Company Reprting – Building a foundation

Proportional consolidation has long been favoured by the construction industry as a method of accounting for joint operations, but the Accounting Standards Board has never been keen on it. Although FRS 9: ‘Associates and joint ventures’ does not prescribe the use of proportional consolidation, construction companies need not panic, for it introduces a new form of consolidation, direct accounting, that is more or less the same thing.

Property developer Kier, housebuilder Beazer and construction company Pochin’s all conduct business through ‘joint arrangements that are not entities’ and follow FRS 9 by accounting directly for their own assets, liabilities and cash flows in accordance with the terms of those arrangements.

The summary section of FRS 9 acknowledges that this can entail a company simply consolidating pro rata to its respective shareholding (that is, proportional consolidation). A huge sigh of relief, then, from companies that carry on much of their business through joint operations that in effect are simply vehicles for their own activities. If equity accounting had been used, the above companies would have suffered a reduction in both reported operating profit (as joint venture profit comes after group operating profit on the face of the profit & loss account) and various asset balances.

While some may view this as a sop, it can be argued that FRS 9 has taken a pragmatic stance in bringing proportional consolidation under its wing rather than risk being ignored by an entire industry.

Impairment pioneer

FRS 11: ‘Impairment of fixed assets and goodwill’ is not yet effective and few companies are rushing to adopt its requirements early. Indeed, property company Marylebone Warwick Balfour seems to be the first company to do so, with results that are not as calamitous as some predicted.

Marylebone Warwick Balfour tells us that, due partly to its size, a policy of annual impairment reviews has been in place for some time, anyway.

It has also adopted FRS 11 in tandem with FRS 10: ‘Goodwill and intangible assets’. This makes sense, since the two are inter-related (for example, FRS 10 requires impairment reviews to be performed in accordance with FRS 11). Despite FRS 11 introducing a new method of measuring impairments, based on discounting future estimated cash flows and attaching them to ‘income generating units’, the company tells us that its adoption of FRS 11 has had no significant effect on the financial statements this year.

While FRS 11 may have major implications for the recognition and measurement of impairments, it requires little change to the way in which they are actually accounted for. This is borne out in the accounts of property company Town Centre Securities and engineer Eleco, which account for impairments under the existing regime, and find that their treatment would be just as acceptable under FRS 11.

Both meet the pending requirement that, for revalued assets, impairments should be recognised in the statement of total recognised gains and losses until the carrying amount of the asset reaches its depreciated historical cost, and thereafter in the profit & loss account.

No consensus on transition

So far, the most popular of FRS 10’s transitional options among early adopters has been that of leaving old goodwill languishing in reserves, but no consensus has formed over which reserve should be used for this purpose.

Under FRS 10, old goodwill may not remain in a separate goodwill reserve but should instead be set off against the profit & loss reserve or another ‘appropriate reserve’. Electronics company Amstrad follows majority practice and uses its profit & loss reserve. But another electronics company, Channel, takes a different approach by holding goodwill in special reserve and merger reserve.

FRS 10 gives no guidance as to what it considers an ‘appropriate reserve’, although the ASB has told us this term effectively rules out the use of capital reserves. Will any company will be bold enough to simply change the name of its goodwill reserve to something else, and be done with it?

Bad sign for future derivatives

Moves by the ASB to force derivatives onto balance sheets at fair value are much anticipated. As only 12% of companies that have evidence of derivatives even bother to disclose their fair values – let alone include them on the balance sheet – there seems little enthusiasm for the change.

Smiths Industries also discloses the book and fair values of all of its financial instruments. Contrasting the two columns gives an indication of how the balance sheet of tomorrow may look and shows why companies are wary of the ASB’s agenda. For example, interest rate swaps that have no carrying value under present historical cost rules in Smiths Industries’ balance sheet have a fair value of almost #3m. This latter value may be forced onto the balance sheet at some time in the future, introducing volatility into the accounts on behalf of instruments whose primary use is risk reduction.

Disclosure of auditor fees

Analysts are used to seeing auditors’ fees broken down into audit and non-audit work. But what of fees not charged to the profit & loss account? Specialist distributor Optoplast provides a table that discloses this very item, analysed into (i) fees included within fixed asset investments in relation to acquisitions and (ii) flotation expenses charged to share premium account.

Rewarding non-executives

The role of non-executive directors continues to be central to corporate governance discussions. An ideal method of remunerating them has yet to be found, especially as the twin goals of aligning their interests with those of shareholders and ensuring that they retain their independence, can conflict. As a result, practice remains diverse.

In its remuneration committee report, Smiths Industries discloses that some 20% of non-executive directors’ fees are paid in shares. While the Hampel report sees this as a valid way of aligning the interests of non-executive directors and shareholders, its combined code makes no mention at all of non-executive directors’ remuneration.

In line with the Greenbury recommendation that directors’ service contracts be no longer than one year, furniture manufacturer Cornwell Parker discloses that its non-executive directors do not have service contracts. This has not stopped the company paying one of them a #35,000 termination payment on top of his basic #28,000 fee, though.

Compensation payments are not unusual in the UK but tend to be confined to the wallets of executive directors, as is the case with Upton & Southern.

Ignoring minor disclosures

Companies can perhaps be forgiven for taking their eyes off the ball and lapsing on trivial disclosure requirements.

Construction company Kier joins the 29% of companies that provide an additional earnings per share figure that removes the effect of exceptional items in order to give a better picture of underlying performance. In doing so, it is not alone in failing to meet the longstanding FRS3: ‘Reporting financial performance’ requirement that any additional eps be reconciled to the standard one. This does introduces an interesting question, however, as to how rigid accounting standards really are. The ASB obviously feels this is not a redundant piece of over-disclosure, since it has included it in FRS 14: ‘Earnings per share’.

Looking for a pat on the back

In its financial review. Smiths Industries states that it proposes to adopt FRS 10 in its next set of accounts, intending to capitalise future goodwill and amortise it over 20 years.

This is unlikely to cause much celebration at the offices of the ASB, however, as Smiths Industries’ next set of accounts will be covered by FRS 10 anyway – leaving the company with little choice but to follow its requirement.

This feature is an edited version of the review published in Company Reporting magazine, a monthly title monitoring financial reporting practices in the UK. Details from: 0131 558 1400

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