Problematic financial reporting issues

In a lot of cases, particularly with clients who operate in the ‘SME’ sector, the preparation of financial statements is often straight forward.  However, situations may arise when complex financial reporting problems become apparent and some practitioners may have difficulty in deciphering the correct accounting treatment.

In this article, I will look at three of the more complex areas which have come up during lectures to accountants, that of: provisions for onerous contracts, merger relief and impairment testing.  A future article on complex financial reporting will look at: share-based payments, the accounting differences between acquisitions and mergers and accounting for investment properties.

1.         Provisions for onerous contracts

The first thing to establish in the case of onerous contracts is whether the contract is onerous or not.  FRS 12 ‘Provisions, Contingent Liabilities and Contingent Assets’ defines an onerous contract as:

‘a contract in which the unavoidable costs of meeting the obligations under it exceed the economic benefits expected to be received under it.’

Figure 1

Company A Ltd occupies two properties.  One of the properties is owned by Company A and the other property is occupied under an operating lease.  The provisions in the lease state that Company A Ltd will pay the landlord monthly rentals amounting to £1,000 per month from 1 April 2007 to 31 March 2011.  However, due to the economic downturn, Company A has been forced to ‘down-size’ and has abandoned the property it occupied under an operating lease from 1 April 2009.

In the illustration above, Company A has vacated a property it held under an operating lease but the contract is onerous as Company A is still committed to pay the landlord future rentals until 31 March 2011.

Figure 2

Company B Ltd has an operating lease on a Cafe situated in a busy town centre location.  The landlord has notified Company B that the property’s central heating system has to be replaced and because of health and safety reasons the Cafe must close for a few weeks commencing on 1 July 2010.  Company B’s year-end is 30 April 2010.  Company B’s accountant is proposing to make a provision for the rent that will still be payable to the landlord during the week the Cafe is closed.

In terms of providing for future operating losses, FRS 12 specifically prohibits this.  A provision in respect of rentals paid under the lease can also not be made unless the contract is onerous.  The contract would only be onerous if the unavoidable costs of meeting the obligations under it exceed the economic benefits expected to be received under the contract.  In this illustration, the operating lease cannot become onerous simply because the tenants expect to incur an operating loss for a small period of time.  The facts in this illustration are that the rentals payable over the full lease term are more than likely going to be recovered through future sales when the Cafe is re-opened and so the contract is not onerous.

Figure 3

Company C Ltd has a contract with a supplier which is an onerous contract.  The provisions in the contract stipulate that Company C will enter into the contract on 1 January 2009 and it will run for three years until 1 January 2012.  Company C wishes to terminate the contract in 2010 because a competing supplier has offered more favourable terms, however it will incur an early termination fee to terminate the contract by its existing supplier.

Company C wishes to make a provision in the 2009 accounts for the cost of terminating the contract.

In this illustration the contract has been determined as an onerous contract.  It should therefore make provision under FRS 12 for the net cost of terminating the contract.

In Figure 3 we have automatically deemed the contract as onerous, purely for illustrative purposes to show which costs need to be provided for.  However, consideration needs to be given to whether the business in which the products are used in is profitable.  If it is profitable, the contract will not be onerous and the early termination fee should be charged when it is incurred (i.e. in 2010).

2.         Share premium

When a company issues shares over and above par value, the company must recognise the premium on the share issue in a share premium account.  This was tested in the tax case of Shearer v Bercain Ltd where the court held that section 56 of the 1948 Companies Act applied (this is now found in section 610 of Companies Act 2006).  The Act states that the premium is to be carried in a share premium account and the premium can only be distributed if the procedure for capital reduction was complied with.

‘Merger relief’ is a statutory relief from recognising share premiums when an entity acquires the shares of another entity.  This is not, however, a free for all, and strict criteria have to be met and will affect the issuing company’s capital and reserves section of its separate financial statements.

In order to obtain merger relief the transaction must satisfy all three of the following conditions:

• A company (known either as the issuing company or the acquiring company) secures at least 90% of the nominal value of each class of the equity share capital of another company as a result of the arrangement.
• The arrangement provides for the allotment of equity shares in the issuing company (such allotment will normally be made to the acquired company’s shareholders).
• The consideration for the shares allotted is either the issue or the transfer to the issuing company of equity shares in the acquired company, or the cancellation of those equity shares in the acquired company that the issuing company does not already hold.

Figure 4

Company D Ltd acquires a 95% holding in Company E, the terms of the transaction being on a share-for-share exchange basis.

Company D is entitled to merger relief because it has obtained more than 90% of the equity capital in Company E.

Figure 5

Company F Ltd acquires all of the ‘A’ shares in Company G Ltd.  Company G Ltd also has ‘B’ shares in issue.  Company F Ltd has not acquired any of the ‘B’ shares.

Company F is not entitled to merger relief because it has not obtained a 90% holding of each of Company G’s class of share capital.  This would apply even if the ‘B’ shares represent 10% or less of the entire issued equity share capital.

In terms of merger relief, it is important to understand that it is not ‘merger accounting’.  Merger relief is a relief given under section 612 of the Companies Act 2006 from the requirement to carry the premium on shares issued to acquire shares in another company in a share premium account.

The advantage of being granted merger relief is that it allows the distribution of pre-acquisition profits which would otherwise be locked up in the subsidiary it acquires, hence the need to comply with the very strict criteria.

3.        Impairment

Impairment testing is always a bone of contention because it is dependent on a lot of uncertain variables.  Unfortunately, impairment testing has become increasingly more important over the last couple of years due to the economic downturn but it is still a very much subjective area of accounting so I have illustrated the concept to try and make it more understandable.

Impairment testing is required under the provisions in FRS 11 ‘Impairment of Fixed Assets and Goodwill’ and IAS 36 ‘Impairment of Assets’.  The standard ensures that fixed (non-current) assets are carried at no more than their recoverable amount in the balance sheet (statement of financial position).

Recoverable amount is the higher of ‘fair value less costs to sell’ and ‘value in use’.

Figure 6

Company H Ltd has one of its many departments that performs machining operations on parts that are sold to contractors.  A group of machines have an aggregate book value as at 31 December 2008 totalling £123,000.  It has been determined by the directors of Company H Ltd that this group of machinery constitutes an ‘income-generating unit’ under FRS 11(referred to as a ‘cash-generating unit’ in IAS 36).

Upon analysis, the following facts about future expected cash inflows and outflows become apparent based on reduced productivity due to the age of the machinery and the increase in costs to generate output from the machines.

After deducting the costs of disposal, the net selling price of each machine in the income-generating unit is £84,500.  This figure has been arrived at by using machinery quotations from a well-known prominent dealer.  Value in use is determined with reference to the above expected cash inflows and outflows which is discounted at a risk rate of 5%.  This yields a present value of approximately £91,982 as shown below:

*value in use

Since value in use exceeds net selling price (£84,500), value in use is selected to represent the recoverable amount of this income-generating unit.  This is lower than the carrying value of the group of assets and therefore an impairment loss should be recognised amounting to (£123,000 – £91,981) £31,019.

The impairment loss will be recognised as an operating expense as either depreciation or a separate heading in the statement of comprehensive income.

Category: Accounting and standards, Audit