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Financial reporting errors: What you need to know

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15th Oct 2012
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In the first of a series of three articles, Steve Collings highlights some key issues from the Financial Reporting Review Panel’s latest report on errors made in companies’ reports and accounts.

In September 2012, the Financial Reporting Review Panel (FRRP) issued their annual report outlining their conclusions on the accounts they have inspected. The scope of the FRRP is to ensure that the reports and accounts published by public and large private companies comply with the requirements of Companies Act 2006, which also includes applicable accounting standards.

The vast majority of accountants will deal with smaller clients in the SME sector, but the report issued by the FRRP can highlights some of the problems faced by the larger practices with their large clients. While many accountants primarily deal with SME-based clients, many firms do have larger firms on their books and the findings of the FRRP can be a helpful insight into issues which they have found, which may flag up issues in other firms to help during any QAD or monitoring visit.

The report confirms that in the year to 31 March 2012, the FRRP reviewed 326 sets of reports and accounts (as opposed to 301 in the previous year). These reports and accounts had been issued by both public and large private companies. The FRRP found it necessary to write to 130 companies (as opposed to 141 in the previous year) concerning issues in their reports and accounts. The FRRP will write to companies when it believes that a company’s report and accounts do not comply with legislation. The FRRP will attempt to persuade the company to resolve the issues the panel have identified by either restating the report and accounts or by making prospective improvements. If the panel’s approach falls on deaf ears, they have the power to apply to the courts to decide whether the particular report and accounts comply with the law. However, in 2011/12 the FRRP was successful in settling all of its cases without the need to take the matters to court.

In addition, the FRRP has not published any press notices in the year. Press notices are published when the FRRP identifies any corrections which they consider significant. 

There were seven panel references agreed and published in 2011/12 which occur when a company makes a prior year correction following an enquiry by the FRRP. Three further panel references have been since agreed relating to accounts reviewed during the year. 

Five panel groups were in operation during the year and the report confirms that all of the groups have now concluded. A panel group is formed where, during the course of an inquiry, the FRRP believes there to have been a breach of relevant reporting requirements. A panel group is formed to consider the matter. Out of the five panel groups formed, three led to the relevant companies agreeing to enhanced disclosure in their next financial statements to either to explain the subsequent events, or actions which had resolved the FRRP’s concerns or to significantly enhance the quality of the information provided. One case resulted in a panel reference, and the FRRP agreed the remaining company’s proposal to change an accounting policy. 

In cases where the number, or significance, of corrections required to a company’s financial statements is deemed to be exceptional, the FRRP may copy the senior partner or chairman of the company’s auditor its letter to the company concerned closing a case. However, the report confirms that in 2011/12, there were no such letters in the year and acknowledged that such letters are issued sparingly.

Overall, the FRRP found the quality of financial statements and reports by companies who they reviewed to be good. The FRRP does have concerns about the quality of reporting by some smaller listed companies and those companies listed on the Alternative Investment Market (AIM). The FRRP are concerned because they feel that smaller listed and AIM listed companies lack the accounting expertise of their larger listed counterparts. The report emphasises that directors should not under-estimate the importance of their legal responsibility to prepare financial statements that comply with law and accounting standards (in other words, give a true and fair view).

The report highlights some key weaknesses which may also serve to assist accountants in practice that act for smaller clients. The weaknesses are as follows:

Directors’ reports and business reviews

Under Section 417 (3)(a) of Companies Act 2006, companies that are not small must provide a business review in the directors’ report. This business review must contain a fair review of the company’s business, together with a description of the principal risks and uncertainties the company faces. The concerns highlighted by the FRRP surround disclosures in the directors’ report which fall short of the requirements, particularly where companies merely:

  • provide bullet point headings as opposed to giving a comprehensive description of the principal risks faced by the company
  • simply provide a long list of risks, as opposed to separating out the risks from the uncertainties.  In some cases, the FRRP have questioned whether the risks and uncertainties disclosed in the directors’ report were, in fact, principal

Companies must also disclose in the report of the directors’ the actions they have taken to mitigate both the likelihood and the impact of the principal risks and uncertainties faced by the business, though the FRRP have acknowledged that in the most part, this issue is being dealt with generally well.

The FRRP identified some companies where they questioned whether the business review included in the report and accounts was fair, balanced and comprehensive and in most cases, the FRRP recommended enhanced explanation to be included going forward. This was particularly the case where the company incurs significant impairment charges, undertakes a significant business acquisition in the period or incurs significant redundancy and reorganisation costs. 

Some companies had made disclosure in the report of the directors’ in relation to unexpected significant finance costs and a significant release of a provision against debtors (receivables) which was net of an undisclosed impairment charge. While this is reasonable to include in the business review, the FRRP flagged the point that these issues were not separately disclosed in the financial statements. Accounting standards require that where such matters are considered substantial (or material), separate disclosure should be made as a separate line item in the financial statements.

The FRRP also wrote to companies asking them to explain why there were certain material variations in the current accounting period compared with the previous one. The report highlights an instance where there had been a significant variation in the tax charge resulting from a prior year adjustment as well as a significant movement in bad debt provisions.

The business review should include an analysis using KPIs so the user can gain an understanding of the development, performance or position of a company’s business. The FRRP has expressed concerns that some of the reports reviewed contained these KPIs as simply bullet point lists and did not contain explanations or were not referred to in the narrative about the business’s performance. 

Some reports and accounts reviewed by the FRRP contained some items that had been ‘adjusted’ and the FRRP requested reconciliations from some companies that contained such items, but which had not been adequately explained in the report. The FRRP’s report explained that the most common item was ‘adjusted operating profit’ where operating profit is a sub-total in the income statement. The FRRP require the nature and amount of such adjustments to be clearly explained and the measures referred to consistently.

Part 6 of Schedule 7 of the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 requires certain disclosures to be made in the financial statements regarding companies which have securities admitted to trading on a regulated market. These disclosures require detailed information relating to any significant agreements to which the company is a party to which take effect, alter or terminate upon a change of control of the company following a takeover bid, together with the effects of such agreements. The FRRP noted that all, or part, of these disclosures were absent in a number of companies’ reports during their review and reminded directors of the requirement to consider all of the necessary disclosures that are relevant in their corporate reports.

The report of the directors also requires a statement to be made on behalf of each director acknowledging the disclosure of information to the company’s auditor. The FRRP is concerned that it has encountered circumstances where this statement is missing.

Clutter issues

The FRRP writes to companies addressing some disclosures that companies should consider when preparing their annual report and accounts. Some of the disclosure points which feature most commonly in the letters sent to companies by the FRRP are set out in Appendix A to the September 2012 report. However, the FRRP does discourage companies from including unnecessary disclosures in their financial statements. Clearly unnecessary disclosures serve no purpose and merely go to increasing ‘clutter’ which the Financial Reporting Council (FRC) are trying to minimise wherever possible. The FRRP encourages companies to exercise judgement about the disclosures raised by the FRRP and consider their materiality. If the disclosures are not considered to be material, there is no need to make such disclosures. 

Indeed, the discussion paper issued by the FRC in 2011 emphasises the need for companies to avoid placing unnecessary disclosures in the financial statements and focus on the key issues at hand in their reports. When assessing whether an issue is material, consideration must be given to both its qualitative and quantitative aspects depending on the company’s individual facts and circumstances and the FRRP confirms that such materiality derives from the value of such information and not from the disclosure requirements contained in a specific accounting standard. It is important that companies understand, however, that what is material to one company may be immaterial in another company. Conversely, what may be material this year, may not be material next year.

Accounting policies

The FRRP’s report again highlights the issue of accounting policies. This is as relevant to a large, blue-chip PLC as it is to a smaller company.

Accounting standards require companies to disclose their significant accounting policies which are relevant to gain an understanding of the company’s financial statements. The problems highlighted in this area are generally polarised. The FRRP has identified situations where companies have not included a description of accounting policies which are considered to be significant in relation to the size, nature and complexity of a company’s business. Conversely, the FRRP (and, indeed, professional bodies) has criticised companies which include every conceivable accounting policy there is. If a company does not have leased assets or leasing transactions, there is little point in having a detailed accounting policy on leasing.

A key point to note (which I have often flagged up in lectures) is the use of boiler-plate accounting policy terminology. Indeed, the FRRP report highlights this issue as well – particularly in relation to revenue recognition. We all recognise the standard ‘turnover is stated net of VAT and trade discounts’. However, the issue in hand here is the fact that this sort of policy is deemed to be a ‘boiler-plate’ policy, which professional regulators and the FRRP do not like. There has to be a description of how, and at what point, revenue is recognised and it is important that such policies give an understanding of the business, rather than merely one-line generic descriptions.

Judgements have also come in for some criticism. Accounting standards require a description of significant judgements made which have the most significant impact on the carrying amounts to be disclosed within the financial statements so that users can understand the reported aspects of performance which have been most influenced by the decisions of the directors. The FRRP has challenged those companies that have failed to make any such disclosure, or those that just simply cross-referenced to the accounting policies. In some cases, companies had disclosed that such judgements were disclosed in other areas of the financial statements, but, in fact, were not upon subsequent investigation. The FRRP says:

"We expect boards to explain the nature of the judgements applied to significant items in the accounts such that users can better appreciate the importance of the area and its sensitivity to management opinion."

Items in other comprehensive income

Again, while this issue is confined to companies that prepare accounts under IFRS, the issues flagged up may be relevant to other companies and firms of accountants dealing with larger private companies. 

Under the provisions in IAS 1 Presentation of Financial Statements, a company can prepare a single statement of comprehensive income, or two statements - being that of the income statement and a statement of other comprehensive income (OCI). Most UK companies preparing financial statements under IFRS prepare two separate statements.

The FRRP’s review revealed some instances where items charged, or credited, to OCI should have either been included directly in the income statement or taken directly to equity and cites the following three examples:

  • Share-based payments and related deferred tax
  • Put options written on non-controlling interests (‘non-controlling interests’ may be more familiar as ‘minority interests’ to those of you preparing accounts to UK GAAP)
  • Convertible bonds

In addition, IAS 1 requires reclassification adjustments from OCI to the income statement to be disclosed separately and in some accounts reviewed by the FRRP, no such disclosure had been made. 

Disaggregation

The FRRP noted a number of companies that aggregated accrued income with prepayments and combined deferred income with accruals. Where the FRRP noted this treatment, they requested the companies concerned to disclose the amounts separately in the notes because the assets are different in nature and liquidity and the liabilities are different in nature and timing.

Netting off

Accounting standards and the Companies Acts don’t particularly approve of the act of netting off assets against liabilities (sometimes referred to as ‘offsetting’). The reason is that such acts can mask the substance of the underlying events or transactions and therefore make it difficult for users to understand their significance. For example, offsetting a large amount of section 455 corporation tax recoverable against the company’s corporation tax liability can distort the balance sheet, so GAAP encourages gross values to be disclosed, unless offsetting is required or permitted by an accounting standard (but this is relatively rare). 

The report by the FRRP cites a company that had to restate its balance sheet in respect of amounts owed to its dormant and semi-dormant subsidiaries. The directors of the company concerned believed the amounts would be settled when the reserves of the subsidiaries were distributed upon liquidation and were therefore reducing the parent’s investment in the subsidiaries, hence netted against the parent’s investments in the subsidiaries. The FRRP investigated the matter and it was concluded that the amounts in question should be reported as creditors falling due after more than one year because there was no legally enforceable right of set off.

Cash flow statement

The report by the FRRP identifies six areas where companies are misclassifying or misstating items in the statement of cash flows:

  • cash flows related to the purchase of own shares which are classified as investing rather than financing activities
  • cash inflows and outflows relating to assets held for rental and routinely resold which are classified as investing activities rather than operating activities
  • classifying as investing activities cash flows that did not result in the recognition of an asset
  • the acquisition of assets under finance leases reported as a cash outflow
  • ordinary shares issued following the conversion of debt into equity incorrectly reported as cash flows
  • reclassification from current to non-current liability reported as a cash inflow and cash outflow

The FRRP report also encourages companies to explain large and unusual cash flows in the business review, or in the notes to the accounts.

A fundamental criticism by the FRRP is that they are concerned that some companies do not devote enough care in the preparation of their statement of cash flows and supporting notes as they do with the other primary financial statements.

Income tax

Current and deferred tax are recognised outside profit or loss if they relate to items that are recognised outside profit or loss, regardless of the fact that it may be a different accounting period in question. The FRRP noted that the most common error related to companies reporting deferred tax on share-based payments in other comprehensive income as opposed to directly in equity. 

The FRRP’s report also highlights the preference by investors to regard the effective tax rate as a performance measure to understand factors that may affect the company in the future. The FRRP challenged a number of companies where the reconciliation of profit before tax to the tax charge in the income statement was unclear. An example of this was where the deferred tax movement was merely a reconciling item. 

A somewhat old chestnut, but companies have been criticised for the recognition of a deferred tax asset for unused tax losses. Such assets can only be recognised to the extent that it is probable that future taxable profit will be available against which the asset can be offset. The mere existence of tax losses should be taken as evidence that there will not be future taxable profits yielded, unless there is evidence to the contrary.

Conclusion

While the majority of this article has focused on what the big companies are doing wrong, the intention is to flag up some issues which those preparing financial statements for SME clients may glean some information that will help them potentially clear up some issues that may be familiar to them.

The next article will consider the findings by the FRRP in respect of:

  • Fixed assets
  • Leasing
  • Revenue
  • Employee benefits
  • Foreign currency
  • Related parties (no surprises there)
  • Consolidated and separate financial statements

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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Replies (2)

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By cfield
21st Oct 2012 17:26

Disaggregation

Good article by Steve as ever. I must admit, I didn't know about the need to show accrued/deferred income separately from accruals and prepayments.

Does this apply to small companies too?

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By futureb00ks
15th Nov 2012 12:48

when its time to hire a CFO

 

We teach our clients to enjoy counting money to improve their appreciation for bookkeeping, and their company’s performance.

 

As the founder of a start-up you wear many hats. Some days you are the CEO – other days the CTO. And some days you need to be the CFO. Until you hire a CFO – you’re it.

 

There are answers in the numbers. If you do financial analysis every six months, you can reverse engineer from the books and create new products and services. Analysing the company’s financials gives you a focal point to understanding what to do next in the business.

We posted more here: http://bit.ly/X6t9en

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