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This page intentionally left blank Accounting Principles for Non-Executive Directors Good quality non-executive directors are essential to good corporate governance. They bring a wealth of experience to the boardroom, and together with their fellow board members they are responsible for the company’s annual report and accounts. However, few are trained accountants. This volume explains the key elements of a listed company’s annual report and accounts. Part I explains the difference between profit and cash flows, the accounting profession, the international harmonisation of accounting rules, the origins of the rules governing the preparation of accounts, the regulation of financial reporting and the overarching principles behind accounting rules. Part II discusses issues relevant to listed companies: mergers and acquisitions; earnings per share; realised and distributable profits; financial instruments; and other key topics. An appendix sets out 50 questions, linked to the chapters, which nonexecutive directors might like to ask at meetings of the board and audit committee. peter holgate is senior accounting technical partner with PricewaterhouseCoopers LLP. As such, he heads the largest accounting consulting team in the UK. A member of the ASB’s Urgent Issues Task Force, he is also chairman of the Institute of Chartered Accountants in England and Wales’ Centre for Business Performance management board and a member of the advisory board of the ICAEW’s Financial Reporting Faculty. elizabeth buckley is a consultant to PricewaterhouseCoopers LLP. She has worked in the accounting technical departments of two of the ‘Big 4’ accounting firms, and at the ICAEW. She is a member of the Institute of Chartered Accountants of Scotland and of the joint Institutes’ working party on distributable profits. Law Practitioner Series The Law Practitioner Series offers practical guidance in corporate and commercial law for the practitioner. It offers high-quality comment and analysis rather than simply restating the legislation, providing a critical framework as well as exploring the fundamental concepts which shape the law. Books in the series cover carefully chosen subjects of direct relevance and use to the practitioner. The series will appeal to experienced specialists in each field, but is also accessible to more junior practitioners looking to develop their understanding of particular fields of practice. The Consultant Editors and Editorial Board have outstanding expertise in the UK corporate and commercial arena, ensuring academic rigour with a practical approach. Consultant editors Charles Allen-Jones, retired senior partner of Linklaters Mr Justice David Richards, Judge of the High Court of Justice, Chancery Division Editors Chris Ashworth – Lovells LLP Professor Eilis Ferran – University of Cambridge Timothy Polglase – Allen & Overy Stephen Hancock – Herbert Smith Judith Hanratty – BP Corporate Lawyer, retired Keith Hyman – Clifford Chance Keith Johnston – Addleshaw Goddard Vanessa Knapp – Freshfields Bruckhaus Deringer Charles Mayo – Simmons & Simmons Andrew Peck – Linklaters Richard Snowden QC – Erskine Chambers William Underhill – Slaughter & May Sandra Walker – Rio Tinto For a complete list of titles in the series see back of book Accounting Principles for Non-Executive Directors PETER HOLGATE AND ELIZABETH BUCKLEY PricewaterhouseCoopers LLP CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521509787 © Cambridge University Press 2009 This publication is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published in print format 2009 ISBN-13 978-0-511-51778-5 eBook (NetLibrary) ISBN-13 978-0-521-50978-7 hardback Cambridge University Press has no responsibility for the persistence or accuracy of urls for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Contents Acknowledgements x Which standards and legislation has this book been based on? xi Glossary of terms xii Part I: The accounting environment 1. Introduction Aim of this book What is accounting? The components of a company’s annual report The difference between profit and cash flow Performance statements The use of accounting terms in agreements What is GAAP? 2. Accounting in the UK and the effects of international harmonisation The UK’s Accounting Standards Board International harmonisation The International Accounting Standards Board The EU Regulation for harmonisation within Europe Convergence with US GAAP Implications for the UK In a nutshell where are we now? 3. The legal framework for accounting Introduction: the Companies Act 1985 and the Companies Act 2006 The Companies Act 2006: accounts and reports Application of the Companies Act to IFRS and UK GAAP companies Accounting provisions of the Act applying to IFRS and UK GAAP companies Accounting provisions of SI 2008/410 applying to UK GAAP companies only 3 3 3 5 7 9 12 12 15 15 17 18 20 22 23 25 26 26 27 28 28 32 v Contents 4. The accountancy profession and the regulatory framework for accounting and auditing The accountancy profession The Financial Reporting Council The Financial Reporting Review Panel Audit reporting The role of accountants in capital markets transactions 5. Substance over form Form v. substance Early examples Emergence of the off-balance-sheet industry in the UK FRS 5 ‘Reporting the substance of transactions’ Examples of FRS 5 in practice in the UK The future of FRS 5 in UK GAAP Does substance over form have a place in IFRS? 6. Communicating accounting information Background Summary financial statements The corporate reporting supply chain The reality of the ‘earnings game’ Alternative performance measures Users and analysis of accounting information 35 35 36 39 40 42 44 44 44 45 45 47 50 50 52 52 53 54 55 57 58 7. Current trends in accounting 60 Why all the change? Current trends in thinking 60 62 Part II: Some specifics 8. Individual entity and consolidated financial statements The distinction between individual entity financial statements and consolidated financial statements When to consolidate What to consolidate Exemption re holding company income statement Techniques of consolidation Associates and joint ventures 9. Presentation of financial statements Introduction Statement of comprehensive income Balance sheet vi 69 69 71 72 74 75 77 80 80 81 88 Contents Cash flow statement Accounting policies Notes Individual entity and consolidated financial statements: combined or separate 90 91 93 93 10. Earnings per share 95 Introduction Summary Basic EPS Diluted EPS Adjusted EPS 95 95 96 97 98 11. Mergers and acquisitions Introduction Overview of acquisition and merger accounting Application of IFRS 3 Goodwill and other intangibles UK accounting in overview Share premium, merger relief and group reconstruction relief 12. Interaction of accounting with tax Introduction Accounting profit and its adjustment Accounting for current and deferred tax HM Revenue & Customs and the move to IFRS 13. Assets Introduction Definition of an asset Recognition of assets Measurement of assets Impairment of assets Classification and presentation of assets Depreciation Disclosure 14. Liabilities Introduction Definition of a liability Recognition of liabilities Measurement of liabilities Presentation of liabilities on balance sheets Disclosure, including contingent liabilities 100 100 101 104 108 110 112 115 115 115 117 121 124 124 124 124 125 125 126 127 129 130 130 130 131 133 133 134 vii Contents 15. Leases Introduction Leases under IFRS Leases under UK GAAP The way forward 16. Pensions Introduction Defined contribution and defined benefit schemes Accounting for defined benefit schemes IAS 19 Differences between IFRS and UK GAAP The effect of pensions on realised and distributable profits 17. Financial instruments Introduction Background Definitions Debt and equity Categories of financial instrument Amortised cost Fair value Derivatives and embedded derivatives Hedge accounting Recognition and de-recognition Other matters Disclosures Accounting under UK GAAP 18. Share-based payment Introduction Accounting under IFRS Trusts Accounting for share-based payment under UK GAAP 19. Realised and distributable profits Introduction ‘Realised’ and ‘distributable’ General rules on distributions Relevant accounts Relationship with reporting of performance TECH 01/08 Effects of TECH 01/08 viii 137 137 138 145 147 148 148 148 149 150 153 154 156 156 156 157 158 161 164 165 166 167 168 168 169 169 171 171 172 177 178 179 179 179 180 181 183 184 188