Blind Freddy – Common errors in presentation of financial statements – Part 1

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

AASB 101 Presentation of Financial Statements is perhaps the most overlooked accounting standard. It is the standard which sets out a number of key principles around disclosure, all of which are intended to assist a user of a set of financial statements in understanding the performance of that entity. Any ‘Blind Freddy’ error in application of AASB 101 is by its nature likely to cause a user to either be misled, or to be provided with insufficient information to make an economic decision, particularly in respect of investing in that entity.

AASB 101 is the standard that resulted in Justice Middleton coining the phrase ‘Blind Freddy’ in the Centro case, where even Blind Freddy should have realised that the clear requirement in AASB 101 in respect of classifying debt as either a current or non-current liability had not been followed.

AASB 101 sets out amongst other things:

  1. The need to include four primary statements in a financial report
  2. The layout of those primary reports
  3. The need to include notes to support those primary statements
  4. The need to include comparatives
  5. The need to have the third balance sheet when there is retrospective restatement
  6. Key guidance as to going concern
  7. Key guidance on disclosing estimates and judgements
  8. Requirement to refer to the accounting framework
  9. Requirement to provide additional disclosures where specific disclosure requirements in accounting standards are insufficient
  10. Offsetting
  11. Classification of assets and liabilities as current and non-current, and
  12. Disclosures relating to the primary statements.

Although AASB 101 does not contain any direct guidance on measurement of accounting transactions, many of the potential Blind Freddy errors can lead to users being misled and preparers and auditors opening themselves up to significant criticism and potential litigation.

Due to the number of potential Blind Freddy errors that can occur when applying this ‘easy’ standard, in this article we will focus on Blind Freddy errors occurring in 1. to 10. above, and will follow next month with more Blind Freddy errors arising from applying AASB 101.

Blind Freddy error 1 - Not including all four primary financial statements

AASB 101, paragraph 10 describes a complete set of financial statements as including all four primary financial statements, being the statement of profit or loss and other comprehensive income, the statement of financial position (referred to also in this article as ‘balance sheet’), statement of cash flows and statement of changes in equity.

A common Blind Freddy error occurs among entities preparing special purpose financial statements, where many preparers think that including a cash flow statement and statement of changes in equity is optional.

If the entity is claiming compliance with AASB 101, as is the case for entities lodging special purpose financial statements under Part 2M.3 of the Corporations Act 2001, or under Subdivision 60-C of the Australian Charities and Not-for-profits Commission Act 2012 , AASB 101, paragraph 10 requires all four primary financial statements to be included.

A complete set of financial statements comprises:

(a) a statement of financial position as at the end of the period;

(b) a statement of profit or loss and other comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period;

(e) notes, comprising significant accounting policies and other explanatory information;

(ea) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A; and

(f) a statement of financial position as at the beginning of the preceding period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements in accordance with paragraphs 40A–40D.

An entity may use titles for the statements other than those used in this Standard. For example, an entity may use the title ‘statement of comprehensive income’ instead of ‘statement of profit or loss and other comprehensive income’.

AASB 101, paragraph 10

Blind Freddy error 2 - Not including comparatives

In a number of situations, an entity may find that it requires an audit for the current financial year, but was not required to produce audited financial statements in the past. For example, the company may exceed the ‘large’ size threshold test in s45A of the Corporations Act 2001 for the first time, and may find itself now requiring an audit, or it may be planning an IPO or have new shareholders that require an audit.

If the entity wants to comply with accounting standards, particularly AASB 101, it must show comparatives, and include at least:

  • Two statements of financial position
  • Two statements of profit loss or other comprehensive income
  • Two statements of cash flows
  • Two statements of changes in equity, and
  • Related notes.

Except when Australian Accounting Standards permit or require otherwise, an entity shall present comparative information in respect of the preceding period for all amounts reported in the current period’s financial statements. An entity shall include comparative information for narrative and descriptive information if it is relevant to understanding the current period’s financial statements.

AASB 101, paragraph 38

An entity shall present, as a minimum, two statements of financial position, two statements of profit or loss and other comprehensive income, two separate statements of profit or loss (if presented), two statements of cash flows and two statements of changes in equity, and related notes.

AASB 101, paragraph 38A

Blind Freddy error 3 - Not showing a third balance sheet when there is retrospective restatement

Another clear requirement in AASB 101, paragraph 10(f) that often results in a Blind Freddy error is forgetting to include the third balance sheet (statement of financial position) when an entity has made retrospective restatements in its financial statements, either because of a:

  • Voluntary change in accounting policy,
  • Prior period error, or
  • Reclassification of items in the prior year’s statement of financial position.

A complete set of financial statements comprises:

(a) a statement of financial position as at the end of the period;

(b) a statement of profit or loss and other comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period;

(e) notes, comprising significant accounting policies and other explanatory information;

(ea) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A; and

(f) a statement of financial position as at the beginning of the preceding period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements in accordance with paragraphs 40A-40D.

AASB 101, paragraph 10

AASB 101 does provide some relief in these scenarios, which means that:

  • The third balance sheet need only be disclosed where the retrospective application has a material effect on the information in the third balance sheet (paragraph 40A), and
  • A three column note format for the balance sheet is not required for all balance sheet items included in the third balance sheet. Only information about the amended items in the third balance sheet need to be disclosed, which can be provided via the relevant AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors disclosures (paragraph 40C).

An entity shall present a third statement of financial position as at the beginning of the preceding period in addition to the minimum comparative financial statements required in paragraph 38A if:

  1. it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial statements or reclassifies items in its financial statements; and
  2. the retrospective application, retrospective restatement or the reclassification has a material effect on the information in the statement of financial position at the beginning of the preceding period.

AASB 101, paragraph 40A

When an entity is required to present an additional statement of financial position in accordance with paragraph 40A, it must disclose the information required by paragraphs 41–44 and AASB 108. However, it need not present the related notes to the opening statement of financial position as at the beginning of the preceding period.

AASB 101, paragraph 40C

Perhaps the easiest way for users to be placed on alert as to the retrospective adoption of a new accounting policy or a retrospective restatement (error) or reclassification in the financial statements is the presentation of a third balance sheet. Therefore failing to show a third balance sheet can easily result in users being misled. Users may perform a flawed analysis of key performance issues, failing to adjust for restatements, and most importantly, failing to recognise the reduction in the entity’s previously reported profits.

Blind Freddy error 4 - Not disclosing material uncertainty about going concern

Although much of the guidance on going concern is contained within Auditing Standard, ASA 570 Going Concern, AASB 101 is the accounting standard that requires full disclosure about uncertainties around going concern. Without any disclosure of the existence of uncertainty, a user could reasonably argue that they invested in the entity, or did business with the entity, on the basis that there was no uncertainty as to its ability to continue as a going concern.

Going concern

When preparing financial statements, management shall make an assessment of an entity’s ability to continue as a going concern. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern.

AASB 101, paragraph 25

Blind Freddy error 5 - Not disclosing key judgements where uncertainty regarding going concern was considered but determined that there is no uncertainty

There is usually judgement involved in determining whether there is material uncertainty as to an entity’s ability to continue as a going concern.

If the conclusion from this analysis is that there is no significant uncertainty, and therefore not required to be disclosed under AASB 101, paragraph 25 (refer Blind Freddy error 4 above), because it was a ‘close call’, and does represent a key judgement, this fact should be disclosed.

If the entity subsequently gets into distress, users may reasonably claim they were misled if it was not bought to their attention that it was a ‘close call’ as to whether material uncertainty existed about the entity’s ability to as a going concern.

Sources of estimation uncertainty

An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in 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:

(a) their nature, and

(b) their carrying amount as at the end of the reporting period.

AASB 101, paragraph 125

Blind Freddy error 6 - Incorrectly claiming compliance with IFRS

Although AASB 101 requires an explicit statement for compliance with IFRS, for many Australian entities applying AASB 101, such a statement may not be appropriate, principally for those entities:

  • Preparing special purpose financial statements under Part 2M.3 of the Corporations Act 2001 that only apply AASB 101, AASB 107 Statement of Cash Flows, AAB 108 and AASB 1054 Australian Additional Disclosures
  • Reporting under the reduced disclosure regime (RDR), and
  • Availing themselves of the special measurement rules applicable to not-for-profit entities (NFPs), for example income recognition under AASB 1004 Contributions, revaluations under AASB 116 Property, Plant and Equipment, etc.

An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes. An entity shall not describe financial statements as complying with IFRSs unless they comply with all the requirements of IFRSs.

AASB 101, paragraph 16

In the case of special purpose financial reports and those prepared by applying RDR, these do not comply with all of the disclosure requirements of IFRS and therefore the IFRS compliance statement is not appropriate. Similarly, in respect of NFP measurement, these rules are not IFRS compliant.

Blind Freddy error 7 - Not providing additional disclosures where specific disclosure requirements are insufficient

The disclosure requirements for specific transactions and events is included in the various accounting standards dealing with specific topics and this is all that most entities would generally include in the notes to their financial statements. However, sometimes this disclosure is not enough, and more information about a particular transaction or balance needs to be disclosed to achieve fair presentation.

In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable Australian Accounting Standards. A fair presentation also requires an entity:

….

(c) to provide additional disclosures when compliance with the specific requirements in Australian Accounting Standards is insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

Extract of AASB 101, paragraph 17

Blind Freddy error 8 - Justify the application of inappropriate accounting policies

Another Blind Freddy error occurs where an entity tries to justify an inappropriate accounting treatment by either merely disclosing a different accounting policy, or by including additional notes in the financial statements showing the impact of the correct policy which has not been recognised and measured in the financial statements.

For example, some entities are still in denial about the need to record all derivative assets and liabilities on their balances sheet in respect of interest rate swaps or forward foreign exchange contracts entered into for non-speculative hedging purposes. Simply disclosing the fact that had AASB 139 Financial Instruments: Recognition and Measurement been complied with, a derivative asset/liability of $xxxx would have been recognised does not mean AASB 101 has been complied with.

An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting policies used or by notes or explanatory material.

AASB 101, paragraph 18

Blind Freddy error 9 – Not referring to the Framework when no guidance contained in accounting standards

In preparing financial statements that comply with accounting standards, preparers must comply with the Framework. This may result in assets not being recognised where a specific standard is silent on the issue. For example, intangible assets such as customer relationships and employee relationships cannot be recognised as an asset because they fail the ‘control’ test set out in the Framework.

Similarly, this is a key requirement in considering whether the transaction that gave rise to an asset or liability was part of a linked transaction.

When the accrual basis of accounting is used, an entity recognises items as assets, liabilities, equity, income and expenses (the elements of financial statements) when they satisfy the definitions and recognition criteria for those elements in the Framework.

AASB 101, paragraph 28

Blind Freddy error 10 – Offsetting

A common Blind Freddy error occurs where entities incorrectly offset assets and liabilities or income and expenses.

Certain key performance ratios can be significantly impacted by balance sheet or income statement presentation and AASB 101, paragraph 32 specifically prohibits this offsetting.

An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an Australian Accounting Standard.

AASB 101, paragraph 32

Blind Freddy error 11 – Reporting periods not equal to 12 months

In certain circumstances, a set of financial statements may cover a period that is shorter or longer than a year (12 months). This is typically the case where an entity is newly incorporated or decides to change its year end.

In order to understand trends and performance against the prior period, users need to know the duration of the period covered, i.e. they should be able to ‘compare apples with apples’. If the period covered is shorter or longer than 12 month, AASB 101 requires this be clearly disclosed together, with the reason for this.

An entity shall present a complete set of financial statements (including comparative information) at least annually. When an entity changes the end of its reporting period and presents financial statements for a period longer or shorter than one year, an entity shall disclose, in addition to the period covered by the financial statements:

(a) the reason for using a longer or shorter period, and

(b) the fact that amounts presented in the financial statements are not entirely comparable.

AASB 101, paragraph 36