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Financial reporting: How to avoid costly mistakes

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1st Nov 2012
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In the final article in the series, Steve Collings takes a look at the Financial Reporting Review Panel’s (FRRP) Annual Report on its review of companies’ accounts and flags up the points that other firms may need to take on board in their preparation of financial statements.

Financial instruments: Presentation

The standard that governs the way in which financial instruments are presented in a company’s accounts is that of IAS 32 Financial Instruments: Presentation with its UK counterpart being that of FRS 25 Financial Instruments: Presentation.

The report confirms that several companies had been asked by the FRRP to confirm the method used to allocate amounts paid to extinguish convertible loan stock (such loans are either derecognised by way of redemption or purchase). The report also cites a company that had failed to present the liability and equity components of a convertible debt instrument separately (a convertible debt instrument is one which contains an option to convert to shares at a later date). When challenged about this treatment, the company in question said that it was due to the fact that on the date of issue, the company’s share price was significantly lower than the conversion price. However, the problem with this treatment is that any difference in pricing does not exempt a company from recognising both a financial liability and the right to convert this liability to a fixed number of shares.

Earnings per share

IAS 33 Earnings per Share and its UK counterpart FRS 22 Earnings per Share outline the ways in which a company should calculate and disclose its earnings per share (EPS).

The FRRP challenged companies that appeared to have made errors in the way EPS had been calculated, namely:

  • Inclusion of non-controlling interests (minority interests) amounts in the earnings figure which should be profit attributable to equity shareholders
  • Inclusion of shares held by the company or employee share ownership plans in the weighted average number of ordinary shares in issue during the period
  • Inclusion of anti-dilutive options and warrants in the determination of the weighted average number of ordinary shares in which only dilutive instruments should be included

Some companies also choose to give additional information relating to EPS, over and above that which is required by IAS 33. IAS 33 only requires basic and diluted EPS and the FRRP has reminded companies that choose to disclose additional EPS amounts that such additional disclosures must not be given greater prominence than the information required by IAS 33 (basic and dilutive EPS) and must be calculated using the weighted average number of shares determined in accordance with IAS 33. 

A company should provide a reconciliation between the component of income used to determine EPS and the line item that is presented in the statement of comprehensive income where the component of income used is not reported as a line item in the statement of comprehensive income.  Some companies had not provided this reconciliation in their financial reports and the FRRP have said that such a reconciliation cannot be performed satisfactorily from the disclosures that had been provided.

The FRRP made enquiries into a company that had incorrectly included shares issued after the year-end for cash in the EPS calculation and the FRRP have confirmed that a panel reference has been given in the accounts of this company.

Impairment of assets

IAS 36 Impairment of Assets and its UK counterpart, FRS 11 Impairment of Fixed Assets and Goodwill seems to be on the radar of, not only the FRRP, but also by professional bodies because of the nature of the economic environment. The overarching principle in financial reporting is that assets should not be carried at any more than their recoverable amount (recoverable amount being determined in accordance with IAS 36/FRS 11) and the standard also covers the applicable disclosure notes that are needed to be made. 

A significant difference between UK GAAP and IFRS 3 Business Combinations is that IFRS 3 prohibits the amortisation of goodwill and instead requires companies to do annual impairment tests.  Companies are also required to undertake impairment tests at least once a year where there is an indicator of impairment. It seems that the impairment of assets has caused a considerable number of difficulties for companies and the FRRP have identified three pages of issues in their report where companies are incorrectly applying the concepts in IAS 36. Three separate issues are identified in their report which have been raised by the FRRP as follows:

  • As the testing of material assets, including goodwill, for impairment requires management to make both significant judgements and estimates, the panel would usually expect to see them identified as such as required by IAS 1
  • When a significant proportion of total goodwill is allocated to a cash-generating unit (CGU) or group of CGUs, the disclosures provided should indicate the amount allocated to the CGU or groups of CGUs concerned together, where recoverable amount is based on value in use, with the key assumptions on which the cash flow projections are based and a description of the company’s approach to determining the value assigned to each key assumption
  • Where the company’s CGUs have disparate activities, the panel will generally query the application of a single discount rate to the testing for impairment of all CGUs. IAS 36 requires the pre-tax discount rate used to reflect the risks specific to the CGU for which the future estimated cash flows have not been adjusted

IAS 36 contains two values to be derived in undertaking an impairment test:

  • Value in use
  • Fair value less costs to sell

The FRRP has expressed concern that some companies are confused between the different considerations that apply to the above.

When a company calculates value in use, the cash flows used are to be in the currency in which they will be generated and then discounted using a rate appropriate for that particular currency. In translating those currencies, the rate used must be the exchange rate at the date the value in use calculation is performed. The FRRP has asked certain companies to justify their use of estimated future exchange rates in order to determine value in use. 

The FRRP also raised questions to certain companies where there were concerns about double-counting of impairment reviews. In particular, the FRRP have asked companies for confirmation relating to benefits of prior year tax losses where these appeared to have been recognised as an asset on the statement of financial position (balance sheet) and also included in the recoverable amount for testing purposes.

The FRRP has felt it necessary to remind boards that the discount rate used to bring future cash flows to today’s values must be the rate that reflects the return that an investor would require, at the date of the impairment test, to invest in a particular CGU. This is particularly the case where such a discount rate is not an asset-specific rate which can be obtained directly from the market. The FRRP confirmed that in some reports that have been reviewed, there was little evidence that sufficient thought had been given as to the determination of an investor’s return and the FRRP has flagged up the suggestion in IAS 36 that the board may want to consider the company’s weighted average cost of capital, the company’s incremental borrowing rate and other market borrowing rates. Where companies do adopt the suggestion in IAS 36, the rates used must be adjusted for the market’s assessment of the risks that are attached to the particular asset’s cash flows and the FRRP have criticised companies where it is apparent that they have not had any regard to these considerations in arriving at a particular discount rate. In addition, the FRRP has expressed concern that some companies are using out of date rates as well as some companies using rates that are based on a company’s borrowing rate which were essentially lower than the company’s cost of equity.

The FRRP has reminded companies in their report that they will be challenged where there is no evidence of the basis on which they determined the rates to apply. 

Disclosures in respect of IAS 36 requirements have also come in for criticism by the FRRP. In particular, the description of management’s approach to determining the value(s) to be assigned to each assumption used when the recoverable amount has been determined on the basis of value in use. The FRRP have has said that in the accounts they reviewed, the approach assigned to each assumption was either “poor or non-existent”. In light of this, the FRRP has warned that they intend to focus on compliance with this requirement going forward.

Some companies have also identified the growth rate used to extrapolate cash flow projections and the pre-tax discount rate as their ‘key assumptions’ and the FRRP have confirmed that, while important, such assumptions are not ‘key’ assumptions on the basis of which the cash flow projections for the period covered by the most recent budgets or forecasts are based. In particular, the FRRP has said that references to ‘growth’ are meaningless unless the item is identified, such as sales, margins or costs.

Smaller companies reviewed by the FRRP were commended for quantifying, as well as describing, the key assumptions in the cash flow projections even where no reasonably possible change in key assumptions would indicate impairment as the FRRP view these disclosures as enabling users to evaluate the reliability of the estimates used by management to support carrying amounts of goodwill and intangible assets with indefinite lives.

Provisions, contingent liabilities and contingent assets

Provisions and contingencies are dealt with in IAS 37 Provisions, Contingent Liabilities and Contingent Assets with the UK counterpart being that of FRS 12. The FRRP has expressed concern that certain disclosures in financial statements indicate the need for a provision, but the provision does not appear in the financial statements. The report cites a company in the mining industry which omitted to include a provision for rehabilitation, but whose development costs were stated to include amounts incurred to rehabilitate production facilities.

Companies were also challenged when provisions had been included within accruals, with no disclosure of their nature, or of the expected timing and any uncertainties regarding the amount or timing of the cash outflows. The report cites onerous lease liabilities where these had been included within accruals, rather than as provisions.

Intangible assets

A key principle laid down in IAS 38 Intangible Assets and its UK counterpart FRS 10 Goodwill and Intangible Assets is that internally-generated intangible assets cannot be recognised on a company’s statement of financial position. The FRRP have found it necessary to challenge companies that have recognised such internally-generated intangible assets.

Other companies have been challenged where certain classes of intangible assets had been aggregated when it was apparent that such assets had substantially different useful economic lives.  In addition, the FRRP has found it necessary to remind companies that impairment charges should be aggregated with accumulated amortisation and not as a deduction from cost.

The FRRP challenged a company that had classified an intangible asset as having an indefinite life on the basis that it was renewed indefinitely and following the enquiry, the company has now changed its accounting policy and has decided to start amortising the relevant asset.

Financial instruments: recognition and measurement

Financial instruments have been the subject of criticism following the banking crisis and the FRRP has confirmed that they have raised fewer questions in this area in the current year. Companies were questioned when the treatment adopted in relation to financial instruments was not sufficiently clear.

Investment property

IAS 40 Investment Properties requires disclosure of the significant assumptions and methods used in arriving at a fair value. The standard also requires a disclosure of whether, in determining fair value, this determination was supported by market evidence, or more heavily based on other factors. 

The FRRP said that this requirement is not satisfied by a statement that the valuation was carried out in accordance with standards issued by the Royal Institution of Chartered Surveyors or under International Valuation Standards. The FRRP has also been explicit on this point – they will challenge such minimal disclosures in the future.

Companies were questioned when it was unclear as to how they determine the classification between investment property (as accounted for under IAS 40) and owner-occupied property (which is accounted for under IAS 16 Property, Plant and Equipment). IAS 40 specifically requires disclosure of the criteria applied when classification is difficult.

Finally, in respect of investment property, the FRRP has said that it continued to challenge companies when it appeared that direct operating expenses should have been analysed between properties generating rent and properties that did not.

Business combinations

The report confirms that the FRRP is pleased to note that fewer companies were questioned on this particular area than before.

However, the FRRP has said that boards still need to remain alert to the wide-ranging impact of key changes brought about by the revised IFRS 3 Business Combinations particularly in areas such as reacquired rights and transactions with non-controlling interests. 

Certain companies were also challenged on the accounting treatment for the purchases of assets when there seemed to be doubt as to whether such assets should have been accounted for in accordance with IFRS 3 (revised). 

Companies that had entered into business combinations under common control, and whose applied accounting was unclear also faced questions by the FRRP. IFRS 3 (revised) does not cover common control acquisitions and companies that had applied merger accounting, as permitted, also faced questions when their disclosures included inappropriate terminology and the disclosures explaining their general approach was weak.

The FRRP is still concerned that where a business combination, as defined in IFRS 3 (revised), is undertaken, that not all identifiable intangible assets which meet the recognition and measurement criteria are actually recognised on acquisition. It is to be noted that all intangible assets acquired during a business combination are now deemed to be capable of reliable measurement and the FRRP challenged companies where it was apparent that such assets had been subsumed within goodwill as opposed to being accounted for separately.

Contingent consideration issues also seemed to cause an element of confusion. The report cites the circumstance of contingent consideration payable to a vendor, subject to the vendor continuing to provide services to the business following its purchase by the acquirer. A company was challenged by the FRRP regarding its accounting treatment of contingent consideration in such circumstances, and following the enquiry agreed to restate an acquisition to account for the contingent consideration as post-acquisition remuneration for services provided. 

Financial instruments: disclosures

The current economic climate is still on shaky ground and earlier this year, the Financial Reporting Council (FRC) reminded directors of the range of disclosures that are needed in financial statements in order that the accounts give a balanced and fair view of the company’s exposures.

The FRRP challenged companies where it appeared that liquidity risk was a major concern, but their disclosures were weak. The FRRP has also reminded companies to consider the quantitative information disclosed in their annual reports and to consider whether this information is representative of the position during the year. Where such quantitative information is not represent of the position during the year, the company must provide further information which is representative.

Boards were also reminded of the need to provide disclosures which provide the user with an understanding of the nature or extent of the company’s risk exposure, or how it is managed. The report cites an example of a company that changed its banking facilities after the year-end but failed to amend the disclosures to reflect that fact.

Conclusion

This series of articles has provided an insight as to the work of the FRRP in its review of companies’ accounts and disclosures. While the work of the FRRP is dedicated to large listed and smaller listed companies, the content of the report is applicable to much of the rest of the UK-based companies and can be a helpful insight as to what is actually required either in legislation or by way of accounting standards. 

With disclosure issues and the way in which items are recognised and measured in the financial statements coming under increasing amounts of scrutiny, it is somewhat helpful to understand where the larger companies are going wrong in order to avoid costly mistakes being made at the smaller company level.

Further reading:

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB Guide to IFRS’ and ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.

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