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ORP30 - Financial reporting standard for smaller entities - a fundamental or cosmetic change?
John and Healeas 2000
Executive summary
Introduction
Since the introduction of accounting standards in the UK in 1971, there have been very few concessions for small businesses. On the contrary, since the formation of the Accounting Standards Board in 1990, the standards that have been issued have become longer and more complex. There has been an increasing feeling in the small firms sector that these complex standards could not, and should not, apply to them.
The financial reporting framework for small companiesUntil the incorporation of the provisions of the Fourth EC Company Law Directive into the 1981 Companies Act, the only concession to smaller companies in their financial reporting resulted from the ‘public/private’ divide, which dated back to 1907. Since the end of the Second World War, the regulatory framework for company reporting has been dominated by the requirements for large, rather than small companies. The law, up to and including the Companies Act 1985, has been framed on the basis that the ‘principals’ (the shareholders) should be protected from flagrant abuses of power by the ‘agents’ (the directors). Some advantage was taken of the concessions granted in the EC Fourth Directive, i.e. that ‘abbreviated’ accounts could be filed with the Registrar of Companies and that, if the shareholders agreed, they could be provided with ‘modified’ accounts. However, the initial publication of the Financial Reporting Standards for Smaller Entities (‘FRSSE’) in 1997 and the recently-completed consultation on company law reform show a sudden acceleration in the move towards the establishment of separate ‘big’ and ‘little’ GAAPs (Generally Accepted Accounting Principles).
Research methodologyThere are two strands to the methodology used in the study: a literature-based ‘tour d’horizon’, drawing together various perspectives in the financial reporting literature; and ten semi-structured interviews with representatives of key constituencies within the financial reporting arena (large and small audit firms, the Accounting Standards Board, the Trades Union Congress, Chambers of Commerce, a charitable trust and a small practitioner and author on small company financial reporting).
Key findings
• The notion that FRSSE will simplify ‘big GAAP’ requirements and still be consistent with company law
Although FRSSE does allow smaller entities to be exempted from complying with some SSAPs and FRSs (especially the later, more complex ones), compliance with a large number of them is still required. The intention of the working groups developing ‘little GAAP’ was that the proposals made should be consistent with the accounting principles and practice already laid down in the Companies Act. This would harmonise the FRSSE and Companies Act requirements. The implication here is that, within a reasonable time-scale, the sources of ‘little GAAP’ might consist of general principles or ‘ground rules’ to be found in the Companies Act, together with more specific regulations or practice which would be found in accounting standards dealing with topics (e.g. depreciation) that apply to the generality of companies, including small ones.
• Crossing the threshold to medium-sized
This issue was cited as a possible reason for lack of adoption of FRSSE by some small entities. One view suggested that, as many small companies were likely to cross the threshold to ‘big GAAP’ in the foreseeable future, they might as well get into the practice of ‘proper financial reporting’ sooner rather than later. However, it seemed likely that small companies that expected to stay small were more likely to adopt FRSSE.
• The right definition for small companies?
A significant number of those interviewed raised the issue of finding the most suitable definition for ‘small’ that would allow entities to be exempt from the full rigour of ‘big GAAP’. One opinion expressed was that the definition should be qualitative, rather than quantitative, i.e. the fact that the business is owner-managed.
• Impact on tax calculations and payments
There was some evidence to support the contention that the tax authorities are relying more on statutory accounts for tax purposes. Clearly, liability for tax is a major consideration for all small businesses. It would be unfortunate if the ‘technically correct’ accounting practice required in the FRSSE had the perverse effect of having a major impact on the tax liabilities of small businesses.
• Impact of FRSSE on costs of the small business
The impact was felt to be neutral. Although the intention behind the FRSSE was probably to make rules simpler, and the process of accounts preparation less time-consuming, this objective has not yet been achieved, largely as a result of the Companies Act requirement to prepare full accounts for the shareholders even when abbreviated accounts are filed with the registrar.
• Disclosure changes vs measurement changes
Many interviewees stressed the importance of consistency being practised in measurement rules, regardless of entity size. The main effect of FRSSE so far is to exempt small businesses from many of the disclosures required by ‘full GAAP’. Since these items do not occur in most small businesses, however, no real benefit is gained by them. This seems to support the contention that, so far, the change brought about by FRSSE is cosmetic, rather than fundamental.
• Accounting awareness and understanding on the part of the owner-managers
As implied by the notion of ‘insiders’ and ‘outsiders’ mentioned earlier, very few of the owner-managers have a proper understanding of the contents of statutory accounts. They tend to rely heavily on their accountant to explain what they mean. They often take the view that the statutory accounts are of no practical use for decision making and prefer to use management accounts and a cash flow forecast.
• Who are the published accounts of small companies for? What form should they take?
Most interviewees mentioned this issue. Concepts of stewardship, accountability, wider stakeholder interests were implicitly or explicitly referred to. The question was often raised of why an owner-manager, who might be the only significant shareholder, needs to produce a set of accounts in standard format. Accounting standards exist to allow ‘other people’ to understand the business. For the owner, ‘key management accounting information’ would be more important. The point that emerged here was that statutory accounts are not useful for decision making.
• Commitment to the ‘true and fair view’ for small company reports
There was strong support for the retention of the ‘true and fair view’ in small company accounts. The statutory accounts do give ‘comfort’ to a wide range of stakeholders having dealings with the company.
• Does FRSSE now constitute ‘little GAAP’?
Adoption is voluntary. Clearly, to what extent FRSSE in reality constitutes ‘little GAAP’ depends on the rate of take-up. No work has yet been undertaken to ascertain the rate of take-up.
• The motivations of the ASB
One interviewee took the view that a possible motivation of the ASB in taking the FRSSE initiative was to ‘redress the balance’ after having required small companies to comply with a large number of complex standards on issues that did not really affect them. Another felt that the composition of working parties developing ‘little GAAP’ tended to be biased in favour of large businesses, because those running small businesses had no spare time to devote to such activities.
• FRSSE as the ‘first step on the road’ to differential reporting
Interviewees tended to support the basic idea behind FRSSE, i.e. that it was a ‘step on the road’ to a lighter regulatory regime for small companies, which needed to be taken, but that the touch was still heavy rather than light. So far, the effect is cosmetic only, but it was fundamental that this ‘first step’ should be made.
Conclusions
There seemed to be general agreement among those interviewed that FRSSE’s achievement of reducing over 700 pages of regulations to 76, which apply explicitly to smaller entities, was a welcome development. However, smaller companies should not be regarded as scaled-down versions of large ones. Compliance costs would not be reduced as a result of FRSSE.
There seemed to be wide acceptance that companies that raised capital from the public had a strong duty of accountability towards these ‘external’ shareholders. They are ‘public interest’ companies and have a duty to report to a wide range of stakeholders.
It was not generally accepted that small businesses, where the owners tend to be the managers, had a similar duty. Stakeholders such as banks, the Inland Revenue and the Customs and Excise already have access to inside information. The information requirements of stakeholders in large and small businesses differ greatly. FRSSE can go further in simplifying corporate reporting.
The way forward?
There was general agreement that the changes brought about by FRSSE so far are cosmetic, rather than fundamental. However, they are ‘the first step on the road’. The advent of FRSSE does formally recognise that small businesses should be subject to a simplified reporting regime. With the current consultation on company law complete, there is now an ideal opportunity to change the agenda for small company reporting.