How much will disclosure in and presentation of accounts differ under the new regime?
One of the first things that is obvious about FRS 102 when compared to UK GAAP is that the terminology is quite different.
The terms relating to financial statements that are familiar to UK accountants and have been used for many years are mostly lacking in FRS 102 and are replaced by the terminology of the international standards.
The balance sheet is referred to as the ‘statement of financial position’, and the profit and loss account as a ‘statement of comprehensive income.’
The format of the accounts will remain largely similar. Section 4 of FRS 102, which deals with the statement of financial position, states:
'The statement of financial position (which is referred to as the balance sheet in the Act) presents an entity’s assets, liabilities and equity as of a specific date - the end of the reporting period.
This section applies to all entities, whether or not they report under the Act.
Entities that do not report under the Act should comply with the requirements of this section, and with the Regulations (or, where applicable, the LLP Regulations) where referred to in this section, except to the extent that these requirements are not permitted by any statutory framework under which such entities report.'
The regulations referred to are those in Statutory Instrument 2008/410, which set out the acceptable formats that financial statements may take under UK law.
FRS 102 allows accounts to continue to be prepared using the Companies Act formats.
It is a little more complex when looking at the statement of comprehensive income, as FRS 102 allows the entity to present its income in one OR two statements; either in a single statement of comprehensive income, or in two statements - an income statement (which is referred to as the profit and loss account in the Act) and a statement of comprehensive income.
The standard uses other terms that are different to what we are used to in UK GAAP, such as calling stock ‘inventories’, tangible fixed assets ‘property plant and equipment’, and a cashflow statement is a ‘statement of cash flows’, but there is nothing there that cannot easily be understood by someone with accounting knowledge.
On first-time adoption of FRS 102 an entity shall restate its comparatives to recognise, reclassify and measure items in accordance with the requirements of FRS 102.
In particular, the comparatives that have to be restated are those at the date of transition to FRS 102.
This date is the beginning of the earliest period for which the entity presents full comparative information; that means that for an entity applying FRS 102 for the first time for the year ended 31 December 2015, the date of transition will be the first day of the comparative year to 31 December 2014, ie 1 January 2014.
The adjustments resulting from the restatement of comparatives in accordance with the requirements of FRS 102 are recognised directly in retained earnings, or another category of equity if appropriate, at the date of transition.
An entity needs to produce disclosures about how the transition to FRS 102 affected its reported financial position and financial performance. In order to do so, the first financial statements prepared under FRS 102 need to include:
a) a description of the nature of each change in accounting policy;
b) reconciliations of equity determined in accordance with the previous financial reporting framework to equity determined in accordance with FRS 102 for both of the following dates:
(i) the date of transition to FRS 102 and
(ii) the end of the period covered by the previous financial statements prepared;
c) A reconciliation of the profit or loss determined in accordance with its previous financial reporting framework, for the last period covered by the previous financial statements, to its profit or loss determined in accordance with FRS 102 for the same period.
Possibly one of the biggest differences between FRS 102 and the current standards is the treatment of investment properties.
SSAP 19 defines investment properties as 'held not for consumption in the business operations but as investments', and excludes a property let to and occupied by another group company.
FRS 102 defines an investment property with different words, but has largely the same meaning:
'Investment property is property (land or a building, or part of a building, or both) held by the owner or by the lessee under a finance lease to earn rentals or for capital appreciation or both, rather than for:
(a) use in the production or supply of goods or services or for administrative purposes;
or
(b) sale in the ordinary course of business.'
However, SSAP 19 requires investment properties to be held on the balance sheet at open market value, although it does not require the valuation to be made by qualified or independent valuers.
FRS 102, on the other hand, requires valuation at fair value, only if the property can be measured reliably without undue cost or effort.
If that is not possible, the property should be accounted for as ‘property, plant and equipment’, and not as investment property.
If the investment property fair value can be measured reliably, it shall be measured at fair value at each reporting date with changes in fair value recognised in profit or loss. This is clearly quite a departure from SSAP 19 and the use of a revaluation reserve.
Another difference between the current standards and FRS 102 is the treatment of subsequent expenditure on fixed assets.
FRS 15, Tangible Fixed Assets, deals at some length with accounting for subsequent expenditure.
Paragraphs 34 to 41 set out how ‘repairs-and-maintenance’-type expenditure should be recognised in the profit and loss account as incurred, while recognising the fact that this type of expenditure prevents an increase in depreciation which would ensue, should the asset not be properly maintained.
It sets out the three circumstances when subsequent expenditure should be capitalised:
'(a) Where the subsequent expenditure provides an enhancement of the economic benefits of the tangible fixed asset in excess of the previously assessed standard of performance.
(b) Where a component of the tangible fixed asset that has been treated separately for depreciation purposes and depreciated over its individual useful economic life, is replaced or restored.
(c) Where the subsequent expenditure relates to a major inspection or overhaul of a tangible fixed asset that restores the economic benefits of the asset that have been consumed by the entity and have already been reflected in depreciation.'
FRS 102 does not explicitly set out circumstances when subsequent expenditure should be capitalised, though some of the wording does mirror what is in FRS 15.
In paragraph 17.15 it states:
'An entity shall recognise the costs of day-to-day servicing of an item of property, plant and equipment in profit or loss in the period in which the costs are incurred.'
Paragraph 17.6 says:
'Parts of some items of property, plant and equipment may require replacement at regular intervals (eg the roof of a building).
An entity shall add to the carrying amount of an item of property, plant and equipment the cost of replacing part of such an item when that cost is incurred if the replacement part is expected to provide incremental future benefits to the entity.'
Additionally, paragraph 17.7 states:
'A condition of continuing to operate an item of property, plant and equipment (eg a bus) may be performing regular major inspections for faults regardless of whether parts of the item are replaced.
When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant and equipment as a replacement if the recognition criteria are satisfied.
Any remaining carrying amount of the cost of the previous major inspection (as distinct from physical parts) is de-recognised.'
Other than these few paragraphs, FRS 102 does not refer to subsequent expenditure, so the correct accounting treatment is far more subjective than under FRS 15.
The accounting treatment of certain employee benefits varies considerably as there is no explicit guidance in current UK GAAP.
FRS 102 defines them as 'all forms of consideration given by an entity in exchange for service rendered by employees, including directors and management.'
This section will apply to such things as wages, bonuses, termination payments and pension contributions; these will be accounted for largely as they are under current UK GAAP.
However, the standard specifically refers to 'paid annual leave and paid sick leave.' FRS 102 requires that 'an entity shall recognise the cost of all employee benefits to which its employees have become entitled as a result of service rendered to the entity during the reporting period.'
The detail of how an entity should recognise paid annual leave is set out in paragraphs 28.6 and 28.7 of FRS 102:
'An entity may compensate employees for absence for various reasons including annual leave and sick leave.
Some short-term compensated absences accumulate - they can be carried forward and used in future periods if the employee does not use the current period’s entitlement in full. Examples include annual leave and sick leave.
An entity shall recognise the expected cost of accumulating compensated absences when the employees render service that increases their entitlement to future compensated absences.
The entity shall measure the expected cost of accumulating compensated absences at the undiscounted additional amount that the entity expects to pay as a result of the unused entitlement that has accumulated at the end of the reporting period.
The entity shall present this amount as falling due within one year at the reporting date.
An entity shall recognise the cost of other (non-accumulating) compensated absences when the absences occur.
The entity shall measure the cost of non-accumulating compensated absences at the undiscounted amount of salaries and wages paid or payable for the period of absence.'
FRS 102 classifies leases into finance and operating leases respectively, depending on whether or not a lease transfers substantially all the risks and rewards incidental to ownership from the lessor to the lessee.
Such an approach and classification is consistent with current UK GAAP (SSAP 21); however, FRS 102 removes the presumption that a lease would be a finance lease if the present value of the minimum lease payments amounts to 90% or more of the leased asset.
This change may result in a different classification of some leases.
FRS 102 also confirms that the classification of a lease depends on the substance of the transaction rather than the form of the contract, and includes examples of situations in which a lease would be normally classified as a finance lease:
a) The lease transfers ownership of the asset to the lessee by the end of the lease term.
b) The lessee has an option to purchase the asset at a price sufficiently lower than fair value at the date the option becomes exercisable that it will be reasonably certain at the inception of the lease that the option will be exercised.
c) The lease is for the major part of the asset’s economic life, even if the title is not transferred.
d) At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. In this example, there is no mention of the 90% test.
e) The leased assets are of such specialised nature that only the lessee can use them without major modifications.
FRS 102 also includes indicators of situations that could result in a lease being classified as a finance lease:
a) The lessor’s losses associated with the cancellation of the lease are borne by the lessee.
b) Gains or losses from the fluctuation of the residual value of the leased asset accrue to the lessee.
c) The lessee has the ability to continue to lease the asset for a secondary period for a rent substantially lower than market rent.
Another difference between FRS 102 and the current UK GAAP is in respect of the recognition of lease incentives for operating leases - for example, rent-free periods.
FRS 102 requires recognition of the incentive over the lease term while, under UK GAAP, the benefit is allocated over the shorter of the lease term and the period ending when market rent will be payable, ie the period up to the first rent review.
Thus, under FRS 102, lease incentives may be spread over a longer period of time.
FRS 102 includes separate accounting requirements, outlined in two different sections of the standard, for ‘basic’ and ‘other’, more complex, financial instruments and transactions. The requirements that apply to basic financial assets and liabilities are relevant to all entities, whilst if an entity only enters into basic financial instrument transactions it will not need to apply the section of the standard that deals with more complex financial instruments. However FRS 102 clarifies that entities deemed to have only basic financial instruments should ensure that they are exempt by considering whether any of their financial assets or liabilities falls within the scope of ‘complex’ instruments.
FRS 102 also allows an entity to apply the recognition and measurement provisions of IAS 39 or IFRS 9 as an alternative to its own requirements for basic and complex financial instruments.
Basic financial instruments will normally include:
a) trade accounts receivables and payables;
b) loans from banks or other third parties;
c) loans to and from subsidiaries and associates or to other third parties;
d) bonds and similar debt instruments; and
e) investments in non-convertible preference shares and in non-puttable ordinary and preference shares.
Examples of more complex financial instruments include:
a) options and forward contracts;
b) interest rate swaps;
c) investments in convertible debt and convertible preference shares;
d) investments in another’s entity equity instruments other than non-puttable ordinary and preference share; and
e) rights, warrants and futures contracts.
For a debt instrument (like a bond, loan or trade receivable or payable) to be classified as a basic financial instrument, a number of conditions need to be satisfied.
For instance, the return to the holder should be either a fixed amount, or at a fixed rate over the life of the instrument, or at a variable rate linked to a quoted or observable interest rate (eg LIBOR), or even a combination of fixed and variable rates (eg LIBOR plus x basis points), provided that both components are positive (ie not a positive rate offsetting a negative rate as in an interest rate swap).
Another important condition is that the holder of the instrument should not be able to put it back to the issuer before maturity, ie to obtain immediate repayment, unless that is permitted to protect him from the credit deterioration of the issuer - for instance, in case of defaults, breaches of loan covenants or credit downgrades of the borrower.
Basic financial instruments are required to be measured in different ways depending on the type and characteristics of the instruments:
a) Debt instruments such as bonds and loans will be measured at amortised cost using the effective interest method.
b) Debt instruments that are payable or receivable within one year, typically trade payables or receivables, will be measured at the undiscounted amount of the cash or other consideration expected to be paid or received, net of impairment.
However, if the arrangement constitutes a financing transaction - for instance, if the payment of a trade debt is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate, or in the case of an outright short-term loan - the financial asset or liability will be measured at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.
In practice, for goods or services sold to a customer on short-term credit, a receivable is recognised at the undiscounted amount of cash receivable, normally the invoice price.
The same applies for a purchase on short-term credit where a payable is recognised at its undiscounted invoice amount. If, instead, an item is sold to a customer on two-year interest-free credit, a receivable should be recognised at the present value of the cash receivable, for which the cash sale price of the item may be used as a close approximation.
If, however, the cash sale price is not known, the cash receivable should be discounted using the prevailing market rate of interest for a similar receivable.
c) Debt instruments may also be designated by entity to be measured at fair value through profit or loss in certain specific circumstances.
d) Investments in non-convertible preference shares and in non-puttable ordinary and preference shares should be measured:
i. at fair value, with changes recognised in profit or loss if the shares are publicly traded or their fair value can otherwise be measured reliably;
ii. at cost less impairment for all other investments.
Other complex financial instruments are required to be measured at fair value, with changes in fair value recognised in profit or loss except for:
a) investments in equity instruments that are not publicly traded and whose fair value may not be reliably estimated which shall be measured at cost less impairment; and
b) hedging instruments for which the entity is applying the hedge accounting provisions in FRS 102.
Some of the complex financial instruments would not be recognised under current UK GAAP but would only require disclosures.
FRS 102 requires an entity to present a statement of cashflows providing information about the changes in cash and cash equivalents for a reporting period that should be classified under three headings:
Compared to UK GAAP (FRS 1), FRS 102 extends the scope of the statement of cashflows by requiring the inclusion not only of inflows and outflows of cash, defined as cash in hand and demand deposits, but also of cash equivalents, which are short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of changes in value.
Cash equivalents include investments with a maturity of three months or less that under FRS 1 are normally classified as short-term investments.
Bank overdrafts repayable on demand and integral to the entity’s cash management are also a component of cash and cash equivalents.
The three headings for classification of cashflows are also a significant reduction on the nine required by FRS 1 and will require careful rethinking for the reclassification of items on first adoption of FRS 102.
Operating activities are the main revenue-producing activities of the entity and therefore cashflows from such activities normally result from transactions that generate a profit or a loss. Examples are:
a) cash receipts and payments for sale or purchase of goods and services;
b) cash payments and refunds of tax, unless they relate specifically to investment of financing activities;
c) cash receipts and payments from investments, loans and other contracts held for dealing or trading purposes, ie those similar to inventory acquired specifically for resale.
However, the cashflows for some transactions that result in a gain or loss, such as the sale of plant by a manufacturing entity, are classified as from investing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Examples of investing activities cashflows are:
a) cash payments and receipts to acquire or to sell property, plant and equipment, intangible assets and other long-term assets;
b) cash payments and receipts to acquire or sell equity or debt instruments of other entities and interests in joint ventures; and
c) cash advances and loans made to other parties and connected repayments.
Financing activities are activities resulting in changes in the size and composition of contributed equity and borrowings of an entity. Examples of cashflows from such activities are:
a) cash proceeds from issuing shares and other equity instruments;
b) cash payments to owners to acquire or redeem the entity’s shares;
c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other long- or short-term borrowings;
d) repayments of amounts borrowed; and
e) lessee’s payments to reduce a liability on a finance lease.
In respect of interest and dividends, FRS 102 requires that cashflows from interest and dividends paid and received should be presented separately. An entity may classify interest paid and interest and dividends received as operating cashflows.
Alternatively, interest paid may be classified as financing cashflows and interest and dividends received as investing cashflows.
Dividends paid may be classified as financing cashflows because they are a cost of obtaining financial resources; alternatively, they may be classified as a component of cashflows from operating activities because they are paid out of operating cashflows.
Under FRS 102, goodwill acquired in a business combination, ie the combination of separate entities or businesses into one reporting entity, is considered to have a finite useful life and should be amortised systematically over its life.
If it is not possible to make a reliable estimate of the useful life, it should be deemed not to exceed five years.
UK GAAP (FRS 10) presumes that the useful economic life of goodwill would not exceed 20 years but the presumption may be rebutted if it is possible to justify a longer or indefinite useful economic life.