Financial Reporting - IFRS & UK GAAP- July 2006

International standards continue to develop, particularly as the process of achieving convergence with US GAAP gathers pace. While there may have been few new UK accounting standards so far in 2006, legislation continues to provide plenty of challenges for all preparers of financial statements. In this edition, we look at two proposed changes to international standards dealing with the presentation of financial information and the effects of further changes to UK company law.

Re-presenting financial Performance

The International Accounting Standards Board (IASB) recently issued an exposure draft of proposals to amend IAS 1 ‘Presentation of financial statements’.

This exposure draft is a culmination of Segment A of the IASB’s joint project with the US Financial Accounting Standards Board on the important subject of performance reporting. The exposure draft considers the fundamental issue of what information should comprise ‘a complete set of financial statements’.

It is proposed that ‘balance sheet’ be replaced by ‘statement of financial position’, a term that is considered to better reflect the information being presented. In addition to the name change, a complete set of financial information would be required to include a statement of financial position, as at the beginning of the reporting period. Therefore, UK companies required to produce comparative information for the previous period would, under the new proposals, be required to produce three statements of financial position.

Statement of recognised income and expense

The statement of recognised income and expense under the proposed revised IAS 1 will combine the information currently contained in the income statement with that included in the existing statement of recognised income and expense. The latter being a statement that broadly mirrors the UK GAAP statement of recognised gains and losses. The proposals do, however, retain the previous distinction of showing both profit or loss for the period and other recognised income and expense.

The IASB has said that it would prefer all items to be recorded in one statement, but has acknowledged that it would be premature to make this a requirement until the other stages of the project are complete. Companies will therefore be allowed to choose between presenting all items in one statement or using two statements. However, where the latter approach is adopted the statement of profit or loss must be placed immediately before the statement of other recognised income and expense.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Items that would be included in other recognised income and expense include:

• changes in revaluation surpluses in accordance with IAS 16 ‘Property, plant and equipment’

• the foreign exchange gains and losses that arise in consolidated accounts as a result of translating the financial statements of foreign operations in accordance with IAS 21 ‘The effects of changes in foreign exchange rates’

• gains and losses arising on measuring available for sale financial assets in accordance with IAS 39 ‘Financial instruments: recognition and measurement’

• the effective portion of gains and losses on hedging instruments in a cash flow hedge accounted for in accordance with IAS 39

• actuarial gains and losses on defined benefit plans in accordance with IAS 19 ‘Employee benefits’.

Statement of changes in equity

The statement of changes in equity will reconcile opening and closing equity showing:

• the total recognised income and expense

• the effect of changes in accounting policies and corrections of errors accounted for in accordance with IAS 8 ‘Accounting policies, changes in accounting estimates and errors’

• changes in equity arising from transactions with owners (e.g. equity dividends).

Notes to the accounts

Notes to the accounts will continue to be regarded as an essential component of a complete set of financial statements.

Establishing the correct way to report financial performance is an area of accounting standards that has a long history. One of the major challenges that standard setters face is the continued use of a mixed measurement framework, whereby some items are reported at historical cost and some at fair value. The ever-widening use of fair values in IFRS serves only to complicate the position further. How to combine these two bases of measurement in one standard whilst still providing meaningful information is difficult. At this stage of the project, we are only seeing the foundations being laid for what will almost certainly be further, and potentially more controversial, debate in the future.

As a further part of the process of convergence of IFRS with US GAAP, the IASB has issued an exposure draft ED 8 ‘Operating segments’.

Any new standard based on the exposure draft will replace IAS 14 ‘Segment reporting’ and achieve convergence with the US standard SFAS 131 ‘Disclosures about segments of an enterprise and related information’, whose wording the exposure draft largely replicates.

The current requirement of IAS 14 to identify two sets of segments (products and geographic) and then determine which is primary and which is secondary will no longer apply. Instead the segmental information that will need to be reported will be based on those operating segments that management use when monitoring the performance of the business. Companies will be required to present segment profit or loss, certain specified income and expense items, and gross assets.

The move to using a management information basis means that companies will also be required to provide reconciliations between the amounts disclosed with respect to reportable segments and the amounts in the financial statements. Information about revenue derived from different products or services, the countries in which the revenues arise and where assets are used, together with information about major customers, will also need to be provided, irrespective of whether it is used by management.

A description of how the reportable segments are identified will also need to be included within the financial statements.

A proposed amendment to IAS 34 ‘Interim financial reporting’ will result in the need for certain segmental information to be reported in interim statements.

The use of a management information approach is likely to produce more meaningful information for the users of financial statements and align it more closely to the information presented in the management commentaries contained in many accounts. As is already the case with IAS 14, companies will face complexities in respect of gathering the information and the requirement for reconciliations will further extend already long and complex IFRS-compliant financial statements. Companies also need to be aware that there are no exemptions from disclosing segments that mostly trade intercompany – information which may be sensitive for some.

UK GAAP

The Financial Reporting Standard for Smaller Entities (FRSSE) is designed to act as a one-stop shop for smaller companies (i.e. small companies as defined in companies legislation and other entities which meet the same criteria).

The January 2005 version, for the first time, incorporated the relevant small company law requirements, as well as accounting standards, making it a comprehensive source of financial reporting requirements. Small companies, in most cases, do not need to refer separately to other accounting standards or Companies Act provisions.

The recent pace of change in UK company reporting, however, means that the Accounting Standards Board (ASB) is already proposing a new version of the FRSSE, despite the most recent version only having come into effect in January of this year. The proposed new standard is likely to be effective for accounting periods beginning on or after 1 January 2007.

The scope of the FRSSE

The exposure draft is proposing to prevent small companies that are also applying the fair value rules of the Companies Act from using the FRSSE. It is considered unlikely that a small company would want to apply these rules and, as a result, many of the complicated fair value rules for financial instruments contained in FRS 26 ‘Financial instruments: measurement’ have been omitted.

UITF 40: Revenue recognition and service contracts

The main provisions of this abstract are now included in the FRSSE. UITF 40 did not change UK accounting practice but provided much needed clarification of the existing guidance contained in Application Note G to FRS 5, which was included as an appendix to the previous FRSSE. On publication of UITF 40, many companies found that they needed to refine their existing policies for revenue recognition. This may also be true, therefore, for some FRSSE companies.

FRS 20: Share-based payment

The principles of FRS 20 are to be incorporated into the new FRSSE, but the detailed disclosure requirements are not. Therefore, smaller companies granting share options to employees will be required to recognise an expense based on the fair value of the options granted.

It is important that the FRSSE keeps pace with mainstream financial reporting whilst remaining a practical and cost-effective standard for small entities. In that regard the decision to limit the scope of the FRSSE to small entities that are not applying the fair value measurement rules of the Companies Act makes good sense for the majority of potential FRSSE users. However, the proposed requirement to fair value options granted to employees could still prove complex for small companies. Determining the fair value of the options granted is a technical area and likely to require the advice and assistance of professional valuers. As the options will relate to unlisted shares, the process will be further complicated by having to first value the shares before the value of options over those shares can be established. It is to be hoped that the ASB will weigh up the costs and benefits of these proposals for those small companies that do grant share options, which might be achieved through enhanced disclosure.

The amendment to the Companies Act permitting an intermediate parent company to take advantage, subject to certain conditions, of an exemption from preparing group accounts regardless of where its parent undertaking is incorporated, was discussed in the last issue of our Financial Reporting newsletter. Previously the exemption was only available where the parent entity was established under the law of a European Economic Area (EEA) state.

To take advantage of this exemption, which came into effect from 1 January 2005, the consolidated accounts for the larger group in which the company is included are required to be drawn up in a manner ‘equivalent to consolidated accounts drawn up in accordance with the EU Seventh Company Law Directive.’ Interpreting how to apply these equivalence provisions is difficult in practice, so the UITF has issued a draft abstract to help companies determine if they can take advantage of the exemption.

Accounts prepared in accordance with IFRS as adopted for use in the EU will always be expected to meet the equivalence test. However, this will not necessarily be the case for other accounting frameworks. Frameworks which are based on IFRS, such as Australian GAAP, Hong Kong GAAP and South African GAAP, will usually meet the test of equivalence. However, the differences between the GAAP used and IFRS will need to be considered before a final conclusion is reached.

Accounts prepared in accordance with US GAAP and Canadian GAAP will also meet the test of equivalence subject to the following.

• Ensuring that the entities which are included in the consolidated accounts are consistent with those that would be included under the rules in UK GAAP and IFRS.

• Ensuring that consistent accounting policies are used for all the entities included in the consolidated accounts.

• Evaluating the effect of any exemptions or modifications to the GAAPs which might be allowed by specialised industry standards. Accounts prepared under any other GAAP will need to be assessed for equivalence based on the relevant facts, including the similarities to and the differences from the GAAPs discussed above.

It is useful that consideration has been given to helping those many UK companies to which the new law applies and who will be relieved of the burden of preparing group accounts. The draft abstract is, however, quite brief and questions remain about whether even the most widely used GAAPs can be viewed as equivalent or not.

Clarifying the scope of FRS 20: Share-based Payments

UITF Abstract 41 ‘Scope of FRS 20 Share-based payments’ deals with circumstances where, because of public policy or other reasons, shares are given to individuals or entities that have either not provided goods or services or have provided them but at less than the fair value of the share-based payment.

The abstract mirrors an interpretation by the International Financial Reporting Interpretations Committee (IFRIC) in respect of IFRS 2 and applies for periods beginning on or after 1 May 2006.

Where the services or goods received in consideration for equity in an entity cannot be identified and, therefore, cannot be measured in accordance with FRS 20, the entity should measure the transaction at the fair value of the relevant financial instrument. In addition, where the consideration is identifiable but appears to be at less than the fair value of the equity instruments, the abstract concludes that other consideration has been received. The identifiable element should continue to be measured in accordance with FRS 20 and the unidentifiable element, as the difference between the fair value of the financial instrument and the identifiable element.

While the giving of shares in this way is unusual, this abstract has provided the necessary certainty as to the required accounting treatment.

It seems that the uncertainty over the future of the mandatory Operating and Financial Review (OFR) has finally come to an end.

In May, as part of a series of new draft clauses for the Company Law Reform Bill, the Government proposed changes to the Companies Act, which will simplify and clarify the narrative reporting requirements for quoted companies.

As discussed in the last issue of the Financial Reporting newsletter, for periods beginning on or after 1 April 2005, all apart from the smallest of companies will need to produce a Business Review within their Directors’ Report. The draft clauses laid before Parliament in May specify additional disclosures that quoted companies will be required to make in their Business Review over and above that required by unquoted companies, but they will not be required to produce a full OFR. The requirements are intended to ensure that meaningful narrative information is provided to shareholders without the additional burden of producing everything that was required in a statutory OFR.

In addition to the changes applicable to quoted companies, the draft clauses also set out a proposed exemption from making available to all companies information in the Business Review which will be seriously prejudicial to the company’s interests. At present, this exemption is not part of the Companies Act.

While the saga of the mandatory OFR may have finally drawn to a close, it is unlikely to be the end of discussions on narrative reporting, not least because the IASB has an active project in this area. Many listed companies already produce levels of information which go beyond that suggested by the revised legislation, an indicator that market forces also have their part to play in determining the information included in financial statements.

The revised LLP SORP came into effect for periods ending on or after 31 March 2006.

The SORP reflects amendments made as a consequence of new accounting standards and the most significant effects are changes to the presentation of members’ interests, and remuneration and accounting for annuities. A copy of our publication, ‘Revised LLP SORP – under starter’s orders’ may be obtained from your usual Smith & Williamson contact.

2004 saw a number of statutory instruments affecting financial statements and annual reports, with application dates affecting 2005 and 2006 year-ends.

All but the smallest companies must now include in their Directors’ Report a ‘fair review of the business’, including analysis using key performance indicators together with disclosure regarding the use of financial instruments. Proposed dividends are no longer accrued unless approved before the year-end and unlisted companies now have the option to prepare IFRS accounts. All of these changes have already been covered in our Winter 2005 and Spring 2006 Financial Reporting newsletters.

The final change to come out of these statutory instruments is in relation to the disclosure of auditors’ remuneration. While in the past all but the smallest companies have had to disclose details of amounts paid to their auditors split between audit and non-audit services, for periods beginning on or after 1 October 2005, new rules require that companies and LLPs provide considerably more analysis of the amounts paid to their auditors.

The intention of the changes is to achieve greater transparency in financial statements to help combat the perceived threat to auditor independence where auditors also provide ‘other services’ to their audit clients. In future, the fees from those other services must be analysed and disclosed within one of ten categories specified in the legislation including ‘Other services relating to taxation’, ‘Internal audit services’, ‘Valuation and actuarial services’ and the far from concise ‘Services relating to corporate finance to be entered into by or on behalf of the company or any of its associates’.

The rules dealing with which fees should be included within which heading are complicated and not always intuitive. For example, in a set of group accounts the work performed by the auditor on the consolidation return of a subsidiary of the group is disclosed as part of ‘Remuneration for audit services’. However, fees receivable by the same auditor in respect of the statutory audit of that subsidiary are deemed to relate to ‘other services’ and are included in the group accounts under the heading of ‘The auditing of accounts of associates of the company pursuant to legislation’.

It is not just the analysis between these different categories that will increase the amount of time and effort spent to ensure compliance. For a group, the previous disclosure requirements for non-audit services were restricted to only including amounts paid to the parent company auditors for services provided to that company and its UK subsidiaries. Under the new regime, the disclosure must include amounts paid in respect of any ‘associate’ of the company. Confusingly a company’s associates are defined as all of its subsidiaries, whether UK or foreign, and its associated pension schemes. Associates and joint ventures as defined in UK accounting standards are not included in the definition of an associate!

Widening the net further, the definition of ‘auditor’ does not just include the UK firm which provides audit services to the parent company. Where another firm which is part of the same network as the auditor performs services for that company or its subsidiaries, these amounts must now also be included.

In order to produce the disclosures for a set of group accounts, the finance director will need to determine which pension schemes are ‘associated’. They will then need to determine which of the associated pension schemes and subsidiaries had services provided to them by the parent company’s auditors or by firms from the same network as the parent company’s auditors. Information will also need to be gathered about what services were provided and how much was paid for those services. Finally the finance director will need to establish which of the ten categories these services fall into.

There is, however, some good news. Subsidiaries of groups which have included the disclosure of fees for other services in the group accounts are entitled to an exemption from disclosing this information in their individual accounts. In addition, small and medium-sized companies will also continue to be exempt from providing the disclosure relating to other services.

While we support the reasons for these additional disclosure requirements, gathering the information will add further complications to the year-end process. Unfortunately, further changes in this area are also expected over the next few years. The EU 8th Directive on Statutory Audit of Annual and Consolidated Accounts, which is due to be implemented across the EU by 2008, will also require detailed disclosure of auditors’ remuneration, but this is likely to differ from the requirements discussed above.