Corporate Financial Reporting I Lecture 2 The UK Regulatory Framework

Aims and Outcomes Aims: This lecture aims to outline the regulatory framework for financial reporting that has developed in the UK. Learning outcomes After the lecture and recommended reading students should be able to: Discuss generally various ways that financial reporting may be regulated Outline the development of statutory regulation in the UK, give an overview of the current Companies Act ands outline possible future developments Explain the nature of the true and fair override in company law and state the accounting principles given therein Discuss the development of accounting standard setting in the UK Discuss the relationship between law and accounting standards in the UK

Remember from last weeks lecture and your reading: Financial reporting is part of the accountability element of the UK system of corporate governance There are arguments that certain features of this system indicate the need for its regulation (there are also arguments against this)

How might we regulate financial reporting? Puxty et al (1987) – theoretical framework Three “ideal” ways company reporting can be regulated Market Each company chooses own rules pressured by capital markets State Decrees the rules and provides enforcement mechanism Community Spontaneous solidarity Within this exists a continuum Liberalism – Associationism – Corporatism – Legalism Associationism – regulation through organisations formed to represent its members UK = associationist

Further dimensions to the model Also consider there may be two further aspects to the analysis: The creation and approval of rules Their enforcement The most important types of regulation with respect to the UK are the law and accounting standards (and the stock exchange for listed companies). Regulation covers: Disclosure Valuation/measurement Presentation Audit and Publication

Company Law – The development 1844 - Joint Stock Companies Act : Incorporation by Registration, audited balance sheet required 1855 - J.S.C.A.: Creation of Limited Liability 1856 - J.S.C.A.: Consolidation of 1844 and 1855 Acts, model accounting procedures made optional 1900 - Companies Act: Compulsory audit of balance sheet required 1929 - Companies Act: Profit statement required (unaudited), disclosure of balance sheet items required 1948 - Companies Act: Balance sheet and profit and loss to be true and fair, minimum disclosure levels introduced, audit requirements established, group (consolidated) accounts required 1980 - Companies Act: EC Second Directive – public/private company definitions 1981 - Companies Act: EC Fourth Directive – formats, true and fair override, principles, measurement and valuation rules, extended disclosure, modified accounts for small and medium businesses 1985 - Companies Act: Consolidating Statute 1989 - Companies Act: EC Seventh and Eighth Directives – role of accounting standards, rules for consolidated accounts, regulation of auditors

The growth of legalism The early years of statutory regulation reflected more a ‘market’ approach to regulation Even as late as 1980 company law was limited to ensuring minimum disclosures levels of accounting information The result of this limited legislation was to allow a high degree of flexibility to UK financial reporting The significant change since the 1980s represents implementation of EU harmonisation requirements with respect to financial reporting This introduced more detailed rules into UK law and significantly reduced the flexibility that had been characteristic of UK regulation.

The current framework The current framework for financial reporting involves an overriding true and fair requirement, the adoption of a number of accounting principles and the following of a number of detailed accounting rules True and fair override (s. 226) Directors are required to prepare a profit and loss account and balance sheet in respect of each financial year that give a true and fair view and complies with Schedule 4 Where compliance with the Act does not give a true and fair view Directors may provide further information or may depart from the Act Accounting principles (Schedule 4) Going concern Consistency Prudence (including realisation and the recognition of post-balance sheet events) Accruals (matching) Separability

The scope of company law accounting provisions Keeping of accounting records Publication Formats (Schedule 4) A true and fair view (s. 226) Accounting principles (Schedule 4) Accounting rules (Schedule 4) Disclosure requirements (Schedule 4) Distributions (s. 263 and s. 264) Consolidated accounts Small and medium sized companies Audit (s. 384-394A) Role of accounting standards (s. 256 and Schedule 4)

Accounting Standard setting in the UK – a brief history 1942: ‘Recommendations’ of the ICAEW 1960s: Scandals/catastrophes e.g. GEC/AEI and Pergamon/Leasco 1970: Accounting Standards Steering Committee established by ICAEW (renamed ASC in 1976) as a Committee of the Consultative Committee of the Accounting Bodies (CCAB). Issued Statements of Standard Accounting Practice (SSAPs) Given the legislative context at the time the UK regulatory framework could be described as ‘associationist’

Problems of authority, independence and coherence 1988: Dearing Report 1989: Solomons Report 1990: Accounting Standards Board (ASB), which issues Financial Reporting Standards (FRSs) Financial Reporting Review Panel (FRRP) and Urgent Issues Task Force (UITF) Established under the remit of the Financial Reporting Council (FRC) “Foreword” to Accounting Standards (1993): discusses authority, scope, compliance and the true and fair view with respect to the ASB

The relationship between the law and accounting standards - Authority/enforcement True and fair requirements and its override The auditor’s report shall state whether the accounts have been prepared in accordance with the Act and, in particular, whether a true and fair view has been given in accordance with the relevant financial reporting framework (s. 235) Accounts must also state whether they have been prepared in accordance with applicable accounting standards with particulars of any material departures (Schedule 4, s. 36A) Accounting standards are recognised as those statements issued by bodies prescribed by regulation. There is provision for the establishment of such a body as well as provision for the revision of ‘defective accounts’ (s. 245 and s. 256)

The relationship between the law and accounting standards - Authority/enforcement The law does not give statutory backing to accounting standards However, the ASB is a recognised body for the issuance of accounting standards that are to be complied with under the provisions of the Companies Act. FRSs issued and SSAPs adopted by the ASB are ‘accounting standards’ for the purposes of the Act The councils of the CCAB bodies expect their members, whether in their role as Directors or auditors, to observe accounting standards Compliance with accounting standards will normally be necessary to give a true and fair view (see Arden, 1993) Only in exceptional circumstances will departure from standards be necessary to give a true and fair view FRRP is authorised (via the law) to investigate departures from the Companies Act, including the requirement to give a true and fair view

Opinion of Mary Arden QC In a legal opinion sought by the UK Accounting Standards Board (ASB), Hoffman and Arden (1983), while concluding ‘true and fair view’ is a legal concept, stated That the courts will treat compliance with accepted accounting principles as prima facie evidence that accounts are true and fair, and equally the converse would apply The Companies Act 1989 gave statutory recognition of accounting standards Arden (1993) wrote that an accounting standard upheld by the law becomes an authoritative source of law itself Yet case law would suggest that compliance with the rules is in itself insufficient to comprise a ‘true and fair view’ or ‘fair presentation’

Forward to the Accounting Standards (paras 18 & 19) The requirement to give a true and fair view may in special circumstances require a departure from accounting standards. However, because accounting standards are formulated with the objective of ensuring that the information resulting from their application faithfully represents the underlying commercial activity, the Board envisages that only in exceptional circumstances will departure from the requirements of an accounting standard be necessary in order for financial statements to give a true and fair view. If in exceptional circumstances compliance with the requirements of an accounting standard is inconsistent with the requirement to give a true and fair view, the requirements of the accounting standard should be departed from to the extent necessary to give a true and fair view.

Aim & Coverage Both the law and standards aim for the profit and loss account and balance sheet to give a true and fair view FRSs are developed within the context of current legislation with the aim of ensuring consistency between accounting standards and the law Both the law and standards cover measurement rules, disclosure and format items Accounting standards Amplify the law (e.g. SSAP 13 Research and Development) Add to the requirements of the law (e.g. FRS 1 Cash flow statements) Overlap certain areas of the law

Overlap The law and standards overlap on a number of topics in the area of accounting measurement. There is no problem with respect to formats and disclosure. The following types of overlap occur: Restrictions of the law by accounting standards, e.g. the use of LIFO (SSAP 9) Restrictions of accounting standards by the law, e.g. accounting for government grants (SSAP 4) The use of clever definitions in accounting standards to effectively remove legal options, e.g. extraordinary items (FRS 3) The use of the true and fair override in accounting standards to contradict the law, e.g. accounting for investment property (SSAP 19)

When rules conflict… The use of the true and fair override in practice: In the UK 39% of FTSE 100 companies invoke the override Most often it is the Companies Act that is overridden where it conflicts with accounting standards The most common overrides are: Investment properties Omission of goodwill amortisation Consolidation Government Grants

From 2005 Legal requirements will impose accounting standards in certain circumstances From 2005 onwards, the consolidated statements of listed companies must by law comply with International financial reporting standards (IFRS) The legal mechanism is a Regulation of the EU In the UK other financial statements may also adopt IFRS rather than UK rules Where IFRS are adopted there is no requirement to follow any of the accounting requirements of the Companies Acts or ASB standards. Under the Puxty model the regulatory system for financial reporting is becoming increasingly ‘corporatist’