Financial reporting and the future of audit – webinar
Peter Manser, our Partner and Head of Audit and Assurance hosted a live webinar looking at the past, present and future of audit, as well as financial reporting developments. The webinar is key for those in business requiring a more in-depth update on financial reporting and compliance issues.
As the current debate surrounding audit continues, and in light of high-profile corporate scandals hitting the headlines, Peter speaks about how audit needs to adapt and change to meet 21st century business needs.
Peter also outlines key financial reporting developments and explains how they may impact upon business reporting over the next year or so.
Topics covered included:
- Past: looking at events that have caused a shift in the perception of audit and initiated a need for change.
- Present: an outline of the key benefits of an audit and current financial reporting issues.
- Future: the changing scene of the profession; a look at upcoming changes, including some expected developments for the future.
We have detailed the webinar transcript below. If you would like to view a particular section, please use the links:
Financial reporting update
Financial reporting update – Disclosure changes
Financial reporting update – Accounting changes
Financial reporting update – Narrative reporting
The theme of our webinar today is to look at the past, present and future of audit. We will look at some of the key events that have arisen that are shaping the current debate on how audit needs to adapt and change to meet 21st century business needs.
We will also be looking at some actual financial reporting developments as well that may impact upon your reporting over the next year or so.
Also on the agenda is a look at other ways in which audit is changing to meet the needs of business.
In the press
As a general rule the audit profession is not one that likes to draw attention on itself, instead we much prefer to just get on with the job. Unfortunately for us though this has not been possible over the last couple of years, with a succession of high-profile corporate scandals hitting the headlines and often with the auditors concerned being apparently at fault.
BHS, Carillion and Patisserie Valerie are just three of the names that have rarely been out of the press recently, and this has put auditors on the defensive. Or at least it has put some auditors on the defensive. Much of the criticism has been levelled at the top end of the profession, the Big 4 firms of KPMG, PWC, EY and Deloitte and those other large firms that operate in the audit market for listed and other public interest entities. Allegations of poor audit quality arising from a lack of scepticism, a focus on more lucrative non-audit services and the complacency that comes from a lack of meaningful competition have all featured, and collectively as a profession we are taking steps to address these issues and restore the public’s faith in the audit profession. We do like to think though that issues are actually less prevalent in the SME market in which most of you watching today operate. There is certainly no lack of competition in this sector leading to any complacency, we are always aware at Kreston Reeves that you have a choice of advisers, and there does not appear to be any evidence that the audit profession is not routinely meeting the needs of the SME marketplace.
The high-profile corporate failures already alluded to haven’t gone unnoticed by those in power though, and a number of reviews have been undertaken that are designed to address the apparent weaknesses that exist in the current regulatory framework.
The Competition and Markets Authority (CMA) has already reported on ways by which competition between audit firms at the top end of the market can be improved, and the Kingman review has concluded that the UK needs a brand new regulator to oversee listed companies and the audit profession that is more effective than the Financial Reporting Council has been in recent years. The Brydon review is looking at the auditing standards themselves and the legislation that underpins them to see if audit is meeting the needs of modern business and whether they need strengthening at all.
Parliament is also looking at the audit profession closely at present, the Business, Energy and Industrial Strategy (BEIS) Select Committee undertaking its own inquiry on The Future of Audit – an inquiry which saw our own former Chairman Clive Stevens being grilled by a panel of MPs. As Rachel Reeves MP, chair of the inquiry, has made clear “It’s now up to the Government to deliver with legislation to ensure that audits provide what businesses, investors, employees, pension –holders and the public expect.”
We’ll look more at these reviews later as we consider what changes may be instore in the drive to improve the reliability of financial reporting.
What is an audit?
At this point it’s worth a reminder as to what an audit actually is, and of course what it isn’t. This difference has created an ‘expectation gap’ in the minds of many which needs to be closed.
The definition on screen now is taken from the current auditing standards that all auditors are obliged to follow when undertaking their work, whether it be the audit of some of the largest companies in the country or your business. An audit is about providing credibility in financial reporting, so that the users of the accounts can have confidence that reported results are an accurate reflection of a company’s financial performance, that a company’s balance sheet is a fair reflection of a company’s financial strength and stability, and that all matters that are necessary to have an adequate understanding of the company’s financial position have been disclosed in line with current expectations of full corporate transparency.
But we must be aware that audit does have its limitations. It is not an absolute level of assurance, nor can it provide assurance in respect of future viability – companies can and do fail and this will continue. Although audits are planned to detect material misstatements in accounts however they may arise, they do not provide a guarantee that fraud hasn’t arisen.
It is issues such as these that have resulted in an expectation gap arising, and which the reviews are seeking to address. How this might be achieved we will look at later.
The benefits of an audit
The Association of Practising Accountants (APA) is a network of 16 leading business advisory firms, of which we are a part, meeting the needs of the real economy from SMEs through to AIM companies as well as the third sector. Earlier this year they conducted a client survey, aimed at providing member firms with a better understanding of how business owners view the current economic environment.
One area that was looked at was audit, and what is considered to be the main benefit for SMEs arising from the audit process. Just over half of respondents cited meeting statutory obligations as the principal benefit, which is perhaps a little disappointing. At Kreston Reeves we believe that audit has the potential to provide far greater benefits for clients than simply complying with legal red tape. The survey does show that we need to do more as a profession to ensure that our clients are of the same view by providing an audit service that delivers real, tangible benefits for clients, and this will continue to be our focus.
Alternatives to audit
For companies and LLPs the requirement to have an audit is set out in company law, and if the law says that you’re required to have your accounts audited then an audit is required.
It’s probably worth taking a second though to remind ourselves on which companies and LLPs are subject to audit. There are no changes to the statutory audit exemption criteria to advise you of at present, nor are any planned, but given that audit exemption rules are set in part by the European Union this could change post-Brexit. It’s unlikely that audit exemption will be a priority for the Government, but changes may be introduced. We shall see. Anyway, at present though the rules are unchanged. A company is eligible to take advantage of audit exemption if it is small in size, which broadly means meeting two of the following three criteria: annual turnover of no more than £10.2m, gross assets of no more than £5.1m and no more than 50 employees. There are special rules for companies that are part of a group, in that the group must comply with size criteria as well as the individual company – a small company that is part of a large group will require an audit, and this includes taking overseas companies into account. There is an alternative for subsidiary companies though. Provided that audited consolidated accounts are prepared by an EEA based parent company, and that parent is willing to provide a guarantee to the company’s creditors, then audit exemption can be taken advantage of regardless of the size of the subsidiary undertaking.
We do appreciate though that a statutory audit can be limited in scope, ensuring that the accounts show a true and fair view and comply with legal requirements, and this does not always meet the assurance needs of our clients. This is why audit is only one of the assurance services we are able to provide, and once free of the need to comply with a statutory framework there can be considerable flexibility in developing an approach to assurance that meets an individual client’s needs.
‘Agreed upon procedures’ is fairly self-explanatory. The work to be performed is discussed and agreed in advance so as to arrive at a programme of procedures and tests that are clear and unambiguous. The accountant will provide detail of the factual findings arising from those procedures in the form of a report. A conclusion may not be provided, but value is derived from having an objective review by an expert. An agreed upon procedures engagement can be carried out for purely internal purposes, for example a review may solely focus on the stock valuation as this may be a highly material area upon which added assurance is sought, and procedures similar to those incorporated in an audit in respect of stock valuation and existence may be undertaken. Additionally, agreed upon procedures can also be used to provide comfort to a third party. For example, they are often used to assess compliance with the terms of grant funding or in support of covenant compliance in a lending agreement.
The assurance service relates specifically to the financial statements and is primarily designed for companies and other entities that are not required to have a statutory audit, but still wish to present accounts that have some form of independent assurance in order to provide the users of those accounts with added comfort that the accounts are reliable. The work that is performed goes beyond what is required to just prepare the accounts on behalf of management but will not be as detailed as an audit engagement. It will focus on inquiries of management and the use of analytical review techniques, with the possibility of additional tests being performed to address any identified concerns. A conclusion is presented in a report that accompanies the financial statements so that anyone that reads them can see that an independent review has taken place.
Internal audit on the other hand is usually not so public, and would involve reporting solely to the entity’s management, or if there is a separate audit committee. Again, the nature of work to be performed is one of agreement between the client and adviser, and generally would involve reviewing the operation and effectiveness of an area of the entity’s system of internal control. Internal audit can often go into much greater detail than statutory audit, which is of course focused mainly on material areas. For example, an error in petty cash is unlikely to be material and may not be an area of interest for an external auditor, but could be an area where errors are commonplace and an internal audit could be of real benefit.
Financial reporting update
It’s now time to look at a few changes to the reporting requirements to advise you of. There’s not been many changes, but those that have been brought in could be quite significant to some so they’re certainly worth a look.
We’ll start off by looking at the recent triennial review of FRS102 that has recently come into force, before moving on to see what has been happening internationally and how this might affect UK reporting in the future. We’ll round off this session with a look at some major changes to narrative reporting that larger businesses are going to have to address.
FRS102 is the single accounting standard followed by the majority of UK businesses. It became mandatory for accounting periods commencing on or after 1 January 2015, although there was an optional delay until 2016 for small entities. Either way we’ve had a few years now to get used to the new standard, and on the whole it has been well received. There have been a few areas in the standard though that have caused a few problems.
The standard is due to be reconsidered and updated where required every three years. The first triennial review was completed in 2017 and was focused on the various problem areas that use of the standard had highlighted, and putting things right. It takes effect for accounting periods commencing on or after 1 January 2019, but early adoption is permitted. So, for the majority of businesses this means accounts for the year ended 31 December 2019 onwards, although there could be some earlier year ends affected for newly incorporated companies or LLPs, or where the year end has been changed and the accounting period shortened.
Given that the aim of the triennial review was to deal with problem areas, early adoption may well be an attractive proposition for you. Note that where early adoption is being taken advantage of your accounts will need to state this fact.
If you do choose to early adopt you are required to adopt all changes to the standard, you can’t cherry pick. There is one exception to this rule though in respect of small companies, which we will look at shortly.
Financial reporting update – Disclosure changes
As for the content of the revised FRS102 we’ll break this down into two segments, first looking at some disclosure changes that have been introduced.
FRS triennial review
Small entities continue to be able to adopt the reduced disclosure framework as set out in Section 1A of the Standard. As a reminder a small entity is broadly one that meets two of the following three size criteria – Turnover £10.2m, Gross assets £5.1m and no more than 50 employees. As the disclosure rules for small entities is set out in legislation, and this hasn’t changed, there are no significant changes to the disclosure rules for small entities to advise you of. In addition, they continue to be able to file so-called ‘filleted’ accounts with Companies House, that is with the directors’ report, profit and loss account, and related notes omitted.
There are some changes to the disclosure requirements for non-small entities to let you know about though.
When FRS102 was introduced it became necessary for the first time for accounts to include disclosure of the financial instruments held by the company. Broadly speaking a financial instrument is any contract that will be settled in cash, which is quite wide-ranging in scope. It will include bank overdrafts and loans, trade debtors and creditors, finance leases, accruals and non-group investments. This disclosure is usually made in a stand-alone note to the accounts, detailing all the financial instruments held. Many commentators thought that this disclosure was onerous, and the standard setters have agreed such that for many businesses this disclosure will no longer be required. The requirement has not disappeared entirely though, any entity that has financial instruments that are measured at fair value will still need to include relevant disclosures in their accounts. This will include any entities that hold listed investments for example, or have entered into any derivative arrangements, including foreign exchange forward contracts. Details of these more complex arrangements will still need to be disclosed, including details of how the fair values used have been arrived at. For many businesses though there will be one less note to include in the accounts.
Moving on, there has been a statutory requirement for companies to disclose details of the remuneration paid to directors. When FRS102 was first introduced it added to this requirement with the need to disclose compensation payable to an entity’s ‘key management’. As well as having a slight difference in way the numbers are calculated, FRS102 requires employer’s national insurance contributions to be included in the disclosure, the Standard also goes further than statute through its definition of who is included within the definition of ‘key management’ which the Standard makes clear includes ‘those persons having authority and responsibility for planning, directing and controlling the activities of the entity.’ Using this definition, the directors of a company will clearly always be considered to be key management, but it could extend to other key members of staff that have a management role in the organisation. The Standard now recognises that for many privately-owned businesses the key management will comprise solely of the company’s directors, and where this is the case there is no longer any requirement to disclose key management personnel compensation. Directors’ remuneration will still need to be disclosed of course, but that disclosure will not need to be repeated elsewhere in the notes to the accounts. There is no change to the disclosure rules for entities that have members of key management that are not directors, they will still be required to disclose the amount of compensation paid to key management separately from directors’ remuneration.
The disclosure relaxation for inventories, or stock as it is more generally known in the UK is quite straight-forward. There is no longer any requirement to disclose the amount of inventories recognised as an expense in the notes to the accounts. Given that not many businesses were making this disclosure anyway it won’t come as a big change.
So far we have looked at some reductions in the disclosure requirements. There is one significant new disclosure requirement though that will impact upon non-small entities, and this relates to the cash flow statement. In support of this primary statement there is now the need to include by way of a supporting note an analysis of the changes in the entity’s net debt from the beginning to the end of the reporting period. This is quite similar to a disclosure requirement that existed before the introduction of FRS102 that some of you may remember. This reconciliation will highlight the cash transactions that have impacted upon the entity’s net debt such as loan advances and capital repayments, but will also need to show any non-cash changes that have had an impact on the debt position, such as new finance leases entered into or the effect of foreign exchange fluctuations on non-sterling debt. This disclosure is not required for any entity that isn’t required to include a cash flow statement in its accounts, which for non-small entities will primarily be subsidiary undertakings that are taking advantage of the reduced disclosure rules that are available for groups.
Financial reporting update – Accounting changes
Leaving disclosure behind, there have been a few changes to accounting requirements as a result of the triennial review of FRS102. We’ll look at some of the most significant, as well as what might be the subject of a future change.
FRS triennial review
I mentioned earlier that there was one accounting change that could be adopted early without having to adopt all the changes introduced as a result of the triennial review of FRS102, and this is it.
It only relates to small entities as defined earlier, usually those with turnover less than £10.2m. Such entities are often financed by loans from the company’s directors and this relaxation to the accounting rules is aimed at them.
When FRS102 was introduced it provided guidance for the first time that the accounting for loans had to reflect the time value of money. For any loans that had a market rate of interest applied this wasn’t an issue, but it had major implications for loans that were interest free. Although we have had relatively low interest rates in the UK for many years now, the complete absence of interest being applied to a loan was not considered to be a market-rate loan. Given that it is not unusual for directors to lend money to their company on very favourable terms have been affected significantly by this change.
The accounting for non-market rate loans is actually quite complicated and involved discounting the loan using an appropriate interest rate. I won’t explain this any further now though, this is mainly because with a little bit of planning this ceased to be an issue for most entities that were affected. By treating the loans as repayable on demand these onerous accounting requirements simply went away, although it did often have an adverse impact on the presentation of the balance sheet. Prior to FRS102 being introduced it was common to present directors’ loans as long-term debt, boosting the company’s solvency position as reflected in its net current assets figure.
The Standard has now been revised and provides an option for small entities to record loans from directors at ‘transaction price’ without any discounting required. This includes long-term loans as well as those that are repayable on demand, so there is an opportunity here for some small entities to improve the look of their balance sheet. If considering this we would recommend that any loan agreement is clearly documented, to provide evidence of the repayment terms to support the treatment of directors’ loans as a long-term creditor.
This relaxation covers loans from directors and their close family members – this includes a director’s spouse/domestic partner, children and other dependants, as well as any other family member who may be expected to be influenced by the director in their dealings with the company. If they’ve been willing to advance funds free of any interest that’s a good sign that they have been subject to influence from the director and are included within the exemption. At least one person within the director’s family group must be a shareholder of the company though, this relaxation to the rules does not apply to directors that do not have any equity interest in the company and are only employees.
This accounting change will only apply to groups of companies. It is a common arrangement within groups that property is held in a separate company from that which undertakes the primary trading activity.
Before FRS102 was introduced such group property was exempt from the accounting requirements that apply to investment property, namely to recognise them in the balance sheet at their market value. Instead they were treated as regular fixed assets, at cost less depreciation. FRS102 changed this, recognising that for the company holding the property but not undertaking the trading activity it was in fact an investment, and should be treated in the same way as any other investment property. The property would be stated at its fair value, with any changes in that value recognised in the company’s profit and loss account. The accounting is particularly difficult when the group is required to prepare consolidated accounts, where the property will need to account for those consolidated group accounts as a ‘regular’ fixed asset at cost less depreciation, resulting in different approaches being required at group and entity level.
The Standard now recognises that approach can be unduly onerous and provides an option for companies at entity level. They can either continue to treat them as investment properties, or instead reclassify them as regular fixed assets and account for them under the cost model, at historic cost less depreciation and amortisation. Note that the revaluation model is not an option for the entity, if it wishes to show a stronger balance sheet by stating properties at market value, then treatment as an investment property is the only option for them.
For groups that have been affected they do now have the ability to have a common accounting approach at group and entity level if they wish. The decision to do so though is not an easy one as treatment at entity level as an investment property does have its advantages – firstly the ability to present a stronger balance sheet as just mentioned, but also the possibility of reporting higher profits as there is no need to provide for depreciation in respect of investment property. If you are affected by this it’s probably worth sitting down with your adviser to discuss the best way forward.
Whilst on the subject of investment property, there has been a more general change introduced by the triennial review of FRS102. The original version of FRS102 provided an exemption from recognising investment property at its fair value if that value could not be measured reliably without undue cost or effort. It was believed that this exemption was being abused with it being used as an excuse to not value investment property. This exemption has now been removed, providing clarity that it is expected that all investment property will be stated at its fair value.
The last major accounting change that has been implemented by the triennial review of FRS102 will again be one that relates primarily to groups, although it may possibly also affect the entity accounts of individual companies.
When FRS102 was introduced it significantly changed the accounting for intangible assets that arise on business combination. This includes both how the acquisition of a company is reflected in group accounts, but also how an individual company accounts for an ‘asset purchase’ when it acquires the trading assets of a business, rather than an entire company. Provided it could be measured reliably separate recognition was required for any intangible asset where it was probable that the expected future economic benefits that are attributable to the asset will flow to the entity. This resulted in intangible assets such as brands, customer lists and know-how being recognised for the first time in UK accounting.
It is now appreciated that obtaining a reliable valuation for such intangible assets can be a costly process that can actually have little real benefit to a company’s accounting. Thus the rules have been changed such that separate recognition will only be required for intangible assets that arise from contractual or other legal rights, and are considered to be separable, that is capable of being separated or divided from the entity and disposed of without significantly impacting on the trading activity of the company.
For all other intangible assets separate recognition is now optional, which should make accounting for business
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