6.1 CLERP 1 reforms
The Government issued its CLERP 1 paper in 1997. Following an extensive consultation process, legislation was enacted in 1999 to implement the paper's policy proposals.
The key reforms were:
- an overhaul of the institutional arrangements for accounting standard setting;
- the Australian Accounting Standards Board (AASB) was re-constituted independently of the accounting profession which previously provided its secretariat;
- the Financial Reporting Council (FRC), comprising key stakeholders in the accounting standard setting process, was established to: provide broad oversight of the standard setting process; seek contributions towards the costs of the process; appoint the members of the AASB (other than the Chair who is appointed by the Treasurer); approve and monitor the AASB's priorities, business plan, budget and staffing arrangements; and determine its broad strategic direction; and
- an objective of furthering the development of a single set of high quality accounting standards for world-wide use, including their adoption in Australia.
The new institutional arrangements have been in place formally since 1 January 2000 and are working well. The Government is satisfied that the AASB has access to appropriate resources to meet its heavy workload. In line with the tripartite funding model proposed in the CLERP 1 paper, funding is currently provided by government (at the Commonwealth, State and Territory levels, totalling $2 million a year) and the accounting bodies ($750,000 a year), and is being sought from the business sector.
In July 2002, the FRC approached Australia's top 100 listed companies for voluntary contributions, seeking a total annual funding commitment of $750,000 over three years.
In addition, in June 2002, the Parliamentary Secretary to the Treasurer announced $2 million in additional funding over two years to help Australia meet its goal of adopting international accounting standards. This funding will be sourced from the Financial Industry Development Account maintained by the Australian Stock Exchange.
These initiatives will see substantially more investment going into the building of quality accounting standards than at any time previously.
While these new funding sources will enable Australia to make a significant financial contribution to the International Accounting Standards Board (IASB), the FRC has made it clear to the AASB that it will have first call on the funds to meet its own standard setting priorities, including public sector projects and the significant preparations needed for adoption by Australia of international accounting standards by 2005.
The Government has no plans at present to alter the institutional arrangements as they relate to accounting standard setting. However, as proposed in Part 2, it would like to make use of the expertise of the FRC in the audit area. This is seen as preferable to establishing a new body which would in any event require a similar composition and stakeholder support base.
6.2 Adoption by Australia of international accounting standards by 2005
Australian accounting standards are recognised by accounting standard setters world-wide as being of high quality. However, with Australia comprising less than two per cent of the world capital market, participants in markets overseas have little incentive to understand them.
The Government has long recognised the benefit to Australia of a common global accounting language. In a globalised economy with large and growing cross-border capital movements, high quality internationally accepted accounting standards will facilitate cross-border comparisons by investors and enable Australian companies to access international capital markets at lower cost. Business and other stakeholders have given strong support to the Government's convergence objective.
The 1997 CLERP 1 paper proposed that a key role of the FRC should be to ensure that the AASB is committed to, and works towards, the adoption of IASB standards in Australia. This objective was reflected in amendments in 1999 to the Australian Securities and Investments Commission Act (ASIC Act) which took effect from 1 January 2000 - except that the Act was silent on the source of international best practice accounting standards to apply in Australia, reflecting the debate then current about whether US GAAP or IASB standards were likely to fulfil that role.
It was nevertheless recognised at the time that there were potential disadvantages in Australia adopting US GAAP. These are black letter standards and interpretations which are unfamiliar to most Australian companies, have been developed in the context of the US legal environment and enforcement regime, and over which Australia has no influence.
The United States has yet to commit to the adoption of IASB standards and continues to require that Australian and other foreign companies seeking to raise funds or list on the US market reconcile their financial statements to US GAAP. However, the US is reviewing its standards with a view to making them more principles-based and is working with the IASB to achieve greater convergence of US and IASB standards.
Meanwhile, as part of its move to a single capital market, the European Union has decided that EU listed companies will be required to apply IASB standards in their consolidated financial statements for reporting dates beginning on or after 1 January 2005. EU member states have the option of extending this requirement to the individual financial statements of listed companies and to the financial statements of non-listed entities.
European developments are likely to put pressure on the US at least to accept IASB standards for cross-border raisings and listings.
IASB standards have been adopted, or are in the process of being adopted, by significant Asian economies, including Singapore, Hong Kong and China. The International Organisation of Securities Commissions (IOSCO) has also recommended that its member countries adopt 30 core IASB standards for purposes of cross-border offerings and listings, subject to reconciling items.
Against that background, the FRC, on 3 July 2002, announced its formal support for the adoption by Australia of IASB standards by 2005. In practice, this will mean that single entity and combined financial statements required under the Corporations Act will need to be prepared in accordance with IASB standards for accounting periods beginning on or after 1 January 2005. With the need to present one year comparatives, the changeover will effectively commence for most Australian reporting entities from 1 July 2004.
The FRC's announcement was fully consistent with long-standing Government policy under CLERP 1, as reflected in the 1997 paper and subsequent legislation. Indeed, the 2005 timetable is considerably later than envisaged by the Government in 1997, due to slower than anticipated progress at the international level.
In any event, Australia could not realistically adopt IASB standards earlier than Europe. Equally, adoption by Australia later than the European timetable would result in Australian accounting standards being out of step with both Europe and the United States - an outcome the Government does not believe Australia could contemplate.
Accordingly, the Government fully supports the FRC's position on the timing of adoption of IASB standards in Australia. The Government will continue to support the FRC and AASB in discharging their responsibilities for managing the transition to 2005 and encourages stakeholders to work constructively with these bodies on implementation issues.
6.2.1 Implementation issues
Australia would in virtually all cases accept IASB standards without modification (except to ensure that they are appropriate to the Australian legal and institutional environment). Under the ASIC Act, adoption would occur unless considered not to be in t
he best interests of the Australian private and public sectors. However, such instances are likely to be extremely rare. Any departures by Australia from IASB standards could rapidly erode the advantages of a common accounting language and in particular the acceptance overseas of Australian companies' financial statements as IASB compliant.
The body of IASB standards would be adopted in Australia for reporting periods beginning on or after 1 January 2005. However, existing AASB standards which do not have international counterparts would generally be retained after that date until IASB standards are developed.
The AASB has had a program of harmonisation of its standards with IASB standards since 1996, except where it considered it had a better solution or to remove choices available under IASB standards. The IASB, under its old structure and since the reconstituted Board began operations in April 2001, has been aggressively improving the quality of its standards, drawing on the best the world (including Australia) has to offer with the aim of producing a body of standards that represents world's best practice and is capable of world-wide adoption. Substantial progress has already been made and the IASB is committed to further improvement of its standards in the period to 2005.
To ensure the consistent application of IASB standards across countries, it will be necessary for Australia to also adopt, from 2005, interpretations of IASB standards issued by the IASB's International Financial Reporting Interpretations Committee (IFRIC) and, in the meantime, for the AASB to continue to harmonise interpretations by its Urgent Issues Group with IFRIC interpretations. Similarly, the Government and ASIC will need to further consider measures to promote international cooperation in enforcing IASB standards, having regard in particular to the harmonised enforcement regime being developed by the EU. Even with a common set of accounting standards, the comparability of financial statements could be impaired if standards are subject to differing interpretations and markedly different enforcement regimes.
The AASB has formed a close partnership with the IASB, aligning its work program to the extent possible and standing ready to allocate resources to lead or support projects on the IASB agenda. Recently, the AASB issued a number of IASB exposure drafts in Australia for comment by Australian constituents. It will be important for the business community and other stakeholders to engage fully in commenting on these and future IASB exposure drafts.
The 2005 date will require a major transition by the AASB, the business community, the accounting profession, and users of financial statements, although the harmonisation program has made this transition more manageable than it would otherwise have been.
Many of the details will be a matter for the AASB as the independent standard setter. For example, judgements will need to be made about whether particular IASB standards could be adopted in Australia prior to 2005, or whether the adoption of some standards should be delayed until 2005 in view of their newness and complexity. The AASB will also need to decide how to handle non-conformities between existing AASB and IASB standards - particularly where an Australian treatment is regarded as preferable to the IASB approach. In such cases, the AASB would need to decide whether to seek changes in the IASB standard prior to 2005.
The FRC and AASB have particular responsibilities for ensuring that a strategy for adoption is developed and communicated to stakeholders at an early stage, and that stakeholders are kept fully informed of progress. The accounting bodies also have a key contribution to make through their programs of professional development and their influence on accounting education.
The FRC has indicated that it will carefully consider any AASB requests for additional resources to ensure it is ready for 2005.
Over the years, Australia has influenced IASB standards more than might be expected on the basis of our relative economic position, reflecting our strong expertise in standard setting and the high profile adopted by our standard setting bodies internationally. This contribution is expected to continue in the period up to and beyond 2005 through the work of the AASB and through the active involvement of Australians in senior positions within the IASB (at the oversight, Board, Standards Advisory Council, Interpretations Committee and staff levels).
Proposal 14 - Adoption by Australia of IASB accounting standards by 2005
Australia will adopt accounting standards issued by the International Accounting Standards Board (IASB) for reporting entities under the law for accounting periods beginning on or after 1 January 2005, in line with the European timetable.
6.3 Purpose of accounting standards
As part of the CLERP 1 reforms, the objectives of accounting standard setting were spelled out in section 224 of the ASIC Act. These are:
- to facilitate the development of accounting standards that require the provision of financial information that: allows users to make and evaluate decisions about allocating scarce resources; assists directors to discharge their obligations in relation to financial reporting; is relevant to assessing performance, financial position, financing and investment; is relevant and reliable; facilitates comparability; and is readily understandable;
- to facilitate the Australian economy by: reducing the cost of capital; enabling Australian entities to compete effectively overseas; and having accounting standards that are clearly stated and easy to understand; and
- to maintain investor confidence in the Australian economy (including its capital markets).
A provision was also included (section 228) to make it clear that accounting standards should be interpreted by reference to these objectives and to the purpose or object of the standard. This provision reinforces the principles-based nature of Australian accounting standards by comparison with the more prescriptive, 'black letter' approach applied in the United States.
Although US standards start from broad concepts, they are supported by detailed rules of the Securities and Exchange Commission (SEC) and industry interpretation. This detail can have the unintended effect of encouraging aggressive accounting techniques aimed at circumventing the broad intent of standards (an attitude of 'where does it say I can't do this?').
For example, in the case of Enron, special purpose vehicles were used to avoid the ownership tests in US accounting standards governing the consolidation of entities into group accounts. By focusing on the economic substance, the equivalent Australian test is less susceptible to circumvention than the US test. The Australian standard uses a 'capacity to control' test which looks at whether there is a capacity, whether direct or indirect, to control financial and operating policies of the other entity.
Authorities in the United States have recently called for the development of more principles-based standards and the SEC and Financial Accounting Standards Board (FASB) are reviewing US standards with this in mind.
IASB standards, with which Australia has been harmonising for some years and which will be adopted here from 2005, are also principles-based.
The Government is generally satisfied that the accounting standards that currently apply in Australia, and that will apply in the future after convergence with IASB standards, look to the economic substance rather than the form of transactions.
6.4 Particular accounting standards
In cases where financial reporting concerns hav
e been raised, it is important to distinguish between any identified weaknesses in accounting standards -requiring action by the independent standard setter - and instances of non-compliance with accounting standards or audit failure, which are a matter for the corporate regulator and/or regulatory policy.
Australian accounting standards are acknowledged to be of high quality.
The standard relating to the consolidation of special purpose entities includes a control test that is substantially stronger than the equivalent US test. The question of the appropriate accounting for special purpose vehicles, and the broader question of off balance sheet financing, will be further considered by the AASB as part of the IASB convergence project on business combinations.
The question of insurance accounting, including accounting for reinsurance contracts, has arisen in the context of the HIH collapse. The IASB has an active project on accounting for insurance contracts which the AASB is monitoring and participating in through other processes such as field-testing. The AASB has made a submission to the HIH Royal Commission and will carefully examine the outcome of the Royal Commission for issues of relevance to this project.
The question of the measurement and recognition of derivatives will be considered by the AASB as part of an IASB convergence project relating to Financial Instruments: Measurement and Recognition. The AASB recently sought comments from Australian constituents on an IASB exposure draft of this standard.
The IASB will soon be commencing a project on revenue recognition which the AASB will monitor in accordance with its policy on harmonisation and convergence with IASB standards.
Accounting for stock options
This issue has received attention in the United States where the use of stock options as a component of executive remuneration is more extensive than in Australia. US accounting standards generally do not require the expense recognition of stock options, resulting in significantly higher reported earnings than would otherwise be the case.
Proponents of expensing argue that options are compensation with inherent value and represent a cost to the company which is properly recognised as an expense. They argue that expensing would provide better information to the market and reduce incentives for management to manage earnings to inflate the share price.
Those who oppose expensing have argued that the market already has enough information to be able to value the cost of stock options and factor it into the share price. They also point to measurement difficulties and adverse effects of expensing on small, high-tech companies which rely on options compensation to minimise their start-up costs.
There appears to be strong support among users of financial statements in the US and elsewhere for the expensing of employee stock options.
In Australia, sections 300 and 300A of the Corporations Act include requirements for the disclosure of components of director and executive remuneration, including stock options. The AASB currently has no standard on stock options but is developing a disclosure standard, outlined below.
Section 300 of the Corporations Act requires that 'details' of the options granted as part of the remuneration of directors and the five most highly remunerated officers of a company be disclosed in the annual directors' report. Under section 300A, listed companies are also required to disclose 'details of the nature and amount' of each element of emolument. ASIC has issued a practice note indicating that it expects listed companies to disclose the value of options as emoluments.
The Government has indicated that it will amend the Corporations Act to make it clear that the value of stock options must be disclosed. In addition, the AASB has included in a proposed accounting standard on Director, Executive and Related Party Disclosures a requirement that disclosing entities disclose as remuneration:
- the value of equity-based compensation benefits based on the net fair value of the equity instruments; a valuation methodology is also specified; and
- information on the terms and conditions of grants of equity compensation and other bonuses in the year of grant and in subsequent years until fully vested; this includes the price at which options may be exercised and the performance criteria that must be met in order for them to vest.
The AASB issued an exposure draft of this proposed standard on 31 May 2002 and has sought comments by 30 September 2002 with the aim of finalising a standard by early 2003. The proposed AASB standard is a disclosure standard only and would not require the expensing of stock options.
The IASB does not currently have a standard on options generally. However, it has on its agenda a high priority project, 'Accounting for Share-Based Payment', which would require expensing of equity-based remuneration, including stock options. The IASB's aim is to develop a high quality accounting standard that will provide a basis for international convergence of standards in this area (few countries currently have standards on the topic).
The IASB has agreed in principle that share-based payment transactions should be expensed in the financial statements at the fair value of the shares or options issued, estimated at grant date. A valuation model would not be prescribed but entities would be required to disclose the model used and the inputs to it. The IASB aims to issue an exposure draft of this standard towards the end of 2002.
In line with its policy of harmonisation and convergence of its standards with IASB standards, the AASB intends to mirror this project and to issue the IASB exposure draft in Australia on the same time-frame as the IASB's due process. The IASB could issue its final standard in late 2003. It would then be adopted by the AASB.
In the meantime, the ASX's Corporate Governance Council has urged listed companies to voluntarily and fully disclose the existence and conditions of all share and options schemes currently in operation, together with details of performance hurdles.
A number of major Australian companies have reviewed their stock option schemes in the light of market concerns about whether they are a transparent and effective method of executive remuneration. Some have announced that they will suspend or discontinue their schemes. The Government encourages similar reviews by all companies which provide remuneration in this form.
Proposal 15 - Expensing share options
The IASB standard requiring expensing of share options will have the force of law on adoption by the AASB, expected to be in the second half of 2003.
In relation to risks surrounding the amounts disclosed in financial statements, the IASB has proposed in its initial improvements project that financial reports should include the following additional disclosures:
- their nature; and
- their carrying amount as at the balance sheet date.'
'An entity shall disclose, in the summary of significant accounting policies and/or other notes, the judgements made by management in applying the accounting policies that have the most significant effect on the amounts of items recognised in the financial statements.
An entity shall disclose in the notes information regarding key assumptions about the future, and other sources of measurement uncertainty, that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of:
The AASB will monitor the resp
onses to the IASB exposure draft and IASB deliberations on this issue. Under the convergence objective, Australia would adopt the final form of this provision in 2005 at the latest.
The Government encourages the AASB to continue to work in close cooperation with the IASB to address any gaps or deficiencies in the body of accounting standards that apply in Australia - in particular, any that potentially give rise to systemic risk or industry vulnerability.
6.5 Requirement for accounts to be true and fair
Under section 297 of the Corporations Act, annual financial statements and notes must give a true and fair view of the financial position and performance of an entity and, where consolidation is required, the consolidated entity.
The Corporations Act also notes that this section does not affect the obligation under section 296 for a financial report to comply with accounting standards. If the financial statements and notes prepared in accordance with accounting standards would not give a true and fair view, additional information must be included in the notes to the financial statements under subsection 295(3)(c) of the Act. This subsection states that the notes to the financial statements are: disclosures required by the regulations; notes required by the accounting standards; and any other information necessary to give a true and fair view.
Equivalent provisions of the Corporations Act apply to half-year financial reports (subsection 303(3)(c) and sections 304 and 305).
The so-called 'true and fair override' was removed from the Corporations Act in 1991. This provision effectively allowed entities to depart from accounting standards by forming a subjective view that complying with standards would not result in a true and fair view of their financial position.
Such cases may have reflected the unusual circumstances of a particular company which were not adequately dealt with by a standard, or deficiencies in standards that promoted the form of transactions over their substance. However, in other cases, departures from accounting standards involved attempts to conceal relevant information from the market. The subjective nature of these judgements gave rise to inconsistent and non-comparable results as well as difficulties from an enforcement viewpoint.
In response, the provision was amended to require financial reports that include:
- financial statements and notes that comply with accounting standards; and
- additional information in the notes to ensure a true and fair view where compliance with accounting standards would not do so.
This approach preserves the requirement to comply with accounting standards - to ensure consistency and comparability of financial information and for enforcement purposes - while at the same time requiring a true and fair view. In most cases, compliance with accounting standards is likely to lead to a true and fair view.
It is nevertheless important that deficiencies in accounting standards not lead to an unintended requirement that entities report the form over the substance of a transaction - and hence, to a less than true and fair view that would need to be corrected in the notes to the financial statements. If this were to occur, the appropriate response would be an amendment of the accounting standard.
The accounting standards issued by the IASB are rigorous, principles-based, and reflect a broader trend towards the application of fair value accounting. Australia will continue after 2005 to have input to the formulation of these standards. It is important that this input rigorously address any form over substance issue that might otherwise result in a gap between the requirements of accounting standards and the obligation to present a true and fair view.
Proposal 16 - Requirement for accounts to be true and fair
The legal requirement that financial statements comply with accounting standards and that the financial statements and notes together present a true and fair view of an entity's financial position and performance will be maintained.
If any deficiencies in accounting standards have a general, unintended result that compliance with the standard would not result in a true and fair view, the appropriate response would be reform of the standard.