DIRECTORS of small companies are facing significant changes to the rules regarding the preparation of annual accounts following the government’s final recommendations on how the new EU Accounting Directive will be implemented in the UK.
For one, the definition of a small company is changing while the changes, which are intended to make life simpler particularly in terms of disclosures, have ended up bringing their own complexities. Finally, the standards governing how the numbers in the accounts are calculated will be changing too.
Currently, the main definition has depended on whether you meet two out of three thresholds (see table). As can be seen, two of the criteria for small companies are increasing significantly, so several thousand companies that are now medium-sized will become small in the future. It is also worth noting that these new thresholds apply in terms of the statutory audit requirement. There are restrictions that prevent financial services companies and those in groups containing listed companies from being small, and these largely remain unchanged.
The other thing to note is that there is an important category of micro companies. This will not be changed at this time, as it already exists, but it has, perhaps, not been as widely recognised as expected. Micro companies are allowed reduced reporting requirements.
The EU directive has brought in changes to the Companies Act that are designed on the whole to reduce requirements on small companies. The main simplification included in these changes is to limit the disclosure requirements in the notes to the accounts to thirteen items (see box).
Some of these may potentially entail quite extensive disclosures – for example financial commitments and off-balance sheet arrangements. In these cases, a revised version of the accounting standard FRS102 will make this plain.
There are other changes – such as greater flexibility in the formats – which may help companies use the IFRS layouts for income statements and balance sheets. The default life for goodwill has been increased from five to ten years.
Although that all seems like good news, these changes may also create some complexity. The disclosures are apparently limited, but the obligation remains for the directors to ensure that the financial statements show a true and fair view. More than before, meeting the disclosure requirements of the law or the Financial Reporting Standard for Smaller Entities (FRSSE) may not be enough to meet the true and fair test. That judgement will be left to the board.
This has also given problems in drafting the accounting standard FRS102. The proposal (in FRED59) is that, in addition to the thirteen above, companies will be ‘encouraged’ to disclose a few others, including uncertainties about the going concern assumption and dividends. The last one is worth noting – without dividends, the profit for the year may not fully explain the movement in the shareholders’ funds between the balance sheets.
When must these changes be made?
The changes to the Companies Act are currently going through Parliament. They can be applied early but must be in place for accounting periods starting January 2016. The changes in accounting standards are in exposure draft form (FREDs 58 to 60) and so inevitably running a little further behind, but will apply in the same way. From then, the FRSSE will be withdrawn.
Accessing the disclosure reductions as soon as possible might seem an attractive option to consider, but there may be drawbacks. Any software may not be adjusted for early adoption. There are also significant accounting changes which would have to be applied early as well.
From 2016 onwards, small companies would have to use the accounting treatments in FRS102 instead of the FRSSE that they may currently use. Medium-sized and large companies are currently making the shift from old UK standards (FRSs and SSAPs) to FRS102. The experience of this transition will be helpful for the small companies needing to make the change a year later.
To give some examples, the accounting for financial instruments has probably produced the most substantial and difficult changes. The FRSSE has very little guidance. FRS102 requires share holdings to be valued at fair value and likewise any derivatives such as forward contracts or interest rate swaps. Hedge accounting was barely covered by the FRSSE, but FRS102 regulates the accounting and requires designation and documentation of the hedges in place. Loans which carry nil or a below-market interest rate must be valued by imputing a market rate in discounting the cash flows.
Investment properties would be stated at fair value as now, but the changes in value will be included in the profit for the year and not in the Statement of Recognised Gains and Losses as they do now. Deferred tax must be provided on all revaluation surpluses.
The above are examples. It must be remembered that FRS102 is a new standard and there may be more detailed differences which could turn out to be significant for some companies. FRS102 needs to be gone through thoroughly. Most changes will need to be reflected by restatement of comparative figures, but there are some exceptions where this need not be done on pragmatic grounds.
In addition to small companies, there are also micro companies. They are allowed a reduced regime of a simplified profit and loss account and balance sheet with minimal note disclosures – essentially just loans to directors and commitments and contingencies. Micro companies would also enjoy a simpler accounting regime.
Revaluations and fair value accounting are not allowed, neither would be the capitalisation of borrowing costs or of development costs. Deferred tax and share-based payments would not have to be accounted for.
What to do now?
As noted above, there will be more companies that will count as small with the increased thresholds. For their 2016 accounts, they will have to use the new UK accounting standard FRS102 and the FRSSE (which most are following now) will be scrapped (see FRSSE box). This entails some significant changes to accounting as the medium-sized and large companies are finding, as they do a similar switch in 2015 – accounting numbers may need to be restated.
While there will be significant reductions in the specified note disclosures, the need to show a true and fair view may mean some need for restatements. Many small companies could use the micro company regime which is lighter-touch still, both in terms of accounting and disclosures.
Though the legislation is essentially ready now, the accounting standard changesare still proposals being exposed for comment and may not be finalised until the summer. After that, the process can begin of detailed assessment of the changes, any restatement of prior years and reformatting of the financial statements. ?
Richard Martin is head of corporate reporting at ACCA
• Accounting policies
• Effects of revaluation of assets
• Effects of assets at fair value
• Financial commitments, guarantees or contingencies
• Loans to directors
• Exceptional items
• Amounts owed due after five years
• Average number of employees
• Events after the balance sheet date
• Off-balance sheet arrangements
• Related party transactions
• Movements on fixed assets • Name of the parent company
Financial statements prepared in accordance with the legal requirements of the micro-entities regime are presumed to give a true and fair view, so directors are not required to consider what additional information is required for the financial statements of the entity to give a true and fair view. This is in contrast to the FRSSE where directors are legally obligated to ensure the financial statements provide a true and fair view.
Micro entities are only required to prepare a balance sheet and profit and loss account and not a statement of recognised gains and losses (STRGL) or a cash-flow statement. Condensed formats of statements The statutory formats for the balance sheet and profit and loss accounts are significantly condensed – for example, ‘‘current assets’’ is not disaggregated into stocks, debtors, investments and cash.
Micro entities are legally required to provide two disclosures, and are not required to provide any more. However, micro entities can voluntarily provide more disclosures. This is in contrast to the FRSSE which mandates significantly more disclosures.
Draft FRS 105 has simplified the accounting treatment for some transactions – for example, there is no requirement to account for deferred tax or equity-settled share-based payments.
Micro entities are not permitted to use fair value or revalue any assets or liabilities, so all assets and liabilities (such as land, buildings and investment properties) must be held at cost. This differs from the FRSSE which permits certain assets to be revalued.
All policy options have been removed. The mandatory treatments result in earlier recognition of income or expenses in the profit and loss account rather than deferring to the balance sheet. So government grants must be accounted for using the performance, not accruals, method.
In many instances, the requirements of draft FRS 105 do not differ from those of the FRSSE, but more guidance is provided in FRS 105 to help preparers apply and interpret the treatment required.
Draft FRS 105 does not reproduce all the reporting requirements from company law applicable to micro entities unlike the FRSSE, but does incorporate those relating to the financial statements. Micro entities will need to satisfy themselves that they have met all their legal requirements.
Draft FRS 105 uses terminology consistent with FRS 102 such as ‘statement of financial position’ rather than ‘balance sheet’.