Financial Statements of UK Strengths and Weaknesses Essay

Introduction

UK GAAP has undergone significant changes recently. Also with the advent of IFRS, accountants are experiencing a great deal of limitations and advantages while formulating financial statements. With the results the financial statements prepared under guidance as well as surveillances of UK GAAP read with International Accounting Standards (now called International Financial Reporting Standards) are inhibited with certain strengths as well weaknesses. Strengths constitute freedom of reporting matters recognizing the realities surrounding an entity; and weaknesses are repercussions and effects of newly constituted guidelines and compulsions both under UK GAAP and IFRS. An effort has been made in this write up to evaluate strengths and weaknesses of financial statements prepared following UK GAAP and IFRS.

Strengths

Fair value reporting

Fair value reporting is the most important and featured strength of UK financial statements. Companies are evaluating assets on fair market values. The basis adopted for the calculations of fair values are depicted in the financial statements. To provide an example of such reporting a reference is drawn to Annual report & Accounts of Johnson Matthey for the year 2008. Note 28d on the accounts declare clearly the technique adopted to determine the fair value of financial instruments. It states that “The fair values are calculated by discounted future cash flows to net present values using appropriate market interest rates prevailing at the year end. It is not possible to determine reliably the fair value of the group’s unquoted available- for – sale investments.” (Johnson Matthey Annual Reports & Accounts 2008, page 90)³

This strength of fair value accounting enlightens the users of financial statements about real current worth of assets of the companies, and the companies are following this standard of reporting with a sense of responsibility towards stakeholders.

But there is other side of the picture as well This is a fact that no legal definition is available to terms ‘True & Fair’, but financial statements in UK are required to be framed under fair value accounting. Criticizing such fair value accounting, recently a lot has been stated about fair value accounting. This is natural that market volatility has direct effect on assets being reported as per fair value accounting. Therefore fair value reporting sometime wipes out reported profits or increases the losses.

Recently ‘The Financial Times’ carried an article ‘Reporting move could break down the write down spiral’ that was published on April2, 2008 and was written by three members of European Union advisory group ‘EFRAG’, namely Crasten Zilke, Michal Starkie, and Thomas Seeberg². This article has made fair value accounting, which according to them is forced upon companies to report assets on current market prices, responsible for writing down billions of the value of financial instruments and creating a credit crunch in the market as a direct result.

But as said earlier this is one way of looking the things. Such accounting is bound to increase profits in booming markets. At that time such effort of fair value accounting will be applauded. The matter is not of losses or profits resulting from reporting. The importance of the matter is that actual values of assets of the company are reported for the benefit of the users of financial statements.

Group financial statements

Barring certain exclusions from consolidation, the Companies Act and FRS 2 require entities to present group financial statements as if those are being presented for a single economic entity. Group financial statements in fact take the form of consolidation of statements from all subsidiaries, unless the group as a whole is an exempt entity. The basic strengths or advantages of group statements presented in UK financial statements are as under:

• In present scenario ‘group’ is treated as a separate economic entity and subsidiaries are treated as units having concentration of economic resources belonging to parent. Accordingly such separate economic entity must gather information from concentrated economic centers in order to draw out or analyze its own results in totality as a separate entity. That is why UK financial statements consolidate accounts for the group in order to amplify information in the financial statements of the parent.
• Consolidation helps in assessing the ability of parent and its subsidiaries to meet their debt liabilities. A subsidiary would be treated as having highly geared capital resources when its assets are mostly financed through debts. Such subsidiary would find it difficult to raise further debt finance based on its own financial statements. Financial institutions may not extend facilities when only a subsidiary’s financial statements are presented. But group financial statement may fetch further loans to such subsidiary even under most difficult circumstances.
• UK financial statements carry group (consolidated) statements in addition to parent company’s own separate financial statement. This way the consolidated and separate results and performances of the group are conveyed to the users of financial statement.

Weaknesses

Continued and discontinued operations

UK GAAP does not require operating results of discontinued operations to be shown separately. In fact those are classified as part of total operating results. “FRS 3 requires full information to be given about discontinued operations (for example, turnover, cost of sales, and net operating expenses) in the profit and loss account. IFRS requires only the profits from discontinued operations to be shown on the face of income statement (after profits from continued operations), with an appropriate analysis given in notes.” (HM Treasury, 29 June 2006)¹ The weakness is that users of financial statements have to refer to notes to dig out the losses suffered under discontinued operations, that could be adjusted some where with operating results, as IFRS 3 requires only profits to be separated and to be shown after regular business operations results. Accordingly the management inefficiency could never come to fore unless the user of financial statement is an expert analyst of financial statements.

Weaknesses of Group Statements

• Common suppliers or customers interchanging roles with subsidiaries would render consolidation, as required under FRS 2, as a meaningless exercise. This is because most common accounts would be squared up in consolidating exercise, providing an altogether different scenario of group financial statements. “A material level of transactions between the businesses with common customers/ suppliers would make it more difficult to present carve out/ combined financial statements for one of the businesses.” (David Smailes, March 2008)⁴
• It is assumed that parent company is a separate economic entity that has invested resources in different subsidiaries. Actual business transactions reflected in subsidiaries’ financial statements are not the business transaction of the parent company. Consolidations of subsidiaries’ financial statement would thus create ‘hypothetical’ financial statements of that separate economic entity which is not responsible for all those transactions on the basis of which consolidated statements are framed. In this way consolidation is a sham exercise that presents everything for an entity that has only parted with resources or made investments in subsidiaries and has not executed the actual business.
• On circulation of such hypothetical statements among financial institutions and stock exchanges, an altogether different impression about the parent entity would be created. It may be summarized by stating that UK financial statements are instrumental in creating artificial stock market rates that are based on farce information contained in such sham consolidated statements.
• Like in any other country, UK companies are also controlled and operated upon as per the provisions of the Companies Act. It may be noted that “in UK companies and not groups are legal entities. Groups cannot enter into contracts or enforce them. The starting point for taxation is individual companies though some group reliefs are available, and legally distributable profits are a company not group matter”. (Paul Taylor) ⁵. Keeping in view these facts it can be said that in UK consolidation of financial statements is a superficial exercise without any legal sanctity provided for such consolidation act.

Applicability of IFRS

International Accounting standards are applicable to those companies that are registered with stock exchanges. Other companies follow Financial Reporting Standards of UK GAAP. The effect of this is that financial statements prepared using UK GAAP are not comparable with financials statements prepared as per IFRS so far following matters are concerned:

• IAS 1 contain format for company financial statements that are somewhat different from the format required under the UK Companies Act and FRS 3.
• IAS 7 contains the format for the Cash Flow Statement that is quite different to that required by FRS 1.
• In case of segment reporting the requirements of IAS 14 are far more extensive and detailed than those required by SSAP 25. For example, a local authority has to disclose the costs and income for each of its service lines, but these requirement sterns from legislation rather than SSAP 25.” (Financial and Performance Reporting)⁶.

Inflexibility and Rigidity

It has been proved that UK financial statements lack the basic requirements of ‘flexibility’. These are in fact infested with disqualification of ‘rigidity’. It has been observed that most companies are finding it difficult to switch over to IFRS. Majority of companies availed exemptions wherever those were available.

According to a research conducted by ICAEW, “Many UK listed companies are still ‘disturbingly unaware’ of the impact of that Internal Financial Reporting Standards (IFRS) will have on their Key Performance Indicators (KPI)” (Eric Anstee, 28 June, 2008)⁷ According to Eric Anstee, the study revealed that 58% of listed companies were not sure of the impact of IFRS on KPI, 27% of the listed companies expected that impact would be negative, and 14% of companies think that impact would be positive.

This reflects aptly the character of financial statements so far being prepared by the companies. Those statements are not at all flexible but rigid even to accept even the statutory changes. In fact changes are required to be forced upon them in order to get implemented.

Conclusion

UK financial statements have responded very well to fair value reporting, despite a lot of hue and cry in the press from vested interests. Though one of the strengths is group consolidated statement, but legally a group is not an entity to represent the activities of its subsidiaries as its own. It ha also been observed that there is a lacuna in reporting of losses from discontinued operations. Entities those are still continuing with FRS have to remain traditional in cash flow and some other reporting. Over all, financial statements of UK are inflexible and rigid as entities still are afraid of switching over to IFRS for no specific reason to express.

References

HM Treasury, Financial Reporting Advisory Board Paper, 2006, page 3, Web.

Crasten Zilke, Michal Starkie, and Thomas Seeberg, ‘Reporting move could break the write down spiral’, The Financial Time, 2008, Web.

Johnson Matthey, Annual Report & Accounts 2008, page 90, Web.

David Smailes, IFRS news, 2008, Web.

Paul Taylor, Consolidated Financial Reporting, page 17, Web.

Financial and Performance Reporting- UK and International Accounting Standards, 2008, Web.

Eric Anstee, Chief Executive ICEAW, 2008, Web.