UK: Financial Reporting - A Briefing For Finance Directors, May 2007

Last Updated: 24 July 2007

In this issue


All change for segmental disclosure

Revenue recognition and upfront fees


Narrative reporting – how are companies doing?

Defined benefit schemes – more accounting changes

Clarifying the scope of FRS 20

FRSSE 2007

Among accounting standard setters, convergence continues to be the key word. Whether it is IFRS and US GAAP or, nearer home, the continuing debate about how best to introduce IFRS into the UK accounting framework without over-burdening preparers of accounts. In the first Financial Reporting newsletter of 2007, we address new and revised standards, both at an international level and in UK GAAP.


All Change For Segmental Disclosure

IFRS 8 ‘Operating segments’ was issued towards the end of 2006 and will apply to periods beginning on or after 1 January 2009.

The new IFRS 8 ‘Operating segments’ will replace IAS 14 ‘Segment reporting’ and apply only to listed entities. The new standard broadly follows the provisions of the exposure draft discussed in the July 2006 edition of Financial Reporting and represents part of the short-term convergence project between IFRS and US GAAP. The new standard follows closely the requirements of FASB Statement No. 131 ‘Disclosures about segments of an enterprise and related information’.

Key Features Of IFRS 8

  • Operating segments are recognised based on internal reporting lines.
  • Disclosable operating segments include any component selling primarily or exclusively to other components.
  • Measurement of reported items is by reference to how they are reported internally and, as a consequence, reconciliations between the reported segment information and that reported in the financial statements must be included in the notes to the accounts.
  • Disclosure of revenue from products and services, the countries in which the revenues are earned and assets held, and about major customers is required irrespective of whether this information is used by operational decision-makers.

Smith & Williamson Commentary

While the first date for mandatory application may be a couple of years away, the need for comparative information brings implementation much nearer. Those responsible for preparing financial statements should start to think now about the additional sensitivity of some of the information that may need to be disclosed and how best to present this within the confines of the standard.

Revenue Recognition And Upfront Fees

How should fees received upfront, prior to the provision of services, be accounted for? IFRIC recently considered this question but was unable to reach a definitive answer.

The role of the International Financial Reporting Interpretations Committee (IFRIC) is to provide interpretations on how IFRS should be applied in situations where:

  • there are newly identified financial reporting issues not dealt with in IFRS, or unsatisfactory or conflicting
  • interpretations of how IFRS should be applied have developed in practice.

However, the majority of issues raised for consideration by the committee are never added to its agenda, either because the issue is considered to be clearly dealt with by existing guidance in IFRS or because the project is outside the scope of IFRIC.

In this case, IFRIC considered how revenue should be recognised where a fund manager receives a one-off, non-refundable upfront fee followed by regular payments for ongoing services received. Normally in these situations the upfront fee remains non-refundable, even if the investor leaves the fund immediately after paying the fee. Therefore, many fund managers have immediately recognised such a fee as revenue.

However, IFRIC does not consider that this will normally be appropriate and argues that the recognition of revenue should depend on the point at which services were provided to the customer in return for the upfront fee. Even where a service is clearly provided to the customer upfront, that service may not have been ‘performed’ for the purposes of IAS 18 ‘Revenue’.

IFRIC debated this issue over three meetings with a view to issuing a draft interpretation. In the end the issue was removed from the agenda on the basis that it was "unlikely within a reasonable time frame to reach a consensus on further principles for determining the extent to which an upfront service had been provided".

IFRIC did agree on the following principles.

  • Fees may be recognised as revenue only to the extent that services have been provided.
  • While the proportion of costs incurred in delivering services may be used to estimate the stage of completion of the transaction, incurring costs does not, by itself, imply that a service has been provided.
  • The receipt of a non-refundable initial fee does not, in itself, give evidence that an upfront service has been provided nor that the fair value of the consideration paid in respect of any upfront services is equal to the initial fee received.

The committee went on to explain that initial fees of a similar nature exist in many different industries, but the services provided and the revenue recognised will be dependent on the specific circumstances of the individual transaction and industry.

Smith and Williamson Commentary

Sometimes the published discussions of IFRIC surrounding whether items should be added to its agenda can, in themselves, provide useful information for the preparers of accounts. IAS 18 is a short and, on the face of it, quite straight forward standard. Yet, revenue recognition is a complex area and interpreting the principles of IAS 18 can prove difficult in practice. In this particular case, there is a very clear implication that IFRIC sees the performance of services as key to revenue recognition and not just the fact that a fee cannot be returned. IFRS reporters need therefore to think carefully about when to recognise the provision of services as revenue. IFRIC’s views on this matter does not just impact on fund managers, but also provides further guidance to all IFRS reporters, particularly those who are accounting for any kind of upfront fee.


Narrative Reporting: How Are Companies Doing?

The introduction of several new narrative reporting standards over the past two years has made it a confusing time for companies.

During 2005 and 2006 we saw the introduction and then subsequent removal of the statutory Operating and Financial Review (OFR) and the issue of the Accounting Standards Board’s (ASB) reporting standard on the OFR, which was quickly changed to a best practice reporting statement. Finally, there was the establishment of the requirement for all but the smallest of companies to prepare a ‘business review’ for inclusion in the directors’ report, as well as disclosure of risks arising from the company’s use of financial instruments.

At present, quoted companies (i.e. those whose shares are quoted on the official list of the London Stock Exchange) are subject to the same narrative reporting requirements as any other large company in the UK (although, as discussed below, this will change under the Companies Act 2006). However, the majority of quoted companies voluntarily provide a significant amount of additional narrative reporting and many provide a full OFR.

The ASB conducted research during 2006 into the narrative disclosures made by listed companies, with the dual objectives of assessing:

  • best practice – the degree to which companies have adopted the recommendations in the ASB’s Reporting Statement on the OFR
  • compliance – how UK companies are performing in light of the legal requirement under the Companies Act 1985 for them to prepare a business review.

In January this year the ASB published the results of its review and the conclusions were, overall, positive.

With respect to the requirements to prepare a business review, it was noted that companies are generally complying. However, this overall conclusion was not without some caveats.

The review highlighted that the disclosure of key performance indicators (KPIs) appears to be one of the most challenging areas for companies, with a warning issued that a lack of inclusion of any KPIs in a business review would suggest to the Financial Reporting Review Panel (FRRP) that the review may not be compliant with the law. Listed companies should therefore be very careful if they fail to include any KPIs or any non-financial KPIs in their business review, as this could lead to their annual report being investigated by the FRRP.

The review also noted that companies could be better at providing a "balanced" analysis of development and performance of the business, as required by the Companies Act. It seems that, quite understandably, companies are keener to tell readers of the accounts about good news rather than bad.

In order to review the examples of narrative reporting against best practice, the ASB looked to their reporting statement on the OFR.

The review noted that the greatest area of difficulty is the disclosure of forward looking information, although it is to some extent understandable that companies are hesitant to include this information for fear of increasing or decreasing the expectations of shareholders, potential future investors and lenders.

There also appears to be a need for improvement in the description of resources available to a company not reflected in the balance sheet; in particular, intangible items such as brand strength and corporate reputation. The report gave as an example of best practice a company which had provided details of contractual agreements, reputation, employees and trademarks.

The review highlighted a wide divergence in practice with regard to the number and level of disclosure of principal risks and uncertainties. It was particularly scathing about one company which had disclosed 33 principal risks and uncertainties. It noted that companies need to describe more carefully their principal risks and uncertainties, and set out their approach to managing and mitigating those risks, rather than simply providing a list of all risks.

Smith & Williamson Commentary

Although the ASB’s review focused on narrative reporting by fully listed companies, the findings are equally important for AIM and PLUS market companies, as well as unlisted companies. It is already becoming clear that areas of non-compliance with the requirements set out in the Companies Act are being challenged by shareholder groups and lenders. All companies should therefore take the opportunity to review their most recent directors’ report disclosures in light of the findings and ensure that they are meeting the business review requirements going forward.

And there’s more to come...

For quoted companies, the Companies Act 2006 (the Act), which received Royal Assent last November, will bring back some of the provisions contained in the original OFR legislation.

To the extent that it is necessary for an understanding of the company, quoted companies will be required to provide information about environmental matters, the company’s employees, social and community issues, and individuals with whom the company has contractual or other arrangements which are essential to the business.

The transitional provisions in relation to this part of the Act have yet to be published. However, we know that it is the Government’s intention that all parts of the Act will be effective by October 2008. It therefore looks as though 2008 will be yet another year of change for narrative reporting by quoted companies.

Defined Benefit Schemes – More Accounting Changes

A number of further amendments made to the disclosure requirements for companies with defined benefit schemes may be unwelcome news for those who have only just come to terms with the complex disclosure requirements of FRS 17.

A number of changes to the accounting requirements of FRS 17: ‘ Retirement benefits’ will take effect for periods beginning on or after 6 April 2007.

While the main principles of FRS 17 are similar to those of its international equivalent, IAS 19, these further changes will bring the disclosure requirements of the two standards into closer alignment. The ASB is encouraging the preparers of accounts to adopt the new standard ahead of the mandatory application date. The majority of the changes are to disclosure requirements; however, there is also one amendment to the measurement criteria used in determining the defined benefit surplus or deficit. At present, FRS 17 requires that when valuing quoted securities held by a defined benefit pension scheme, this should be by reference to mid-market price. IAS 19 requires the use of bid price and FRS 17 has been amended to require the same basis.

The Main Changes

The main changes required for disclosure are as follows.

  • FRS 17 previously required disclosure of the main financial assumptions used to measure the defined benefit asset or liability – the amendment requires disclosure of the principal actuarial assumptions. The most significant consequence of this change will be that many companies will have to disclose mortality rates.
  • Opening and closing scheme assets and liabilities must be shown separately, together with an analysis of the movements.
  • Scheme liabilities will need to be analysed between those that are unfunded and those that are fully or partly funded.

Good News

There is also some good news. The following disclosure requirements have been removed.

  • The date of the most recent actuarial valuation and if the actuary is an employee or officer of the reporting entity.
  • The financial assumptions at the beginning of the period.
  • An analysis of reserves in the accounts showing the defined benefit asset or liability separately.
  • For closed schemes and those where the age profile of active members is rising significantly, the fact that the service cost under the projected unit method will increase as the members near retirement.
  • The fair value of the assets of the scheme at the beginning and end of the period, together with the assumed expected rate of return.

As the assumptions that are to be disclosed are now those at the balance sheet date rather than the opening position, there will no longer be a need to disclose three years’ worth of information.

It will also no longer be necessary to disclose the difference between the expected and actual rate of return on assets for the current period and past four periods. Instead, the amount of the obligation, the fair value of the assets and the surplus and deficit will be required for the equivalent period, together with the experience adjustments arising on the assets or liabilities which can be expressed either as a percentage of scheme assets or an amount.

Smith & Williamson Commentary

While these changes are relatively small compared to those needed to harmonise some standards with IFRS, many companies have only recently come to terms with the complex disclosure requirements of FRS 17 and, as such, any change could be a source of irritation. The requirement with respect to the disclosure of principal actuarial assumptions and the possibility that this will, for many, include mortality rates has also caused some controversy. Businesses in some sectors may find this information particularly sensitive.

More Pensions Disclosures

At the same time, as the revisions to FRS 17 were issued, the ASB also issued a non-mandatory Reporting Statement: ‘Retirement benefits – disclosures’. Designed for use by all companies with defined benefit pension schemes whether they use UK GAAP or IFRS, the Reporting Statement suggests additional disclosures covering the following.

  • The relationship between the reporting entity and the trustees of the pension scheme.
  • The principal assumptions used to measure scheme liabilities. While the revised FRS 17 and IAS 19 require disclosure of principal actuarial assumptions, the Reporting Statement emphasises the need to disclose mortality rates if not already disclosed by accounting standards (i.e. where they were not otherwise considered material). Where there are variances in the mortality rates for geographical, demographical or other reasons, these should also be disclosed.
  • Sensitivity analysis of the principal assumptions used to measure the scheme liabilities.
  • How the liabilities arising from defined benefit schemes are measured. While FRS 17 requires defined benefit liabilities to be measured using the projected unit method, the Reporting Statement discusses the other bases that can be used for measuring liabilities and suggests that, where the cost of buying out defined benefit scheme liabilities is made available to the trustees, this information should also be disclosed.
  • The future funding obligations that the reporting entity has, e.g. commitments to make up deficits.
  • The nature and extent of the risks arising from financial instruments held by the defined benefit scheme.

Smith & Williamson Commentary

The ASB describes the Reporting Statement as "persuasive" rather than mandatory and companies will need to weigh up the relative costs and benefits of the additional disclosure requirements. While most major corporations will probably make the further disclosure, the potential sensitivity of some of the information that will be included in the financial statements means that smaller companies may wish to monitor developments in the marketplace before deciding on which approach to take.

Clarifying The Scope Of FRS 20

The UITF has recently provided clarification of the application of FRS 20 in the context of arrangements within groups.

The Urgent Issues Task Force (UITF) Abstract 44 "FRS 20 (IFRS 2) – Group and Treasury Share Transactions" provides clarity when applying FRS 20 in three situations which are not explicitly dealt with in the standard.

  • Arrangements involving an entity’s own equity instruments where the entity chooses or is required to purchase its own shares in order to satisfy its obligation.
  • Arrangements involving an entity’s own equity instruments where the award is made, or will be settled, not by the entity but by the entity’s shareholders.
  • Arrangements where goods or services are received in exchange for equity instruments of another member of the same group.

The abstract mirrors an IFRIC interpretation in respect of IFRS 2 and applies for periods beginning on or after 1 March 2007.

It is not unusual for these situations to arise when an entity awards its employees either shares or share options in return for their services. Accounting for the first two circumstances is relatively straightforward. Any arrangement in which an entity receives goods or services as consideration for its own equity instruments should be accounted for as ‘equity settled’ in accordance with FRS 20, regardless of who will actually settle the arrangement or how the equity instruments needed are obtained. Equity-settled share-based payments are reflected in the accounts by charging through the profit and loss account an expense based on the fair value of the equity instrument measured at the grant date. The credit side of the double entry is taken directly to equity to reflect the shares which are, or will be, issued.

The requirements of the abstract become more complicated when looking at arrangements involving groups.

Consider the circumstances where the employees of a subsidiary are granted options over the shares of the parent company. UITF 44 specifies how the transaction should be accounted for in the subsidiary’s accounts and this is dependent on which entity (the parent or the subsidiary) granted the options to the employees.

If the grant was made by the parent directly to the subsidiary’s employees, then the transaction is accounted for as equity settled in the subsidiary’s accounts with the credit entry treated as a capital contribution from the parent.

However, if the grant was made by the subsidiary, the subsidiary must reflect a ‘cash-settled share-based payment’ in its accounts. The rationale is that this is more consistent with the principles of FRS 20 because the subsidiary has an obligation to provide its employees with the equity instruments of its parent. Cash settled share-based payments are reflected in the accounts by expensing the fair value of the equity instrument through the profit and loss account over the vesting period. The credit side of the entry is shown as a liability and the fair value of this liability (and hence the fair value of the instrument) must be re-measured at each balance sheet date until the options vest.

On consolidation, adjustments will be required to ensure that the group accounts reflect the substance of the arrangement from the group perspective and show the transaction as equity settled.

Smith & Williamson Commentary

The abstract mirrors exactly the requirements of IFRIC 11 which received a great deal of resistance while still in draft form. It is clear from the ASB’s press release, which talks about "an additional burden on subsidiaries out of proportion to the benefit to the users of their accounts" that they are less than happy with the final versions of IFRIC 11 and UITF 44. The ASB have always publicly stated their support for convergence of UK GAAP to IFRS, however their comments in relation to this abstract have indicated a willingness to at least consider the practicalities of detailed IFRS requirements where cost may outweigh benefit.

…More Clarification Needed?

Currently, neither the IFRIC interpretation nor the UITF Abstract deals with how to account for funding arrangements between the parent and subsidiary, e.g. where the subsidiary agrees to pay the parent an amount equal to the difference between the exercise price of the options and the fair value of the shares at the date of exercise. The UITF is concerned that this issue may need clarification and is considering whether it is necessary to develop additional guidance as a supplement to UITF 44.

FRSSE 2007

The latest version of the FRSSE provides small companies with much needed and welcome relief from one of the most complex accounting standards of recent times.

The new Financial Reporting Standard for Smaller Entities (FRSSE) can be applied by all companies which qualify as ‘small’ under companies legislation, or by any other entity which would have qualified as small were it incorporated. The effective date is periods beginning on or after 1 January 2007, although earlier adoption is permitted.

Main Changes

The main changes from the previous version of the FRSSE (effective January 2005), are as follows.


Previous versions of the FRSSE have specifically excluded certain types of financial services firms from applying its provisions, even if they would otherwise have met the qualifying conditions. While this is no longer the case, companies that choose to use the fair value rules in the Companies Act 2006 (i.e. they take unrealised gains and losses on fair value movements in certain financial assets and liabilities to the profit and loss account) will not be able to apply the FRSSE.

Share-Based Payment

When the draft version of the 2007 FRSSE was originally published, it included provisions to apply all the measurement rules of FRS 20 share-based payment (but with reduced disclosure requirements). This would have resulted in all share options issued to employees in return for services being valued and charged to the profit and loss account.

A number of respondents, including the Institute of Chartered Accountants for England and Wales, raised concerns about this proposal, suggesting that the difficulties and potential expense of valuing share options would prove overly burdensome for small companies

The ASB has responded to those concerns by significantly changing the requirements for share-based payments. Unless an entity has a ‘non-standard’ scheme, such as a phantom share scheme where cash amounts based on the price of the entity’s shares are paid instead of actual shares being issued, there will be no requirement to value share-based payments and charge them to the profit and loss account. There will need to be disclosure, but this will not include the fair value of the options.

Other Changes

The FRSSE now contains detailed examples of how to apply its requirements in two areas which have caused some confusion in the past: defined benefit pension schemes and preference shares, which have the features of liabilities.

In addition, the previous version of the FRSSE included guidance on accounting for revenue from service contracts as an appendix. This guidance, which incorporates the key provisions of UITF 40 into the FRSSE, has now been moved into the main body, thus avoiding any confusion as to its applicability.

Smith & Williamson Commentary

In the past, some small companies have chosen not to apply the FRSSE on the basis that its provisions would not have made a significant difference to the costs they incur in producing financial statements. The FRSSE has always provided significant disclosure exemptions, but exemptions from actual accounting entries have been limited. For those preparers who are entitled to use the FRSSE and who have more conventional share-based payment transactions, this is no longer the case. Significant cost can be saved in adopting the FRSSE, as adopters will avoid three costs.

  1. Having to value share options (probably with the help of a professional valuer).
  2. Having to apply reasonably complicated accounting rules to calculate the profit and loss charge.
  3. Potentially incurring further costs in having these items audited.

It is to be hoped that this represents a shift in the ASB’s approach and future versions of the FRSSE will incorporate complex standards by offering significant simplifications of the accounting requirements of those standards.

"Significant savings can be made by adopting the FRSSE, as adopters will avoid several costs"

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.

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