Chapter 12: Regulatory Framework Flashcards
12.1 Introduction
Companies are subject to increased regulation in the way they prepare their accounts and present information.
12.2 Companies Act 2006
This is the main piece of information relevant to financial reporting of companies. This requires companies to prepare the following documents annually, both for shareholders and for filling with the registrar of companies (companies house):
• Financial statements comprising a balance sheet and profit and loss account
• Additional information in the notes to the accounts (disclosures)
The financial statements must show the true and fair view of the state of affairs of the company and the profit and loss for the period.
12.3 Accounting standards
Accounting standards add to the statutory requirements by outlining more specific and detailed requirements on how to account for particular types of transaction and offering help and guidance on their interpretation. Companies have different options under which they can prepare their accounts, some are forced upon a company and others are a choice.
IFRS (International Financial Reporting Standards) – are mandatory for listed groups within the EU. This is for both the main stock market (London Stock exchange, LSE) and the alternative investment market (AIM). This is usually for very large companies.
UK GAAP – this is mandatory for all companies. UK GAPP consists of the following main standards:
• FRS 100 – sets out the overall reporting framework
• FRS 102 – main source of accounting rules for most companies
• FRS 105 – sets out specific accounting rules for micro entities.
The majority of UK companies use FRS 102. FRS 102 uses different terminology than in Companies Act 2006, however it states other terminology can be used throughout as long as its not misleading and the text uses the terminology from Companies Act 2006 throughout.
Purpose of accounting standards – basic purpose is to outline the accounting practice which the company is expected to follow for a transaction or event. Financial statements which comply with accounting standards generate a common understanding between users and preparers of financial statements on how particular items have been treated.
Scope of accounting standards – they should be applied to financial statements that intend to give a true and fair view of a reporting entity’s state of affairs at the balance sheet date and of its profit and loss for the financial period. They must be followed by companies and LLP’s; they should be followed by sole traders and partnerships. Businesses are required to calculate the profit for tax purposes on a basis which complies with GAAP. Where they are relevant for the determination of profit, appropriate accounting standards must also be applied by unincorporated businesses.
12.5 FRS: Objective of financial statements
FRS 102 contains sections dealing with the accounting treatment of various transactions and events and it covers the objectives and basis of preparation of the financial statements.
The objective of financial statements is to provide information about the financial position and performance of an entity that is useful for economic decision making for a range of users. They also show the results of the management and how well the directors have run the company on behalf of the shareholders.
12.6 FRS 102 Qualitative characteristics of information in the financial statements (1)
In order to meet objectives, the information in the accounts has to have qualitative characteristics.
Understandability – the information should be presented in a way that someone with reasonable knowledge of accounts will be able to understand the financial position of the business and its performance.
Relevance – in order for users to make economic decisions, they must be provided with information that is relevant to the decisions. It should help them evaluate past, present or future events of the business.
Materiality – information is material and therefore relevant, if it omission or misstatement could influence the economic decisions of users. This concept can be applied to one item individually or several items collectively. Whether an item is material is not only based by value, but if it turns a profit into a loss it may influence a user’s view of the business, and hence be material to their economic decisions. Areas such as directors’ remuneration are often considered material by nature rather than by amount.
Reliability – the information must be reliable, which means it’s free from material error and bias. The information included and the way in which it is presented should be neutral.
Substance over form – transactions and events should be accounted for and presented in accordance with their substance and not merely their legal form. For example the legal form under hire purchase states you don’t own the car, the economic substance shows you own the car, the accounts should show the car as if it was your asset from the start of the contract, with an associated amount owed to the hire purchase company.
12.6 FRS 102 Qualitative characteristics of information in the financial statements (2)
Prudence – accounts will include an element of uncertainty, where there is uncertainty surrounding a transaction or event, prudence is exercised. This means a degree of caution, so assets and income are not overstated, and liabilities are not understated. Prudence should be applied in an unbiased manner.
Completeness – to be reliable, the information should be complete. An omission can lead to information being misleading and therefore unreliable and less relevant.
Comparability – a user should be able to compare the accounts of one entity over time to assess trends and compare different entities to show performance. This means accounts should be prepared in a consistent manner and users informed of the accounting policies used to enable comparison between different businesses. Users should be informed about any changes to accounting policies.
Timeliness – information should be provided to users whilst it can be used to aid in their decision making. There should be no undue delay in reporting the information as this may affect its relevance.
Balance between benefit and cost – the benefit derived from information should exceed the cost of providing it. The evaluation of this is a judgemental area, plus the costs are not necessarily borne by the person benefiting from the information.
12.7 FRS 102 Financial position
The financial position is shown by its assets, liabilities and equity at a specific date and its presented in the balance sheet (statement of financial position).
Asset – is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. For example, a company makes a credit sale (past event) and as a result they expect to receive cash from the debtor (future economic benefit. The debtor is an asset to the company.
Liability – is a present obligation arising from past events, which is expected to result in an outflow of economic benefits from the entity. For example, a credit purchase will result in the entity paying cash out.
Equity – is the residual interest in the assets after deducting the liabilities, the net assets of the company.
12.8 FRS 102 Performance
Performance is the relationship between the income and expenditure for a reporting period. This is shown in the profit and loss account (income statement).
Income – is transactions and events that increase equity, other than capital contributions from the owners. The definition includes revenue and gains. Revenue is income arising in the ordinary course of business, this includes sales, interest receivable etc. Gains are other items that meet the definition of income but are not revenue, for example profit on sale of investments. Revenue and gains have to be disclosed in separate parts of the profit and loss account.
Expenses – costs to and losses of the business, other than distributions to owners (drawings/dividends).
12.9 FRS 102 Recognition of assets, liabilities, income and expenses
Recognising an item means to include it in the balance sheet or profit and loss account. In order to recognise an asset, liability, income or expense:
• It must meet the definition of an asset, liability, income or expense
• It must be probable that future economic benefit will flow to or from the entity, and
• The item must have a cost or value that can be reliably measured. This includes the use of reliable estimates
For an asset to be recognised, the flow of economic benefits must be virtually certain.
12.10 FRS 102 Accruals basis
An entity should prepare its financial statements using the accruals basis of accounting. On this basis items are recognised when they satisfy the criteria above, not in the period in which any cash involved is received or paid.
Businesses are eligible to use the cash basis if they are unincorporated (sole trader/partnership), with income no more than a given threshold, currently £150,000. The cash basis means income is accounted for when it is actually received, and allowable expenses deducted when the cash is paid. LLP’s and partnerships where at least one of the partners is a company are ineligible to use the cash basis.
12.11 FRS 102 Offsetting
An entity is not allowed to offset assets and liabilities or income and expenses unless it is required or permitted by accounting standards. This is because such offsetting results in both figures being understated and will affect the completeness and relevance of the information.
12.12 FRS 102 Going Concern
When preparing accounts, management should make an assessment as to whether the entity is a going concern. An entity is a going concern unless management intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. Management should consider all available information about the future, which is at least 12 months from the date the accounts are authorised.
12.13 FRS 102 Provisions and contingencies
Provision – is a liability of uncertain timing or amount. Provision also used in the context of items such as depreciation and doubtful debts, but these are reductions in the carrying amount of assets rather than liabilities (which results in an entity paying cash out). A provision should be recognised (liability on balance sheet and expense in P+L) when:
• An entity has an obligation at the reporting date as a result of past event;
• Is it probable that a transfer of economic benefits will be required to settle the obligation; and
• A reliable estimate can be made of the amount of the obligation
Contingent liabilities – this is a liability that hasn’t met the recognition criteria above, either because it is possible rather than probable or because it cannot be reliably measured. These should not be recognised in the accounts; however, a disclosure note should be included explaining the position to users of the accounts. An example is where a company has provided a guarantee to a third party (landlord) that it will pay the rent owed by the tenant if the tenant is unable to do so. The amount can be reliably measured but it is only possible not probable that the third party will not pay its rent. The note shows that this outflow could occur. If the likelihood of paying cash out is remote, it is not recognised an no disclosure note is required.
Contingent assets – if the inflow of economic benefits is virtually certain, this is an asset and is recognised on the balance sheet with the associated income on the profit and loss account. If the inflow is provable but not certain, this is a contingent asset. These are not recognised on the balance sheet but are disclosed to users in a note to the accounts. If the inflow is only possible or remote, it is not recognised, and no disclosure note is included. There is inconsistency between the recognition of a liability and of an asset, this is due to the accounting concept of prudence.
12.14 FRS 102 Disclosure
FRS 102 provides additional details on the relevant disclosure required for the accounting areas it covers. The overriding aim of the disclosures is that they ensure that the accounts are true and fair. There are differing disclosure requirements depending on the size of the company. IFRS companies have the most onerous and detailed requirements as they tend to be listed. FRS 102 for non-small entities have less requirements than IFRS but is still onerous. FRS 102 has section 1A for small entities, it is similar to the normal FRS rules but section 1A simplifies the burden of reporting by reducing some of the disclosures. Also, under section 1A entities have the option to produce abridged accounts, they are summarised accounts with less detail than a full balance sheet and profit and loss account.
12.15 FRS 105
FRS 105 may be adopted by micro entities offering major (but optional) accounting simplifications. The size thresholds for a micro entity are:
• Turnover less than £632,000
• Total assets less than £316,000
• Average number of employees less than 10
For an entity to qualify as micro it needs to meet 2 out of the 3 criteria above. Micro entity accounting means many of the normal accounting policy choices are removed.
