Financial reporting problems highlighted – part 2

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In the second article of a series of three, Steve Collings considers the findings of the Financial Reporting Review Panel’s (FRRP) Annual Report issued in September 2012 which can serve to highlight issues that accountants dealing with clients in the SME sector which may help during the course of any regulatory review.

While the FRRP’s report is based on listed companies and large private companies reporting under IFRS, the principles addressed in the report are similar to the principles contained in UK GAAP and some of the comments flagged up in the report are broadly similar to those flagged up by file reviewers.

Property, plant and equipment

The report acknowledges that the FRRP has rarely felt the need to challenge companies in how they report property, plant and equipment which are dealt with in IAS 16 Property, Plant and Equipment (FRS 15 Tangible Fixed Assets).  However, the FRRP have said that in the period under their review, they have questioned companies where it is unclear as to whether they have used the cost or the revaluation model laid down in the IAS.  As mentioned in the previous article, accounting policies (both in UK GAAP and IFRS) require material accounting policies to be disclosed and where fixed assets are material to the financial statements, adequate disclosure of the accounting policies should be made.

IAS 16 also permits aggregation where property, plant and equipment meets the relevant criteria (namely that they are of a similar nature or put to similar use in their operations) and the FRRP contacted a number of companies to explain the basis on which they had grouped material amounts of different assets that, on the face of it, did not appear to meet the aggregation test.

Lease transactions

The standard that prescribes the accounting and disclosure requirements for leases is that of IAS 17 Leases (SSAP 21 Accounting for Leases and Hire Purchase Contracts).  The criticism here by the FRRP is one which is prevalent within the profession as a whole and is frequently cited by file reviewers.

Accounting standards require disclosure of the total of future minimum lease (and sub-lease) payments to be made in respect of non-cancellable operating leases and the FRRP have criticised companies that fail to make such disclosure.  The FRRP have acknowledged that such a disclosure is important to users of financial statements when they are reviewing financial statements of companies which are facing funding difficulties.

On a less familiar note, the FRRP contacted companies to provide further information that reported sale and leaseback transactions as operating leases but the information provided in the financial statements gave rise to doubt as to whether the risks and rewards of ownership had been substantially transferred which would indicate that the lease is a finance, rather than an operating, lease.

Revenue recognition

Again, the FRRP have cited accounting policies as lacking in substance, largely because companies are relying on ‘boilerplate’ accounting policies generated by accounts production software.  The FRRP have criticised companies for failing to clearly explain the basis on which the relevant qualifying criteria for revenue recognition, required by IAS 18 Revenue, had been met in respect of the specific income streams of the relevant company.

The FRRP have also said that where a company had disclosed accounting policies for revenue recognition, these had been drafted in broad generic terms, or simply cited directly from the accounting standard which does not allow users to understand the transactions entered into, or the point at which revenue would be reflected in the income statement.  As a consequence, the FRRP contacted various companies to request confirmation of how management have satisfied itself that:

  • the significant risks and rewards of ownership had been transferred to the customer or the stage of completion could be determined reliably;
  • the amount of revenue could be measured reliably; and
  • it was probable that the company would benefit economically from the transaction.

The FRRP have also advised companies to consider the following when assessing both the appropriateness and adequacy of their disclosures relating to revenue recognition policies:

  • categories of revenue
  • stage of completion
  • complex arrangements

Employee benefits

Under IAS 19 Employee Benefits a reporting entity has to recognise a liability in its financial statements when services have been provided in exchange for future employee benefit.  An expense has to be recognised when the company consumes the economic benefit arising from the service provided by the employee.

Defined benefit pension plans are frequently in deficit, resulting in large liabilities being shown on companies’ balance sheets that are involved in such pension plans.  The FRRP sought to further understand the accounting for such plans with pension trustees where company assets are transferred to a partnership in which the pension fund is a limited partner and a Panel Group was formed in respect of one case where the company concerned had changed the terms of the arrangement, resulting in the company’s interest held by its pension fund in a partnership controlled by the company being classified within equity, rather than as a liability.  The company had transferred a number of its properties to the partnership subject to leaseback. The limited partnership interest held by the pension scheme entitled it to receive dividends from the profits of the partnership earned from rental income with the exception being if the company did not pay a dividend or make any other form of distribution to its shareholders and where this was the case the dividend was deferred until such time the company paid a dividend.

The FRRP challenged the company’s treatment having regard to IAS 32 Financial Instruments: Presentation.  Broadly speaking, IAS 32 requires any form of financial instrument to be recognised as a liability if that instrument entitles the holder to receive cash (either by way of redemption or by way of dividend).  The FRRP felt that even though the terms of the arrangement were such that a dividend could be deferred until such time the company paid a dividend, such discretion was not truly unconditional and thus treatment as equity was not appropriate in the circumstances.

Following the FRRP’s inquiry into this transaction, the company has since changed its terms of partnership and will make a prospective change to its accounting policy which will result in the derecognition of the equity instrument, and instead recognition of a liability in the next published accounts.

Finally, with regards to employee benefits and the fact that many companies continue to report significant deficits on their balance sheets relating to defined benefit plans, the FRRP have recommended that companies make additional disclosures, over and above those required in the accounting standard, for example the source of mortality data and life expectancies in order to aid users’ understanding.

Foreign currency

The accounting standard that prescribes the necessary accounting treatment and disclosure issues is that of IAS 21 The Effects of Changes in Foreign Exchange Rates with the UK equivalent being that of SSAP 20 Foreign Currency Translation.

The FRRP came across instances where material amounts of translation differences had not been recognised in the group financial statements in a separate component of equity.  The FRRP reviewed the accounts of smaller listed companies and AIM-listed companies and noted some additional errors in foreign currency translation.  Such errors included inconsistencies in the statement of cash flows or inconsistencies with the front end narrative.  The FRRP have cited a poor understanding of accounting for the effects of changes in foreign exchange rates as the reason for such errors.

Related party disclosures

An article on financial reporting problems would not be complete without related party disclosures featuring at some point! Unfortunately it seems that this is an area that is open to a lot of misinterpretation and I suspect it is down to the fact that IAS 24 Related Party Disclosures and its UK counterpart, FRS 8, have both become complex over the years.  The FRRP have had to contact a number of smaller companies reporting under IFRS to remind them that all directors, including non-executives, fall under the related party classification as ‘key management personnel’ and must be included in the related party disclosures.  The FRRP expressed concern that a number of companies failed to disclose the amount of remuneration in each of the five categories specified in the IAS.  The FRRP have said that such disclosures can be made within the remuneration report, provided a cross-reference to the specific information in the remuneration report is included within the accounts, and that the information is covered by the audit report.

The FRRP have also said that share-based payment transactions attributable to key management personnel must also be disclosed and included in total compensation.

Consolidated and separate financial statements

The FRRP said that the majority of their challenges were borne out of suspicion that not all relevant subsidiaries may have been included within the group financial statements due to the fact that there can be an element of significant judgement needed to determine whether, or not, a company has the power to govern the financial and operating policies of another company (hence having ‘control’ as defined in IAS 27 Consolidated and Separate Financial Statements).  The FRRP have said that where the decision was finely balanced, the financial statements did not contain sufficient explanation describing the basis of control.  The FRRP also criticised companies where disclosures were weak and therefore failed to describe the timing of events which gave rise to question as to the date control was obtained.  The FRRP have cited examples of conflicts, where the disclosures in the financial statements conflict with information included in market announcements at the time, or where there was reference to the signing of conditional agreements.

The FRRP’s report states that the Panel did not find it appropriate to seek corrective action in the accounts under review, but they have requested various companies to put in additional disclosures in future to explain the board’s judgement.

If a company increases its stake in another company (for example where P owns 70% in S and then P purchases an additional 10% resulting in an 80% share) then there is no change to the original amount of goodwill recognised – it is merely a transaction between equity holders and as such the revised IFRS 3 Business Combinations requires such a transaction to be reflected in equity.  In one case, a company had adjusted goodwill and following a challenge by the FRRP, the company concerned has agreed to correct this situation in its next financial statements, to which the FRRP agreed.

The FRRP have found it necessary to advise boards to ensure that their accounting treatment and judgements relating to liabilities arising from non-controlling interests’ (minority interests’) put options (for example acquisitions involving earn-out arrangements) are clearly disclosed and that the descriptors of non-routine movements in the statement of changes in equity are clear.  The FRRP acknowledge that whilst such transactions are rare, in such situations the disclosures must be clear, comprehensive and appropriately cross-referenced to other notes providing relevant supporting detail.

The FRRP have also found it necessary to remind companies that non-controlling interests must be disclosed separately from the equity of the owners of the parent, including total comprehensive income attributed to the owners of the parent and the non-controlling interests, regardless of the fact that in some cases the non-controlling interests may show a deficit.

Directors are also advised to take steps to obtain all relevant information and explanations which are considered necessary to support their consolidation of subsidiary companies.

Finally, in one case, an investment company had restructured a subsidiary’s shareholdings which resulted in the investment company acquiring a controlling stake.  However, the directors were of the opinion that due to the envisaged short-term nature of control, it would have been considered to be misleading and impracticable to consolidate the subsidiary.  Following the enquiry by the FRRP, the company concluded that the subsidiary should have been consolidated from the date on which control was obtained and therefore made a prior year adjustment.


The final article in this series will consider:

  • Financial instruments – presentation
  • Earnings per share
  • Impairment of assets
  • Provisions and contingencies
  • Intangible assets
  • Financial instruments – recognition and measurement
  • Investment property
  • Business combinations
  • Financial instruments – disclosures


Category: Accounting and standards

About the Author ()

Steve Collings is the audit and technical director at Leavitt Walmsley Associates Ltd and the author of 'Interpretation and Application of International Standards on Auditing'. He is also the author of 'IFRS For Dummies' and 'The AccountingWEB Guide to IFRS'. More about Steve's publications can be found by clicking on the 'Published Work' tab on the homepage. Steve is also a regular contributor of articles to www.accountingweb.co.uk, the UK's largest resource for professional accountants on a free subscription basis and is a member of the Society of Authors. Steve is an Editorial Board member for Wiley Insight IFRS and sits on the AAT's Financial Reporting Technical Panel. In 2011 Steve was named 'Accounting Technician of the Year' at the British Accountancy Awards and won 'Outstanding Contribution to the Accountancy Profession' by the Association of International Accountants in 2013. Follow Steve on Twitter - @stecollings

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