A review of recent financial reporting exposure drafts

In May 2002, the IASB issued an Exposure Draft (ED) entitled ‘Improvements to International Accounting Standards’. This ED proposed improvements to 12 IASs with the objectives of reducing or eliminating alternatives, redundant clauses and conflicts within the standards, and obviously the main purpose was to enhance the standards. The ED also deals with convergence issues and incorporates Standing Interpretation Committee (SIC) consensus wherever possible. Additionally, the IASB has issued in July 2002 an ED with the title ‘First time Application of IFRS’. This ED sets out the precise way in which companies should make the change to IFRS. These two EDs (where the content has not been issued already as a FRED) have themselves been issued by the ASB as consultation papers for public comment.

At the same time as the IASB issued its ‘improvements’ ED, the ASB issued Freds 23 to 30. These Freds are essentially the text of the revised IASs as adjusted for inconsistencies with certain aspects of UK GAAP. For example, currently ‘discontinued’ operations are dealt with in UK financial statements and not ‘discontinuing operations’ as in IASs. However, not all of the improved IASs are dealt with by the new FREDs. Some of the more contentious areas such as leases, borrowing costs and accounting for associated companies have been ignored for the time being by the ASB.

Thus the current position is quite confusing and is constantly changing for those companies planning a change to IASs. Companies are only just coming to terms with relatively new standards such as FRS 15, ‘Tangible Fixed Assets’ but as a result of the recent FREDs, they will have to change their accounting practices again in order to comply with the revised IAS (IAS 16 in the case of fixed assets). The existing differences between IASs and UK GAAP will change. Some current differences will disappear for example on the treatment of proposed dividends. Some differences will remain, for example in the area of deferred tax and new differences will emerge for example in the amortisation of goodwill where the IASB are likely to insist on no amortisation coupled with an impairment test. This latter procedure is compatible with FRS 10 but most UK companies still amortise goodwill. The ‘convergence handbook’ may have to become a monthly publication!

Let us turn to the detail of the newly issued FREDs. It would be impossible to set out in a single article the detail of what are essentially eight accounting standards. The focus will therefore be on the main changes to existing UK standards.

At present there is little authoritative literature in the UK on how to account for financial instruments. In May 2002, the ASB issued FRED 23, ‘Financial Instruments; Hedge Accounting’ which proposes the use of hedge accounting for financial instruments where certain hedging relationship and effectiveness criteria are met. Basically, there must be formal documentation relating to the hedge and the hedge is expected to be effective from the outset with the effectiveness of the hedge being capable of reliable measurement.

In June 2002, the IASB issued an ED of a revised IAS 39, ‘Financial Instruments, Recognition and Measurement’. IAS 39 requires some financial instruments to be measured at fair value and the rest to be measured at cost-based amounts. It also specifies the criteria for hedge accounting to be applied. At the same date the ASB issued FRED 30, ‘Financial Instruments: Disclosure and Presentation and Recognition and Measurement’. This FRED seeks to implement IAS 39 and IAS 32, ‘Financial Instruments: Disclosure and Presentation’ with some modifications. Some of the main changes, which will be introduced by this FRED, are in the presentation of hybrid sources of finance. Under FRED 30, these instruments will have to be broken down into their debt and equity components and accounted for separately. Preference shares will have to be classified as debt and their dividend treated as interest. The main differences between the proposed UK standards and IAS 32 / 39 are that if the entity adopts fair value accounting in its financial statements then it is mandatory to follow the measurement and hedge accounting techniques of IAS 39. Further, unlisted companies need not follow IAS 32’s disclosure requirements, and finally the recycling of gains and losses is not allowed. IAS 39 requires the use of ‘mark to market’ accounting which is prohibited by UK company law. The ASB are hoping that by 2004 UK company law will have been amended to eliminate any such inconsistencies.

FRED 24, ‘The effects of changes in Foreign Exchange Rates: Financial Reporting in Hyperinflationary Economies’ proposes two new standards based on a revised IAS 21, ‘The effects of changes in Foreign Exchange Rates’ and IAS 29, ‘Financial Reporting in Hyperinflationary Economies’. They would replace SSAP 20, ‘Foreign Currency Translation’ and the related UITF Abstract 9. The recycling of translation differences arising from the disposal of a foreign entity from the statement of recognised gains and losses to the profit and loss account is prohibited unlike under IAS 21. New terminology is introduced by the FRED with terms like ‘functional’ and ‘presentational’ currencies. A company measures items using its functional currency but presents its accounts using any currency. Key differences from current UK GAAP include the translation of the profit and loss account at actual (average) rate as opposed to the closing rate, goodwill should be translated at closing rate and entities operating in hyperinflationary economies should not use a hard currency as the functional currency but should restate their financial statements using appropriate indices.

FRED 25, ‘Related Party Disclosures’ proposes to replace FRS 8 with the revised IAS 24, ‘Related Party Disclosures’. There were significant differences between IAS 24 and FRS 8. However after the revision of both standards the only differences will be that in the UK, the

FRED 26, ‘Earnings per Share’ proposes to replace FRS 14 with the revised IAS 33, ‘Earnings Per Share’. The main changes will be in the disclosure of information, as FRS 14 and IAS 33 were very similar and there have not been significant changes to IAS 33. The main difference between the Standards will still remain which is that net profit from continuing operations is determined differently under International and UK GAAP so that potential ordinary shares may be dilutive under UK GAAP but not under International.

Throughout the proposed standard there are references to discontinued operations whereas the IAS refers to discontinuing operations. This in itself is one of the reasons why the ‘control’ number may be different under the two standards and may cause differences in the information disclosed. The proposals are that basic and diluted eps be disclosed on the face of the profit and loss account both for net profit / loss for the period and for profit / loss from continuing operations. The equivalent eps for discontinued operations may be shown in the same way or as a note. Additional per share amounts may only be shown as a note. This latter change will be relatively controversial as it is relatively common in the UK to show alternative eps figures on the face of the profit and loss account.

Another interesting point is that there are numerous references to existing FRSs in this and other FREDs. Many of these FRSs will be changed by the new FREDs and even replaced so that the references are at best redundant and sometimes positively misleading.

FRED 27, Events After the Balance Sheet Date recommends that the revised IAS 10 should replace SSAP 17. The main change to existing UK requirements is the stricter definition of ‘adjusting events’. The FRED states that dividends declared after the balance sheet date are not liabilities at that date and should be shown as a note. A dividend should not be recognised until it becomes a liability of the company. This requirement conflicts with UK company law. SSAP 17 permits the recognition of a dividend declared by a subsidiary / associated company after the balance sheet date that relates to a period before the balance sheet date. This is a non-adjusting event under the FRED.

FRED 28, ‘Inventories: Construction and Service Contracts’ proposes to replace SSAP 9, ‘Stocks and long-term contracts’ with two international standards: one based on the revised IAS 2, ‘Inventories’, and another based on IAS 11, ‘Construction Contracts’ with the incorporation of some of the text of IAS 18, ‘Revenue’. SSAP 9 has been used in the UK to account for contracts for services as well as construction contracts but internationally IAS 18 has been used. The ASB are working on a ‘Revenue’ standard and do not wish to adopt as yet IAS 18 and therefore they have simply included the ‘relevant’ elements of IAS 18 in FRED 28. SSAP 9 requires that ‘prudently calculated attributable profit’ be recognised when the outcome of the contract can be assessed with ‘reasonable certainty’. The FRED places emphasis on probability and reliability rather than prudence that makes it more consistent with the ASB’s Statement of Principles. SSAP 9 includes extensive guidance on the presentation of assets and liabilities arising from long-term contracts including whether certain assets should be shown as debtors or work in progress. The FRED does not deal with the classification of balance sheet items.

FRED 29, ‘Property, Plant and Equipment; Borrowing Costs’ includes the text of a revised IAS 16, ‘Property, Plant and Equipment’ and IAS 23, ‘Borrowing Costs’. The proposed revised IAS 16 and FRS 15 have a degree of commonality but there are some important differences. A major difference is that the IAS uses a ‘fair value’ model rather than FRS 15’s ‘value to the business’ model. The main changes to FRS 15 are in the areas of exchanges of assets, donated assets, residual values, renewals accounting and revaluation of assets including the reporting of revaluation gains and losses. The convergence of the two standards was perhaps the most difficult task in this initial phase of the convergence process.

Convergence to IAS seems to be inevitable both in the UK and Internationally. The variety of GAAPs used by multi national companies will be reduced. Reconciliation statements will eventually be a thing of the past as the acceptance of IAS financial statements as the primary statements grows. GAAP reconciliations are not normally controlled by regulation and are often outside the scope of the auditors report. US GAAP is no longer seen as the most risk-free regulatory system although at present most multi-nationals who want access to the capital markets prepare reconciliations to US GAAP. Thus, the move to IASs has that air of inevitability about it. However, there are some significant differences in practice to be overcome not least the accounting for development expenditure, merger accounting, retirement benefits and deferred taxation!

Graham Holt is Examiner for Paper 3.6