FRS 3: Reporting financial performance
Over recent years, there have been a few Any Answers posts relating to certain disclosures within the financial statements such as when ‘exceptional items’ are encountered and there is uncertainty as to how to disclose such items, explains Steve Collings.
This is the first of a series of several articles which will take a look at each FRS/SSAP/UITF and outline the fundamental principles contained in each standard with the intention of being a form of ‘refresher’ as to the principles contained in the various standards. This particular article will consider reporting financial performance in general to offer a reminder of some of the main issues that may crop up and how to deal with such issues.
Reporting financial performance
The standard which governs the way financial performance is reported is that of FRS 3 Reporting Financial Performance. The objective is outlined in paragraph 1 of FRS 3 which says:
‘The objective of the FRS is to require reporting entities falling within its scope to highlight a range of important components of financial performance to aid users in understanding the performance achieved by a reporting entity in a period and to assist them in forming a basis for their assessment of future results and cash flows.’ [FRS 3 paragraph 1]
The objective is to ensure that those with an interest in the company have sufficient information available to them in order to make judgements about the company’s performance as well as allowing them to form a basis for predicting future trends in the company’s performance.
FRS at paragraph 14 requires turnover and operating profit to be shown separately on the face of the profit and loss account and should be split between ‘continuing operations’, ‘acquisitions’ (as a component of continuing operations) and ‘discontinued operations’. An important point to understand is that accounting standards in UK GAAP only deal with material items, hence the requirement to disclose results of acquisitions will only apply if those results are material in aggregate (this also applies to discontinued operations).
Company A Ltd is preparing accounts for the year-ended 31 August 2012. On 1 May 2012 it sold a material operation to an unconnected third party.
Company A Ltd will restate the previous year’s comparatives so as to show the prior year’s results attributable to those operations as discontinued.
When a company prepares the profit and loss under Format 1 (turnover, cost of sales, distribution costs) these format headings should also be analysed between turnover and operating profit. However, this analysis can be shown within the notes to the financial statements as opposed to showing the analysis on the face of the profit and loss account, if so desired.
Formats one and two
The term ‘operating profit’ is described in FRS 3 as being normally the profit before income from shares in group undertakings and in Formats one and two operating profit is presented in different places. The following table illustrates where operating profit is typically presented under formats one and two:
|Format one||Format two|
|Cost of sales||Change in stocks of finished goods and work in progress|
|Gross profit or loss||Own work capitalised|
|Distribution costs||Other operating income|
|Administrative expenses||Raw materials and consumables|
|Other operating income||Other external charges|
|Operating profit or loss||Staff costs:(a) wages and salaries
(b) social security costs
(c) other pension costs
|Depreciation and other amounts written of tangible and intangible fixed assets|
|Exceptional amounts written off current assets|
|Other operating charges|
|Operating profit or loss|
FRS 3 requires four conditions to be met before an operation can be classified as discontinued:
- The sale or termination is completed either in the period or before the earlier of three months after the commencement of the subsequent period and the date on which the financial statements are approved
- If a termination, the former activities have ceased permanently
- The sale or termination has a material effect on the nature and focus of the reporting entity’s operations and represents a material reduction in its operating facilities resulting either from its withdrawal from a particular market (whether class of business or geographical) or from a material reduction in turnover in the reporting entity’s continuing markets
- The assets, liabilities, results of operations and activities are clearly distinguishable, physically, operationally and for financial reporting purposes. [FRS 3 paragraph 4]
When the Accounting Standards Board (ASB) produced FRS 3, they chose to deliberately use the term ‘discontinued’ operation as opposed to ‘discontinuing’. This was because the ASB acknowledged that there had to be a clear cut off point where an entity disposes of, or closes, a part of its operation. Had the ASB used the term ‘discontinuing’ there would have been more scope for entities to manipulate the financial statements. This could have been achieved if the reporting entity had, say, a loss-making division which it planned to discontinue, hence separating out the results of that division because the reporting entity planned to dispose of it in the future. This would then enable the reporting entity to focus on the profitable elements of the business.
Company B Limited has three divisions: (a) (b) and (c). Division (a) has suffered a decline in turnover and has become loss-making. The directors are in discussion about the possibility of discontinuing division (a) but at the year-end had not terminated the division. The accountant is proposing to show division (a) as a discontinuing operation in the financial statements.
The explanatory note to FRS 3 emphasises that income and costs relating to a sale or termination that has not been completed within the prescribed period after the year-end must still be included within the continuing category. The standard does, however, acknowledge that in some cases it may be appropriate to make separate disclosure in the notes to the financial statements the results of operations that, while not ‘discontinued’, are in the process of being discontinued and recognises that such disclosure will be a subdivision of continuing operations. The reason the explanatory material offers this presentation is that it is considered to enhance the predictive value of the company’s financial statements by presenting the results of operations that will not be in existence in the next financial year.
For the purposes of FRS 3, a discontinued operation must be material and must have a material effect on the nature and focus of the reporting entity’s operations. The standard also requires a discontinued operation to be clearly separable from the rest of the reporting entity’s operations.
What is important to emphasise where this is concerned is that a discontinued operation does not need to be a completely separate business segment for the purposes of SSAP 25 Segmental Reporting. This is an important point because whilst the operation has to be separate (as required in paragraph 4(d) to FRS 3), the operation need not be different.
Reporting profits and losses on sale
When an operation qualifies as discontinued and is sold, the results of the operation up to the date of sale must be disclosed as part of the normal profit and loss account, under the heading of ‘discontinued operations’. The resulting profit or loss on disposal should also be shown as an exceptional item after operating profit and before interest and should also be shown as a discontinued operation.
Company C Limited has two divisions (a) and (b). The company is preparing financial statements up to 30 June 2012. On 31 August 2012 it sold division (b). The accountant is proposing to bring forward all income and expenses relating to division (b) into the financial statements for the year-end 30 June 2012 as the sale occurred within three months after the commencement of the subsequent period.
Only the operating results up to the year-end 30 June 2012 can be included in the profit and loss account for division (b) and should be shown as a discontinued operation. In the financial statements to 30 June 2013, the operating results up to the date of sale (31 August 2012) will be shown as a discontinued operation in that year.
Paragraph five to FRS 3 defines an exceptional item as:
“Material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and which individually, or, if of a similar type, in aggregate, need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view.”
There are rules within FRS 3 which outline how exceptional items should be presented. There are three types of profit or loss which, when material, must be shown on the face of the profit and loss account after operating profit but before interest. They should also be described as continuing or discontinued. The Financial Reporting Review Panel (FRRP) has been known to challenge incorrect positioning of such exceptional items. The three types of exceptional items referred to here are:
(a) Profits or losses on the sale or termination of an operation
(b) Costs of a fundamental reorganisation or restructuring having a material effect on the nature and focus of the reporting entity’s operations
(c) Profits or losses on the disposal of fixed assets
If the above three are included before operating profit they would clearly distort the operating profit line and it is therefore important that professional accountants keep in mind the importance of correct presentation of such exceptional items.
The standard requires that where the net amount of (a) or (c) are not material, but the gross profits or losses are material, the relevant heading must still appear on the face of the profit and loss account with a reference to a related note analysing the profits and losses.
Clearly the three exceptional items shown above are not exhaustive and different situations may present different exceptional items. Other exceptional items (with the exception of those described in (a) to (c) above) should be shown within the statutory format headings to which they relate, so of course other exceptional items would be shown in arriving at operating profit. However, where this is the case paragraph 19 to FRS 3 requires separate disclosure by way of a note, or on the face of the profit and loss account in order that the financial statements give a true and fair view.
Note of historical cost profits and losses
When a company uses the revaluation model and there is a material difference between the result as disclosed in the profit and loss account and the results on an unmodified historical cost basis, reporting entities must include a note of the historical cost profit or loss for the period as required by paragraph 26 to FRS 3. This note must include a reconciliation of the reported profit on ordinary activities before taxation to the equivalent historical cost amount. The note should also show the retained profit for the financial year reported on the historical cost basis. An illustration of this concept is shown below:
Note of historical cost
Profits and losses
|Profit on ordinary activities before taxation||X||X|
|Realisation of property revaluation gains of prior years||X||X|
|Difference between the historical cost depreciation charge and the actual depreciation charge on the revalued amount||X||X|
|Historical cost profit on ordinary activities before taxation||X||X|
|Historical cost profit for the year retained after taxation||X||X|
Statement of total recognised gains and losses
In developing FRS 3, the ASB acknowledged that the statement of total recognised gains and losses (STRGL) was to be classified as a primary financial statement and therefore should be presented with the same prominence as the other primary statements. This is acknowledged in paragraph 27 to FRS 3. The ASB also confirmed that the STRGL was not a performance statement, but the objective of the STRGL is to bring together all items that affect shareholders’ funds.
Prior period adjustments
Prior period adjustments are accounted for by restating the previous period’s primary financial statements and associated notes and adjusting the opening balance of reserves accordingly. Such prior period adjustments are also shown within the STRGL. They are usually undertaken because of errors or omissions. However, FRS 3 refers to ‘fundamental errors’ and therefore such errors are only corrected by way of a prior period adjustment if they are considered to be ‘fundamental’. The term ‘fundamental error’ refers to those errors which are so significant that they destroy the true and fair view and hence the validity of the financial statements. Because of this definition, fundamental errors cannot be corrected in the current year and hence the correction must be applied retrospectively. The opening balance of reserves should also be adjusted to recognise the correction. In addition, the cumulative adjustment should also be noted at the foot of the current period’s statement of total recognised gains and losses.
Fundamental versus material
A fundamental error goes beyond that of a material error because the standard recognises that such errors destroys the true and fair view and gives rise to a set of financial statements that are misleading. In real life, such errors are relatively rare. Paragraph 60 to FRS 3 recognises that the majority of items relating to prior periods arise mainly from the correction and adjustments that are as a result of estimations inherent in the world of accounting. As a result, errors that are not fundamental, but are mainly corrections of prior period estimates are corrected in the financial statements in the period in which they are discovered and where such errors are deemed to be material, the effect of such correction should also be disclosed.
The standard recognises that such errors are not exceptional or extraordinary items simply because they relate to a prior period – what will determine their classification is the nature of the error.
Clearly FRS 3 is an important standard and one which has the potential to lend itself to a degree of misinterpretation. This article has not covered every single aspect of FRS 3, but has merely pulled out some of the more important concepts contained within the standard.
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.