Convergence of UK GAAP to IAS: Part 1

It is important that students have knowledge of the changes that will be required to UK regulations, particularly Statements of Standard Accounting Practice (SSAP) and Financial Reporting Standards (FRS), and to International Accounting Standards (IAS) to harmonise the two sets of regulations into a single set of standards (the new International Financial Reporting Standards (IFRS)). This is the objective of the ‘convergence project’. Some of the changes will be to bring UK GAAP into line with current IAS, while other changes will be made to the IAS to bring them into line with UK GAAP. It will not be a one-way process.

We shall be comparing the principles and practices contained in particular standards (or groups of related standards) throughout this series but first it is necessary to consider the background to the convergence project and the convergence of the basic frameworks (principles) that underlie current accounting UK and International Standards.

Background
IASs have been developed since 1973 by the International Accounting Standards Committee (IASC), now the International Accounting Standards Board (IASB), while in the UK the Accounting Standards Committee (ASC) and the Accounting Standards Board (ASB) were producing independent UK SSAPs and FRSs respectively. Although there was a degree of cooperation between the standard setting bodies, and several members of the UK accounting profession made a significant contribution to the development of IASs, neither produced standards in line with an agreed conceptual framework and both appeared to produce standards in a fire-fighting fashion.

Two sets of standards were developed which had, and still have, a considerable number of differences. Some of these differences arose because of differing constraints – EU Directives in the UK, the need for a 75% majority vote from several national accounting professional bodies at the IASC – and / or differing conclusions at different times on regulatory requirements. Recently the two standard setting bodies have developed joint regulations, e.g. FRS 14 and IAS 33 on Earnings Per Share, but even here there are still significant differences.

However, this situation could not be allowed to continue if accounting regulations were to continue to be applicable in a business environment that has become global. There is a need to harmonise and converge the various standards that exist in the world and we shall be reviewing the UK / IAS convergence as an example of this harmonisation process. This ‘need’ has become a priority in recent years for several reasons including:

• The completion of a set of core standards that the International Organisation of Securities Commissions (IOSCO) has recommended can be used by Multi-National Enterprises (MNE) for cross-border listings and offerings.
• The requirement by the European Commission that all listed companies in the EU use IASs (or most probably IFRSs) for their consolidated financial statements by the year 2005. (Note however that EU directives would still be applicable to all limited liability companies within the EU).
• The consideration of the US Securities and Exchange Commission (SEC) to allow the use of IAS for foreign registered companies without the need for restatement or reconciliation to US GAAP.

Conceptual Frameworks
Before attempting to converge the individual accounting standards it is essential that an agreement be reached on the wording and content of a conceptual framework on which the standards can be based. This will help ensure that the convergence process is undertaken with a common set of objectives and fundamentals for financial reporting.

The UK Conceptual Framework is the ASB Statement of Principles (SP), published in December 1999, which is based on the IASC ‘Framework for the Preparation and Presentation of Financial Statements’ (Framework), published in July 1989, which in turn is based on the US Financial Accounting Standards Board’s Conceptual Framework (CF) published nearly a decade before that (but recently extended). It might therefore be expected that these CFs would be the same, but unfortunately this is not the case.

The existence of the differences between the SP and the IASC Framework is acknowledged by the ASB who have included an appendix to the SP comparing the two statements.

The principal differences which need to be eliminated as part of the convergence project, as per the ASB commentary, can be summarised as follows:

• The IASC Framework does not refer to the ‘stewardship function’ of financial reporting in its overall objectives for financial statements.
• Only the SP deals with determining the boundary of a reporting entity.
• While the qualitative characteristics of relevance, reliability, understandability and comparability are effectively the same for each CF, the elements to be reflected in financial statements are different. There are seven elements in the SP and five in the IASC Framework, and the definitions for the common elements are not the same. This specific problem is discussed in more detail later.
• The ASB states in the SP recognition criteria ‘that sufficient evidence should exist that the new asset or liability has been created or that there has been an addition to an existing asset or liability’, is a development of the IASC Framework reference to ‘it needing to be probable that any future economic benefit associated with the item will flow to or from the enterprise’. A further development is the inclusion of sections covering ‘derecognition’ in the SP. These developments should be reflected in any converged statement.
• The SP has more extensive descriptions of measurement bases (e.g. Historic or Current cost), including reference to the ‘value to the business’ model for choosing between current values. The SP also covers both discounting and subsequent remeasurement, neither of which is contained in the IASC Framework.
• The IASC Framework has no specific requirements covering the presentation of financial information, this being dealt with in IAS 1, Presentation of Financial Statements. The SP has a separate chapter covering the set of primary financial statements (profit and loss account and statement of total recognised gains and losses for performance, balance sheet for position and cash flow statement for cash generation and use) and details of classification and aggregation. There is also reference to reporting supplementary information (e.g. operating and financial review) necessary to providing a clear understanding of the financial statements.
• The SP includes a chapter on ‘accounting for interests in other entities’ that does not appear in the IASC Framework. This chapter merely confirms the disclosures for investments by reference to the level of control or influence by the entity holding the interest. Most importantly, the SP goes against proportional consolidation and supports the use of merger accounting. These are both controversial issues and will need to be resolved before or during the convergence process.

All of these differences need to be eliminated but perhaps the agreement on the elements and their definitions should be given priority. Failure to agree on such fundamentals would clearly undermine the whole convergence project.
The current elements are:

Note: Equity could be sub-classified in the balance sheet to cover ownership interests and contributions from / to owners. Both the conceptual frameworks are based primarily on the definitions of assets and liabilities but unfortunately, the definitions are not the same:

Asset:
SP - Rights or other access to future economic benefits controlled by an entity as a result of past transactions or events.

Framework - A resource controlled by the entity as a result of past events, and from which future economic benefits are expected to flow to the enterprise.

Note that only the UK definition using the phrase ‘rights or other access’ clearly indicates that ownership is not required. This is very important when considering substance over form, which is discussed in the next section.

Liability:
SP - Obligation of an entity to transfer economic benefits as a result of past transactions or events.

Framework - A present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

The former appears to be a simplification of the latter but it is confusing to have such a basic item defined differently. This difference has continued into the standards; FRS 12 uses the SP definition while IAS 37 continues to use the more tortuous Framework definition, even though the two standards were supposedly produced as a joint project!

These disagreements give an indication of the amount of work that is needed if a new, converged, framework is to be developed to replace the SP and the IASC Framework. This harmonisation of the basics is however, essential to the whole convergence process and its importance should not be underestimated. This of course assumes that an internationally acceptable conceptual framework is a requirement for internationally acceptable regulations.

Having reviewed the basic conceptual frameworks, we will now proceed to review the individual regulatory standards starting with those concerned with Objectives, Substance and Accounting Policies (as per the ASB Convergence Handbook).

Objectives, Substance and accounting Policies
This part of the convergence project covers:

• Accounting Policies (FRS 18 ‘Accounting Policies’ and IAS 8 ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’).
• Reporting of Financial Performance (FRS 3 ‘Reporting Financial Performance’ and IAS 1 ‘Presentation of Financial Statements’ (as supplemented by interpretation SIC 18 ‘Consistency – Alternative methods’)).
• Reporting the Substance of Transactions (FRS 5 ‘Reporting the Substance of Transactions’ and (in part) IAS 1).

A comparative review of Accounting Policies indicates that there is a need to remove the option available in IAS 8 to treat adjustments relating to accounting policy changes as current period items. Only the benchmark treatment, where the adjustment is reported as an adjustment to the opening balance of retained earnings, should be retained. This will bring IAS 8 into line with the requirements of FRS 18. It will also be necessary to eliminate a similar choice in IAS 8 for adjustments relating to fundamental errors. Both of these items are clearly not related to current period performance and should not be reported as if they were. It is, however, essential that the adjustments are clearly disclosed and not hidden away in the depths of detailed notes.

Other changes to the performance statement include the removal from UK GAAP of legislation (and some of the requirements of FRS 18) that only permits ‘realised’ profits to be included in the profit and loss account.

There is currently both a UK project and an international project on the development of a performance statement that will report all gains and losses for the period in a single statement, analysed into their operating, financing and other elements. This will effectively combine the profit and loss account and the statement of total recognised gains and losses in the UK, and extend the income statement content currently described in IAS 1. As a primary statement, the ‘Reporting of Financial Performance’ is an essential part of the convergence project and its harmonisation will greatly enhance its usefulness to readers comparing such performance on a global scale. The importance of getting this ‘right’ cannot be overstated.

IAS 1 covers the inclusion of assets and liabilities in the balance sheet, and requires that ‘management should develop policies to ensure that the financial statements provide information that is reliable in that they reflect the economic substance of events and transactions and not merely their form’. However, there is no international standard in the nature of FRS 5. This UK standard is the cornerstone of the standard setters ‘battle’ against off balance sheet financing and other forms of creative accounting practice. In particular, FRS 5 gives essential guidance on transactions that include features such as:

• The entity that gains the principal benefits generated by an item is not the legal owner of the item.
• A transaction linked with others in such a way that the commercial effect can be understood only by considering the series as a whole.
• An option included in terms that make its exercise highly likely.

Examples of such transactions are consignment stock, debt factoring and securitised assets, all of which present problems of recognition, derecognition and presentation. While the definitions could be developed as part of the Conceptual Framework convergence, it would seem to be essential to have a specific accounting standard, similar to FRS 5, for use by entities operating in countries with developed economies where such complex transactions arise and whose substance may not be readily apparent.

Revenue
Linked to the recognition of assets and liabilities, and changes in the measurement of such elements (including derecognition), is the recognition of revenue. IAS 18 ‘Revenue’ is the international standard on revenue recognition but there is (surprisingly) no UK equivalent other than legislation that requires revenue to have been ‘realised’ before inclusion in the profit and loss account, and accounting for long term contracts under SSAP 9. (Detailed discussion of long term contracts is deferred to a later article). Fortunately IAS 18 does not rely on, or refer to, the realisation concept and therefore this concept is only an obstacle to the development of improved recognition criteria in the UK.

Working on the assumption that any future IFRS will be in line with the new conceptual framework, then IAS 18 presents a serious problem as a template for the new international standard. The current standard is based on the assumed primacy of the income statement whereas CFs are invariably based on a balance sheet approach. The latter relates revenues (gains) to an increase in net assets (increase in ownership interest not resulting from new contributions from owners) rather than recognising revenue first, with the movement in net assets the residual.

IAS 18 will need to be changed to reflect the CF focus on the balance sheet elements and should perhaps be linked, or even subsumed, in a new IFRS covering ‘substance over form’. This will enable gains on such items as sale and repurchase agreements to be covered in addition to the more obvious revenue generating activities, in a single statement.

IAS 18 gives guidance on the recognition of revenue from the sale of goods, rendering of services and interest, royalties and dividends, but the standard does not provide a ‘basic framework that can be used consistently to address issues arising in different situations’. This is one of the objectives of the current ASB Discussion Papers, ‘Revenue recognition’, and is perhaps the best way forward to an agreed international standard on this most fundamental issue. There appears to be little point in the ASB proceeding with this project unless it is an integral part of the international accounting convergence process.

Clearly this area of multi-national convergence is not going to be easy as the following paragraph taken from IAS 18 (in the section covering Sale of Goods) illustrates:
‘The law in different countries may mean the recognition criteria in this Standard are met at different times. In particular, the law may determine the point in time at which the enterprise transfers the significant risks and rewards of ownership. Therefore, the examples in this section of the appendix need to be read in the context of the laws relating to the sale of goods in the country in which the transactions take place.’

Summary
That reference to the possible interference by national legislation to this international process completes the introductory review of the convergence project and the development of an agreed conceptual framework. In addition to gaining international agreement on a new framework, there is an urgent need to harmonise the fundamental accounting policies, including those related to revenue recognition. The non-accountant may be surprised that there is no worldwide agreement on these issues and the accountant (both qualified and training) may be surprised at the amount of time and effort that is going to be needed to achieve such an agreement.

The other articles in this series will review the particular problems of converging certain accounting practices. Hopefully, then the problems of harmonising on an international scale will become more apparent.

Steve Lawrence MSc FCCA is Senior Lecturer in Accounting, University of East London.