Accounting comment: IFRS

As of 1 January 2005, listed companies in Europe will report their financial performance using international accounting standards. But what of the unlisted companies? Richard Martin writes on the IASB's project on SME reporting while Robin Jarvis considers the needs of small companies

IFRS harmonisation - a long and winding road?

Harmonisation of national accounting systems in Europe with International Financial Reporting Standards (IFRS), though widely seen as inevitable, seems further off than before. The road to adoption of IFRS by listed companies by 2005 is proving more problematic than expected. All the more difficult will be harmonised accounting for the six million or so SMEs and other privately-held companies in Europe. This seemed to be the overall picture at a recent ACCA conference, Beyond 2005: Financial Reporting by EU Private Companies.

National authorities have two big issues to resolve before further harmonisation of national standards with IFRS is possible. First, national accounting systems applied to individual company accounts are the basis for taxation. Good reasons why tax and accounting should be decoupled include:

• tax consequences sometimes make companies reluctant to account for items in accordance with their substance, and
• tax authorities would not want their revenue to be affected by changes in accounting rules.

Decoupling is being addressed, but no immediate implementation seems likely. Alternatively, tax may be so important a use for private company reporting that its needs should predominate over IFRS style reporting aimed at the needs of investors.

Secondly, individual accounts determine profits available for dividend distribution. IFRS accounting treatments are not driven by the concept of realised profits as a limitation on the recognition of profits. The EU Commission accept decoupling in this area realistically as a longer term prospect, though they may be able to offer some shorter-term fixes.

The other major factor at work is IASB's own project on SME reporting. The bulk of accounts using the national accounting systems are SMEs. IFRSs are being developed with listed companies in mind and so become much longer and more complex as a result. Harmonisation of national systems with IFRS would be helped if there were some adaptation of IFRS to make them more relevant to SMEs. Comparability across the EU's single market would be helped if this adaptation were done by IASB rather than separately by each of the 25 national authorities in the EU.

There is a distinct sense that the IASB's SME project, whilst apparently developing quickly, has not resolved a number of fundamental issues. Robin Jarvis in the adjoining article highlights problems of defining SMEs in the first place. The chosen definition of SMEs then leads to whether the existing IFRS conceptual framework should apply to any SME standards, given particularly its emphasis on investors as the key users and their need for information to help predict future cash flows.

A different framework might lead to different solutions to accounting issues in terms of recognition and measurement of profits or balance sheet items, as well as in terms of disclosures in notes to the financial statements. At present, the IASB appears to have ruled out a reconsideration of the framework and assumed that any SME standards will reduce disclosures but make no recognition or measurement changes from full IFRS. This seems both prejudging the SME standards and ensuring they will fail to deliver what is needed. Allowing the possibility of recognition and measurement differences appears to be the defining issue. For some, this undermines the idea of a true and fair presentation. How can the size of an entity make a difference to how it reports an item? For others, without it, there is too little to be gained from the whole exercise - if perhaps deferred tax accounting, impairments based on risk adjusted discount rates and the like are going to be required nonetheless.

Add to these unresolved issues - known splits among the IASB members and staff on whether this project should be pursued at all (or left to others) - and there must be considerable doubts about whether the IASB project on SME reporting will bear fruit.

Whilst the idea of harmonisation of the national accounting systems with the IFRS that will be used by listed companies remains an objective, this seems likely to evolve over the longer rather than the nearer term. Tax and dividends are known problems. Without the expected SME guidance from IASB the increasing complexity and length of full IFRS risks putting off the harmonisation process almost indefinitely.

Richard Martin is ACCA's head of financial reporting.

Accounting standards for SMEs

The requirement for listed companies to adopt IFRSs is receiving more and more press coverage as 2005 draws near. Little, however, has been written about what financial reporting options are likely to be available to unlisted companies and particularly small companies. This is surprising as 99.2% of companies in the UK are unlisted and of these, applying the current UK definition, 92% are categorised as 'small'.

The Department of Trade and Industry has said that UK unlisted companies will have a choice of using IFRS or UK generally accepted accounting principles (UK GAAP) from 2005. For small companies it is very unlikely that the majority will adopt the full IFRS or UK GAAP. Both are over-burdensome in their application and probably not relevant to the users of small company financial reports. At present, the evidence indicates that by far the majority of UK small companies are using the Financial Reporting Standard for Smaller Entities (FRSSE).

There is likely to be another reporting option for UK small companies which is a set of standards designed by the IASB specifically for small entities based on IFRS. This may be an attractive option as these standards will be consistent with standards for small entities in other countries (assuming these standards are adopted globally). They are likely to be more credible because of the status of IFRS and for smaller entities who wish to eventually become listed, this will be a first step on to the full IFRS ladder.

One of the major issues in developing these standards which has been hotly debated in the IASB is the definition of a small entity. This perhaps is not surprising as, way back in 1970, the influential UK Government commissioned Committee of Inquiry on Small Firms, better known as the Bolton Report, which also grappled with the problem of definitions. The Committee had a preference for a qualitative definition. The financial regulators in the UK, in contrast following the EU lead, have adopted quantitative definitions in terms of the size of turnover, net asset values and number of employees. These quantitative measures adopted appear to be arbitrarily based on no or little research nor rationale.

The IASB, in setting international standards for small entities, has sensibly decided to adopt a qualitative definition, primarily because monetary values, from an international perspective, do not satisfactorily capture the size of an entity in an economic sense. For example, a small entity in, say, Uganda, defined by turnover, is likely to be very different in nature from a small equivalent sized company in the UK. The IASB has then said that because of this problem it will leave it up to each country's national regulators to define which entities will be allowed to apply the standard. Nonetheless, there is still a debate within the IASB about which qualitative definition they should adopt. The definition adopted should be based on users of financial reports and their needs. The prime objective of financial reporting is to satisfy this group. In the case of IFRS they have been designed in the main to meet the needs of users in the capital markets.

Following its decision to adopt a qualitative definition, the IASB has recently decided to develop standards for small and medium size entities that are not publicly accountable. Its argument is that all entities, whether listed or unlisted, that are publicly accountable, should adopt the full IFRS. It has also defined what it means by 'publicly accountable'. Inevitably, the concept of 'public accountability' has caused some debate. It is questionable whether the criteria of public accountability, vis á vis non publicly accountable, captures the needs of users. For example, those unlisted companies which may be small, who meet the publicly accountable definition, will have to adopt IFRSs, which are designed for users in the capital markets. For these companies, therefore, there must be an assumption that their user needs are similar to those of the capital markets which, of course, is highly unlikely. The term 'non-publicly accountable' arguably also indicates that they are someway less important to the economy.

In the context of users and their needs driving the case for some degree of differentiation, the most appropriate position for the IASB to take would be to have different standards for listed and unlisted companies. All listed companies would, therefore, have to adopt IFRS and alternative standards should be developed by the IASB for unlisted companies which reflect the needs of these companies. If various regulators such as the FSA and others wish unlisted companies to adopt IFRS they should be allowed to do so.

Robin Jarvis is ACCA's head of small business and a member of the IASB's SME Advisory Panel.