Accounts prepared under the historical cost convention had two pillars of integrity, the matching concept and the prudence concept. The matching con- cept applied the principle that in a given period, sales and the costs associated with those sales must match, giving rise to accruals and prepayments. The prudence concept was unequivocal; profits could not be taken before they were earned and companies had to create a provision to account for any potential liability. These two concepts ensured that provided accounts were honestly prepared, the ‘profit and loss’ account would show a profit or loss that was prudent. What ‘prudent’ in this context meant was that taking into account that the profit or loss was struck after making a series of judgements, it was very unlikely that the profit was overstated or loss understated.
The historical cost convention, therefore, produced a Profit and Loss account that could usually be relied upon and using this document to calculate earnings per share allowed investors to assess the trend over time. However, the down- side of the historical cost convention was that if the accounting standards were applied literally, key liabilities (usually long-term liabilities), namely pension liabilities and liabilities relating to financial derivatives, could be missed off the Balance Sheet.
As discussed in the following chapter, companies can be valued by assessing future potential income streams and the asset value of the company. Investors found that they could make valid investment judgements from the Profit and Loss Account only to be caught out by not knowing the true liabilities of the company. The Cash Flow Statement helped in that if assets were over- stated, the company would not be generating the cash their operating profit suggested should be. But there was no way of assessing what the missing lia- bilities might be as they would only come to light at the time they had to be settled.
The ASB concluded that the way to resolve this problem of missing liabilities was to move from historical costing (assets and costs are recorded at their transactional values) to ‘fair value’ accounting.
All companies who are members of either Le Capital Investissement, the British Venture Capital Association or the European Private Equity & Venture Capital Association have agreed to value their investments using fair value principles. These organisations have produced a booklet ‘International Private
Equity And Venture Capital Valuation Guidelines’, which defines the concept of ‘fair value’:
Fair Value is the amount for which an asset could be exchanged between knowl- edgeable, willing parties in an arm’s length transaction.
The estimation of Fair Value does not assume that the Underlying Business is saleable at the reporting date or that its current shareholders have an intention to sell their holdings in the near future.
The objective is to estimate the exchange price at which hypothetical Market Participants would agree to transact.
Fair Value is not the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distressed sale.
Although transfers of shares in private businesses are often subject to restrictions, rights of pre-emption and other barriers, it should still be possible to estimate what amount a willing buyer would pay to take ownership of the investment.
These organisations own assets in the form of investments that they plan to dispose of in the medium to longer term. Accordingly, as a matter of course, they will seek to establish ‘fair value’ on an ongoing basis to enable them to make the key decision of staying with a particular investment or disposing it of. Do nothing in the long term is not an option. In other words, if there was no market for a particular investment, because for example there would never be a willing buyer, then that investment would have to have a ‘nil’ valuation.
So investment companies should be able to establish ‘fair value’ because they hold assets that they intend to sell and would not have bought them in the first place if they knew there was no market for their assets.
However, the concept of ‘fair value’ under IFRS goes further and insists that a ‘fair value’ calculation be made even where there is no market for the asset.
Some academics argue that this is perfectly valid and that estimating fair values will become a culture. Dimitris N. Chorafas writes:
Fair value: This will, in all likelihood, be the most significant impact of IFRS.
Fair value of assets and liabilities that have not been traded will become a cul-
However, the contrary view is that calculating fair values where there is no discernable market could lead to assets being overstated and that in such cir- cumstances it would be more prudent to use historical cost values. In addition, it could be argued that in applying fair value this way the safeguards inher- ent in historical cost accounting have been abandoned, in that the matching concept and the prudence concept no longer apply. For example, bookmakers often take bets ante-post for events that take place after the company’s year end.
Under UK GAAP, these were treated as payments in advance (creditors in the Balance Sheet) and had no impact on the Profit and Loss Account. Under IFRS, such payments in advance are treated as financial instruments and accordingly must be valued a ‘fair value’. But it is absolutely impossible to estimate this, as the results of the events betted on cannot be reliably predicted. All the book- makers can do is make an assessment taking into account the ante-post bets already lost through already declared non-runners and the overall betting mar- gin usually achieved. This means that the bookmaking company will be forced to take a profit before it is earned, something that can hardly be described as being prudent.
A further difficulty is that there is no longer a distinction between a real liability and the one that could be described as imaginary. A ‘real liability’ is one where the liability will eventually have to be settled and an ‘imaginary liability’ is one that is never settled in the books of the company for which accounts are to be prepared.
At the beginning of 2007 a brief questionnaire was sent to the Finance Director of 100 FTSE 350 companies. Two of the questions were:
• From an investor point of view, do you believe that IFRS provides better information than UK GAAP?
• In the last complete financial year, how much extra have you spent complying with IFRS than you would have spent producing accounts under UK GAAP (if any)?
There were eighteen respondents (18% of sample) and while such a low res- ponse rate might not be statistically sufficient to form a judgement, only three (17%) voted in favour of IFRS. They gave the cost of implementing IFRS in the range of zero (we have used internal resources and have not quantified the cost) to £2 million. The average was £384 000.
Some respondents volunteered opinions and the three given below were representative of the overall view:
In favour: ‘I think it very important that we have International Standards so that companies in different companies can be compared.’
Against: ‘I do not believe that IFRS provides any better information but at least there is a greater consistency between all European companies. The Investors have struggled to understand the impact of IFRS upon companies and spend even more time reviewing cash flows.’
Against: ‘Not quite the contrary, IFRS has resulted in considerable pollution of reporting. A point which it seems the IASB is now starting to recognise since it has observed that the merging of cash and value based items is not helpful.
We have maintained our split of “Trading” and “Other Items” in our Income Statement – an approach which is non-compliant with IFRS but which it is possible the standards will change to!!’
The point made by the respondent about merging of cash and value-based items is the same as the point about a real liability (cash) and an imaginary liability (value-based). An example of an ‘imaginary liability’ is ‘share-based payments’, where the ‘fair value’ of share options must be charged to the Income Statement, with the credit going to ‘equity’ in the Balance Sheet. But if no entry was made for share-based payments, then although the ‘retained earnings’ would be higher, the figure for ‘equity’ would be the same. The effect of this ‘share-based payments’ entry, therefore, is that it is a one-sided entry (debit) only. Even worse, as companies continue to show ‘diluted earnings per share’, it means that this calculation has been subject to a double hit for the same thing, firstly the cost of the option and secondly the dilution.
Apart from imaginary liabilities, the worst aspect of IFRS is the abandonment of the prudence concept, as under this current standard, profits are taken into the Income Statement before they are earned. Such imaginary profits are then taxed. The accounts for the ‘Big Yellow Group plc’ demonstrate this absurdity;
having to comply with IFRS, their Consolidated Income Statement for 31 March 2006 showed profits of £118.547 million and taxation of £35.112 million, giving earnings per share of 82.10 pence. However, ‘to give a clearer understanding
So we are left in the position that IFRS has improved matters by forcing compa- nies to provide a Balance Sheet that includes all known liabilities, but has made matters worse by changing a Profit and Loss Account from a document where earnings per share could be extracted to establish a trend over the years to an Income Statement that is subject to so much volatility that it becomes potentially meaningless. However, the good news is that the ‘Cash Flow Statement’ can be adjusted to assess what the earnings per share should really be and this combined with a better Balance Sheet means that investors have, overall, improved tools to work with. How ‘earnings per share’ can be validated is illustrated in Chapter 4.
In Chapter 2, Figures 2.3 and 2.4 showed the Profit and Loss Account, Balance Sheet and Cash Flow Statement for ‘A Food Manufacturing Company’ using a UK GAAP format. Figures 3.1–3.3 show the same accounts for 2006 as they would appear under IFRS. Note that as the format is different, the numbers are also different. The format differences are explained below:
A Food Manufacturing Company Income Profit & Loss
Statement Account
IFRS UK GAAP
31 Dec 06 31 Dec 06
£’000 £’000
Revenue 128,500 128,500 Turnover
Cost of sales Note 1 96,200 96,700 Cost of sales
Gross profit 32,300 31,800 Gross profit
Distribution and Administration Note 2 25,768 24,968 Distribution and Administration
Profit from Operations 6,532 6,832 Operating profit/(loss) before amortisation
Other operating costs Note 3 0 1,750 Amortisation/impairment/exceptional
Operating profit/(loss) 6,532 5,082
Finance costs (net) 2,503 2,503 Interest payable/(receivable)
Profit before taxation 4,029 2,579 Profit before taxation
Taxation 875 875 Taxation
Profit for period 3,154 1,704 Earnings
Note 4 200 Dividends
1,504 Retained profit for year Statement of
Recognised Income &
Expense
Profit for period 3,154 Net assets reported under UK GAAP
Actuarial loss on defined benefit pension scheme Note 5 (1,230) Dividends
Deferred tax on actuarial loss Note 5 369 Note 6 Unwinding of deferred tax discounting Note 7
Note 3 Goodwill amortisation Total recognised income for the period 2,293 Note 5 Retirement benefits
Add back: share based payments Note 8 800
Profit & loss account at beginning of period 6,470
Profit & loss account at end of period 9,563 Revised net assets as restated under IFRS
Difference 31 Dec 06
£’000
(500)
(800) (300) (1,750) 1,450
1,450
1,450 (200) 1,650 Net asset reconciliation
33,680
(255) 1,787 (5,229)
30,156
Figure 3.1 A Food Manufacturing Co. – Profit and Loss Account (IFRS vs. UK GAAP)
0
500
0
0
2005
173
A Food Manufacturing Company
Balance Balance
Sheet Sheet
IFRS UK GAAP
31 Dec 06 31 Dec 06
£’000 £’000
Assets Non-current assets
Goodwill Note 3 35,743 32,206
Other intangible assets Note 1/9 1,700 0
Property, plant and equipment Note 9 59,260 60,460
Deferred tax asset Note 3 2,610 0
Investments Note 10 1,100 1,200
100,413 93,866
Current assets
Inventories 9,720 9,720
Trade and other receivables 21,417 21,417
Cash and cash equivalents 4,456 4,456
35,593 35,593
Total assets 136,006 129,459
Liabilities Current liabilities
Trade and other payables Note 4 28,867 29,240
Current tax liabilities 3,635 3,635
Borrowings 4,200 4,200
36,702 37,075
Non-current liabilities
Long term borrowings 50,000 50,000
Financial instruments Note 11 103
Retirement benefit obligations Note 5 8,700
Deferred tax liabilities Note 6 255
Other provisions for liabilities & charges 7,200 7,200
66,258 57,200
Total liabilities 102,960 94,275
Net assets 33,046 35,184
Equity
Called up share capital 3,632 3,632
Share premium account 18,024 18,024
Revaluation reserve
Other reserves 1,827 2,030
Retained earnings (as fig. 3.1) 9,563 11,498
Total shareholders’ equity 33,046 35,184
(UK GAAP Balance Sheet is in IFRS Format) Difference 31 Dec 06
£’000
Goodwill 3,537
Other intangible assets 1,700
Tangible assets (1,200)
2,610
Investments (100)
6,547
Stock 0
Debtors 0
Cash 0
0
Total assets 6,547
Trade creditors Other creditors Bank overdraft and loans
(373) 0 0 (373)
Long term debt 0
103 8,700 255
Other long term liabilities 0
9,058
Total liabilities 8,685
Net assets (2,138)
Share capital 0
Share premium account 0
0
Capital reserves (203)
Retained earnings (1,935)
Total shareholders’ equity (2,138)
Figure 3.2 A Food Manufacturing Co. – Balance Sheet (IFRS vs. UK GAAP)
The Income Statement
The Income Statement replaces the Profit and Loss Account; the only real for- mat difference between the two being that the former does not show dividends, so that the bottom line is ‘profit after tax’. In the Profit and Loss Account, ‘profit after tax’ was the same as ‘earnings’ and represented the profit that belonged to shareholders, which, in theory at least, could be distributed to sharehold- ers. This is no longer the case because as non-monetary adjustments are now
IFRS Style Cash Flow Statement for
A Food Manufacturing company
31 Dec 06
£’000 Reconciliation of profit to net
cash inflow from operating activities Profit after taxation
Taxation Interest
Operating profit
Depreciation of tangible assets Share based payments (Increase)/decrease in stocks (Increase)/decrease in debtors Increase/(decrease) in creditors Cash generated from operations Interest paid
Tax paid
Net cash inflow from operating activities
Investment in development costs
Net cash outflow from investing activities Repayment of bank loans
Dividends paid to shareholders
Net cash outflow from financing activities
Net increase in cash and cash equivalents
Reconciliation of cash flow with
movements in cash and cash equivalents
3,154 875 2,503 6,532 5,740 800 380 8,697 1,199 23,348 (2,503)
(467) 20,378
(500) (500) (15,000) (173) (15,173)
4,705
Opening cash and cash equivalents (4,449)
Closing cash and cash equivalents 256
Movement in cash and cash equivalents 4,705 Figure 3.3 A Food Manufacturing Co. – Cash Flow Statement (IFRS vs. UK GAAP)
The Balance Sheet
The Balance Sheet under UK GAAP style and IFRS style changes both in format and terminology. In essence, IFRS uses American terminology. The differences are:
UK GAAP IFRS
Current assets manufactured for sale or Stock Inventory bought for resale
People who owe the business money Debtors Receivables People the business owe money to Creditors Payables
The UK GAAP Balance Sheet was designed to show the ‘total capital employed’, and after deducting long-term debt this agreed with ‘shareholders’ funds’, so the format was:
Fixed assets at cost less cumulative depreciation=Net fixed assets Current assets less current liabilities =Working capital
Net fixed assets plus working capital =Total capital employed.
Total capital employed less long-term debt= Net assets.
Share capital plus share premium plus capital reserves plus cumulative Profit and Loss Account =Shareholders’ funds.
Net Assets=Shareholders’ funds.
The IFRS Balance Sheet is much more informative, with the following informa- tion available on the face of the Balance Sheet, rather than in the notes under UK GAAP
• Goodwill is separated from ‘other intangible assets’.
• The deferred tax asset is not netted off with the deferred tax liability.
• Investments are shown separately.
• Current tax liabilities and borrowings are shown separately and not sim- ply lumped together with ‘trade and other payables’.
• Provisions have to be evaluated so that they are shown correctly as current or non-current (formerly known as ‘fixed’ under UK GAAP) liabilities.
• Retirement benefit obligations are included in non-current liabilities.
Total assets less total liabilities=Net assets Net assets= Total shareholders’ equity.
Figure 3.2 illustrates the differences between the Balance Sheet under UK GAAP and the Balance Sheet under IFRS.
The Cash Flow Statement
The Cash Flow Statement is much clearer under IFRS than it was under UK GAAP and is easier to follow. The main difference between the two statements is that under UK GAAP, ‘operating profit’ (profit before interest and tax) is reconciled to ‘net cash inflow from operating activities’, whereas under IFRS,
‘profit after tax’ is reconciled with ‘net cash inflow from operating activities.’
Under IFRS, the starting figure is ‘profit after taxation’, to which interest and tax (as shown in the Income Statement) are added to get to ‘operating profit’.
From this figure, non-cash charges such as depreciation and share-based pay- ments are added and then movement in working capital is either added or deducted, as the case may be, to arrive at ‘cash generated from operations’.
This figure represents what ‘cash inflow from operating activities’ was under UK GAAP. Finally, the actual interest and the tax paid are deduced from ‘cash generated from operations’ to arrive at ‘cash inflow from operating activities’
under IFRS style.
This is simpler than it was under UK GAAP, because we now have just three sections:
Net cash inflow/(outflow) from operating activities Net cash inflow/(outflow) from investing activities Net cash inflow/(outflow) from financing activities
The sum of these three sections is the same as the increase/(decrease) in cash and cash equivalents.
With regard to the Cash Flow Statement, the only other difference between UK GAAP and IFRS is that the former reconciles to ‘cash’, whereas the latter reconciles to ‘cash and cash equivalent’. A ‘cash equivalent’ is a financial instrument where the value is known and secure and can be converted to cash within 3 months of the Balance Sheet date.
Figure 3.3 illustrates the differences in Cash Flow Statement under UK GAAP and IFRS. In our ‘Food Manufacturing Company’ illustration, there are no ‘cash
equivalents’ and accordingly unlike the Income Statement and the Balance Sheet, the numbers between the two systems match. This is because all the changes made by IFRS are book entries that have no impact on cash.
These differences in the Income Statement and the Balance Sheet are explained below and match with the ‘note numbers’ shown in the accounts.