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REVIEW OF FINANCIAL REPORTING BY ISSUERS
CYCLE 9

INTRODUCTION

1. The Securities Commission's Financial Reporting Surveillance Programme (FRSP) is an ongoing surveillance programme. This report sets out findings from Cycle 9 of the FRSP.
2. Appendix 1 sets out the background to the Commission's FRSP, including how issuers are selected for review and how matters are dealt with when identified.

CYCLE 9 FINDINGS

Scope and issuer selection

3. In Cycle 9 the Commission reviewed the annual reports of 24 issuers with balance dates from 30 June 2008 to 31 December 2008.
4. The 24 issuers were:¹
   1. 13 issuers listed on the equity security market (NZSX) of NZX Limited (NZX);
   2. 4 issuers with debt listed on the debt security market (NZDX) of NZX;
   3. 1 issuer listed on both the NZSX and the NZDX;
   4. 1 issuer listed on the alternative market (NZAX) of NZX;
   5. 1 issuer listed on both the NZAX and the main board equity security market of the Australian Stock Exchange (ASX);
   6. 1 issuer listed on the Unlisted exchange; and
   7. 3 issuers whose shares are not listed on any exchange.
5. No issuer from Cycle 8 was reselected for review. Three financial institutions were selected for review.
6. Of the financial statements reviewed, 23 were prepared under NZ IFRS and one under US GAAP.

Overall comments on Cycle 9

7. The Commission considers that issuers' overall compliance with NZ IFRS is satisfactory. Notwithstanding that compliance with NZ IFRS was generally good in many areas, in Cycle 9 the Commission continued to find inadequacies in matters that were previously alerted to issuers in our news releases and in previous public reports. These matters include:
   1. financial instrument disclosures;
   2. related party information, in particular, key management personnel compensation;
   3. impairment of assets and associated disclosures;
   4. significant judgements, key assumptions and major sources of estimation uncertainty; and
   5. significant assumptions relating to valuation of investment properties.
8. Seventeen of the 24 issuers' annual reports reviewed contained matters that prompted the Commission to write to the issuers. In writing to the issuers on the 31 matters raised, the Commission also drew the attention of those issuers to 26 other matters.

Outcome of matters raised

9. Table 1 shows the outcome of matters raised in Cycle 9.

10. The Commission again notes that the responses from issuers explained and clarified many of the matters raised. The Commission is pleased with the high percentage of agreement reached with issuers based on the initial letter.
11. However, the Commission continues to remind issuers to ensure that all disclosures are sufficiently transparent, complete and coherent to explain matters included in their financial statements.
12. The Commission will follow up and review the next annual reports of the issuers to ensure that matters raised with them previously have been taken into account.

Specific comments on Cycle 9 findings

13. Figure 1 presents the matters that were most frequently raised with issuers. Each of these matters is discussed in more detail below.

Financial instrument disclosures

14. Financial instrument³ disclosures continue to be a problem area. In the current environment these disclosures are particularly important to enable users to assess the liquidity, market and credit risks of an entity's financial instruments. However, some entities fail to make all the disclosures required by NZ IFRS 7 Financial instruments: disclosures. In particular, the Commission wishes to highlight the inadequate disclosures relating to liquidity risk and fair value assumptions.

Liquidity risk disclosures

15. We have observed over recent cycles that some financial institutions are failing to comply with all the liquidity risk disclosures required by NZ IFRS 7.
16. All entities are required to disclose for each type of risk arising from financial instruments, including liquidity risk, summary quantitative data about their exposure to that risk at the end of the reporting period. This disclosure must be based on the information provided internally to key management personnel, for example the entity's board of directors or chief executive officer (NZ IFRS 7, paragraph 34). These disclosures are intended to provide a useful insight into how the entity views and manages risk.
17. In addition, financial institutions must comply with Appendix E of NZ IFRS 7. Appendix E (paragraph 20) requires that in the absence of sufficient information regarding liquidity risk, financial institutions that manage their liquidity risk on the basis of expected maturity dates are required to provide an analysis of financial instruments on this basis.
18. Besides the liquidity risk disclosures in NZ IFRS 7, we also draw issuers' specific attention to another liquidity-related disclosure requirement. NZ IAS 1 Presentation of financial statements (paragraph 61) requires all entities to disclose, for each line item presented in the statement of financial position, the amount expected to be recovered or settled within and after the twelve months following the end of the reporting period.
19. For some entities the contractual maturity analysis required by NZ IFRS 7 (paragraph 39) may represent similar information to that used by key management personnel to manage their liquidity risk. However, we expect that most financial institutions manage their liquidity risk on the basis of the expected maturities of their financial instruments. For example, where a financial institution has a significant proportion of deposits that are repayable on demand but are not expected to be withdrawn in the near future. Therefore, the quantitative liquidity risk disclosures of financial institutions should, in addition to the contractual maturity analysis, disclose the expected maturities of their financial instruments.
20. The Commission has observed that many financial institutions do not provide any quantitative information other than a contractual maturity analysis. The Commission considers this non-disclosure unacceptable. The issuers we have written to have agreed to make additional disclosures that reflect how they manage their liquidity risk. The Commission will review their next financial statements to ensure these disclosures have been made.
21. An entity we wrote to cited a lack of industry practice of making these disclosures. We remind issuers that to assert compliance with NZ IFRS requires compliance with all applicable standards and interpretations. Entities should not fail to disclose required information simply because other entities are failing to do so.

Fair value assumptions

22. NZ IFRS 7 (paragraph 25), with limited exceptions, requires entities to disclose the fair value⁴ of each class of financial assets and liabilities in a way that permits comparison with its carrying amount.
23. NZ IAS 39 Financial instruments: recognition and measurement contains a hierarchy for determining the fair value of financial instruments. The best evidence of fair value is quoted prices in an active market (paragraph 48). If the market for a financial instrument is not active entities are required to establish fair value by using valuation techniques.⁵ During stressed market conditions the Commission anticipates that entities will need to increase their reliance on valuation techniques to establish the fair value of their financial instruments. This requires more judgement on the part of the issuer.
24. Consistent with this increase in judgement NZ IFRS 7 (paragraph 27(a)) requires entities to disclose:

"the methods and, when a valuation technique is used, the assumptions applied in determining fair values of each class of financial assets or financial liabilities. For example, if applicable, an entity discloses information about the assumptions relating to prepayment rates, rates of estimated credit losses, and interest and discount rates." [emphasis added]

25. The Commission has observed that several issuers use valuation techniques to measure the fair value of their interest rate swaps. However, the issuers did not disclose the assumptions applied in determining those fair values. The disclosures the issuers made only included the method of valuation and a general reference that market interest rates were used to discount the cash flows relating to the swaps.
26. The Commission considers that the actual assumptions applied in determining the fair values of interest rate swaps should be disclosed. The Commission does not consider that general disclosures such as 'market rates were applied' are sufficient to meet the requirements of paragraph 27(a) of NZ IFRS 7.
27. The issuers written to have agreed to make further disclosures to comply with paragraph 27(a) of IFRS 7.

Footnotes

1. The number of issuers reviewed in Cycle 9 is less than previous cycles due to the lower number of issuers with a December balance date.
2. The matters raised exclude the instances where the Commission had written directly to audit firms and/or directors of issuers.
3. Financial instruments include financial assets and financial liabilities. Examples of financial assets include cash, shares in other entities, trade receivables and derivatives that are 'in the money'. Financial liabilities include trade payables, loans received, and derivatives that are 'out of the money'.
4. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.
5. Valuation techniques include using recent arm's length market transactions between knowledgeable willing parties, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis and option pricing models.