Chairman's Report

Portrait image of Michael Coleman, Chairman of the FRC

2013-14 has been an important year of change for the Financial Reporting Council (FRC). This report reflects activities undertaken during the Chairmanship of Lynn Wood whose term ended on 9 June 2014. We have made a number of influential submissions to international financial reporting organisations, and we had a variety of distinguished international visitors, keen to engage the views of FRC members. The FRC has become involved with some new issues, finished its work on others, and there has been a substantial turnover in key members.

Deregulation

The FRC is responsible for overseeing the effectiveness of the financial reporting framework in Australia. FRC’s key functions have included the oversight of the FRC’s accounting and auditing standards setting processes for the public and private sectors, providing strategic advice to the Minister and professional accounting bodies in relation to the quality of audits conducted by Australian auditors, and advising the Minister on these and related matters to the extent that they affect the financial reporting framework in Australia. Following the Australia’s Government’s public commitment to identifying deregulation opportunities, announced in late 2013, the FRC has been asked to provide advice on potential areas for deregulation in the financial reporting sphere, and this process will continue for at least the remainder of 2014. This has very much dovetailed with the work of the FRC’s existing Financial Report Taskforce.

One Set of Global Accounting Standards

Australia was an early adopter of International Financial Reporting Standards (IFRS) in 2005 and this was because Australia recognised early on that with the current pace of globalisation to move to a global set of accounting standards is a logical transition. In today’s world where businesses and investments operate on a global level — companies, investors and other stakeholders all gain from the use of one set of accounting standards. Companies can prepare reports for subsidiaries located in different countries on the same basis; and these companies will face a lower cost of capital because investors can easily understand and compare financial information across jurisdictions, while the problem of regulatory arbitrage is minimised.

In economic terms having one set of accounting standards allows the capital market to operate efficiently and everyone benefits from an efficient market. IFRS are particularly important to Australia given we are a capital importing country. IFRS are now being used by over 120 countries around the world and they are a major contributor to transparency in financial reporting. Furthermore convergence projects between IFRS and US Generally Accepted Accounting Principles (GAAP) have significantly reduced the differences between them. Since 2007 foreign registrants in the US can lodge their financial reports in IFRS without reconciliation to US GAAP.

It is important to recall that US GAAP takes a rules-based approach to accounting standards while IFRS exemplifies a principled-based approach. In general rules-based approaches tend to have a greater regulatory impact, allowing entities to follow the detail of the standards while potentially evading the spirit of the standards. The G20, meeting in Australia this year, has long encouraged adoption of a single set of high quality global accounting standards. For most jurisdictions it is now clear that these global standards are IFRS.

This was a theme of this year’s Ken Spencer Memorial Lecture, given by the International Accounting Standards Board (IASB) Chairman, Hans Hoogervorst. Mr Hoogervorst and the IFRS Foundation Trustees met in Australia for the first time in April 2014. Michel Prada, Chairman of the IFRS Foundation Trustees, attended the April FRC Meeting and gave an insightful update of international financial reporting developments. Australia’s existing strong influence in the financial reporting world was also reflected in the then FRC’s Chairman, Lynn Wood’s appointment as an IFRS Trustee in January 2014 for three years.

An increased international focus on audit

Audit reforms were introduced in Australia in 2012. These reforms were under the Corporations Legislation Amendment (Audit Enhancement) Act 2012 and arose from a 2010 strategic review of audit quality undertaken by Treasury, which considered how Australia’s audit quality framework compared internationally. The general conclusion of the review was that Australia’s audit environment was stable and no major changes were needed. Changes introduced by the Audit Enhancement Act included:

  • Changes to the FRC’s role giving it a strategic policy role to provide advice on audit quality in Australia to the Minister and professional accounting bodies;
  • Provision of flexibility to companies to extend the five-year auditor rotation period by up to two years, provided the audit committee or directors are satisfied that audit quality and independence can be maintained;
  • The requirement for audit firms that audit more than ten significant entities per year to publish a transparency report, ensuring that there is publicly available information about the firms that audit listed and other key entities including banks; and
  • Allowing the Australian Securities and Investments Commission (ASIC) to publish audit deficiency reports when ASIC believes an audit firm has not taken appropriate remedial action to remedy deficiencies, and also allowing ASIC to communicate directly with the audited entity.

By contrast audit reforms being developed in Europe are more detailed and rules-driven and include a 10 year mandatory audit firm rotation regime for the audits of European Union (EU) public interest entities (with a member state option to allow for a further ten years if a competitive tender or further 14 years if a joint audit is held).

US Congress, on the other hand, has passed a law banning the Public Companies Accounting Oversight Board (PCAOB) from requiring audit firms rotation, and a Canadian review of audit quality in 2013 took a similar view against mandatory audit firm rotation. Thus it will be difficult for Australia to ensure its regulatory regime remains of a similar design to both the EU and North America as we have tended to do in the past.

Given the Government’s deregulatory focus it appears unlikely Australia will emulate EU developments.

A number of reforms being undertaken through the International Auditing and Assurance Standards Board (IAASB) will influence audit firm behaviours around the world including Australia, given that we conform with International Standards on Auditing (ISAs). These reforms are aimed at enhancing audit quality and reducing options for regulatory arbitrage.

IAASB projects likely to be of relevance to Australia include:

  • The auditor reporting project by which the IAASB seeks to enhance the auditor’s report to provide more meaning and value for investors and other stakeholders. The FRC made a submission, developed by the Audit Quality Committee, on the IAASB’s Exposure Draft;
    • Users of financial reports have widely divergent understandings of the concepts of ‘going concern’. As such, the FRC proposed that care should be taken when considering expanding auditor commentary on this concept. This position was verified via a 2012 FRC survey conducted on the perceptions of the usefulness of audit reports to retail shareholders. The FRC believes that the concept of ‘going concern’ and its application is a matter better addressed by accounting standards rather than auditing standards. We continue to encourage the IAASB to liaise with the IASB to clarify the relationship between accounts prepared on a going concern basis and the medium to long-term viability of an entity.
  • In December 2013 the IAASB released A Framework for Audit Quality: Key Elements that Create an Environment for Audit Quality which describes in a holistic manner the different elements that create the environment for audit quality at the engagement, firm, and national levels, as well as relevant interactions and contextual factors.

Financial Literacy of Directors

In 2011 the FRC established the Board Education Taskforce to consider the issue of board understanding of financial reporting. In September 2012 the Taskforce released its report with the results of a survey and its recommendations and concluded its work. There have been three areas of follow-up activity from the Taskforce’s work during 2013-14 (involving a considerable amount of work from the FRC’s stakeholder bodies):

  1. ASIC has developed a webpage on financial literacy for directors with links to appropriate courses on financial literacy for directors provided by Chartered Accountants Australia and New Zealand (formerly ICAA), CPA Australia, the Institute of Public Accountants (IPA) and the Australian Institute of Company Directors (AICD);
  2. A free directors’ financial literacy app is being developed by a working group of the same organisations so that directors will be able to self-test their financial literacy and take appropriate education if warranted; and
  3. The AICD has developed and released a publication called Financial Fundamentals for Directors. This follows the AICD introducing compulsory continuous professional development requirements for all directors. These require directors to keep up to date with developments affecting directors, including changes to financial reporting requirements, accounting standards and regulatory expectations.

Complexity

In 2011 the FRC established a taskforce looking at ways to reduce complexity in financial reporting. The Managing Complexity Taskforce recommended in its final October 2012 report that the FRC should:

  1. Examine how the current financial reporting regime for the various types of reporting entity in Australia can best be explained and understood and — if needed — seek rationalisation of the regime (for example through further deregulation of who needs to report).The FRC Financial Report Taskforce has been established to look at this question and is expected to report in 2014-15.
  2. Encourage a more coordinated approach between different agencies of government when considering accounting disclosure requirements.The Australian Accounting Standards Board (AASB), Auditing and Assurance Standards Board (AUASB) and ASIC are working closely to encourage simplification of reporting practices in Australia. As a result the AASB released a staff paper To Disclose or Not to Disclose: Materiality is the Question on the AASB website. The AASB is also contributing to the IASB’s efforts to achieve simplified disclosure requirements. ASIC has confirmed that its financial reporting surveillance program focuses on the importance of material disclosures and emphasises that directors and auditors should focus on disclosures of useful and meaningful information for investors and other users.
  3. Encourage preparers to make better use of developments in information technology in financial reports. For example companies can present their online reports in an interactive format rather than in PDF alone to allow users to better navigate the reports. The Taskforce suggested that consideration be given to allow companies to present governance policies and procedures online to help prevent boilerplate language in annual reports.The third edition of the Australian Stock Exchange (ASX) Corporate Governance Council’s Corporate Governance Principles and Recommendations has taken up this suggestion and is offering greater flexibility to listed companies to make online governance disclosures.

Forward-looking information and integrated reporting

The Corporations Act 2001 (Corporations Act) requires disclosing entities, public companies, large proprietary companies and registered schemes (s. 292) to prepare a financial report with specified content (s. 295(1)) including financial statements, the notes and directors’ declaration. The financial report is designed to assist stakeholders in the reporting entity to make informed decisions about allocating scarce resources. Financial reports are helpful in reviewing the performance and financial position of an organisation at a point of time, in the past. At least since the global financial crisis (GFC) there has been a group of users of financial reports seeking more forward-looking information. This trend has led to more attention being assigned to the management discussion and analysis (MD&A) in the annual report.

Last year ASIC introduced Regulatory Guide 247 (RG 247) to assist preparers better complete the MD&A, known in Australia as the Operating and Financial Review (OFR). RG 247 guides the reporting entity to tell its story effectively. It describes how to provide shareholders (and other stakeholders) with a narrative and analysis to supplement the financial report and assist them in understanding the operations, financial positions, business strategies and the entity’s prospects.

Integrated reporting is another development relevant to the objective of demonstrating how an organisation creates value over the short, medium and long term and includes forward-looking reporting. In 2011 the FRC established an Integrated Reporting Taskforce, which has coordinated FRC submissions to the International Integrated Reporting Council (IIRC). The FRC made a submission on the IIRC’s proposed framework in July 2013, raising concerns about the potential addition to reporting burdens.

The FRC continues to monitor developments in integrated reporting, but it seems clear that there will be no move to mandate such reporting in Australia in the short term.

Full compliance with the principles of Integrated Reporting would require forward looking disclosures. Company directors continue to be concerned about the inherent uncertainty of forward looking disclosures and whether there are appropriate and adequate protections for corporations and directors when making these disclosures. They argue further protections are needed for directors to be able to make more meaningful forward looking disclosures.

The current ‘business judgment rule’ in the Corporations Act does not provide comprehensive protection to directors. The ‘business judgement rule’ is only a defence to the directors’ duty of care and diligence, it is not available as a defence to allegations of false or misleading forward looking statements or any other reporting requirement in the Corporations Act.

Outlook for 2014-15

Over the coming year the FRC will continue its work providing advice on potential deregulatory initiatives in the financial reporting sphere. We also expect that the work of the Financial Report Taskforce will provide useful background to the long run work of governments (including the States and Territories) in this area.

We also anticipate that the FRC will continue to closely monitor developments in audit quality, as required by the Australian Securities and Investments Commission (ASIC Act). This will be largely achieved by a program of consultation with the key professional bodies, and other relevant agencies such as ASIC.

Finally we expect a continued renewal in the membership of the FRC, with Jan West and Andrew Fleming stepping down.

Acknowledgements

I would like to acknowledge the contributions of all FRC members for the generous assistance they have provided, not least their tireless input to the work of our various Committees and Taskforces. I would particularly like to note the contribution made by Lynn Wood, Chairman from March 2011 to June 2014 and who has done an exemplary job as Chairman, brought an enormous energy to the role and a genuine desire to ensure the FRC’s relevance. The creation of detailed Strategic Plans and the FRC Taskforces will be seen as significant legacies of her term as Chairman. I wish Lynn the best in her important role representing Australia, and indeed the region, as an IFRS Foundation Trustee, overseeing the work of the IASB.

I would also like to especially thank a number of longstanding FRC members who have stepped down this year after making a significant contribution:

  • Kevin Stevenson (Chairman AASB)
  • Kevin Simpkins (Chairman New Zealand External Reporting Board)
  • Grant Hehir, Heads of Treasuries Accounting and Reporting Advisory Committee (HoTARAC)
  • Jim Murphy (Treasury).

SIGNED

Michael Coleman
Chairman of the Financial Reporting Council
17 October 2014