Financial Reporting - IFRS & UK GAAP- March 2006

Article by Yvonne Lang, Giles Murphy, Stephen Drew, Nigel Bolt, Chris Appleton and Ian Cooper

IFRS

2005 was a year of significant change for the financial reporting frameworks affecting all companies. Fully listed companies are now required to use International Financial Reporting Standards (IFRS) in place of UK GAAP, while UK standards have also undergone considerable change. However, this is far from the end of the story. In the first Financial Reporting newsletter of 2006, we look at further proposed changes to IFRS, as well as the UK Accounting Standards Board’s continuing deliberations on the timing of the switch from UK accounting standards to IFRS.

When IFRS 3 ‘Business combinations’ was first issued in March 2004, it was on the basis that it was only the initial guidance in this important area. Finance directors of companies adopting IFRS were just about getting to grips with its requirements when the International Accounting Standards Board (IASB) issued an exposure draft setting out significant proposed revisions. The exposure draft ‘Proposed amendments to IFRS 3 Business combinations’, reflects the end of phase II and the culmination of a joint project between the IASB and the US Financial Accounting Standards Board (FASB).

The exposure draft, which was issued by both the IASB and FASB, has provoked considerable controversy, with some of the proposed changes affecting all business combinations whilst others are set to change significantly the accounting in circumstances where control is obtained over less than 100% of an entity.

Currently, costs associated with making an acquisition, such as professional fees, are considered to be part of the cost of that acquisition and are included within the cost of investment. The costs are therefore taken into account when calculating goodwill. The IASB argues however that such costs are not part of the consideration and should not be included as part of the cost of acquisition. Instead, they would need to be expensed to the income statement as incurred.

The IASB is also looking to rewrite some established rules of accounting by suggesting a different model for reporting business combinations, the impact of which will be significant where control of less than 100% is acquired. Current accounting, both in the UK and under international standards, reflects the cost of the acquisition and, to the extent that exceeds the identifiable assets and liabilities acquired, the goodwill that arises is included as an asset in the accounts. However, the proposed new approach requires the total fair value of the acquired business to be measured and reflected in the accounts, even in circumstances where less than 100% is acquired. As a consequence, 100% of the calculated goodwill will be included in the accounts, even where control over less than 100% of the acquired entity has been obtained.

Whilst under both the existing and proposed practices the assets and liabilities are consolidated in full, even where there is not full ownership, any outside interest in the acquired business is viewed differently. The term minority interest will be replaced by ‘non-controlling interest’ and because the group will now be viewed as a single entity, any changes in those non-controlling interests will not be reflected in the profit and loss account but as movements within shareholders’ funds. The proposed standard also continues to exclude accounting guidance on business combinations between entities under common ownership. Therefore, the important area of accounting for group reconstructions remains outside of the scope of IFRS 3.

The exposure draft has attracted considerable criticism from commentators including the UK Accounting Standards Board. These criticisms relate not just to the appropriateness of the technical content but also to the consultation processes used by the IASB. It is generally thought that introduction of a new accounting model is more appropriately dealt with in a discussion paper, which would allow for a proper debate of the concepts involved. We are therefore concerned that standards may be introduced whose principles, once applied, may not improve the quality of financial reporting.

In particular, there is a very real risk of the introduction of significant subjectivity (and cost) associated with fair valuing a business where less than 100% has been acquired.

We doubt that this will be the last example of intellectual argument overriding clarity of financial reporting, but there is some hope in that the IASB anticipates that it will take about a year to redeliberate the principles of the standard in light of the nearly 300 comment letters it has received.

IFRS 7 ‘Financial instruments: disclosures’ will apply for periods beginning on or after 1 January 2007 and will replace the presentation part of International Accounting Standard 32: ‘Financial instruments: disclosure and presentation’(IAS 32). The standard will also replace IAS 30 ‘Disclosures in the financial statements of banks and other financial institutions’. Earlier application will be permitted.

The IFRS applies to all risks from all financial instruments and to all entities, even where they have few financial instruments (for example, a manufacturer whose only financial instruments are accounts receivable and accounts payable). However, the extent of the disclosure will depend on the extent to which the financial instruments are used and the risks the entity faces.

As with the previous standard, there are two aspects to the disclosure requirements, which are:

• the significance of financial instruments; and

• qualitative and quantitative information about exposure to risks arising from financial instruments. The standard includes specified minimum disclosures about credit risk, liquidity risk and market risk.

Whilst many of the requirements remain the same as those in IAS 32, there have been some simplifications, particularly the removal of requirements that result in duplication of information. However, some further disclosure will also be necessary. The most significant changes include:

• disclosure of the carrying amounts of financial instruments under each of the classifications in IAS 39 ‘Financial instruments: recognition and measurement’

• the need to provide further information about assets and liabilities designated as at fair value through profit and loss 
• an analysis of the age of financial assets that are past due and an estimate of the fair value of collaterals held by the reporting entity

• separate disclosure of the amount of ineffectiveness recognised in profit and loss on cash flow hedges and hedges of net investments in foreign operations

• additional requirements with respect to sensitivity analysis of market risks and how changes in those risks affect the profit and loss account and equity in the period

• disclosures with respect to the management of capital.

Whilst some of the changes have removed requirements which could have resulted in the duplication of information, for most companies, the new standard will result in a net increase in disclosure. Companies will therefore need to look to their existing systems and reporting lines to ensure that they are capable of capturing the necessary information.

The fact that companies may adopt the standard early means that those companies required to apply IAS 32 but which have yet to draft their disclosure notes, might want to consider moving straight to IFRS 7 to avoid having to apply two separate standards in a period of two years.

Financial Reporting – UK GAAP

The Accounting Standards Board (ASB) has issued an exposure draft of the full text of the revised IFRS 3 for comment. As well as the proposed changes discussed above, the existing provisions of IFRS 3 would result in, amongst other things, the abolition of merger accounting, goodwill being subject to annual impairment review rather than amortisation, and the immediate recognition in income of negative goodwill. FRED 36 ‘Business combinations’ was issued as part of the general policy of alignment of UK GAAP with IFRS.

However, the ASB’s invitation to comment has raised a number of significant issues as to the effect of the proposed changes. Convergence – will it be a big bang?

In March 2004, the ASB issued its plans for converging UK standards with IFRS. The phased approach set out in its discussion paper, intended to limit the burden of change in any one year, would see:

• a number of new standards in 2005 and 2006 to enhance current UK standards

• a series of ‘step changes’ from 2007, replacing UK standards as their international equivalents were completed.

By the end of 2005, we were already a significant way through the process, with ten new IFRS-based standards in issue and exposure drafts of three further standards issued for comments, including the revised IFRS 3 discussed earlier in this newsletter.

However, as listed companies have begun to experience the reality of applying IFRS, many UK businesses have become increasingly vocal about the benefits of convergence to a new set of accounting standards, which are often seen as overly complex, even for publicly listed companies, and could therefore be even more so for private and smaller companies.

In addition, uncertainty as to the content of international standards as a consequence of the IASB’s convergence project with FASB and the delay in completing the project on the application of IFRS to smaller companies has caused support for a phased approach to convergence to wane.

This was highlighted in recent comments made by Eric Anstee, chief executive of the Institute of Chartered Accountants in England and Wales:

"If the ASB was to proceed with the current IFRS convergence programme, private companies could face the grim prospect of switching from UK GAAP to full IFRS to simplified IFRS in short succession".

In December last year the ASB responded to these growing concerns by issuing for discussion proposals for a revised convergence strategy. The suggested ‘big bang’ approach would mean that all UK standards not yet consistent with IFRS would be replaced by IFRS-based standards, all applicable from the same date. The ASB is proposing that this date be periods beginning on or after 1 January 2009.

To ensure that there is a stable platform of standards for UK companies to apply in 2009, the ASB is further proposing that the new standards be based on IFRS, applicable as at 1 January 2006.

Not all entities will be required to comply with the full requirements of the IFRSbased standards. In writing its proposed convergence strategy, the ASB has assumed that, when issued, the IASB’s Standards for Small and Medium-Sized Enterprises (SMEs) will be applicable for entities similar to those which can currently apply the Financial Reporting Standard for Smaller Entities (FRSSE) (i.e. those currently meeting the Companies Act definition of a small entity). However, if the IASB’s Standards for SMEs appear more suitable for entities larger than small companies the ASB will consider developing its own replacement for the FRSSE, based on IFRS.

Also under consideration is the possibility of a three-tier approach, with the largest, publicly accountable entities applying full IFRS and the smallest applying the IASB’s Standards for SMEs or the ASB’s own version. Entities that fall in between these two categories would be permitted some modifications from the full standard (for example, reduced disclosure requirements) on the grounds of cost benefit.

Anyone reading the invitation to comment sections of recent exposure drafts issued by the ASB will be aware of its increasing concerns about the appropriateness of some of the changes to the IASB’s proposed standards. It is also clear that the ASB has taken notice of the public response to those comments in reconsidering the approach to convergence.

With IFRS containing no exemptions for smaller companies or those within groups, the issue of the applicability of IFRS to different sizes of entity will be key to any final decision.

The consultation paper was issued as a prelude to a roundtable meeting held in late January. At the meeting, many of those present expressed concerns about the appropriateness of IFRS for use in the UK, even in the longer term, given the way those standards appear to be developing. We expect that we will be returning to this subject in future newsletters.

Gordon Brown’s speech in November last year announcing the removal of the requirement for listed companies to provide a mandatory Operating and Financial Review (OFR) came as a surprise to most of the accounting community.

However, before company directors start celebrating, they should bear in mind that the idea of a mandatory OFR was a UK extension of wider requirements introduced into legislation as a consequence of the EU Accounts Modernisation Directive (the Directive). Company law, consistent with the general requirements of the Directive, was introduced by Statutory Instrument 2005/1011 ‘The Companies Act 1985 (Operating and financial review and directors’ report etc) Regulations 2005’. The changes to the Companies Act remain in place and have implications for all except the smallest of companies, whether they are listed or not.

Although the need to provide a fair review of the business has long been required in the directors’ report, the content of that review had never been specified, often resulting in bland, boiler-plate statements considered to be of little value to the users of the accounts. The new legislation expands upon these existing requirements for large and medium-sized (but not small) companies.

With effect from periods beginning on or after 1 April 2006, the directors’ ‘Business Review’ will need to include:

• a balanced and comprehensive analysis of the development and performance of the business of the company during the financial year and the position of the company at the end of that year

• a description of the principal risks and uncertainties facing the company

• further analysis using both financial and non-financial key performance indicators (KPIs).

Companies and groups that qualify as medium sized under the Companies Act criteria are exempt from providing information on non-financial KPIs. This means that companies with a turnover of below £22.8m and total assets below £11.4m will only have to provide information on financial KPIs, as long as they are not an ‘ineligible company’ as defined by the Companies Act, for example, a public company or a company that is regulated under the Financial Services and Markets Act.

The Department for Trade and Industry has recently announced that listed companies will need only to publish the ‘Business Review’ as required by the Directive. Although this review will include much of the information that the OFR would have covered, it is in less prescriptive form and omits some of the more forwardlooking information, such as the main trends and factors likely to affect the company’s future.

The ASB’s Reporting Standard 1 ‘The Operating and Financial Review’ (RS1), which all mandatory OFR preparers would have had to comply with, will remain in issue but has been redesignated from a mandatory standard to best practice. As a consequence, companies that choose to produce an OFR will not have to comply with the standard.

Smith and Williamson commentary Whilst the removal of the mandatory OFR has been seen by many as a political response to ‘gold plating’ of EU legislation, it is clear that the inclusion of increased narrative information in the annual report is here to stay. Many listed companies already produce comprehensive information similar to that envisaged in the mandatory OFR and this trend is likely to continue. In the future, there is also likely to be influence from international accounting and the IASB has recently issued an exposure draft in this area – ‘Management Commentary’, a project in which the ASB has been heavily involved.

These changes to the Companies Act are likely to prove more challenging for those businesses that have historically spent little time on this area and will now find themselves having to provide far more information about how their business is run.

Company law – change at last November 2005 finally saw the Company Law Reform Bill introduced into Parliament. The changes in legislation reflect one of the Government’s key aims – making life simpler for privately owned companies. The draft bill identifies the requirements for small companies first and then addresses the additional requirements for larger companies. Whilst the draft bill runs to some 500 pages, it was accompanied by a much shorter and easier ‘Guidance to key clauses’, which provides a useful steer through the legislation. Both the bill and guide are available on the UK Parliament website (www.publications. parliament.uk/pa/pabills.htm). Some of the main areas of change are considered below.

Simplification of share capital rules In keeping with the aims of making it easier to form and run a company, a number of changes are being made to the existing rules on share capital.

• The concept of authorised share capital is to be removed.

• The current rules, which prohibit the giving of financial assistance for the purchase of own shares in a private company, will be revoked. The rules will however continue to operate for public companies.

• Private companies will be able to reduce their share capital without court application, although they will be required to make a statutory statement as to their solvency.

A number of the ongoing administrative requirements placed upon companies will also be amended. This will include the removal of the need to have a company secretary for private companies and the statutory requirement to hold an Annual General Meeting.

However, the period allowed for delivery of accounts to the Registrar of Companies will be shortened to nine months for private companies and six months for public companies.

The revised Act will also put the responsibilities of directors, many of which are currently established through case law, onto a statutory footing. As a consequence, the draft Act contains provisions that directors will be required to act in good faith and in such a way that:

• is likely to promote the success of the company for the benefit of its members

• considers the long-term consequences of any decisions they take

• exercises reasonable skills and care and avoids conflicts of interest.

The legislation will also introduce further provisions for quoted companies, which will include requiring them to publish both their preliminary announcements and annual accounts on their website.

Members of a quoted company will also be given increased rights to request information about the conduct of an audit and, subject to certain shareholding limits, to have those questions published on the company’s website.

The ability of auditors to limit their liability has been widely publicised. The limitation will require shareholder agreement, but the exact way in which the provisions will operate has still to be determined.

The long gestation period for these changes means that most of them will not come as a surprise. It is pleasing to see that the promised simplification for smaller companies is reflected in the draft Act, the language of which is also much clearer. There are, however, a number of areas where the legislation gives power to the Secretary of State to write the necessary rules. Accordingly, there are a number of detailed provisions which have still to be produced.

Whilst this newsletter’s primary focus is to update you on changes to financial reporting, many of our readers are also subject to audit. Auditing standards have undergone significant change in the past 12 months and whilst most of the changes resulting from the introduction of International Standards on Auditing (UK and Ireland) (ISA) affect the procedures undertaken by auditors, they will also affect every entity that is subject to an external audit.

All audits of financial periods beginning on or after 15 December 2004 will need to be conducted in accordance with the new standards. Therefore, irrespective of your year-end, your next audit will be carried out in accordance with ISA.

The respective responsibilities of auditors and directors remain unaltered. The main changes arising from these new auditing standards relate to the auditors’ consideration and documentation of risk and fraud. The style of the standards has also changed, with increased emphasis on mandatory procedures. The three main effects that you will notice are:

1. You may be asked some questions which you have not been asked in the past.

2. You may be asked to make certain representations that you have not had to make in the past, particularly with reference to fraud.

3. There is an increased volume of prescribed audit procedures, some of which may not have been performed on your audit in the past.

ISA place considerable emphasis on the area of fraud risk. Therefore, your auditors will be required to discuss fraud as it affects the financial statements with you. This discussion will usually include matters such as where you think there is a risk of fraud that could result in a material error in the accounts and what you can do to avoid that risk. You will also be asked to provide the auditors with details of any fraud or alleged fraud in the period.

Whilst your auditors will have talked to you about business risk and internal control in the past, the level of information which they now need to gather has increased considerably. You are now far more likely to be asked questions such as:

• what are the goals and strategies of your organisation and how do you measure your success?

• how do you communicate the importance of financial controls to your staff?

• what policies do you have in place to ensure the security of your computer system?

ISA are part of the response to further improve the quality of UK audits and boost the assurance provided by the audit report to users of the accounts. Some of these new requirements may also help you to rethink your own risk assessment procedures and how they contribute to your business.

However, the new standards do result in an increase in audit procedures and documentation and, whilst the exact effect will vary from entity to entity, this will be a challenging time for everyone involved in the audit process.