ABSTRACT 43 UITF abstract 43 The interpretation of equivalence for the purposes of section 228A of the Companies Act 1985

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1 ABSTRACT 43 UITF abstract 43 The interpretation of equivalence for the purposes of section 228A of the Companies Act 1985 (Issued 23 October 2006) Introduction With effect for accounting periods commencing on or after 1 January 2005, the Companies Act 1985 has been amended to include a new section 228A. This exempts, subject to certain conditions, an intermediate parent undertaking from the requirement to prepare consolidated accounts where its parent entity is not established under the law of an EEA state. The new exemption complements the well established exemption in section 228 for intermediate parent undertakings where the parent entity is established under the law of an EEA state. Section 228A * states that: 1 2 "(2) Exemption is conditional upon compliance with all of the following conditions: (a) that the company and all of its subsidiary undertakings are included in consolidated accounts for a larger group drawn up to the same date, or to an earlier date in the same financial year, by a parent undertaking; (b) that those accounts and, where appropriate, the group's annual report, are drawn up in accordance with the provisions of the Seventh Directive (83/349/EEC) (where applicable as modified by the provisions of the Bank Accounts Directive (86/635/EEC) or the Insurance Accounts Directive (91/674/EEC)), or in a manner equivalent to consolidated accounts and consolidated annual reports so drawn up; (c).." * In the Republic of Ireland the wording of Regulation 9A of the European Communities (Companies: Group Accounts) Regulations 1992 is slightly different but the intention is the same and the underlined phrase is exactly the same. 1

2 UITF CONSENSUS PRONOUNCEMENTS This Abstract provides guidance on interpretation of the underlined words. Questions have been raised as to whether financial statements drawn up in accordance with International Financial Reporting Standards (IFRS), US Generally Accepted Accounting Principles (GAAP) or other GAAPs meet the requirement for equivalence with the Seventh Directive. The UITF believes that guidance would be useful to reduce the likelihood of divergent practice emerging. Background 3 The requirements of section 228A are based on the EU Seventh Company Law Directive. No guidance has been issued at the EU level on the interpretation of the expression "in a manner equivalent" used in the legislation. It is understood that US GAAP is regularly treated as meeting the equivalence test in some of those countries that have implemented similar law based on the Seventh Directive. 4 In the UK, the Department of Trade and Industry has stated in published guidance * that it considers that, in most circumstances, financial statements of a larger group prepared on the basis of IFRS would meet the equivalence test. In relation to US GAAP, Canadian GAAP and Japanese GAAP, the DTI guidance makes reference to the work that was being undertaken at the time that guidance was issued by the Committee of European Securities Regulators (CESR), in accordance with a mandate provided by the European Commission. 5 In June 2005, CESR published its recommendation to the European Commission on the equivalence of the GAAPs in the US, Canada and Japan (together the "third countries") with IFRS as adopted by the EU. CESR's recommendation is that these three GAAPs, each taken as a whole, are equivalent to IFRS subject to certain caveats and additional disclosures. The CESR report does not deal with equivalence with the Seventh Directive, which is generally less prescriptive than IFRS, and the study was conducted for a different purpose in connection with the Prospectus Directive and the Transparency Directive. Nevertheless, it is expected that similar principles will apply to the consideration of equivalence between the Seventh Directive and third countries' GAAPs as apply to the consideration of equivalence between those GAAPs and IFRS. * DTI, 'Guidance for British companies on changes to the accounting and reporting provisions of the Companies Act 1985', August 2005, paragraphs 5.3 to 5.6. Technical advice on equivalence of certain third country GAAP and on description of certain third countries mechanisms of enforcement of financial information (Ref: CESR/05-230b). The European Commission has announced plans to postpone by two years implementation of the requirement for equivalence in the Prospectus and Transparency Directives and so the CESR guidance may not be implemented. 2

3 ABSTRACT 43 The issue Use of the exemption in section 228A requires an analysis of a particular set of consolidated accounts to determine whether they are drawn up in a manner equivalent to consolidated accounts that are in accordance with the Seventh Directive *. However, whilst the analysis ultimately has to be on a case by case basis, it should be possible to identify some GAAPs that usually result in consolidated accounts being drawn up in a manner equivalent to the Seventh Directive. The UITF believes that guidance would assist entities to adopt a consistent approach to this issue. In the absence of such guidance, companies and their auditors might feel obliged to take an overly cautious approach in response to uncertainty about whether the exemption can be used. This would result in unnecessary burdens on businesses in the UK and Republic of Ireland and might disadvantage them when compared to companies operating elsewhere in the EU. 6 7 General approach to assessing equivalence It is generally accepted that the reference to equivalence in section 228A does not mean compliance with every detail of the Seventh Directive. The UITF believes that a qualitative approach, i.e. with a focus on compliance with the basic requirements of the Directive and in particular the requirement to give a true and fair view, is more in keeping with the deregulatory nature of the exemption than a requirement to consider the detailed requirements on a checklist basis (see also paragraph 15 below). 8 UK accounting standards Some entities have parents that are established in jurisdictions outside the EU and prepare consolidated accounts that give a true and fair view and comply with accounting standards applicable in the UK and Republic of Ireland. Those accounts will meet the requirement for equivalence. 9 * The Seventh Directive deals with consolidated accounts and applies most of the requirements of the Fourth Directive to those consolidated accounts. Consideration of equivalence with the Seventh Directive therefore requires consideration of equivalence with the relevant provisions of the Fourth Directive. References in this Abstract to accounts being prepared in accordance with the Seventh Directive include, where appropriate, compliance with the relevant provisions of the Fourth Directive. 3

4 UITF CONSENSUS PRONOUNCEMENTS IFRS adopted by the EU 10 The procedure for adoption of IFRS by the EU requires a standard to meet the basic requirements of the Fourth and Seventh Directives, including the requirement to give a true and fair view, without implying a strict conformity with each and every provision. Accounts prepared in accordance with IFRS as adopted by the EU will therefore always meet the test of equivalence. IFRS 11 IFRS as issued by the IASB (i.e. without the qualifying "as adopted by the EU") will currently meet the test of equivalence. This is because there are no standards or interpretations issued by the IASB that conflict with the basic requirements of the Directives *. The fact that a standard or interpretation has not been adopted because of the time taken to complete the adoption process will not of itself indicate a lack of equivalence. However if, in future, the European Commission fails to adopt a standard on the grounds that it does not meet the basic requirements of either the Fourth or Seventh Directive, it will be necessary to consider whether the reasons for the failure to adopt the standard suggest that compliance with that standard will fail to give a true and fair view and will, therefore, fail the test of equivalence. Accounting standards based on IFRS 12 There are some GAAPs (e.g. those in Australia, Hong Kong and South Africa) which are based on IFRS but may not correspond with IFRS in all respects. It is not practicable to give specific guidance on all of the increasing number of GAAPs that are based on, or are converging with, IFRS. In those cases where they are more restrictive than IFRS by eliminating choices, they will meet the test of equivalence for the purposes of section 228A. In other cases, it will be necessary to obtain an understanding of how they differ from IFRS and whether those differences might result in a departure from the basic requirements of the Fourth or Seventh Directives. Accounting standards not based on IFRS 13 There are other GAAPs that are not based on IFRS. These include the third countries' GAAPs (i.e. US, Canadian and Japanese GAAPs) which were the subject of the CESR recommendation to the European Commission. CESR's recommendation was made from the perspective that investors' decisions should be unaffected by the use of different accounting standards. This test is not directly relevant to the accounts of the higher parent required under section 228A because these will not be used for the purposes of investing in shares of the UK reporting entity - investors that are not part of the controlling interest have in any case a legal right to require consolidated accounts of the UK parent. However, an assessment of whether the third countries' GAAPs meet the section 228A equivalence test can be built upon the work of CESR. * The adoption of the Fair Value Amendment to IAS 39 has removed the possibility of a lack of equivalence through compliance with the "full" IAS 39 rather than the "carved out" version originally adopted by the EU. 4

5 ABSTRACT 43 The Fourth and Seventh Directives are generally less prescriptive than IFRS. For example, they do not prohibit merger accounting or include any particular requirements about how to account for share-based payments. The work undertaken by CESR in relation to equivalence with IFRS suggests that US GAAP, Canadian GAAP and Japanese GAAP will, in most cases, result in accounts that comply with the basic requirements of the Fourth and Seventh Directives. Some of the issues identified by CESR as resulting in a possible lack of equivalence between IFRS and the third countries' GAAPs are not relevant for the purposes of section 228A; however, two issues, namely the scope of consolidated accounts and the consistent use of accounting policies, are particularly relevant to assessing equivalence. The UITF believes that the basic requirement for a true and fair view includes the scope of consolidated accounts and consistent accounting policies. Therefore, meeting the test of equivalence is subject to ensuring both that the scope of entities included in the consolidated accounts is consistent with the Seventh Directive and that consistent accounting policies have been used for all entities included in the consolidated accounts Scope of consolidated accounts As a result of section 228A (2)(a) there is a specific requirement that the UK parent company and all of its subsidiary undertakings (as defined in the Act) are included in the consolidated accounts of the larger group. The requirement for undertakings outside of the UK sub-group is less stringent in that they need meet only the minimum requirements of the Seventh Directive assuming that the Member State options had been implemented in the least restrictive way. The text of Articles 1-3 of the Seventh Directive, which includes a definition of those undertakings that must be included in the consolidation, is set out in Appendix 1 to this Abstract for reference. Some parts of the definition in Article 1 are Member State options that cannot be regarded as mandatory requirements of the Directive. In particular, the requirement that an undertaking should be consolidated on the grounds of actual exercise of, or power to exercise, a dominant influence is a Member State option which was taken up in the UK but which need not be considered for the purpose of assessing equivalence. For example, some Special Purpose Entities would not have to be consolidated under the requirements of Article 1 even if they would have to be consolidated under UK GAAP. On the other hand, there may be cases where a third country's GAAP does not require the consolidation of an entity in circumstances where the Seventh Directive would do so. This would lead to a lack of equivalence for the purposes of section 228A where the effect on the consolidated accounts of the larger group is material to those accounts

6 UITF CONSENSUS PRONOUNCEMENTS Consistent accounting policies 19 The Seventh Directive includes a requirement that consolidated accounts should be drawn up on the basis of consistent accounting policies. There may be instances where other GAAPs do not include such a requirement. This could lead to a lack of equivalence for the purposes of section 228A where the effect on the consolidated accounts of the larger group is material to those accounts. Other differences 20 There are other areas of difference between the third countries' GAAPs and the Seventh Directive, for example in relation to the treatment of goodwill and negative goodwill. However, the requirements of IFRS 3 Business Combinations for goodwill and negative goodwill also differ from the detailed provisions of the Fourth and Seventh Directives. IFRS 3 has been adopted by the EU and therefore it may be considered that such differences are not material for the purpose of assessing equivalence. Specialised industries 21 The UITF's consideration of this issue did not extend to those cases where the consolidated accounts of the larger group are prepared in accordance with specialised industry standards, including those that may be applicable to banks and insurance companies *. The UITF noted that some GAAPs include industry specific standards which grant exemptions from other standards. For example, US GAAP grants an exemption from the requirement to consolidate certain subsidiaries of some types of investment vehicle. Consideration should be given to whether the application of such industry specific standards will result in a lack of equivalence with the Directives. Annual report 22 Section 228A (2)(b) imposes a condition that "where appropriate" the "annual report" of the larger group must be drawn up in accordance with the provisions of the Seventh Directive or in a manner equivalent to reports so drawn up. The term "annual report" is used in the section in the sense that it is used in the Directive and should be read as "Directors' report" in the UK context. 23 Section 228A does not provide further elaboration of the expression "where appropriate". Possible interpretations include "where the larger group prepares an annual report" or "where the larger group would be required to prepare an annual report under the Directive". The Directive provides that a Member State may waive the requirement for small companies to prepare an annual report. This Abstract does not provide guidance on the interpretation of the expression "where appropriate" as used in section 228A. * In the case of banks and insurance companies the requirements of the Seventh Directive to be considered are those as modified, where appropriate, by the Bank Accounts Directive or the Insurance Accounts Directive. 6

7 ABSTRACT 43 For ease of reference, the requirements of Article 46 of the Fourth Directive dealing with the contents of the annual report are set out in Appendix 2 to this Abstract. In keeping with the approach to equivalence of financial statements taken in this Abstract, any consideration of equivalence of the annual report would be at a high level rather than considering the detailed requirements on a checklist basis. 24 Application to smaller entities Reporting entities applying the Financial Reporting Standard for Smaller Entities are exempt from this Abstract *. 25 UITF Consensus The UITF reached a consensus that for the purposes of section 228A of the Companies Act 1985: 26 (a) (b) when assessing whether consolidated accounts of a higher non-eea parent are drawn up in a manner equivalent to consolidated accounts drawn up in accordance with the Seventh Directive, it is necessary to consider whether they meet the basic requirements of the Fourth and Seventh Directives, in particular the requirement to give a true and fair view, without implying strict conformity with each and every provision; and the consequences of adopting the principle in (a) above are: i) consolidated accounts of the higher parent that give a true and fair view and comply with accounting standards applicable in the UK and Republic of Ireland will meet the test of equivalence with the Seventh Directive; ii) consolidated accounts of the higher parent prepared in accordance with IFRS as adopted by the EU will meet the test of equivalence with the Seventh Directive; iii) consolidated accounts of the higher parent prepared in accordance with IFRS as issued by the IASB will meet the test of equivalence with the Seventh Directive subject to the consideration of the reasons for any failure by the European Commission to adopt a standard or interpretation; iv) consolidated accounts of the higher parent prepared using GAAPs which are closely related to IFRS will meet the test of equivalence with the Seventh Directive subject to consideration of the effect of any differences from IFRS as adopted by the EU; * Companies applying the Financial Reporting Standard for Smaller Entities will be entitled to the exemption from preparation of consolidated accounts for small groups in s248 and will not therefore have to rely on the exemption in s228a. 7

8 UITF CONSENSUS PRONOUNCEMENTS v) consolidated accounts of the higher parent prepared in accordance with US GAAP, Canadian GAAP and Japanese GAAP will normally meet the test of equivalence with the Seventh Directive subject to consideration of developments in those GAAPs following the date of issue of this Abstract and: ensuring the scope of entities included in those consolidated accounts is consistent with the Seventh Directive; ensuring that consistent accounting policies have been used for all entities included in those consolidated accounts; and evaluating the effect of any exemptions or modifications to the GAAPs allowed by specialised industry standards which have been applied in those consolidated accounts; and vi) consolidated accounts of the higher parent prepared using other GAAPs should be assessed for equivalence with the Seventh Directive based on the particular facts, including the similarities to, and differences from, the GAAPs considered specifically in this Abstract. Date from which effective 27 The interpretation of equivalence set out in this consensus for the purposes of section 228A should be adopted as soon as practicable. References EU Directives Seventh Directive 83/349/EEC Fourth Directive 78/660/EEC Legislation Great Britain Companies Act 1985 section 228A Northern Ireland The Companies (Northern Ireland) Order 1986 Article 236A Republic of Ireland The European Communities (Companies: Group Accounts) Regulations 1992 Regulation 9A 8

9 ABSTRACT 43 Appendix 1 Extract from the Seventh Directive concerning undertakings to be included in the consolidation SECTION 1 Conditions for the preparation of consolidated accounts Article 1 1. A Member State shall require any undertaking governed by its national law to draw up consolidated accounts and a consolidated annual report if that undertaking (a parent undertaking): (a) (b) (c) (d) has a majority of the shareholders' or members' voting rights in another undertaking (a subsidiary undertaking); or has the right to appoint or remove a majority of the members of the administrative, management or supervisory body of another undertaking (a subsidiary undertaking) and is at the same time a shareholder in or member of that undertaking; or has the right to exercise a dominant influence over an undertaking (a subsidiary undertaking) of which it is a shareholder or member, pursuant to a contract entered into with that undertaking or to a provision in its memorandum or articles of association, where the law governing that subsidiary undertaking permits its being subject to such contracts or provisions. A Member State need not prescribe that a parent undertaking must be a shareholder in or member of its subsidiary undertaking. Those Member States the laws of which do not provide for such contracts or clauses shall not be required to apply this provision; or is a shareholder in or member of an undertaking, and: (aa) a majority of the members of the administrative, management or supervisory bodies of that undertaking (a subsidiary undertaking) who have held office during the financial year, during the preceding financial year and up to the time when the consolidated accounts are drawn up, have been appointed solely as a result of the exercise of its voting rights; or (bb) controls alone, pursuant to an agreement with other shareholders in or members of that undertaking (a subsidiary undertaking), a majority of shareholders' or members' voting rights in that undertaking. The Member States may introduce more detailed provisions concerning the form and contents of such agreements. The Member States shall prescribe at least the arrangements referred to in (bb) above. They may make the application of (aa) above dependent upon the holding's representing 20 % or more of the shareholders' or members' voting rights. However, (aa) above shall not apply where another undertaking has the rights referred to in subparagraphs (a), (b) or (c) above with regard to that subsidiary undertaking. 9

10 UITF CONSENSUS PRONOUNCEMENTS 2. Apart from the cases mentioned in paragraph 1 the Member States may require any undertaking governed by their national law to draw up consolidated accounts and a consolidated annual report if: (a) (b) that undertaking (a parent undertaking) has the power to exercise, or actually exercises, dominant influence or control over another undertaking (the subsidiary undertaking); or that undertaking (a parent undertaking) and another undertaking (the subsidiary undertaking) are managed on a unified basis by the parent undertaking. Article 2 1. For the purposes of Article 1 (1) (a), (b) and (d), the voting rights and the rights of appointment and removal of any other subsidiary undertaking as well as those of any person acting in his own name but on behalf of the parent undertaking or of another subsidiary undertaking must be added to those of the parent undertaking. 2. For the purposes of Article 1 (1) (a), (b) and (d), the rights mentioned in paragraph 1 above must be reduced by the rights: (a) (b) attaching to shares held on behalf of a person who is neither the parent undertaking nor a subsidiary thereof; or attaching to shares held by way of security, provided that the rights in question are exercised in accordance with the instructions received, or held in connection with the granting of loans as part of normal business activities, provided that the voting rights are exercised in the interests of the person providing the security. 3. For the purposes of Article 1 (1) (a) and (d), the total of the shareholders' or members' voting rights in the subsidiary undertaking must be reduced by the voting rights attaching to the shares held by that undertaking itself by a subsidiary undertaking of that undertaking or by a person acting in his own name but on behalf of those undertakings. Article 3 1. Without prejudice to Articles 13 and 15 *, a parent undertaking and all of its subsidiary undertakings shall be undertakings to be consolidated regardless of where the registered offices of such subsidiary undertakings are situated. 2. For the purposes of paragraph 1 above, any subsidiary undertaking of a subsidiary undertaking shall be considered a subsidiary undertaking of the parent undertaking which is the parent of the undertakings to be consolidated. * These Articles refer to circumstances in which the Directive permits an undertaking to be excluded from consolidated accounts. 10

11 ABSTRACT 43 Appendix 2 Extract from the Fourth Directive dealing with contents of the annual report Contents of the annual report Article (a) The annual report shall include at least a fair review of the development and performance of the company's business and of its position, together with a description of the principal risks and uncertainties that it faces. The review shall be a balanced and comprehensive analysis of the development and performance of the company's business and of its position, consistent with the size and complexity of the business; (b) To the extent necessary for an understanding of the company's development, performance or position, the analysis shall include both financial and, where appropriate, non-financial key performance indicators relevant to the particular business, including information relating to environmental and employee matters; (c) In providing its analysis, the annual report shall, where appropriate, include references to and additional explanations of amounts reported in the annual accounts. 2. The report shall also give an indication of: (a) any important events that have occurred since the end of the financial year; (b) the company's likely future development; (c) activities in the field of research and development; (d) the information concerning acquisitions of own shares prescribed by Article 22 (2) of Directive 77/91/EEC. (e) the existence of branches of the company; (f) in relation to the company's use of financial instruments and where material for the assessment of its assets, liabilities, financial position and profit or loss, - the company's financial risk management objectives and policies, including its policy for hedging each major type of forecasted transaction for which hedge accounting is used, and - the company's exposure to price risk, credit risk, liquidity risk and cash flow risk. 3. Member States may waive the obligation on companies covered by Article 11 to prepare annual reports, provided that the information referred to in Article 22 (2) of Directive 77/91/EEC concerning the acquisition by a company of its own shares is given in the notes to their accounts. 4. Member States may choose to exempt companies covered by Article 27 from the obligation in paragraph 1(b) above in so far as it relates to non-financial information. 11

12 UITF CONSENSUS PRONOUNCEMENTS 12