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UK GAAP: War stories - Sarah Hughes

New UK GAAP: War stories - Sarah Hughes:

SH Thank you. Good afternoon, everyone. My name is Sarah Hughes, and I'm a Director in KPMG’s Accounting Advisory Services department, and for the last couple of years my key area of focus has been new UK GAAP, so I've been travelling around the country, talking to clients, and helping them understand the impact of conversion on their company, and I want to share some of that practical insight with you today.



Let's just start with a quick recap. Just to remind you, these new requirements are applicable for accounting periods beginning on or after 1 January 2015, so you'll be restating your 2014 comparatives, and you'll have a transition date as at 1 January 2014.

Broadly speaking, you can choose, for each individual company within your group, to apply FRS 101, IFRS accounting and measurement, with reduced disclosures, or FRS 102.


In the discussions I've been having with clients it's very clear that this is about much more than just the debits and credits that go through your financial statements. There are going to be much wider business consequences for your companies. You might, for example, have to update your systems and processes to make sure you can capture all of the data that you need for these new requirements, or you might have to make changes to your debt covenants or your performance related remuneration, if they're based on old UK GAAP numbers.


But they're not the areas I'm going to focus on today. Today I'm going to focus on tax and distributable reserves, because they're the two areas that I've seen conversion have the biggest impact on, so let's start with distributable reserves, and firstly, everybody’s favourite subject, derivatives.



You're probably aware that under both FRS 101 and FRS 102 you'll need to bring derivatives on balance sheet and measure them at fair value, and if you're not doing hedge accounting, then you'll be measuring them at fair value through profit and loss.


Those movements through P&L for the year will impact your distributable reserves available for distribution, because they're realised gains and losses. [Break] hedge accounting, because Tech 2/10, the guidance on determining your distributable reserves, tells you to look at the hedge relationship as a whole.


So let's take an example of a forward foreign currency contract, and you're doing cash flow hedge accounting. Let's assume we live in an ideal world, and our hedge is 100% effective, all of the movements in fair value will be parked in the cash flow hedge reserve, until the hedge transaction occurs, so it won't impact your reserves available for distribution.


That's if you're a limited company. If you're a plc you also need to think about what we call the net assets test. This means that you also need to take into account those unrealised losses that are sitting within your reserves. So if you're a plc and you're doing cash flow hedge accounting, and you’ve got a loss sat in your cash flow hedge reserve, that will reduce the reserves that you have available for distribution.



I have actually seen this in practice. I was working with a FTSE 100 company. They had Topco plc, obviously. They also had a plc directly below that and that was the treasury company for the group. It was entering all of the derivative contracts on behalf of the group. It was doing hedge accounting, but on conversion it would be sat there with a loss in its cash flow hedge reserve, which would reduce its reserves available for distribution, and potentially create a dividend block, so in this particular instance it doesn’t need to be a plc any more, so they're going to reregister the company as a limited company, so that they no longer have to comply with the net assets test.


The next area is fair value as deemed cost. This is one of the first time elections that are available under both FRS 101 and FRS 102. Many companies out there, they want to boost their net asset position, and what this transitional election allows you to do is revalue certain assets in your balance sheet, on an item-by-item basis, taking the other side to reserves.


FRS 101 lets you do this for intangible assets, investment property, property, plant and equipment, and investments in subsidiaries, associates and joint ventures. FRS 102 lets you do it for the first three, so, intangibles, property, plant and equipment, and investment property. So presumably here we're talking about a revaluation upwards, so you're strengthening your net asset position.



Now, some companies are thinking about taking this one step further. That amount that we put into reserves isn't distributable; that revaluation amount is not distributable. However, you can do a bonus issue of shares out of that reserve, using that reserve, and with the resulting share capital, on that bonus issue, you can do a capital reduction, and therefore create distributable reserves.


It all sounds a bit dodgy, but you really can use this first time election to create distributable reserves in accordance with the Companies Act. That's certainly something to think about if you’ve got distributable reserves issues in any of your individual companies.


The next one is goodwill written off to reserves, and we have to think back quite a long way when we're thinking about this topic. If you remember back to December 1998, prior to that date you were able to write goodwill immediately off to reserves. Okay, so you didn’t put it in the top half of your balance sheet, you wrote it off to reserves. A question arises as to whether that debit to reserves is a realised loss or not, so does it impact your reserves available for distribution?


Under current UK GAAP, had you recognised that on balance sheet, you would have been amortising it over a period of time. Let's say old UK GAAP, probably 20 years? So what we said under UK GAAP is that that would become a realised loss over the 20-year period, or if there's an impairment, at an earlier date.



So let's say you bought some trade and assets in an individual company, in 1994, you wrote it immediately off to reserves, that would become a realised loss over the 20 years, and by 2014 the full amount would represent a realised loss, and impact your reserves available for distribution.


Now, under IFRS we take a different approach. You'll be aware that under IFRS, and therefore FRS 101, we don’t amortise goodwill. Instead there's an annual impairment test. So what we can do is look, and if we can support the carrying value of that goodwill, had we recognised it on balance sheet, we would say it would not represent a realised loss.


Okay, so that helps your distributable reserves position. We're not talking here about restating any amounts in the top half of your balance sheet. We're just thinking about, are my reserves distributable or not?


The last area in relation to distributable reserves is deferred tax; and in talking to clients there's been quite a bit of confusion here, and I think it's because of the terminology that's used. So under UK GAAP at the moment you'll be very familiar with doing the timing differences approach, and under IFRS, FRS 101, we've got the temporary difference approach.



FRS 102 also refers to a timing difference approach. So does that mean I'm going to end up with the same deferred tax number as I have under current UK GAAP? Unfortunately not. Current UK GAAP has certain exemptions in it, so there are certain timing differences for which you don’t have to recognise deferred tax, and some examples there include revaluation gains and rollover gains. FRS 102 doesn’t have those types of exemptions. They are timing differences, and therefore you will have to recognise deferred tax. So, generally speaking, we will see more deferred tax under FRS 102 than we currently have under UK GAAP, which will impact your reserves.

Okay, now let's take a moment to think about tax, and firstly, let's think about functional currency and the effect that might have on your tax payments. Under UK GAAP, current UK GAAP, you currently very much focus on the cash flows of a company when you're determining what its functional currency is. Okay, so if I've got an intermediate holding company, based in the UK; it has borrowed some funds from its UK parent, US dollar funds, and it has invested that in a US trading subsidiary. All it has got is this US investment in US borrowings. If you look at its cash flows it has got US dollar dividends, it has got US dollar interest, so it’s likely that the functional currency of that company under UK GAAP would be US dollars.


However, both FRS 101 and FRS 102 require you to think about whether that company is just an extension of the parent or whether it's independent, whether it's autonomous. If you conclude that it's just an extension of the parent - the parent could have gone out and bought the US subgroup itself, didn’t need to use that intermediate vehicle - then you'd say it was just an extension of the parent, and therefore it should have the same functional currency as its parent, so in my example it would change its functional currency to sterling, the same as its immediate parent. So suddenly you’ve got very different foreign exchange movements going through your profit and loss account, which are taxable, or deductible.



However, under tax legislation, you can make an election to choose your functional currency to be what it wants for tax purposes. So, in my example there's a rationale for having US dollars as a functional currency for tax purposes, and so if you make that election you won't be taxed on those movements that are seen for accounting purposes, so quite a useful election there, and something I'm seeing quite common in practice, particularly where you’ve got a tower structure or a financing structure that has intermediate parent companies.


Interest free loans from shareholders, or in fact any inter-company, any fellow subsidiaries. Under current UK GAAP, non-FRS 26 UK GAAP, if one subsidiary lent to another subsidiary, say 100, you'd put that in your accounts, generally speaking, at 100. It's all a bit boring. Under FRS 101 and FRS 102 you're required to fair value all financial instruments, and these inter-company loans, shareholder loans, are financial instruments.


Now, if it's repayable on demand, then the fair value is equal to the face value, so in my example it would still be in the accounts at 100. However, if you’ve got a term loan, so say, for example, a five-year loan, and it's interest free, the fair value of that loan is no longer going to be 100. You need to discount it back to present value. So you might, for example, have a balance of 80. So you’ve received 100 of cash, but you’ve only got an inter-company balance of 80. That discount, that difference of 20, is taxable or deductible, if that accounting entry is made under the new requirements, so for December year-ends, if you're making that entry for 2015. But if you're doing it before the change in rules then you don’t have a problem.



So, where I've seen this in practice is I had a client, who wanted to adopt early, so they wanted to adopt in 2013 and they had one of these interest free loans from a shareholder. The adjustment that they would have to book was material and would have led to a material tax charge, so they actually decided to amend the terms of that loan and postpone adoption of FRS 101 until 2014. So another practical example of where the tax can drive the timing of adoption.


Classification of software: so at the moment, under UK GAAP, usually all hardware, all computer hardware, all software is included within property, plant and equipment, within tangible fixed assets.


Under IFRS it says that only the software that is integral to the related hardware is included within plant, property and equipment. Any other software is included within intangible assets.


Okay, you might be sitting there thinking, well, do I really care? It's still in my balance sheet. It's still being depreciated or amortised. Does it really matter? Well, when you look at the tax legislation you’ve got two different sets of rules, okay, and by moving it from PP&E to intangibles it’s actually more beneficial, generally speaking, a more beneficial tax regime, so you actually might be able to accelerate your deductions, your tax deductions, so another useful planning point there as well.



And then, finally, goodwill amortisation, you will have heard us talk about this before. It is one of those GAAP differences that we have signposted all along. You'll know that, as I said earlier, under UK GAAP you amortise your goodwill. Under FRS 102 you continue to amortise your goodwill, but under FRS 101 you don’t amortise; instead, you do an annual impairment test.

So that has been a driver for certain companies I'm talking to. They might be a listed group; they want to do FRS 101 in all of their subsidiaries, but if they went to FRS 101 they would lose their tax deduction because they’d stop amortising that goodwill, so instead they're going to move to FRS 102 for that company.


Now, just to take that one step further, I often get asked, well, I'm amortising my goodwill under a useful life of 20 years under UK GAAP. Under FRS 102 it talks about five years. It says if you can't reliably estimate your useful economic life, then use a maximum life of five years.


So people ask me, particularly if there's someone from tax in the room, will I change from my useful economic life of 20 years to five years, and therefore get a quicker tax deduction? Well, I wouldn’t expect that to be the case, because if you’ve justified a life of 20 years, you’ve been able to support that life of 20 years under UK GAAP, then I'd expect you to be able to support a life of 20 years under FRS 102 as well, so unfortunately that won't be a planning idea to accelerate your tax deductions.



Just to wrap up with a couple of other reminders, firstly, if you're part of a UK consolidation then remember, as I said at the beginning, you can choose, on a company-by-company basis whether to adopt FRS 101 or FRS 102, okay, and it’s a really important process to go through on a company-by-company basis, to make sure you're choosing the right framework.


The second point there, dormant entities, a useful election in FRS 102, but not FRS 101, so it’s only available under FRS 102, and that's to grandfather your existing accounting for dormant companies, which means these changes wouldn’t result in a change that would make you lose your dormant company status. It's only when there's some other transaction within that company that you'd have to start applying these new requirements.


The last one there, if you are one of those groups that did adopt IFRS in its parent company or in any of its subsidiaries, you can revert back to Companies Act accounts, so to FRS 101, in order to take advantage of the reduced disclosures within that framework, so again, another useful point there.


Okay, that was all I was going to talk about today. I will be around at the end for questions, but I shall now hand over to Brian, who’s going to talk about revenue.

New UK GAAP: War stories - Sarah Hughes