Chris Smith is the Partner who heads up Grant Thornton's Financial Reporting Advisory Group ("FRAG") which specialises in helping companies find their way through the myriad of different accounting rules and standards. FRAG can help with training or providing accounting assistance and advice and has particular expertise in IFRS, UK GAAP and Japanese GAAP.

Financial reporting never stands still so nobody should be surprised by the relentless charge towards further change over the next few years to both UK GAAP and International Financial Reporting Standards ("IFRS"). Covering each change would probably require a book as large as the accounting standards themselves. In this article, therefore, we highlight some of the key changes that private equity firms should be looking at, both from an investor and an investee's perspective.

Say goodbye to UK GAAP

Broadly speaking, UK GAAP as we know it is likely to disappear, to be replaced by a cut-down version of IFRS otherwise known as the FRSME ("Financial Reporting Standard for Medium Entities"). The standard is currently being finalised and is likely to be somewhat different to full IFRS – for example previous drafts would have prevented entities from capitalising R&D costs which was an issue for many technology companies. A final draft is to be published later this year/early next year with an implementation date likely to affect 2014 December year-ends first.

Further details of the project's status can be found at:
http://www.frc.org.uk/asb/technical/projects/project0072.html

I would strongly recommend that you read the next draft and respond to the ASB with any of your concerns. Throughout the consultation period to date there has been vigorous debate and the ASB has recognised the concerns raised and the next draft is expected to take many of those concerns into account – i.e. the next draft will be different.

Once the final standard is published investee companies will need to assess whether they should be looking to adopt the FRSME or whether they should be moving towards full IFRS as used by listed companies.

Key considerations will be the impact of the FRSME compared to full IFRS on reported earnings and the balance sheet. Companies will need to consider, for example, tax and dividend implications – as well as the impact on loan covenants. For some companies who already report internally to parent companies under IFRS for group consolidation purposes, full IFRS might seem the easiest option. All I would say is it's best to review the options first as once one form of GAAP has been adopted it is very difficult to change it at a later date.

New rules on consolidation

Under IFRS – IAS27 to be precise, shortly to be replaced by IFRS10 - private equity companies often get caught by the concept of control and are required to consolidate their investments – usually on the basis that they either have a majority shareholding or have strategic control, or both.

Interestingly, when drafting IFRS10 the IASB listened to feedback from the investment community and recently published an exposure draft for investment entities which, if certain criteria are met, may mean that investments instead of being consolidated are measured at fair value with movements being taken through profit and loss.

Clearly this introduces a level of complexity around the measurement of fair value – and associated disclosures - but from the simple perspective of preparing financial statements, not having to consolidate investments should make the year-end process a lot easier. It should make the financial statements more useful to users as well which must be a good thing.

The qualifying criteria that are being discussed to get out of consolidation are currently as follows:

1. the entity's nature is such that its only substantive activities are investing in multiple entities to achieve capital appreciation, earn investment income, or both;
2. the entity's business purpose is investing to earn capital appreciation, investment income, or both and it makes an explicit commitment to investors about this;
3. investors own units of investments (e.g. shares or partnership interests) in the entity;
4. the entity pools the funds it receives from its investors, so that the investors can benefit from professional management;
5. the entity manages and evaluates the performance of its investments on a fair value basis; and
6. the entity provides financial information about its investment activities to its investors.

For the enthusiasts out there I would strongly recommend that you read the Exposure Draft and respond by way of letter to the IASB as it's best that they know your concerns at the drafting stage rather than after the final standard is released.
http://www.ifrs.org/Current+Projects/IASB+Projects/Consolidation/IE/Investment+entities.htm

Lease accounting for lessees – everything's coming on balance sheet

Currently IFRS requires lessee companies to consider whether for lease agreements substantially all the risks and rewards incidental to ownership have been transferred. If the answer is yes then it's a finance lease, if it's no then it's an operating leases.

The proposed new standard removes this concept, replacing it with one based on a right of use. Simplistically, where there is a right to use an asset an entity is required to recognise an asset and with that asset comes a liability.

This fundamental change to lessee accounting means that the majority of leases will come on balance sheet which will have a significant impact on companies who have a number of leases (there is an exemption for certain short-term leases, being 12 months or less).

Sectors likely to be particularly affected include retailers (property leases) and airlines (aircraft). If you think that the lease commitments of the major supermarkets alone, for example, are estimated to be £45bn it is clear how significant the impact will be and how it will affect key performance indicators, e.g. debt-to-equity ratios, returns of capital as well as borrowing facilities and loan covenants.

Following numerous rounds of consultation a revised Exposure Draft is expected later this year with a final standard sometime in 2012. It should be noted that the debate on lessor accounting continues as the original proposals raised a number of concerns and at this time it is not clear whether the model based on right of use will be used or whether the current model based on risks and rewards will be retained.

Further details of the project's status can be found at:
http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/Leases.htm

To date this fundamental change, whilst much debated within the profession and amongst lessors, has not been on the radar of many lessees. It should be.

Revenue recognition – when can revenue be recognised?

Proposed changes to the recognition of revenue under IFRS could have a significant impact on a number of companies, particularly those in the technology and service sectors.

Simplistically, the current underlying principle to recognising revenue under IFRS is whether significant risks and rewards have passed. The proposed standard requires that revenue should only be recognised once control has passed. This might sound like a small change but it could have a material impact on the timing of revenue recognition as it isn't always easy to define when control has passed, for example, when a product or a service is being delivered over a period of time.

The current plan is for a revised draft standard to be issued later this year with a consultation period of 120 days. The final standard should then be issued in 2012.

Again, I would strongly recommend that the document once published is reviewed and responded to. The current status of the project can be found at the following link:
http://www.ifrs.org/Current+Projects/IASB+Projects/Revenue+Recognition/Revenue+Recognition.htm

With all of the above changes the key is to understand not just how they will affect you once effective, but what it is that needs to be done in advance. For example, long-term leases being negotiated now will in the short-term continue to be accounted for using the old methodology. That accounting, however, will look very different in a couple of years time. When negotiating that lease, therefore, is there anything that can be now to mitigate the impact over the next 5, 10 or 15 years? Also, changes to accounting standards often require retrospective adjustments – i.e. adjusting previously prepared financial statements – giving rise to a material change in financial track records.

Whilst I wouldn't quite say, to borrow a phrase, everything you know is wrong, everything is going to look different and you need to be on top of the changes before they get on top of you.