Dispatch (UK/ROW version)

• market instability puts fair value on trial
• accounting standards are converging, says EU
• Arctic in from the cold
• ‘aggressive tax planning on the decline’
• UK ‘uncompetitive in corporation tax’
• fraud rises dramatically

market instability puts fair value on trial

Audit teams in at least two of the Big Four firms have been told to consider the impact of recent market instability on asset valuations. There are serious concerns that book valuations may have quickly become out-of-date, while fair value calculations relying on computer modelling could have been subject to manipulation or mistaken programming assumptions.

Fair value is difficult to assess in volatile markets, especially for long-term assets and liabilities, or where it is used to price complex financial products, such as derivatives, securities and collateralised debt obligations (CDOs). Recent instability has particularly focused on these products, especially where there has been securitisation of US sub-prime loans. Two of Bear Stearns’ hedge funds were heavily invested in securities based on US sub-prime mortgages and the funds lost nearly all value.

Because of the complexity of some funds, and the lack of any liquid market to test the value of underlying assets, fair valuation can rely on computer modelling. However, sellers can distort the effectiveness of modelling by avoiding disposing of assets where this would have the effect of driving down generalised asset values. Analysis conducted by consultants RiskData found that more than a third of hedge funds had manipulated computer modelling by timing trades to smooth market valuations of illiquid securities.

But Paul Boyle, chief executive of the UK’s Financial Reporting Council, told accounting & business that despite the pressures on fair value accounting, fair value remained the only practical option. ‘I am very sympathetic to fair value accounting for assets and liabilities, for which there is a ready market,’ he said. ‘One of the reasons for the instability is that there is a market and we are seeing it move. There is a whole different question about whether you can fair value long-term assets and liabilities, but what is the alternative? The best view you can have is the one the market shows. If not, you have to go with someone’s subjective view and people will always have incentives to put forward an optimistic answer.’

Ken Wild, IFRS leader at Deloitte, had greater reservations, saying that it was important to distinguish between mark-to-market and mark-to-model valuations. ‘Fair value works very well where it is mark-to-market,’ he said. ‘Where it is mark-to-model it starts getting a bit more dubious. I would have concerns about this. But I would guess that about 80% of fair value is mark-to-market.’

accounting standards are converging, says EU

Progress towards international convergence in accounting standards is well under way, reports the European Commission. A Commission review of standards in Canada, Japan and the US found that national GAAPs are moving closer towards IFRS, while India and China are making positive moves towards the adoption of IFRS.

The Commission is required under EU rules to report regularly to the European Parliament and the European Securities Committee on the progress of convergence. The report particularly welcomed moves by the US Securities and Exchange Commission to allow IFRS-based financial statements to be filed without any reconciliation to US GAAP. The Commission is calling for deeper co-operation and regular meetings between the EU and US to establish staging posts and take stock of ongoing developments towards abolishing the need for any reconciliation.

Internal Market and Services Commissioner, Charlie McCreevy, said: ‘I draw encouragement from the progress made in these important partner countries. It shows that we are on the right track. I welcome all initiatives that pave the way for IFRS to become the global accounting standard.’

However, the UK’s Financial Reporting Council (FRC) has suggested caution about the move towards standards convergence. Speaking at a conference discussing corporate governance, the FRC’s chief executive, Paul Boyle, said that the advantages of convergence may not necessarily outweigh the financial and time costs involved in achieving it.

Arctic in from the cold

Geoff and Diana Jones (pictured) have won a landmark victory in a House of Lords judgment vindicating the split of profits in their family business. Their company, Arctic Systems, paid profits as dividends shared equally between husband and wife, despite Mr Jones being the principal person in the business. HM Revenue & Customs (HMRC) argued that dividend payments to Mrs Jones should be treated as her husband’s income, but it lost the case on final appeal.

The Arctic Systems case has taken three years to conclude, with Geoff and Diana Jones strongly supported by their representative body, the Professional Contractors Group (PCG). PCG argued that a victory for HMRC would have constituted ‘a tax hike for thousands of family businesses’.

Geoff Jones said: ‘Diana and I are delighted that the Law Lords have vindicated our position, and confirmed that we have done nothing wrong. This has been a terrible ordeal for us, which looked like it could cost us our home at one point. We’re relieved it’s all over, but I am still extremely angry that the Government tried to pull this stunt in the first place.’

PCG’s chairman, David Ramsden, added: ‘This is an enormous relief for family businesses throughout the UK, who had been facing a tax rise from a previously obscure bit of law. We will now be working to ensure that HMRC respects this decision and does not attempt to penalise family businesses unfairly.’

ACCA said that the ruling brought much-needed clarity for small business owners, especially those jointly owned by husbands and wives. Chas Roy-Chowdhury, ACCA’s head of taxation, said: ‘It means similar small businesses will now be able to run their affairs without fear of being classed as tax avoiders. What Mr and Mrs Jones were doing was a well-used practice within such businesses. The argument has been rather esoteric, and the case cuts across the whole idea of the independent taxation of husband and wife, which is widely agreed to have been a healthy development in the tax system in recent years.’

Guidance on the implications of the case is available on the ACCA website. ACCA warns that Arctic Systems’ experience shows the importance of companies paying directors realistic salaries. HMRC has indicated that it will introduce new legislation to prevent husbands and wives avoiding tax by compensating for low salaries through high dividend payments.

‘aggressive tax planning on the decline’

The study, conducted by FDS International, found a wide spectrum of corporate attitudes and practices regarding corporation tax, ranging from aggressive to risk averse. Where a company sits in that spectrum is influenced by the corporate style of management and approach of individual tax managers.

Management, shareholders, financial commentators and tax authorities all shape attitudes to tax planning, researchers were told. Effective administration of tax compliance is universally regarded as important and is sometimes used as an indicator in incentive packages for tax managers. Tax planning is included within the corporate risk management approach of some companies. Reducing tax risks is achieved by improved forecasting accuracy, precautionary provisions and aiming for consistency in the effective tax rate.

Tax managers also told the survey that they distinguish between tax planning in the structural and operational contexts. Structural tax planning deals with capital transactions, while operational tax planning considers routine business. Tax managers regard structural tax planning as a legitimate objective, but operational tax planning is discouraged by tax authorities and therefore difficult to sustain.

Study participants said that the 2004 disclosure rule changes made tax avoidance devices less attractive. Companies have become more wary of those who promote these devices. Most companies interviewed do not use bonuses or incentives to tax managers to reduce their corporate tax bills.

Working relationships with HMRC were generally seen as effective and tax managers said they were positive about reform to the Large Business Service. Companies aim to be seen by HMRC as open and candid in their dealings, they said.

Dave Hartnett, HMRC’s director-general, said that the purpose of the study was to ‘explore the factors that influence the attitudes, motivations and practices underpinning tax management in large companies’. It would now be used by HMRC for service planning, including in how to reduce the so-called ‘tax gap’.

UK ‘uncompetitive in corporation tax’

The UK is becoming increasingly uncompetitive in its rate of corporation tax, according to a survey conducted by KPMG. A decade ago the UK had the fourth lowest rate out of the then 15 member states in the European Union, but it now has the sixth highest of today’s 27 countries.

Corporation tax rates increasingly drive corporate location, said 86% of survey respondents – compared with 68% who said the same last year. Almost half of companies – 44% – said they had considered moving out of the UK in the past 12 months. Some 6% are currently actively considering relocation. The survey asked the opinions of 50 senior tax decision-makers in FTSE 100 and FTSE 250 companies and UK subsidiaries of major multinationals.

Sue Bonney, head of tax and people services at KPMG in the UK, said: ‘In a decade where average EU corporate tax rates have come down by over 10 percentage points – a reduction of almost a third – the UK’s headline corporate tax rate has moved by just 1%. Consequently, we have tumbled down the table in terms of relative rankings.’

Bonney added that while the cut in rates from 30% to 28% from April next year is a step in the right direction, the impact of indirect taxes is also important. According to KPMG analysis, the average corporation tax rate in the EU is now 24.2%, against 35.5% in 1997 – but indirect taxes have increased over the same period. The EU average rate of VAT is 19.5%, with the UK’s 17.5% rate the fourth lowest. The average indirect tax rate across the OECD is 17.7%, and that in the Asia Pacific region is 10.8%.

fraud rises dramatically

Simon Bevan, head of the fraud services team at BDO Stoy Hayward, said: ‘Professional criminals have been quick to notice the millions that can be made from VAT carousel frauds. While there has been a crackdown, I am sceptical it will halt this avalanche of huge frauds against the taxpayer. If you make tens of millions, and then succeed in keeping even a few percent hidden when you get caught, then you will end up with a small sentence and a large amount hidden in an offshore bank. Many fraudsters are laughing all the way to their offshore tax haven.’

Figures collated by BDO show that rather than slowing down, the incidence of carousel fraud continues to increase. It reports that in the first half of 2007, some 23 VAT carousel frauds cost £468m – more than in the whole of last year.

But this analysis is rejected by HM Revenue & Customs (HMRC). Its spokeswoman said that Office of National Statistics figures show the incidence of carousel fraud fell by over 90% during the summer of 2006, and HMRC believes the trend is continuing. BDO’s figures related to successful prosecutions and were not a reflection of current events, while illustrating HMRC’s success in tackling fraud, said HMRC. Further measures against VAT fraud are also taking effect, it added, with 96% of traders who had withheld VAT refunds being subsequently proved to be connected to criminal activity.

However, KPMG argued that the incidence of commercial fraud in the UK has undergone a ‘step change’ in recent years. It pointed out that for the fourth six-month period in succession, more than 100 cases of fraud valued at over £100,000 have gone to court. Hitesh Patel, director in KPMG Forensic, said: ‘The good news is that more fraud is being detected and prosecuted in court. The bad news is that this is probably – at least in part – because more fraud is being committed.’

KPMG warned of increases in insider frauds and professional criminals’ involvement in cigarette and duty frauds, benefits scams, ID theft, bank card fraud and money laundering. KPMG suggested that the high level of personal indebtedness may drive increased fraud against employers.

in brief...

PwC concedes on Yukos
PricewaterhouseCoopers has accepted the evidence of Russian prosecutors resulting from criminal investigations into audit client Yukos. PwC has now withdrawn its audit reports of Yukos for the years from 1995 to 2004. The move ends a stand-off between the Russian authorities and PwC that involved a police raid on the firm’s Moscow offices. PwC said that it now believed that past statements provided by Yukos management may not have been accurate.

E&Y censured
The Securities and Exchange Commission (SEC) has censured Ernst & Young for allegedly ‘engaging in improper professional conduct’ in connection with multiple audits and periodic reviews of the Irish company SmartForce. Audit lead partner Denis O’Hogan, based in Dublin, has been suspended for two years from practising before the Commission. E&Y has agreed to pay US$725,000 in penalties – equivalent to its audit fees – although both it and O’Hogan neither admit nor deny the SEC findings. Software company SmartForce overstated revenue by US$113.5m and net income by US$127m during a three-and-a-half year period.

Deloitte pays up
Deloitte is to pay US$167.5m to former audit client Adelphia, to settle claims relating to the company’s operations before it entered Chapter 11 reorganisation. The trust overseeing the recovery says that action will still be taken against former Adelphia staff who were alleged to be responsible for frauds and against the company’s banks.

Moore Stephens faces claim
Moore Stephens failed in an attempt to strike out a claim for negligence filed by creditors of former audit client Stone & Rolls. But Moore Stephens succeeded in having the claim reduced from US$174m to US$93m. Creditors argue that Moore Stephens was negligent in not detecting a fraud conducted through Stone & Rolls of a Czech bank, a claim denied by the accountants. The costs of the legal action are being met by third party litigation funders, who would take a share of the proceeds if the plaintiffs win the case.

Parmalat auditors escape charges
Deloitte, Grant Thornton, Citigroup and Bank of America have all avoided facing charges in the US over the collapse of Parmalat, after a federal judge ruled that the case was outside the remit of the US courts as most of the alleged offences occurred outside the country.

‘Focus on biggest tax losses,’ says NAO
HM Revenue & Customs’ (HMRC) use of a more open approach in working with large companies is proving effective, says a report from the National Audit Office (NAO). But HMRC could make further improvements by concentrating on where the highest amounts of tax are at risk, it says. HMRC should move away from its traditional approach of automatically opening enquiries whenever tax is at risk, without taking into account the total amount at risk, which leads to an excessive focus on small and old cases.

Hector Sants takes over FSA
Hector Sants, the Financial Services Authority’s (FSA) managing director of wholesale and institutional markets, has been appointed its chief executive, following the resignation of John Tiner. In a statement issued on his appointment, Sants said that he supported the FSA’s move to a more risk-based and principles-based approach to regulation.

IAASB in convergence push
ACCA has congratulated the International Auditing and Assurance Standards Board (IAASB) for pushing forward with convergence of international standards by approving nine proposed standards for public comment. Sara Harvey, chair of ACCA’s Auditing Committee, said: ‘The next step is for the European Commission to move towards an appropriately early adoption of the clarified ISAs, and ACCA encourages all jurisdictions not currently using ISAs to follow a convergence strategy.’

Pensions accounting warning
New guidance on the balance sheet treatment of pension fund surpluses could affect investment decisions, pensions consultants Mercer warn. The latest guidance from IASB on IAS 19 states that companies can only take credit for a pension fund surplus if they have the ‘unconditional’ right to a refund of the surplus, or if they can use it to reduce future employer contributions. Mercer says the strongest impact of this will be felt in countries, such as the UK, that have strong minimum funding rules for pension funds.