.

However, application of the detailed requirements is likely to result in greater complexity in recognising revenue, as contracts containing multiple different promises to a customer must be split into their component parts, with the value of each promise determined and recognised separately. Contracts which contain ancillary services, such as maintenance or technical support, are likely to have multiple performance obligations. There will be greater deferral of revenue in many instances, particularly since AASB 15 allows revenue to be recognised only where it is highly probable that recognition will not be reversed.

For many entities, the biggest challenge may be the changes to accounting systems necessary to apply the standard.

The impact will vary by industry. The construction and engineering industries, software businesses, and any others engaging in complex long-term contracts will be significantly affected. Seemingly more straightforward industries, such as retailers or wholesalers, may initially think that the effect is minimal, but it is important for all companies to consider the full range of impacts. For example, issues such as volume discounts for large customers, customer loyalty programs, or the right for retail customers to return unwanted purchases could all significantly impact how income is recognised.

Leases

The new lease standard, AASB 16 Leases had a difficult birth, going through several different exposure drafts. As a result of this lengthy process, it comes into effect one year after the revenue standard. At its heart is the concept that a lease contract represents a liability of the entity, and therefore that liability should be shown on the balance sheet.

The necessary corollary of this is that the right to use the leased asset must also be recognised. As a result, there is no longer ‘rent’ as an expense. Instead, companies will recognise interest on the lease liability, and depreciation on the right-of-use.

The increase in liabilities recognised will significantly impact gearing ratios and the level of indebtedness, particularly for sectors that make extensive use of leases, such as retail or transport.

The new model means that the expense of a long-term lease is no longer recognised on a straight-line basis. Instead, since it is partly treated as interest, the cost is front-loaded, with a greater expense being recognised in the earlier years of a contract.

Financial instruments

The new financial instruments standard, AASB 9, is perhaps the most overlooked of the three, as there is a common misconception that it only significantly affects banks and financial institutions. While the ‘expected credit loss model’ will impact banks the most, any business with trade receivables will require a new approach to assessing their impairment. It will no longer be permitted to wait until a receivable is past due before a provision is recognised. Instead, entities will have to estimate the expected loss on their entire trade receivables balance.

Transition

The new standards allow the use of a modified retrospective approach to transition. This means that, instead of full retrospective restatement of comparative results, only those contracts open at the date of adoption are recalculated as if the new standard had always applied, and any difference is recognised directly through equity. While this may lessen the burden of transition, it may make financial statements more difficult to compare, since an entity may end up reporting three consecutive years under three different sets of standards.

The future

Once the changes above are implemented, the expectation is that there will be a relative period of calm in accounting standards. While significant changes to the standards themselves may reduce, the next key area of focus for preparers is likely to be making their financial statements more relevant and easily comprehensible to users.

This involves using them as a communication tool to tell investors the story of what is happening in the business. The ever-increasing length of financial reports means that many readers now question the value of much of the information contained within them.

The IASB has already made one small but significant change in this area, by changing the standards to emphasise the application of materiality in preparing financial statements. In particular, it has emphasised that materiality applies to disclosures, and that a disclosure required by the standards should only be included where it provides relevant information to users. Indeed, inclusion of too many immaterial disclosures may sometimes be seen as an attempt to distract from more relevant information.

The IASB’s recent paper on Better Communication in Financial Reporting gave an insight into the board’s proposed direction. There was a strong emphasis on refreshing the usefulness of financial statements by treating them as an important communication platform rather than a compliance tool.

This included emphasis on:

-Use of clear, plain English, in relatively short sentences, rather than technical language;

-Changing the order of the notes to the financial statements to group relevant items together, and including details on accounting policies together with the relevant note;

-and Increased use of charts and graphics to present data more clearly.

By adopting these principles, financial statements can be used to help investors better understand the story behind the results presented, and to retain their relevance even in a world where traditional methods of communication are subject to rapid digital disruption.

Ralph Martin, national technical director, RSM Australia