Financial Reporting Update
Changes to Companies Act 2006: guaranteed subsidiary audit exemption
Amendments to the Companies Act with effect from 1 October 2012 will enable some subsidiary undertakings to be exempt from audit, subject to certain conditions. The Act is also amended to allow an entity that prepares its accounts under EU-endorsed IFRS a free choice to revert back to UK GAAP, so long as it has not already done so within the past five years.
The Companies Act 2006 is amended* to:
- exempt certain subsidiary undertakings from audit (subject to certain conditions);
- simplify the audit exemption for small companies; and
- allow entities that prepare their accounts under EU-endorsed IFRS to switch back to UK GAAP.
These amendments will apply for financial years ending on or after 1 October 2012.
Guaranteed subsidiary audit exemption
Under new sections 479A to 479C (of the Companies Act 2006), a company, that is itself a subsidiary undertaking, can be exempt from audit if a number of conditions are met, chiefly:
- its parent (incorporated in the EEA**) guarantees all of the liabilities of the company as at the year end in question and files a declaration to effect that guarantee at Companies House (this guarantee and related filing is required each year);
- it is included in that parent undertaking’s audited consolidated accounts that are prepared in accordance with the provisions of the Seventh Directive or EU-adopted IFRS;
- all of the subsidiary's shareholders agree that the company be exempt from audit; and
- the subsidiary is not a quoted company, bank, insurance company or one of several other specified types of financial sector company.
The guarantee is a legally enforceable liability. It is made by the parent’s filing of specified details at Companies House, with the statutory consequence that the parent thereby becomes the guarantor of each and every liability (including contingent liabilities, including, for example, defined benefit pensions) of the subsidiary existing at the subsidiary’s year end until that liability is satisfied in full. The audit exemption applies only in relation to guarantees given by an EEA parent. The guarantee is enforceable against the parent by any party to whom the subsidiary is liable: no provision exists for the guarantee to be withdrawn.
The guarantee need not be given by the ultimate parent. For subsidiary undertakings of a U.S. group, for example, an intermediate EEA parent would be able to give a guarantee in relation to its own subsidiary undertakings, so long as it prepares its own audited consolidated accounts.
The new audit exemption applies to the audit only: there is no exemption from preparing and filing the subsidiary undertaking’s accounts, unless it is also a dormant company.
This exemption is similar to those in some other EU countries. For companies contemplating this exemption a key consideration is likely to be the appetite for spreading liability and risk around the group, as well as the potential reduction in the cost of ‘signing off’ the statutory accounts of the subsidiary (itself still subject to audit as part of the group). Please speak to your usual contact at KPMG for further information.
For dormant companies, the existing audit exemption in the Companies Act (sections 480 – 481) for small companies remains. However, if a dormant company is a subsidiary and a parent guarantee is put in place, then regardless of the size of that dormant company:
- the audit exemption as set out in new sections 479A to 479C (outlined above) is available;
- the company need not file accounts with Companies House (under new sections 448A to 448C); and
- the company need not prepare accounts at all (under new sections 394A to 394C).
However, under the existing requirements of the Companies Act, a dormant company must prepare a directors’ report and file it at Companies House.
Simplification of small company audit exemption
The audit exemption for small companies has been simplified by removing the requirement for a company to meet both the turnover and balance sheet total thresholds for the current year. This is likely to benefit those companies with significant amounts of assets but low turnover and employee numbers, for example, certain property companies.
Under the amended Act, a company qualifies as a small company in relation to a financial year and is exempt from audit if:
- it qualifies as a small company in relation to the year (i.e., meets two of the three size thresholds on a two-year rolling basis);
- it is not a public company, bank, insurance company or one of several other specified types of financial sector company; and
- minority shareholders holding at least 10% of the share capital have not demanded an audit.
Increased ability to revert back to UK GAAP
Currently, all UK companies (other than charities) may prepare their individual accounts under EU-adopted IFRS or UK GAAP. This choice also extends to consolidated accounts, unless the company is subject to Article 4 of the IAS Directive or listed on the Alternative Investment Market (in these cases it is mandatory). Once a company has prepared its consolidated or individual accounts under EU-adopted IFRS, it cannot revert back to UK GAAP unless there is a specified ‘relevant change in circumstances’, e.g., if the company (or its parent) ceases to have its securities admitted to trading on a regulated market in an EEA state.
Although the existing ‘relevant change in circumstances’ requirement will remain, new provisions in the Companies Act will allow a company to revert back to UK GAAP as its basis of preparation for both individual and/or group accounts, so long as it has not previously switched back to UK GAAP in the preceding five years. Any change in the previous five years due to a ‘relevant change in circumstances’ is ignored. The existing consistency requirements are unchanged, i.e., a UK parent company that prepares consolidated accounts must ensure that all UK companies in the group use either EU-adopted IFRS or UK GAAP unless there are ‘good reasons’.
This change in the law will permit those UK companies that prepare their accounts under EU-adopted IFRS to early-adopt FRS 101 Reduced Disclosure Framework and use FRS 102, once applicable in the UK. As set out in our Financial Reporting Supplement, it is proposed that entities not following EU-IFRS or the FRSSE will follow FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland for periods starting on or after 1 January 2015.
* By Statutory Instrument (SI) 2012/2301 The Companies and Limited Liability Partnerships (Accounts and Audit Exemptions and Change of Accounting Framework) Regulations 2012
** European Economic Area
Revisions to UK Corporate Governance Code
The UK Corporate Governance Code has been amended to recommend that directors make an explicit statement that the annual report as a whole is fair, balanced and understandable and provides the necessary information for shareholders. It will also require the directors to disclose the significant accounting issues considered by the audit committee.
Further to our article in the March/April 2012 Update, the Financial Reporting Council (FRC) has issued amendments to the UK Corporate Governance Code, the UK Stewardship Code and International Standards on Auditing (UK and Ireland). All of these changes are effective for periods beginning on or after 1 October 2012.
Compliance with the revised UK Corporate Governance Code requires that:
- the board states explicitly in the annual report that it considers the annual report to be fair, balanced and understandable and that it provides the information necessary for shareholders to assess the company’s performance, business model and strategy;
- a separate section of the annual report describes how the audit committee discharged its responsibilities, the significant issues considered by the audit committee and how those issues were addressed; and
- FTSE 350 companies put the external audit contract out to tender at least every ten years.
The UK Corporate Governance Code has also been updated to include the provisions announced in October 2011 requiring boards to report on their diversity policies (including gender). The regime continues to be that of ‘comply or explain’ and the FRC’s guidance on what makes an explanation informative has been incorporated into the Preface to the UK Corporate Governance Code.
For entities that are required, or choose voluntarily, to comply with UK Corporate Governance Code, the auditor must report by exception (or confirm explicitly that there is no exception) on:
- whether the board’s statement, that the annual report and accounts taken as a whole is fair, balanced and understandable and provides the information necessary for shareholders to assess the company’s performance, business model and strategy, is inconsistent with the knowledge acquired by the auditor in the course of performing the audit, or
- whether the board’s description of the work of the audit committee addresses those matters communicated by the auditor to the committee appropriately.
Auditing standards are also amended to require the auditor explicitly to read the other information in the annual report to identify any information that is apparently materially incorrect based on, or materially inconsistent with, the knowledge acquired by the auditor in the course of performing the audit. This revision would apply for the audit of all entities, not just for those that apply (or choose to apply) the UK Corporate Governance Code.
The FRC’s press release with links to the relevant documents is available here.
FRRP Annual Report 2012
The FRRP reports that from its reviews of reports and accounts for the year to 31 March 2012, the general quality of reporting is good. There was evidence of improvement in the reporting of principal risks and uncertainties and early signs that boards were reconsidering the presentation of their financial information in order to focus on the key messages. However, the Panel continues to be concerned about the quality of the reports and accounts of some smaller listed and AIM quoted companies.
The Financial Reporting Review Panel’s (Panel) report provides a comprehensive analysis of the issues identified and discussed with companies in the year to March 2012. Highlights include:
- general quality of reporting continues to be good;
- continued willingness of boards to hold constructive and open dialogue with the Panel and to respond to and volunteer suggestions on improving the quality of reports;
- ongoing concern for the quality of reporting of some smaller listed and AIM quoted companies. The Panel noted that it had raised potentially substantive issues with a number of companies, which took considerable time to resolve satisfactorily. Directors of those entities were reminded of their legal responsibilities to prepare accounts that comply with law and accounting standards;
- early signs that boards are reconsidering the presentation of their financial information to give greater prominence to material disclosures. There was evidence of elimination of unnecessary detail and a change in the order of content to improve understanding of the company’s business, policies, performance and position;
- a notable increase in the number of references to the Panel as part of prior year correction disclosures. In a bid by the Panel to make its involvement in changes in financial reporting more transparent, it has changed its procedures in order that press releases are issued more frequently.
The report did not highlight any particular changes in how the Panel will operate although it did identify some issues that it believes will be significant going forward, for example:
- concern that a number of companies did not appear to take as much care in the presentation of their cash flow statements and notes as they did with other primary statements;
- the introduction of IFRSs 10, 11 and 12 could pose challenges for a number of companies that may need to reconsider their scope of consolidation and how to account for joint ventures;
- for investment properties held at fair value, it did not believe a simple statement that the valuation was carried out under the standards issued by RICS* or IVSC** was sufficient and in future would challenge any such minimal disclosures; and
- highlight that it intended, for goodwill impairment review disclosures, to focus on the requirement to provide a description of each key assumption on which management has based its cash flow projections and a description of management’s approach to determining the values assigned to each such assumption.
Activity levels have increased in the year although a fall (to 40% from 47%) in the percentage of companies approached following a review of their accounts may reflect the Panel’s stated intent of writing to companies only when its initial review indicates that there appears to be the potential for a substantive error or non-compliance in the accounts.
In the year to 31 March 2012 326 sets of accounts (2011: 301) were reviewed, including 29 (2011: 33) referred to the Panel. 130 companies (2011: 141) were approached by the Panel for further information or explanation. No company (2011: 4) was the subject of a Panel press release. Since 31 March 2012, one press release has been issued. Seven companies (2011: 4) made a reference to the Panel when explaining a correction in their accounts and, since 31 March 2012, three further references have been made.
A selection of the more topical or wide-ranging issues noted in the Panel’s review covering financial years ended 31 December 2010 to 30 September 2011 include:
|Principal risks and uncertainties
||Improvement in disclosures noted, particularly with respect to reporting of mitigating actions. Still instances, however, of companies providing lists of bullet points or a long description of potential risks rather than focusing on principal risks.|
||Nature of adjustments between IFRS and non-GAAP measures had not been clearly explained and the measures were not referred to consistently.|
|Capital management disclosures
||Lack of quantitative and qualitative disclosures still a common issue. Narrative identification of components of capital was unclear and the disclosure omitted on actual specific transactions (e.g. share buy-backs/dividend policy). |
|Statement of cash flows
||A number of misclassifications or misstatements of cash flows between operating, investing and financing, as well as inappropriate netting of certain cash flow items (including borrowing draw-downs and repayments).|
Accounting policies did not explain clearly on what basis the relevant revenue recognition criteria had been met. Particular issues were:
- generic policies that did not reflect the actual underlying transactions;
- unclear explanation of how the stage of completion was assessed; and
- whether recognition was appropriate in franchise-type arrangements or where an agent or distributor was involved.
The Panel sees this as an area where judgement disclosure could be appropriate.
|Asset-backed transactions with defined benefit pension schemes
||The Panel noted that the accounting for each transaction is specific to the terms and conditions and that it will continue to consider the accounting for these transactions. It noted one instance where, following its review, a group changed the terms and hence its accounting going forward.|
|Impairment of assets
Focus areas included:
- extent of review where net assets exceed the group’s market capitalisation;
- application of a single discount rate to disparate-activity cash-generating units (CGU);
- restrictions on future restructuring assumptions and foreign currency rates in value-in-use calculations; and
- unrealistically low discount rates which do not appear to be a reflection of the return that an investor would require to invest in the particular CGU.
Disclosures also continue to be an area of focus.
||Not all identifiable intangible assets that meet the criteria for recognition and measurement on acquisition are recognised; related deferred tax liabilities were also not always recognised.|
The Panel highlighted a particular case where contingent consideration was conditional on the vendors continuing to provide services to the business following the purchase, which resulted in the company restating the accounting to reflect this payment as post-acquisition remuneration for services.
The Panel’s press release and the report are available from the FRC’s website.
* Royal Institution of Chartered Surveyors
** International Valuation Standards Council
FRC’s Conduct Committee specific review finding – Pendragon PLC
The Financial Reporting Council reports on its specific review finding in respect of Pendragon PLC’s financial statements for the year ended 31 December 2011. The FRC notes a misclassification of cash flows relating to the group’s contract hire operations.
As explained in our last Update, the Financial Reporting Council’s (FRC) Conduct Committee now carries out the role previously performed by the Financial Reporting Review Panel.
The FRC has reported on its review of the financial statements of Pendragon PLC for the year ended 31 December 2011, noting a cash flow statement error due to the misclassification of cash flows relating to the group’s contract hire operations.
In the consolidated cash flow statement certain cash flows for the purchase and sale of assets relating to those operations had been treated as property, plant and equipment cash flows within investing activities. However, under IAS 7 Statement of Cash Flows cash payments to acquire assets held for rental to others and subsequently held for sale are cash flows from operating activities, along with the cash receipts from rental and subsequent sales of such assets. In its June 2012 interim results the group has corrected its 2011 cash flow statement to now show all cash flows relating to its contract hire operations within operating activities.
The FRC’s press release is available here.
Investors want more and better information on net debt
The FRC's Lab report on net debt reconciliations encourages companies to present a net debt reconciliation of net cash flows to net debt in their annual report.
In its September 2012 report on net debt reconciliations the FRC’s Financial Reporting Lab highlights investor demand for more and better information on net debt. A majority of investors are reported to use net debt reconciliations or reconciliation of net cash flows to net debt when valuing a company’s equity or when analysing perceived problems with debt or liquidity. Where a reconciliation of net debt is not presented (there is no requirement to do so under IFRS), investors often attempt to reconstruct one.
The report encourages companies to consider enhancing their reporting of net debt in order to meet investors’ needs more fully, in particular by explaining/analysing:
- what the entity considers to be part of its net debt (particularly as the term is not defined in IFRSs) and how these relate to amounts on the balance sheet at the start and end of the period; and
- the movements in net debt in the year, making clear which are cash and which are non-cash movements, and how those movements relate to amounts in the income statement and cash flow statement etc.
This is an opportunity for companies to enhance their communication with shareholders. The FRC’s Lab report includes further guidance and example disclosures and is available here.
Closer alignment of hedge accounting and risk management: IASB issues revised proposals
The IASB’s review draft of its forthcoming IFRS on general hedge accounting is generally consistent with the original exposure draft issued in December 2010. It offers a more principles-based approach rather than the application of stringent rules and allows for closer alignment of hedge accounting with how an entity actually manages its risks.
On 7 September 2012, the International Accounting Standards Board (IASB) issued a review draft of its forthcoming IFRS on general hedge accounting. The review draft proposals are generally consistent with the IASB’s initial proposals set out in ED/2010/13 Hedge Accounting (issued in December 2010). There is a shift away from the stringent rules in IAS 39 to a more principles-based approach, which seeks to align hedge accounting with companies’ risk management policies.
The proposals would not fundamentally change the current types of hedging relationships, or the current requirement to measure and recognise hedge ineffectiveness but it is expected that more hedging strategies used for risk management would qualify for hedge accounting under the new proposals. For example, it is expected that those entities that manage significant commodity price exposures will have much to gain from the proposals as hedge accounting for risk components of non-financial items would now be permitted.
The shift towards a more principles-based approach may also require the application of greater judgement, particularly in the assessment of hedge effectiveness: the bright-line effectiveness assessment test under current IAS 39 would disappear under these new proposals. Additional disclosures would be required to inform users of how an entity is managing its risks.
The proposals would be effective for annual periods beginning on or after 1 January 2015. Early application would be permitted (subject to EU-endorsement) only if all existing IFRS 9 requirements are applied at the same time or have already been applied.
The review draft will remain on the IASB website until early December 2012, after which time the IASB intends to proceed to finalise the draft.
Please refer to KPMG’s In the Headlines: Hedge accounting moves closer to risk management for further insight and discussion of the proposals.
News in Brief
Thinking about disclosures in a broader context: FRC issues its proposals
The FRC has published a discussion paper Thinking about financial reporting disclosures in a broader context in its bid to develop a coherent framework for disclosures in the financial report. The paper sets out a road map for a disclosure framework for financial reporting aimed at improving the quality of disclosure and their value to the users. In particular, it covers the reduction of clutter in financial reports by avoiding duplication in disclosures and using tests of materiality more rigorously.
A copy of the discussion paper can be obtained here. The consultation period closes on 31 January 2013.
FRC proposes limited scope amendments to FRED 48 (draft FRS 102)
The limited scope proposed amendments relate to the accounting for non-group multi-employer pensions and for grantor accounting for service concession arrangements, and are likely to affect only a small proportion of entities applying UK accounting standards. Since these amendments are limited in scope, the comment period closes on 3 December 2012.
The FRC anticipates finalising draft FRS 102 in early 2013 and for it to be effective for accounting periods beginning on or after 1 January 2015. The FRC also hopes to finalise its draft FRSs 100 and 101 later this year, enabling subsidiaries and parent entities to take advantage of the reduced disclosure framework for 31 December 2012 year ends should they choose to do so.
A copy of the exposure draft is available here.
Activity report on IFRS enforcement in 2011: still room for improvement
The European Securities and Markets Authority (ESMA) has released its activity report of the European Enforcers Co-ordination Sessions (EECS) in respect of the period to 31 December 2011.
EECS found that the quality of financial reporting has improved generally, year on year, but considers there is still room for improvement, particularly in relation to the continued use of boiler-plate disclosures and the disclosure of the potential effects of risks and uncertainties faced by issuers.
Other areas for attention arising from the sample of listed entities selected by European enforcers include impairment of financial and non-financial assets; financial instruments disclosure; going concern; and consolidation.
ESMA publishes review of accounting for Greek government bonds
ESMA has published a Review of Greek Government Bonds accounting practices in the IFRS Financial Statements for the year ended 31 December 2011, which sets out the results of its review of accounting practices and disclosures regarding exposure to Greek government bonds.
The review found a good degree of consistency regarding the level of impairment of Greek sovereign debt, but found that a number of issues remain to be addressed by issuers in relation to their transparency to investors.
On the basis of its findings and market developments, ESMA will focus on the application of IFRS specific and general requirements related to financial instruments accounting and disclosure, in particular for sovereign debt, in issuers’ 2012 IFRS financial statements.
IFRS newsletters and other publications
KPMG in the UK publishes Financial Reporting Matters, a short newsletter to alert you to key changes in UK and International Financial Reporting Standards and UK company law. It is available for download here. Alternatively, you may subscribe by sending an email to Financial Reporting Matters.
KPMG IFRG Limited has published the following since the May/June/July 2012 Update, which are available on its web site at www.kpmgifrg.com:
IFRS Disclosure Checklist (August 2012)
IFRS Practice Issues for Banks: Fair value measurement of derivatives – the basics (September 2012)
Insights into IFRS 2012/13 9th edition (September 2012)
Insights into IFRS – An overview (September 2012)
IFRS for Investment Funds: Fair value measurement of financial assets and financial liabilities (September 2012)
New on the Horizon: Hedge accounting (September 2012)
Insights into IFRS – Supplementary information (September 2012)
IFRS Newsletter: Banking, Issue 7 (October 2012)
IFRS Newsletter: Financial instruments, Issue 5 (October 2012)
IFRS Newsletter: Insurance, Issue 29 (October 2012)
IFRS Newsletter: Leases, Issue 12 (October 2012)
IFRS Newsletter: Revenue, Issues 1 and 2 (July and October 2012)
IFRS compared to US GAAP (October 2012)
IFRS compared to US GAAP: An overview (October 2012)
Current trends in central bank financial reporting practices (October 2012)
KPMG IFRG Limited also publishes In the Headlines, which provide information in relation to new exposure drafts and standards issued by the IASB, as well as any other relevant developments affecting current and future IFRS reporters, including summaries of IASB meetings on a monthly basis.
In the Headlines, Issue 11 – Adopting the consolidation suite of standards
In the Headlines, Issue 12 – Hedge accounting moves closer to risk management
In the Headlines, Issue 13 – Reminder: effective dates of IFRS