Caroline Biebuyck 8 Feb 2017 10:00am

FRS 102: Treading carefully

Small and micro companies need to beware of a number of pitfalls under new accounting regimes, as Caroline Biebuyck finds out

Caption: Illustration: Maria Corte

Change time is here for small business accounting. The FRSSE is history.

Companies at the smaller end of the scale will this year be producing and filing their accounts under new GAAP, with small companies able to use section 1A of FRS 102 and micro entities FRS 105.

An accounting transition is always tricky and this one is no exception. What is different this time is that companies and their accountants can learn from the experience of others, in this case small companies that chose to early-adopt new GAAP and that have already filed their first accounts under section 1A.

One issue relates to the new type of shorter form accounts that can be filed with Companies House. Under the old rules, small companies could choose to file abbreviated accounts – a popular choice with smaller businesses, which preferred not to put more onto public record than they needed. Under the new company regulations, small companies can now choose to file filleted accounts. These do not need to include a profit and loss account or directors’ report, but have to include a note to the balance sheet stating what has been omitted.

A problem arose with some early adopters who were able to file filleted accounts but still had to have an audit. “The Companies Act says that if you’re not submitting a profit and loss account, you don’t have to submit an audit report,” says Matt Howells, head of the national assurance technical group at Smith & Williamson. “The problem is that the Companies House system seems to be set up to ask: Is the company audit exempt? If not, and there is no audit report, then the accounts are being rejected.”

Surely this won’t be a problem for accounts with a year end in 2016 when the new audit exemption thresholds take effect? Not so, says Howells. “This will still be an issue if a company voluntarily chooses to have an audit. Quite a few of our smaller company clients do. After all, ‘small’ for GAAP purposes means turnover of less than £10.2m, which is pretty substantial.”

The new regulations also introduce abridged accounts, under which small companies have the option to file an abridged balance sheet, abridged profit and loss account, or both. Marianne Mau, technical manager at ICAEW’s Financial Reporting Faculty, thinks there is a lot of confusion around the terms and various statements allowed under the new rules. “The new standards and regulations have to be adopted at the same time. I don’t think it’s clear to everyone how they all slot together,” she says.

Companies that fall below the micro entity thresholds can decide whether to follow the minimal FRS 105 or to step up their game and apply FRS 102, making use of the reduced disclosure requirements of section 1A.

The simplicity of FRS 105 is certainly seductive: a plainer balance sheet and profit and loss account, no need for a director’s report, no fair value accounting and no deferred tax. And at first glance, that simplicity does not seem to come at a cost, since the Companies Act specifies that accounts that comply with FRS 105 are deemed to show a true and fair view.

However, Paul Creasey, director at Wilkins Kennedy, thinks that the market does not yet understand accounts prepared under FRS 105. “I heard of a consultant who filed micro entity accounts with Companies House and then applied to get a lease on a new vehicle. The leasing company bounced the application because they couldn’t make head nor tail of his accounts.”

Meanwhile accounts prepared under section 1A of FRS 102 are not deemed to show a true and fair view simply because they include the bare minimum legal disclosure.

This represents a big change for small companies, says Tessa Park, technical partner at Kingston Smith. “The FRSSE had its own set of disclosure requirements, more extensive than section 1A and all mandated. Section 1A sets out the legal minimum of 13 notes and then other disclosures that are encouraged. Assessing whether the accounts do show a true and fair view becomes a massive judgement call, and one which needs to be thought about on a company-by-company basis.”

The fact there are fewer rules and more judgement in FRS 102 is leaving many uncomfortable, says Mau. “This can make the transition from FRSSE difficult. Also transition to FRS 105 – even though this is a much simpler standard, it’s still a version of FRS 102, not a version of the FRSSE. Companies and their accountants have to be careful: there are significant changes they need to think about on transition.”

Transition is one of the main problem areas that HMRC has informally identified from its preliminary review of small company accounts prepared under new GAAP. For example, adjustments to accounting policy, changes in estimates and prior period adjustments of errors have been wrongly bundled together as transitional adjustments.

“Small companies are not required to disclose a reconciliation on the transition from the FRSSE to FRS 102,” Park says. “However, this could be important if there are material differences.”

There are several problem areas with practical implementation of FRS 102, with one of the most widespread being loans from directors. Many smaller businesses are owner managed and it is not uncommon for one of the owners to loan money to tide the business over. FRS 102 says these loans must be discounted using a market rate of interest.

Howells saw an example of this recently. “The shareholder had lent the businesses funds it needed. His view was that if he had gone to the market for funds, most banks would have turned him away. In this case, how do you reasonably estimate what the market rate of interest is? Say we use 50%, because this is a risky-looking proposition, and put that imputed interest charge in the profit and loss account. This doesn’t reflect the reality of the situation as it’s based on a guesstimate. Plus the shareholder would ask: ‘What’s this telling me? I made the loan and I know I’m charging 0% interest’.”

The new treatment of share-based payments is causing confusion. Under the FRSSE, small companies had to disclose share-based payment arrangements in the notes to the accounts but did not have to expense them. That situation is now reversed. “Under FRS 102 section 1A small companies have to measure and recognise these arrangements as a charge in the profit and loss account, although disclosures aren’t mandatory,” says Park. “If the charge is material then this is certainly an area where you may need to think about whether disclosure is needed.”

Fair valuation is integral to FRS 102 [see p.78]. For example, investment properties now need to be included at market value. So do non-basic financial instruments – and this area can be a minefield. The temptation is to assume smaller companies will only be involved in basic financial instruments. But this is not always the case. Sometimes a financial contract that looks simple can include complex conditions.

Howells points out that a number of otherwise basic loan agreements have featured new terms in the wake of the LIBOR scandal. “Some lenders are including terms saying that if LIBOR ceases to be an effective measure of a market rate, the bank has the discretion to use an alternative measure for the interest rate. That gives the bank the unilateral right, in certain circumstances, to change the base rate. For a financial instrument to be basic, the interest rate has to be determinable. Is it in this case here? Different people have different views on this. But this level of complexity is mind-blowing for a small business.”

This sums up the real problem. Larger companies with time and resources had a couple of years to introduce FRS 102. Applying this standard in the small company arena where there are fewer resources and fewer skilled people on the client side is taking longer and proving to be a real challenge, says Creasey.

“Many things that need to be done, such as valuing financial instruments or intangibles, don’t necessarily scale down for smaller companies. There has been a very short window in bringing in section 1A – it’s been more of a rush than we had when adopting FRS 102 for larger companies. I think that the real test is yet to come.”