Mind the GAAP

Lisa McClure, PwC assurance director, issues a timely reminder that new UK GAAP is here and asks: Are you prepared for the change?

If you had not heard, UK GAAP, as it is currently used for financial reporting, is being replaced by new standards that focus on reducing the reporting burden and ambiguity within the current standards for those entities not having to comply with full International Financial Reporting Standards (“IFRS”)….are you ready?

Background

Effective from 1 January 2015, new UK GAAP provides a clear, robust, straightforward yet flexible framework which is generally being well received by financial reporters.  Its scope covers all entities that are not forced to use full IFRS (or IFRS as adopted by the EU). The guidance allows the revaluation of fixed assets, capitalisation of borrowing costs, stays close to the UK concept of deferred taxes arising out of timing differences and continues to allow merger accounting for group reconstructions. 

All of these elements are allowed under current UK GAAP but not permitted under IFRS for Small and Medium Sizes Entities (“IFRS for SMEs”), which is the framework on which “new” UK GAAP was originally based.

Why should you pay attention?

Many entities are underestimating the effort needed to adopt the new guidance and the potential impact of conversion.  IFRS adoption by listed groups in 2005 was a complex and time-consuming process, resulting in conversion projects lasting many months.  Whilst there may be many entities that are only marginally affected by the changes, a conversion from old to new UK GAAP could be, if you are not fully prepared, an equally challenging exercise.

The following are common myths we encounter with our clients when discussing the required consideration of, and transition plans relating to, a replacement reporting accounting framework where old UK GAAP has been used up until now:

  • “I don’t need to adopt New UK GAAP until my December 2015 financial statements – so there is plenty of time”

Incorrect – 2014 comparatives are required, meaning 1 January 2014 is the transition date for December year end entities.  Some major accounting choices under new UK GAAP, especially in the area of derivative hedges, can be applied prospectively only.

Have you thought about how many entities you have in your group; the resources you have in your organisation to complete the transition process; and what other projects you have going on over the next two years?

Have you carried out a GAAP (Current UK GAAP vs new UK GAAP, IFRS and US GAAP; being the most commonly used) comparison exercise to understand the changes and the potential accounting choices?

Have you prepared your chosen GAAP financial statement templates?

  • “FRS 102 is similar to current UK GAAP”

Similar does not mean the same – there are major differences in areas such as financial instruments and business combination accounting.

In particular, the accounting rules for financial instruments are more complex and will require detailed analysis and may require the involvement of financial instruments accounting and tax experts.  

  • “We already apply IFRS for our group reporting, so applying the new guidance in the subsidiary financial statements should be easy”

Not necessarily – if your group reporting materiality is higher than materiality for your subsidiaries, then additional effort may be needed to apply these new requirements in your subsidiaries.  

You may also have significant intra-group transactions, which eliminate at group level but, to which the new guidance will need to be applied. New UK GAAP and the additional guidance thereto for groups have specific rules for intra-group transactions which are different from current UK GAAP rules and might result in additional income statement volatility.

A particular focus must be given to derivatives and hedging as this is the most significant change between current and new UK GAAP.  Under new UK GAAP –derivatives will be brought on balance sheet at fair value, with changes recorded through the income statement.  

Under current UK GAAP, derivatives are typically held off balance sheet, with changes reported in the income statement only as they arise.  This major change will likely gross-up the balance sheet, impact net earnings and increase volatility in the income statement.  

The income statement volatility can be reduced if hedge accounting is applied.  

In addition, just because you achieve hedge accounting for derivatives at the group level does not mean the same treatment will be available in the stand-alone accounts.  Should you fail to achieve the onerous criteria required to apply hedge accounting; the derivative fair value changes will create income statement volatility.

  • “I’m a listed group – no-one cares about the financial statements of my wholly owned subsidiaries”

Not true - any tax computation is generally based on your GAAP accounts, so changes in your accounting under new UK GAAP could impact the timing of tax related cash.  Changing the entity level numbers may also impact your ability to pay dividends as it impacts the distributable reserves.  

New UK GAAP will require more items to be measured at fair value leading to increased income statement volatility unless appropriate hedging strategies are adopted.  Remember that any hedging can be applied on a prospective basis only, with full hedge accounting requirements being met on the date hedge accounting starts being applied.

So what should you be thinking about now?

New UK GAAP provides a number of different options and now is the time to consider your choice.  Remember, this is not just an accounting change – other factors to consider when making your decision include:

  • Impact on tax and distributable reserves
  • People – what resources will you need to complete the transition?  Do your teams need to be trained to deal with the increased complexity of some of these accounting areas?
  • Systems and processes – what accounting data will be required – will this be available using existing systems and processes?
  • Key financial ratios – how could your key ratios be impacted?  And how will you communicate these changes to key stakeholders?
  • Lending covenants – do you have agreements which refer to your UK GAAP financial reporting measures?  How will the transition to new UK GAAP impact your lending ratios?  Do you need to renegotiate your covenant terms?  
  • Involve experts and get support from external parties – have you consulted and involved your accounting consultants, auditors and tax advisors?

For more information on how you can prepare for new UK GAAP, contact Lisa McClure or Roland Mills whose details can be found on this page.