The historical development of accounting standards - part 3
| by Steve Lawrence
01 Jun 2000
This is the third in a series of articles covering the historical development of specific Financial Reporting Standards (FRS) and Statements of Standard Accounting Practice (SSAP). The first two each concentrated on the history of a single standard; FRS 1, Cash Flow Statements in part 1 and SSAP 15, (Revised) Deferred Tax in part 2. This current article covers the development of Accounting for Groups and will include a review of the history behind FRS 2 Accounting for subsidiary undertakings and FRS 6, Acquisitions and Mergers. (Note: FRS 7, Fair Values in Acquisition Accounting, FRS 10 Goodwill and Intangible Assets and SSAP 20, Foreign Currency Translation, also have relevant sections on group accounts but these standards will be specifically covered in a subsequent article).
Most large enterprises are structured as a group of limited liability companies and the accounting principles and practices relating to such organisations are therefore very important. It is essential to remember that we are considering the development of standards that enable the financial performance and position of several individual legal entities (several companies) to be disclosed as if these companies were a single economic entity — The Group. This ‘group’ will be made up of a single parent company that controls the resources of the other group companies, the subsidiary companies, and the group accounts are produced by ‘consolidating’ the financial reports of all the group companies (with certain exclusions which are detailed later). These combined financial statements are usually referred to as ‘Consolidated Accounts’.
The problems of producing consolidated accounts have existed for many decades. They include the exclusion of subsidiaries and the elimination of inter-company items (FRS 2), and the decision as to whether the group should be considered a merger of two or more companies, or an acquisition by one company of another (FRS 6). Hopefully this historical review will help in achieving an understanding of the reasoning behind these complex standards.
A late ‘start’ for Consolidated Accounts
During the latter part of the 19th century and the early part of the 20th century organisations began to conduct their business through groups of companies controlled by a single holding company. There were many reasons why such group structures evolved, including the creation of strategic advantages and the diversification of limited liability. Accounting regulations and practices did not advance at the same speed as the economic development of the group structure and for many years the parent company shareholders only received the individual accounts of the parent company. These were not very informative, providing only a limited view of the financial performance and position of the group. The lack of useful information became more apparent as subsidiaries began to undertake crucial group activities, drawing attention to the need for a more appropriate form of financial reporting. The concept of ‘off balance sheet financing’ through subsidiaries that were effectively ‘hidden’ from the parent company shareholders was appreciated even then and it was clear that there was a need to develop financial reporting practices to eliminate this problem.
As a result, the production of consolidated financial statements became general practice in the USA by the 1920s. In the UK companies led the way in the development of financial reporting for groups. For example, Nobel Industries Ltd published the first British set of consolidated accounts in 1922, and Dunlop Ltd brought in new and higher standards of group reporting in 1933 but consolidation techniques they did not become widespread until the introduction of group accounting requirements in the 1948 Companies Act. This Act required group accounts in addition to the parent company accounts and thus, the history of regulating consolidation had finally begun. Thus, consolidating the financial statements of a group of companies began in the UK as part of legislation introduced by government, not as an accounting standard requirement introduced by the accounting profession. The legislation was however introduced several decades after the economic developments which created the need for such an accounting technique — but better late than never!
The history of FRS 2The first pronouncement by a standard setting body representing the accounting profession in the UK was ED 20, Group Accounts. This statement was not published until July 1977, nearly 30 years after the first legislation on the subject and many more decades after the creation and adoption of the group structure by most significant organisations. This exposure draft was followed by SSAP 14, Group Accounts, in 1978.
The extracts below are from the introduction given in SSAP 14 and clearly show that the influence of the International Accounting Standards Committee (IASC) is far from new and also (perhaps) indicates the ‘relaxed’ attitude to accounting standards at that time.
Introduction to SSAP 14
‘This standard deals with the presentation of group accounts for a group of companies. The practice of preparing group accounts for a company and its subsidiaries, usually in the form of consolidated financial statements, has become well established in the United Kingdom and Ireland since 1948, and there has therefore been no urgent need for an accounting standard on the subject. However the issue of International Accounting Standard No. 3 Consolidated Financial Statements (IAS 3) which, while generally in accordance with the law and practice in the United Kingdom and Ireland, differs in some respects, has made it desirable for there to be a domestic standard on the subject.
Compliance with this standard will result in compliance with IAS 3 so far as it relates to consolidated financial statements…’
This standard clearly established the consistent use of co-terminus year ends for all group companies, the exclusion of certain subsidiaries from consolidation in specified circumstances, the separate disclosure of minority interest and the elimination of inter-company balances and unrealised profits. SSAP 14, supported by the 1948 Companies Act provisions (which were to become part of the 1985 Companies Act), was the primary pronouncement on group accounts for over 20 years. Then, as with the original regulations, it was the legislator that changed the rules relating to the production of group accounts in the UK.
The European Economic Community (EEC), now the European Union (EU), company harmonisation programme included the issue of ‘Directives’. These Directives are not laws, but once adopted require member states to incorporate them in their own national legislation. The Seventh Directive deals with financial information on groups of companies. It was adopted by the EEC in 1983 and required implementation by member states by 1 January 1988, with enforcement from 1990. The UK implemented the seventh directive in the Companies Act 1989. This directive was generally considered to be a statement that reflected accounting practices already prevalent in the UK, compared with, say, the fourth directive which introduced to the UK the continental concept of standard profit and loss account and balance sheet formats. Conflicts between the Companies Act 1989 and SSAP 14 would therefore have been expected to be few and insignificant. This however was not the case and it became necessary to hurriedly review SSAP 14 to eliminate the inconsistencies between the standard and the legislation.
For example SSAP 14 had very simplistic definitions of a subsidiary company and a holding (parent) company:
Para. 7: A company shall be deemed to be a subsidiary of another if, but only if:
Para. 8: A company is a holding company of another if, but only if, that other is its subsidiary as defined above.
The Company’s Act 1989 however defines a parent undertaking (note not a ‘company’) and a subsidiary undertaking using a set of conditions that reflect the ability of one undertaking to control the other. This is the concept that we have come to accept as the normal method of determining group status.
A further discrepancy related to the Companies Act 1989 exemption from preparing group accounts based on size criteria. No such provisions exempting small and medium-sized groups from preparing group accounts was contained in SSAP 14.
To remedy this unsatisfactory situation the ASC issued ED 50 in 1990 covering the revision of both SSAP 14 and SSAP 1, Associates. Shortly after this exposure draft was issued the ASC was disbanded and replaced by the ASB. The follow up to ED 50 was the first formal pronouncement of the ASB entitled, ‘Interim Statement: Consolidated Accounts’. One of the most important developments in the ‘Interim Statement’ was the inclusion of definitions for ‘Dominant Influence’ and ‘Actual Exercise of Dominant Influence’. These terms were crucial to an assessment of the establishment of parent/subsidiary relationships. The ‘Interim Statement’ also restricted the provisions of the Companies Act 1989 on the exclusion of a subsidiary from the consolidation process. While the legislation ‘permitted’ the exclusion in certain circumstances the ‘Interim Statement’ made exclusion ‘compulsory’ where the specified conditions for exclusion were met.
In addition while the Companies Act 1989 allows inter-company transactions to be eliminated in proportion to the group’s interest in the shares of an enterprise, the ‘Interim Statement’ required full adjustment for all inter-company transactions regardless of whether or not there were any minority interest shareholders.
The ‘Interim Statement’ had provisions relating to subsidiaries, associates and joint ventures. However, when FRS 2, Accounting for Subsidiary Undertakings, was issued in December 1990 only the paragraphs relating to subsidiaries were superseded. The current position is still covered by FRS 2, and FRS 5, Reporting the Substance of Transactions (Relating to Quasi-Subsidiaries). The detailed requirements of these standards are well known but always consider the historical influence of the EU, particularly in relation to the concepts of exemption based on a size test and the regulations relating to exclusion of subsidiaries.
The history of FRS 6
The Companies Act contains rules on both acquisition accounting and merger accounting but FRS 2 only deals with the acquisition accounting method for groups. It is therefore necessary to review another history — that which leads to the merger accounting requirements prescribed in FRS 6. However it is important to remember that FRS 6 covers acquisitions and therefore while the two methods of accounting for a combination are very different their development cannot be reviewed in isolation.
Once again a pronouncement in the USA and the legislation on group accounting had important influences on developments in the UK. In 1970 the Accounting Principles Board (the USA standard setting body before the Financial Accounting Standards Board) issued Opinion No.16 (an ‘Opinion’ was the APB form of accounting standard) on accounting for Business Combinations. The statement set out for the first time principles on which decisions on the Polling of Interest (merger) and Acquisition methods could be based. The following year the ASSC published ED 3Accounting for Acquisitions and Mergers. ED 3 introduced a distinction between the two types of combination, one being a purchase by one company of another, and the other being a genuine merging of interests involving on an exchange of shares. ED 3 contained strict conditions based on substance, relative equity voting rights, a form of size test and acceptance by 90% of equity shareholders.
However, ED 3 was severely criticised. There was disagreement on its provisions relating to the treatment of goodwill and was considered to be in conflict with the legislation, which at that time required companies to recognise the premium on the issue of shares in a separate share premium account. This apparent conflict was confirmed in a tax case Shearer v. Bercain’ in 1980 and so ED 3 was never developed into a full standard.
The idea of merger accounting as a suitable technique in certain circumstances was not however lost. And in the Companies Act 1981 (now part of the Companies Act 1985) ‘merger relief’ was provided in s.131 from the s.130 requirements to transfer any premium on the issue of shares to a share premium account. Thus, the change in legislation opened the way for the ASC to develop a standard advocating the use of the merger accounting method.
The next pronouncement was ED 31, Accounting for Acquisitions and Mergers, which was published in October 1982. This ED again proposed the two methods of accounting for a business combination, stating that they should not be alternatives in accounting for the same combination. As with ED 3 there was a set of criteria which if met, required the use of the merger method. Unfortunately these criteria were effectively ‘watered down’ when the resulting standard SSAP 23 was published in 1985. This standard made the ‘fatal’ mistake of ‘permitting’ rather than requiring the use of the merger method when the specified criteria were met.
There are perceived to be considerable benefits in terms of financial reporting in using the merger method including no recognition of goodwill, no loss of pre-combination reserves and no fair value adjustments. The SSAP 23 conditions were such that it was easy for companies to devise simple schemes to bring what are in substance acquisitions within its merger rules and therefore gain these benefits. Two common schemes at the time were:
It was usual for a merchant bank to act as an intermediary, making its own profit from the relevant banking fee.
The following is an illustration which was widely reported in the financial press and accounting literature in the mid-1980s:
Systems Design International
A UK consultancy firm, Systems Design International (SDI), whose shares were then quoted on the Unlisted Stock Market (USM), decided to buy an American software company, Warrington. Warrington’s shareholders wanted cash rather than share certificates and the purchase price reflected a substantial element of goodwill. If acquisition accounting were to be used the goodwill write off (Note: Remember SSAP 22 would have been applicable at the time and allowed for such an immediate write off) would have been difficult because it exceeded existing group reserves and, if amortised, would have had a significant effect on reported earnings per share.
Samuel Montagu, SDI’s financial advisers, suggested a scheme whereby SDI would issue shares in exchange for Warrington’s and Samuel Montagu would then offer cash as an alternative. This would leave Samuel Montagu with all the SDI shares issued to Warrington’s original shareholders, but the bank would recoup its outlay by offering those shares to existing SDI shareholders by way of a vendor rights issue. Samuel Montagu would benefit from the merchant bank fee and SDI would be able to use merger accounting to overcome the goodwill problem. The company had been able to adapt the application of merger accounting to meet their needs because of SSAP 23’s emphasis on ‘no resources leaving the group’.
Clearly this was unacceptable and it therefore comes as no surprise that after a very short period of time efforts were made to improve the position so that only ‘true’ mergers could be accounted for as such.
The ASC started the revision process by issuing ED 48 in February 1990. The most important change was to the underlying principles that determine the identification of a merger. SSAP 23 chose to identify a merger on whether or not material resources had left the combining companies, whereas ED 48 stated that the merger accounting method would only be applicable where no acquirer or acquiree could be identified. If that was the case then the merger method must be used. The ability of companies to choose the method was to be removed. The following criteria for the use of the merger method were stipulated in ED 48 and effectively established the position which exists today:
ED 48 merger accounting criteria:
As with ED 50 (see earlier) it was left to the new ASB to develop ED 48 into an accounting standard. ED 48 was replaced by FRED 6, Acquisitions and Mergers, in 1993. The new exposure draft made few changes but emphasised that under ‘normal’ circumstances the acquisition method is likely to appropriate and only in rare circumstances would the substance of a merger actually exist. In late 1994 the ASB issued FRS 6, Acquisitions and Mergers, using the same recognition criteria as FRED 6 for the use of the merger accounting method. This standard still provides the frame of reference for determining the most suitable method of accounting for a business combination but the influence of ‘foreign’ principles and practices is looming large on the horizon. The USA has recently decided to abolish the use of the ‘pooling of interest method’ and require all business combinations to be accounted for as acquisitions. The G4 + 1 (UK, USA, Australia, Canada and New Zealand plus representatives from the IASC) group of standard setters is currently addressing the problem and has concluded that the use of a single method of accounting is preferable and that the purchase method is the appropriate method. This position has clearly been influenced by developments in the USA. It could therefore be the case that the problem of allowing two methods to deal with business combinations was created by the American standard setters and will be eliminated by them.
SummaryTwo of the most important standards covering group accounting are FRS 2 and FRS 6. FRS 2 has been developed from the detailed legislation originally introduced in the UK in the Companies Act 1948, enhanced in the Companies Act 1989 and from the original standard SSAP 14 which was issued in 1977.
Accounting for acquisitions and mergers is now covered by FRS 6 but started as an exposure draft as far back as 1971. It has had a chequered history, with SSAP 23 being one of the most criticised standards issued by the ASC.
Both FRS 2 and FRS 6 have been heavily influenced by practices in the USA and it is ironic that this international area of influence may eventually negate the need for FRS 6. We shall have to wait and see!
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