A project that at its simplest is about the layout of financial statements should be uncontroversial. But the International Accounting Standards Board’s Primary Financial Statements project faces a potentially big test.
• IASB has launched a project to improve financial statements
• Brexit means UK must independently license accounting standards by end of year
• High-profile UK corporate collapses are generating concerns about auditing process
It embodies the tension between the UK’s commitment to a single set of global accounting standards and its willingness to assert its post-Brexit sovereignty.
But first some technical background. The IASB launched the project in 2017 with the ambition of improving the way in which information is communicated through an entity’s financial statements. The proposals focus mainly on the income statement. They come in response to complaints from analysts of financial statements that they are not getting the information they need in an accessible format, because:
• The structure and content of the income statement varies across entities, even within the same industry, reducing comparability;
• There is a lack of decision-useful disaggregation in the income statement, and;
• Non-GAAP (generally accepted accounting principles) information, while useful, lacks standardisation, can be hard to find, and changes from one accounting period to another.
The board has three fixes:
• Define sub-totals in the statement of profit or loss;
• Strengthen the requirements for entities to disaggregate information, and;
• Define non-performance measures and require companies to make disclosures about them in the notes.
Sub-totals and disaggregation
So how do these look in detail? At the moment, International Financial Reporting Standards (IFRS) require the profit or loss account to provide a revenue line item and a profit or loss sub-total – but specifies nothing else in between. Some complain that this leads to a lack of consistency across entities.
The IASB, therefore, wants to divide the income statement between four new categories – operating, integral associates and joint ventures, investing and financing – and insert three new sub-totals – operating profit, operating profit and income and expense from integral associates and joint ventures, and, finally, profit before financing and income tax.
There is certainly a lack of consistency. Operating profit is one of the most commonly used sub-totals, and a broad analysis of 100 companies has found that 63 reported operating profit. However, this term is not defined in IFRSs. That analysis also identified at least nine different definitions of the term. Moreover, some investors are unaware that it is not a defined sub-total.
Taken in isolation the board’s proposals for sub-totals can be expected by themselves to bring about some changes – arguably improvements – to disaggregation. However, the exposure draft also continues with further proposals to specify how financial information is broken down in the financial statements and the notes. These are:
• General proposals setting out the purpose of the primary financial statements and the notes;
• Principles for aggregation and disaggregation;
• Specifying new required line items, and;
• Stronger requirements dealing with the analysis of operating expenses.
In addition, the IASB wants to tackle unusual items by introducing a definition of unusual income and expenses. Such items are often one-off events that, while material, are not necessarily recurring and might have limited predictive value. The board wants entities to disclose these items in a single note and has developed application guidance to help entities to do so.
Finally, we have management performance measures. Again, although such information can be useful, some users say it lacks transparency, can be hard to locate, and is inconsistent from one period to another. To make good this deficit, the IASB has defined a subset of measures and proposed disclosure and reconciliation requirements.
All of these changes will eventually result in the replacement of IAS 1 with a new standard that sets out:
• New requirements for presentation and disclosure, and;
• Limited but necessary amendments to IAS 1
The LAPFF challenge
It is this new IFRS which gives the UK’s Local Authority Pension Fund Forum (LAPFF) the opportunity it has been waiting for to challenge the endorsement of an IFRS on its home turf. Because once the UK has formally left all of the EU’s structures, the UK’s own institutions will take over responsibility for endorsing IFRSs. In other words, the powers currently exercised by EU institutions to endorse accounting standards in the bloc will be repatriated back to the UK. Once there, they will be exercised by an endorsement board which will be hosted by the Financial Reporting Council.
Documents obtained by IPE using the Freedom of Information Act, as well as a recent ministerial answer to a parliamentary question, reveal that the UK business department has held talks with representatives of the IFRS Foundation to license those standards in the UK.
But why is IAS 1 so central to the whole question of IFRS accounting? Put simply, it serves as the gateway through which entities pass when they first adopt IFRSs as the basis for their accounting. Among the elements of the accounting model that it regulates are such key components as the minimum format and content of financial statements. It also includes important concepts such as accruals accounting and going concern.
Going concern is essentially the auditors’ endorsement of management’s assessment that their business has the ability to keep on trading. It is the claim that auditors are insufficiently robust with management that has caught the attention of politicians in the UK. This comes in the wake of recent high-profile corporate collapses such as Carillion in 2018 and Thomas Cook in 2019.
Maintenance and going concerns
And so, in a comment letter addressed to the IASB on the proposals, LAPFF complained that the IAS 1 going concern assessment is flawed.
The letter complains the assessment contains insufficient mechanisms to ensure capital maintenance. It argues that the IFRS approach “confuses management intent with the de facto position of the company”. This, the letter continues, creates a situation where auditors could use the IFRS model as a shield to dodge their liability under UK law for fraud and leave shareholders without adequate redress. That is why, they conclude, the whole IFRS model cannot satisfy UK company law’s capital maintenance regime.
Tim Bush, head of governance and financial analysis at Pensions & Investment Research Consultants (PIRC), is, it is probably fair to say, bemused by the situation. “Up until now,” he says, “the auditors have convinced themselves that they have successfully dodged liability for fraud by faithfully adhering to the IFRS model. However, the recent AssetCo ruling against Grant Thornton in the High Court in London and Parliament’s scrutiny of the outcome has showed they can’t. It really is as simple as that.
“Now, AssetCo is interesting because it was a high-level fraud involving management where the company sued the auditors for breach of duty. They claimed damages for unlawful trading, the wasted expenditure that they had invested on the premises that the company was profitable when in fact it was loss-making, as well as unlawful dividends.
“Ironically, this case makes it clear that damages for consequential loss are in fact a far more serious consequence for the auditors than any fraud that they might prefer not to find. In my view, it renders the auditor like the burglar who fails to disable the burglar alarm.”
The IASB has extended the comment period on the exposure draft from 30 June 2020 to 30 September 2020. You would not want to miss out.