A pragmatic approach

A pragmatic approach

Company Reporting reviews merger reserves, trust status, corporate governance.

Merger relief has for years been a relatively uncomplicated matter; companies transfer to a merger reserve premium arising on shares used to fund an acquisition. The premium is then used to eliminate any goodwill arising on the same acquisition. However, with FRS 10: ‘Goodwill and Intangible Assets’ to ensure all future goodwill will be capitalised, companies will have to find alternative uses for merger reserves that arise on acquisition.

Some may choose to follow the example of Arriva and consider drip-feeding amounts from merger reserve into profit & loss reserve, in tandem with goodwill amortisation charges. Motor component wholesaler Finelist, though, takes a more straightforward approach, using a direct transfer of all of its merger reserve to reduce its p&l reserve deficit by nearly 20% to #48m.

FRRP catches up The Financial Reporting Review Panel has been having a busy time of late.

It recently gave Harveys Furnishing a hard time. This month, Photo-Me has dropped a long-held accounting policy following ‘discussions’ with the panel.

For many years, Photo-Me has included sales made to other group companies within turnover. While acknowledging that recognition of intra-group transactions does not follow applicable UK accounting standards, the company has been of the opinion that excluding this figure would not have given a true and fair view of its activities. Further, an identical amount has always been included in cost of sales, so that any intra-group profits were eliminated in accordance with FRS 2: ‘Accounting for Subsidiary Undertakings’.

Despite these arguments, Photo-Me has been persuaded to drop its policy, resulting in a reduction to both cost of sales and turnover of #22m this year, and #11m in the comparative year. The FRRP is right to criticise the recognition in turnover of sales made by a group to itself, but one wonders why it took so long to do so.

When is a trust not a trust?

To qualify as an investment trust under the Companies Act 1985, a company must not invest any more than 15% of its investment portfolio in any one company or group of companies. This month, we report on two investment trusts that have temporarily fallen foul of this rule, and account for their period of non-trust status in distinctly different ways.

Investment trusts normally follow the Association of Investment Trust Companies’ SORP ‘Financial statements of investment trust companies’, presenting their results in a statement of total return. Despite no longer qualifying for investment trust status, Aberdeen Latin American Investment Trust continues to present its results in this way, invoking the true and fair override to do so. Following Urgent Issues Task Force 7: ‘True and Fair Override Disclosures’, the company explains why it continues to report in this fashion and summarises how different its results would have been if reported under the statutory p&l account format.

Taking a different stance, Brazilian Investment Trust accepts its loss of status and reports along statutory lines, albeit for a shortened four-month period. The company supplies a standard p&l account and statement of total recognised gains and losses and, in a note to the accounts, summarises the difference between the two methods.

The company also publishes a statement of total return for comparative purposes, and its revenue result of $0.4m (#0.24m) compares favourably with its statutory loss of $3.5m. Both companies are at pains to point out that they enter their next accounting periods as qualifying investment trusts.

Internal control statements

Although the Cadbury Code recommends that ‘the directors should report on the effectiveness of the company’s system of internal control’, both the guidance of Rutteman and Hampel’s combined code have helped to render this clause ineffectual and pointless. All that directors have to do to meet this recommendation is report that they have reviewed the effectiveness of internal controls, without having to discuss either the controls, their review methods or their findings.

Allied Carpets suffered a well-publicised breakdown in internal financial controls, which led to a cumulative error in sales of #6.4m and an operating profit charge of #3m. Its corporate governance statement discloses that a review has been undertaken and its findings acted upon, ensuring that such an event cannot happen again. Despite having to strengthen several key internal control systems, Allied Carpets was able to state full compliance with the Cadbury Code both this year and last.

It is all too frequent occurrences such as this which lead us to suggest that the directors’ duty to report on internal control matters in the annual report should be either strengthened considerably or dropped completely.

A taste of things to come

No company likes to report a loss on the disposal of a fixed asset, but at least under FRS 3: ‘Reporting Financial Performance’ they can be stripped from operating profit as one of the three so-called ‘super exceptionals’.

Change, though, is looming. FRED 17: ‘Measurement of Tangible Fixed Assets’ proposes, controversially, that the carrying value of a tangible fixed asset be adjusted to its disposal proceeds immediately before a disposal takes place. This means that companies will never again record a loss on disposal of a tangible fixed asset and, hand in hand with this, FRS 3 would be amended to remove them from ‘super exceptional’ status.

European Leisure follows along similar lines to this proposal by charging its p&l account with a #7.6m impairment to the carrying values of venues that have been, or are in the process of being, disposed of. Consequently, for those venues sold in the period, no loss on disposal has been recognised, although the impairment has quite correctly been included as a ‘super exceptional’ item after operating profit and before interest. Unfortunately, for companies in this position in future, if FRED 17 evolves unchanged into a full FRS, similar impairments will have to be charged as part of operating profit.

Swimming against the tide

If the practice of companies that adopt early FRS 10 is anything to go by, the most favoured of its transitional approaches will be that of simply leaving old goodwill languishing in reserves. We are used to seeing companies gearing up for FRS 10 by closing down goodwill reserve to another reserve (as FRS 10 does not allow old goodwill to be retained as a debit balance in a goodwill reserve), but retailer UNO acts as if oblivious to the impending change.

An adjustment to the fair values of UNO’s prior year acquisition of World of Leather has led to an increase of #1.8m in goodwill, the majority of which has eliminated via the application of merger relief. The remaining balance has been debited to a newly created goodwill reserve, which is set to have a short and eventful life. Next year, as UNO’s accounts come under the jurisdiction of FRS 10, it will have to be closed down – either by retrospective capitalisation or a simple transfer to more appropriate reserve.

Thomas the Tank Engine

According to FRS 10, the maximum life of an intangible asset under normal circumstances is 20 years. There are, though, exceptions to every rule, and broadcasting contractor Britt Allcroft believes it has acquired one this year.

Britt Allcroft has purchased the copyright of ‘The Railway Series’ books for #13.5m and calculates its economic life with regard to the actual length of copyright protection – 70 years from the death of the author in the UK and Europe, and around 50 years in most of the rest of the world.

In keeping with the requirements of FRS 10 for amortisation periods of over 20 years, the intangible asset will be subject to annual impairment tests to ensure that its recoverable amount has not fallen below its carrying value.

Issue of the month

An examination of quantitative derivative disclosures, in the light of the September publication of FRS 13: ‘Derivatives and other Financial Instruments: Disclosures’ shows that current practice lags far behind ASB best practice.

It is impossible for analysts to assess the risk profile of a company’s treasury function, given the level of information disclosed currently.

With so few companies disclosing the fair value of their financial instruments, attempts by the ASB to force derivatives onto company balance sheets at fair value will not be greeted with much enthusiasm.

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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