Major changes to accounting standards are producing both accounting issues and legal problems which UK companies need to plan for this year.
Companies in the UK that are not following International Financial Reporting Standards (IFRS) are required to move to new UK accounting standards for accounting periods beginning on or after 1 January 2015, with further changes due in 2016. These changes are far-reaching and require substantial planning, which may require help from external accounting advisers. There are also related legal issues to deal with, and we can help you both reduce the legal risk attached to the changes and take advantage of some positive benefits arising from the new regime.
The new standards are produced by the Financial Reporting Council and details of the new regime, including all the new standards, are available on the FRC website at https://www.frc.org.uk/Our-Work/Codes-Standards/Accounting-and-Reporting-Policy/New-UK-GAAP.aspx. For companies moving to the main new UK standard, FRS 102, there are a host of issues to deal with, and there are some legal potholes to avoid but also some potential legal opportunities. A company with a 31 December year end will apply the new standard on a mandatory basis for the first time for accounting periods beginning on 1 January 2015. However, the “date of transition” is the beginning of the earliest period presented, which will be the comparative period ending 31 December 2014. This is important as companies will need to establish an opening position at 1 January 2014 to comply with the new rules.
Strengthening your balance sheet and distributable reserves
As a transitional arrangement, FRS 102 allows a one-off uplift in value of assets such as property to current market value, which can then be carried forward as a “deemed cost”. Companies that do not have a policy of revaluing assets can take advantage of this to strengthen their balance sheet in terms of asset values, but can also improve their distributable reserves position if they so wish.
Example: An asset has a carrying value of £100,000 but on the date of transition its market value is £500,000. On transition to new UK GAAP the company can record £500,000 as the new “deemed cost” of the asset. The difference of £400,000 is recorded as a revaluation reserve.
A company may thus improve its leverage or gearing ratios, and this may be of even greater help if the asset in question is being used to secure new borrowing. The revaluation reserve can also be capitalised by way of a bonus issue of ordinary shares. A private company can then carry out a solvency statement capital reduction (under sections 641-644 Companies Act 2006), converting the balance into a realised profit, which can be used to augment distributable reserves. This will benefit companies whose cash flows run ahead of profit or where it is possible to borrow to distribute.
A modest disadvantage is that the new carrying value will be used for future depreciation (although freehold land is not depreciated). So if depreciation, in the above example, increases from £10,000 per year to £50,000 per year, this will hit annual profits, although where EBITDA is used as a key performance measure, this will not be such a major issue. In addition, however, to the extent that the revaluation reserve has been capitalised as suggested above, it will not be possible to utilise any of it to offset the increased depreciation charge and hence future realised profits will also be reduced by the increased depreciation charge each year.
The process of capitalising a reserve by way of a bonus issue and performing a solvency statement reduction of capital are very familiar to us and we can provide further advice on how to take advantage of this opportunity, including preparing the relevant documentation.
New issues in relation to intra-group lending
Another consequence of the new UK standards relates to lending between parties at off-market rates, which often occurs between group companies. Depending on the substance of the arrangement, the rules on financial instruments (including debtor and creditor balances) require anything which constitutes a financing transaction to be recorded at the present value of the future payments discounted at a market rate of interest for a similar instrument. This affects profits and losses recorded at inception and over the life of the loan, and distributable profits will also be affected.
Example: A group company lends another group company £5m for five years and charges no interest, the balance being repaid as a lump sum at the end of five years. If the market rate of interest is 5%, the value of the loan recorded at inception will be the value of the cash flows discounted at 5% over the five years of the loan. The interest amortisation that is charged each year will increase the carrying value of the loan each year until repayment of the £5m in cash at the end of the five year period.
|Year||Carrying amount of loan at start of period||Interest at market rate of 5%||Cash flow||Day one discount||Carrying amount of loan at end of period|
The day one discount is the difference between the cash transferred and the present value of the loan amount. This difference reflects the fact that the lender has made a loan at a lower than market rate of interest and thereby has provided an additional benefit to the borrower. In each year the interest due will be charged against profit and the balance due on the loan will be increased.
The overall impact on distributable reserves will depend on which companies within the group are lending and which are borrowing:
|Parent to subsidiary||The day one discount increases the parent’s cost of investment in the subsidiary and is treated as a capital contribution by the subsidiary. If in the form of qualifying consideration, this is a realised profit in the hands of the subsidiary.|
|Subsidiary to parent||The day one discount represents a distribution to the parent. The subsidiary must have sufficient distributable reserves to cover the amount; but when it is recorded by the parent it can be treated as a realised profit as it arises from qualifying consideration.|
|Subsidiary to subsidiary||The transaction is treated as if being conducted via the parent (although the parent does not need to account for anything), so the above analysis will apply to each limb of the transaction from each subsidiary’s perspective.|
This approach will also apply to financing transactions between companies owned and controlled by the same person (making them related parties). And any such transaction between a company and a director – whether that director has an ownership interest or not – will also need to be considered carefully.
An alternative to avoiding the above situation is to charge market rates of interest. Companies may also wish, however, to change the terms of existing balances, including switching to on-demand loans which must be paid by the borrower immediately if required by the lender. There is likely to be more call to document intra-group arrangements, which in the past may have remained undocumented. There may be problems in changing terms, however, if letters of support are required from a parent to a subsidiary for going concern and audit purposes. If such a letter states that amounts due to a parent will not be recalled for at least a year, then the substance of the arrangement may be a longer term loan, which will cause the above treatment to be applied. Directors will therefore need to consider the wider consequences of changing the terms of amounts outstanding between group companies.
The FRC has published a Staff Education Note on this topic, which can be found at https://www.frc.org.uk/Our-Work/Publications/Accounting-and-Reporting-Policy/SEN-16-Financing-Transactions-%28Oct-2015%29.pdf.
The changes to accounting for intra-group arrangements are complex. We can assist clients in deciding how to respond to these changes and in implementing any such response.