Change in accounting standards and the implications for transactions involving “small” companies
The use of accounting standards is well established in the preparation of company annual accounts and completion accounts in transactions.
The use of accounting standards is well established in the preparation of company annual accounts and completion accounts in transactions. Accounting standards are authoritative statements of how particular types of transaction and other events should be reflected in financial statements.
"Accounting Standards" for the purposes of the Companies Act 2006 (CA 2006) and any Regulations made under CA 2006 are generally recognised as being:
- The Statements of Standard Accounting Practice (SSAPs);
- Financial Reporting Standards (FRS);
- Financial Reporting Standard for Smaller Entities (FRSSE);
- Urgent Issues Task Force (UITF); and
- Abstracts and FRC Abstracts issues by the FRC.
Subject to section 407 (Consistency of financial reporting within group), the CA 2006 allows companies (other than charities) to prepare their individual accounts in accordance with either UK Generally Accepted Accounting Practice (UK GAAP) or International Financial Reporting Standards (IFRS) as adopted by the EU (section 395). Charitable companies must use UK GAAP for their individual accounts.
There is no formal definition of UK GAAP in UK companies legislation, but in simple terms it denotes the body of practices forming the basis for determining what constitutes a true and fair view: that is, broadly, accounting standards and, where relevant, the accounting requirements of company law.
Changes for 'small' companies
For accounting periods beginning before 1 January 2016, companies that qualify as “small” under companies’ legislation may choose to observe the requirements of the Financial Reporting Standard for Smaller Entities (FRSSE) as an alternative to complying with all other UK accounting standards when preparing their Companies Act accounts.
The FRSSE is an accounting standard that was developed specifically for smaller entities by collecting together into one document, in simplified form, the requirements from other UK accounting standards and UITF Abstracts that are applicable to smaller entities.
FRSSE does not apply to large or medium-sized companies, public companies, banks, building societies or insurance companies, certain authorised persons under the Financial Services and Markets Act 2000, or companies preparing accounting in accordance with IFRS.
For accounting periods beginning on or after 1 January 2016, with early application permitted for accounting periods beginning on or after 1 January 2015, the FRSSE is withdrawn.
For accounting periods beginning on or after 1 January 2016, the following FRSs apply:
- FRS 100: Application of Financial Reporting Requirements, as amended
- FRS 101: Reduced Disclosure Framework, as amended
- FRS 102: The Financial Reporting Standard applicable in the UK and Republic of Ireland, as amended
- FRS 103: Insurance Contracts
- FRS 104: Interim Financial Reporting
- FRS 105: The Financial Reporting Standard applicable to the Micro-entities Regime
- Section 1A (Small Entities) in FRS 102. This replaces FRSSE which is now withdrawn.
From a transactional perspective (as illustrated in the case study below), issues can arise due to the different accounting standards (and differing policies) that apply to Buyer, Seller and Target. Determining which accounting standards will apply to the relevant financial records that underpin the transaction (whether the Accounts, Locked Box Accounts or Completion Accounts) is likely to become an issue of increasing importance and should be addressed at the outset (preferably in the Heads of Terms).
Implications for transactions involving Completion Accounts: case study
Target was sold to Buyer for a purchase price equivalent to the Net Asset Value of Target. Net Asset Value was to be calculated using Completion Accounts. The Heads of Terms made it clear that Target was being purchased as a going concern and Buyer intended to continue to trade Target post completion.
Target qualified as a smaller entity and prepared its annual accounts in accordance with FRSSE. Buyer prepared its group accounts using FRS102.
On completion, Buyer was required to apply FRS102 to the accounts of Target. As a consequence, Buyer had to provide in full for a deferred tax liability on the carrying value of the revalued assets. Buyer claimed that this deferred tax liability should be recognised in the Completion Accounts. Buyer argued that the offer was such that the Net Asset Value of Target would be paid for the sale shares and that a failure to recognise the deferred tax liability in the Completion Accounts would effectively result in a payment for goodwill equivalent to the value of the deferred tax. Net Asset Value calculated under FRSSE would be greater than the Net Asset Value calculated under FRS102.
Seller was ultimately able to reject Buyer’s argument on the basis that the Heads of Terms made it clear that the Net Asset Value was to be calculated and the Completion Accounts prepared on the basis adopted by the Target’s last annual accounts and that Target was being sold as a going concern. The effect of Buyer’s argument would be to ask Seller to pay the deferred tax on a future disposal of the assets of Target by accounting for a deferred tax liability. Seller would be paying the tax on the increase in value of Target’s assets even though such assets were still owned by Target and any profits of any future disposal would be for the Buyer’s benefit.
With the change of accounting standards, examples such as this are likely to become more commonplace and an issue in a number of corporate transactions. It is important to establish clearly the bases on which Completion Accounts are prepared and how Net Asset Value is calculated. The mandatory change in accounting standards will be beyond Buyer’s control but, unless the position is clear, could have a punitive effect on the price achieved by Seller. Similarly, where Buyer is part of larger group it will need to be clear as to the accounting treatment of the purchase price once the new accounting standards are applied to Target.
If you are interested in finding out more about this or any other corporate or commercial issue, please contact Roland Hutchins, a partner in the Corporate department, on 0151 243 9539 or email firstname.lastname@example.org.