Reporting Entities
59. A key issue of general application is "who is required to report?" Reporting requirements place a significant compliance burden on entities. These compliance costs can clearly be justified for large or important public issuers and government organisations that are responsible for significant amounts of investor and taxpayer funds. However it is less apparent that the compliance burden is justified for medium-sized enterprises, and even less so for small operations.
60. In October 2002, the Ministry of Economic Development released a discussion document26 outlining New Zealand's exempt company regime. The exempt company regime provides for lesser reporting requirements for companies that fall below certain income and asset thresholds. The discussion document went on to outline the rationale behind such exemptions from financial reporting requirements.
Rationale Behind Small and Medium Entity Exemptions
61. The Ministry's October 2002 discussion document outlined the following as the typical distinctive characteristics of small and medium enterprises:
- the business is managed by its owners;
- limited internal resources, especially for external "specialist" advice such as lawyers and accountants;
- a high proportion of trade debtors and creditors in their total assets and liabilities; and
- often reliant on short-term loans or overdrafts rather than shareholder capital to finance assets.27
62. The combination of these factors is such that the range of potential users of any financial reports produced by a smaller entity is significantly reduced. The lack of separation between ownership and management means that there is no separate accountability for shareholder or stakeholder monies. Further, it is unlikely that the entity is seeking prospective shareholders or other members who need to evaluate their possible investment or involvement.
63. As a result, some of the accountability and transparency rationales for imposing financial reporting requirements are not applicable to small and medium enterprises. This is compounded by a lack of resources to employ external "experts" to assist in the production of reports. The likely lack of experience in the required law and/or accounting procedures may limit the value of any reports that are produced.
64. This may be further tempered by the usual personal relationships between the management and the owners or stakeholders of smaller entities. An example is the family-owned business with several family members with shareholdings that do not participate in the day-to-day operation of the business. Family members may rely on the relationship with the operator, rather than the accounts produced by that person. Another example is a small incorporated society (for example, a sports club) where members are often either directly involved as club officers or know the officers personally. Further, the owner-operator of a small business is likely to know many of his/her suppliers and/or debtors personally. The alternatives to general purpose financial reports may also be more widely used in the case of smaller entities. Banks are likely to require special purpose financial reports, tailored to their specific needs, while trade creditors may be more likely to use a credit check.
65. On the other hand, some transparency rationales remain in the fact that the more highly geared nature of a small or medium entity means that banks contemplating lending, or suppliers considering extending credit, may wish to inspect financial reports to evaluate the creditworthiness of the entity (notwithstanding other alternatives).
66. It is also possible to overstate the compliance costs of preparing financial reports, given that similar information is required (although in a different format) for tax requirements. Further, the costs of preparing the raw data for different purposes are likely to decrease as technology advances, in particular, accounting software packages.28
67. Nevertheless, there is still a direct and often significant cost. In the following table, it is apparent that the benefits that flow from requiring financial reporting are likely to be reduced the smaller or less important an entity becomes, while at the same time the costs that result are less easily justified.
Figure 1: Should Small and Medium Entities Be Required to Produce Financial Reports? Summary of Factors For and Against
| | For | Against |
| Accountability | Assist owners, shareholders or stakeholders in holding management to account | Unlikely to be separation of ownership and management |
| Transparency | Transparency to external parties (banks, debtors, creditors, employees etc.) | Relationships not usually determined by financial reports - either special purpose reports, personal relationships, credit checks etc. |
| Monitoring and Enforcement | Record of financial performance | |
| Internal Governance | Some benefits in financial discipline | |
| Others | | Cost |
| Required to disclose similar information for tax purposes | Different requirements for different purposes |
| | Lack of resources and experience |
68. New Zealand and most of its major trading partners have therefore decided that, on balancing the rationales for financial reporting with the costs imposed, the full requirements for financial reporting are not justified for small and medium enterprises. Regimes are therefore provided whereby these smaller entities do not have to meet the full requirements. All submissions received in response to the Ministry's October 2002 discussion document supported a proposal to retain reduced reporting requirements for small businesses.
69. Assuming therefore that some form of differentiation is appropriate, further issues are raised in relation to the delineation of large entities from small.
New Zealand
70. The Companies Act generally requires New Zealand companies to maintain accounting records that record and explain transactions and enable the financial position of the company to be determined with reasonable accuracy.29 However, the more detailed financial reporting, filing and auditing requirements are found in the Financial Reporting Act.
71. Under the Financial Reporting Act, New Zealand has a statutory two-tier system for financial reporting, with a further non-statutory intermediate tier implemented by ICANZ. The top tier consists of "reporting entities," which must prepare full financial statements in accordance with all applicable financial reporting standards. The bottom tier of "exempt companies" (companies that fall below certain asset and income thresholds) must complete a very basic financial report, set out in the Financial Reporting Order 1994.
72. The intermediate tier allows appropriate entities (medium-sized and small entities that cannot otherwise take advantage of the exempt companies regime) to prepare financial reports appropriate to their situation.
The Top Tier
73. The concept of reporting entities includes all companies (other than exempt companies), persons that are deemed to be reporting entities by statute,30 and "issuers."31 For the purposes at hand, an issuer includes:
- every person who has allotted securities in accordance with the Securities Act 1978 through an offer made in a registered prospectus or investment statement, or by virtue of an exemption from that Act granted by the Securities Commission;
- every manager of a unit trust; and
- every person that is a party to a listing agreement with a registered stock exchange.32
74. However, the Act deems that certain persons are not issuers, most significantly including:
- the Crown;
- local authorities;
- the Reserve Bank; and
- companies that would fall within the provisions of the Securities Act 1978 by virtue of allotting securities, but have less than 25 shareholders.33
The Bottom Tier
75. An exempt company is defined as a company, other than an overseas company or an issuer, that, in the accounting period for which the financial statements are required:
- has assets less than $450,000;
- has turnover of less than $1,000,000;
- is not a subsidiary of another company, nor itself have any subsidiaries;34 and
- Does not have more than 25 shareholders.35
The Intermediate Tier
76. The intermediate tier is defined in ICANZ's Framework for Differential Reporting.36 This provides scope for an entity to prepare financial reports that differ from the general norm, but are appropriate to that entity's circumstances. This is consistent with general purpose financial statements' overarching principle of presenting information in a true and fair manner.
77. ICANZ's framework identifies three factors in determining whether an entity qualifies for differential reporting exemptions:
- public accountability;
- ownership-management separation; and
- size.
78. These are used as "surrogates" for determining whether an exemption from the full requirements of financial reporting is justified on a cost-benefit analysis. ICANZ considers that when certain requirements for each of the above criteria are satisfied, the costs of requiring financial reporting are not outweighed by the benefits of such requirements, and hence differential reporting exemptions allowed.
79. In this context, in line with the accountability rationales for financial reporting, an entity is deemed to have "public accountability" if the body is an "issuer" under the Financial Reporting Act as described above, or if the entity has the coercive power to tax, rate or levy to obtain public funds. Public accountability is essentially deemed if the entity is responsible for public monies, whether raised through voluntary contributions or coercive powers. A body with this form of accountability should not be able to avail itself of the differential reporting exemptions.
80. Owner-management separation is important for differential reporting, again on the basis of the accountability rationales. Where management is accountable to distinct owners, shareholders or stakeholders, full financial reporting can bring significant benefits, assisting owners, shareholders or stakeholders in holding management to account for an entity's performance. On the other hand, where the management of an entity also owns it, financial reports will do little in holding management to account, and is therefore not justified on cost-benefit analysis.
81. Again on the basis of a cost-benefit analysis, the differential reporting framework is limited to small and medium entities. Even where an entity is not responsible for public monies, nor accountable to distinct owners, shareholders or stakeholders, requiring financial reports will still bring benefits, in particular in terms of transparency, monitoring and enforcement. Parties such as banks, trade creditors, employees and regulators will typically have a legitimate interest in the performance of any entity. However, larger entities are more likely to have larger numbers of interested persons, and are able to better meet the costs involved. Further, the potential economic impact of a large entity, whether through its activities or in the event of liquidation, is such that the transparency, monitoring and enforcement benefits are likely to be greater. As such, the balance of costs and benefits tends toward requiring reporting by large entities, notwithstanding any lack of public accountability or separation of ownership and management.
82. For this purpose, ICANZ defines an entity as "large" if it exceeds two of the following:
- total revenue of $5 million;
- total assets of $2.5 million; and
- 20 employees.
Comparable International Jurisdictions
The United Kingdom
83. In a similar manner to New Zealand, the United Kingdom places a general reporting requirement on all entities registered under the Companies Act 1985,37 with further specific, detailed obligations on most entities. However, the Companies Act goes on to provide that small and medium-sized companies that meet certain criteria can take advantage of reduced reporting requirements.
84. The United Kingdom has a system with "two-out-of-three" thresholds that a company must fall below to be considered small or medium-sized. A small company is one that has:
- turnover less than ₤5.6 million;
- balance sheet totals less than ₤2.8 million; and
- less than 50 employees.38
85. A medium-sized company must have:
- turnover less than ₤22.8 million;
- balance sheet totals less than ₤11.4 million; and
- less than 250 employees.39
86. However, certain types of companies cannot avail themselves of the reduced reporting requirements, even if they would otherwise fall below the thresholds. These exceptions include public companies, banking and insurance companies, and certain providers of financial services.40
Singapore
87. The Singapore Companies Act41 sets out the regime for financial reporting, and has recently been modified.42 Following these recent amendments, Singapore has a three-tier regime for financial reporting. However, the differential requirements are in relation to audit and filing requirements (see below43) and all companies must maintain accounting records that comply fully with all applicable standards. However, the three tiers of company are delineated as follows:
- First Tier: all companies that do not otherwise fit within the second or third tiers, and second and third tier companies;
- Second Tier: "exempt private companies," which must have fewer than 20 persons as shareholders, with no direct or indirect beneficial interest held by any corporation;44 and
- Third Tier: "small exempt private companies," which have the same 20 shareholder requirement as for second tier exempt private companies, with the additional proviso that its annual revenue does not exceed a prescribed threshold. However, shareholders representing five per cent or more of the company's shares, or the Registrar of Companies and Businesses, can require the company to prepare audited statements. The small exempt private company provisions were one of the recently-introduced amendments, and, as a transitional step, the annual revenue threshold has been set at S$2.5 million for the first year, but will be raised to S$5 million after that.
Australia
88. Australia also generally requires all entities to maintain accounting records that correctly record and explain an entity's transactions, financial position and performance,45 and then imposes further reporting requirements on certain entities. Australia requires full financial reports to be prepared by all "disclosing entities," "public companies," "large proprietary companies" and all registered schemes.46
89. If any of the securities of any body are "enhanced disclosure" securities, then that body is a "disclosing entity."47 Enhanced disclosure securities are in turn defined as:
- securities that are included in a licensed market's official list;48
- equity securities that have a lodged prospectus;49
- managed investment products held by more than one hundred people;50 and
- securities that are a part of an off-market scrip takeover offer issued to more than one hundred people.51
90. "Public companies" refers to listed companies incorporated under state or territory law, predating the Corporations Act.
91. The key distinction, however, is contained in the differentiation of "large" and "small" proprietary companies. A large proprietary company, is, as stated above, obliged to comply with the full requirements for financial reporting. A small proprietary company, on the other hand, is only obliged to prepare full statements if shareholders possessing five per cent or more of the voting rights of that company elect,52 or if it is a foreign company,53 or directed to do so by the Australian Securities and Investments Commission ("ASIC").54
92. A small proprietary company is distinguished from a large proprietary company if it satisfies two of the three following thresholds:
- its consolidated gross operating revenue for the financial year (including subsidiaries) is less than A$10 million;
- the value of its consolidated gross assets at the end of the financial year (including subsidiaries) is less than A$5 million; and
- the company and its subsidiaries have less than 50 employees at the end of the financial year.55
Comment
93. It is widely considered that the New Zealand approach to differentiating small and medium entities from large can be improved, or at the very least clarified and made more internally consistent. The discussion document released by the Ministry of Economic Development in October 200256 arose from the findings of the Ministerial Panel on Business Compliance Costs,57 which in turn arose from the 1998 Commerce Committee Inquiry into Compliance Costs for Small Businesses.
94. Following stakeholder input, the Ministerial Panel concluded that there were four areas of the Financial Reporting Act that needed review.58 Two of these, the complexity of the legislation and its exemption regime, and the unnecessary costs associated with producing financial reports with unclear benefits, relate directly to the regime for reporting requirements of small and medium enterprises. In its October 2002 discussion document, the Ministry further identified that the major problems with the current differentiation approach were its complexity and the inappropriate threshold levels.59
95. There are clearly a wide variety of approaches taken on this issue. However, given New Zealand's present framework and business landscape, it does not seem appropriate to introduce the more stringent requirements of Singapore because of the significant costs involved. A better approach would be maintaining a tiered approach to financial reporting requirements, as is also currently the case in Australia and the United Kingdom, providing relief from the full requirements of disclosure for smaller and medium-sized entities.
96. There are, however, issues in the delineation of these tiers. In line with a traditional cost-benefit analysis, the costs involved in preparing financial statements should only be imposed when outweighed by the resulting benefits. In this case, the benefits are those that flow from the rationales for financial reporting as outlined above. However, these benefits do not necessarily accrue in the case of smaller entities and the costs of preparing full financial statements are probably not justified on a utilitarian basis.
97. In acknowledgement of this, the various international jurisdictions outlined above and the statutory New Zealand regime essentially adopt an underlying "economic impact" theory to determine reporting requirements. Those entities with potentially high economic impacts should disclose fully, those with less potential impact to disclose on a reduced basis, and those with little to no potential impact to disclose on an even further reduced basis or not at all.
98. However, determining potential economic impact is subjective. In order to provide certainty, impact is typically equated with certain asset and revenue thresholds, and also, in the United Kingdom, Australia and New Zealand's non-statutory intermediate regime, with employees. New Zealand's current statutory regime also includes whether the company has subsidiaries and whether it is offshore or domestically controlled.
99. Although these measures are all helpful to some degree, they do not necessarily provide a complete solution in themselves. Consideration must be given to the applicability and necessity of the factors. For example, if most entities that cross any two of the thresholds would likely cross the third as well, it is questionable that a third criterion to measure economic impact adds anything.
100. Further, given that it may be desirable to ensure New Zealand has a single set of standards applicable to entities beyond the profit-seeking corporate (see below60), some consideration should also be given to the applicability of any thresholds to public benefit entities. Other factors beyond economic impact should therefore be taken into account.
101. In this respect, the analytical regime of ICANZ's Framework for Differential Reporting61 is superior and provides some potential further factors. Although the accountability rationales can be considered to some degree proportionate to the size of a company, there are other factors within the rationales that do not directly correspond to size alone. ICANZ includes public accountability and owner-management separation, neither of which depends on the size of a given entity. This includes at least some public benefit entities, although limited to those with coercive powers of taxation.
102. ICANZ's broader focus may therefore be more appropriate than an economic impact test alone. This has some backing in the approaches of New Zealand and Singapore, both of which also have regard to the number of shareholders in some manner. If a company is not closely held, management and ownership are likely to be separated and hence there is greater need for accountability. Further, it is also more likely that there is some form of public fund raising in a widely held company, again indicating that requiring disclosure could lead to more widespread benefits.
103. Further precedent for this type of approach can also be found elsewhere in New Zealand law. For example, the Takeovers Act 1993 applies to "specified companies," a criterion for which is 50 or more shareholders. This is predicated on the assumption that in a closely held company (in this case, one with less than 50 shareholders), shareholders are more likely to have access to all the necessary information to make a decision on the merits of a takeover offer. Carrying the same argument across to financial reporting, the shareholders of a closely held company (however defined) are more likely to be kept informed and have access to financial information where necessary.
104. A further issue is the question of which tier is the "default" or "catchall" category. The Financial Reporting Act regime is structured so that it is generally assumed all reporting entities must comply with the full requirements for financial reporting (that is, they are in the "top tier"), unless a specific exemption applies. This may not be entirely appropriate in all circumstances. For example, a very small company with negligible accountability or economic impact could conceivably breach the measures and be subject to the full requirements of financial reporting. Under the current New Zealand regime, an otherwise exempt company can easily fall afoul of the full requirements for financial reporting. A small company with three shareholders would fall outside the exemption if one of those shareholders migrated to Australia, as more than 25 per cent of the votes would be based off-shore.62 Another company could exceed the thresholds due to an atypically large transaction or contract that is not likely to be repeated. In both cases, the benefits that would flow from requiring full financial reports are questionable. On the other hand, this is an issue that may be able to be adequately addressed through careful choice and drafting of the thresholds.
105. Closely related to the above point is whether it is desirable to have a form of "opt-in" or "opt-out" requirement for reports. For example, Singapore has a system whereby five per cent or more of the shareholders of an exempt private company can require that company to prepare fully audited financial reports. The reverse would be requiring an entity to produce reports unless some percentage of shareholders elect otherwise. This is one possible way to incorporate the accountability rationale. Where owners, shareholders or stakeholders either do not need management to account (for example, in a closely held company), have faith in the management or are able to get financial information via an alternate method, the accountability rationale has less impact.
The Accounting Standards Review Board Proposal
106. Combining various considerations as outlined above, the ASRB has released a proposal63 that, in its opinion, offers the best model for New Zealand financial reporting. The Ministry of Economic Development is seeking comments on this proposal as the basis for discussion as to the best financial reporting framework for New Zealand.
107. In formulating the proposal, the ASRB consulted a number of parties who expressed concern that the application of IFRS to all entities would, in many cases, result in financial reporting where the costs that outweigh the benefits.
108. Drawing on international and ICANZ's models, the proposed structure identifies four proxies. Although these proxies could be considered somewhat arbitrary, there are major benefits in having a high degree of certainty about whether an entity is required to comply with each set of requirements. The proposed proxies are:
- The status of the entity as an "issuer" or otherwise (with issuer accorded its current Financial Reporting Act definition);
- The coercive power to impose taxes, rates or levies;
- A responsibility to report; and
- Size.
109. The first two are largely self-explanatory. In relation to the third, an entity will be regarded as having reporting responsibilities if:
- Its constitution or governing legislation requires the entity to account to the public (or a public official);
- Its office holders are accountable to the general public;
- The elected officers are, or are analogous to, trustees (for example, clubs or member-owned entities);
- The entity has a charitable purpose (as approved by the Inland Revenue Department);64
- The entity's ownership is "foreign" (as defined by the Financial Reporting Act); or
- There is separation of ownership and management.
110. Further, in line with the Australian model, the proposal sets out a "two-out-of-three" size test. An entity would be "large" for the purposes of the Financial Reporting Act if it exceeds two of the following (although the Ministry of Economic Development notes that it is likely that any strict numerical thresholds would be able to be changed easily, either through an additional ASRB power or by the Minister by notice in the Gazette65):
- More than $5 million in assets;
- More than $10 million in revenue; and
- More than 20 full-time equivalent employees.
Figure 2: The Proposed Financial Reporting Framework
111. As per the current financial reporting framework, the proposal identifies three tiers of reporting requirements. A combination of the proposed proxies would determine the tier of any given entity. Tier 1 entities would be required to comply with the full reporting requirements of New Zealand IFRS, and would comprise:
- Issuers;
- Entities with a coercive power to tax, rate or levy;
- Large entities controlled by entities with a coercive power to tax, rate or levy;
- Large entities with reporting responsibilities; and
- Entities that would otherwise be in tier 2, but five per cent or more of the owners, shareholders or stakeholders request full financial statements.
112. Tier 1 entities would include listed companies, government departments, and large widely held companies (though not listed). It would also include large charities and clubs.
113. Tier 2 entities would also be required to produce reports, but with some relief from the full disclosure requirements (to be determined by the ASRB66). This category would comprise:
- Small public sector entities, unless its controlling entity requests full financial statements, in which case the entity would shift to tier 1;
- Small entities (despite otherwise having reporting responsibilities), unless five per cent or more of the owners, shareholders or stakeholders request full financial statements as above
- Large entities without reporting responsibilities, unless five per cent or more of the owners, shareholders or stakeholders request full financial statements as above; and
- Entities that would otherwise be in tier 3, but five per cent or more of the owners, shareholders or stakeholders request financial statements.
114. Tier 2 entities would include smaller public sector entities (in particular, schools). Significantly, it would also incorporate smaller entities such as clubs,67 and large closely held companies. This is a significant departure from current requirements. Large, closely held companies are subject to the full requirements of financial reporting under current New Zealand law, and the proposal would reduce their obligations.
115. Finally, tier 3 entities would have no formal reporting requirements beyond the Companies Act requirements, subject to five per cent or more of the owners, shareholders or stakeholders requesting financial statements. This reflects general feedback on the October 2002 Ministry of Economic Development Discussion Document on the Exempt Companies Regime.68 Submissions generally supported the removal of any formal reporting requirements from the Financial Reporting Act as an unnecessary compliance cost, given the perception that the reports produced were of limited use.
116. Typical tier 3 entities would include all entities that are owned or represent only a few people, and would include a significant proportion (probably in excess of 90 per cent) of entities in New Zealand, including virtually all small businesses.
117. However, the ASRB proposal raises the possibility of the ASRB or ICANZ developing an optional "best practice" regime for small entities similar to the current exempt companies regime. In order to encourage the use of this regime, the Ministry of Economic Development believes it may be desirable to provide that entities that comply with these best practice guidelines are deemed to fulfil the general reporting requirements they are required to meet. For example, a tier 3 company, although having no formal reporting requirements, must still comply with section 194 of the Companies Act. Although the best practice regime would be optional, any company that did comply would be assured it fulfilled its other legislative requirements.
The Trans-Tasman Perspective
118. It is not necessary to have the same reporting regime as Australia, even should a joint trans-Tasman institution be created. Although this institution may set the reporting standards for both countries, it will still be the substantive law of the individual countries that will establish which entities must comply with the financial reporting requirements.
119. On the other hand, generally co-ordinating New Zealand's reporting requirements with Australia could prove beneficial. As stated above, if both countries are IFRS-compliant, the reports produced in one are almost certain to satisfy the requirements of the other. However, this only applies where both countries require the same sets of financial reports, particularly for smaller entities that do not have to meet the full requirements of IFRS.
120. In this regard, a point of particular significance is that Australia only has two classes of reporting entities (an entity must either fully comply with the reporting requirements or not at all), whereas the ASRB proposal includes tier 2 entities that would still be required to report, but only in accordance with reduced requirements. A New Zealand tier 2 entity would not be able to choose to provide their New Zealand reports for Australian purposes, as they would (most likely) be subject to the full requirements of financial reporting.69
Question 1 - Reporting Entities
- Do you agree that it is appropriate to have different reporting requirements for different types and sizes of entities in New Zealand? If not, what reporting requirements should there be and why?
- If you believe that there should be different reporting requirements for different types and sizes of entity, do you agree with the ASRB proposal on how the different types and sizes of entity should be determined? Are there any additional factors or considerations that you believe are appropriate to consider in determining the tier of a given entity?
- Do you agree that the ASRB's proposed two-out-of-three combination of assets, turnover and employees is appropriate? Do you agree that the figures used are appropriate?
- Do you agree with the removal of reporting requirements for tier 3 entities under the ASRB proposal? If not, what reporting requirements should there be and why?
- Do you believe that optional compliance with a "best practice" guide would prove beneficial? If so, do you agree that meeting the best practice guide should mean automatic compliance with the general reporting requirements (for example, of the Companies Act 1993) through a deeming provision?
- Do you agree that the current tier 2 categorisation of large entities without reporting responsibilities, and small entities with reporting responsibilities, is appropriate?
- If the ASRB proposal was adopted, are you aware of significant reporting issues that may arise for any entities?
- If, instead of the ASRB proposal, a two-tier structure like that operating in Australia was adopted, are you aware of significant reporting issues that may arise for any entities?
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