Convergence of UK GAAP to IAS - part 3

The harmonisation of group accounting, commencing with a review of the standards (and UK legislation where relevant), covering consolidated financial statements, including the discussion of goodwill and fair value recognition will be discussed. The differing methods of accounting for business combinations will be covered and the need to move to a globally accepted single method of accounting for such combinations will be assessed.

As well as discussing the consolidation of subsidiaries, the convergence requirements relating to two other forms of investment vehicle – the Associate (based on significant influence) and the Joint Venture (based on joint control) will be reviewed. The final topic is that of foreign currency translation, both as it relates to groups with investments in foreign operations and individual entity foreign currency transactions.

Consolidated financial statements
Both the UK standard, FRS 2, ‘Accounting for Subsidiary Undertakings’, and the international standard, IAS 27, ‘Consolidated Financial Statements and Accounting for Investments in Subsidiaries’, are based on the EU 7th directive and therefore contain very similar requirements for the consolidation of subsidiaries. It is important to note that any adjustments made to these accounting standards should still be in line with the requirements of this directive, or if not, notification given to the European Commission of the changes that may need to be incorporated in any revised directive. Both the FRS and the IAS base the establishment of a parent / subsidiary relationship resulting in the need for consolidated financial statements on control of operating and financial policies. However, while the general approach is the same there are differences in the detail that could result in differing conclusions on the membership of a group. The additional provisions contained in the UK standard that need to be included in the international standard as part of the convergence project include:

• The more detailed requirements in FRS 2 where control is determined by reference to the ability to appoint directors, including the need to be a shareholder and reference to directors holding a majority of voting rights.
• Under FRS 2 the parent / subsidiary relationship can result when there is a participating interest and the parent actually gives direction on operating and financial policies.

Other differences relate to the exclusion of subsidiaries. IAS 27 for example, does not allow exclusion based on dissimilar activities. Under FRS 2 it is permitted, even though it is only expected to be applied in exceptional circumstances. It would seem sensible to adopt the IAS approach and just ‘disallow’.

Both standards require exclusion when ‘control is intended to be temporary’, but IAS 27 requires the excluded subsidiary to be measured at fair value. FRS 2 requires the application of the current asset rule of lower of cost and net realisable value. A further measurement problem, which needs to be resolved, arises where a subsidiary is excluded because there are ‘severe long term restrictions’ on the parent entity’s ability to exercise control. Again, the IAS requires the use of fair value; but FRS 2 adopts the use of the equity method in such circumstances (if significant influence is possible) or values the investment at ‘cost’ (if both control and significant influence are lost).

FRS 2 also has more extensive disclosure requirements for subsidiaries excluded from consolidation and these need to be incorporated into any harmonised standard.

One last difference relates to the treatment of minority interest debit balances (arising from accumulated losses). This balance is only recognised under IAS 27 where the minority interest shareholders have a binding obligation to make good the losses. Under FRS 2 the debit balance is always recognised and a provision is made where an obligation exists for the group to provide irrecoverable finance to the subsidiary. The converged standard should only permit one of these methods.

Goodwill
Accounting for goodwill is considered by the IASB to be an integral part of accounting for business combinations. The regulations relating to positive and negative goodwill are contained in IAS 22, ‘Business Combinations’. In the UK, goodwill is covered by a separate standard, FRS 10, ‘Goodwill and Intangible Assets’. The first priority is therefore to decide where in the set of accounting standards goodwill should be positioned.

As far as the detail is concerned, there are significant differences between the standards. IAS 22 considers all goodwill to have a finite life and must therefore be amortised. Under FRS 10, providing certain criteria are met, goodwill does not have to amortised if it is considered to have an indefinite life. Also of relevance are the recent developments in the US accounting standards where FAS 142, ‘Goodwill and other Intangible Assets’ has recently been issued. This American standard states that ‘goodwill will no longer be amortised but will be tested for impairment on an annual basis, or more frequently if circumstances warrant’. Expect the international and UK position to move in this direction.

The second difference relates to the recognition of credit entries in the annual performance statements for negative goodwill. FRS 10 recognises such ‘income’ by reference to non-monetary assets and the periods expected to benefit from the use of such assets. IAS 22 requires this ‘income’ to be recognised:

1. when related future losses and expenses are recognised;
2. on a systematic basis over the weighted average useful lives of identifiable acquired depreciable / amortisable assets (but only to the extent of the fair values of those assets);
3. insofar as any negative goodwill remains, immediately as income.

Fair values
As with goodwill, there is a difference in the way the requirements relating to the recognition and measurement of fair values are standardised. Again IAS 22 contains the international requirements, while in the UK another separate standard has been issued; this time it is FRS 7, ‘Fair Values in Acquisition Accounting’.

There are several areas requiring harmonisation, with the most significant being:

• Under FRS 7 the fair value of the purchase consideration must include a reasonable estimate of any contingent elements. This is not a requirement of IAS 22 where such items are not recognised until the contingency position has been resolved and any additional payment has become probable and capable of reliable measurement.
• IAS 22 permits the recognition of a provision relating to reorganisation and / or reconstruction as an acquired liability even where it was not a liability in the books of the acquiree. FRS 7 does not allow such recognition unless the item meets the criteria of FRS 12. If it does not, then it should be treated as a post-acquisition transaction.
• FRS 7 has been amended by FRS 19, ‘Deferred Tax’ so that the liability (or asset) relating to deferred tax can only be recognised if there are timing differences arising in the acquiree’s books. The international position (IAS 12) is not so restrictive, merely making reference to the difference between the fair value and the tax base of acquired assets and liabilities. This difference also applies to tax losses not relating to the acquiree; international standards allowing recognition of a deferred tax asset where the losses of the acquiree entity can be offset against the profits of the acquiring entity. FRS 7 (as amended by FRS 19) does not permit the recognition of such an asset.
• IAS 22 does not require that the fair values of acquired assets and liabilities reflect the conditions at the date of acquisition. Such a requirement is a basic element of FRS 7.

Overall, it is likely that the more detailed approach of FRS 7 will have to be incorporated into the international standards.

Business Combinations
This is an area where harmonisation of accounting standards is vital. The importance of distinguishing between the commercial conditions that determine the application of either the merger (uniting of interest) method, or the acquisition (purchase) method for accounting for a business combination cannot be overstated.

The need for global standardisation in this area is perfectly illustrated by the reporting in the UK of the combination of Glaxo Wellcome and SmithKline Beecham to form GlaxoSmithKline. The combination on 27 December 2000 was reported in the consolidated financial statements for the year ended 31 December 2000 following UK GAAP as a merger, with no pre / post combination split, no recognition of goodwill and no adjustments to fair values.This resulted in the reporting of profit attributable to shareholders of £4,154 million and equity shareholders funds of £7,711 million. However, following an alternative set of GAAP, in this case those of the USA, the combination was reported as an acquisition (purchase). The resulting reconciliation statements can be summarised as follows:

Reconciliation of profit attributable to ordinary shareholders:

* Mainly the write-off of in-process Research and Development

Reconciliation of equity shareholders funds:

While this may be an extreme case, it shows how ridiculous it is to have regulations in countries that produce such divergent measures of financial performance and position.

In the US they have recently decided to use a single method system whereby all business combinations are accounted for as acquisitions, and with the IASB currently working on a joint project with the American standard setting body it is likely that the international standard will be pushed in this direction.

However, both the UK regulations, FRS 6, ‘Acquisitions and Mergers’ and the Companies Act 1985 (CA 85), and the current international regulation, IAS 22, permit the use of the two alternative methods. Both restrict the use of merger (uniting of interest) accounting to those combinations where very specific criteria can be met. There are some important differences between these criteria that need to be eliminated if this method of group accounting is to survive in the converged regulations. The most important differences between the regulations are as follows:

• The CA 85 has sections requiring a 90% shareholding, whereas IAS 22 only requires a substantial majority of shares being pooled;
• The CA 85 specifically requires that the 90% shareholding be attained pursuant to an arrangement for the issue of equity shares but IAS 22 only implies this criteria.
• FRS 6 and the CA 85 restrict the level of non-equity share element of the consideration but again IAS 22 only implies rather than requires this criterion.
• Another criteria only implied in IAS 22 is the FRS 6 requirement that no party to the business combination can be portrayed as either an acquiror or an acquiree.
• FRS 6 states more clearly than IAS 22 that there must be involvement of all the combining parties in the establishment of the management team for the new enlarged group.
• FRS 6 has a ‘size test’, which states that an entity will be deemed the acquiror if it is 50% larger than the other entity. The percentage is judged by reference to ownership interest in the combined business. IAS 22 is less precise only stating that ‘the pooling of interest method may not be used when the fair value of one entity is significantly different from that of the other’.
• To avoid certain piecemeal acquisitions being treated as a merger, FRS 6 requires that any equity share acquisition by one entity in the other in the two years prior to the combination date should be taken into account. IAS 22 has no such requirement.

The harmonisation of these criteria, probably moving towards the FRS 6 requirements, is only necessary if the merger accounting method is to be continued as a combination method. Therefore, efforts to converge these criteria should be deferred until after the debate on the need for one or two consolidation methods is concluded.

One last point to consider relates to the value of net assets attributed to Minority Interest shareholders (MI) when the acquisition method is employed. Under FRS 6, all assets and liabilities should be included in the consolidated financial statements at their fair values and the Minority Interest in such items is based on these values. IAS 22 treats this as an acceptable alternative to the benchmark treatment of valuing the Minority Interest share of the assets and liabilities of the subsidiary at their carrying amount before the acquisition. Only the group share is adjusted to fair values. This benchmark treatment can result in very confusing values being reported in the consolidated accounts and should not be permitted in any harmonised statement.

Associates
These types of investment are covered in the UK by a single standard, FRS 9 ‘Associates and Joint Ventures’, but by two international standards, IAS 28, ‘Accounting for Investments in Associates’ and IAS 31, ‘Financial Reporting of Interests in Joint Ventures’.

Associates are accounted for using the equity method under both FRS 9 and IAS 28. The UK standard requires that the significant influence required for an investment to be classified as an associate, be active and evidenced by some formal or informal agreement / understanding. No such evidence of active influence is required in IAS 28. Thus, an associate under IAS 28 is not necessarily an associate under FRS 9. This position obviously cannot be allowed to continue.

Where the associate incurs losses, this may lead to the cessation of the equity method under IAS 28 when these losses exceed the carrying value of the investment. Normally under FRS 9, losses continue to be recognised. One other significant difference is in the use of the equity method in the individual financial statements of the investor. FRS 9 does not permit this but IAS 28 does allow such an accounting method and under the current IASB ‘Improvement to International Accounting Standards’ project this becomes a requirement. This may be a useful development in financial reporting that could be introduced in any review of FRS 9.

Joint Ventures
IAS 31 deals with three types of joint venture – jointly controlled operations, jointly controlled assets and jointly controlled entities. FRS 9 only deals with joint ventures that are entities and it is therefore necessary to consider the relevance of the regulations relating to the first two types of joint venture in IAS 31. It is probable that the recognition and measurement requirements of any converged standard should concentrate on the third type.

As for reporting joint ventures that are entities there are some fundamental differences between the standards. Under IAS 31, such joint ventures should be accounted for using proportional consolidation. If this benchmark treatment is not used then the allowed alternative is the equity method. Neither of these is acceptable under FRS 9 which requires the use of the ‘Gross Equity Method’. This is merely an extension of the normal equity method. It should not prove too difficult to agree on the use of this method, provided agreement on the elimination of the confusing proportional consolidation can be achieved.

Foreign currencies
For individual company transactions, there is one significant difference to be eliminated. This relates to a foreign currency transaction that is to be settled at a pre-determined contracted exchange rate. To avoid the unnecessary recognition of exchange gains or losses in such a position, the UK standard, SSAP 20 ‘Foreign Currency Translation’, requires that the contracted rate be used to determine the sterling figures to be included in the accounts. IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’ does not permit this, requiring initially the use of the exchange rate at the date of the transaction, with any outstanding balance at the balance sheet date being retranslated at the closing rate. Therefore, exchange differences will probably arise at the balance sheet date and at the date of settlement when the contracted rate will apply. If any related forward contract rate has a value, this should be recognised during the accounting period in which the value arises. Hopefully the more realistic (and straightforward) UK method will prevail.

The position on the translation of foreign operations for consideration is less clear. There are currently moves both in the UK, through FRED 24, ‘The Effects of Changes in Foreign Exchange Rates’ and ‘Financial Reporting in Hyperinflationary Economies’, and by the IASB through its proposed improvements to IAS 22, to bring the two sets of standards closer together. This development includes an emphasis on the use of the ‘functional currency’ (the currency in which the entity measures the items in its financial statements) and the ‘presentation currency (the currency used by an entity for financial reporting purposes). The current usage of the closing rate method and the temporal method will disappear. In addition, all items in the performance statements will be translated using actual or average rates, the option of using the closing rate being eliminated.

Finally, an entity operating in hyper-inflationary economies will not be able to use a stable / hard currency as its functional currency, but will have to restate its figures using appropriate indices. This change applies to both UK and international standards.

Thus foreign currency translation is an area where convergence is already progressing and indicates the level of changes that are going to take place in this most important area of financial reporting – group accounting.

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