The impact of the FRS on accounts

In January the Accounting Standards Board (ASB) issued revised exposure drafts 46, 47 and 48 outlining their intention to replace all current FRSs/SSAPs and UITF Abstracts with a new ‘Financial Reporting Standard applicable in the UK and Republic of Ireland’ which is scheduled to take effect for accounting periods commencing on or after 1 January 2015. Steve Collings highlights the key changes in store.

During lectures, the reaction from delegates has been mixed. Many practitioners have expressed their reluctance for the new UK GAAP to take effect as they view UK GAAP in its present form to be fit for purpose, while other practitioners are welcoming the new UK GAAP, provided resources are available to help them not only apply the new standards, but also to plan for the change. This article will look at some of the issues within the financial statements that practitioners deal with on a daily basis. It will not go into every conceivable difference between mainstream UK GAAP in its current form and the proposals contained in draft FRS 102, but I have picked out some of the more notable changes that practitioners need to have at the forefront of their mind.

The new UK GAAP will affect many practitioners that deal with clients who are not eligible to apply the FRSSE (effective April 2008). I have always subscribed to the belief that while UK GAAP in its current form is more or less parallel with its proposed successor, there are differences that firms will need to be aware of and additional work will need to be undertaken in the first year that the new standard is applied. For now I will focus on how the accounts might look if the exposure draft is issued without further amendment (which may be unlikely but working on the basis that wholesale changes to the recently issued exposure draft are also unlikely).

Accounting policies

Accounting policies, estimates and errors are covered within section 10 of the draft FRS.  Paragraph 10.4 tells practitioners that if the draft FRS does not specifically address a transaction, or other event or condition, an entity’s management must develop and apply an accounting policy that is:

  • relevant - information is relevant to aid the decision-making process of the users
  • reliable - will result in the financial statements faithfully representing the financial position, performance and cash flows. In addition, the policy must also reflect the economic substance of the transaction(s)/event(s) or condition(s) rather than reflecting the legal form. To achieve reliability the policy adopted must also be neutral, prudent and complete in all material respects

Currently FRS 18 Accounting Policies is very similar, but in some cases the end result and impact on profit or loss may not necessarily be the same. 

Error correction

Again, error correction is dealt with in section 10 (specifically at paragraphs 10.19 to 10.23).  Current UK GAAP deals with error correction in FRS 3 Reporting Financial Performance. Paragraph 10.21 of the draft FRS requires an entity to correct a “material” prior period error retrospectively in the first financial statements which are authorised for issue after discovery of the error by way of a prior period adjustment.

Paragraph 63 to FRS 3 requires the correction of “fundamental errors”. Fundamental errors are those which are so significant they destroy the true and fair view (and the validity) of the financial statements. Again, this paragraph in FRS 3 requires fundamental errors to be corrected by way of a prior period adjustment.

The terms “material” and “fundamental” could be interpreted differently among practitioners, but they do amount to the same thing. This interpretation aspect will mean that more errors will be corrected retrospectively by way of a prior period adjustment.

Investment property

SSAP 19 Accounting for Investment Properties requires such properties to be classified in the balance sheet at their market value, with any changes in market value going through the revaluation reserve account (i.e. through the statement of total recognised gains and losses). 

Paragraph 16.7 of the draft FRS extinguishes the use of the revaluation reserve account and requires all changes in fair value of an investment property to be recognised in profit or loss. 

The upshot of this treatment would be that reported profit or loss would be different than would otherwise be under SSAP 19, but there would not be a tax effect until such time the investment property was disposed of.

It is also worth noting that the draft FRS requires fair values to be obtained where obtaining such does can be done without “undue cost or effort” whereas SSAP 19 does not make this exception. In the draft FRS if obtaining fair values would result in undue cost or effort then it will account for investment property in accordance with section 17 Property, Plant and Equipment until a reliable measure of fair value becomes available.

In reality it is fairly easy to obtain a market value for investment property through the use of an external valuer but the draft FRS points users to the guidance on obtaining fair values in paragraphs 11.27 to 11.32.

Fixed assets

Paragraph 17.5 to the draft FRS acknowledges that spare parts and servicing equipment are normally carried in the financial statements as inventory with recognition taking place as and when such parts/equipment are used in the business. The draft FRS at para 17.5 requires “major” spare parts and stand-by equipment to be included within the cost of the fixed asset(s) to which it relates when the business is expected to use them for more than one accounting period. 

The main difference here is that FRS 15 Tangible Fixed Assets does not make specific reference to “major spare parts/servicing equipment”. The treatment under the draft FRS would essentially mean that the cost of major spare parts/servicing equipment would be recognised within the depreciation charge rather than in the profit and loss through consumption of stock (cost of sales).

If fixed assets are acquired under a deferred payment arrangement (in other words deferred beyond normal credit terms), the cost of the asset must be the present value of all future payments in accordance with paragraph 17.13 of the draft FRS. Such issues are not specifically covered in current FRS 15 and this would mean that under FRS 15, the value of assets currently capitalised would essentially be under-stated, giving rise to a lower depreciation charge also. The draft FRS addresses this issue so the net book value of fixed assets would be higher, but this would also have a consequential increase in the depreciation charge, thus reducing profitability (or increasing losses).

FRS 15 goes into a lot more detail at paragraphs 34 to 41 relating to “subsequent expenditure”. However, the draft FRS does not specifically cover subsequent expenditure, but merely states at paragraph 17.15 that day-to-day servicing of property, plant and equipment, must be recognised in profit or loss in the period in which the costs are incurred.

Users would therefore be directed to the “Concepts and Pervasive Principles” in section 2 of the draft FRS to determine whether any subsequent expenditure does, in fact, meet the definition and recognition criteria of an asset outlined at paragraph 2.15(a) and paragraph 2.27 (a) and (b).

Borrowing costs

Section 25 deals specifically with “borrowing costs” which are interest and other costs that an entity incurs in connection with the borrowing of funds. It is not uncommon for an entity to construct its own asset (for example when a company builds its own offices) and consequently it may take out a loan specifically to construct its own asset. Paragraph 25.2 of the draft FRS allows an entity to adopt a policy of capitalising borrowing costs which are directly attributable to the acquisition, construction or production of a “qualifying” asset as part of the cost of that asset.

Section 25 does not define a qualifying asset, but IAS 23 Borrowing Costs at paragraph 5 says that a qualifying asset is: “an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.”

The option to capitalise borrowing costs is optional so if a company does decide to capitalise borrowing costs then it should do so consistently for all qualifying assets. Where the company decides not to capitalise borrowing costs, then such costs are recognised in the profit and loss account in the period in which they are incurred.

Intangible assets and goodwill

When a company cannot reliably estimate the useful economic life of goodwill and intangible assets, such assets must be amortised over a default period of five years under the draft FRS.

Paragraph 19 to FRS 10 Goodwill and Intangible Assets contains a rebuttable presumption that the useful economic lives of purchased goodwill and intangible assets are limited to periods of 20 years or less. 

Clearly the impact under the draft FRS will result in lower profitability or higher losses when goodwill and intangible assets’ useful economic lives cannot be reliably determined because the period over which they are being amortised over is accelerated under the draft FRS than what is currently permitted under FRS 10.

Leasing

Current SSAP 21 Accounting for Leases and Hire Purchase Contracts sets out a specific numeric benchmark when determining whether a lease is a finance or operating lease as is demonstrated in paragraph 22 of the Guidance Notes in SSAP 21.

The classification under the draft FRS does not refer to a 90% benchmark, but instead offers examples of various situations that individually, or in combination, would give rise to a lease being classified as a finance lease. These classifications can be found in paragraphs 20.5 and 20.6 of the draft FRS. 

The classification criteria is based upon the risks and rewards of ownership of the associated asset and which party retains those risks and rewards. There are a number of factors that can determine whether risks and rewards have, or have not, been transferred from lessor to lessee and therefore paragraph 20.7 acknowledges that the examples of indicators contained in paragraphs 20.5 and 20.6 of the new FRS will not be conclusive in every single respect and consideration must therefore be given to other indicators that risks and rewards may (or may not) have transferred from lessor to lessee, thus there could be more judgement needed in this subjective area.

In some cases lessees may receive an incentive payment to take up a lease. Paragraph 20.15 does not make reference to the effect of incentive payments relating to operating leases. In current GAAP, UITF 28 Operating Lease Incentives at paragraph 8 says that any incentive should be allocated to match the effect of the increased rentals in later periods so that the financial statements reflect the true effective rental for the premises – in other words an incentive is not recognised immediately.

Revenue recognition

There are some slight variations in the wording relating to the measurement of revenue. For example, paragraph 23.3 of the draft FRS refers to revenue being the fair value of the consideration “received or receivable”. Application Note G to FRS 5 at paragraph G4 says that a seller recognises revenue under an exchange transaction with a customer, when, and to the extent that, it obtains the “right to consideration” in exchange for its performance.

This subtle difference in wording could potentially allow for later recognition of profit which would result in a potentially different tax treatment as the tax treatment would follow the accounting treatment. 

Paragraph 23.15 of the draft FRS refers to a “specific act” and a “significant act”. The paragraph says that when a specific act is much more significant than any other act, the entity postpones revenue recognition until the significant act is executed. UITF 40 (Application Note G to FRS 5) is more prohibitive in that it requires revenue to be recognised in line with performance (passing a “milestone” or a “critical event”) and earning the right to consideration, hence there is the potential here to the possibility of recognising profit later than would otherwise be the case under UITF 40 principles. This would also have a direct effect on tax as the tax treatment follows the accounting treatment.

Paragraph 23.16 of the draft FRS says that if a client cannot estimate the outcome of a service contract (more likely to be the case with construction contracts) then the client should only recognise revenue to the extent of the costs incurred. In contrast, paragraph 10 to SSAP 9 Stocks and Long-Term Contracts says that where the outcome of long-term contracts cannot be assessed with reasonable certainty, no profit should be reflected in the P&L account and suggests showing as turnover a proportion of the total contract value using a zero estimate of profit.

Share-based payment

Paragraph 26.10(c) of the draft FRS requires the directors to use their own judgement in applying a generally accepted valuation methodology for valuing equity instruments when the fair value of an observable market price is not available and obtaining a reliable measurement of such is impracticable. 

FRS 20 Share-based Payment generally requires fair values to be used for all share-based payment transactions. However, when fair values are unreliable, paragraphs 24 and 25 gives guidance and paragraph 24(a) requires intrinsic values for shares to be used. Intrinsic values are the difference between the price paid for the share and market value of the share when the share is issued. 

Short-term employee absences

Paragraph 28.6 of the draft FRS recognises that some short-term absences are/can be accumulated and can be carried forward for use in future periods where the employee does not utilise their full quota in the current accounting period. This paragraph requires payments to employees for short-term absences to be accrued using an undiscounted additional amount that the entity expects to pay as a result of the unused entitlement that has accumulated at the end of the accounting period. 

Currently this requirement is not covered within current UK GAAP and in reality it is quite uncommon for such payments to be provided for.

Deferred tax

The draft FRS requires deferred tax to be recognised in respect of all timing differences at the balance sheet date which is similar to current FRS 19 Deferred Tax. However the draft FRS uses a “timing difference plus” approach for deferred tax which could result in larger deferred tax balances being recognised because the following will give rise to deferred tax considerations under the draft FRS:

  • Revaluations including investment property
  • Fair values on business combinations
  • Unremitted earnings on overseas subsidiaries or associates

There is also prohibition in the new FRS which says that an entity will not discount deferred tax liabilities or assets. In practice hardly any firms discount deferred tax balances to present day values so this prohibition will generally go unnoticed.

Conclusion

The draft FRS contains some very good illustrative examples of how the new standards are to be applied in real life. The move over to the new UK GAAP is scheduled for 1 January 2015, but it is important that practitioners start to consider the impact the switch will have on their practice.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB.co.uk Guide to IFRS’ and ‘IFRS For Dummies’ and was named ‘Accounting Technician of the Year’ at the 2011 British Accountancy Awards.

Comments

Investment Properties

Stephen Morris |

I believe the proposed treatment of investment properties is dreadful. The proposal to recognise unrealised holding gains through the income statement is a fundamental error in my view. Enron's accounts just before it failed showed how such treatments can easily mislead the user of accounts.

investment properties

CLD |

I agree with Stephen Morris's view entirely !!

Steve Collings's picture

Investment Properties

Steve Collings |

Hi both

You're not the first accountants to criticise the ASB's approach in the way that investment properties are proposed to be measured in the financial statements, but it can be explained and whether it is right or wrong is, of course, subject to individual opinion. The reason the ASB are proposing this treatment is twofold. Firstly the draft FRS is based on an IFRS framework (notably IFRS for SME's, which has been tweaked). IFRS For SMEs is based on full mainstream IFRS.  Secondly IAS 40 'Investment Property' on which essentially our draft FRS is based also requires any changes in fair value of investment property to be reported in profit or loss, as opposed to a revaluation reserve account which we currently do under SSAP 19 and the FRSSE (eff April 2008).

The reason the draft FRS (and indeed IFRS for SME's and IFRS) doesn't require the use of a revaluation reserve for investment properties is because an investment property is neither depreciated, nor subjected to an impairment test.  Instead, all valuation changes from one accounting period to the next are reported in profit/loss. However, on the flip side if you revalue (say) a building which a company uses to undertake its day to day activities and therefore would be classified as 'property, plant and equipment' thus accounted for under the provisions in section 17 of the draft FRS you will then subject this building (plus all the other buildings in that asset class) to the revaluation model.  In this case any revaluation gains/losses would be accounted for under paras 17.15E and 17.15F which does require a revaluation reserve to be set up and accounted for in the same way we currently do so under FRS 15 principles.

Regards

Steve

Investment Properties

Stephen Morris |

Thanks, Steve, for describing the rationale for the change.

I still think it is wrong though. The net income, as reported by the income statement, is supposed to represent a) a measure of disposable wealth (available for distribution) and b) a measure of performance. Unrealised holding gains are not distributable, nor should they be. Neither is an unrealised holding gain a measure of performance - the gain is fortuitous. Reporting unrealised holding gains in the proposed way destroys the functions of the income statement.

The justification for reporting unrealised investment property gains through the income statement seems to be wholly irrelevant to the issue of depreciation and impairment testing. Depreciation and revaluations are two entirely separate issues (save for increased depreciation charges where revaluation has occurred). Why must UNREALISED revaluations surpluses on non-depreciable asset be recorded in the income statement? It does not make sense to me. Is this the start of "mark-to-market" accounting, the same model that enabled the Enron directors to mislead its investors? 

I believe the accounting standard setters have lost the plot on this one.

 

 

 

Capital Leasing

KarenConneely1 |

 

It is looking inevitable that leases will be reclassified under strict guidelines brought into force by the IASB in April 2013, resulting in finance leases being included on the balance sheet and properly accounted for. The IASB has been making changes to IFRS legislation and accounting requirements since 2010 and organisations should be carefully monitoring the impact any changes will have on current accounting processes.

The majority of organisations will review their current lease arrangements and may argue that they should remain as operating leases under the current IFRS criteria - this approach is short-sighted. Admittedly any changes to IFRS legislation will impact different sectors at different times, however the re-classification of leases, will affect all sectors over the coming years.

If Financial Directors are not looking at a specialist software solution already, they should certainly be looking at their leased asset register and planning a strategy of how to migrate leases into a specialist software solution. Why wait to make a last minute decision?

Putting off such a decision seems even less sensible when businesses are seeing the benefits now of having a solution in place that assists with calculation and payment of finance and operating leases.

Karen Conneely

Group Commercial Manager

www.realassetmgt.co.uk