Convergence of UK GAAP to IAS - group accounting

In discussing ‘presentation and disclosure’, this article considers the need for convergence in: the format of fundamental financial statements (e.g. balance sheet and profit and loss account); the disclosure of cash flow information; segmental data reporting; the need to expose related party transactions; and the calculation of one of the most important performance indicators, Earnings Per Share (EPS).

Financial Statement Presentation
The problem of convergence on reporting periodic financial performance was briefly discussed in the first article in this series (see student accountant, August 2002). At this point, some of the more detailed divergences between UK GAAP and International Accounting Standards were reviewed, starting with ‘extraordinary items’. Extraordinary items were effectively removed from UK financial reporting with the publication of FRS 3, ‘Reporting Financial Performance’, in October 1992. This standard contains a definition of ‘ordinary items’ that is so broad that it makes any reference to extraordinary items superfluous (although the standard does contain a definition of such items!). However, the international standards currently have definitions (in IAS 8, ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’) and disclosure requirements (in IAS 1, ‘Presentation of Financial Statements’), which make the recognition of extraordinary items in a performance statement more likely. This position is likely to change in the near future as part of the IASB project ‘Improvements to International Accounting Standards’ where reference to presentation will be moved from IAS 8 to IAS 1. The latter will include the requirement that, ‘An entity shall not present any items of income and expense as extraordinary items either on the face of the income statement or in the notes’. Thus, it appears that the days of the extraordinary item are numbered, and fortunately, will not present a harmonisation problem in the future. It will, however, still be necessary to decide how to deal with the ‘exceptional items’ that require separate disclosure (this term is not a term used in IASs).

Another presentation problem relates to discontinued / discontinuing operations. Under FRS 3, entities must disclose separately details relating to operations that have discontinued – although discontinued includes those events where discontinuance is completed within three months of the financial year end under IAS 35, ‘Discontinuing Operations’, separate disclosure is required for events that are discontinuing. Again, there are current developments that should remove the disparity between the two standards, but this time the changes are to the UK regulations. FRED 22, ‘Reporting Financial Performance’ is proposing a definition of discontinuing operations, which is almost identical to that contained in IAS 35. This is another development that can only be helpful to the harmonisation process. It is interesting to note that the two items discussed so far – extraordinary items and discontinued / discontinuing operations – clearly illustrate that the convergence of UK GAAP to IAS will be a two-way process, requiring changes to both sets of regulations.

A further development in the UK relating to the financial performance reporting of a business, again contained in FRED 22, is the amalgamation of the profit and loss account and the statement of total recognised gains and losses (STRGL) into a single statement. There is no international equivalent to the STRGL (although its content is incorporated within the international statement of changes in equity) so there would have to be significant changes to the income statement layout to bring IAS 1 into line with the proposed UK statement. This is appreciated by the IASB who have made this the subject of a special project.

As for the balance sheet, the main differences are in the type of regulations. In the UK, the Companies Act covers balance sheet format, while IAS 1 covers the international position. It may be beneficial for the UK to have a standard on this important statement. Efforts should also be made to reduce the differences in terminology (e.g. fixed assets = non-current assets, debtors = trade receivables) and gain agreement on whether there should be emphasis on net assets (the usual UK position) or on total assets / liabilities (the usual international position). These differences in terminology and format on the balance sheet do not present insurmountable problems to a financial analyst trying to compare position statements produced under the differing regulations, but a reduction in the differences would be a useful outcome from the convergence project.

Finally, changes proposed in FRED 22 relating to the introduction of a statement providing a ‘Reconciliation of Ownership Interest’ should bring the UK closer to the international treatment of dividends, where in IAS 1 ‘Statement of Changes in Equity’ they are treated as a distribution of profit, rather than as a deduction from profit, which is the case under UK legislation.

Earnings Per Share (EPS)
This is a vital performance indicator and efforts have been made to harmonise the rules governing the computation of the two main EPS ratios, basic and diluted. FRS 14, ‘Earnings Per Share’ is based on the requirements of IAS 33, ‘Earnings Per Share’, with certain additional interpretative guidance. It is proposed to update IAS 33 to include this additional guidance and incorporate more extensive illustrations, e.g. guidance on dealing with contingently issuable shares.

IAS 33 and FRS 14 have differing requirements relating to reconciliations where alternative EPS figures are disclosed. FRS 14 requires a reconciliation of the alternative EPS figure to that required by FRS 14, while IAS 33 only requires a reconciliation if the additional amounts are determined by reference to components of net profit that are not reported separately as a line item. These differences should be eliminated to make such reconciliations easier to use and compare.

Despite the efforts to harmonise the various EPS ratios, the usefulness of these indicators as comparative performance measures is very dependent upon the figures that constitute the ‘earnings’. Until this computation is harmonised it will not be possible to compare the published EPS figures without adjusting the numerator. This is particularly true at the moment, for example, on the classification of items such as continued / continuing or discontinued / discontinuing. An item may be continued in the UK EPS calculation, but excluded under the international standard as discontinuing. This in turn would affect an assessment of whether an item was dilutive. This would become even more critical if the proposal in FRED 26, ‘Earnings Per Share’ to have more EPS figures disclosed on the face of the Profit and Loss account becomes part of any new standard. Clearly a confusing position which should be eliminated in the convergence project.

Related Party Transactions
The presentation and disclosure of the financial effect of transactions between parties that are related in a manner so that they are unlikely to reflect conditions that would normally exist in arms length transactions, has been recognised by the ASB in the UK and by the IASB. FRS 8, ‘Related Party Disclosures’ and the UK Companies Act require extensive disclosure of details of such transactions, as does IAS 24, ‘Related Party Disclosures’. However, the international standard is not as extensive or as up-to-date as FRS 8 and is currently under review. The proposed changes would bring IAS 24 in line with FRS 8 in several areas including:

• The removal of the exemption that financial statements of state controlled enterprises need not disclose transactions with other state controlled enterprises.
• Amendments to the paragraphs permitting disclosure of proportions of transactions and outstanding balances. The full amounts would have to be disclosed as required by FRS 8.
• Adjustments to bring within the definition of ‘related party’ – parties with joint control over the entity and joint venturers in which the entity is a venturer.

A useful additional disclosure to FRS 8 would have been details of pricing policies applied to material related party transactions. This is not likely to occur because it is an IAS 24 disclosure that the IASB is proposing to remove. Thus, with FRED 25, ‘Related Party Disclosures’ being based on the revised IAS 24, a useful disclosure may be lost as part of the convergence project.

One other disclosure requiring consideration relates to transactions and outstanding balances with directors. Regulations for such disclosures are contained in the UK legislation. Standard setters need to consider whether such disclosures should be incorporated into any set of harmonised standards, including notes on such items as directors’ holdings and dealings in shares of the reporting entity. Following recent global events, these disclosures are considered very important.

Cash Flow Statements
One would expect that, with such a fundamental issue as the presentation and disclosure of cash movements, the requirements of the UK and international regulations would be the same. Nothing could be further from the truth. The regulators cannot even agree on what a statement of cash flows should analyse. In the UK, FRS 1, ‘Cash flow statements’, focuses on the movement in cash, including positive and negative bank balances, while IAS 7, ‘Cash flow statements’ focuses on changes in cash and cash equivalents. The difference is the inclusion of cash equivalents, which are defined in IAS 7 as ‘short term highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk in changes in value’.

The concept of cash equivalents used to apply in the UK but was dropped because it was not easily understood by users and contained a level of subjectivity that should not apply to cash flow reporting. Therefore, a positive step could be made by revising the international standard to focus purely on inflows and outflows of cash.

The other major difference is the basic formats of the cash flow statement. The respective cash flow classifications are as follows:
IAS 7

• operating activities
• investing activities
• financing activities.

FRS 1

• operating activities
• dividends from joint ventures and associates
• return on investment and servicing of finance
• taxation
• capital expenditure and financial investments
• acquisitions and disposals
• equity dividend paid
• management of liquid resources
• financing.

Obviously, this level of discrepancy cannot be allowed to continue but it is necessary to consider in which direction the changes should proceed. The IAS 7 format has the advantage of simplicity and being similar to other national standards e.g. FAS 95 in the USA. However, for financial analysis purposes the more extensive disclosure requirements of FRS 1 would be more useful. For example, the computation of Free Cash Flows (FCFs) would be greatly simplified. These FCFs can be defined as ‘cash from operations less the amount of capital expenditure required to maintain an entity’s present productive capacity’. FCFs are available for discretionary uses including growth-orientated expenditure (e.g. the acquisition of a subsidiary), debt reduction and equity dividend payments. These figures are more readily identified using the FRS 1 format – this is the one to which the convergence should proceed.

Both FRS 1 and IAS 7 allow the use of either the direct method or indirect method of presenting cash flows from operating activities. The indirect method is the most popular form of presentation and in both standards effectively involves a reconciliation of operating profit to operating cash flow.

The alternative direct method (which is encouraged under IAS 7) shows actual cash flows from customers less cash flows to employees and suppliers. However, only under FRS 1 is the entity still required to disclose the profit to cash flow reconciliation (as a note to the accounts). This is not required by IAS 7 but should be incorporated into any harmonised standard, as perhaps the need to use the direct method should be.

FRS 1 also requires a note that provides a reconciliation of changes in net debt. This is a very useful piece of information giving more details of an entity’s treasureship activities and should also be included in any new standard.

Segmental reporting
Segmental reporting relates to the presentation and disclosure of information, by reference to distinguishable components of the reporting entity. This form of reporting requires the determination of what is a reportable component (segment) and what information is to be disclosed for each segment. Both the UK standard, SSAP 25, ‘Segmental Reporting’, and the international standard, IAS 14, ‘Segment Reporting’ require information to be disclosed by type of business and by geographical segment but they differ significantly on how these segments are determined and what information is presented.

Under SSAP 25 reportable segments are determined by reference to:

• return on investment
• degree of risk
• rates of growth
• development potential.

IAS 14 requires entities to refer to the way segments are reported within the organisation to the board of directors. The internal system therefore determines both internal and external segmental reporting structures. The international standard may adopt what appears to be the most appropriate system but the UK method could be considered the system that provides the most relevant information.

The segmental reporting situation is further complicated by the international standard requiring segment classification to be categorised as primary and secondary; no such categorisation exists in SSAP 25. Thus, business segments could be categorised as primary, leaving geographical segments as secondary, or vice-versa. The disclosure requirements for the primary category are more extensive than under SSAP 25 (for example segment assets and segment liabilities are disclosed separately), but for the secondary category, the disclosures are less extensive than under SSAP 25 (for example segment net assets are not disclosed). Therefore, the convergence project would have to assess these varying levels of disclosure and decide whether to keep the categorisation process of IAS 14 or keep the equitable disclosure system of SSAP 25.

This is a very important area of financial reporting and the differing levels of disclosure currently existing in accounting standards must not be allowed to continue. Anyone who has tried to analyse a set of financial statements for a multi-national enterprise would appreciate how essential it is to have segmented data available for a proper appreciation of the enterprise’s financial performance and position. Hopefully the convergence project will lead to a harmonised position where extensive segmented statements are published in the interim and annual accounts.

Summary
This final article has briefly discussed some of the areas of presentation and disclosure in accounts that need to be harmonised if there is to be meaningful convergence of UK and international regulations. Changes to some financial standards may require amendments to UK legislation while others will require developments and alterations to both UK accounting standards and International Accounting Standards. This is a difficult process but one which is essential to the development of accounting on an international level.

The first article in this series discussed the convergence of the basic principles and practices of accounting, including a conceptual framework. The second moved from the fundamentals to review the measurement and recognition of elements in financial statements, while the third considered the convergence of regulations concerning accounting for groups. Thus, the four articles give a broad coverage of many of the issues in the convergence project.

It is very important that you keep up-to-date with developments in financial reporting over the next few years. The recent issue of several FREDs by the UK ASB indicates the changes, both nationally and internationally, are going to come thick and fast.

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