Module 7 Emerging Issues and Managerial Options in Financial reporting 7 1 Introduction Managers are free to determine their detailed financial reporting procedures within the accounting framework The pressure on managers to show growth in their profits and earnings per share is called short termism largely created by investment analysts If this externally imposed target on companies is not easily achievable through normal trading activities management can take steps to trim expenditure or adopt accounting principles which give the appearance of an upward trend in performance There are financial instruments companies can use to finance their business and fend off takeovers 7 2 Research and Development Hi tech companies can spend up to 10 of sales on R D R D is a corporate investment in the present to secure a better future so it should appear as an asset in the balance sheet is of uncertain value However R D is often written off in the P L rather than capitalized because it is a risky activity and According to SSAP 13 the accounting standards research expenditure must be written off but development expenditure may be capitalized if i ii iii iv It is a clearly defined project Related expenditure is separately identifiable its technically feasible and commercially viable adequate resources exist or will exist to enable project to be completed Many computer and smaller companies capitalize some R D to avoid a major hit to profits and so to Earnings per share require further expenditure This may adversely effect working capital should the technical difficulties be encountered in R D that Auditors need to weigh management s view against the R D track record of success he may decide that previously capitalized expenditure should now be written off in the P L this can have a devastating effect on profits and on market confidence 7 3 Off Balance Sheet Transactions A highly geared company may want to drive further borrowing off its balance sheet especially if its share price has been reduced in anticipation of a share rights issue 7 3 1 Quasi Subsidiaries Company X avoids owning more than 50 of company Y but still retains control of managerial decisions For example company X can own all the ordinary shares of company Y but a friendly third party owns more than 50 of the equity shares So company X controls voting rights to appoint a board but company Y is not an official subsidiary Accounting standards would insist that company X regards company Y as a quasi subsidiary So all assets and liabilities of Y appear in company X s accounts Company X is involved in a joint venture i ii iii X must consolidate the financial affairs of the JV if it is in effect the lead partner to avoid consolidation the risks and rewards of ownership must be fully transferable to the JV and one company cannot buy back its assets at anything other than full market value to avoid consolidation of accounts both companies must share profits losses dividends and or loan guarantees equally These issues are covered in the accounting standard FRS 5 A company that is controlled by another even though the other company does not have more than 50 of the equity shares is termed a quasi subsidiary it is the control that is important 7 3 2 Consignment Inventories Manufacturers may send their dealers products to sell but not request payment until the product is actually sold Where the dealer can return unsold products without incurring a significant penalty he can avoid putting this inventory its associated financing on his balance sheet Where the dealer does have to pay whether they are sold or not the inventory and its financing needs to accounted for on the balance sheet 7 3 3 Sale and repurchase agreements Sometimes companies sell inventory to a third party often a bank with an agreement to re purchase it back at a later stage The re purchase price would include interest FRS 5 says this agreement should not appear as a sale in the accounts but as a short term loan with an interest charge appearing in the P L account in the year when the stock is re purchased Inventories are unchanged cash increases creditors increase short term loan 7 3 4 Debt Factoring Companies who wait for money from debtors may have to borrow money to fund their working capital until payment is received behalf To avoid this companies can sell or factor their debts to a finance house to collect the debts on its If the finance house has no recourse to the company in the event of bad debts then it s a straightforward commercial transaction cash goes up debtors goes down and the difference is written off as an expense in the P L If there is recourse than FRS 5 says that the company should treat the factoring as a short term loan until the factoring company recovers all the debts 7 4 Accounting for Acquisitions and Mergers Acquisition accounting is used to reflect normal takeovers where the predator or holding company acquires more than 50 of the equity share capital of the target for cash shares in the holding company or a combination of the two Example Forth offers to acquire the entire share capital of Clyde Its offering one of Forth s shares worth 5 for each of Clyde s one million shares Before the offer their balance sheet looked like this Net Assets Forth Ltd M Clyde Ltd M 6 4 Represented by Share Capital 1 ord 1 5 Distributable reserves 6 1 3 4 Forth Group balance sheet after the offer is accepted Net Assets Goodwill Represented by Share Capital 1 ord Share premium Distributable reserves Forth Group M 10 1 11 2 4 5 11 Note Share premium is 4m because Forth had to issue 1 million share 5 5m The share premium is the difference between this and the nominal amount 1 million 1 1m This money is not normally available to the Forth Group shareholders Merger accounting presumes agreement between the two parties to pool their respective interests rather than for one to hand over its assets to the other Merger accounting restate the two companies accounts as if they had always been one Example Using the example above in a merger situation the combined balance sheet would look like Forth Clyde group m Net Assets Represented by Share Capital 1 ord Distributable reserve 10 2 8 10 No Goodwill to write off More flexibility management under a merger has free access to reserves whereas in an acquisition it has no access to the share premium A merger is only a merger when according to FRS6 i ii iii iv v none of the parties see itself as acquirer or acquired none of the