NEW UK GAAP ONE YEAR IN: PRACTICAL DEVELOPMENTS AND EMERGING ISSUES

Transcription

1 NEW UK GAAP ONE YEAR IN: PRACTICAL DEVELOPMENTS AND EMERGING ISSUES February 2017

2 TABLE OF CONTENTS TABLE OF CONTENTS NEW UK GAAP ONE YEAR IN Summary of new UK GAAP Increased size thresholds CAPITAL OR REVENUE EXPENSE? Major spare parts and standby equipment Subsequent expenditure Major inspections and overhauls FINANCIAL INSTRUMENTS Classification of basic versus non-basic Accounting for basic instruments (FRS 102 v previous UK GAAP) Financing transactions (FRS 102 versus previous UK GAAP) Calculating an effective interest rate Loan from a shareholder TRANSITION TO FRS Mandatory exemptions from retrospective application Optional exemptions from retrospective application Exemptions specific to small entities USING PREVIOUS VALUATIONS AS DEEMED COST Previous GAAP valuation as deemed cost Fair value as deemed cost Revaluation reserve for property, plant and equipment versus investment property FRS 102: SECTION 1A SMALL ENTITIES Section 1A True and fair view Complete set of financial statements Transactions with shareholders Presentation of the financial statements Small groups preparing consolidated financial statements Abridging and adapting the balance sheet formats Disclosure requirements for small entities Emerging issues in respect of disclosures How do we achieve a true and fair view under Section 1A? Lessons to learn from other companies that have adopted FRS LATEST DEVELOPMENTS IN UK GAAP Why the need for change? The FRC s principles supporting the overall objective of financial reporting The changes proposed Other changes to FRS Amendments to IFRS for SMEs FOREIGN CURRENCY Forex derivatives Quantum Professional Training Page 1

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4 1. NEW UK GAAP ONE YEAR IN The new suite of UK and Republic of Ireland accounting standards have now been put into practice by those companies outside of the small companies regime for one year. Some companies have found the transition to be more complex than others and recent reviews of financial statements prepared under the new regime have highlighted some common issues faced by reporting entities. Small companies are required to apply new UK GAAP for accounting periods starting on or after 1 January 2016 (i.e. December 2016 year-ends will be the first ones prepared for small companies that have not early-adopted the standards). There are some issues that have been faced by companies outside of the small companies regime which can give rise to lessons being learnt by small companies as they prepare for the transition. This course will look at some of the main issues that are currently emerging, including: the distinction between capital and revenue expenditure under FRS 102; financial instruments and how to classify as basic and non-basic; related party transactions when and how to disclose; the lessons small companies can learn in readiness for transition; and new developments in FRS 102 since the standard was first implemented. 1.1 Summary of new UK GAAP New UK GAAP is made up of six standards: FRS 100 Application of Financial Reporting Requirements This standard provides an overview of the financial reporting regime; i.e. which entities can use which accounting frameworks. FRS 101 Reduced Disclosure Framework This standard offers qualifying entities a reduced disclosure framework for subsidiaries and ultimate parents that apply the recognition, measurement and disclosure requirements of EUadopted IFRS. FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland This standard replaces previous FRSs, SSAPs, UITFs and the FRSSE and applies to those reporting entities that do not report under IFRS for periods commencing on or after 1 January Small companies reporting under FRS 102 apply the presentation and disclosure requirements in Section 1A Small Entities although recognition and measurement of amounts in the financial statements are based on full FRS 102. This will enable consistency of accounting treatments if a company becomes medium-sized and hence reports under full FRS 102. FRS 103 Insurance Contracts This standard outlines the reporting requirements for entities applying FRS 102 that issue insurance contracts or hold reinsurance contracts. A revised edition of FRS 103 was issued on 13 February 2017 incorporating amendments arising as a result of Solvency II that were issued in May Paragraph A4.2A clarifies a legal requirement regarding a reference to the Solvency II Directive in the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410), on which the Department for Business, Energy and Industrial Strategy has written to the FRC confirming that there is no requirement to change the accounting basis to one consistent with Solvency II. FRS 104 Interim Financial Reporting FRS 104 outlines the reporting requirements for entities that apply UK and Irish GAAP and who prepare interim financial reporting for periods commencing on or after 1 January Page 2 Quantum Professional Training

5 FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime FRS 105 outlines the reporting requirements for those entities that qualify as a micro-entity. The FRC made significant simplifications to FRS 102 in arriving at FRS 105 and there are some additional factors that should be considered by micro-entities in considering whether to apply FRS 105 as it may not be suitable for some micro-entities. 1.2 Increased size thresholds In 2015, the Department for Business Innovation and Skills (now replaced by the Department for Business, Energy and Industrial Strategy) issued SI 2015/980 which transposed the requirements of the EU Accounting Directive (the Directive) into company law. The Directive primarily reduces the disclosure requirements that small and micro-entities have to make in their financial statements in order to reduce the burdens placed on such companies in preparing annual accounts. The Directive itself is quite powerful because it restricts the ability of regulators (such as the Financial Reporting Council) in mandating disclosures over and above those required by law. Another notable feature of SI 2015/980 is that it increases the thresholds that define whether a company or group is micro, small, medium-sized or large as follows: Turnover Balance sheet total Average no. of employees Micro-entity Not more than 632,000 Not more than 316,000 Not more than 10 Small company Not more than 10.2 million Not more than 5.1 million Not more than 50 Small group Not more than 10.2 million net or not more than 12.2 million gross Not more than 5.1 million net or not more than 6.1 million gross Not more than 50 Mediumsized company Not more than 36 million Not more than 18 million Not more than 250 Mediumsized group Not more than 36 million net or not more than 43.2 million gross Not more than 18 million net or not more than 21.6 million gross Not more than 250 Large company 36 million or more 18 million or more 250 or more Large group 36 million net or more or 43.2 million gross or more 18 million net or more or 21.6 million gross or more 250 or more The qualifying conditions above are met by a company, or a group, in a year in which it satisfies two, or more, of the turnover, balance sheet total and employee headcount criteria. Section 382(4) of the Companies Act 2006 says that if a company has a short accounting period, the turnover figure is proportionately adjusted. SI 2015/980 allows a company to early-adopt the above thresholds. Therefore, if a company or group would have been classed as medium-sized under the old thresholds, but would now be classed as small under the new thresholds, it can early-adopt SI 2015/980 for accounting period starting as far back as 1 January 2015 if it wishes. However, in taking advantage of this early-adoption clause, the company or group must also apply the new accounting standards Quantum Professional Training Page 3

6 (i.e. FRS 102). In addition, where the company would have needed an audit under the old thresholds, because it was not included in the small companies regime, for example, then it will need to have an audit under the new regime because early-adoption of the revised audit exemption thresholds is not permitted (they can only be applied for audits of accounts for periods commencing on or after 1 January 2016). Page 4 Quantum Professional Training

7 2. CAPITAL OR REVENUE EXPENSE? Tangible fixed assets are dealt with in FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland in Section 17 Property, Plant and Equipment. Section 17 says that property, plant and equipment are tangible assets that: (a) (b) the entity holds for use in the production or supply of goods/services, for rental to third parties or for administrative functions; and the entity will expect to use for more than one accounting period. The scope of Section 17 does not extend to biological assets (living animals or plants) which relate to agricultural activity or heritage assets. It also does not apply to mineral rights and mineral reserves. For these types of assets, Section 34 Specialised Activities will apply. A tangible fixed asset can only be recognised on the balance sheet where the recognition criteria are met as follows: (a) (b) it is probable (i.e. more likely than not) that the entity will receive future economic benefits from the fixed asset; and the cost of the asset can be reliably measured. If these recognition criteria are unable to be met, the item is not capitalised and is recognised in profit or loss. The cost of an item is often quite easy to determine because it will be the price which the entity pays. Where the reporting entity may be self-constructing an asset, the production cost will be established by aggregating the price that it has paid for material, labour and other inputs used in the construction process. Under the historical accounting rules, fixed assets must be shown at their production price or purchase cost, less any amounts in respect of depreciation or diminution in value (impairment). The Companies Act 2006 defines purchase price as including any consideration (whether in cash or otherwise) given by the company in respect of that asset or those material or consumables, as the case may be. 1 FRS 102 outlines the elements of cost at paragraph components, including: (a) (b) (c) Cost can include several the initial purchase price: this includes incremental costs such as legal fees, brokerage fees, import duties and irrecoverable purchase taxes and is stated net of trade discounts and rebates; directly attributable costs incurred in bringing the asset to the location and condition necessary for it to be capable of operating in the manner that management intend. Such costs can include site preparation fees, initial delivery and handling costs, installation and assembly and the testing of functionality; an initial estimate of costs that the entity expects to pay in respect of dismantling and removing the item and restoring the site on which it is located; and (d) borrowing costs that the entity chooses to capitalise in accordance with Section 25 Borrowing Costs (note borrowing costs cannot be capitalised if the entity is a microentity reporting under FRS 105). Costs which will never meet the recognition criteria and which must always be expensed to profit or loss include: (a) (b) (c) the costs of opening a new facility; costs incurred in introducing a new product or service which include advertising and promotional activities; costs of undertaking business in a new location or with a new class of customer (this also includes costs of staff training); and 1 SI 2008/ Sch 12 Quantum Professional Training Page 5

8 (d) administration and other general overhead costs. 2.1 Major spare parts and standby equipment A notable difference between FRS 102 and previous FRS 15 Tangible fixed assets and the FRSSE is that Section 17 of FRS 102 deals with the issue of major spare parts and standby equipment. Paragraph 17.5 recognises that these are usually carried as inventory and recognised in profit or loss by a reporting entity as they are consumed, usually in cost of sales. Some medium-sized companies have had to change their accounting practices as a result of FRS 102 s requirements. FRS 102 says that if major spare parts and standby equipment are expected to be used by an entity for more than one accounting period, then they should be recognised as fixed assets on the balance sheet. This also applies to any spare parts and servicing equipment which can only be used in connection with an item of property, plant and equipment. Major spare parts and standby equipment should always be depreciated from the date on which they become available for use. 2.2 Subsequent expenditure Accountants will be familiar with the term subsequent expenditure where fixed assets are concerned. FRS 102 does not, however, use this term and there is very little in the way of guidance on the treatment of subsequent expenditure in FRS 102 in comparison to previous FRS 15 which contained over two pages of guidance. Paragraph of FRS 102 merely states that an entity must recognise the costs of day-to-day servicing of an item of property, plant and equipment in profit or loss in the period that the expense is incurred. Accountants will, therefore, need to be familiar with the Concepts and Pervasive Principles contained in Section 2 of FRS 102 if there is any uncertainty as to how to treat an item of expenditure in terms of capitalising it or expensing it in profit or loss. Generally, only those costs which a reporting entity incurs to achieve greater future economic benefits should be capitalised on the balance sheet as part of the cost of an existing fixed asset. If the costs merely relate to maintaining an asset, then it should be expensed. If, however, an entity incurs expenditure on improving an asset beyond its previously assessed state, then that item of expenditure will qualify for capitalisation on the balance sheet. The key question to ask is whether the expenditure will result in any additional economic benefits flowing to the entity? If the answer is yes then it will qualify for capitalisation on the balance sheet Component accounting FRS 102 places more emphasis on the concept of component accounting than previous UK GAAP did. Component accounting means that an asset is disaggregated into its major components and if each major component has a shorter useful economic life than the main asset itself, each component is depreciated over its useful life and is derecognised when the component is replaced. Component accounting is useful for items of a fixed asset that are replaced and/or refurbished on a regular basis either as part of legislation, or to keep the asset in working order. Paragraph 17.6 of FRS 102 says that an entity will add to the carrying value of an item of property, plant and equipment the cost of replacing the component part if the replacement part is expected to provide incremental future benefits to the entity. Therefore, it is important to distinguish between those expenditures that relate to repair and maintenance of an existing fixed asset and those expenditures which improve an existing fixed asset beyond its previously assessed state. Component accounting has proven quite difficult to apply in practice, particularly from transition and for those companies that are very plant-intensive (such as manufacturing companies). However, applying the concept of component accounting means that the carrying value of the asset in the balance sheet is a truer reflection of the net book value of the entity s tangible fixed assets. Page 6 Quantum Professional Training

9 FRS 102 does not provide any guidance as to how the cost of an asset should be allocated among its major components where such components have been identified as separately depreciable assets. In practice, an invoice from a supplier for, say, a machine used in the manufacturing process, will not split the asset into its major components. It is therefore advisable to estimate the cost of the identifiable components by reference to their current market prices, or by inquiring with the seller. Example Replacement of a machine part A company purchases a machine for 65,000 and does not apply component accounting to the asset. The machine is determined to have a useful economic life of ten years but at the end of year five it breaks down due to a major component having to be replaced at a cost of 14,500. Advances in technology have also meant that the machine will provide greater output than previously once the part is replaced. Management have decided to replace the part rather than purchase a new machine as this is deemed to be the cheapest option for the company. The useful economic life of the machine remains at five years once the part has been replaced. The cost that the entity will incur to replace the machine will meet the recognition criteria for capitalisation on the balance sheet because it will provide future economic benefit and the cost can be reliably measured. The cost of the component that broke down was not separately identified when the entity first acquired the machine, but the cost of the replacement part can be used as a basis to retrospectively work out the cost of the replaced component. In this example, the accountant has assumed an appropriate discount rate to be 5%. The discounted value of the replaced component is 11,361 ( 14,500 / ). After five years worth of depreciation has been charged the carrying amount would be 5,681 ( 11,361 x 5/10). This is derecognised from the net book value of the machine of 32,500 ( 65,000 x 5/10) at the end of year 5 and the cost of the new component of 14,500 would be added to the carrying value. The revised carrying value of the machine in the balance sheet is 41,319 ( 32, ,500-5,681). 2.3 Major inspections and overhauls Paragraph 17.7 of FRS 102 acknowledges that some entities may be required, by law or regulation, to have assets subjected to major inspections for faults as a condition of continuing to operate them. An example cited within the standard is that of a bus. These costs are incurred by the entity regardless of whether parts of the asset are replaced. It is important to distinguish between pure inspection costs and the costs of replacing any parts. Overhaul costs will ordinarily include replacement parts and major repairs and maintenance. Whether major repairs and maintenance costs are classed as inspection costs will depend on whether, or not, those costs meet the recognition criteria as an asset. As discussed above, routine day-to-day servicing costs are treated as expenses and are recognised in profit or loss as incurred because such costs do not meet the recognition criteria for an asset. Major repair and maintenance work programmes, however, that are undertaken as part of a routine inspection and overhaul, and which will result in future economic benefits flowing to the entity, may qualify for recognition as a fixed asset. Example Major inspection capitalised Tours R Us Ltd operates a fleet of coaches and minibuses to take tourists on tours across various parts of the country. On 1 January 2016, the company purchased a fleet of coaches for 450,000 and the useful economic life of these coaches is five years. Licensing conditions state that the coaches have to be routinely inspected and overhauled at least every three years from the date of purchase and the expected current costs of such an overhaul for similar coaches which are three years old is 65,000. The overhaul and inspection costs are a significant part of the total cost of the fleet of transport and therefore a proportion of the cost of the asset equivalent to the expected cost of overhaul ( 65,000) is depreciated over the period to the next inspection/overhaul. The remaining cost which may require replacement over the useful economic life of the fleet is 385,000 ( 450,000-65,000). Quantum Professional Training Page 7

10 3. FINANCIAL INSTRUMENTS Financial instruments are one of the main areas of financial reporting that tend to have accountants glazing over, but they are a significantly important topic, albeit one of the most complex areas of accounting. FRS 102 has also overhauled the way in which financial instruments are accounted for in comparison to previous UK GAAP and the changes should not be underestimated. Financial instruments are dealt with in FRS 102 at Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues. Since the inception of FRS 102, certain accounting treatments for financial instruments have been causing issues, including (but not limited to): classification of basic v non-basic; calculation of an effective interest rate; and treatment of derivative instruments. This section of the course will take a look at some of these issues, but it is also worth flagging up the following Staff Education Notes, which can be downloaded free of charge from the FRC s website ( as they provide useful guidance in applying the detailed rules in Sections 11 and 12: SEN 02 Debt instruments (updated October 2015) SEN 11 Forward exchange contracts SEN 16 Financing transactions Staff Education Notes are not a substitute for reading and understanding the detailed intricacies of Sections 11 and 12, although the terminology used and concepts applied in these sections is not easy to understand and may need to be substituted for wider reading around this complicated area. 3.1 Classification of basic versus non-basic All entities will have some form of financial instrument such as share capital, trade debtors, trade creditors and cash and bank balances. In the broadest sense of the term, a financial instrument is created when one entity wishes to raise money and another entity provides that money. FRS 102 uses terminology such as the issuer that is the borrower and the holder which is the lender. Most financial instruments will fall to be classed as basic; however, since FRS 102 came into force, there have been a lot of questions raised as to whether certain financial instruments are basic or not. Generally, the features of some loans may mean that a financial instruments is not within the scope of Section 11 and hence is not basic and therefore needs to be accounted for under the provisions of Section 12, which may include: interest rates that are linked to commodity prices, such as the House Price Index; leveraged rates (e.g. 2 x standard variable rate); inverse floaters (e.g. 5% less LIBOR); negative margins (e.g. LIBOR less 10%); loans giving the lender power to unilaterally alter the terms (e.g. Housing Association loans); Page 8 Quantum Professional Training

11 loans that risk the lender losing principal or interest (e.g. repayment at fair value); and prepayments that are contingent on future events other than for defaults, change of control or to protect either party against central bank levies, tax changes etc. The most common types of financial instruments that would fall within the scope of Section 11 include: trade debtors and trade creditors; loans with straightforward terms; directors loans; bank overdrafts; hire purchase agreements; and intra-group loans (e.g. a loan from parent to subsidiary). 3.2 Accounting for basic instruments (FRS 102 v previous UK GAAP) Initial recognition Initial recognition of a basic financial instrument under Section 11 is at transaction price, including transaction costs (transaction costs are not included if the instrument is measured at fair value through profit or loss). This is a similar treatment to previous UK GAAP Subsequent measurement In terms of subsequent measurement, Section 11 would normally require the instrument to be measured at amortised cost using the effective interest method (the similar method in previous UK GAAP was described as a constant rate on the carrying amount ) Derecognition A financial liability is derecognised (or partly derecognised) only when it is extinguished (i.e. when the contractual obligation is discharged, cancelled or expires). This is similar to previous UK GAAP. A financial asset is only derecognised when: a) the contractual rights to the cash flows from the financial asset expire or are settled; or b) the entity transfers to another party substantially all of the risks and rewards of ownership of the financial asset; or c) the entity, despite having retained some significant risks and rewards of ownership, has transferred control of the asset to another party and the other party has the practical ability to sell the asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer. In this case, the entity shall: i. derecognise the asset; and ii. recognise separately any rights and obligations retained or created in the transfer. Quantum Professional Training Page 9

12 Example Sales ledger sold to a factoring company: risk retained On 31 October 2016, Company A sold its sales ledger to a factoring company for 1.1 million. The fair value of the trade debtors at the date of sale is 1.2 million. The terms of the sale are that Company A transfers credit risk, but retains late payment risk. Any trade debtors which becomes overdue by more than 130 days are deemed to be in default and Company A will suffer any resulting loss. The directors have concluded that both credit risk and late payment risk are significant risks. While the company has transferred some risks to the factoring company, it has still retained some of the significant risks of ownership (it has retained late payment risk). In this scenario, Company A does not derecognise the value of the sales ledger at the date of sale and treats the 1.1 million consideration as a financial liability (a loan). Example Sales ledger sold to a factoring company: no risks retained On 31 October 2016, Company B sold its sales ledger to a factoring company for 1.1 million. The fair value of the trade debtors at this date is 1.2 million. The terms of the sale are that the entire risks and rewards of ownership are transferred to the factoring organisation and Company B is not responsible for any customers who pay late, or who are unable to pay. In this example, Company B has transferred substantially all the risks and rewards associated with the sales ledger. Company B therefore derecognises the sales ledger from its balance sheet at the date of sale. The difference between the carrying amount of the debtors ( 1.2 million) and the cash received ( 1.1 million) is recognised immediately in profit or loss as a finance cost. 3.3 Financing transactions (FRS 102 versus previous UK GAAP) A financing transaction might arise when a company sells goods or services and defers payment beyond normal credit terms, or is financed a rate of interest which is below market rate Initial measurement Initial measurement of the financing transaction is at the present value of the future payments. These future payments are discounted using a market rate of interest for a similar debt instrument. Under previous UK GAAP, the financing transaction would have been recognised at transaction price with any contractual interest being allocated on a constant rate. Any interest-free loans, under previous UK GAAP, would incur no interest. Example Cash sale on deferred payment terms A company sells goods to one of its major customers on a two-year interest-free credit basis for 1,000. The cash sales price of the goods is 900 (VAT has been ignored for the purposes of this example). The market rate of interest is 5.4%. The company initially recognises the sale at the undiscounted amount of cash receivable from the customer, which is invoice price (i.e. 900), thus the entries are: Dr Trade debtors 900 Cr Revenue 900 Being initial recognition of sale Subsequent measurement After initial recognition at present value, the financing transaction is accounted for using the effective interest method. This is a method of calculating the amortised cost of a financial instrument and allocating the interest income or expense over the relevant period. The Page 10 Quantum Professional Training

13 amortised cost of a financial instrument is the present value of future cash flows which are then discounted at the effective interest rate. Example Effective interest method Using the example above, the difference between the present value ( 900) and the amount payable ( 1,000) of 100 will be recognised in the financial statements using the effective interest method as follows: Opening Interest at Closing Balance 5.4% Cash flow balance Year Year ( 1,000) Calculating an effective interest rate Calculating an effective interest rate can be done using Microsoft Excel in two ways: the goal seek function; and the internal rate of return function Goal seek function The goal seek function is found in the Data tab and What-if Analysis : Example Calculating the effective interest rate using goal seek A company borrows 1m on 1 January 2017 for a 10-year period with a coupon rate of 7%. The provider charges an arrangement fee of 12,500. Interest is payable at a rate of 7% and this is payable annually starting at the inception of the loan. The redemption amount is at par at the end of year 10. The company has chosen not to prepay any of the loan amounts. The company reports under FRS 102. The first step is to calculate the effective interest rate which will be used to charge the interest to the profit and loss account over the life of the loan. The loan can be profiled on an Excel spreadsheet as follows: The above spreadsheet shows the formulas behind the numbers, and is profiled as follows: Quantum Professional Training Page 11

14 The idea behind the goal seek function is to get cell E13 to agree to the redemption amount of 1m by allocating the interest in column C. We can use the goal seek function to do this via Data What-if Analysis Goal Seek. This will bring up the following: Once you click OK, Excel will calculate the interest automatically. Page 12 Quantum Professional Training

15 The effective interest rate is 7.179% and the total interest over the life of the loan is 712,500 equivalent to 10 x 70,000 interest plus the 12,500 arrangement fee. At the end of year 10, the maturity amount is paid and the journals are: Dr Loan payable 1m Cr Cash at bank 1m Being redemption of loan Internal rate of return An alternative method of calculating the effective interest rate is to use the internal rate of return function (IRR) in Excel. For the IRR function to work, at least one number must be negative with the other cash flows being positive values. Example Internal rate of return Using the facts in the above example, the effective interest rate is calculated as follows: =IRR(A1:A11) Quantum Professional Training Page 13

16 The entries in respect of the loan in year 1 are: Dr Bank 987,500 Cr Loan payable 987,500 Being initial recognition of bank loan (net of transaction costs) Dr Interest payable 70,897 Cr Loan payable 70,897 Being year 1 interest Dr Loan payable 70,000 Cr Bank 70,000 Coupon interest at 7% 3.5 Loan from a shareholder Quite often a shareholder(s) may lend money to the business and either not charge a rate of interest or charge a rate of interest which is below market rate. Where a loan is made by a shareholder which is not at market rate, paragraph of FRS 102 would classify this as a financing transaction. The loan would be initially recognised at the present value of the future payments which are discounted at a market rate of interest for a similar debt instrument Loans with no formal terms attached Loans which do not have formal terms attached to them would be regarded as being repayable on demand. The fair value of a financial liability that is due on demand is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid (FRS ). Example Fixed rate loan from a shareholder Janine is a shareholder of Company A Ltd. On 1 January 2016, she makes a loan to the company of 350,000. Janine has agreed for the company to make repayment in two years time. The interest on the loan is 5%, but if the company were to obtain a similar loan from its bank, it would be charged interest at a rate of 10%. The loan is below market rate and hence constitutes a financing arrangement. There are terms in place for the loan and hence it is not repayable on demand. The equivalent rate is 10% and the present value of the loan is calculated as: Cash Discount Present Year payable factor (10%) value , , , , ,629 There is a difference between the cash transferred ( 350,000) and the present value of the loan calculated above ( 319,629) which amounts to 30,371. This amount is referred to as a measurement difference and must be brought into the financial statements. The measurement difference represents the value of the benefit received by the company because the shareholder has provided it with a loan that is below market rate. It also reflects the substance of the arrangement which is that the shareholder is providing the company with implicit financing as well as the underlying loan through the reduced rate of interest. The entries in respect of this loan on initial recognition are: Dr Cash at bank 350,000 Cr Loan payable 319,629 Page 14 Quantum Professional Training

17 Cr Capital contribution 30,371 Being initial recognition of loan from shareholder at present value Draft ICAEW TECH 05/16bl Guidance on Realised and Distributable Profits Under the Companies Act 2006 does not regard the credit to equity as an accounting, or legal, profit and hence is not distributable. The loan is profiled as follows: Effective interest rate 10% Opening Interest Cash Closing Year balance at 10% (EIR) flow balance ,629 31,962 (17,500) 334, ,091 33,409 (367,500) - The entity may choose to make a transfer from the capital contribution reserve to the profit and loss account reserve represent an amount equivalent to the annual interest charge, hence the journals in the 2016 year would be: Dr Interest 17,500 Cr Cash at bank 17,500 Interest paid to shareholder Dr Interest 14,462 Cr Loan payable 14,462 Additional loan interest to take interest up to EIR ( 31,962-17,500) Dr Capital contribution reserve 14,462 Cr Profit and loss reserves 14,462 Being transfer between reserves In addition, as this loan has not been concluded under normal market conditions, details would need to be disclosed as related party transactions, even under Section 1A of FRS 102. Quantum Professional Training Page 15

18 4. TRANSITION TO FRS 102 FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland has now come into mandatory effect for accounting periods commencing on or after 1 January 2015 (with earlier adoption permissible). The transition to FRS 102 can be a complicated task to perform and it is crucial that it is undertaken in a logical manner. Section 35 Transition to this FRS at paragraph 35.7 outlines a four-step approach to the transition as follows: a) recognise all assets and liabilities whose recognition is required by this FRS; b) not recognise items as assets or liabilities if this FRS does not permit such recognition; c) reclassify items that it recognised under its previous financial reporting framework as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity under this FRS; and d) apply this FRS in measuring all recognised assets and liabilities. The first step is to prepare an opening FRS 102 balance sheet which will involve taking the opening balances under old UK GAAP at the date of transition and then adjusting these to become FRS 102-compliant. For example, including any relevant holiday pay accruals or deferred tax balances on investment property revaluations. It is worth pointing out that Section 35 does not require the opening balance sheet to be presented in the first set of FRS 102 financial statements. 4.1 Mandatory exemptions from retrospective application In dealing with the transition, it is worth pointing out that there are FOUR mandatory exemptions from retrospective application as follows: Derecognition of financial assets and financial liabilities Entities cannot recognise financial assets and financial liabilities which were derecognised under previous UK GAAP. For those instruments that would have been derecognised under FRS 102 and arose in a transaction that took place before the date of transition, but were not derecognised under old UK GAAP, there is a choice either derecognise them on adoption of FRS 102, or continue recognising them until they are disposed or settled Accounting estimates Entities cannot use hindsight to change the value of accounting estimates recognised at the date of transition. Should additional information have come to light about the estimate, this should be treated as a non-adjusting event and accounted for in the current (not previous) accounting period unless there is clear evidence that the accounting estimate is incorrect Discontinued operations On transition to FRS 102, a reporting entity cannot change the accounting it followed under previous GAAP in respect of its discontinued operations and hence there will not be any reclassification or remeasurement for discontinued operations that have been previously accounted for Non-controlling interests Entities cannot retrospectively change the accounting that it followed for measuring noncontrolling interests. Page 16 Quantum Professional Training

19 4.2 Optional exemptions from retrospective application There are 18 optional exemptions from retrospective application and a client can use all, some or none of them as they so wish. The optional exemptions are as follows: Business combinations, including group reconstructions A first-time adopter does not have to apply Section 19 Business Combinations and Goodwill to those business combinations that took place before the date of transition. However, where the entity restates any combination so as to comply with Section 19, it must restate all later combinations. Where the provisions in Section 19 are not applied retrospectively, all assets and liabilities acquired or assumed in a past business combination at the date of transition will be recognised and measured in accordance with paragraphs 35.7 to 35.9 (or if applicable paragraphs 35.10(b) to (r)). There are two exceptions to this requirement in respect of: intangible assets (other than goodwill): intangible assets subsumed within goodwill should not be separately recognised; and goodwill: no adjustment is made to the carrying value of goodwill Share-based payment For equity instruments granted before the date of transition, a first-time adopter need not apply Section 26 Share-based Payment. This exemption also applies to liabilities arising from sharebased payment transactions which were settled before the date of transition. Where a first-time adopter has previously applied either FRS 20/IFRS 2 Share-based Payment to equity instruments granted before the date of transition, the entity must then apply either FRS 20/IFRS 2 (whichever applies) or Section 26 at the date of transition. Small entities For a small entity that first adopts FRS 102 for an accounting period which starts before 1 January 2017, this exemption is extended to equity instruments that were granted before the start of the first period that complies with FRS 102, provided that the small entity did not previously apply FRS 20 or IFRS 2. Where the small entity chooses to apply this exemption, it must provide disclosures in accordance with paragraph 1AC Fair value as deemed cost For items of property, plant and equipment, investment property or intangible assets (other than goodwill), the first-time adopter can use fair value as deemed cost on transition to FRS 102. The term deemed cost is defined in the Glossary as: An amount used as a surrogate for cost or depreciated cost at a given date. Subsequent depreciation or amortisation assumes that the entity had initially recognised the asset or liability at the given date and that its cost was equal to the deemed cost Revaluation as deemed cost Again, for items of property, plant and equipment, investment property or intangible assets (other than goodwill), a first-time adopter can use a revaluation amount as deemed cost. This might be of benefit to a client who wishes to cease getting periodic valuations and move back onto the depreciated historic cost model for measuring fixed assets (e.g. a building). Be careful with this exemption; valuations should be obtained at, or before, the date of transition, but not after Individual and separate financial statements Paragraphs 9.26, 14.4 and 15.9 of FRS 102 require an entity to account for investments in subsidiaries, associates and jointly controlled entities at either cost less impairment or at fair Quantum Professional Training Page 17

20 value in the individual or separate financial statements. Where cost is used, the first-time adopter must use one of the following amounts in the individual/separate opening balance sheet: cost as per Section 9 Consolidated and Separate Financial Statements, Section 14 Investments in Associates or Section 15 Investments in Joint Ventures; or deemed cost. In this respect, the deemed cost is the carrying amount at the date of transition which has been determined under previous UK GAAP Compound financial instruments The use of split accounting is adopted for compound financial instruments (an instrument which contains a mix of both debt and equity and the two components are accounted separately). A first-time adopter does not have to use split accounting if the liability portion of the instrument has been settled at the date of transition Service concession arrangements A service concession arrangement is defined in the Glossary as: An arrangement whereby a public sector body or a public benefit entity (the grantor) contracts with a private sector entity (the operator) to construct (or upgrade), operate and maintain infrastructure assets for a specified period of time (the concession period). For such arrangements, a first-time adopter does not have to apply the provisions in paragraphs 34.12I to 34.16A for service concession arrangements entered into before the date of transition as these arrangements will continue to be accounted for using the same accounting policies applied at the date of transition Extractive industries Where a first-time adopter has previously accounted for exploration and development costs for oil and gas properties which are in the development/production phases in cost centres that included all properties in a large geographical area, it can choose to measure oil and gas assets at the date of transition on the following basis: Exploration and evaluation assets at the amount determined under previous UK GAAP. Assets in the development/production phase at the amount determined for the cost centre under previous UK GAAP (this amount will be allocated to the cost centre s underlying assets on a pro-rata basis using reserve volumes/values at the date of transition). First-time adopters must test exploration and evaluation assets and assets in the development and production phases for impairment at the transition date in accordance with either Section 34 Specialised Activities or Section 27 Impairment of Assets Arrangements containing a lease First-time adopters can choose to determine whether an arrangement that exists at the date of transition contains a lease on the basis of facts and circumstances existing at the date of transition, rather than when the arrangement was originally entered into Decommissioning liabilities included in the cost of property, plant and equipment (PPE) The cost of an item of PPE should include the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. A first-time adopter can choose to measure this portion of cost at the transition date rather than on the date(s) when the obligation initially arose. Page 18 Quantum Professional Training

21 Dormant companies NEW UK GAAP ONE YEAR IN: PRACTICAL DEVELOPMENTS AND EMERGING ISSUES A company which is dormant (as defined in the Companies Act) can retain its accounting policies for reported assets, liabilities and equity at the date of transition until such time that there is a change to those balances or the company enters into new transactions Deferred development costs as deemed cost The carrying amount of development costs capitalised under previous SSAP 13 Accounting for research and development can be used as deemed cost on transition to FRS Borrowing costs When a first-time adopter decides to capitalise borrowing costs as part of the cost of a qualifying asset, it can treat the transition date as the date on which capitalisation of such costs commences Lease incentives A first-time adopter does not have to apply paragraphs 20.15A and 20.25A to lease incentives provided that the lease was entered into before the date of transition. The first-time adopter can continue to recognise any remaining lease incentive (or cost associated with lease incentives) on the same basis as that applied at the date of transition to FRS Public benefit entity combinations A first-time adopter does not have to apply paragraphs PBE34.75 to PBE34.86 to public benefit combinations that had taken place before the transition date. However, if the first-time adopter restates any entity combination to comply with FRS 102, it must restate all later combinations Assets and liabilities of subsidiaries, associates and joint ventures When a subsidiary becomes a first-time adopter later than its parent, the subsidiary measures its assets and liabilities at either: the carrying values that would be included in the parent s consolidated accounts. These values would be based on the parent s date of transition to FRS 102 if no consolidation adjustments were made and for the effects of the business combination in which the parent acquired the subsidiary; or the carrying values required by the rest of FRS 102 which are based on the subsidiary s date of transition. The carrying values in the second bullet could be different from the carrying values in the first bullet where the exemptions result in measurements which are dependent on the transition date. In addition, differences could also arise where the accounting policies used by the subsidiary differ from those in the consolidated accounts. Similar exemptions are available for an associate or joint venture which becomes a first-time adopter later than the entity which holds significant influence or joint control over it. Conversely, when the parent or investor becomes a first-time adopter later than its subsidiary, associate or joint venture, the parent/investor will, in the consolidated accounts, measure the assets and liabilities of the subsidiary, associate or joint venture at the same carrying amount as in the subsidiary s associate s or joint venture s financial statements which takes into account consolidation and equity accounting adjustments as well as the effects of the business combination in which the parent acquired the subsidiary or transaction in which the entity acquired the associate or joint venture. Quantum Professional Training Page 19

22 Where the parent becomes a first-time adopter in respect of its separate financial statements earlier or later than for its consolidated accounts, the parent measures its assets and liabilities at the same values in both sets of accounts, except for consolidation adjustments Designation of previously recognised financial instruments FRS 102 allows a financial instrument to be designated on initial recognition as a financial asset or financial liability at fair value through profit or loss, provided certain criteria are met. Section 35 allows an entity to designate any financial asset or financial liability at fair value through profit or loss provided the asset or liability meets the criteria in paragraph 11.14(b) at the date of transition Hedge accounting There are exemptions available in respect of hedge accounting that may be applied in respect of: a hedging relationship existing at the date of transition; a hedging relationship which ceased to exist at the date of transition because the hedging instrument had expired, was sold, terminated or exercised before the date of transition; a hedging relationship which commenced subsequent to the date of transition; and entities that choose to take the accounting policy choices under paragraphs 11.2(b) or (c) and apply IAS 39 Financial Instruments: Recognition and Measurement or IFRS 9 Financial Instruments Exemptions specific to small entities There are two exemptions in Section 35 which are specific to small entities as follows: Fair value measurement of financial instruments A small entity that first adopts this FRS for an accounting period that commences before 1 January 2017 need not restate comparative information to comply with the fair value measurement requirements of Section 11 Basic Financial Instruments or Section 12, unless those financial instruments were measured at fair value in accordance with the small entity s previous accounting framework. A small entity that chooses to present comparative information that does not comply with the fair value measurement requirements of Sections 11 sand 12 in its first year of adoption: (a) (b) (c) shall apply its existing accounting policies to the relevant financial instruments in the comparative information and is encouraged to disclose this fact; shall disclose the accounting policies applied (in accordance with paragraph 1AC.3); and shall treat any adjustment between the statement of financial position at the comparative period s reporting date and the statement of financial position at the start of the first period reporting period that complies with Sections 11 and 12 as an adjustment, in the current period, to opening equity. Financing transactions involving related parties A small entity that first adopts this FRS for an accounting period that commences before 1 January 2017 need not restate comparative information to comply with the requirements of paragraph only insofar as they related to financing transactions involving related parties. A small entity that chooses to present comparative information that does not comply with the financing transaction requirements of Section 11 in its first year of adoption: (a) shall apply its existing accounting policies to the relevant financial instruments in the comparative information and is encouraged to disclose this fact; Page 20 Quantum Professional Training