Convergence of UK GAAP to IAS: Part 2

Tangible fixed assets
In the UK this area is covered by FRS 15, ‘Tangible Fixed Assets’, with IAS 16, ‘Property, Plant and Equipment’ being the international equivalent. It will be necessary to agree on a general title for a converged statement with a decision made on whether to use the UK term ‘fixed’ or the international ‘non-current’ in the title. Standardisation of terminology throughout the convergence process will be a useful improvement in global financial reporting particularly for the users of financial statements who do not have an accounting background.

Both FRS 15 and IAS 16 cover the initial measurement of these types of asset, their valuation and subsequent depreciation. They base initial measurement on ‘directly attributable cost’, including the estimated cost of dismantling and removing the asset and restoring the site, to the extent that it is recognised as a provision under FRS 12 (or IAS 37). In addition, both allow the capitalisation of finance (borrowing) costs although not in the same manner. IAS 16 needs to be brought into line with the more extensive requirements of FRS 15. Note that there are currently exposure drafts in the UK (FRED 29) and internationally on this subject.

As with initial measurement, there is close agreement on the depreciation of tangible fixed assets in the two standards although the definitions are not identical and it would be sensible to have agreement on such a basic item. One important difference is the need for an impairment review under FRS 15 where the depreciation period exceeds 50 years; no such requirement exists under IAS 16. Perhaps feedback on the importance and relevance of this requirement should be considered before including it in any harmonised standard.

It would appear that the most important area that needs review is the position when reporting entities choose to revalue their assets. IAS 16 considers this to be an ‘Allowed Alternative Treatment’, to the ‘Benchmark Treatment’ of carrying Property, Plant and Equipment at historical cost. This emphasis may deter entities from revaluing. FRS 15 can be considered to be more positive about revaluations. Both standards do require all assets of a similar class to be revalued if that is the policy of the entity and FRS 15 states that they should be at ‘current value’. They also agree that such revaluations should be kept up-to-date with valuations every three to five years.

Having made the adjustments to harmonise the general requirements for revaluation it will be necessary to eliminate the differences in values to be used. FRS 15 requires reference to ‘value to the business’ in certain circumstances (particularly for property) while IAS 16 refers only to market value. The standards also differ on the treatment of losses that need to be recognised as part of the revaluation process. For example, FRS 15 requires revaluation losses that are due to a clear consumption of benefits to be taken to the profit and loss account; IAS 16 does not apply this rule to the extent that there is a related revaluation surplus. In addition, the UK system allows losses to be charged in certain circumstances to the Statement of Total Recognised Gains and Losses. Such a statement does not exist in International Accounting Standards. This convergence problem needs to be addressed when harmonising the statement(s) relating to reporting periodic financial performance.

Intangible assets
This article does not consider goodwill. This will be reviewed in an article on groups later in this series.

One obvious difference between UK and International regulations in this area is the continuing existence of a separate standard in the UK on Research and Development, SSAP 13. The original international standard, IAS 9, on this specific intangible asset has been superseded as part of the development of IAS 38, which covers all intangible assets. The convergence programme should see the absorption of SSAP 13 into a new standard, which would also include the general requirements of FRS 10, ‘Goodwill and Intangible Assets’. As part of this process, the UK should change its recognition criteria for the capitalisation of development expenditure to that of IAS 38. A reporting entity would have to ‘demonstrate’, rather than have reasonable expectations of, future benefits to be able to capitalise. A positive development in UK financial reporting would be to make capitalisation mandatory, as in IAS 38, rather than optional as is the current position in SSAP 13.

Another important area requiring agreement is intangible asset life. FRS 10 allows an indefinite life, while IAS 38 does not. The international standard only allows for the choice of a very long depreciable life, which may have the same effect on periodic financial performance assessment. FRS 10 needs to be extended to cover the treatment of revaluation gains / losses and accounting for disposals. Note that both FRS 10 and IAS 38 allow for the recognition of internally generated intangible assets but not in exactly the same manner. The UK standard requires a ‘readily ascertainable market’, while IAS 38 uses general recognition criteria plus a paragraph stating that ‘internally generated brands, mastheads, publishing titles, customer lists and items similar in substance should not be recognised as intangible assets’. These exclusion requirements should be standardised.

Stocks and Long term contracts
In the UK, these are dealt with in a single standard, SSAP 9, while stock (inventories) is dealt with by IAS 2 and construction contracts (basically long term contracts) by IAS 11. Therefore, the first convergence decision in this area will be on whether to incorporate the new rules in a single standard or in separate standards. FRED 28 indicates that the UK will go for the two standard format separating stock from long term contracts.

When looking in detail there is a very important difference between SSAP 9 and IAS 2 on the use of LIFO. SSAP 9 specifically criticises the use of LIFO stating that it can lead to misstatement and distortion in the accounts. IAS 38 makes no such statement, allowing a free choice on the inventory valuation method. The use of LIFO is unlikely to provide the fairest practicable approximation to cost and should therefore be excluded. The international Exposure Draft of ‘Proposed Improvements to IAS’ indicates that this will be the case from 2003.

IAS 2 includes more detail than SSAP 9 in several areas which should be incorporated in a harmonised standard but it does not include guidance on the allocation of costs; such guidance should be incorporated into the new standard. In addition both the UK and the international standard need to be brought into line with the standard on Tangible Fixed Assets by restricting the inclusion of overheads in cost to those that can be directly attributable. As for long term, contracts the UK regulations need to be extended to cover the recognition of revenues and costs when no profit is to be recognised. At present, there is the option of showing some level of matched revenue and costs or no revenue and costs.

Finally there needs to be a standard format for reporting long term contracts in the balance sheet with IAS 38 probably needing to be brought into line with the current SSAP 9 requirements on disclosure of ‘Amounts recoverable on contracts’, ‘Payments on account’, ‘Stocks’ and ‘Provisions for foreseeable losses’.

Government grants
This is a subject, which has not caused significant problems in the UK even though SSAP 4 allows the use of the netting method, which goes against the requirements of the Companies Act. The alternative of treating the grant as deferred income has been found to be perfectly acceptable. IAS 20, ‘Accounting for Government Grants and Disclosure of Government Assistance’ also gives the same choice but is of course not hindered by national legislation. Any convergence in this area should follow the international standard, in particular requiring the disclosure of any unfulfilled conditions attached to government grants. This may not appear to be an important issue in the UK environment but several countries still have government grants as significant sources of finance for entities and as such, their reporting in the financial statements is important. IAS 20 should, however, be altered to require the use of fair values, instead of nominal amounts, where government grants are in the form of non-monetary assets as per SSAP 4.

One important development has been the issue of a discussion paper by the G4 + 1 group (whose work is now undertaken by the IASB) ‘Accounting by Recipients for Non-Reciprocal Transfers, Excluding Contributions by Owners: Their Definition, Recognition and Measurement’. This paper’s recommendations would have grants relating to fixed assets credited directly to the performance statement in the period it is received, with the asset being carried at its original gross cost. This a significant departure from current practice and it will be interesting to see if the concept is included in a harmonised statement.

Impairment of assets
FRS 11, ‘Impairment of Fixed Assets and Goodwill’ and IAS 36, ‘Impairment of Assets’ were produced at the same time and are very similar in their approach. Although the title of the latter standard refers to all assets, it removes several assets from its scope, including inventories, leaving coverage very similar to that of FRS 11. Despite their common creation dates, there are important differences between the two standards that need to be eliminated as part of the convergence process.

FRS 11 is consistent with FRS 15, requiring losses (impairment) on revalued fixed assets to be charged to the profit and loss account if they are caused by a clear consumption of economic benefits. IAS 36 allows such losses to be set against previous related gains before recognising the loss in the income statement. A further difference relating to impairment losses that needs to be resolved is the allocation of losses to income (cash) generating units. FRS 11 states that they should first be ‘charged’ against any obviously impaired assets, and then arbitrarily allocated to goodwill, intangible assets and tangible assets, in that order. IAS 36 does not refer to specific impaired assets; losses are ‘charged’ to goodwill then to assets, with no distinction between intangibles and tangibles. While adopting the use of the title cash (rather than income) generating units, any converged standard should adopt the more appropriate UK allocation formula.

The two standards also differ on the treatment of loss reversals. IAS 36 applies a general rule that impairment provisions that are found to be unnecessary be reversed, irrespective of the type of asset to which it relates. FRS 11 does not permit such an impairment reversal when the cash outflow that caused the write-down has passed and restricts reversals relating to intangible assets to those with readily ascertainable market values.

There is a technical difference between the two standards relating to impairment losses identified when an existing entity combines with an acquired entity. FRS 11 requires the recognition of notional goodwill (of the existing entity) in the allocation process but IAS 36 has no such recognition criteria. (Note that the recognition of notional goodwill only relates to the impairment loss allocation and is not recorded in the accounts). This can make a significant difference to the consolidated financial statements at the time of the combination and in subsequent years when goodwill is being amortised. This clearly requires standardisation, as does the requirement, in FRS 11 but not IAS 36, for entities to continue to review 'value in use' tests retrospectively for the next five years and make write-downs revealed by hindsight to have been necessary.

The disclosure requirements of IAS 36 are the more extensive and should be adopted. Particularly useful are the disclosure by segment of impairment losses (and any reversals).

Deferred tax, Leases and Retirement (Employee) Benefits
While the previous section shows there are significant differences where none should exist, the recent changes in the UK from SSAP 15 to FRS 19 on deferred tax shows a harmonisation where one might expect it not to exist. Both FRS 19 and IAS 12, ‘Income Taxes’ require deferred tax to be calculated on a full provision, rather than partial provision, basis.

However, there are still some differences between the two standards. The FRS 19 liability method is based on timing differences, with no recognition of permanent differences. IAS 12 adopts the temporary difference approach whereby an entity should provide for deferred tax whenever there is a difference between the carrying amount and the tax base of an asset / liability. Although IAS 12 does preclude the recognition of deferred tax in some temporary different circumstances, there is still the possibility of providing for some permanent differences. The convergence project should try to eliminate this possibility.

There are also differences to be resolved relating to the recognition of deferred taxes on unremitted profits of subsidiaries, joint ventures and associates, and the rate of tax to be applied when the deferral is recognised. Overall, it will probably be necessary to align IAS 12 with the requirements of FRS 19, and for the discounting problem to be resolved during this process.

Accounting for leases is a topic under current review by the ASB and the IASB. Hopefully any new standard(s) that emerge will standardise the accounting for leases into a single method similar to that currently applied by SSAP 21, ‘Accounting for Lease and Hire Purchase Contracts’ and IAS 17, ‘Leases’ to finance leases. Both standards require capitalisation and recognition of obligations for the finance leases by the lessee and the recognition of the investment in the lease by the lessor. This is clearly the best way to disclose lease transactions in financial statements and eliminates one form of ‘off balance sheet financing’. However, the standards do not agree on how the finance should be allocated over the primary term of the lease. IAS 17 uses the ‘net investment method’, while SSAP 21 requires the use of the ‘net cash investment method’ which incorporates the tax cash flows of the lease. These tax cash flows are important because they have direct impact on the decision to use this form of financing. Only one method of finance allocation should be permitted. The UK method is more theoretically correct but the international standard’s approach is more practical – a choice needs to be based on which attribute is considered the more desirable.

There are also differences in the treatment of sale and lease-back transactions. In the UK the SSAP 21 provisions need to be brought into line with the requirements of FRS 5, ‘Reporting the substance of transactions’ and the IAS then brought into line with these standards. No profits would be recognised on such transactions and the sale proceeds would be disclosed as a liability (as per the FRS 5 requirements for sale and repurchase agreements).

Accounting for retirement benefits is covered in the UK by FRS 17 which has moved the UK position much closer to IAS 19 ‘Employee Benefits’. The UK predecessor to FRS 17, SSAP 24, was very different, being based on a profit and loss account approach, while the new standard adopts the more internationally acceptable balance sheet approach, as advocated in most conceptual frameworks. While the approach may be the same, there are still significant differences between the two standards not least of which is the reporting of actuarial gains and losses (unexpected gains and losses on retirement fund assets and liabilities) through the Statement of Total Recognised Gains and Losses in the UK.

As no such statement exists in the international standards, it is necessary for IAS 19 to use an alternative method to reduce the volatility in reported earnings that arise from the recognition of movements in the value of retirement assets and liabilities. The standard uses what is referred to as the ‘corridor approach’ whereby only gains and losses that are outside a 10% corridor (by reference to gross assets or gross liabilities) are reported in the income statement, such excess gains or losses being spread forward over the expected average remaining working lives of the employees participating in the scheme. This can lead to some ‘odd’ results. Hopefully, the problem will be solved as part of the reform on the reporting of periodic performance.

Provisions and contingencies
We come to an area that exemplifies the benefit of cooperation between the two standard setting bodies. The requirements of FRS 12, ‘Provisions, Contingent liabilities and Contingent assets’, is the same (even the title) as IAS 37. There appears, for once, to be no problem with harmonisation and the two sets of accounting standards can already claim to be converged in this area. This is clearly not the case with the other topics discussed in this article.

Steve Lawrence MSc FCCA is Senior Lecturer in Accounting, University of East London.