Compare the accounting principles in the uk the us and iass

Next, any financial instrument IAS or security US held for tradingpurposes, and all derivatives other than those held as certain hedges, are stated at fair value withthe resulting adjust

Global accounting

UK, IAS and US compared

UK, IAS and US comparedGlobal accounting

1 Executive summary

2 Introduction

3 Regulatory background

3.1 Generally accepted accounting principles

3.2 Legal and listing requirements

4 Financial statement requirements

4.1 Form of the financial statements

4.2 Comparatives

4.3 Audit reports

4.4 Accompanying financial and other information

5 General issues

5.1 Classification and presentation within the financial statements

5.2 Prior period adjustments and other accounting changes

5.3 Statement of cash flows

5.4 Basis of accounting

5.5 Reporting the substance of transactions

5.6 Consolidation

5.7 Business combinations

5.8 Foreign currency translation

5.9 Hedging

5.10 Interim financial reporting

6 Specific balance sheet items

6.1 Intangible assets

6.2 Fixed tangible assets

6.3 Capitalisation of interest

6.4 Impairment of fixed assets other than investments

6.5 Investments in associates and joint ventures

6.6 Other investments and financial instruments

6.7 Stock

6.8 Debt instruments

6.9 Leases

6.10 Product financing arrangements

6.11 Tax provisions

6.12 Other provisions

6.13 Contingencies

6.14 Capital & reserves, or shareholders’ funds

7 Specific profit and loss account items

7.1 Revenue

7.2 Advertising costs

7.3 Non-monetary transactions

7.4 Holiday pay

7.5 Pensions and other post-retirement benefits

7.6 Other post-employment benefits

7.7 Other long-term employee benefits

7.8 Employee share purchase and option schemes

7.9 Exceptional items

7.10 Sale or termination of an operation & discontinued operations

7.11 Sales of property

7.12 Imputation of an interest cost

1 8 10 10 11 14 14 15 15 16 18 18 22 24 27 29 33 36 46 51 58 60 60 66 69 71 76 80 87 88 93 96 97 103 108 111 116 116 118 119 120 121 126 128 129 134 136 139 141

This book has been prepared to assist clients and others in understanding the differences of

principle between accounting standards and the accounting requirements of company law in the

United Kingdom, generally accepted accounting principles in the United States and accounting

standards and other pronouncements of the International Accounting Standards Committee

Whilst care has been taken in its preparation, reference to the standards, statutes and other

authoritative material should be made, and specific advice sought, in respect of any particular

transaction No responsibility for loss occasioned to any person acting or refraining from action

as a result of any material in this publication can be accepted by any member of KPMG

International

ISBN 1 85061 2560

© 2000 KPMG International, a Swiss association All rights reserved Printed in the

Netherlands

KPMG and the KPMG logo are trademarks of KPMG International

No part of this publication may be reproduced, stored in any retrieval system or transmitted in

any form by any means, electronic, mechanical, photocopying, recording or otherwise, without

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Designed and produced by Mattmo concept & design, Amsterdam

Printed by Drukkerij Dombosch, Raamsdonklsveer

1 Executive summary

Introduction

Despite having a great deal of common purpose and common concepts, the accounting principles in the UK and the US and under International Accounting Standards (IASs) can lead

to markedly different financial statements This is not merely of academic interest In the global market for capital, the differences need to be understood and, eventually, eliminated

This book examines, but not exhaustively, those areas of UK, IAS and US requirements most frequently encountered where principles, or their application, differ

Regulatory background

The overriding requirements for a UK company’s financial statements is that they give a ‘true and fair’ view Accounting standards are an authoritative source as to what is and is not a true

and fair view, but do not define it unequivocally Ad hoc adaptations to specific circumstances

may be required Moreover, if, rarely, following the requirements of standards would fail to give

a true and fair view, those requirements must be departed from to the extent necessary to give

a true and fair view Under IAS the situation is very similar In the US however, financial statements are more closely tied into the rule-book by the requirement that they be prepared in accordance with GAAP

General issues

Substance

The ‘true and fair’ approach is typified by the UK standard that requires transactions to be accounted for in accordance with their substance Whilst the real targets of this requirement were the (now defunct) off balance sheet finance schemes, it is significant that the way in which this has been achieved is by a highly conceptual standard Assets and liabilities are defined and attention is directed toward analysing probable changes in benefits, risks and obligations in order to determine the substance - the so called risk-and-rewards approach In contrast, the US deals with similar issues by detailed prescription for each type of transaction, eg leasing, product financing, sale of properties or transfers of financial assets and those prescriptions do not necessarily follow a risks-and-rewards approach, for example transfers of financial assets are on the so-called financial components basis (see below) As a general principle IASs follow the risk-and-rewards approach but have rather less guidance as to how this might be carried out;

and in the case of transfers of financial assets they follow the American components approach

Revaluation

Having established that an asset exists, the IAS and British bases of measurement can be fundamentally different from that of America In Britain and under IASs certain classes of assets, principally but not solely property, may be revalued provided that this is done consistently and the valuations are kept up to date In America the historical basis must be retained (aside from certain financial instruments)

Business combinations

Business combinations are often a source of accounting issues A few, important differences remain between the three GAAPs Both IAS and the UK include a size test in their uniting/

pooling-of-interests (merger) criteria; the US does not As a result, pooling-of-interests accounting is comparatively common in the US but not in the UK or under IAS When

7.13 Extraordinary items

7.14 Dividends

7.15 Earnings per share (EPS)

8 Specific major disclosure items

8.1 Segmental reporting

8.2 Disclosures about financial instruments

8.3 Related party transactions

Appendices I Common differences in accounting terminology

II Common accounting abbreviations

142 143 144 148 148 151 158

160 164

For many years perhaps the most significant differences between the three approaches lay in thearea of intangibles In the US, the long standing treatment of (positive) goodwill is the same asfor any other acquired intangible Such assets must be capitalised and subsequently amortisedover their expected useful lives which may not exceed 40 years (although there are someproposals to modify this) Before 1998 in the UK and before 1995 under IASs, (positive)goodwill could be written off directly to shareholders’ funds and usually was This has nowchanged and (positive) goodwill must be capitalised in both regimes However, it should not beoverlooked that both sets of transitional rules permit the old goodwill to remain in shareholders’

funds

A new set of differences now arises in respect of amortisation of (positive) goodwill andintangibles Under IASs the life is usually limited to 20 years but this may be rebutted and alonger, but finite period may be used In such a case annual impairment testing of the (positive)goodwill or intangible is required The UK approach is very similar save that it is permitted forthe life even to be indefinite

In addition, the US rules prohibit the carrying of development costs as an asset In the UK theymay, at the company’s option, be carried as an asset if certain conditions are satisfied Under

IASs they must be carried as an asset, again if certain conditions are met.

Fixed tangible assets (property, plant and equipment)

As mentioned above, this is the principal category of assets subject to optional revaluation in

Britain and under IASs However, in Britain one category of asset - investment properties - must

be revalued Moreover, these investment properties must not be depreciated because of theirspecial purpose IASs take a different approach to investment properties From 2001 they neednot be depreciated, in which case they must instead be stated at market value with changes

therein flowing through the profit and loss account In the US all property other than land must

be depreciated but not be revalued

The US also requires interest to be capitalised during the period of an asset’s being made readyfor use Under IASs and in the UK this is optional

Impairment

The existence of an impairment is judged differently by the US on the one hand and the UK andIASs on the other The US considers that an asset is impaired only if its book value exceeds theundiscounted cash flows expected to be obtained from its use If that is the case then it is written

down to its fair value, which may be the present value of those cash flows (if fair value cannot

be determined in other ways) Under both IAS and UK principles recognition and measurementare consistent: an impairment occurs when and to the extent that the book value exceeds thehigher of the net realisable value and the present value of the cash flows expected to arise fromthe continued use of the asset

The US does not permit any subsequent reversal of the impairment Both IASs and the UK dopermit reversal but in respect of goodwill (IAS) and goodwill and intangibles (UK) There aresome restrictions on this

Associates and joint ventures

Under US GAAP there is no accounting distinction between associates and joint ventures: bothare equity accounted Under IASs certain types of joint venture may, optionally, beproportionately consolidated In the UK joint ventures may not be proportionately consolidated,

such restructurings may increase the goodwill

In addition, where the fair value of the acquired assets and liabilities is greater than the pricepaid - negative goodwill - the US rules require the non-current asset fair values to be reduced

to eliminate the difference and thereafter a deferred credit arises for any remaining differenceand is amortised over up to 40 years The UK records negative goodwill as a separatelydisclosed deduction from positive goodwill and amortises it in line with depreciation and sale

of the acquired non-monetary assets Any remainder is taken to the profit and loss account inthe periods expected to benefit The IAS approach involves a similar presentation but therelease to the profit and loss account is as follows: first, to match any costs that it has beenidentified with; then to match and to the extent of the depreciation of acquired non-monetaryassets; and any balance thereafter is taken immediately to income

Foreign currency translation

The translation of foreign currency financial statements of foreign operations throw up someimportant differences All use the closing rate/ net investment method but in the UK the profitand loss account may be translated at either the average or the closing rate Some companies dochoose the latter Under IASs and in the US the actual, or an average rate, must be used

Moreover, under IASs it is a matter of choice as to whether to include capitalised goodwill andfair value adjustments as part of the retranslated net investment, whereas in the UK and US theyare always included

Lastly, under IASs and US GAAP the cumulative translation adjustment on a net investment isrecycled through the profit and loss account on disposal of the net investment In the UK there

is no recycling

Hedging

Both IASs and US GAAP have comprehensive standards on hedging; the UK does not Some ofthe differences in approach here are typified by the case of a hedge of a future transaction, whichcan be either a contracted future transaction or a forecast one In the UK the hedge would usually

be held off balance sheet until the transaction occurs, the transaction then being stated on thehedged basis Under IASs the cash flow hedging model is applied to this hedge: the hedge is stated

at fair value with the resulting adjustment, so far as it is an effective hedge, taken directly to equity;

it is held there until the transaction occurs when it is then recycled out to adjust the transaction(either affecting the profit and loss account immediately or adjusting the cost of the purchasedasset as appropriate) The US uses the cash flow hedging model for hedges of forecasttransactions; however, the gains and losses initially taken to equity are not recycled into the cost

of the hedged purchased asset (if that is the case) but are instead recycled into the profit and lossaccount to match the cost of the asset as it flows through, eg as it is depreciated Where the futuretransaction is a contracted one the US uses the fair value model: the hedge is stated at fair valuewith the resulting adjustment flowing through the profit and loss account; the hedged item, in thiscase the contract, is stated at fair value to the extent hedged with the resulting adjustment flowingthrough the profit and loss account (IASs also use the fair value model for some hedges.)

1 Executive summary

2

gain or loss is required to be treated as an extraordinary item The IAS guidance is somewhatmore brief, and the UK guidance very much so, but for all practical purposes neither permitsclassification as extraordinary

Deferred tax

Under UK principles deferred tax is provided in respect of timing differences - differencesbetween the timing of inclusion of items in accounting and in taxable profit The IAS and USprovisions are in respect of the rather different, wider concept of temporary differences Theseare the differences between the balance sheet carrying amounts of assets and liabilities andthose carried in the tax computation The purpose is to provide for the tax arising on therecovery of each asset (or settlement of each liability) at book value whether that recovery isthrough use, realisation or whatever

Furthermore, in the US and under IAS, provision is made in full for all liabilities (and for assetsbut subject to a recoverability test) In the UK the provision is only for that element of the fullpotential liability that will probably crystallise In determining this ‘partial provision’, account

is taken of the effect of future transactions (eg, capital expenditure) on the deferral, perhapsindefinitely, of crystallisation of the tax relating to past timing differences However, the UK’spartial provision approach looks set to change towards full provision

Other provisions

The UK and IASC standards on provisions are virtually identical, as IASC based its standard

on the UK one They provide comprehensive frameworks for provisions, whereas the US doesnot One of the main UK and IASC principles is that all restructuring costs are provided on thebasis only of a commitment resulting from some form of external action; the same applies inthe US as regards redundancy costs, but other costs are still provided on a decision-basis Onthe other hand, the US prohibits provision for voluntary redundancies until an employee hasaccepted the invitation Under UK and IAS standards provision is made for the expected take

up once the terms have been announced

Decommissioning costs are another specific area of difference In the UK and under IAS thecost of necessary decommissioning of a plant or facility is made, on a discounted basis, whenthe plant is constructed and is charged as part of its cost (and then depreciated) In practice inthe US such costs are usually spread over the plant’s life on an undiscounted basis A furtherspecific area is repairs and maintenance The UK and IAS prohibit provision for themaintenance of own assets, but the US does not

Purchase of own shares

It is a permitted, and not uncommon practice, for US companies to hold their own shares astreasury stock Such shares are shown as a deduction from stockholders’ equity (shareholders’

funds); IASs require the same treatment Under UK law a company cannot formally hold itsown shares without cancelling them Nevertheless companies may hold such shares insubstance in connection with employee share option schemes Such shares are shown as an asset

in the balance sheet (usually a fixed asset)

Specific profit and loss account items

Defined benefit pensions and similar

The current UK standard is quite different from those of the US and IAS The UK approachcould be termed actuarial: it uses valuation assumptions, for both assets and liabilities, that look

to the long-term outcome The US and IASs use current market rates for high quality corporatebonds to discount the obligation and use market values for the assets (although in the US certain

although the equity accounting is expanded somewhat to give a similar effect in the profit andloss account It is also worth noting that the US and IASs presume a 20% investee to be anassociate whereas the UK has no such presumption but more closely defines ‘significantinfluence’ In addition, IASs distinguish between types of joint venture on the basis of legalform, whereas the UK uses substance

Financial instruments

Comprehensive standards in this area are a recent innovation IASs and US GAAP have them;

the UK does not The IAS and US standards are very similar They have three differenttreatments for financial instruments (other than hedges, for which see above) One is amortisedcost This is reserved firstly for a very restricted class of assets for which there is the positiveintention and ability to hold it to maturity It also applies under IAS to any loan or receivableoriginated by the company, or in the US to any non-marketable equity securities and any debtsthat are not securities Next, any financial instrument (IAS) or security (US) held for tradingpurposes, and all derivatives other than those held as certain hedges, are stated at fair value withthe resulting adjustments taken to the profit and loss account Lastly, any asset (US – a security)not fitting in the other categories is known as ‘available-for-sale’ These are stated at fair valuealso In the US the fair value adjustments are taken to shareholders’ funds (through othercomprehensive income) and are recycled into the profit and loss account when the item is sold

Under IASs a company may choose to use the US treatment for the fair value adjustments or totake them immediately to the profit and loss account

In the UK market-makers, for example, mark their financial instruments to market through theprofit and loss account but otherwise investments are usually held at amortised cost

Investments may be revalued but the resulting adjustment goes directly to shareholders’ fundsand is not recycled

The UK does, however, have a standard dealing with transfers of financial assets An asset isderecognised on a substance basis, ie only if all significant risks and rewards of the assets aretransferred If credit risk is retained then the asset remains on the balance sheet Under the USand IAS financial components approach, however, a credit risk component would be retained toportray the credit risk but the rest of the asset would be taken off the balance sheet

Stock (inventory)

In Britain the LIFO method of establishing the cost of stock would rarely be appropriate; inAmerica and under IASs it is acceptable

Debt

Where a company’s own shares contain an obligation, as for example some preference shares

do, IASs classify them as debt In the UK they would be classed as shareholders’ funds, albeitthe ‘non-equity’ element thereof Under US GAAP there is ‘mezzanine’ level shown separatelyfrom both debt and shareholders’ funds; preference shares whose redemption is not controlled

by the company are reported at this level

Where an instrument contains both debt and equity-share characteristics, for exampleconvertible debt, IASs split the two elements and report them as debt and shareholders’ fundsrespectively In the UK and US this is only done if the equity element is actually separable

There are also differing treatments for the maturity classification of debt Under IASs and USGAAP a short-term debt can be reclassified as long-term on the basis of a post-balance sheetlong-term refinancing This is not possible in the UK

The US rules provide copious guidance on the extinguishment of debt and in many cases any

speaking, the management approach is used to identify the segments but the UK approach is used

to report figures for them In addition, under IAS the amounts disclosed include gross assets andliabilities, depreciation and cash flow information; none of these is given in the UK; in the USgross assets are required and other items may be required depending upon the internal reporting

Financial instruments

All three GAAPs have plentiful disclosure requirements for financial instruments However, thereare a number of differences between them First of all, the UK has a wide requirement to makequalitative disclosure of the objectives, policies and strategies for holding or issuing financialinstruments The SEC requirement in the US is very similar Under IASs the equivalent disclosure

is in relation only to instruments held for risk management

IASs require disclosure for all financial instruments of the terms and conditions, which may includenotional principals, maturities, amount and timing of future cash payments etc In the UK there are nogeneral terms and conditions disclosures at all In the US this sort of disclosure is similar to the

‘tabular’ options for dealing with market risk (the other two options are sensitivity analysis and at-risk) Further, the US requires separate disclosure about four components of market risk: interest,currency, commodity and other market risk, such as equity price risk The UK has requirements forinterest and currency but only encourages other market price risk disclosures IAS has specificrequirements only for interest risk and otherwise other market risks are dealt with only by the generalterms and conditions disclosures (which would have some similarities with the US tabular option)

value-The UK does not require any disclosure of credit risk On the other hand US GAAP calls fordisclosure of concentrations of credit risk IASs go further and require all credit risk, as well asall concentrations thereof, to be disclosed

Lastly on financial instruments, the UK requires disclosures about unrecognised or deferredgains and losses on all hedges other than of net investments in foreign entities Under US GAAPand IASs the equivalent requirements apply only to cash flow hedges, which are used, forexample, for hedges of future transactions whether contracted or uncontracted in the case of IASand, for example, for hedges of forecast (eg, future uncontracted) transactions in the US

Future developments

In all three GAAPs a number of areas of accounting practice are under review, although havingemerged from a period of intense standard setting there is perhaps less just over the horizon than

is usual Those that are under review are quite major areas

In some instances the UK proposals would, if carried through to future standards, narrow butnot eliminate some areas of difference with the US and IASs First, it is proposed that deferredtax will remain on the timing differences basis but will move towards full provision Second,after drawn out debate it looks as though the measurement principles for pensions will bealigned with IASs; however there will be no spreading at all - the whole change in value will

go onto the balance sheet immediately but with the other entry split between the profit and lossaccount and the statement of total recognised gains and losses (other comprehensive income)

In the US also, some of the proposals would also narrow the differences At present it is fairlycommon for US business combinations to use pooling/ uniting-of-interests (merger)accounting, whereas it is comparatively rare under UK and IAS principles The FASB proposes

to prohibit the method entirely The IASC is monitoring US developments and may re-examinethis area The FASB has also proposed that the maximum life of goodwill should be reduced to

20 years However, other intangibles might in some cases have longer lives, even indefinite lives

if there is an observable market price for the intangible

or instead any faster, systematic recognition method may be used

The cost of employee share schemes

Where an employee is awarded a share option the cost to the company is based, in the UK, onthe intrinsic value (the difference between the option exercise price and the share’s market price)

at the grant date In the US the cost may be based either on intrinsic value at a measurementdate that may be later than the grant date, or on the fair value of the option itself (It should benoted that in both countries, if certain conditions are met, no intrinsic value-based cost at all isaccrued.) IASs have no rules on share-based remuneration

Sale or termination of an operation and discontinued operations

The US definition of a discontinued operation is more narrowly drawn than that of the UK; that

of IASs is between the two In addition, a major difference arises in the presentation ofdiscontinued operations In the US the post-tax results are presented as a single line itempositioned immediately before extraordinary items Furthermore, the assets and liabilities of theoperation are presented as a single net amount in the balance sheet In the UK the revenues,expenses, assets and liabilities remain in their normal locations in the accounts The results ofthe discontinued operation are separately identified but only by analysis, on the face of theprofit and loss account, of the turnover and operating profit of the whole group into continuingand discontinued elements The assets and liabilities are not identified The IAS requirementsare similar to those of the US insofar as they require all profit and loss account items down toprofit after tax, and assets and liabilities, to be attributed to discontinued operations However,

it is not clear whether the US single line item presentation is possible under IAS; and, in contrast

to the UK, amounts so attributed may be given in the notes rather than on the face

So far as provisions for sales or terminations of operations are concerned the US rules requireprovision for a discontinued operation to be made on a decision-basis IAS and the UK require

a commitment basis, whether the sold or terminated operation is a discontinued one or not

When provision is made the UK and US approaches include certain operating losses in thatprovision, but under IAS they may not be included

Dividends

In the UK a dividend declared after the year end, but in respect of the year just ended, isaccounted for in that previous year In the US and under IAS such a dividend would be dealtwith in the year of declaration

Specific major disclosure items

Segmental reporting

Rather different approaches are taken by the three for segmental reporting In the UK segmentsare distinguished from one another by their differing risks and returns and the amounts reportedtherefor are analyses of the relevant figures as stated in the financial statements By contrast, the

US uses the management approach whereby the company is split into segments in line with theinternal reporting structure, whatever that may be Moreover, the amounts reported are the

1 Executive summary

6

constitutional arrangements for setting IASs have been put in place in order to improve boththat process and the relationship with national standard setters and others Where these reviewsand new arrangements will in practice leave the balance between IASs and national standards,such as those of the UK and US, is difficult to predict If US endorsement is slow in comingthen IASs may be marginalised But there might then develop a powerful IAS-bloc, perhapscentred on the European Union, including the UK, to rival the other standard setters’ power-bases The European Commission is already proposing, again with some qualification, thatIASs become mandatory for listed European companies On the other hand, the IAS table mightbecome the place where national standard setters thrash out agreed treatments to be put intotheir own national standards and into IASs Or IASs might even become the single global super-code replacing national standards altogether – indeed, this is the only rational long-termobjective.

Notwithstanding this hurly-burly, none of UK, IAS or US standards will disappear overnight

Important differences between them, and the need to cope with them, will remain for someyears to come

This book describes the significant differences between accounting principles followed in the

UK, under IASs and in the US It is not a complete listing; rather it is a summary of those areasmost frequently encountered where the principles differ or where there is a difference inemphasis between the three Furthermore, it does not address accounting in specialisedindustries, for example banking and insurance It looks first at the regulatory background and

at general requirements and issues before turning to specific matters affecting the balance sheet,the profit and loss account and finally major disclosure matters The comparison is effected byexamining the UK principles in the left-hand column, those of IASs in the middle and those ofthe US on the right As far as possible then, the requirements of the three frameworks dealingwith the same circumstances are set out side-by-side The narratives use the terminology of the

UK, IASs or the US as appropriate A table of common differences in terminology is provided

in Appendix I In addition, the narratives usually refer to the reporting entity, for the sake ofconvenience, as being a company However, the terms ‘entity’, ‘enterprise’ or ‘undertaking’ areused where the context requires it (eg, where an ‘entity’ is a quasi-subsidiary) References to thesources of the accounting requirements or practices are included in the headings or sub-headings as appropriate The key to these and other abbreviations is set out in Appendix II USreferences which comprise a letter followed by a number (eg, B50 for business combinations)

are to the section of the Current text (a condensed version of the requirements of the standards

ordered by subject and issued by the FASB) with that same reference The last standards which

were taken into consideration in writing this book were FRS 16 (Current taxation) in the UK, IAS 40 (Investment property) and the US’s SFAS 138 (Accounting for certain derivative

instruments and certain hedging activities - an amendment of FASB Statement No 133); the text

reflects the latest standards even though some of them are not yet mandatory

The matters referred to in this book are complex Legislation, accounting standards and otherauthoritative material are, of course, subject to change Accordingly, professional advice should

be sought before acting on, or refraining from acting on, any material in this book

2 Introduction

As this book rolls off the presses, the course of international accounting harmonisation hasreached a defining but as yet unclosed chapter in its history There will soon crystallise intoreality the international relationship between different standards, and their standard setters, formany years to come Before looking forward to that, the progress to date should not beoverlooked The force that drove it, and continues to do so, can be stated in three words: globalcapital markets

Both Britain and America have long histories of exchange traded equity investment by thepublic and their accounting has developed to report companies’ activities from this perspective

As the capital markets become increasingly global other countries that have hitherto used, say,the perspective of the tax authorities or lenders as their accounting model, have found that toparticipate in the market they need to adopt its perspective At the same time globalisationdemands that the various versions of that perspective come closer together, if not becomereplaced by a single version Here International Accounting Standards, IASs, join the story

IASs are another version of that Anglo-Saxon model But with the world as their constituencythey have the potential to achieve more widespread acceptability than other versions In so

saying, one cannot but recognise that these three are indeed different versions of the same basic

model The apparently common language of the capital markets has marked differences whenput into effect by these three proponents Why should this be so?

There are probably many factors at work On the cultural side, the US puts the emphasis onconsistency between companies and, combined with a traditionally litigious environment, thistends toward the formulation of accounting rules for almost all conceivable circumstances Inthe UK and under IASs the drive has been towards a few principles (although the detailed ruleapproach has made a modest showing of late) and a more pragmatic approach Moreover, theBritish and IAS standard setting processes started only in the 1970s - America had somethinglike a 30 year head start The result is that in the US there is very little scope for alternativetreatments, whilst a range of detailed adaptations of the principles to specific cases is oftenpossible in the UK On the academic side there are the intractable accounting problems, such asdeferred tax - is it really a liability and if so how much should be recognised? There are varioussolutions to the intractables but no one solution is without its drawbacks The result is thatdifferent nations opt for different drawbacks just as much as they opt for different solutions

IASs are perhaps mid-Atlantic In some areas the UK approach is favoured, for example the trueand fair view and, usually, substance; in others the US approach is adopted, for example thecomponents approach to financial asset transactions

However, the gap between the GAAPs has narrowed of late IASs have undergone a period ofoverhaul, eliminating many of the optional treatments; the UK has changed to deal with some

of the intractables, for example goodwill, by accepting largely the same drawbacks as others do;

and in the US there has even been recognition that its standards are not the most rigorous when

it comes to the availability of pooling (merger) accounting Moreover, the standard setters indifferent countries have co-operated on issues such as the overhaul of earnings-per-sharestandards So there is cause to hope that there might be less divergence in the use of thecommon concepts

Looking forward, whilst IASs have received endorsement, albeit somewhat qualified, from theInternational Organisation of Securities Commissions (IOSCO), significantly they await theresults of a review by the US Securities and Exchange Commission that may bring about a gooddegree of endorsement for their use in the US by non-US registrants And lately, new

3 Regulatory background

3 Regulatory background

3.1 Generally accepted accounting

principles

The term ‘generally accepted accounting principles’

has no formal meaning in the UK The term

‘generally accepted accounting practices’ (GAAP)

is used informally in the UK to denote the corpus of

practices forming the basis for determining what

constitutes a true and fair view: that is, broadly,

accounting standards and, where relevant, the

accounting requirements of company law and The

Listing Rules of the Financial Services Authority

Accounting standards are applicable to the accounts

of a reporting entity that are intended to give a true

and fair view (see 3.2 below) of its state of affairs at

the balance sheet date and of its profit or loss for the

financial period ending on that date The

development of such standards is overseen by the

Financial Reporting Council (FRC), a body

representing a wide constituency of interests Its

function is primarily to guide the Accounting

Standards Board (ASB), its subsidiary body, on its

work programmes and issues of public concern The

ASB does the work of developing, issuing and

withdrawing accounting standards Such standards

developed and issued by the ASB are known as

Financial Reporting Standards (FRSs); the standards

issued by the ASB’s predecessor body, and which

3.1 Generally accepted accounting principles

(IAS 1, SIC 18)

Under IASs there is no formal term ‘generallyaccepted accounting principles’ (or ‘practices’),although ‘GAAP’ may occasionally be used tosignify the whole body of IASC authoritativeliterature

The sources of such accounting requirements arethe International Accounting Standards (IASs)themselves and interpretations thereof made by theIASC’s Standing Interpretations Committee (suchpronouncements being known as ‘SICs’) Whenthese sources do not cover a particular issue then

the IASC’s conceptual framework, Framework for

the preparation and presentation of financial statements (the Framework), should be consulted.

If that does not provide guidance then it ispermitted to look to the pronouncements of otherstandard setting bodies (eg, the UK’s ASB and theUS’s FASB) and to accepted industry practice,provided that conflicts with neither IASs, SICs northe Framework

IASs sometimes include optional treatments One

is designated the Benchmark Treatment and theother is designated the Allowed AlternativeTreatment For each such choice a company should

3.1 Generally accepted accounting principles

The principal sources of generally acceptedaccounting principles (GAAP) are Statements ofFinancial Accounting Standards (SFASs) issued bythe Financial Accounting Standards Board (FASB)together with Accounting Research Bulletins(ARBs) and Accounting Principles Board Opinions(APBs) which were issued by predecessor bodies ofthe FASB The FASB is the designated organisation

in the private sector for establishing financialaccounting and reporting standards Its board iscomposed entirely of full time members It alsoissues Interpretations (to clarify, explain, orelaborate on existing SFASs, ARBs or APBs) andTechnical Bulletins (to address issues not directlycovered by existing standards) US pronouncementsare issued sequentially They are not withdrawn butmay be revised or superseded by subsequentpronouncements

The FASB publishes each year the updated

Original pronouncements and the Current text The

former contains the original text of all FASBpronouncements, Interpretations and TechnicalBulletins presented in sequential order The

latter is a reorganised version of the Original

3 Regulatory background

have been adopted or amended by the ASB, are

known as Statements of Standard Accounting

Practice (SSAPs) The ASB is composed of two

full-time and eight part-full-time members

A committee of the ASB, known as the Urgent

Issues Task Force (UITF), assists the ASB in areas

where an accounting standard (or a Companies Act

provision) exists, but where unsatisfactory or

conflicting interpretations have developed or seem

likely to develop In these circumstances the UITF

will seek a consensus as to the appropriate

accounting treatment The ASB publishes abstracts

of the UITF’s consensuses (known informally as

‘UITFs’) which are considered to be part of the

body of practices forming the basis for determining

what constitutes a true and fair view

3.2 Legal and listing requirements

(CA 85, UITF 7, The Listing Rules)

Significant difference

The overriding requirement is for the financial

statements to give a ‘true and fair view’.

The Companies Act 1985 sets out the accounting

requirements for companies The overriding

requirement is for the accounts to give a true and

fair view of the company’s (or group’s) state of

affairs as at the balance sheet date and of the profit

or loss for the financial period ending on that date

apply the Benchmark or Allowed Alternativeconsistently

IASs are developed and issued by the board of theIASC, which was hitherto composed entirely ofpart-time members The board has now beingreconstituted to become composed of twelve full-time members and two part-time members, all ofwhom will be appointed by the trustees of an IASC,itself newly constituted as an independentfoundation SICs are developed by the StandingInterpretations Committee, a sub-committee of theIASC, and are approved by that committee and bythe board SICs are intended to give guidance incases when IASs are unclear or silent

3.2 Legal and listing requirements

pronouncements are not withdrawn nor(necessarily) revised as they are affected bysubsequent publications, it is usually advisable to

consult the Current text rather than the Original

pronouncements The Original pronouncements do,

however, contain background information and thebasis for the FASB’s conclusions which may bevaluable to a reader unfamiliar with the relatedconcepts or accounting treatments

Further accounting guidance is provided byconsensuses of the FASB Emerging Issues TaskForce (EITF) and Statements of Position, IssuesPapers and Industry Audit and Accounting Guidesissued by the American Institute of Certified PublicAccountants (AICPA)

3.2 Legal and listing requirements

(Securities Act 1933, Securities Act 1934)

Significant difference

The main requirement is for (domestic companies’) financial statements to be prepared in accordance with US GAAP.

In general, only those companies which areregistered with the Securities and ExchangeCommission (SEC) are under any legal obligation topublish audited financial statements Certain othercompanies may publish audited financial statementsdue to other regulatory requirements (for example

3 Regulatory background

A ‘true and fair view’ is not defined but for a

combination of reasons, including the authorisation

of the ASB to issue accounting standards under the

Act, it is generally accepted as requiring compliance

with applicable accounting standards - indeed the

ASB has received, and published, legal opinion to

this effect However, since the ‘true and fair’

requirement is an overriding one, companies must

depart from any specific accounting practices

prescribed by law or by standards if those practices

would fail to give a ‘true and fair view’ in the

particular circumstances and to adopt some

alternative that does give such a view Such

circumstances are expected to occur only rarely and

when they do a company is required to disclose the

particulars of the departure (the prescribed

treatment that would fail to give a true and fair view

and the alternative adopted), the reasons for it (why

the prescribed treatment would so fail) and its

effect

The Act sets out the detailed requirements for all

companies to prepare accounts, prescribes their

form and content, prescribes the requirements for

audit and requires publication of the accounts to

shareholders and others including their filing on

public record with the Registrar of Companies

There are some derogations of the rules for

accounting disclosure and for filing by small and

medium sized companies (as defined) and, for

certain very small companies (as defined), there is

an exemption from the requirement for audit

Significantly, the Act provides for the Secretary of

State (for Trade and Industry) to enquire into

accounts where it appears that the requirements of

the Act - including the ‘true and fair’ requirement

and thus requirements of accounting standards

-might have been breached Where such accounts do

work to bring about convergence of IASs andnational accounting standards The IASC itself has

no power to require companies to adopt itsstandards, although some countries may permittheir companies to do so (as an alternative tonational standards) or may require it by importingthe standards wholesale However, any companyclaiming compliance with IASC standards mustcomply with all IASs and all SICs

Similarly to the UK, the overriding requirement isfor a fair presentation, which is not defined Thuscompanies must depart from the specificprovisions of standards in order to give such a viewwhen to do otherwise would not In these

‘extremely rare’ cases, disclosures similar to thoserequired in the UK are to be given

The IASC does not carry out any inquiry orenforcement role regarding the application of itsstandards

In addition, accounts prepared under IASCstandards often contain supplementary informationrequired by local statute or listing requirements

banks) The financial statements of domestic SECregistrants must be prepared in accordance with USGAAP and in conformity with other SECregulations regarding accounting and disclosures,and form part of the Annual Report on Form 10-Kfiled on public record with the SEC Foreignregistrants are required to prepare and file theirAnnual Report on Form 20-F, in accordance eitherwith US GAAP or with foreign GAAP includingreconciliations to US GAAP, and which is similar toForm 10-K In addition to 10-K and 20-F filings,SEC registrants must make regular filings ofadditional financial information

Many companies which are not required to registerwith the SEC include the additional accounting anddisclosure requirements imposed on SECregistrants

In addition to the SEC various other regulatoryorganisations, such as the GovernmentalAccounting Standards Board and the Office ofThrift Supervision, issue accounting and reportingrequirements relevant to entities within theirjurisdictions

Forms 10-K and 20-F are periodically reviewed bythe SEC for compliance with GAAP (including thelocal GAAP of a foreign registrant) and otherrelevant regulations The review findings arecommunicated by private comment-letters to thecompany Significant inadequacies can lead to re-issue of prior year financial statements Lesserproblems may be dealt with by amended currentyear filings or improved disclosures in futurefinancial statements

3 Regulatory background

appear to be defective he may require the directors

to revise the accounts, applying to the Courts if

necessary to enforce this The Secretary of State

has, under the Act, authorised the Financial

Reporting Review Panel (FRRP) - a subsidiary body

of the FRC - to carry out this enquiry and

enforcement role in respect of large companies (as

defined) To date the FRRP has not found it

necessary to apply to the Courts in order to enforce

its will

The Financial Services Authority (a regulatory

body) imposes some additional disclosure

requirements on companies whose securities are

listed The requirements are contained in its rule

book, The Listing Rules

4 Financial statement requirements

4 Financial statement requirements

4.1 Form of the financial statements

(CA 85, FRS 1, FRS 3)

The following are normally presented:

balance sheet;

profit and loss account;

statement of total recognised gains and losses,

known informally as the ‘STRGL’ (see 5.1);

note of historical cost profits and losses (see 5.1);

cash flow statement; and

notes to the accounts (including the reconciliation

of movements in shareholders’ funds)

The reconciliation of movements in shareholders’

funds (equivalent to the IAS or US statements of

changes in shareholders’ equity) may also be shown

as a primary statement but may not be combined

with the STRGL

A parent company must present consolidated

accounts, subject to three exemptions The first, and

major, exemption is that, broadly speaking, if the

company is itself a wholly owned subsidiary of

another European Union (EU) company in whose

consolidated accounts it is included then it need not

prepare consolidated accounts itself The second

exemption is similar to this but applies where the

company is only majority owned by another EU

parent (but subject to certain minority protection

procedures) Lastly, certain medium and small sized

4.1 Form of the financial statements

(Framework, IAS 1, IAS 27)

The following are normally presented:

balance sheet;

income statement;

a statement of changes in equity, or a statement

of recognised gains and losses (see 5.1);

cash flow statement; andnotes to the accounts

A parent company must present consolidatedfinancial statements unless it is itself a whollyowned subsidiary or, subject to the minority’sconsent, is virtually wholly owned (usually 90% ormore of the voting power) Usually onlyconsolidated financial statements are presented asinternational standards do not contain arequirement to present the parent company’sfinancial statements However, if such statementsare prepared, all relevant standards would applyequally to the individual financial statements

4.1 Form of the financial statements

(SFAS 130, ARB 43, F43, Regulation S-X)

The following are normally presented:

balance sheet (or statement of financialposition);

income statement (also known as statement ofearnings or statement of operations);

statement of changes in stockholders’ equity(sometimes combined with the incomestatement, occasionally included in the notes);statement of cash flows; and

notes to the financial statements (including thestatement of comprehensive income - see 5.1).Usually consolidated financial statements only arepresented

4 Financial statement requirements

companies (as defined) may opt not to prepare

consolidated accounts

Where consolidated accounts are required, the

parent company’s balance sheet (but not its other

statements), and related notes, and certain other

disclosures are nevertheless required to be given

A cash flow statement is not required for a company that

is a 90% or more owned subsidiary of another company

in whose publicly available consolidated accounts it is

included In addition, a cash flow statement is not

required of a small company (as defined)

4.2 Comparatives

(CA 85)

Financial statements are presented for the current

and the preceding periods only

4.3 Audit reports

(CA 85, SAS 600)

The audit report refers to the current year only

(although a mis-statement in the comparatives

would probably lead to a qualification since those

comparatives would not have been properly

prepared in accordance with the Companies Act

The IASC does not issue auditing standards

Audits of IAS financial statements would usually

be carried out under local standards, or, often,International Standards on Auditing (ISAs)issued by the International Auditing PracticesCommittee of the International Federation of

4.2 Comparatives

(ARB 43, F43, Regulation S-X)

Except for SEC registrants, financial statements areusually presented for the current and the precedingyears SEC registrants are generally required topresent income statements, statements of changes instockholders’ equity and statements of cash flowsfor each of the most recent three years and balancesheets for each of the most recent two years

4.3 Audit reports

(SAS 58, SAS 64)

The audit report refers to all years presented.Statements on Auditing Standards (issued by theAuditing Standards Board of the AICPA) prescribethe form of the report, which usually states that theaudit has been conducted in accordance withgenerally accepted auditing standards and whether

4 Financial statement requirements

The Companies Act 1985 requires auditors to report

whether or not the accounts give a true and fair view

and whether they have been properly prepared in

accordance with that Act; Statements of Auditing

Standards (SASs), issued by the Auditing Practices

Board (APB), prescribe the form of that report The

report distinguishes the respective responsibilities

of company directors and of auditors; describes in

general terms the audit process (confirming that it

has been carried out in accordance with Auditing

Standards) as the basis of the audit opinion; and

states the auditors’ opinion

The report would be qualified if the scope of the

audit was limited or if the auditor disagreed with an

accounting treatment or disclosure (including the

comparatives) In addition, where proper accounting

records had not been maintained or where all

necessary information and explanation had not been

received by the auditor, this would be stated in the

report Uncertainties, if properly disclosed in the

accounts, would not result in a qualified audit report

but if ‘fundamental’ would be mentioned in the

report

4.4 Accompanying financial and

other information

(CA 85, The Listing Rules, SAS 600)

The accounts must be accompanied by a Directors’

Report containing certain information specified by

the Companies Act 1985 That Directors’ Report is

usually rather brief and it must be filed, with the

accounts, on public record with the Registrar of

Companies, except for the case of small companies

(as defined) which need not file the report

Accountants, a private sector internationalprofessional body

Under ISAs the audit report refers to the currentyear and/ or the prior year depending on whetherthe comparatives are seen as a sub-set of the currentyear financial statements or as a separate set offinancial statements (Even if not ordinarilyreferred to, a misstatement in the comparativeswould probably lead to a qualification if themisstatement was considered material in thecurrent year comparison) The report states whetherthe financial statements present fairly in allmaterial respects (or give a true and fair view of)the financial position, performance and cash flows

The format of the report is similar to that of theUK: respective responsibilities are explained; theaudit process is described; and the opinion is stated

The report would be qualified if the scope of theaudit was limited, there was a disagreement over anaccounting treatment or information could not beobtained In some situations it will be appropriate

to include an emphasis of matter referring to anuncertainty; such emphasis is not a qualification

4.4 Accompanying financial and other information

(IAS 1)

In the UK and US the accompanying informationarises out of legal and listing requirements SinceIASs do not relate to any particular legal or listingframework, there are no such requirements,although, of course, the particular company usingIASs will be subject to its own such requirements

However, IAS 1 does encourage but does not

or not the financial statements are presented fairly

in conformity with GAAP Certain situations must

be disclosed in the audit report, such as when thefinancial statements are not in accordance withGAAP, significant uncertainties exist, the scope ofthe audit was limited or necessary informationcould not be obtained

SEC regulations (where applicable) are also relevant

to the form of report given For example, the reportmay have to be extended to cover certain schedulesrequired by the SEC

4.4 Accompanying financial and other information

(Regulation S-K, Regulation S-X)

The annual financial statements filed on Form 10-K

or 20-F must be accompanied by a number ofadditional SEC disclosures including management’sdiscussion and analysis of financial conditions andresults of operations (MD&A), selected financialdata, supplementary financial information andcertain prescribed financial schedules

4 Financial statement requirements

The accounts will in practice be accompanied by a

statement acknowledging the directors’

responsibilities, principally for the preparation of

the accounts (The audit report refers readers to this

statement and, if the statement is not present, the

auditors would give the equivalent information in

their report)

The directors of a company often use the annual

report and accounts as an opportunity to include

information for shareholders on selected operating

and financial matters The ASB has sought to

regularise the completeness and content of such

information It has issued a non-mandatory

statement setting out its recommendations for a

thorough ‘Operating and Financial Review’

In addition to this, listed companies are required to

include in their annual report and accounts a

statement as to the extent to which they have

complied with a code of corporate governance best

practice (known as the ‘Combined Code’), a

statement dealing with how the Combined Code’s

principles have been applied and certain details of

directors’ emoluments (over and above that required

by law) The code covers the proceedings and

composition of the board - including the need for

and role of non-executives - directors’ remuneration,

relations with shareholders and certain board

responsibilities in connection with financial

reporting and internal controls Furthermore, the

directors of all listed companies are required in all

cases to make a statement as to whether the business

is a going concern with supporting assumptions and

qualifications as necessary

require, a financial review by management whichdescribes and explains the main features of thecompany’s financial performance and position andthe principal uncertainties it faces

5 General issues

5 General issues

5.1 Classification and presentation

within the financial statements

Balance sheet (CA 85, UITF 4, FRS 4)

The Companies Act 1985 prescribes the available

balance sheet formats The format usually adopted

is one where total assets less liabilities balances

with capital and reserves (shareholders’ funds) plus

minority interests Assets are generally presented in

ascending order of liquidity (least liquid first) and

liabilities in descending order (most liquid first)

The Act prescribes minimum standards of balance

sheet disclosure, specifying certain balance sheet

captions and the allocation of items between those

captions

Current assets and current liabilities are separately

presented from other assets and liabilities Current

assets are those which are not intended for use on a

continuing basis in the company’s activities

However, an anomaly arises in that current assets

could include amounts receivable after more than

one year If the amount concerned is sufficiently

material (in the context of total net current assets)

then that amount must be disclosed on the face of

the balance sheet

Current liabilities comprise creditors falling due

within one year Short-term obligations are included

5.1 Classification and presentation within the financial statements

(IAS 1)

Balance sheet

Whilst certain items are, as a minimum, required to

be shown on the face of the balance sheet, there is

no prescribed format in which they should bepresented However, there is a general requirement

to present the balance sheet either on the basis ofdistinguishing current from non-current assets andliabilities, or broadly in order of liquidity

Current assets are those assets that are: eitherexpected to be realised in, or are held for sale orconsumption in, the normal course of thecompany’s operating cycle; or are held primarilyfor trading purposes or for the short-term and areexpected to be realised within twelve months of thebalance sheet date Current liabilities are thoseliabilities that are expected to be settled in thenormal course of the company’s operating cycle, orare due to be settled within twelve months of thebalance sheet date

The current portion of long-term debt (but not term debt itself) should be classified as non-current

short-if there is an intention and supporting agreement torefinance on a long-term basis (see 6.8)

5.1 Classification and presentation within the financial statements

(SFAS 130, ARB 43, B05, C49, Regulation S-X)

Balance sheet

The balance sheet is generally presented as totalassets balancing with total liabilities andstockholders’ equity Assets and liabilities aregenerally presented in descending order of liquidity(most liquid first) SEC regulations prescribe theformat and certain minimum balance sheetdisclosures for public companies Otherwise,balance sheet detail should generally be sufficient toenable material components to be identified.The balance sheet usually presents current assetsand current liabilities separately from other assetsand liabilities (known as a ‘classified balancesheet’) The ‘current’ classification applies to thoseassets which will be realised in cash, sold orconsumed within one year (or within one operatingcycle, if longer), and those liabilities that will bedischarged by the use of current assets or thecreation of other current liabilities within one year(or operating cycle, if longer)

The current liability classification includesobligations that, by their terms, are due on demand

or will be due within one year (or operating cycle, iflonger) from the balance sheet date, even though

5 General issues

within current liabilities regardless of anticipated

re-financing subject to one narrow exception

Where a committed back-up facility is effectively an

integral part of the related debt (according to

narrowly defined conditions), then that debt may be

classified according to the maturity of the back-up

facility (see 6.8)

Shareholders’ funds and minority interests are each

required to be analysed into equity and non-equity

elements (as defined - see 6.14) If the non-equity

element is immaterial then the analysis may be

given in the notes

Profit and loss account (CA 85, FRS 3)

The Companies Act 1985 specifies four acceptable

formats for the profit and loss account (of which

only two are often used in practice), prescribes

minimum standards of disclosure and specifies how

certain items should be allocated in the profit and

loss account Both of the commonly used formats

reconcile turnover to the profit for the financial

year, from which dividends are then deducted

‘Format 1’, the more common of the two, analyses

expenses by function (cost of sales, distribution

costs, administrative expenses) and requires gross

profit to be disclosed ‘Format 2’ analyses expenses

by type, such as salaries and wages, and does not

show gross profit FRS 3 supplements the statutory

formats with an operating profit sub-total and three

additional, or supplementary, format items which

appear after operating profit but before interest:

profits or losses on sale or termination of an

operation (paragraph 20(a) FRS 3);

costs of a fundamental restructuring (paragraph

In addition, an analysis of expenses by either theirtype or function should be disclosed on the face ofthe income statement or in the notes

they may not be expected to be discharged withinthat period Short-term obligations expected to berefinanced on a long-term basis can be excludedfrom current liabilities only if the company intends

to refinance the obligation on a long-term basis andhas demonstrated the ability to accomplish thatrefinancing (see 6.8)

in a multiple-step format where the cost of sales

is deducted from sales to show gross profit, thenother income or expenses are added or deducted

to show income from operations and incomebefore and after income taxes

SEC regulations also prescribe the format andcertain minimum income statement disclosures forregistrants Otherwise, income statementdisclosures should generally be sufficient to enablematerial components to be identified

5 General issues

The second of the three items is intended to be used

very rarely (that is, when the restructuring has a

material effect on the nature and focus of the

company’s operations)

The formats do not provide a line for exceptional

items and companies are prevented from including a

separate line for them - they must be subsumed into

the format item to which they relate (see 7.9)

Typically, however, companies manage to isolate

exceptionals on the face of the profit and loss

account by a columnar analysis

Companies are also required to analyse the format

items, from turnover down to operating profit,

between operations acquired in the year (as a

component of continuing operations), continuing

operations and discontinued operations (as defined

- see 7.10)

As a general principle, the Companies Act 1985

requires that only realised profits be recognised in

the profit and loss account

Statement of cash flows

See 5.3 for a separate discussion of statements of

cash flows

STRGL (FRS 3, Statement of Principles)

The components of this statement are the gains and

losses of the period attributable to shareholders, that

is, increases and decreases in net assets other than

contributions from, or distributions to, owners Thus

it includes, inter alia, the profit for the financial

year, any revaluation of assets or exchange

differences dealt with in reserves

Statement of cash flows

See section 5.3 for a separate discussion onstatements of cash flows

Statement of recognised gains and losses

There is a choice of presenting as a primarystatement either a statement of recognised gainsand losses (like the UK) or a statement of changes

in equity (see below)

Statement of cash flows

See 5.3 for a separate discussion of statements ofcash flows

Other comprehensive income (OCI)

A statement of comprehensive income, on the samebasis as the UK’s STRGL, is required to bepresented either as a separate primary statement ortogether with the income statement or statement ofchanges in stockholders’ equity Comprehensiveincome other than net income reported in theincome statement is known as other comprehensiveincome (OCI) and should be separately reported assuch in the statement In addition, items reported

5 General issues

Reconciliation of movements in

shareholders’ funds (FRS 3)

This reconciliation deals with the movements in the

total shareholders’ funds and is very often presented

with the primary statements rather than as a note

Movements on individual items of capital and

reserves are usually dealt with separately in other

notes to the accounts (although the two may be

combined in some suitable format) The

components of the reconciliation are the profit for

the financial year, dividends, other recognised gains

and losses (usually as a single aggregate figure) and

each other movement individually

Note of historical cost profits and losses

(FRS 3)

The note of historical cost profits and losses, whilst

not strictly a primary statement, is presented

together with the primary statements where there is

a material difference between the result as disclosed

in the profit and loss account and the result as if an

unmodified historical cost basis had been adopted

(ie, if no revaluations had been made - see 5.4) Its

basic format is that of a reconciliation of the

reported profit before tax to that which would have

been shown on the unmodified basis

Statement of changes in equity

A statement of changes in equity (similar to those

of the UK and US) must be presented either as aprimary statement (if there is no statement ofrecognised gains and losses) or as a note (if there is

a statement of recognised gains and losses)

Note of historical cost profits and losses

There is no equivalent of the UK statement

therein should be accumulated in a separate

‘accumulated OCI’ component of stockholders’equity and the balance thereon should be analysed

on the face of the balance sheet, in the statement ofchanges in stockholders’ equity or in the notes

Statement of changes in stockholders’ equity

The statement of changes in stockholders’ equity isusually presented as a separate statement showing,for each category of equity, the opening and closingbalances and movements during the period.Alternatively, a separate statement may be omitted ifthe information is shown in the notes to thefinancial statements or combined with the incomestatement

Note of historical cost profits and losses

There is no equivalent of the UK statement

5 General issues

5.2 Prior period adjustments and

other accounting changes

Significant difference

Most accounting policy changes are dealt with

by restatement of all periods presented.

Prior period adjustments (FRS 3)

Prior period adjustments, as defined below, are dealt

with by restatement of the opening position and of

the comparatives for prior periods The cumulative

effect of the change - as at the start of the year in

which the change is made - should be shown as a

separate item in the current year’s STRGL

Prior period adjustments are defined as material

adjustments applicable to prior periods arising from:

changes in accounting policies (see below); or

the correction of fundamental errors

They do not include normal recurring adjustments

or corrections of estimates made in prior periods

In addition, prior periods are restated when using

merger accounting (see 5.7)

Changes in accounting policy and method

(FRS 3, FRS 10, FRS 15, CA 85, SSAP 2, UITF 14)

A change in accounting policy must be justified as

preferable and should be accounted for as a prior

period adjustment, as discussed above The effect of

the policy changes on the preceding and current

5.2 Prior period adjustments and other accounting changes

Significant difference

Most accounting policy changes may be dealt with by restatement or by passing the cumulative adjustment through the current year.

Prior period adjustments (IAS 8)

Where a prior period adjustment is applicable theopening balance of retained earnings and thecomparatives are restated

Prior period adjustment is the Benchmark Treatmentfor:

certain changes in accounting policy (seebelow); and

the correction of fundamental errors

In both cases the Allowed Alternative Treatment is

to put the adjustment through in the current yearand no restatement occurs However, in both theBenchmark and Allowed Alternative Treatments for

a change in accounting policy, if the adjustment toopening retained earnings cannot be determinedthe change should be made prospectively

In addition, prior periods are restated whenapplying uniting-of-interests accounting (see 5.7)

Changes in accounting policy and method

(IAS 8, IAS 16, IAS 38, SIC 8)

A change in accounting policy should be madewhere required to adopt a new IAS or in any casewhere the change will result in a more appropriatepresentation of events or transactions in the

5.2 Prior period adjustments and other accounting changes

Significant difference

Many accounting policy changes are dealt with

by passing the cumulative adjustment through the current year.

Prior period adjustments (APB 9, SFAS 16, A35)

In single period financial statements, prior periodadjustments are reflected as adjustments of theopening balance of retained earnings Whencomparative statements are presented, correspondingadjustments are made of the amounts of net income,its components, the balances of retained earnings,and other affected balances for all of the periodspresented to reflect the retrospective application ofthe prior period adjustments

Such prior period adjustments may only be made:

to correct errors in prior period financialstatements;

for certain changes in accounting principles (seebelow);

for certain adjustments related to prior interimperiods of the current fiscal year; or

to reflect accounting changes that are in effectthe statements of a different reporting entity (eg,pooling-of-interests - see 5.7)

Changes in accounting principle and method

(APB 20, A06)

A change in accounting principle must be explainedand justified as preferable The term accountingprinciple also includes the methods of applyingprinciples In most instances prior periods are not

5 General issues

years should be disclosed where practicable

Changes resulting from the introduction of new

accounting standards are, in general, not treated

differently from other changes in accounting policy;

prior years are restated, although many recent

standards have had different transitional provisions

Accounting methods give effect to accounting

policies Only changes in policy qualify as prior

period adjustments For example, a change from one

method of computing depreciation/ amortisation to

another is not treated as a change in accounting

policy; the unamortised cost should be written off

over the remaining useful life beginning in the

period in which the change is made A change in

estimated useful life or residual value should also be

treated in this way

financial statements In either case if the companychooses the current period adjustment method of

effecting the change it should give pro forma

information on the prior year adjustment basis Inall cases the effect of the change on all periodspresented should be disclosed, together with thereason for the change

All new IASs either have their own transitionalrules (many recent IASs fall into this category) or,failing that, are by default effected as a change ofaccounting policy

A change in depreciation/ amortisation method,useful life or residual value does not qualify as achange in accounting policy

When a company prepares IAS financialstatements for the first time, this is dealt with as achange in policy, but one that is required to beeffected by the prior period adjustment methodsave to the extent that the adjustment relating toprior periods cannot be reasonably determined

adjusted Instead the cumulative effect (net of tax)

of the change should be shown in the incomestatement, after extraordinary items and before netincome, in the year in which the change occurs.Income before extraordinary items and net income

should be shown on a pro forma basis on the face of

the income statement for all periods presented as ifthe newly adopted accounting principle had beenapplied during all periods presented The effect ofadopting the new principle on income beforeextraordinary items and on net income (and on otherrelated per share amounts) in the period of thechange should also be disclosed In the followingcases, however, the financial statements of priorperiods should be restated:

a change from LIFO to another method ofinventory valuation;

a change in the method of accounting for term construction-type contracts (see 7.1); and

long-a chlong-ange to or from the ‘full cost’ method ofaccounting that is used in the extractiveindustries (the details of which are outside thescope of this book)

These general rules do not apply to a change whichresults from the initial adoption of a new accountingpronouncement Initial adoption rules are included

in each new pronouncement; restatement may either

be prohibited, required or optional

A change from one method of computingdepreciation to another (for example, from the sum-of-the-years’-digits to the straight-line method) is achange in accounting principle and should beaccounted for accordingly A change in estimateduseful life or residual value, however, is a change in

an accounting estimate and should be accounted forprospectively

5 General issues

Changes in accounting estimate (FRS 3)

Changes in accounting estimates should be

accounted for in the period of the change, and if

material, their nature and size should be disclosed

5.3 Statement of cash flows

(FRS 1)

Significant differences

The statement is based on cash; there are no

cash equivalents.

Cash includes overdrafts repayable on demand.

Interest, dividends and tax are presented as

separate classes of items.

Cash

A cash flow is an increase or decrease in cash

resulting from a transaction It therefore excludes

the effect of exchange rate changes on cash

Cash is defined as cash in hand and deposits with

qualifying financial institutions repayable on

demand, less overdrafts from such institutions

repayable on demand

There is no concept of cash equivalents Items that

would fall into that category in the US or under

IASs would probably be regarded as liquid

Changes in accounting estimate (IAS 8)

Changes in accounting estimate are included in thenet profit or loss for the period in which the changeoccurs (or the period of the change and futureperiods if the change affects both) Where material,the effect should be disclosed

5.3 Statement of cash flows

(IAS 7)

Significant differences

The statement is based on cash and cash equivalents, the latter including short-term highly liquid investments.

Cash and cash equivalents may include overdrafts repayable on demand in some cases.

Interest and dividends can be classified as operating, investing (if received) or financing (if paid); tax is usually classed as operating.

Cash and cash equivalents

Cash flows are inflows and outflows of cash andcash equivalents; they therefore exclude the effects

of exchange rate changes on cash and cashequivalents as this involves no inflow or outflow

Cash comprises cash on hand and demand deposits

Cash equivalents are short-term highly liquidinvestments that are readily convertible to knownamounts of cash and which are subject to aninsignificant risk of changes in value ‘Short-term’

is not defined but the standard suggests a cut-off of

Changes in accounting estimate (APB 20, A06)

Changes in accounting estimates should beaccounted for in the period of the change as if onlythat period is affected by the change, or in the period

of the change and future periods if those periods areaffected A change in estimate should not beaccounted for by restating prior periods or by

reporting pro forma amounts for prior periods.

5.3 Statement of cash flows

(SFAS 95, C25)

Significant differences

The statement is based on cash and cash equivalents, the latter including short-term highly liquid investment.

Cash and cash equivalents do not include any overdrafts.

Dividends paid are classed within financing; other dividends, tax and (most) interest are classed within operating.

Cash and cash equivalents

A cash flow is an increase or decrease in cash andcash equivalents resulting from a transaction Ittherefore excludes the effect of exchange ratechanges on cash and cash equivalents

Cash and cash equivalents include currency onhand, demand deposits, and short-term highly liquidinvestments (with original maturities of threemonths or less, or with remaining maturities of threemonths or less at the time of acquisition)

5 General issues

resources in the UK Liquid resources are defined as

current asset investments that are disposable

without curtailing or disrupting the business and are

either readily convertible into known amounts of

cash at or close to book value or are traded in an

active market It should be noted that current asset

investments is wider than the three months’ maturity

referred to in the US and IAS Cash flows in respect

of liquid resources are classified separately

Classification and presentation of cash

flows

Cash flows are classified and reported under the

following headings:

operating activities;

dividends from joint ventures and associates;

returns on investments and servicing of finance;

taxation;

capital expenditure and financial investment;

acquisitions and disposals;

equity dividends paid;

management of liquid resources; and

financing

All interest paid, including that capitalised, is

classed as servicing of finance

The statement should be reconciled to the

movement in net debt, which is the net of debt,

liquid resources and cash

Cash flows from transactions undertaken to hedge

another transaction should be reported under the

same heading as that other transaction

Cash flow from operating activities may be reported

on a gross basis (ie, the direct method reporting cash

received from customers, paid to suppliers etc) or as

three months maturity (on acquisition by thecompany) Bank overdrafts repayable on demandare dealt with as cash and cash equivalents wherethey form an integral part of the company’s cashmanagement

Classification and presentation of cash flows

The cash flow statement should split cash flowsduring the period between operating, investing andfinancing activities

A company should choose its own policy forclassifying each of interest and dividends paid asoperating or financing activities and each ofinterest and dividends received as operating orinvesting activities Taxes paid should be classified

as operating activities unless any particular tax cashflow (not merely the related expense in the incomestatement) can be specifically identified with, andtherefore classified as, financing or investingactivities

Net cash flows from all three categories are totalled

to show the change in cash and cash equivalentsduring the period, which is then reconciled toopening and closing cash and cash equivalents Thecompany should disclose the components of cashand cash equivalents and reconcile these to theequivalent figures presented in the balance sheet

When a hedging instrument is accounted for as ahedge of an identifiable position, the cash flows ofthe hedging instrument are classified in the same

Classification and presentation of cash flows

The statement of cash flows classifies cash receiptsand payments as follows:

Net cash flows from all three activities are totalled

to show the change in cash and cash equivalentsduring the period, which is then reconciled to theopening and closing cash and cash equivalents.Cash flows resulting from certain contracts that arehedges of identifiable transactions should beclassified in the same cash flow category as the cashflows from the hedged items

While companies are encouraged to report grossoperating cash flows by major classes of operatingcash receipts and payments (the direct method),presenting such items net (the indirect method) is

5 General issues

a single net amount (the indirect method) In both

cases a reconciliation must be provided separately to

show the derivation of net operating cash flow from

operating profit (whereas the IAS and US

reconciliations start with net profit/ income)

With the following exception, all other sections of

the cash flow statement are to be presented on the

gross basis: in the liquid resources and financing

sections, inflows and outflows may be netted off

where they occur due to rollover or re-issue of short

maturity, high turnover items

Other matters

Material non-cash transactions should be disclosed

where this is necessary for an understanding of the

transaction (eg, vendor placing or the inception of a

finance lease)

Foreign currency cash flows arising in a company as

a result of its own transactions are translated at the

rate at the date of the transaction The cash flows of

foreign companies included in group accounts are

translated by the same method used to translate the

profit and loss account of that company The effect

of exchange rate changes on the balance of cash

(and other elements of net debt) is reported as a

single line item in the note reconciling opening and

closing net debt with the net cash flow for the year

In common with other companies, banks and

insurance companies may report their operating

cash flow on a net basis

manner as the cash flows of the position beinghedged

Cash flows from operating activities may bepresented either by the direct method (grossreceipts from customers etc) or the indirect method(net profit and loss for the period with adjustments

to arrive at the total net cash flow from operatingactivities) Although the standard encourages theuse of the direct method, in practice the indirectmethod is usually used All financing and investingcash flows should be reported gross, save for thefollowing exception Receipts and payments may

be netted where the items concerned (eg, sale andpurchase of investments) are turned over quickly,the amounts are large and the maturities are short

Other matters

Non-cash investing or financing transactions (eg,share-for-share acquisition, debt-to-equityconversion) should be disclosed in order to providerelevant information about investing and financingactivities

Cash flows arising from a company’s foreigncurrency transactions should be translated into thereporting currency at the exchange rate at the date

of the cash flow (where exchange rates have beenrelatively stable a weighted average can be used)

Cash flows of foreign subsidiaries are translatedalso at actual rates (or appropriate averages) Theeffect of exchange rate changes on the balances ofcash and cash equivalents are presented as part ofthe reconciliation of movements therein

Financial institutions may report on a net basiscertain advances, deposits and repayments thereof

allowable in respect of operating activities Underthe direct method, the statement begins with cashfrom operations by source (eg, amounts receivedfrom/ paid to customers, suppliers and employees) The indirect method starts with net income andreconciles it to net cash flows from operatingactivities by adjusting for non-cash items (such asdepreciation) and the net change in most workingcapital items If the indirect method is used, amounts

of interest paid (net of amounts capitalised) andincome taxes paid during the period are disclosed.Under both the direct and the indirect method, cashinflows and outflows from investing and fromfinancing activities should be reported on a grossbasis

Other matters

Information about all investing and financingactivities of a company during a period that affectrecognised assets or liabilities but do not result incash receipts or payments are also disclosed Forexample, the initial recording of a capital (finance)lease results in the recognition of a leased asset and

a corresponding liability in the balance sheetwithout affecting cash flows

Cash flows denominated in foreign currencies aretranslated into the reporting currency using theexchange rates in effect at the time of the cash flows(although a weighted average exchange rate for theperiod may be used) Exchange rate effects on cashbalances held in foreign currencies must be reported

as a single line item in the statement of cash flows.Banks, savings institutions and credit unions arepermitted to report net cash receipts and paymentsfor deposits placed with and withdrawn from other

5 General issues

5.4 Basis of accounting

Significant differences

The modified historical cost basis may be used

to revalue certain assets, usually property.

There are no special requirements when the

reporting company’s functional currency is

hyper-inflationary.

Conceptual framework (Statement of Principles,

SSAP 2)

The ASB has recently published its conceptual

framework, the Statement of principles for financial

reporting Its purpose is to guide the development of

new standards It is similar to the IAS and US

frameworks, save that the emphasis is on substance

Although the framework has been in gestation for

many years, nevertheless during that time it

influenced many of the later UK standards: for

instance, FRS 5 Reporting the substance of

transactions (see 5.5) uses its definitions of assets

and liabilities and its criteria for recognition of these

items in the accounts; and FRS 12 Provisions,

contingent liabilities and contingent assets (see

6.12) uses its definition of a liability for the critical

issue of provision timing

5.4 Basis of accounting

Significant differences

The modified historical cost basis may be used

to revalue certain assets.

If the company reports in a hyper-inflationary currency it must make current purchasing power adjustments.

Conceptual framework (Framework)

The IASC uses its conceptual framework, theFramework, as an aid to drafting new or revisedIASs The Framework also provides a point ofreference for preparers of financial statements inthe absence of any specific standards on aparticular subject (see 3.1) The Framework issimilar to the US conceptual framework, thoughless practical emphasis is placed on consistency(eg, there are some optional treatments in IASs)

financial institutions, for time deposits accepted andrepaid and for loans made to and collected fromcustomers

5.4 Basis of accounting

Significant differences

The historical cost basis is adopted for property (and most other items).

If the reporting company’s functional currency

is highly inflationary then it must instead use US dollars as the functional currency.

Conceptual framework (CON 1, CON 2, CON 3, CON

economic-5 General issues

The modified historical cost convention

(CA 85, FRS 15)

The accounts are prepared under the historical cost

convention although it is permissible to modify that

basis to include the revaluation of certain assets

(usually property) Where revaluations, other than

of investments, are carried out they must be done on

a class-by-class basis and must be kept up to date

(see 6.1 and 6.2); investments may be occasionally

and selectively revalued In addition,

mark-to-market accounting is sometimes used in the

financial sector (eg, see 6.6)

Financial reporting and changing prices

If a company’s subsidiary reports in a

hyper-inflationary currency then adjustments are required

when it is consolidated (see 5.8) Where the

company itself reports in a hyper-inflationary

currency there are no similar requirements

The UK standard on current cost accounting, SSAP

16, was suspended in 1985 and finally withdrawn in

1988 At the time of its withdrawal the ASB’s

predecessor, the ASC, re-affirmed its view that

where historical cost accounts were materially

effected by changing prices it was correct in

principle to give information about those effects

However, it did not mandate this; it merely

encouraged companies to do so In practice very

few companies give such information

The ASC’s publication Accounting for the effects of

changing prices remains the most authoritative

source of guidance for measurement and

presentation under the current cost (and the current

purchasing power) accounting convention(s)

The modified historical cost convention

(IAS16, IAS 38, IAS 39)

Save in respect of certain financial assets andliabilities, financial statements are prepared undereither the historical or modified historical costconvention In the latter case whole classes ofproperty, plant and equipment and of certainintangible assets may be revalued (with therevaluations’ being kept up-to-date)

In addition, all derivatives, all financial assets andliabilities held for trading and all financial assetsthat are classed as available-for-sale are carried atfair value (see 6.6)

Financial reporting and hanging prices

(IAS 15, IAS 29)

Companies are encouraged, but not required, todisclose on the current cost basis certaininformation about the effects of changing prices

Where a company has a subsidiary reporting in ahyper-inflationary currency, its financialstatements must be adjusted before being translatedand consolidated (see 5.8) Moreover, where thecompany itself reports in a hyper-inflationarycurrency its own financial statements must beadjusted to state all items in the measuring unitcurrent at the balance sheet date, ie it must adoptthe current purchasing power concept There is noabsolute numerical test for hyper-inflation, but athree year cumulative inflation rate approaching, orexceeding, 100% is an indication of hyper-inflation

The modified historical cost convention

The basic financial statements are generallyprepared under the historical cost convention;upward revaluation occurs only in connection withpurchase accounting (see 5.7) and certain otherspecific situations (eg, trading and available-for-salesecurities and derivatives - see 6.6)

Financial reporting and changing prices

(SFAS 89, C28)

A business entity that prepares its financialstatements in US dollars and in accordance with USgenerally accepted accounting principles isencouraged, but not required, to disclosesupplementary information on the effects ofchanging prices

Appendix A of SFAS 89 provides measurement andpresentation guidelines for the disclosure ofsupplementary information on the effects ofchanging prices

If a foreign registrant has a highly inflationaryfunctional currency it is, in most instances, requiredinstead to adopt the US dollar as its functionalcurrency Similar procedures are required for theconsolidation of subsidiaries in highly-inflationaryeconomies (see 5.8)

All transactions should be reported in

accordance with their substance on a

risks-and-rewards basis.

There is comprehensive guidance on this.

FRS 5 Reporting the substance of transactions looks

at some of the concepts underlying accounting rather

than addressing a particular area (However, it does

scope out certain arrangements such as forward

contracts, swaps and purchase commitments unless

they are part of a wider arrangement that falls within

its scope.) Its concept is that the commercial effect of

a company’s transactions, and any resulting assets,

liabilities, gains or losses, should be faithfully

represented in its financial statements For most

transactions the substance, and thus the accounting,

are clear The difficult areas are the ‘more complex

transactions, whose commercial effect may not be

readily apparent’ - the real target is so-called off

balance sheet finance

This principle does not take precedence over other

more specific standards, but those other standards

should be applied to the substance of the

transactions and not merely to their legal form For

example, although SSAP 21 contains the more

specific provisions for most leases, FRS 5 will be

relevant in ensuring that they are classified in

accordance with their substance (see 6.9)

5.5 Reporting the substance of transactions

(Framework, IAS 1, IAS 17, IAS 18, IAS 39, SIC 12)

Significant differences

Financial asset transactions are reported on a financial components basis; otherwise substance on a risks-and-rewards basis is used.

There is less guidance on substance than in the UK.

There is no IAS that deals with the whole of thisbroad area The Framework requires reporting to be

in accordance with substance rather than legal formand sets out, very briefly, a risk-and-rewardsapproach to assessing the substance The leasingand revenue recognition standards (IASs 17 and18) and an SIC on special purpose entities (SPEs)(SIC 12) put that into practice in three particularareas However, in its financial instrumentsstandard, IAS 39, the IASC has moved to afinancial components approach (see 6.6)

5.5 Reporting the substance of transactions

Significant differences

Financial asset transactions are on a financial components basis; there is no general requirement to report substance.

There is no standard on substance.

There is no overall conceptual standard in USGAAP However, there are a number of specificpronouncements which deal with some of the issuesencompassed by FRS 5

The specific US GAAP accounting standards, such

as those for leases or for sales of financial assets,need to be consulted when transactions are beingconsidered for off balance sheet treatment

5 General issues

Assets and liabilities

FRS 5 adopts definitions of assets and liabilities as

follows:

Assets are ‘rights or other access to future

economic benefits controlled as a result of

past transactions or events.’ The FRS highlights

risk as evidence of whether or not a company

has an asset Risk, for this purpose, includes the

upside potential for gain as well as the downside

potential for loss

Liabilities are ‘obligations to transfer economic

benefits as a result of past transactions or events.’

A company will have a liability whenever there is

some circumstance in which it is unable to avoid,

legally or commercially, an outflow of benefit

For example, the prospect of a commercial or

economic penalty if a certain action is not taken

may negate a legal right to refrain from taking

that action

When assessing the risks, benefits and obligations

that might provide evidence of the existence of an

asset or liability, it is important to give greater

weight to those which are likely to have a

commercial effect in practice

The effect of applying these definitions is that

so-called off balance sheet finance is brought onto the

balance sheet

Commercial effect in practice - lender’s

return

Whatever the substance of a transaction, it should

have commercial logic for each of the parties

entering into it Thus, in assessing the commercial

effect of a transaction, it is important to consider the

position of all of the parties

In particular, where a transaction involves only two

Assets and liabilities

The Framework uses similar definitions to those ofthe UK and US:

An asset is a resource controlled by the entity as

a result of past events and from which futureeconomic benefits are expected to flow to theentity

A liability is a present obligation arising frompast events, the settlement of which is expected

to result in an outflow of resources embodyingeconomic benefits

Once again the Framework requires substancerather than form to be looked to when determiningwhether an item meets these definitions

Commercial effect in practice - lender’s return

A form of lender’s return test is applied to apurported transfer of a financial asset; if such areturn is involved and the transferor has both the

right and the obligation to repurchase it, then it

remains on the transferor’s balance sheet Thismight be termed a ‘two way’ test and differs fromthat of the UK where a lender’s return is sufficient

Assets and liabilities (CON 6)

CON 6 defines assets and liabilities in a similarfashion to FRS 5, as follows:

Assets are probable future economic benefitsobtained or controlled by a particular entity as aresult of past transactions or events

Liabilities are probable future sacrifices ofeconomic benefits arising from presentobligations of a particular entity to transferassets or provide services to other entities in thefuture as a result of past transactions or events

Commercial effect in practice - lender’s return

There is no ‘lender’s return’ concept under US GAAP.The US GAAP leasing criteria are discussed in 6.9

5 General issues

parties, one of which receives a lender’s return but

no more, this indicates that the substance of the

transaction is that of a secured loan The main

reason for this is that the ‘lender’ is not

compensated for assuming any significant exposure

to loss other than that associated with the

creditworthiness of the other party

This guidance on lender’s return is fundamental, and

for many transactions it will not be necessary to

look any further in determining their substance

The linked presentation

However, there is a special ‘linked presentation’

where the finance is non-recourse and is repayable

only from benefits generated by the assets being

financed, or by transfer of the assets themselves

Where detailed conditions are met, this linked

presentation is required, whereby the

non-returnable finance is shown deducted from the

related gross asset on the face of the balance sheet,

for example:

Securitised mortgages X

Less non-returnable proceeds (Y)

Z

This shows both that the company retains

significant benefits associated with the gross asset

and that the claim of the provider of the finance is

limited strictly to the funds generated by that asset

Options

Off balance sheet finance schemes often make use

of options There is detailed guidance on when an

even if it is only a transferor’s call option thatensures the transferee of this (a ‘one way’ test)

However, where an SPE is involved a lender’sreturn to the SPE’s capital providers is sufficient tobring in the SPE on consolidation This version ofthe lender’s return test is not specifically required

to be a two-way test and so is much more in linewith the UK approach Moreover, given that thisone-way test is part of a risk-and-rewards approach

to SPEs it is arguable that it is applicable byanalogy to all situations to which a risk-and-rewards approach is applicable, ie other than tofinancial instruments

The linked presentation

There is no linked presentation concept underIASs Arrangements qualifying for thatpresentation in the UK would be eitherderecognised or, more likely, on consolidationcontinue to be fully recognised separately from thefinance (see 6.6)

Options

There is no general guidance on options underIASs, save where they are separate financial

The linked presentation

There is no ‘linked presentation’ concept under USGAAP

Options

There is no broad concept similar to that in the UK.However, a transferor’s call option to re-acquire an

5 General issues

option should be regarded as genuinely conditional

and when it should not All the features that are

likely to be relevant during the exercise period of the

option should be taken into account, assuming that

each of the parties will act in accordance with its

economic interests

Transactions in previously recognised

assets

An asset should cease to be recognised only if all

significant rights or other access to benefits related

to that asset, and all significant exposure to risks

inherent in those benefits, have been transferred to

others

However there are ‘special cases’ where the original

asset has been sold but an interest in the asset and/

or an obligation has been retained In such cases the

amount and/ or description of the asset may need to

be changed and any liability recognised in

accordance with the substance

Offset of assets and liabilities

There has been a long standing principle (which is

also embedded in the Companies Act 1985) that

assets and liabilities must not be offset FRS 5

confirms this and enlarges upon it by determining

when debit and credit balances are separate assets

and liabilities, which must not be offset, and when

they are components of a single asset or liability, as

follows Debit and credit balances must be offset

when all of the following conditions are met:

Two parties owe each other known monetary

amounts

The reporting company can insist on net

settlement, although this may be just a

contingent right provided it can be enforced in

all situations of default by the other party

Its ability so to insist is assured beyond doubt

instruments (see 6.6), other than the overallrequirement to account for the substance

Transactions in previously recognised assets

IASs do not have detailed requirements in this area,other than for transfers of financial assets which aredealt with on a financial components basis (see6.6) The general requirement to account for thesubstance would apply

Offset of assets and liabilities

A financial asset must be offset against a financial

of themselves, preclude sales treatment.)

Transactions in previously recognised assets

US GAAP does not have any general rules in thisarea Specific areas of difficulty are dealt with byspecific standards, eg transfers of financial assetswhich are on the financial components basis (see6.6)

Offset of assets and liabilities (FIN 39, FIN 41)

It is a general principle of US GAAP (as discussed

by FINs 39 and 41) that the offsetting of assets andliabilities is improper except where a right of set-offexists A right of set-off exists when all of thefollowing conditions are met:

Each of two parties owes the other determinableamounts

The reporting party has the right to set-off itsamount owed with the amount owed by the otherparty

The reporting party intends to set-off.

The right of set-off is enforceable at law

A debtor having the valid right of set-off may offset

the related asset and liability and report the netamount

5 General issues

(for instance, its ability must be able to survive

the insolvency of the other party, however

remote that insolvency may seem)

Note that IAS and US GAAP on this issue use the

company’s intention or expectation to settle net,

whereas in the UK it is the company’s ability to do

so that matters

5.6 Consolidation

(CA 85, FRS 2, FRS 5)

Significant differences

Consolidation is based on control.

Minorities must be on the consolidated value

basis.

Entities included in the consolidation

Consolidated accounts include all of the parent

company’s subsidiary undertakings (as defined) and

its quasi-subsidiaries (as defined), except that

certain of those undertakings should be excluded in

very restricted circumstances (as detailed below)

The accounting concept that underlies the

parent~subsidiary relationship can be summarised

as control of one undertaking by another Control, in

this context, means the ability of one undertaking to

direct the financial and operating policies of another

undertaking with a view to gaining economic

benefits from its activities; nevertheless, the actual

exercise of such dominant influence is enough to

satisfy this concept without needing to look for any

5.6 Consolidation

(IAS 22, IAS 27, SIC 12)

Significant differences

Consolidation is based on control.

Minorities may be on the subsidiary or the consolidated value basis.

Entities included in the consolidation

Consolidated financial statements should includeall subsidiaries (as defined) of the parent except incertain restricted circumstances (as explainedbelow) where some subsidiaries must be excluded

The definition of a subsidiary focuses directly on

the concept of control, that is, the parent’s power to

govern the financial and operating policies of anentity so as to obtain benefits from its activities

Thus it is possible for a company that has less than

a 50% interest in another still to be considered itsparent so long as it controls that other entity

Moreover, since IASs focus directly on control they

do not need a concept of a ‘quasi-subsidiary’; suchentities would simply be subsidiaries The

Entities included in the consolidation

Consolidated financial statements must includethose companies over which the parent company has

a controlling financial interest through a direct or

indirect ownership of a majority voting interest

(over 50% of the outstanding voting shares).Certain transactions with SPE’s raise questionsabout whether the SPE’s should be consolidated(notwithstanding the lack of majority ownership)and whether transfers of assets to the SPE should berecognised as sales In respect of an SPE holding anon-financial asset, for non-consolidation and salesrecognition by the sponsor or transferor to beappropriate, the majority owners of the SPE must beindependent third parties who have made a

5 General issues

formal power or ability through which it arises The

concept is put into effect by numerous provisions of

company law and of standards The law uses a series

of tests, widely drawn but essentially based on

interests in ownership (including options), rather

than using the concept of control directly However,

the effect in practice is very similar Moreover, any

undertaking which is controlled as described above,

but fails the legal tests, would fall under the

definition of a quasi-subsidiary

Some subsidiaries are required to be excluded from

consolidation The main such exclusion is where

there are severe long-term restrictions that have the

effect in practice of substantially hindering the

exercise of the rights of the parent company over the

assets or management of that undertaking Broadly

speaking, this means that where an undertaking

meets one of the subsidiary undertaking definitions

(which are not directly based on control) but it is not

actually controlled by the (apparent) parent, then

ipso facto it must be excluded If significant

influence was nevertheless still exerted on the

subsidiary it would be treated like an associate and

be equity accounted The second required exclusion

is where the interest of the parent company is held

exclusively with a view to subsequent resale within

approximately one year of its acquisition and the

undertaking has not previously been included in the

parent’s consolidation

Subsidiaries’ accounting periods and

policies

Wherever practicable, the accounts of subsidiary

undertakings which are used for the purpose of

consolidation should be prepared to the same

year-end and cover the same accounting period as the

parent (even if this means preparing accounts

specially for this purpose) Where, rarely, this is not

principles are no different for SPEs However, inthat particular case there is additional guidance ondetermining whether in substance the SPE iscontrolled For example, control would usuallyexist if the parent has the right to the majority ofbenefits of the SPE’s activities, however these areconveyed; the same applies if the parent retains therisks of the SPE’s assets by, for instance, the otherinvestors’ receiving mainly a lender’s return

A subsidiary should be excluded from consolidation

in two cases The first is where the subsidiaryoperates under severe long-term restrictions whichsignificantly impair its ability to transfer funds tothe parent This differs from that of the UK whichlooks simply at the restrictions’ effect on control

The second exclusion is where control is intended to

be temporary because the subsidiary is acquired andheld exclusively with a view to its subsequentdisposal in the near future ‘Temporary’ is notdefined, but in our view one year, following the UKapproach, is generally considered the limit

Such excluded subsidiaries are instead treated asinvestments (see 6.6), ie there is no possibility oftheir being treated as associates

Subsidiaries’ accounting periods and policies

Where practical, a subsidiary’s accounting period,for the purposes of consolidation, should be thesame as that of the parent Where different periodsare used the gap must be no more than three monthseither way and adjustments should be made forsignificant transactions in the intervening period

substantive capital investment in the SPE, havecontrol of the SPE, and have substantive risks andrewards of ownership of the assets of the SPEincluding residuals Where SPE’s asset is afinancial one then a different approach applies: themajority owners must be able to sell or pledge theirinterests; the SPE must be legally separate from thetransferor; and the SPE’s activities are limited atlaw to, broadly, holding the asset in question Ifthese conditions are not met, transfer or non-consolidation still apply if the non-financial assettests are met

A majority owned subsidiary is not consolidated ifcontrol is likely to be temporary or does not restwith the majority owner (because of bankruptcy,reorganisation, foreign exchange restrictions,governmental controls, etc)

Subsidiaries’ accounting periods and policies

If the difference in fiscal periods of a parent andsubsidiary is not more than three months, it isusually acceptable to use, for consolidationpurposes, the subsidiary’s statements for its fiscalperiod Material events in the intervening periodshould be disclosed

5 General issues

practicable, it is permitted to use a subsidiary

undertaking’s non-coterminous accounts provided

that its period end is not more than three months

before that of the parent and adjustments are made

for material events in the intervening period

Assets and liabilities of subsidiary undertakings

should generally be included in the consolidation on

the basis of uniform accounting policies Where the

policies followed in any particular subsidiary’s

individual financial statements differ from those of

the group then appropriate adjustments must be

made on consolidation Where, exceptionally, the

directors of the parent consider that there are special

reasons for departing from this procedure, and the

policies so adopted are acceptable in themselves,

then disclosure of the reasons must be given; in

practice this is rare indeed

Minority interests

Minority interests are calculated as the minority

share of the assets and liabilities as included in the

balance sheet (other than goodwill) This means that

minority interests are based on fair values at the

time of acquisition plus post-acquisition profits

under the parent’s policies

Losses in a subsidiary are required to produce a

negative minority interest save to the extent that the

group has any commercial obligation (whether

formal or implied) to provide finance that may not

be recoverable in respect of the accumulated losses

attributable to the minority Thus a negative balance

is more likely than under the IAS and US approach

Where practical, uniform accounting policiesshould be used throughout the group If, because ofimpracticability, uniform accounting policies arenot used then this fact should be disclosed togetherwith the proportions of the items in the financialstatements to which different accounting policieshave been applied

Minority interests

The Benchmark Treatment for minority interests isfor them to be based on the book values of theassets and liabilities as reported by the subsidiaryitself, ie the US treatment The Allowed AlternativeTreatment follows the UK approach

Losses in a subsidiary may create a debit balance

on minority interests only if the minority has anobligation to make good the losses

While accounting policies throughout the groupmust be in accordance with US GAAP, uniformity

of accounting policies is not required Disclosureshould generally be made where accounting policiesfollowed by various divisions, subsidiaries, etc, ofthe company are not consistent

Minority interests

Minority interests are generally based on theminority share of the book values of the assets andliabilities as reported by the subsidiary itself.Losses in a subsidiary may only create a debitbalance on minority interests if the minority has anobligation to make good the losses

Future developments

A current FASB exposure draft proposes to changethe basis of inclusion in the consolidation to one ofcontrol rather than ownership An exemption fortemporary control would remain

5 General issues

5.7 Business combinations

(CA 85, FRS 6, FRS 7, FRS 10)

Significant differences

A merger is more simply defined than in the US,

including a size test; it is rare.

Costs of restructuring the acquired entity are

always charged to the profit and loss account.

Post-1997 positive goodwill is capitalised and

amortised over up to 20 years but optionally

longer, even an indefinite period.

Negative goodwill is shown as a negative asset

and is taken to the profit and loss account in the

amount of the acquired non-monetary assets as

they are depreciated or sold and the balance in

the periods expected to benefit.

There are special rules governing group

reconstructions.

Applicability of merger or acquisition

accounting

Accounting standards and company law set out

certain criteria which, if met, require a business

combination to be accounted for as a merger This is

a rare occurrence In all other cases acquisition

accounting must be used They are not alternatives

The criteria are designed to determine whether a

business combination meets the conceptual

definition of a merger as one that results in the

creation of a new reporting entity formed from the

combining parties, in which the shareholders of the

Unitings-of-interests are rare in practice.

Some restructuring costs are included in he purchase price where the acquirer has announced certain details at the date of acquisition.

Post-1994 positive goodwill must be capitalised and amortised over a finite life, usually not more than 20 years

Negative goodwill is presented as a negative asset and is taken to income, first, to match any costs that it has been identified with, then to match and to the extent of the depreciation of acquired non-monetary assets and any balance thereafter is taken immediately to income.

There are no rules dealing with transactions between companies under common control.

Applicability of uniting-of-interests or purchase accounting

Uniting-of-interests accounting must be used for abusiness combination where, rarely, no acquirercan be identified; purchase accounting applies inall other cases (ie, the vast majority) Although theprinciple by which a uniting-of-interests is defined

is that no acquirer can be identified - that is, theshareholders of one party do not obtain control overthe combined entity - the standard gives guidance

on characteristics that must be present in such auniting-of-interests, as set out below

Certain costs of restructuring the purchased entity can be recorded as part of the purchase price.

Positive goodwill must be capitalised and amortised over up to 40 years.

Negative goodwill on a purchase is credited first against acquired non-current assets and the balance to a deferred credit thereafter released over up to 40 years.

There are special rules for transactions between companies under common control.

Applicability of pooling-of-interests or purchase accounting

While both purchase and pooling-of-interestsaccounting are used in the US, they are notalternatives Pooling must be used if certain criteriaare met These criteria relate to the attributes of thecombining entities before the combination, themanner of combining the entities, and the absence

of certain planned transactions but do not include asize test In outline, they are as follows:

5 General issues

combining entities come together in a substantially

equal partnership for the mutual sharing of the risks

and benefits of the combined entity, and in which no

party to the combination in substance obtains

control over any other, or is otherwise seen to be

dominant The reporting entity formed by a merger

must be regarded as a new entity rather than the

continuation of one of the combining entities,

enlarged by its having obtained control over the

others An acquisition is a business combination

which is not a merger

The merger accounting criteria (re-arranged to

effect comparison with IAS) are set out below They

are much more conceptual than those of the US and

are perhaps more sharply delineated than those of

IAS

Autonomy of each party: Merger accounting is

not appropriate where one of the parties results

from a recent divestment by a larger entity since,

until it has established its own track record, it

will not have been independent for a sufficient

period to establish itself as a party separate from

its previous owner

Portrayal: No party to the combination is

portrayed as either acquirer or acquired, by its

own board or management or by that of another

party to the combination

Management: All parties to the combination, as

represented by the boards of directors or their

appointees, participate in establishing the

management structure for the combined entity

and in selecting the management personnel, and

such decisions are made on the basis of a

consensus between the parties to the combination

rather than purely by exercise of voting rights

Management: The management of one partyshould not be able to dominate the selection ofthe management team of the enlarged entity

Share-for-share: The substantial majority, if notall, of the voting common shares of thecombining entities are pooled, ie exchanged forshares rather than for, say, cash One party mustnot pool equity shares in return for combined-entity equity shares with reduced rights

Relative size: The fair value of one party is notsignificantly different from that of the other

No change in interests: The shareholders ofeach party maintain substantially the samevoting rights and interests in the combinedentity, relative to each other, after thecombination as before For example, the shareexchange ratio cannot give a premium to oneparty

No other financial arrangements: The financialarrangements do not otherwise provide arelative advantage to one group of shareholdersover the other For example, one party’s share

of the combined equity should not depend onthe post-combination performance of thebusiness that it previously controlled Sucharrangements may take effect prior to or afterthe business combination itself

Transactions among companies under commoncontrol, eg some group reconstructions, andbusiness combinations in the accounts of a jointlycontrolled entity are not dealt with by IASs

Attributes of the entities - autonomy: Each of thecombining entities is autonomous and has notbeen a subsidiary or division of another entitywithin two years before the plan of combination

is initiated

Attributes of the entities - independent of eachother: Each of the combining entities isindependent of the other combining entities (ie,inter-corporate investments do not exceed 10%

of the outstanding voting common stock of anycombining entity)

Manner of combining - single transaction: Thecombination is effected in a single transaction or

is completed in accordance with a specific planwithin one year after the plan is initiated.Manner of combining - share-for-shareexchange: An entity offers and issues onlycommon stock with rights identical to those ofthe majority of its outstanding voting commonstock in exchange for substantially all (90% ormore) of the voting common stock interest ofanother entity at the date the plan ofcombination is consummated

Manner of combining - no prior changes toequity: None of the combining entities changesthe equity interest of its voting common stock incontemplation of effecting the combination(such as distributions to stockholders, newissues, exchanges and retirements of securities)either within two years before the plan ofcombination is initiated or between the dates thecombination is initiated and consummated

5 General issues

Share-for-share: Under the terms of the

combination, equity shareholders of each party

to the combination receive, in relation to their

equity shareholdings, no consideration other

than equity shares in the combined entity, with

the following exception They are, however,

permitted also to receive non-equity

consideration (or equity shares with reduced

rights) provided that this represents an

immaterial proportion of the fair value of the

consideration received In addition, at least 90%

of the new subsidiary must be obtained

Relative size: The relative sizes of the combining

entities are not so disparate that one party

dominates the combined entity by virtue of its

relative size A party would be presumed

(subject to rebuttal) to dominate if it is more

than 50% larger than each of the other parties to

the combination, judged by reference to the

ownership interests; that is, by considering the

proportion of the equity of the combined entity

attributable to the shareholders of each of the

combining parties Thus in a two-party

combination the limiting ratio, subject to

rebuttal, is 60% : 40%

No change in interests: Where the pricing of the

combination puts a bid premium on one party’s

shares - ie, the post-combination relative

interests are not in the same proportions as the

pre-combination ones - then unless there is a

clear explanation to the contrary this portrays

the combination as an acquisition and merger

accounting is prevented

No other financial arrangements:

– No equity shareholders of any of the

combining entities retain any material

Manner of combining - no stock repurchases:Each of the combining entities re-acquiresshares of voting common stock only forpurposes other than the business combination(such as stock option and compensation plans)and no entity re-acquires more than the normalnumber of shares between the dates the plan ofcombination is initiated and consummated.Stock repurchases in the two years beforeinitiation are presumed to be for the purpose ofthe combination, known as ‘tainted stock’ andare also counted as non-share consideration forthe purposes of the share-for-share conditionabove

Manner of combining - no change tostockholders’ proportionate interests: The ratio

of the interest of an individual commonstockholder to those of other commonstockholders in a combining entity remains thesame as a result of the exchange of stock toeffect the combination

Manner of combining - no restrictions onstockholders’ rights: The voting rights to whichthe common stock ownership interests in theresulting combined entity are entitled areexercisable by the stockholders; thestockholders are neither deprived of norrestricted in exercising those rights for a period.Manner of combining - no contingentconsideration: The combination is resolved atthe date the plan is consummated and noprovisions of the plan relating to the issue ofsecurities or other consideration are pending.Absence of planned transactions - no futurestock repurchases: The combined entity does

5 General issues

interest in the future performance of only

part of the combined entity For example the

existence of a material minority would

prevent merger accounting A minority of

10% is acknowledged by the law and

standards as being too much However, this

should not be applied as an arithmetic test

Some lesser figures would also be judged

material

– In assessing the consideration received by all

parties (see above), any related arrangements

should also be considered In particular,

where one of the combining entities has,

within a period of two years before the

combination, acquired equity shares in

another of the combining entities, the

consideration for this acquisition should be

taken into account in determining whether

this criterion has been met

There are special rules governing group

reconstructions These permit merger accounting

where the definition of a merger is not met,

provided certain conditions are fulfilled

not agree directly or indirectly to retire or acquire all or part of the common stock issued toeffect the combination

re-Absence of planned transactions - no otherfinancial arrangements: The combined entity doesnot enter into other financial arrangements for thebenefit of the former stockholders of a combiningentity, such as a guarantee of loans secured bystock issued in the combination, that in effectnegates the exchange of equity securities.Absence of planned transactions - no disposals:The combined entity does not intend or plan todispose of a significant part of the assets of thecombining entities within two years after thecombination other than disposals in the ordinarycourse of business of the formerly separateentities and to eliminate duplicate facilities orexcess capacity

Subsequent transactions - no short-term stocksales: A controlling shareholder of any party tothe combination does not sell his stock in thecombined entity until financial results of thecombined entity are published (covering at least

30 days post-combination)

In practice poolings-of-interest are fairly common;

as a result the FASB is minded to prohibit themaltogether (see ‘Future developments’ below)

In addition, transactions between companies undercommon control are ordinarily accounted for in amanner similar to pooling-of-interests

The above rules also apply to business combinations

in the financial statements of equity method investees

5 General issues

Acquisition accounting

Fair value of assets and liabilities acquired

-general rules

Under acquisition accounting, the ‘identifiable assets

and liabilities’ of an acquired entity that existed at the

‘date of acquisition’ - including any separable

intangibles - are recorded at fair values (as defined)

which reflect the conditions at the date of acquisition

and the accounting polices of the acquirer The

difference between those fair values and the cost of

the acquisition is goodwill: positive goodwill is

capitalised and amortised usually over no more than

20 years, although longer or even indefinite periods

are permitted (see 6.1); positive goodwill from before

1998 may be set off directly against shareholders’

funds (see 6.1); the treatment of negative goodwill is

described later in this section Based on the

‘identifiable’ principle the following must be treated

as post-acquisition items: changes resulting from the

acquirer’s intentions or future actions; impairments,

or other changes resulting from events subsequent to

the acquisition; and future operating losses as well as

reorganisation and integration costs expected to be

incurred as a result of the acquisition, whether they

relate to the acquired entity or to the acquirer

There are rules governing the application of these

principles to specific classes of asset and liability, as

follows:

The fair value of acquired monetary assets and

liabilities must reflect the timing of receipt or

payment (ie, by discounting)

Fair values of tangible fixed assets and

investments are normally based on market value

or depreciated replacement cost

Fair value of an intangible asset is normally

be reliably measured (see 6.1) The differencebetween the aggregate of the fair values and thecost of acquisition is goodwill Goodwill is dealtwith at more length later on (see 6.1), but broadlythat arising after 1994 is capitalised and amortisedover a finite life usually, although not necessarilyalways, of less than 20 years; positive goodwillfrom before 1995 may be set off directly againstequity Negative goodwill is dealt with below

The restructuring provisions that must berecognised, even though they are not a liability ofthe acquired entity, are in respect of the acquirer’srestructuring of the acquired entity, the mainfeatures of which have been planned andannounced by the date of acquisition; a detailedformal plan is then required within three months ofacquisition or by the date of approval of thefinancial statements (whichever is the earlier)

Developments-in-progress must be capitalised andamortised

In other respects the rules for determining the fairvalues of particular classes of assets and liabilitiesare broadly similar to those of the UK Where lessthan the whole of an entity is acquired the grossasset and liability values and minority interest may

be determined on the US fair-and-book mixed basis

In the US, redundancy and reorganisationacquisition-accruals are generally not allowed; onlythe direct costs of an acquisition should be included

in the cost of a purchased entity Indirect expenses

of the acquiring company, including costsassociated with the closing of duplicate facilities,should be charged to expense when incurred Costs

of a plan to exit an activity of an acquired company,

or terminate involuntarily employees of an acquiredcompany, or relocate employees of an acquiredcompany, should be recognised as liabilitiesassumed in the purchase if specified conditions (inEITF 95-3) are met Those conditions are similar tothe normal rules for restructuring provisions (see6.12), save that at the time of acquisitionmanagement needs only to begin to assess therestructuring plan and within one year to finalisethat plan and communicate it to relevant employees

In other respects the rules for determining the fairvalues of particular classes of assets and liabilitiesare broadly similar to those of the UK However, the