In this issue
IFRS
Business Combinations – A New Model
First-Time Adoption – The Impact On Aim Interim Reports
Proposed Amendments To IFRS 2 And IFRIC 11
UK GAAP
Companies Act 2006 Update
Distributable Profits
We look at the impact recent revisions to IFRS will have on both accounting practices and future acquisitions. Whether applying IFRS or UK GAAP, companies are affected by company law. We also look at further implementation of the Companies Act 2006 and the important area of determining distributable profits.
IFRS
BUSINESS COMBINATIONS – A NEW MODEL
Recent revisions to IFRS 3 and IAS 27 mean that changes will be required to long-established accounting treatments and could affect the structure of future acquisitions.
The revised versions of IFRS 3 'Business combinations' and IAS 27 'Consolidated and separate financial statements' were issued at the beginning of the year. They are set not only to change long-established accounting practice, but also the shape of future acquisitions. The revisions mark the culmination of a joint project between the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) and, while there is considerable convergence, some differences remain. As a consequence there could still be significantly different financial reporting between companies applying IFRS and US GAAP.
Both standards come into effect for periods that begin on or after 1 July 2009. While it is possible to adopt for earlier periods, both standards must be adopted together and the revised standards cannot be implemented for periods beginning before 30 June 2007.
Measuring the cost of the business combination
As with the existing version of IFRS 3, consideration in a business combination is measured at fair value at the acquisition date. However, the revised version concentrates on what the vendor receives rather than what the acquisition costs the acquirer. Acquisition costs, such as legal and advisory fees, which have historically been included as part of the purchase consideration and, therefore, within the calculation of goodwill, will, in future, be recognised in the income statement in the period they are incurred.
Contingent consideration arrangements, such as earn-outs, are common to many acquisition agreements. While the fair value of such arrangements will continue to be included as part of the cost of the business combination, subsequent adjustments will be accounted for very differently. Adjustments are currently applied by amending the goodwill figure but, in future, they will need to be dealt with in the income statement.
Provisional fair values
At the date of acquisition, companies need to assess the fair value of the assets and liabilities acquired. Where it is not possible to make a definite assessment, companies can attribute provisional values and agree final figures within 12 months from the date of acquisition. None of this is new. However, whereas previously any adjustments to fair values were accounted for as adjustments in the period in which they were identified, under the revised IFRS 3, they will have to be treated as prior period adjustments and comparatives restated.
Non-contractual customer relationships
What might seem to be a small change in wording within the illustrative examples could have significant implications with respect to the recognition of intangible assets. Intangible assets are recognised if they arise either from a contract or are separable for non-contracted customer relations. The current wording in IFRS 3 implies that evidence of separability exists where there has been an exchange transaction for the same or similar assets. In the revised version, extension of this criteria to evidence that "other entities" have sold or transferred such assets significantly widens the scope and hence the likelihood that such relations will need separate recognition.
The demise of minority interests
Once the new standard comes into effect, the term 'minority interest' will be banished to the history books in so far as IFRS is concerned and will be replaced by 'non-controlling interests'.
It is not only the name that is changing, but potentially the accounting treatment as well. Currently, at acquisition, the non-controlling interest is calculated by reference to the proportionate share of the identified net assets of the acquired entity. In what may seem an unusual move, the IASB is now offering companies a choice of how they account for their noncontrolling interests at the point control is obtained. As part of the convergence with US GAAP, the revised IFRS 3 introduces the option, on a transaction by transaction basis, to measure the non-controlling interest at fair value (US GAAP permits only fair value). In circumstances where the shares are actively traded, this fair value would be measured by reference to market value. Otherwise, a valuation technique would need to be applied.
Step acquisitions
The majority of business combinations arise in circumstances where the interest goes from 0% to 100% in one go. However, this is not always the case and accounting for so-called 'step acquisitions' has always left preparers reaching for their textbooks. However, the position is set to become easier as the IASB has sought to simplify the requirements. Where an entity goes from having an interest in a company (whether investment, associate or joint venture) to a position of obtaining control of that company, it will be required to re-measure to fair value its original investment. This fair value will form part of determining the total consideration given for the acquisition. To the extent that there is a gain or loss on the re-measurement, it will need to be included within the income statement.
However, once control has been obtained, further increases or decreases in ownership interest are treated as transactions with shareholders and recorded in equity. It will not be necessary to re-measure to fair value each time.
Consequential amendments to IAS 27
Certain amendments have also been made to IAS 27, primarily to reflect the new approach to changes in controlling and non-controlling interests.
Changes in a parent entity's interest that do not result in a change of control are dealt with within equity and no adjustment is made to goodwill. When control is lost, all assets, liabilities and non-controlling interests are derecognised. Any interest that remains is recognised at its fair value on the date that control was lost.
There are also consequential amendments to both IAS 28 'Investments in associates' and IAS 31 'Interests in joint ventures'. Where an entity ceases to have significant influence over an associate, it derecognises the associate. It also includes in the income statement the difference between the proceeds received and any retained interest and the carrying amount of the associate at the date significant influence was lost.
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Smith & Williamson commentary With the revised IFRS 3, we see a number of areas that will make understanding the cost and effect of acquisitions more difficult. In addition, greater volatility of reported earnings is highly likely, particularly in very acquisitive companies. For example, take the position of a company that makes acquisitions on a regular basis. If it also usually attributes provisional fair values, then there is the very real prospect of year upon year of prior period adjustments. As well as introducing volatility in earnings, the change in treatment of contingent consideration is likely to lead to some interesting discussions between entities and their auditors. Companies will want to avoid unpredictable 'costs' in the income statement and this could lead to conflict with the requirement that deferred consideration be reflected at fair value. Equally, the writing off of often substantial acquisition costs before the company has the benefit of the associated business activity, could result in not only volatility of results, but also impact on distributable profits. All of these issues are likely to lead companies to look long and hard at the way in which deals are structured and their professional advisers are remunerated. |
Aim companies can look to a number of different pronouncements when deciding on the content of their first IFRS interim report.
FIRST TIME ADOPTION – THE IMPACT ON AIM INTERIM REPORTS
Aim Rule 18 sets out what Aim companies must include in their interim reports. In addition, the newly updated Accounting Standards Board's (ASB) statement on 'Half Yearly Financial Reports' and IAS 34 'Interim Financial Reporting' both provide best practice guidance as to additional disclosures. Aim companies also have a further choice as to whether or not they want to gain the additional comfort of an auditor's review. The requirements for such a review are set out in International Standard on Reporting Engagements 2410: Review of Interim Financial Information Performed by the Independent Auditor of the Entity (ISRE 2410).
What should be included in an interim statement?
With a range of non-mandatory standards available, there is a great deal of choice for Aim companies when deciding what to include and what not to include in their interim statements. Should they include segmental information, earnings per share and a statement of changes in equity? Should they have their interim information reviewed by their auditors? Should they include comparatives for the full year as well as the corresponding comparative interim period, as required by the Aim Rules?
Our review of Aim interim reports
In an attempt to answer these and other questions, Smith & Williamson has reviewed the first 100 interim reports published in October 2007 to see what Aim companies are doing in practice. Our findings are as follows.
- 98% of the statements we reviewed included disclosure of earnings per share, while only 50% included some form of segmental information.
- 91% of companies included a statement of recognised income and expenses or a statement of changes in equity. The latter option was by far the more popular, with 81% of companies that included either statement opting for the more detailed statement of changes in equity. It should be noted however that in full financial statements, those companies choosing the statement of changes in equity will have to present the details of the statement in changes in equity in the notes.
- Of those companies that disclosed comparatives, i.e. those that were not producing information for their first period, 84% went beyond the requirements of the Aim Rules by disclosing full-year comparatives, as well as those for the previous interim period.
- Only 23% of companies had their interim financial information formally reviewed by their auditors.
- 74% of companies adopting IFRS for the first time included the transitional information in their interim reports. The remaining 26% produced a separate, dedicated IFRS transition document or report.
- Although IAS 34 is not mandatory for Aim companies, 17% of companies disclosed full compliance with the standard, 1% were compliant except for specific items, 24% made an explicit statement that they did not comply with the standard and 58% made no reference at all.
PROPOSED AMENDMENTS TO IFRS 2 AND IFRIC 11
Group cash-settled share-based payments transactions
Guidance has been published which aims to clarify how the existing requirements of IFRIC 11 and IFRS 2 should be applied in certain circumstances.
In December 2007, the IASB published an exposure draft of proposed changes to both IFRS 2 'Share-based payments' and IFRIC 11 'Group and treasury share transactions'.
The new guidance does not constitute an addition to the existing requirements of IFRS 2 or IFRIC 11. It is simply intended to clarify how the existing requirements should be applied to particular circumstances.
The amendments are intended to address circumstances affecting groups of companies, where a parent company will be paying employees or suppliers of a subsidiary a cash payment based on the price of either the parent or the subsidiary's equity. A number of preparers of accounts have been unsure how IFRS 2 should be applied in these situations. This is because, while services were being provided to the subsidiary, that subsidiary did not appear to have any obligation to transfer cash. Therefore, it was unclear how the charge arising in relation to these services should be reflected in the accounts of the subsidiary.
For the conditions outlined above, the proposed amendments clarify that the subsidiary should re-measure the value of the share-based payment every year on the same basis that would be applied in cash-settled accounting, but that the subsidiary should not show a liability. Rather, the subsidiary would record a capital contribution from the parent, and it would be that equity amount which would be subject to annual re-measurement.
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Smith & Williamson commentary The proposed amendments to IFRS 2 and IFRIC 11 do not, in our view, change the accounting that should be applied to group cash-settled share-based payments. The accounting described in the amendments reflects the original intention of the standard to capture the full cost of the services received by an entity, even where the providers of the services are paid via share-based payments. However, clear guidance from the IASB as to how standards should be applied is always welcome. |
UK GAAP
COMPANIES ACT 2006 UPDATE
Several provisions of the Companies Act 2006 have been delayed by a year and will now not be enacted until October 2009.
As discussed in previous Financial Reporting newsletters, while the Companies Act 2006 (the Act) received Royal Assent on 8 November 2006, many of its provisions are yet to be enacted. Late changes to previously announced implementation timetables make determining when the various provisions will come into effect even more difficult. In addition, the close links between company legislation and that applicable to limited liability partnerships (LLPs) mean that there will also need to be changes to LLP legislation.
Delayed provisions
Many of the provisions due to be enacted in October 2008 will now not become effective until October 2009. This is due to the possibility that Companies House's systems may not be ready for the changes by October 2008. The delayed provisions include those relating to company formation, share capital and directors. As a result, new companies will continue to be incorporated under the Companies Act 1985 until 1 October 2009.
LLPs
The Department for Business Enterprise and Regulatory Reform (BERR) issued a consultation paper in November 2007 setting out its suggested approach to applying the Companies Act 2006 to LLPs. The paper proposes that the provisions of the 2006 Act should be applied as far as possible to replace the provisions of the Companies Act 1985. However, due to the differences between LLPs and companies, certain provisions are not considered relevant to LLPs, including those relating to narrative reporting, directors and share capital.
Because development of the legislation for LLPs lags behind that for companies, the implementation dates of the new LLP legislation will not be consistent with those for the Companies Act 2006. The majority of the provisions relating to LLPs will not become effective until 1 October 2009. The key exceptions to this include the following.
- Part 15 (accounts and reports) will commence for LLPs in October 2008, apart from the rules on filing deadlines and penalties, which will be implemented in April 2008.
- Part 16 (audit) will commence for LLPs in October 2008.
- Provisions relating to e-communications will commence for LLPs in October 2008.
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Smith & Williamson commentary The new Companies Act was passed over a year ago, but company law is still very much in a state of flux, with three more significant tranches of the Act coming into effect on 6 April 2008, 1 October 2008 and 1 October 2009. The different dates that will apply to LLPs compared to companies will also not help, particularly for groups that include both types of entity. There will be considerable scope for error and misinterpretation until all the changes have taken place. It is therefore very important for companies to seek appropriate legal advice when they wish to take advantage of a particular provision. |
| Small company | Medium-sized company | |||
| Company / group (net) £ |
Group (gross) £ |
Company / group (net) £ |
Group (gross) £ |
|
| Turnover | 6.5m | 7.8m | 25.9m | 31.1m |
| Balance sheet total | 3.26m | 3.9m | 12.9m | 15.5m |
| Number of employees | 50 | 50 | 250 | 250 |
Company size limits
BERR has decided to increase the small and medium-sized company limits by 20% – in line with the increased maximum limit allowed under European Union (EU) legislation. The new size limits, set out above, will be effective for periods beginning on or after 6 April 2008.
The thresholds used to determine audit exemption will also be raised to the small company turnover and balance sheet total amounts.
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Smith & Williamson commentary The increase in the small company threshold will see some companies, currently classified as medium-sized, become small. Those affected will welcome the change, as it also coincides with the removal of the exemption for the preparation of group accounts for medium-sized groups. |
DISTRIBUTABLE PROFITS
Following the introduction of IFRS and IFRSbased UK standards, revised and expanded guidance has recently been issued on distributable profits.
UK legislation only permits companies to pay dividends out of profits available for distribution, i.e. those that are realised profits, in accordance with generally accepted accounting principles. In the past, the majority of companies were able to determine their available levels of distributable profit, simply by referring to the balance on their profit and loss account reserve.
However, as accounting standards have become more complex, the question of whether or not profits are realised seems to be more and more contentious. Because the concept of realised profits is a legal one, accounting standards do not address the impact their provisions may have in an area that is very important to companies. Guidance is, however, produced by the professional institutes. As a consequence of the introduction of IFRS and IFRSbased UK standards, the Institute of Chartered Accountants in England and Wales and the Institute of Chartered Accountants of Scotland have recently issued joint revised and expanded guidance – TECH 02/07 'Distributable profits: implications of recent accounting changes'.
Probably the most significant issue raised by IFRS and UK standards based on IFRS, is the increased use of fair values. The guidance focuses on, but is not limited to, considering how movements in fair values impact the levels of distributable profits.
While the law on profits available for distribution under the Companies Act 2006 has not changed, the technical release effectively alters the definition of what constitutes a realised profit. The general principle is that profits will be considered to be realised to the extent that they either relate to a transaction settled in cash, or to items that are readily convertible to cash.
Many companies not applying IFRS and which do not have particularly complicated accounts might be forgiven for thinking that TECH 02/07 will not have any ramifications for them. However, there are a number of very common and what appear to be straightforward situations in which applying the guidance may result in companies determining different levels of distributable profit than they would have in the past.
For example, those preference shares that are accounted for as compound instruments will be split between a liability element and an equity element. The amount of interest charged to the profit and loss account will be calculated by reference to the recognised liability and, as such, will be higher than what is actually paid. However, this increase in the interest charge has no effect on distributable profits because its effect on reserves is matched against the existing equity element of the instrument. While these amounts are matched for distributable profit purposes, they will almost certainly be presented separately for accounting purposes and, as a result, the balance of retained profits will not represent the company's distributable profit.
TECH 02/07 also reinforces existing guidance in relation to the determination of distributable profit in groups. In particular, where a holding company wants to pay dividends on the basis of dividends received from its subsidiaries, those subsidiaries will need to ensure that their dividends can be treated as realised by the parent at the balance sheet date. For interim dividends, they will need to be paid before the holding company's balance sheet date. For final dividends, they will need to have been formally declared at a general meeting prior to the holding company's balance sheet date.
Furthermore, it should be remembered that profits which are supported by intercompany borrowings are only realised to the extent that the borrowings are readily convertible to cash. Loans which are long term and/or unlikely to be called in the foreseeable future would not normally be viewed as being readily convertible to cash.
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Smith & Williamson commentary TECH 02/07 is a long document, and because it deals with a combination of accounting and legal concepts, it may well seem inaccessible to many readers. However, its provisions have very real ramifications for companies that either pay dividends or want to redeem shares out of profit. It is no longer possible to assume that everything in the profit and loss account is automatically distributable. Directors may therefore find they have to revisit their previous methodology for determining distributable profit and, in some cases, put in place new systems to keep the distributable and non-distributable separate within the accounting records. Whenever there is uncertainty as to the level of distributable profits available, appropriate professional advice should be sought. |
FINANCIAL REPORTING ROUND-UP
In contrast with the many changes currently happening in company law, financial reporting changes have been relatively few and far between. This is particularly the case with regard to UK GAAP, where there have been no published developments for more than six months.
IFRS 8
IFRS 8 'Operating segments' initially received a barrage of criticism, predominantly from European investors who felt it would give too much control to a company's management in deciding what information to disclose. The standard was finally endorsed by the EU in November last year and will be effective for periods beginning on or after 1 September 2009.
FRRP activity
The Financial Reporting Review Panel (FRRP) published its activity report towards the end of last year. They reviewed more than 300 sets of accounts, of which almost three quarters were prepared under IFRS, with the remainder using UK GAAP. They concluded that, overall, there was good compliance with the requirements of standards, but that there are still areas for improvement.
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Smith & Williamson commentary The FRRP report makes useful reading for all IFRS preparers, particularly finance directors of Aim companies about to prepare their first set of IFRS accounts. Learning from others' experiences is likely to be of particular benefit to those adopting IFRS for the first time. |
FRRP priority sectors
The FRRP has announced that its priority sectors for 2008/09 will be banking, retail, travel and leisure, commercial property and house builders. These sectors were chosen following discussions with the Financial Services Authority and Financial Reporting Council advisory groups, as they are thought to be at the highest risk of financial reporting non-compliance.
The FRRP's review will continue to include the largest listed companies, but there will be a shift beyond FTSE 350 companies to include smaller listed companies, Aim companies and large private companies.
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Smith & Williamson commentary The FRRP reviews have not previously been a particular issue for large private companies and Aim companies. However, the revised scope of the FRRP's review will mean that such companies will now be coming under increased scrutiny. |
ON THE HORIZON
UK GAAP
A handful of UK GAAP standards have become effective for periods commencing 1 January 2007, including the latest Financial Reporting Standard for Smaller Entities, FRS 29 (IFRS 7) 'Financial instruments: disclosures', and an amendment to FRS 3 'Reporting financial performance'.
An amendment to FRS 17 'Retirement benefits' becomes effective for periods commencing on or after 6 April 2007. All of these have been covered in previous Financial Reporting newsletters.
IFRS
The table below summarises the effective dates for new and revised international standards and interpretations. Those that are shaded have not yet been endorsed by the EU and the effective date will be contingent on successful endorsement.
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.
