AAT Articles

Problems, Problems and More Problems

Over the last few years the accountancy profession has become increasingly more and more bureaucratic, with much more emphasis being placed on disclosures and the overall way in which financial statements are prepared.

In this article Steven Collings covers some of the common problems faced by preparer’s of financial statements for small Limited companies within the United Kingdom and addresses the issues that practitioner’s face difficulty with in terms of disclosure requirements.

Limited companies in the UK have to prepare financial statements in accordance with Generally Accepted Accounting Practice (commonly referred to as “GAAP”). The GAAP in the UK specifies the framework in which financial statements are to be prepared and details the relevant disclosure requirements which must be disclosed within the financial statements (either within the primary financial statements themselves, or by way of note).

The various professional accountancy bodies have procedures in place, which monitor the way in which practitioners prepare financial statements. These procedures are often referred to as “monitoring visits” or “assurance visits”. A few years ago the body, which monitored professional practices was known as the Joint Monitoring Unit, or “JMU”. The purpose of these visits were to predominantly look at firm’s audit clients to ensure the practice was complying with the now defunct SAS’s and to ensure the files met the minimum standards required by the Auditing Practices Board. Audit is now becoming less predominant with smaller and medium-sized practices due to the substantial increases over the years in the thresholds. A further increase in the thresholds is due to take place in April 2008.

As a result, the professional bodies now look at, not only, a firm’s audit client portfolio but also may review non-audit clients – in particular Limited companies. This article is confined to small Limited company financial statements and does not relate to audit.

The Primary Financial Statements

In UK GAAP, a corporate entity is required to produce, on an annual basis, a set of financial statements, which comprise:

A balance sheet as at the last day of the financial year;
A profit and loss account as at the last day of the financial year;
Notes to the financial statements.

Some entities also produce a cash flow statement. However, for those companies that are reporting under the Financial Reporting Standard for Smaller Entities (commonly known as the “FRSSE”), then the FRSSE encourages, but does not make it mandatory, for a corporate entity to produce a cash flow statement. FRS 1 “Cash Flow Statements” also exempts small companies from producing a cash flow statement.

Common Disclosure Errors

The problem faced with professional firms of accountants is that a lot of firms place heavy reliance on their accounts production packages. Primarily, accounting software packages often only produce a “skeleton” set of financial statements once, say, a trial balance has been entered into it. In recognition that every company is different and have different users of their financial statements which often require varying degrees of financial information, accounting software packages will have facilities in place to tailor various disclosure requirements.

For example, a company operating in the manufacturing industry that has a secured bank loan will have to disclose the bank loan as a “secured debt”. Whereas, a similar company who does not have any form of finance or loans will not have to make this disclosure.

When reviewing files for corporate entities it is extremely easy to place reliance wholly on an accounting software packages and forget that under reporting standards, some disclosures do not have to be made or those that have been made in the financial statements are often incorrect, missed out completely or contain “over-disclosure”.

Over the years I have reviewed financial statements prepared by firms of accountants and have been amazed at the number of errors, omissions and “over-disclosure” those financial statements contain.

Some of the more common disclosure errors and omissions are:

Directors Report Disclosures

Directors Interests
From April 2007 directors interests in the shares of a company no longer have to be disclosed in the director’s report. Only the names of the directors who were on the board at any point during the year have to be disclosed. If any director was appointed or resigned during the year, then the director’s report should contain the date of appointment or resignation of the respective director.

First period/year Companies
For those companies who have commenced trading and the preparer is preparing their first year accounts, the date of incorporation is required to be disclosed.

Political or Charitable Donations
If a company makes charitable donations, which exceed £200, then the directors’ report must contain details of the names of the charities, the relevant amounts and the purpose of the donations. Similarly, political donations in the EU, which exceed £200, should also be disclosed in the Directors report. Please note that £200 relates to individual donations in total, not just individual donations.

Close Companies
Often firms disclose that a company is considered a “close” company for taxation purposes. This disclosure is not required.

Name of Person Signing the Directors Report
Firms often forget that the name of the person signing the Director’s report and the capacity in which they are signing is required.

Disclosure Errors in the Notes to the Financial Statements

The notes to the financial statements are often the “prime target” for monitoring visits as the notes often contain the majority of errors or omissions.

Basis of Preparation
Often the basis of the preparation of the financial statements is not disclosed. This is particularly the case if accounts have not been prepared on a reliable accounting software package. The basis of preparation of the financial statements should disclose the way the accounts have been produced (often under the historical cost convention) and under which framework. A typical note will say:

“The Financial Statements have been produced under the historical cost convention and in accordance with the Financial Reporting Standards for Smaller Entities (effective January 2007).” Note that the right FRSSE version should also be made.

Accounting Policies
The notes to the financial statements should disclose a company’s material accounting policies. It is often the case that accounting policies are disclosed but are not applicable. For example, if a company has foreign exchange transactions, then there should be a foreign exchange policy, which states the translation policies relating to assets, liabilities and profit and loss account transactions.

The common errors found in respect of accounting policies are:

Turnover Note (accounting policies)
The turnover note often refers to net invoiced sales of goods, excluding VAT and net of trade discounts. However, since the inception of UITF 40 or Application Note G to FRS 5, it is often the case that where a company has long-term service contracts or could have long-term service contracts that disclosure of revenue recognition in respect of long-term service is omitted i.e., that revenue is recognised when a right to consideration exists. Judgement in these areas has to be made. For example, it is highly unlikely that an off-licence will have a long-term service contract, so in this respect the additional note relating to UITF 40 is not appropriate. However, a company operating in the construction industry will almost certainly have long-term service contract(s) and therefore UITF 40 is applicable.

Fixed Assets
Often companies just disclose the depreciation rates applicable to the company. It can also be the case that depreciation rates disclosed in the financial statements are often not the depreciation rates actually used when a file review is undertaken.

The fixed asset disclosure in the accounting policies notes should not just contain the depreciation rates. After all, the note is in relation to “Fixed Assets” and not just depreciation.

The note should refer to the way in which a fixed asset is measured in the financial statements. For example the note could say:

“Fixed assets are stated at their cost price, less accumulated depreciation and less amounts recognised in respect of impairment”.

Stock
It is common to rely on accounts production software to generate a standard note, which says that stock is valued at the lower of cost or net realisable value. Preparer’s either forget, or are not aware, that the basis of stock valuation has to be disclosed e.g. whether stock is valued on a first-in first-out basis, last-in first-out or weighted average basis.

Financial Instruments
Financial instruments are often considered by smaller practitioners as being applicable to those companies who are listed. This is not the case at all. A financial instrument can be a bank loan, a bank overdraft, debtors, creditors and such like. Where a company has material loans and material financial instruments then it should disclose the accounting policy it has adopted in respect of financial instruments. Even smaller Limited companies should consider their financial instruments and how material they are. Remember, only the material accounting policies should be disclosed.

Pensions
In the UK a company may have a defined benefit pension scheme or a defined contribution pension scheme – or both.

This article is not going to go into the various disclosure requirements a defined benefit scheme has to disclose because the disclosure are quite complex and long-winded. However, for a defined contribution scheme disclosure should be made that the scheme is a defined contribution scheme and that payments into the scheme are written off to profit and loss. Some practitioners who prepare accounts using non-accounts production software packages often forget to include this note.

Directors Emoluments
This is a particularly easy note to get wrong and it is also a note, which those undertaking monitoring visits “home in” on. The reason – because anything that relates to a directors transaction is material in its nature regardless of the amount involved.

The director’s emoluments should include director’s salaries, compensation for loss of office, benefits in kind and any pension contributions.

Disclosure as to how many directors’ amounts accruing under pension contributions should also be made. This is a particularly common disclosure omission. If the company makes payments into (let’s say) a defined contribution pension scheme for a director(s) then the number of directors for whom the company payments into should be made.

It is also common for employer’s national insurance contributions to be included in the amounts disclosed as director’s emoluments. These should not be included as they are a cost to the company alone.

Deferred Tax
Again, this is a note, which practitioners rely on their accounts production software to get right.

Deferred tax should only be disclosed as an accounting policy if the company has material amounts of deferred tax. The method of measuring deferred tax should also be disclosed i.e. whether it is discounted or undiscounted (often in the UK, deferred tax is accounted for as undiscounted). The policy for deferred tax assets (e.g. if a company has tax losses which it is carrying forward) should also be disclosed.

Those are the common errors and omissions in terms of accounting policies. The following are the common errors and omissions in the notes.

Turnover
If a company supplies goods and services overseas, it should disclose the percentage of goods in European and non-European countries.

Debtors (UITF 40)
Where UITF 40 in respect of long-term service contracts is appropriate it is often the case that companies will include any amounts recoverable on contracts within Trade Debtors or Work-in-Progress. This is not the correct treatment. Any amounts, which are recoverable on long-term service contracts, should be shown within Debtors, under the heading “Amounts Recoverable on Contracts”.

Secured Debts
If a company has secured overdrafts, bank loans, hire purchase contracts and such like which are secured, these amounts should be disclosed under the heading “Secured Debts”.

Corporation Tax
The rates of corporation tax charged are not required to be disclosed.

Dividends
Dividends paid to shareholders are no longer shown on the face of the profit and loss account. Dividends paid are shown in the notes to the financial statements as a reconciling item under the “Reserves” heading which reconciles the opening and closing balances shown in the company’s profit and loss reserves.

Deferred Tax
The deferred tax should note should state the balance of deferred tax brought forward, the movement in the year and the nature of the movement (e.g. accelerated capital allowances) and the deferred tax balance at the end of the year.

Ultimate Controlling Party
If a company has a shareholder who holds 51% of the ordinary share capital or more, this person is the controlling party and the name of the person should be disclosed as the controlling party. Their holding is not required to be disclosed.

Revalued Fixed Assets
If a company adopts a method of revaluing its fixed assets then it should disclose the cost and aggregate depreciation that it would disclose had it not been subject to revaluation. The note should also disclose who undertook the valuation and the date the valuation occurred.

Similarly a company should disclose within the corporation tax note, the amount of corporation tax that it would have to pay if the revalued assets were sold at their carrying values in the balance sheet.

If a company has adopted the revaluation model for its fixed assets and it has not revalued its fixed assets in the year’s in which it is required to do so, then a note to the financial statements stating that it has breached an accounting standard must be made.

Related Parties
These notes always attract the eye of those undertaking monitoring visits. If a director, shareholder or the company holds interests in another company, which they trade with, they must disclose the value of trade between the two companies, the value of monies outstanding to and from the company at the balance sheet date and the terms of the trading i.e. on normal commercial terms. The related party note is often the note, which contains errors and omissions. It is advisable to look at FRS 8 “Related Parties”, or FRSSE 2007 chapter 15 page 75 to understand the disclosures required in respect of related party transactions.

Transactions with Directors
Any director’s loans or quasi-loans should also be disclosed and the maximum amount outstanding during the reporting year should also be disclosed. If creditors falling due within one year contain the director’s loan account(s), then a note under “Transactions with Directors” should be made in the notes stating that the loan accounts were not overdrawn during the year.

General Errors

Accounts prepared by Chartered Accountancy firms, which include the accountant’s reports issued by the Association of Chartered Certified Accountants. Each professional body usually has their version of the accountants’ report.

Accounts prepared under the FRSSE but which refer to full FRS. If you are reporting under FRSSE you should only refer to FRS if the transaction or event concerned is not covered by FRSSE. These instances are quite rare.

Accounts referring to the wrong version of the FRSSE. The latest version of the FRSSE is effective from January 2007 and can be adopted early, whereas FRSSE 2005 could not be adopted earlier.

The word “Abbreviated” not being contained within Abbreviated Financial Statements published at Companies House.

Companies that are eligible to publish abbreviated accounts, publishing absolutely everything including a detailed profit and loss account (the detailed profit and loss account is not a statutory document).

Where LLP’s publish their accounts, the report of the members is not a statutory document and therefore does not need to be submitted to Companies House. A Limited Company has to have a director’s report, but a LLP does not have to have a members’ report.

Extraordinary items in the notes to the financial statements being present. Extraordinary items are no longer permissible – exceptional items are.

Authorised share capital not being disclosed in the share capital note.

Cross references from amounts in the primary financial statements to the notes being incorrect. For example, note 3 in the notes to the financial statements may be the corporation tax note but on the face of the income statement, corporation tax may be cross-referenced to note 4.

The balance sheet and cash flow statement (where prepared) not actually balancing. This is more common than people actually think!

Conclusion
This article aims to highlight the common disclosure failures made when preparing a set of financial statements for a smaller company in the UK. The article cannot pinpoint every failing made but the above are the more common issues faced by smaller firms of accountants who prepare small Limited company accounts. Over reliance on accounts production software packages should not be encouraged, as these packages often do not generate the required disclosures a client has to make in their financial statements.

To overcome failings there are various “Accounts Disclosure Checklists” which can be bought to help preparers of accounts make the right disclosures and avoid errors and ensure that the accounts they are preparing contain all the right disclosures where appropriate and also avoid “over-disclosure”. It is advisable to subscribe to company’s that provide the checklists and model accounts, which illustrate the relevant disclosures required. Often annual subscriptions to these types of outlets enable updates to be given if there are any changes within the Companies Acts or Financial Reporting Standards.

Steven Collings, FMAAT ACCA works for Leavitt Walmsley Associates Ltd as Audit/Accounts Senior and specialises in Technical Compliance issues.