As FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland starts to complete its first year of mandatory implementation for small business, a number of emerging issues have begun to come to the surface, writes Steve Collings.
Part 1 of this two-part series focussed on goodwill, micro-entity disclosures, investment property and directors’ remuneration. This second article will take a look at some of the issues raised in respect of:
- Use of previous GAAP revaluations as deemed cost
- Deferred tax (on revalued assets)
- Undue cost or effort exemptions
- On-demand related party loans
- Software and website development costs
At the outset, it is also worth pointing out that the Financial Reporting Council (FRC) have published 16 Staff Education Notes (SENs) which many practitioners seem to find very helpful.
The aim of the SENs is not to substitute the requirements of FRS 102, but they are designed to help implementation of the standard in areas where there are likely to be difficulties or contentious issues.
The SENs highlight the differences between ‘old’ and ‘new’ UK GAAP and incorporate worked examples which demonstrate how the theory in FRS 102 is applied in practice.
If you encounter difficulties in interpreting some of the requirements of a specific section of FRS 102 then it may be worthwhile having a look to see if there is an SEN on the issue.
Use of previous GAAP revaluation as deemed cost
On transition to FRS 102, paragraph 35.10(d) allows a first-time adopter to use a previous GAAP revaluation as deemed cost. Use of a previous GAAP revaluation will then allow the entity to account for the asset under the cost model. This would be useful where an entity has previously revalued an item of property, plant and equipment (such as a building) but finds obtaining periodic revaluations arduous and hence wishes to report under the cost model.
Ordinarily, a switch back from the revaluation model to the historic cost model is extremely difficult because when the entity initially changes from the cost model to the revaluation model, this is treated as a voluntary change in an accounting policy, which would only be carried out where the change results in the financial statements providing reliable and more relevant information.
It is then inherently difficult to justify how a switch back from the revaluation model to the historic cost model results in the financial statements providing reliable and more relevant information. However, on transition to FRS 102 there is the option to do this, but there are some technical issues which need to be kept in mind.
The important point to note is when an entity chooses to apply the optional exemption in paragraph 35.10(d) and use a previous UK GAAP revaluation as deemed cost, the valuation must be either at or before, the date of transition – but not after.
When a previous UK GAAP revaluation is used the alternative accounting rules in the Companies Act 2006 are still being applied, regardless of the fact that the revaluation is being used as a ‘frozen’ cost on transition. This is because the asset will not be stated at ‘purchase price’ or ‘production cost’, which is a requirement of the historical cost accounting rules – it is still being carried at a revalued amount.
Therefore, an entity using a previous revaluation as deemed cost must continue to present a revaluation reserve in the equity section of the balance sheet and make the disclosures required by paragraph 34(3) of Schedule 1 to the Accounting Regulations. This paragraph requires the comparable amounts determined under the historical cost accounting rules to be disclosed.
Some entities have previously disclosed the difference between the amounts which would have been disclosed under the historical cost accounting rules and the corresponding amounts shown in the balance sheet, but this option was repealed by virtue of The Companies, Partnerships and Groups (Accounts and Reports) Regulations 2015 SI 2015/980.
Deferred tax (on revalued assets)
As all practitioners will, by now, be aware, Section 29 Income Tax of FRS 102 uses the timing difference plus approach, rather than the timing difference approach in previous UK GAAP.
With the exception of micro-entities reporting under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime (micro-entities being prohibited from recognising deferred tax), the scope for deferred tax is wider under FRS 102 as non-monetary assets subjected to the revaluation model will now attract deferred tax consequences.
Investment properties measured at fair value under Section 16 Investment Property are subject to the fair value accounting rules, meaning fair value gains and losses at each balance sheet date are taken to the profit and loss account. Therefore, a £10,000 gain on an investment property at the year-end is accounted for as:
Dr Investment property: £10,000
Cr Fair value adjustments (P&L): £10,000
The deferred tax consequences must also be brought into account where investment properties are concerned and these are also taken to the profit and loss account. Therefore, assuming a 17% tax rate applies to the investment property above, the entries are:
Dr Tax expense (P&L): £1,700
Cr Deferred tax provision (B/S): £1,700
Where an item of property, plant and equipment (PPE) is revalued under Section 17 Property, Plant and Equipment, the alternative accounting rules are still being applied, which requires revaluation gains and losses to be taken to the revaluation reserve (losses to the extent of a credit balance on the revaluation reserve). Therefore, a £10,000 gain on revaluation at the year-end is accounted for as:
Dr PPE: £10,000
Cr Revaluation reserve: £10,000
The £10,000 gain is reported through other comprehensive income as a revaluation gain and the deferred tax consequences are also taken to other comprehensive income. Assuming a 17% tax rate applies to the revalued asset, the entries are:
Dr Revaluation reserve: £1,700
Cr Deferred tax provision (B/S): £1,700
Care should be taken where the deferred tax relating to the fair value gain/loss or revaluation gain/loss is posted in the accounts because it is easy to get it wrong (particularly those firms which continue to recognise investment property fair value gains and losses in a revaluation reserve under FRS 102!).
Undue cost or effort exemptions
The September 2015 edition of FRS 102 is being subjected to the triennial review by the FRC and it is likely that a revised edition of the standard will be published either at the end of this year or very early next year. As noted in the first article, many entities are applying the undue cost or effort exemptions found throughout FRS 102 incorrectly – particularly the investment property one.
FRS 102 does not define ‘undue cost or effort’ (neither does IFRS for SMEs), but it is normally taken to mean that the cost of doing something outweighs the benefits.
The 2015 amendments to IFRS for SMEs saw the International Accounting Standards Board include more undue cost or effort exemptions in the standard, whereas the FRC is proposing to go the other way and remove several undue cost or effort exemptions as they are being incorrectly applied as accounting policy choices. The message here is to apply undue cost or effort exemptions (particularly the one in Section 16) with caution and ensure that, where they are applied, their use can be justified.
On-demand related party loans
It is fair to say that financial instruments in general are probably the number one gripe among practitioners at the moment. This is primarily because of the accounting treatment found in Section 11 Basic Financial Instruments (the amortised cost method).
In the introductory part of the article, reference is made to the Staff Education Notes for which a link is provided. SEN 16 Financing transactions is a good SEN to look at for additional reading around the amortised cost and effective interest method.
However, in terms of related party loans (such as an intra-group loan or a loan to a director from the company), these are usually unstructured loans; in other words, there are no formal loan terms between the lender and the borrower in existence.
Loans which do not have formal terms attached to them are deemed to be repayable on demand. There is usually no need to discount such loans to present values using a market rate of interest.
The issue to watch out for, particularly with intra-group loans, is where they have been presented in the balance sheet under old UK GAAP. If they are repayable on demand, they will need to be shown as a current asset in the lending entity’s balance sheet and a current liability in the borrowing entity’s balance sheet. Hence, where the parent of a small group has, for example, made a loan to its subsidiary which was previously presented in long-term liabilities because the directors had no expectation of it being paid in the foreseeable future, the subsidiary will need to reclassify the loan to current liabilities under FRS 102.
The parent would also reclassify the loan to debtors falling due within one year if it has presented the loan as a long-term debtor under previous UK GAAP. This would also apply to directors’ loans to the company that may have been presented as a long-term creditor under old UK GAAP.
Loans to a small company from a director-shareholder (not loans from a small company to a director-shareholder) are subject to the relief made available by the FRC in May 2017, which means they do not have to be discounted, even in the situation that the loan is formalised with an expected repayment date.
This also applies to loans made by a close member of the director-shareholder’s family to the small company. Many practitioners regard formalised loans from a director-shareholder to a small company as being rare, but do keep in mind that a small company can now have a turnover level of up to £10.2m and have a balance sheet total of up to £5.1m, so it is likely that formalised loans in a small company will be more common than under the previous thresholds, given that many medium-sized businesses have now dropped into the small companies’ regime.
Software and website development costs
Under previous UK GAAP, software and website development costs were usually capitalised as tangible fixed assets. Website development costs were also dealt with in a UITF Abstract – that of UITF 29 Website development costs. Usually, website development costs were capitalised if the website was able to generate revenue for the business (ie when the website had an ordering facility on it).
FRS 10 Goodwill and intangible assets stated that software development costs which were directly attributable in bringing a computer (or computer-operated machinery) into working condition for its intended use in the business were treated as part of the related hardware, ie as a tangible fixed asset.
FRS 102 contains no guidance where software and website development costs are concerned. It will, therefore, usually be appropriate to capitalise such costs as intangible assets unless they are closely related (directly attributable) to bringing specific hardware into operation, for example, an operating system.
Reclassifying existing software and website development costs from tangible to intangible assets on transition to FRS 102 is unlikely to occur in practice because the differences will be immaterial; this issue will more likely affect the future capitalisation of such costs.
Under IFRS, there is a fairly old SIC (Standing Interpretations Committee) interpretation which deals with website development costs, SIC-32, Intangible Assets – Website Costs. SIC-32 regards a website as an internally generated intangible asset which is subject to the requirements of IAS 38 Intangible Assets. Development expenditure on a website can be capitalised if, and only if, it can demonstrate meeting the criteria for recognition on the balance sheet (ie a reliable estimate of cost and the creation of a revenue stream for the business).
This principle is broadly consistent with previous UK GAAP in UITF 29. If the website is just advertising the business, in other words, a customer is not able to order goods or services directly from the website, SIC-32 requires all development expenditure to be recognised as an expense as incurred.
As we progress with FRS 102 into 2018, there are bound to be other areas of the standard which will give rise to uncertainties for practitioners. In complex cases, it is always advisable to run the issue through your professional body’s technical advisory department or a reputable training organisation to avoid any mistakes which may prove costly or embarrassing further down the line.
About Steven Collings
Steve Collings, FMAAT FCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd where Steve trained and qualified.