top stories

by John Davies 01 Oct 1999 Diploma in Financial Management Relevant to All Papers

In the UK, the law requires a company to report its profit (or its loss as the case may be) via a profit and loss (P&L) account. The purpose of this account is to show the extent to which a company has increased its wealth through the pursuit of its activities. The Companies Act requires the P&L account to be presented in accordance with one of two model formats set out in Schedule 4 to the Companies Act 1985, which are themselves laid down by the EU Fourth Company Law Directive.

Even as the UK was implementing the Fourth Directive (in 1980) there was a growing debate in international accounting circles as to the optimum format of company income statements. The original SSAP 6: Extraordinary Items and Prior Year Adjustments was revised in 1986, so as to narrow the range of permitted treatments in this area. Further debate led to the publication by the UK’s Accounting Standards Board (ASB) of Financial Reporting Standard 3: Reporting Financial Performance in 1992. This standard supplemented the provisions of the Companies Act by introducing new components of financial performance. Most importantly, FRS 3 brought in a requirement for companies to differentiate between the results of their continuing and discontinued operations. FRS 3 also required companies to produce a new ‘primary’ accounts statement, the Statement of Total Recognised Gains and Losses.

The rationale behind the introduction of this new statement was to ensure that companies disclosed all their gains and losses, including those which, under the pre-existing rules, need not have been disclosed. An example of such hitherto exempt items would be unrealised gains such as the accounting surplus on the revaluation of a fixed asset. It was felt that the expanded reporting of gains and losses would produce a more informative and accurate picture of the company’s overall financial performance.

FRS 3 has been an integral part of true and fair accounting in the UK since its appearance in 1993. This did not, however, conclude discussion on this matter. In January 1998, the G4+1 group of accounting standard setters (a group which, confusingly, comprises bodies from the US, UK, Canada, Australia and New Zealand, as well as IASC) published a special report which reviewed developments which might influence the future of reporting financial performance. Chief among these developments were the problems that had arisen internationally with regard to accounting for financial instruments.

In conjunction with the other national standard setters represented on G4+1, ASB issued a discussion paper this Summer on possible changes to the rules on the reporting of financial performance.

The paper invited views on the proposal to replace the current two statements - the profit and loss account and the statement of total recognised gains and losses - with one integrated performance statement. All recognised gains and losses would be reported in the single statement under one of three components:

The Paper suggests that gains and losses (taken to include all revenues and expenses) should be reported only once and in the period in which they arise, and therefore should not be reported again in another component at a later date.

Other changes proposed to FRS 3 are as follows:

Presently, certain items are shown separately after operating profit: these items include the profit/loss on the sale or termination of an operation, the profit/loss on the disposal of a fixed asset, and the costs of a fundamental re-organisation. Under the proposed changes, the first two of these items would appear under the ‘Other gains and losses’ component and the latter would appear under operating/trading activities.

Additional disclosures are called for so as to put in context the voluntary presentations of ‘pre-exceptional’ results. Where such results are presented, they should be accompanied by the disclosure of pre-exceptional results, exceptionals and post-exceptional results for the past, say, five years.

The way that errors are corrected in a subsequent set of accounts would change. Under FRS 3, there is a distinction between ‘fundamental errors’ and ‘other material errors’, with the effect that adjustments are not required for normally recurring adjustments or corrections of accounting estimates. The view expressed in the G4+1 report is that it is impracticable to distinguish between the two. Accordingly, ASB now proposes that all material errors should be corrected by means of a prior period adjustment in the next set of accounts.

Dividends would not be treated as items of financial performance, but rather as appropriations of profit. Accordingly, they would not be shown on the face of the performance statement.

Before any changes are made to FRS 3, there will be full consultation with interested parties on the basis of firm proposals put forward by ASB. Any successor to FRS 3 will, therefore, take some time to appear. The publication of this discussion paper at this time reveals two things, however. The first is the extent to which true and fair accounting standards are liable to be revised in order to reflect the dynamic environment of the business world. The second is the extent to which the international standard setters are increasingly working together to harmonise accounting treatments throughout the developed world.

FRS 3 and Insurance Companies
A more immediate revision to FRS 3 concerns the accounts of insurance companies. With respect to accounting periods ending on or after 23 August 1999, insurance companies and groups are required to include in their P&L accounts both realised and unrealised gains and losses on investments held as part of their investment portfolios. At present, as a result of their exemption from two paragraphs of FRS 3, insurance companies are permitted to exclude unrealised gains from their P&L accounts.

The Small Company Audit
The Government is planning to issue proposals this Autumn to raise the Companies Act turnover threshold below which limited companies are exempt from the statutory annual audit of their accounts.

At present, in order to be exempt, a company must first qualify as a small company under the Act. To do this, the company must satisfy two out of the following three criteria by reference to its most recent accounts:

Turnover: £2.8 million max
Balance Sheet Total: £1.4 million max
Number of Employees: 50 max

In order to further qualify for exemption from the annual audit, the company’s turnover must not exceed £350,000. There are safeguards which allow 10% of the company’s shareholders or members to demand that an audit be carried out.

Under the terms of the Fourth Directive, member states can exempt all small companies from the statutory annual audit. Several member states do just this. In the UK, on the other hand, it has historically been accepted that the independent, external audit is a standard quid pro quo for the privilege of limited liability status, a principle that applies to companies regardless of their size and internal structure. The first tentative departure from this principle came as recently as 1994, when companies with turnover of £90,000 were given exemption, the threshold being raised to £350,000 three years later.

The Government is now considering making a radical change to the UK’s rules on audit exemption. One possibility being officially floated is that the UK matches some of its continental partners and exempts from audit all companies that qualify as ‘small’ under the Fourth Directive. Since the Fourth Directive thresholds are currently in the process of being upgraded themselves, this could result in the turnover threshold for audit exemption purposes being raised from £350,000 to some £4.8 million. A change on this scale would lead to many companies which are currently deemed to be ‘medium-sized’ not only being re-classified as ‘small’ but exempted from the annual audit.

The Government believes that such companies would benefit from the cost savings that would result from not having to meet the cost of the annual audit. The consultation exercise this Autumn will focus on whether the modest cost savings of dispensing with the audit are likely to be offset by the consequences of the loss of information to companies, their members, their trading partners and the general public.

Back to top