GT - Financial reporting. Unravelling the future before the future unravels your business

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Key outputs from the International Accounting Standards Board’s major work programme are now appearing and more are on the way. 2013 will see major changes to international requirements on consolidated accounts, joint ventures and fair value disclosures. Big changes to international requirements are on the way for revenue recognition, financial instruments and leasing, which are expected to begin taking effect from 2015 onwards.

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GT - Financial reporting. Unravelling the future before the future unravels your business

  1. 1. Unravelling future the future your before the unravels business AN FD’S GUIDE TO FINANCIAL REPORTING
  2. 2. Contents 03 What is your financing strategy? 09 Risk and Capital management – does your narrative reporting tellIntroduction the story? 13 What will forthcoming changes in accounting standards and regulation do to your company’s financial position and performance? 19 Are you seeking new opportunities through organic growth or throughFinancial reporting is changing acquisition?Key outputs from the International Accounting Standards Board’s 23 Is your business structured somajor work programme are now appearing and more are on the as to optimise management andway. 2013 will see major changes to international requirements on shareholder objectives? consolidated accounts, joint ventures and fair value disclosures. Big 27 Are you geared up to make thechanges to international requirements are on the way for revenue right choices given the proposedrecognition, financial instruments and leasing, which are expected to changes to legislation and thebegin taking effect from 2015 onwards. After several years of relative accounting regime in the UK?stability, the biggest shake-up in UK GAAP for a generation is due totake effect in 2015 when existing UK accounting standards are replaced 31 How might your businessby new requirements based more closely on IFRS. The front end of the operations be affected by marketannual report and accounts is set for an overhaul too as the Government and regulatory changes?plans to replace the existing directors’ report with a new strategic reportand annual directors’ statement. 34 Navigation 38 Contact usGrant Thornton’s FD’s guide to the future of financial reporting putsthese impending developments into the context of key issues facingyour business and highlights the key questions you need to be askingabout how the changes will impact on your business. To help you focuson what is most relevant to you, we have flagged these issues accordingto whether they are relevant where you prepare your annual report andaccounts under IFRS, UK GAAP or both.Dynamic organisations know they need to apply both reason andinstinct to decision making. At Grant Thornton, this is how we adviseour clients every day. We combine award-winning technical expertisewith the intuition, insight and confidence gained from our extensivesector experience and a deep understanding of our clients. We can helpyou unlock the potential for growth in your business by providingworld-class advice on how the changing financial reporting landscapewill impact on your business and its key stakeholders.This guide is based on standards and exposure drafts in issue at 30 June 2012. Joyce Grant Partner National Assurance Services2 AN FD’S GUIDE TO FINANCIAL REPORTING
  3. 3. 1 What is your financing strategy ? Challenging economic conditions make access to traditional sources of funding difficult. Management might need to look to alternative sources of funding to achieve growth or sustain business and should be aware of any accounting considerations. Expected changes in accounting standards could also impact on accounting for existing and new sources of finance, as well as financial covenants. Many transactions may have profit implications which in turn could impact on the amount of tax that your business has to pay. The tax consequences of financial arrangements entered into may, therefore, need careful consideration. AN FD’S GUIDE TO FINANCIAL REPORTING 3
  4. 4. Existing sources of finance Potential impact of future standards Do you have any leasing Very simply, if planned changes go ahead, IFRS arrangements? operating leases will be brought onto the balance sheet. A liability to make lease payments will be Many companies typically enter into operating recognised as well as a right of use asset. Liabilities lease arrangements. Under IAS 17 Leases the and assets will therefore increase. Profit or loss may accounting treatment for an operating lease is also be impacted. Instead of recognising operating straightforward and results in the recognition of an lease charges, an interest expense on the liability to operating lease expense through profit or loss. No make lease payments and amortisation of the right- asset or liability is recognised. of-use asset will be recognised. There may also be Under proposals to replace IAS 17, accounting impairment losses and revaluation gains, if relevant, for an operating lease will change. At the time of arising on the right-of-use asset. The amounts writing the timing of the changes to the leasing ultimately recognised in profit or loss and the timing standard is not yet certain, though it is not of their recognition may therefore be very different expected to be before 2015. compared to the existing accounting treatment. Do you have financial covenants and the amended IAS 19 from 2013 could be greater IFRS than under the current IAS 19. Immediate how sensitive are they to changes? recognition of actuarial gains and losses could Lenders often require the inclusion of financial also affect the net defined benefit asset or covenants to protect themselves and the borrower. liability if you have previously deferred theUK GAAP You may have covenants in place that relate to the recognition of actuarial gains and losses. maintenance of specified ratios or the maintenance • Future of UK GAAP: For those expecting to of the value of certain assets and liabilities above adopt the new Financial Reporting Standard or below specified levels. Changes in accounting applicable in the UK and the Republic of standards can inadvertently have an impact on Ireland (Draft FRS 102) there are numerous financial covenants. changes that will not only impact on profit or If your company is subject to loan covenants, loss but also financial position. Some of the key you will need to assess the potential impact differences between existing UK GAAP and the of changes in accounting standards on the proposed FRS 102 are discussed in more detail measurement, recognition and presentation of in Section 3. amounts in the financial statements on those • Potential changes in the recognition and covenants. This may necessitate early discussion measurement of revenue as a result of the with your lenders. It might also be worth talking proposed IFRS Revenue from Contracts to them about whether stable GAAP covenants with Customers could affect your company’s could be developed such that covenants are profitability and financial position. The amount ‘protected’ against the effects of future and timing of revenue recognised could change, GAAP changes. as could the amount recognised in respect of trade receivables. Areas of future potential impact include: • Operating lease agreements: Proposals to • Defined benefit pension scheme obligations: replace IAS 17 will impact on financial position Changes to IAS 19 Employee Benefits will and profit and loss, as described above. It is impact on the presentation of the net interest likely that both an asset and a liability will be cost and may affect the recognition of actuarial recognised on the balance sheet, and amounts gains and losses. This may impact on profit or recognised in profit or loss will also change. loss and financial position. For example, the net interest charged in the income statement under4 AN FD’S GUIDE TO FINANCIAL REPORTING
  5. 5. Have you considered ways in which with changes recognised through profit or loss. This will also be the case for those expecting toyou could manage the exposure of adopt the proposed FRS 102. At present underyour business to financial risk? UK GAAP, non-small companies that do notEntering into any financial arrangement can lead apply FRS 26 still need to disclose the fair valueto exposure to financial risk. For example, entering of derivative instruments, even if the derivativeinto long term variable rate loan arrangements can instrument is not recognised in the financiallead to volatility in interest charges, particularly statements. A fair value would therefore needgiven the inevitable future rise in interest rates. to be obtained which could involve aSome companies may consider entering into an professional valuation.interest rate swap to manage the exposure to Entities may also enter into other derivativethe future variability in interest rates. However, contracts such as foreign currency forwardcareful consideration will be necessary as swaps contracts, which would normally be accounteddo not always work to the advantage of the for at fair value through profit or loss underparty seeking to manage risk, and can be costly IAS 39 Financial Instruments: Recognition andto exit before the contractual maturity date Measurement (or its UK GAAP equivalent FRShas been reached. Further, under IFRS and for 26) and cause profit volatility. In some cases, thethose applying FRS 26 Financial Instruments: profit volatility can be managed through the useRecognition and Measurement under UK GAAP, of hedge accounting, although this can be complexthese financial instruments are classed as derivative and requires action on formal documentation andinstruments and need to be carried at fair value effectiveness tests on a strict time critical basis. AN FD’S GUIDE TO FINANCIAL REPORTING 5
  6. 6. New sources of finance Impact of current standards Do you have plans to raise funds has been contractually allocated on non-arm’s IFRS from a listing? length terms. In order to consider the accounting substance, it can sometimes be necessary to Companies seeking to expand and grow their use a valuation expert in order to arrive at an business often look to achieve this through a appropriate allocation of proceeds. This can have aUK GAAP public offering of their shares. If your company consequential impact on future finance costs. has a growth strategy which includes listing on a public exchange, depending on the nature of Do you have working capital financial instruments issued, there may be financial instrument classification and measurement balances which could be used to complications whether or not you prepare your secure asset-based finance? accounts under IFRS or UK GAAP. This applies In some cases traditional bank funding is proving not only to an issue of shares, but also listed debt. harder to find given the capital constraints currently in place. One solution available to Do you intend to issue new types of companies is to use the increasingly popular financial instruments? working capital facilities collectively known as asset-based lending. Receivables, or other assets In order to raise finance, entities may issue (eg inventories) against which finance is raised, financial instrument contracts such as share capital remain on balance sheet unless derecognition with non-standard terms, options, warrants or criteria are met and finance obtained against assets some types of loans which include ‘embedded is presented as a financial liability and classified derivatives’. These terms can lead to complex as either current or non-current. The associated accounting treatments. finance charges will impact on profit or loss. For instance, some warrants and options over own share capital would be accounted for as derivative liabilities, depending on what is called Do you have intra-group funding the ‘fixed-for-fixed’ test. Under IAS 39, or its UK arrangements? GAAP equivalent FRS 26, fair value movements in Funding arrangements may involve the creation such derivatives may impact on profit or loss. This of intra-group balances, for example, where a can lead to volatility in results. company in a group has access to external funding Volatility can also arise in non-derivative and lends to another group company. Where liabilities such as some types of loans, where those accounts are prepared under IFRS (and FRS loans have potentially variable cash flows (such as 26 under UK GAAP), there can be valuation contingent premiums). The treatment of fees paid complications. Under IAS 39/FRS 26 loans will in connection with raising finance should also be need to be recognised initially at fair value, which examined carefully. may not be the same value as the actual amounts The classification of financial instruments loaned between the group companies. This is often under FRS 25 Financial Instruments: Presentation the case where the terms of the group arrangement (and its international equivalent IAS 32) can be are different to those that could otherwise be difficult to determine, for example non-standard obtained in the open market. For example intra share capital. For those not familiar with FRS group loans can often attract interest at rates which 25, there can be some surprises. Another issue are preferential to those that a company could is that if more than one instrument is issued in obtain from an external source of finance. combination to the same investor (eg equity This would have an impact on the fair value on shares and loans), the accounting allocation of the initial recognition. proceeds received might not necessarily follow the legal form, particularly if one of the instruments6 AN FD’S GUIDE TO FINANCIAL REPORTING
  7. 7. If you prepare your accounts under UK GAAP a similar treatment is required for companies which apply FRS 26. UITF Abstract 47 Extinguishing Financial Liabilities with Equity Instruments repeats the guidance contained in IFRIC 19. However if your company does not prepare accounts under IFRS and does not apply FRS 26, there could still be implications for your accounts. In certain situations it may be appropriate to adopt a no gain/no loss policy in which case theAre you contemplating a financial value of the equity issued is deemed to match therestructuring? debt given up. However in other cases, where the equity is of little value and in substance the debtYou may be considering a financial restructuring has been waived, it may be more appropriate toat some time in the future. For example you might recognise a gain in profit or loss. In either casewant to improve your company’s gearing ratio or there are likely to be tax implications.financial position in anticipation of a public shareoffering, or the financial restructuring might bedue to an evolving business plan or a challenging Are you considering a change in theliquidity position. A financial restructuring couldbe achieved in a number of ways. For example, terms of your existing debt?it is common for a company to issue equity Where debt is modified, the accounting treatmentinstruments in return for a complete or partial will depend on whether the modification isextinguishment of debt. Alternatively you could substantial or non-substantial and this will dependagree with the lender to modify the terms of on the facts and circumstances of the modification.the existing debt or effectively replace the debt IAS 39 contains guidance. If the modification iswith a new instrument. (These two examples are substantial, then extinguishment accounting underdiscussed further below.) You could also decide to IAS 39 will result in the immediate recognitionrepay debt early. of a gain or loss. In substantial modifications, It is important to be aware that the way IAS 39 requires all fees to be expensed includingin which a restructuring is achieved will have those incurred during the restructuring. This canaccounting consequences, some of which can be sometimes appear harsh where companies feelprofit neutral whilst others may have a significant that at least some element of the fees relate toimpact on profitability, often introducing the future debt. However carry forward of thoseunplanned-for volatility. fees might only be possible in some very narrow circumstances. This contrasts with non-substantialAre you considering a modifications where, typically, no gain or loss need be recognised immediately.debt-for-equity swap? Where debt is modified, companies underWhere equity instruments are issued in return UK GAAP which apply FRS 26 will need tofor a complete or partial extinguishment of debt, follow similar rules to those contained in IAS 39often termed a ‘debt-for-equity swap’, any gain or described above.loss arising on the difference between the carrying However if your company does not apply FRSamount of the financial liability extinguished and 26, again there could still be implications underthe fair value of the equity instruments issued FRS 4 Capital Instruments.in consideration will be recognised in profitor loss. This treatment derives from IFRIC 19Extinguishing Financial Liabilities withEquity Instruments. AN FD’S GUIDE TO FINANCIAL REPORTING 7
  8. 8. Potential impact of future standards Do you intend to issue new types of financial liabilities that are classified as ‘other’ willUK GAAP financial instruments? need to be carried at fair value. This category will include derivatives, but might also include some Companies under UK GAAP will also have to other non-derivative items such as some non- think about the impact of the proposed FRS standard loans. 102 on their financial instruments. Derivative Under the plans for FRS 102, basic instruments instruments that are currently off balance sheet will be carried at amortised cost. The methods may now have to be recognised at fair value used to apply amortised cost are similar to FRS through profit or loss. As well as causing profit 26 and IAS 39, which can lead to more volatility volatility this may also require the use of compared to FRS 4 Capital Instruments in existing valuation experts. UK GAAP, particularly where there is potential Under the proposed FRS 102, all financial assets for variation on the future cash flows of the and financial liabilities will need to be analysed financial instrument. between ‘basic’ and ‘other’. Financial assets and Key actions/considerations • If your company is subject to financial covenants, review them for the potential impact of changes in accounting standards or business decisions • Discuss potential impact on covenants with lenders • If you are planning to issue new financial instruments consider the potential accounting impact of their terms • Consider the impact of financial instruments that are currently off balance sheet, which could require recognition under the proposed FRS 102 • For existing financial instruments, if the company uses UK GAAP then FRS 102 should be carefully considered in terms of whether an instrument is ‘basic’ or ‘other’8 AN FD’S GUIDE TO FINANCIAL REPORTING
  9. 9. 2 Risk and Capital ? management – does your narrative reporting tell the story Changes to your company’s business model arising from the continuing economic uncertainty mean that exposure to and concentration of risk is constantly changing. Consequently, the adequacy of capital and financial capital management policies and objectives are also likely to be of increased importance. Shareholders and other users of the financial statements could misunderstand the company’s exposure to risk if it is not communicated properly. There is also the possibility that if the shares in your company are publicly traded, market expectations of risk may have a negative impact on your share price, in which case better communication of risk can enhance the value of your company. You have the opportunity to manage the possibility that shareholders and other users may misunderstand your company’s exposure to risk by ensuring that relevant material risks and how they are being mitigated and managed are explained clearly in the annual report, and that shareholders and other users are kept up to date as developments occur. Therefore, what are you communicating with shareholders about how you identify and manage risk and how you are managing capital? AN FD’S GUIDE TO FINANCIAL REPORTING 9
  10. 10. Do you know what your investors Is the company’s business model IFRS want to know about? explained clearly? Much of the content of the front end of the annual The continuing economic uncertainty may have report is determined by statute or other regulatory led to changes in your company’s business model.UK GAAP requirements. However your key stakeholders, It is important that stakeholders are kept informed investors, may want to see other information and have confidence that your company is able to presented. It may therefore be useful to seek adapt to changing circumstances. current views from your investors as to the kind of A description of the business is necessary to information that they want to read about in your provide stakeholders with an understanding of annual report and accounts. the industry or industries in which the company operates, its main products, services, customers, Are the key messages regarding business processes and distribution methods, the structure of the business and its economic model, risk and capital management clear? including an overview of the main operating Does the front end of your annual report and facilities and their location. accounts concentrate on the key messages and Discussion of external factors such as the ‘tell the story’ or are key messages obscured company’s major markets and competitive by immaterial detail. In other words, is there position within those markets and the significant unnecessary ‘clutter’ that could be removed? features of the legal, regulatory, macro-economic Proposed changes to narrative reporting will and social environment that influence the business mean that the current Business Review and may also be relevant. Directors’ Report will be replaced with a Strategic Report and an Annual Directors’ Statement. The strategic report will provide key strategic information about the company including key risks and forward looking analysis. It will incorporate the content from the business review that is required by the Companies Act 2006 (CA2006). This is where companies will ‘tell their story’ and should provide enough information for users to make an assessment of the company’s historic performance and future prospects. The most significant changes will apply to the largest companies - quoted companies as defined by CA2006, but any company that is required to produce a business review will be affected. At the time of writing, the changes are expected to take effect in 2013, though this may change. Now may be a good time to rethink the narrative reporting section of your annual report, including the discussion of key risks together with the steps taken by management to mitigate the effect of these risks. Sometimes it can appear that words used in previous years have simply been updated rather than a fresh approach to the narrative having been applied.10 AN FD’S GUIDE TO FINANCIAL REPORTING
  11. 11. Have you considered recently what • Financial instruments: Fair value of financial instruments may be volatile and impairmentyour key business risks actually are? may be an issue.Key business risks are likely to evolve over • Direct or indirect reliance on public contractstime and are often influenced by changes in the for business: Government spending cuts couldexternal environment. It is important that the have a significant impact on your business.narrative disclosures relating to these risks are • Economic stagnation continuing indefinitely:updated regularly. As mentioned above, the way There appears to be no immediate end to thein which business risks are disclosed can have recession. How far into the future have youan impact on the way in which the company forecast and how sensitive are your figures tois perceived externally. The following list may potential changes in circumstances?help you identify key issues which are relevant • Impact on business if interest rates increase:to the continuing economic climate, and which In the UK we are currently experiencing lowmay therefore be relevant to your discussion in interest rates but this cannot continue andthe annual report. The key risks that should be eventually they are likely to rise. Will yourdisclosed are those that specifically affect the business be able to accommodate an increasecompany and not those that are generic to any in rates?company. The description of the risk should • Ability to meet banking covenants: Continuingenable the user to understand the harm to the pressures on property values, impairment andcompany that the risk may cause: fair value losses can impact on the ability to• Foreign currency exposure: The current meet banking covenants and will have a knock- volatility of exchange rates and trade with on effect on liquidity and the company’s ability European countries that may be forced to, or to secure more finance. Potential changes to the choose to, leave the Euro. way in which leases are accounted for will also• Reliance on trade with customers in countries bring more liabilities onto the balance sheet. facing local austerity measures: Overseas countries may be subject to measures which could impact on their ability to trade overseas. AN FD’S GUIDE TO FINANCIAL REPORTING 11
  12. 12. Have you communicated your plan Have you reflected recently on what to mitigate the impact of identified the business regards as capital and business risks? what adequate levels of capital are As well as communicating the key risks, it is considered to be? important that you explain how you manage those If your company prepares accounts under IFRS (or risks. Users of the accounts need to know that the applies FRS 26 Financial Instruments: Recognition company has procedures or controls in place to and Measurement under UK GAAP) then there manage the impact of those risks. The statutory are specific requirements regarding the disclosure business review requirements also anticipate that of capital management policies and processes. this explanation will be given, and regulators such as However even where accounts are prepared under the Conduct Committee of the Financial Reporting UK GAAP, disclosures about capital and how it is Council (formerly the Financial Reporting Review managed are considered necessary for a balanced Panel) will also expect to see this discussed. The and comprehensive business review, which is a way in which the company is perceived externally statutory requirement in the UK. will also be affected by how clearly these plans are Things to consider and what shareholders want to communicated. In the current environment, it is know include: unlikely that business risks will remain unchanged • the nature of capital: equity, preference shares, from one year to the next so it is important that you term loans, leases etc revise your explanations at each reporting date. • dividend policy: including an indication of constraints on future dividend growth • return on capital employed • capital headroom, eg against banking covenants, and the availability of additional capital • long-term funding plans designed to implement business strategy. Key actions/considerations • Seek investor views regarding the content of the annual report • Review narrative reporting within the annual report for unnecessary clutter • Refl ect on the current key risks within the business • Perform sensitivity analysis on profit and cash fl ow forecasts in the event of the difficult economic conditions continuing for a prolonged period • Consider adequacy of principal risks and uncertainties and capital management disclosures12 AN FD’S GUIDE TO FINANCIAL REPORTING
  13. 13. 3 What will forthcoming changes in accounting standards and regulation ? do to your company’s financial position and performance Forthcoming changes in accounting standards and regulation are likely to affect your existing business so you will need to be aware of what those changes are and what they could mean for your company’s financial position and financial performance. Changes will have an effect on the financial statements of companies, even where significant changes to the business model are not anticipated. You will also need to communicate with shareholders and other users of your company’s financial statements what the impact of the changes is likely to be. AN FD’S GUIDE TO FINANCIAL REPORTING 13
  14. 14. Do you have any operating lease Do you currently defer actuarial IFRS agreements in place? gains and losses using the ‘corridor We have already mentioned in Section 1 that method’? the IASB is proposing to replace IAS 17 Under the amended IAS 19, all actuarial gains and Leases although the effective date is not yet losses will be recognised immediately in other certain. However under the proposed new comprehensive income. If you currently apply standard, accounting for operating leases will the corridor method and defer certain actuarial change. Therefore, if you have operating lease gains and losses, this method will no longer be arrangements, you need to be aware that there permitted. The good news is that all actuarial could be significant changes in the accounting gains and losses will be recognised in other treatment. See Section 1 for more details. comprehensive income and hence profit or loss will not be affected by the volatility of actuarial Does your company operate a assumptions and experience gains and losses. defined benefit pension scheme? If you have a defined benefit pension scheme What sort of sales contracts do you your company will be affected by amendments to have in place with your customers? IAS 19 Employee Benefits which take effect for It might be a good time to review your contracts financial years commencing on or after with customers to ensure that the timing of 1 January 2013. recognition and measurement of revenue will The amendments will impact on the income not be adversely affected by the proposed new statement and financial position as a result of revenue recognition standard. The impact of the changes to the way in which interest on the proposed changes to revenue recognition will vary scheme deficit or surplus is calculated and from business to business. The proposed new depending on how you currently recognise IFRS, Revenue from Contracts with Customers actuarial gains and losses. is expected to take effect for financial years At present the finance cost in profit or commencing on or after 1 January 2015. loss typically includes the interest cost which represents the increase in the present value of the defined benefit obligation due to the time value Does your sales model require you of money and the expected return on plan assets. to provide a range of services over Under the amended standard, the discount rate a period of time? currently used to determine the interest cost on the defined benefit obligation will be used to calculate The proposed revenue recognition standard will the net interest on the defined benefit liability (or require identification of separate performance asset). In effect, the expected return on plan assets obligations within a contract, determination of the will be based on the market yields on high-quality transaction price which includes the consideration corporate bonds rather than the higher rate the of factors such as variable consideration, the market would expect to be achieved on the plan time value of money and collectability, and the assets themselves. Reported profit is likely to allocation of the transaction price to distinct reduce as a result of using a different method for performance obligations. These changes could measuring the net interest charge/credit. affect the timing and amount of revenue There is also less flexibility in how components recognised, particularly in situations where of the defined benefit expense are categorised in contracts are complex and involve the performance the income statement. of obligations over a period of time.14 AN FD’S GUIDE TO FINANCIAL REPORTING
  15. 15. Do you prepare group accounts? Do you have any investments whichThere are many changes that will affect companies are not treated as subsidiarieswhich prepare group accounts as three new under IAS 27 but which could beaccounting standards take effect for financial under IFRS 10?years commencing on or after 1 January 2013,subject to adoption by the European Union (EU). The criteria for determining control under IFRSChanges in the definition of control under IFRS 10 are different to those under IAS 27. This could10 Consolidated Financial Statements and the mean that in certain cases a different conclusionclassification of joint arrangements under IFRS would be reached as to whether an investment is11 Joint Arrangements may have an impact on accounted for as a subsidiary.accounting, presentation and disclosures. IFRS For example, if your company holds a12 Disclosure of Interests in Other Entities will significant minority shareholding in an investment,require enhanced disclosures, in particular in but other shareholdings are widely dispersed,judgemental situations. You need to be thinking this could result in control under IFRS 10. Ifabout their impact now as although the new your company holds potential voting rights instandards apply to financial years commencing on an investment which are substantive, either aloneor after 1 January 2013, changes are retrospective or in combination with other rights, this couldand so the restatement of balances at 1 January indicate that power exists over the investee which2012 may be required. in turn would contribute to the determination of control. Under IAS 27 there is a different assessment of whether potential voting rightsDo you have investments in contribute to control. Under IAS 27 the existencesubsidiaries? and effect of potential voting rights that areIf your company has subsidiaries and prepares currently exercisable or convertible are consideredconsolidated accounts, IFRS 10 will be relevant when assessing control. Under IFRS 10, potentialto you. IFRS 10 provides a framework to assess voting rights are not required to be currentlywhen one entity controls another. In most cases exercisable but would need to be exercisable whenthe decision as to whether an investment is a decisions regarding the activities of the investeesubsidiary is straightforward but borderline that significantly affect the investee’s returnsconsolidation decisions taken under IAS 27 (‘relevant activities’) need to be made.Consolidated and Separate Financial Statements orSIC-12 Consolidation – Special Purpose Entities Do you have any jointwill need to be reassessed and this may lead to arrangements?changes in accounting. Investments previouslyaccounted for as a subsidiary may fail to meet If you have joint arrangements, IFRS 11 willthe control definition under IFRS 10 and vice apply. IFRS 11 replaces the three categories ofversa. The definition of control under IFRS 10 joint arrangement under IAS 31 Interests in Jointconsists of three elements and requires all three to Ventures (‘jointly controlled entities’, ‘jointlybe present for control to exist – power over the controlled operations’ and ‘jointly controlledinvestee, exposure, or rights, to variable returns assets’) with two new categories: ‘joint operations’from involvement with the investee and the ability and ‘joint ventures’.to use power over the investee to affect the amount Joint arrangements classified under IAS 31 asof investor’s returns. In some cases, the analysis jointly controlled entities will generally fall intobehind each element will require judgement, in the category of joint venture under IFRS 11 inparticular with regard to the determination of which case the accounting will be unchanged,whether the company has exposure to variable unless proportionate consolidation was previouslyreturns, which has the potential to be interpreted applied (see below).widely. However there are situations where jointly controlled entities under IAS 31 will be classified as a joint operation under IFRS 11. If a jointly AN FD’S GUIDE TO FINANCIAL REPORTING 15
  16. 16. controlled entity was previously accounted for Are there significant non-controlling under the equity method under IAS 31 but the interests in your subsidiaries? investment is classified as a joint operation under IFRS 11, the accounting will be significantly Where a non-controlling interest in a subsidiary different. Under equity accounting, an investment is material to the reporting entity, there is a new is presented as one line within the balance sheet requirement in IFRS 12 to provide summarised and income statement reflecting the investor’s financial information about the assets, liabilities, share of the investee’s net assets and profit or loss profit or loss and cash flows of that subsidiary. for the year. An investment in a joint operation under IFRS 11 will be incorporated into the balance sheet and income statement on a line-by- Does your balance sheet contain line basis, reflecting the joint operator’s share of substantial financial assets? assets, liabilities, income and expenses of the joint arrangement. The IASB is gradually replacing IAS 39 Financial Instruments: Recognition and Measurement for financial instruments measurement with IFRS 9 Do you proportionately consolidate Financial Instruments. However, IFRS 9 is being your jointly controlled entities? completed in stages. The effective date of IFRS 9 If you proportionately consolidate jointly is for periods commencing on or after 1 January controlled entities under IAS 31, this will no 2015, subject to EU adoption. However, EU longer be permitted. Joint ventures will be equity adoption of IFRS 9 has not yet taken place. In accounted under IFRS 11. The effect of this on most cases, financial liability accounting in IFRS 9 the balance sheet will be to collapse the various is the same as IAS 39. The classification of financial assets and liabilities currently included in the assets in IFRS 9 is different compared to IAS 39. balance sheet into a single line item as described IAS 39 had four main classes, whereas IFRS 9 above. Similarly, the investor’s share of income and has only two main classes of financial assets, one expenses will be reflected as a single line item in being at fair value, and the other at amortised cost. the income statement, representing the investor’s Derivative assets will generally remain at fair value. share of the joint venture’s profit or loss for Amortised cost will apply where both (i) the asset the year. is held within a business model whose objective is to hold assets in order to collect contractual cash flows and (ii) the contractual terms of the financial Do your investee relationships asset give rise to cash flows which are solely expose you to any significant risks? payments of principal and interest. The above changes will generally mean that IFRS 12 integrates and makes consistent the for non-financial services businesses, derivative disclosure requirements for subsidiaries, joint assets will be at fair value through profit or loss, arrangements, associates and unconsolidated while most other financial assets such as trade structured entities. IFRS 12 specifies minimum receivables will be at amortised cost, hence little disclosures that an entity must provide. Some of change compared to IAS 39. However, if the this information will be new and its preparation business involves lending, then the business model will require careful planning. This includes and contractual terms of the financial assets will disclosure of the nature of, and changes in, the require very careful consideration. The changes to risks associated with any of these types IFRS 9 are therefore of key interest to banks and of investment. other financial institutions.16 AN FD’S GUIDE TO FINANCIAL REPORTING
  17. 17. Do you already apply or have profit and loss, and so there will be complexity in arriving at the accounting entries. you considered applying hedge As in IAS 39, the plans for IFRS 9 will accounting? only allow hedge accounting where formal Many entities take out derivatives such as interest documentation has been prepared in advance. rate swaps for hedging purposes. Those derivatives can cause profit volatility. Hedge accounting exists Does the company have significant in IAS 39 in order to mitigate that profit volatility, items accounted for at fair value? but is subject to strict rules. Those rules have sometimes acted as a reason for entities not to The IASB have issued IFRS 13 Fair Value apply hedge accounting. Measurement effective for periods commencing As part of the IFRS 9 project, the IASB plans on or after 1 January 2013. IFRS 13 does not alter to amend the hedge accounting model, although which items are carried at fair value but seeks to these proposals are not yet finalised at the time provide principles and guidance for measuring of writing. These proposals could provide more fair value. This is therefore relevant to any entities opportunity than under IAS 39 for entities which have items carried at fair value such as some to apply hedge accounting. In particular, the financial instruments and investment property. It IASB plans to remove the ‘highly effective’ test is also relevant where fair value is determined at which only allows hedge accounting in IAS 39 particular times such as in fair value calculations to continue on a hedging relationship if that for the purpose of impairment reviews and relating hedge has been highly effective. Instead, hedge to business combinations. accounting could continue even if effectiveness IFRS 13 may in some cases alter how fair reduces, but with a rebalancing of the hedging value has been determined compared to the past. relationship leading to a greater potential for Fair value is based on ‘exit’ value and a market- volatility in reported profit or loss and increased based view. In many cases, application of IFRS 13 complexity in the accounting. We anticipate that will not lead to any changes. However there are whilst the plans for IFRS 9 would make hedge numerous points of detail where IFRS 13 could accounting more accessible and more attractive, lead to a change from past practice. Entities that there will still be complexity. In particular, actual have significant items measured at fair value should ineffectiveness will be required to be taken to therefore consider whether IFRS 13 has any impact. Do companies within your group and measurement of financial instruments (seeUK GAAP Section 1), accounting for lease incentives, the prepare their accounts under UK recognition of valuation movements in investment GAAP? property through profit or loss, accounting for The Accounting Standards Board (ASB) is and presentation of defined benefit schemes and proposing changes to UK GAAP. Revised the calculation of deferred tax. proposals were issued in January 2012 with an An alternative to the proposed FRS 102 is effective date expected to be for accounting the proposed FRS 101 Reduced Disclosure periods beginning on or after 1 January 2015. If Framework. This is an option of IFRS recognition your company is intending to prepare its accounts and measurement with reduced disclosures under (Draft) FRS 102 The Financial Reporting for qualifying parent company and subsidiary Standard applicable in the UK and the Republic individual accounts. of Ireland (see Section 6 for accounting choices) You will need to be aware of how the changes there are some significant differences between the could affect your business. You will also need to proposed FRS 102 and current UK GAAP that communicate changes to key users of the need to be considered. Key areas of difference financial statements. include the useful life of goodwill, the recognition AN FD’S GUIDE TO FINANCIAL REPORTING 17
  18. 18. Is your company required to prepare matters (where necessary), key information on IFRS a business review? corporate governance and remuneration. This is where companies will ‘tell their story’ and should The content and structure of the front end of provide enough information for users to make an the annual report and accounts will be changing. assessment of the company’s historic performanceUK GAAP The Government proposes to replace the current and future prospects. requirements under the Companies Act 2006 The Annual Directors’ Statement will consist (CA2006) for a Business Review and Directors’ of detailed disclosures that are required regardless Report with a Strategic Report and an Annual of materiality or impact on the business as a Directors’ Statement. If your company is required whole, as well as information provided voluntarily. to prepare a business review, now might be a good The Statement will have a prescribed structure time to review the front end of your annual report. with a set layout and standard headings. For If your company is a quoted company, as defined quoted companies, it will include the Directors’ in CA2006, the changes will be greater. Remuneration Report, Corporate Governance The purpose of the Strategic Report will be Statement and the Audit Committee Report. to provide key strategic information about the company including key risks and forward looking Do you issue summary financial analysis. It will incorporate the content from the business review that is required currently by statements or is this something that CA2006. It will be prepared for shareholders and you might consider? describe the company’s performance, principal Companies are currently able to ask shareholders risks and uncertainties, key performance indicators if they would like to receive Summary Financial and key financial information. Statements in place of the annual report. For quoted companies, the Strategic Report will Under the Government proposals for narrative also include information on strategy, the business reporting, Summary Financial Statements will be model, social, environmental and human rights incorporated into the Strategic Report. Key actions/considerations • Consider the impact of changes in standards on existing balances and transactions • Review sales contracts for the impact of the new IFRS on recognition of revenue • Consider the potential classification of your investments under the new IFRS consolidation standards, eg as subsidiaries or joint ventures • Consider whether your accounting systems will be able to capture the information required to be disclosed by IFRS 12 • Consider how your accounts might look under the proposed future UK GAAP • Review and update your business review18 AN FD’S GUIDE TO FINANCIAL REPORTING
  19. 19. 4 Are you seeking new ? opportunities through organic growth or through acquisition The challenging business environment is driving businesses to refresh their business models and to seek new opportunities. Rather than viewing the current economic climate as a barrier to growth, many companies see it as an opportunity to refresh their business model and pursue new business ventures. This may be through organic growth, entering into new arrangements, joining forces with third parties or through business acquisitions. AN FD’S GUIDE TO FINANCIAL REPORTING 19
  20. 20. Organic growth Is your company considering Are you considering trading in new IFRS diversifying its range of products or geographical locations? services? If you are looking to trade in new geographical If you are intending to pursue new revenue locations, do you understand the environmentUK GAAP in which you plan to operate? There may be streams, you will need to be aware of the proposed new IFRS Revenue from Contracts economic barriers such as those linked to currency with Customers. The proposed revenue and local trading practices. For example trade recognition standard will require identification with countries with a volatile currency will of separate performance obligations within a impact directly on your results unless you have contract, determination of the transaction price a clear plan to minimise the impact. Entering which includes the consideration of factors into forward currency contracts and possibly such as variable consideration, the time value the adoption of hedge accounting under IAS of money and collectability, and the allocation 39 Financial Instruments: Recognition and of the transaction price to distinct performance Measurement (and FRS 26, where adopted under obligations. These changes could affect the timing UK GAAP) may therefore be a consideration. and amount of revenue recognised, particularly Local austerity measures may impact on your in situations where contracts are complex. You ability to trade freely with that market. There may therefore need to ensure that new sources of also be restrictions on the movement of resources revenue will be accounted for as anticipated. out of a particular location such as assets and Even where you prepare your accounts under profits. There may be unforeseen tax consequences UK GAAP, the way in which new sources of or complex tax systems to negotiate. There may revenue are measured and recognised will need to also be cultural differences to consider. be assessed in conjunction with UK Accounting Standards, principally FRS 5 Reporting the Have you considered hedging Substance of Transactions, Application Note any potential exposure to foreign G and the proposed FRS 102 The Financial Reporting Standard applicable in the UK and the exchange volatility? Republic of Ireland. In order to minimise exposure to foreign exchange volatility, IAS 39 (and FRS 26, where Is your company considering adopted under UK GAAP) permits the option of hedge accounting. An example of where hedge revising the terms on which it trades accounting might be useful is in connection with customers? with a foreign currency forward contract which The current economic environment has forced may be used to hedge the foreign exchange risks companies to be creative in terms of how they relating to future sales or purchases. IAS 39 seek to retain the trade of existing customers and requires such derivative contracts to be included pursue new opportunities. For example, changes in the balance sheet at fair value. In the absence in settlement terms with customers who might of hedge accounting, changes in fair value would otherwise be unable to settle their debts could be recognised immediately in profit or loss. Cash have implications under both the existing and flow hedge accounting allows gains or losses proposed revenue standards. Some changes in on the forward contract to be included in other terms could even be akin to financing transactions comprehensive income until the time of the which could alter the way in which the financial related sales or purchase transactions. IAS 39 instruments standards apply. There may also be contains detailed rules in determining when hedge net present value implications, depending on the accounting is available in which case the adoption timescales agreed with customers for payment. of hedge accounting will require careful and timely consideration.20 AN FD’S GUIDE TO FINANCIAL REPORTING
  21. 21. Is your business able to benefit from IFRIC 12 will apply where contracts for servicing IFRS the outsourcing of public services to the infrastructure of public services such as roads, bridges, tunnels, prisons and hospitals are entered the private sector? into between private sector providers and As part of the Government’s drive to increase government authorities. efficiency and reduce costs in the public sector, opportunities exist for private companies to Are you considering capital enter into contracts with local authorities to investment? provide services. If relevant, are you aware of any opportunities which might be available to In order to meet your plans for organic growth, your business? Where there are opportunities to you may be considering investment in property, take advantage of government contracts, you will plant and equipment. This may therefore involve need to consider factors such as the way in which decisions as to how you finance the investment. contract revenue is recognised and whether or not As we have already discussed in Section 1, the assets and liabilities used in or generated by the proposed new IFRS on leasing could influence arrangement should sit on or off balance sheet. your decision as to whether to lease new assets Furthermore, in some situations IFRIC 12 Service or to choose another method of financing your Concession Arrangements may also be relevant. capital additions.Other methods of growth Are you contemplating entering into You may be planning on acquiring subsidiary IFRS strategic business arrangements companies but changes in the definition of control under IFRS 10 Consolidated Financial Statements with third parties? may affect whether or not your investment is If your plans for growth include entering into accounted for as a subsidiary undertaking. In new arrangements with third parties you need to most cases it will still be evident that control exists consider if and how these arrangements fit in to but in other situations it may not be so clear. For the new consolidation standards and how they example, new specific guidance on arrangements will need to be accounted for. These have been involving special purpose vehicles, large minority discussed in Section 3. shareholdings, potential voting rights which are not currently exercisable and principal and agent arrangements may lead to unexpected Does your business strategy involve accounting consequences. the acquisition of other businesses? The way in which acquisitions are structured If your plans for growth include the acquisition can have an impact on the accounting. You of other businesses you need to ensure that will therefore need to ensure that acquisition you understand the implications of the new agreements carefully reflect the intended nature consolidation standards and that the accounting of the arrangement such that the appropriate treatment is as expected. accounting treatment is clear. AN FD’S GUIDE TO FINANCIAL REPORTING 21
  22. 22. Do your plans for growth include a accounts, the group accounts must be prepared IFRS listing on a public exchange? under IFRS. This could lead to significant differences in the recognition, measurement and If your plans for growth include a listing on a disclosures of amounts included in the financial public exchange, for example as a means of raising statements. You may therefore need to obtainUK GAAP finance to facilitate growth and expansion, there advice on where the biggest accounting differences will be a range of issues to consider such as specific are likely to arise in your specific circumstances. legal requirements, the regulatory requirements However, even where a future listing is of the relevant exchange and any accounting a medium to long term plan, you may be consequences such as the requirement to prepare considering voluntary adoption of IFRS to group accounts under IFRS. This is likely to be improve your prospects for external investment. relevant where your current business consists of Conversion to IFRS can be a time-consuming a group of companies which prepare consolidated exercise and will therefore require careful accounts under UK GAAP. For example, where planning. Given the anticipated changes to UK a parent is listed on AIM or has a listing on the GAAP now may be a good time to consider this. London Stock Exchange and prepares group Accounting choices are discussed in Section 6. Key actions/considerations • Understand the markets in which you intend to operate • Consider the impact of the proposed new revenue standard on new or revised revenue streams • Ensure that you understand the impact of the new IFRS consolidation standards on new business arrangements and investments • Understand the accounting consequences of a transition to IFRS22 AN FD’S GUIDE TO FINANCIAL REPORTING
  23. 23. 5 Is your business structured ? so as to optimise management and shareholder objectives The structure of a business can impact on the potential for management and owners to realise strategic business objectives. Now may be a good time to review the existing group structure with a view to simplification or demerging distinct strands of the business. However in all cases you will need to consider whether there are any tax implications. AN FD’S GUIDE TO FINANCIAL REPORTING 23
  24. 24. Is your group structure of the business has been overstated. Steps that IFRS unnecessarily complex? can be taken now to prepare for a future exit could include: Historically groups may have been set up with • a review of the current accounting policies a large number of companies. Whilst there to ensure that they are the most appropriateUK GAAP may have been legitimate business reasons for and reflect current best practice: A potential creating a particular group structure, changes in purchaser may challenge policies adopted, circumstances may mean that companies within a especially where they indicate that profits may group are no longer required. For example certain be overstated companies within a group may have little trade, • consideration of the value of off balance sheet or may be dormant. These companies, however, assets: Arrangements or assets may exist will still require a certain amount of management which have value to the business, but due to time and involve some administrative tasks, which accounting requirements are not recognised may lead to unnecessary costs. It may therefore in the accounts. For example there may be be a good time to streamline the structure of intangible assets or business contracts in place. your group, for example through the transfer It may therefore be worth considering which of trade and assets, the paying up of dividends unrecognised arrangements and transactions from subsidiaries to parent and the winding up of exist and how they could be valued if necessary companies no longer required. However it is likely • improving the balance sheet position: Now that there will be legal and regulatory implications could be a good time to review the balance to consider, as well as a need to determine the sheet and key financial ratios. For example, are necessary accounting entries to reflect credit control procedures as tight as they could the transactions. be? Are all debtor balances collectible? Are stock provisions adequate? Is there sufficient Could your business benefit from a liquidity? Does the fixed asset register reflect assets actually used within the business? demerger? • simplifying the corporate structure: A In contrast to the situation described above, there complicated group structure can obscure the may be advantages to splitting out an existing underlying business potential. As discussed business into component operations. This could be above, streamlining the group structure could useful where there is an intention to sell off part of make concentration of business activity and the business or to isolate less profitable parts of the value more transparent. This could involve the business which may be having an adverse impact consolidation of parts of the business or on the more profitable parts. For example, access a demerger. to funding may be hindered where unprofitable parts of the business are masking those parts of the Is the business highly geared? business which are profitable. A highly geared business can be unattractive to potential investors, purchasers, creditors and Do the owners of the business intend lenders for example. If your debt to equity ratio to exit from the business at some is high, then it may be time to consider ways to point in the future? redress the balance. For example there may be scope to convert debt to equity (See Section 1 If the owners intend to exit from the business at where debt-for-equity swaps are discussed further) some point in the future then time needs to be or to issue new shares using the funds obtained to spent now in planning for that exit and maximising partially or fully pay off any outstanding debt. the value obtained for the business. It is important Financial instruments which are legally shares to remember that a potential purchaser will be can sometimes be required under accounting looking to minimise the amount that he or she standards to be presented as debt due to the terms is required to pay for the business so will be of the instruments. This can adversely affect the challenging areas that could suggest that the worth gearing ratio. It may therefore be possible to alter24 AN FD’S GUIDE TO FINANCIAL REPORTING
  25. 25. the terms of the instruments such that they meet there are still specific legal steps which need tothe definition of equity, although care would need be followed, including the requirement for theto be taken to ensure that the relevant accounting directors to issue a solvency statement. Where arequirements were met. Additionally care should company is a public company, a capital reductionbe taken when issuing new classes of shares to is still possible although the rules are tighter andensure that the terms on which they are issued do include the requirement to obtain Court approval.not lead to an unintended classification as debt, Where there are significant distributablerather than equity. reserves, a special dividend could be paid. A special dividend is generally a ‘one-off’ dividendIs there surplus equity in the payment, separate to any normal recurring interim or annual dividends.business?On the other hand, surplus equity may exist Are you considering bringing in newin the business. A capital reduction could beused to remove dividend blocks within a group. investors?For example, negative reserves in a subsidiary If there are plans to broaden the investor base incompany could be preventing a profitable your business, have you considered how this willsubsidiary lower down in the group from paying be achieved? For example, in order to differentiatedividends. A capital reduction could therefore the rights of the existing shareholders and newcreate realised profits, which in turn absorb the investors it may be necessary to issue new sharesnegative reserves in the subsidiary company thus with different terms. As noted in Section 1, theremoving the dividend block. However statutory way in which the terms of shares issued arerequirements apply to a capital reduction and contractually constructed, for example in thewill vary depending on whether the company articles of association or shareholders agreements,is a private company or a public company. The can impact on the way in which they areCompanies Act 2006 simplified the capital accounted for, in which case care will be needed toreduction process for private companies, although ensure that there are no unintended consequences. Key actions/considerations • Ensure that the strategic objectives for the business and its owners are clear • Establish a clear plan to achieve the strategic objectives • Consider whether a corporate restructuring might be beneficial • Consider ways to improve the financial position of the business AN FD’S GUIDE TO FINANCIAL REPORTING 25
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  27. 27. 6 Are you geared up to make the right choices given the proposed ? changes to legislation and the accounting regime in the UK The Department for Business, Innovation and Skills (BIS) is proposing to widen the scope of the statutory audit exemption and big changes to UK GAAP are also expected. These proposed changes to legislation and the accounting regime in the UK will therefore require management to balance stakeholders’ needs with preparers’ costs. In many cases, management will have a choice whether or not they take up these changes. You therefore need to be able to make an informed decision and understand the consequences of the choices made. AN FD’S GUIDE TO FINANCIAL REPORTING 27

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