UK GAAP

In the UK, the expression ‘GAAP’ is used more loosely than in most other countries; the reason for this is that GAAP does not have any statutory or regulatory authority or definition, as is the case in, for example, the US, Canada and New Zealand. Consequently, references to GAAP are rarely found in the literature in the UK, and where the expression is used, it is not adequately explained or defined.

In general terms, a conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for a particular field of enquiry. In terms of financial reporting, these theoretical principles provide the basis for both the development of new reporting practices and the evaluation of existing ones. Since the financial reporting process is concerned with the provision of information that is useful in making business and economic decisions, a conceptual framework will form the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. Therefore, although it is theoretical in nature, a conceptual framework for financial reporting has a highly practical end in view.

Revenue is generally discussed in accounting literature in terms of inflows of assets to an enterprise which occur as a result of outflows of goods and services from the enterprise. For this reason, the concept of revenue has normally been associated with specific accounting procedures which were primarily directed towards determining the timing and measurement of revenue in the context of the historical cost double-entry system. For example, APB Statement No. 4 defined revenue as the ‘gross increases in assets or gross decreases in liabilities recognized and measured in conformity with generally accepted accounting principles that result from those types of profit-directed activities of an enterprise that can change owners’ equity’.1 Consequently, the accounting principles which evolved focused on determining when transactions should be recognised in the financial statements, what amounts were involved in each transaction, how these amounts should be classified and how they should be allocated between accounting periods.

A series of spectacular corporate failures and financial scandals in the late 1980s, including BCCI, Polly Peck and Maxwell, heightened concerns about the standard of financial reporting and accountability. These concerns centred around an apparent low level of confidence both in financial reporting and in the ability of auditors to provide the safeguards which the users of company annual reports sought and expected. The factors underlying these were seen as the looseness of accounting standards, the absence of a clear framework for ensuring that directors kept under review the controls in their businesses, and competitive pressures both on companies and on auditors which made it difficult for auditors to stand up to demanding boards.1 These concerns were heightened by criticisms of the seeming lack of effective board accountability for such matters as directors’ remuneration — particularly in the light of an increasing trend in directors being appointed on lucrative rolling contracts, as well as certain well-publicised large compensation payments for loss of office.

Group accounts are designed to extend the reporting entity to embrace other entities which are subject to its control or influence. They involve treating the net assets and activities of subsidiaries held by the holding company as if they were part of the holding company’s own net assets and activities; the overall aim is to present the results and state of affairs of the group as if they were those of a single entity.

Chapter 5 deals with the preparation of consolidated accounts by a parent undertaking, but is restricted to issues such as when such accounts should be prepared, what entities should be considered to be part of the group for the purposes of inclusion therein, and how such entities should be dealt with in the consolidated accounts. This chapter deals with those situations where the group structure changes, through entities either joining or leaving the group.

Traditionally, investments in companies which did not satisfy the criteria for classification as subsidiaries were carried at cost, and the revenue from them was recognised only on the basis of dividends received. However, during the 1960s it was recognised that there was a case for an intermediate form of accounting, since there was a growing tendency for groups to conduct part of their activities by taking substantial minority stakes in other companies and exercising a degree of influence over their business which fell short of complete control. Mere recognition of dividends was seen to be an inadequate measure of the results of this activity (and one which could be manipulated by the investor, where he could influence the investee’s distribution policy). Moreover, since it was unlikely that the investee would fully distribute its earnings, the cost of the investment would give an increasingly unrealistic indication of its underlying value.

A company can engage in foreign currency operations in two ways. It may enter directly into transactions which are denominated in foreign currencies, the results of which need to be translated into the currency in which the company reports. Alternatively, it may conduct foreign operations through a foreign enterprise, normally a subsidiary or associated company, which keeps its accounting records in a foreign currency and, in order to prepare consolidated financial statements, will need to translate the financial statements of the foreign enterprise into its own reporting currency.1 Accounting for these translation processes has been one of the most significant problem areas in financial reporting in recent years.

The development of sophisticated financial markets, which permit companies to trade in previously uninvented contracts and thereby transform their risk profile, is perhaps the new factor in business life that poses the most searching challenge to traditional financial reporting practices. The IASC, in its newsletter of December 1996, commented on the issue in these terms:

‘At the roots of the need for change in accounting for financial instruments are fundamental changes in international financial markets. … An enterprise can substantially change its financial risk profile instantaneously, requiring careful and continuous monitoring. … Alternatively, an enterprise may use derivatives as speculative tools to multiply the effects of changes in interest, foreign exchange or security or commodity prices, thus multiplying the gains if prices move advantageously or, alternatively, multiplying the losses if they move adversely. … Accounting for financial instruments has not kept pace with information needs of financial market participants.

The broad principles for accounting for fixed assets are generally well understood in the UK. The cost of fixed assets should be capitalised when they are acquired, subsequently depreciated through the profit and loss account over their working lives, and written down if at any time the carrying value is seen not to be fully recoverable. When a fixed asset is sold or scrapped, the difference between the written down value and any proceeds is recorded as the gain or loss on disposal. But there are many complications in applying these simple principles in practice. When should a fixed asset initially be recognised? How should its cost be measured? How should it be depreciated? When should it be regarded as not fully recoverable? Worse, a new and confusing dimension is added to these and other problems if management decides to revalue the asset rather than continuing to carry it on the basis of its historical cost.

Investments come in so many different forms, and may be held for such different purposes, that it can be difficult to formulate a precise definition of them. Although not directly relevant to financial reporting, the Financial Services Act 1986 includes the following in its definition of an investment:shares and stock in the share capital of a company;debentures, including debenture stock, loan stock, bonds, certificates of deposit and other instruments creating or acknowledging indebtedness including those issued by public bodies;warrants or other instruments entitling the holder to subscribe for any of the above;certificates or other instruments which confer property rights in respect of the above, rights to acquire, dispose of, underwrite or convert an investment, and rights (other than options) to acquire investments other than by subscription;units in collective investment schemes including shares in or securities of an open-ended investment company;options to acquire or dispose of currency, gold or silver, or any investment as defined in the Act, including other options;futures;contracts for differences and similar instruments;long-term insurance contracts; andrights and interests in any of the above.1

There are essentially four possible methods of accounting for research and development expenditure. These are as follows:(a)charge all costs to expense when incurred; or(b)capitalise all costs when incurred; or(c)capitalise costs when incurred providing specified conditions are fulfilled and charge all others to expense; or(d)accumulate all costs in a special category distinct from assets and expenses until the existence of future benefits can be determined.

A point of contention in determining the initial measurement of a tangible fixed asset is whether borrowing costs incurred during the period of construction of an asset should or should not be capitalised. This issue was referred to in company law for the first time in 1981, with the Companies Act 1981 permitting the inclusion of interest in the production cost of an asset.1

Accounting for stock involves the determination of both the cost of goods sold during the period and the amount that should be carried forward in the balance sheet as stock to be matched against future revenues. This is because the determination of profit for an accounting period requires the matching of costs with related revenues. The cost of unsold or unconsumed stocks will have been incurred in the expectation of future revenue, and when this will only arise in future periods it is appropriate to carry forward this cost to be matched with the revenue when it arises; the applicable concept is the matching of cost and revenue in the year in which the revenue arises rather than in the year in which the cost is incurred.

The accounting treatment of capital instruments — shares and debt securities — by their issuer was not historically regarded as presenting significant problems in the UK. However, the substantial development of innovative forms of finance during the 1980s made the accounting profession ask whether the conventional framework for distinguishing share and loan capital, together with the Companies Act disclosure requirements, remained adequate. With the further development of financial derivatives in recent years this aspect of financial reporting has become increasingly complex.

Off balance sheet finance can be difficult to define, and this poses the first problem in discussing the subject. The term implies that certain things belong on the balance sheet and that those which escape the net are deviations from this norm. But there are as yet no authoritative general principles which determine conclusively what should be on the balance sheet and when. As discussed in Chapter 2, the ASB is attempting to establish such principles in its Statement of Principles project and has used these as the basis of FRS 5 — Reporting the substance of transactions — which directly addresses the issue of off balance sheet finance.

SSAP 21 broke new ground in UK financial reporting in two ways: first, it was the first accounting standard to apply the concept of substance over form. Through this, the requirement for companies to capitalise assets in their balance sheets (together with the corresponding obligations) in prescribed circumstances was introduced — irrespective of the fact that legal title to those assets vested in another party.

Government grants are defined in SSAP 4, the relevant accounting standard on the subject, as ‘assistance by government in the form of cash or transfers of assets to an enterprise in return for past or future compliance with certain conditions relating to the operating activities of the enterprise’.1 Such assistance has been available to commercial enterprises for many years, although its form and extent have undergone various changes according to the shifting economic philosophies of the government of the day.

Segmental reporting involves the reporting of disaggregated financial information, such as turnover, profits and assets, about a business entity. This information is generally analysed in two ways: (a)by industry segment. Industry segments are the distinguishable components of an entity each engaged in providing a different product or service, or a different group of related products or services, primarily to customers outside the entity;1 and(b)by geographical segment. Geographical segments are the distinguishable components of an entity engaged in operations in individual countries or groups of countries within particular geographical areas.2

Accounting for the costs of pensions and similar benefits in the accounts of employer companies presents one of the most difficult challenges in the whole field of financial reporting. The amounts involved are large, the timescale is long, the estimation process is complex and involves many areas of uncertainty which have to be made the subject of assumptions; in addition the actuarial mechanisms used for matching the costs to years of employment are complicated and their selection open to debate.

The two accounting standards that govern tax in the UK are relatively long-established. SSAP 8 was issued in 1974 and SSAP 15 in 1978, and although there have been various amendments since then, the basic rules for accounting for tax have not changed significantly since their original publication. In 1995, however, the ASB published a Discussion Paper1 which reviewed the subject from first principles and concluded that major change was needed. There have also been significant amendments to the equivalent standards of other countries and of the IASC in recent years, and it seems likely that the Board will bring forward proposals for a new regime for tax accounting before long.

Chapter 2 discusses the concept of income and outlines the emphasis placed on the transactions approach to income measurement in the development of historical cost accounting theory. In summary, financial accounting under the historical cost system essentially involves allocating the effects of transactions between reporting periods, with the result that the balance sheet consists of the residuals of the income measurement process. Despite the conflict between the asset and liability vs. the revenue and expense viewpoints discussed in Chapter 2, the importance attributed to income measurement is highlighted by the FASB’s Concepts Statement No. 1, which states that ‘the primary focus of financial reporting is information about an enterprise’s performance provided by measures of earnings and its components. Investors, creditors, and others who are concerned with assessing the prospects for enterprise net cash inflows are especially interested in that information.’1 In addition, the emphasis that analysts place on companies’ reported earnings as a measure of performance further illustrates the importance of income measurement.

Earnings per share (EPS) is one of the most widely quoted statistics in financial analysis. It came into great prominence in the US during the late 1950s and early 1960s due to the widespread use of the price earnings ratio (PE) as a yardstick for investment decisions. By the late 1960s, its popularity had switched across the Atlantic and for the purposes of consistency and comparability, it became important that an agreed method of computed EPS was established.

A ‘post balance sheet event’ is defined by SSAP 17 — Accounting for post balance sheet events — as ‘those events, both favourable and unfavourable, which occur between the balance sheet date and the date on which the financial statements are approved by the board of directors’.1 This definition, therefore, incorporates all events occurring between those dates — irrespective of whether or not they relate to conditions which existed at the balance sheet date. Consequently, the principal issue to be resolved is which post balance sheet events should be reflected in the financial statements?

A contingency is defined in SSAP 18 as ‘a condition which exists at the balance sheet date, where the outcome will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events. A contingent gain or loss is a gain or loss dependent on a contingency.’1

A provision is defined in the Companies Act as ‘any amount retained as reasonably necessary for the purposes of providing for any liability or loss which is either likely to be incurred, or certain to be incurred but uncertain as to amount or as to the date on which it will arise.’1 This definition applies only to ‘provisions for liabilities or charges’, in other words those that appear in the liabilities section of the balance sheet, and not to provisions for depreciation or diminution in value of assets, which are separately defined in the Act.2 Similarly, this chapter focuses only on provisions that are shown as liabilities, and does not deal with amounts written off against assets.

The inclusion of statements of source and application of funds in annual reports can probably be attributed to a desire to provide users with a more complete picture of resource flows than that provided by the profit and loss account.1 The latter is concerned with resource flows that are part of the earnings activity and does not report changes resulting from the business’s investing or financing activities nor does it distinguish between the different types of resources consumed in the earnings activity.2

Related party relationships and transactions between related parties are a normal feature of business; many enterprises carry on their business activities through subsidiaries and associated companies and there will inevitably be transactions between the parties comprising the group. Nevertheless, whilst a number of other countries (including the US, Canada, Australia and New Zealand) have had accounting standards on related party transactions for some time, the relevant UK standard, FRS 8 — Related Party Disclosures, was issued only relatively recently.

Company directors are treated as fiduciaries1 and as such must not permit then-personal interests and their duty to the company to conflict. In order to avoid such conflicts or potential conflicts arising, transactions between a company and its directors are restricted. Such transactions are regulated in a number of ways, in particular, by means of statutory prohibition, corporate approval and disclosure in the statutory accounts. In this chapter, attention is focused on the Companies Act requirements for disclosure in a company’s financial statements of transactions involving directors (except for those relating to directors’ remuneration, including share options, which are dealt with in Chapter 30). The provisions determining the legality or otherwise of such transactions are discussed in outline in the Appendix to this chapter.

This chapter focuses primarily on the disclosure requirements in respect of directors’ remuneration. However, preparers of company financial statements should possess an awareness of the law governing the remuneration of directors and their service contracts. Accordingly, a brief exposition of these requirements has been included (see 1.1 to 1.4 below).1

The publication of interim financial reports has been a requirement for listed companies for many years, although the Stock Exchange’s rules governing their form and content remain sketchy. However, the Accounting Standards Board is in the process of finalising a non-mandatory Statement on the subject, based on work undertaken by the Financial Reporting Committee of the ICAEW.