Financial reporting: FAQs

Steve Collings considers some frequently asked questions in the areas of tainting rules in IAS 39: Financial Instruments: Recognition and Measurement and deferred tax implications, among others.

The FAQs include the taining rules in IAS 39, deferred tax implications on unrealised profits in stock, break clauses in leases and present value tests, provisions for reorganisation costs and capitalising start-up costs.

Can you explain how the ‘tainting’ rules work in IAS 39: Financial Instruments: Recognition and Measurement?

Entities cannot classify a financial instrument as ‘held-to-maturity’ if they have sold or reclassified a significant amount of held-to-maturity investments before maturity. The standard itself requires management to confirm that the relevant criteria have been met to classify investments as held-to-maturity. If management have sold /reclassified held-to-maturity investments (or where put options have been exercised) this will call into question (i.e. taint) management’s intentions to hold all securities in the held-to-maturity category. Therefore if management have sold/reclassified a significant amount of investments in the held-to-maturity category the entity will be prohibited from classifying any financial asset as held to maturity category for two years after the occurrence of this event (note, IAS 39 does not define ‘significant’).

To illustrate:
Consider an entity which has a portfolio of investments consisting of corporate bonds, treasury bonds and eurodollar bonds. Year end is 31 December and during September of the reporting year it sold a certain eurodollar bond to realise a large gain.

Just because the entity has sold one eurodollar investment (which is not considered insignificant in relation to the total held-to-maturity portfolio) it does not mean that only the eurodollar sub-category has been tainted. The tainting rule is very clear – if an entity has sold or reclassified more than an insignificant amount of held-to-maturity investments, the entire portfolio and all remaining investments must be reclassified to the available-for-sale category.

The reclassification is recorded in the reporting period in which the sales occurred (i.e. to 31 December) and the entity will be prohibited from reclassifying any investments in the held-to-maturity category for two full financial years.

When the portfolio becomes cleansed after two full financial years, and it once again becomes appropriate to carry investments at held-to-maturity, the fair value of the affected securities becomes the new amortised cost. Also, worth mentioning, is that in the year tainting occurs the held-to-maturity classification in the comparative year prior to tainting is not affected.

I have a client which operates as a group. A subsidiary has sold goods which cost £50,000 to its parent company for £60,000 and these goods are in stock at the end of the year. Are there any deferred tax implications I will need to consider? The subsidiary pays tax at 26%.

Yes. Because there are intragroup profits in stock which are unrealised at group level, a timing difference occurs for which deferred tax should be provided. A consolidation adjustment will be needed to remove the £10,000 profit from the consolidated profit and loss account. The subsidiary should provide for deferred tax of (£10,000 @ 26%) £2,600. The tax provided by the subsidiary will be eliminated on consolidation by way of recognising a deferred tax asset at group level. This would be permissible under FRS 19 ‘Deferred Tax’ because the deferred tax asset will be recovered when the goods are sold to third parties. It is worth mentioning that the international equivalent (IAS 12 ‘Income Taxes’) differs because IAS 12 requires recognition of a deferred tax asset at the receiving company’s tax rate.

My client has taken out a ten-year lease but this lease contains a break clause where they can walk away from the lease agreement after five years. For the purposes of accounting under UK GAAP, what will be the lease term for calculating the minimum lease payments for the present value test?

Where a lease contains a clean break clause, enabling the lessee to sever ties from the lease without recourse, the lease term will normally be the period between the inception of the lease and the earliest point at which the break option is exercisable by the lessee. Care must be taken here to properly consider the substance of the lease transaction because the inclusion of such break clauses can significantly reduce the minimum lease payments for the purposes of the present value test to such an extent that they fall below the 90% threshold laid down in SSAP 21 ‘Accounting for Leases and Hire Purchase Contracts’ which will mean the lease is classified as an operating lease. Provided that there is a genuine possibility that the lessee will exercise the option, this will not be an unreasonable result.

My client has formulated a plan to reorganise its operations. In the AGM, the directors have approved the plan which will involve the closure of ten major business segments though no decisions as to which segments will close have been made. The client is proposing to provide for reorganisation costs in the financial statements – is this permissible?

The provisions in FRS 12 ‘Provisions, Contingent Assets and Contingent Liabilities’ requires a constructive obligation to arise in order for these sorts of costs to be included in the financial statements. A constructive obligation arises only when the entity has both a detailed formal plan for restructuring and makes an announcement to those affected. In this case, management’s plan does not provide sufficient detail that would permit the recognition of a constructive obligation.

My client has taken over a shop which will need some remedial work doing before they can open.  The landlord still requires rent to be paid even before the shop opens, can the rentals incurred before the shop opens be capitalised and written off over the lease term?

SSAP 21 ‘Accounting for Leases and Hire Purchase Contracts’ requires operating lease rentals to be charged as period expenses over the term of the lease (i.e. from the date of inception of the lease) as opposed to over the period the shop is in use.  UITF Abstract 24 ‘Accounting for Start-up Costs’ states that start-up costs are those costs which are incurred both before and after opening a new facility. Given UITF 24 stance on start-up costs, there would be no basis for capitalising the operating lease rentals prior to the shop opening.

Category: Accounting and standards, Audit