Accounting Standards for Small and Medium-sized Entities
The Board held an educational session on two issues relevant to the project on financial reporting by small and medium-sized entities (SMEs):
1. Bank lending to SMEs
The SME Research Director and Chief Economist of a major United Kingdom bank explained his bank's approach to initial lending decisions and subsequent loan monitoring for borrowings by various size categories of SMEs. He discussed when and how financial statements are used in lending and loan monitoring, including whether adjustments are made to the data in the financial statements; which information is not found to be useful, and why; and which information is missing that lenders would like to have.
The Board was informed of the general credit sanctioning process, which differs depending on turnover levels as well as other factors. Regarding the general process of credit sanctioning, the following was noted and discussed:
- Pre-scoring / approval is generally used to approve loans to borrowers with a turnover of up to £500,000. This process involves using the account data of the individual borrowing. Borrowing levels tend to be up to about £50,000. For 'start up' entities, behavioural scoring is used.
- Up to two-thirds of lending is unsecured, although any collateral offered is priced into the interest rate.
- For borrowers with turnover approximately in the region of £0.5m and £1m the approval process for loans tends to become more complicated. Typically, this group borrows between £50,000 and £100,000.
As regards the financial information needs of lenders, the following was noted and discussed:
- Most of the information required for credit sanctioning as well as ongoing monitoring of borrowers is standardised by individual financial institutions to their information needs and systems and will vary across the banking industry. Information required for such standardised systems is generally obtained from management reports. The requirement of most loan agreements is the furnishing of timely management reports to the lender and such reports are generally viewed as the primary source of information. The frequency with which management reports are required by lenders depends on circumstances and will range from periods of less than one month to six-monthly reports.
- Annual financial statements are used as a 'cross check' of the information contained in management accounts. It was pointed out that the income statement is particularly useful in the credit sanctioning process and that, on the whole, lenders are satisfied by the structure and content of the income statement and balance sheet as currently presented. Those statements provide the minimum information required by lenders. Lenders do not insist that annual financial statements must comply with the FRSSE (see below) or any particular accounting framework. Any changes proposed by the IASB to other aspects of the financial statements would not impact lenders significantly as access to management accounts is generally unrestricted.
- The point was made that consolidated cash flow statements are generally not used by lenders as these are derived by lenders themselves based on the income statement and balance sheet.
It was noted that the above issues may not necessarily be similar to how lending activities are conducted elsewhere in Europe or other parts of the world. Much of the discussion revolved around credit sanction which is distinct from ongoing control and monitoring of borrowers, which was not discussed.
2. UK's Financial Reporting Standard for Small Entities (FRSSE) issued by the UK Accounting Standards Board (ASB)
The chair of the committee of the ASB responsible for developing and maintaining the FRSSE discussed the features of the FRSSE, implementation of the FRSSE by UK SMEs, and acceptance of the resulting financial statements by users. She explain the criteria the ASB has used to make simplifications in the areas of disclosure, presentation, recognition, and measurement and what is required of an SME when the FRSSE does not address a particular accounting issue.
The following issues were discussed and noted:
- The criteria set for entities to qualify to use the FRSSE is based on EU legislation and is as follows:
- Turnover £5.6m
- Balance sheet total £2.8m
- Average number of employees 50
- Certain companies are excluded from the 'small company' criteria for reasons of public interest. These are any entity that is, or is in a group that includes:
- a public company;
- a banking or insurance company;
- a body corporate that (not being a company) has the power to offer its shares or debentures to the public and may lawfully exercise that power;
- an authorised institution under the Banking Act 1987;
- an insurance company to which Part II of the Insurance Companies Act 1982 applies; or
- an authorised person under Part IV of the Financial Services and Markets Act 2000.
- Whilst the FRSSE is now in its fifth edition, it was pointed out that the amendments, which occur on average every two years, are not of a minor nature. The changes have emanated mainly from changes to UK GAAP, and the FRSSE tends to lag behind by between one and two years in this regard. The time lag is intentional as this allows the ASB to gather information about the changed requirements as they affect SMEs and experience, before making amendments to the FRSSE. IASB members indicated their intention to have the IFRS standard running parallel to other IFRSs as this would be a standard applicable on a global scale.
- The only area where the FRSSE is more detailed than UK GAAP is in the area of related party disclosures.
- There is no mandatory fall back to UK GAAP where the FRSSE contains no guidance on a particular issue. Instead, the FRSSE guides preparers as follows:
- first, the financial statements must give a true and fair view;
- accounting policies and estimation techniques must be consistent with the requirements of the FRSSE and of company's legislation. Where a choice is permitted, "an entity shall select the policies and techniques most appropriate to its particular circumstances for the purpose of giving a true and fair view, taking account of the objectives of relevance, reliability, comparability and understandability;"
- paragraph 2.5 of the FRSSE then acts as a 'catch all' by requiring "where there is doubt whether applying provisions of the FRSSE would be sufficient to give a true and fair view, adequate explanation shall be given in the notes to the accounts of the transaction or arrangement concerned and the treatment adopted."
- In addition, the introductory remarks on the status of the FRSSE state that "financial statements will generally be prepared using accepted practice and, accordingly, for transactions or events not dealt with in the FRSSE, smaller entities should have regard to other accounting standards and UITF Abstracts, not as mandatory documents, but as a means of establishing current practice." There was some discussion about what constitutes 'established practice' when an SME is seeking to establish accounting policies for transactions that are not specifically dealt with by the FRSSE. Some believed this would involve determining the requirements in UK GAAP for such transactions as they apply to other entities (a type of indirect fall back to UK GAAP) as there could be no established practice amongst SME's as the transactions are neither common nor is there any accounting guidance for that section of preparers (not included in the FRSSE). It was pointed out that when looking for established practice, this involved surveying SME's to assess prevalence of the transactions as well as the treatment adopted. Consequently, only when SME's are generally issuing share-based payment transactions will this type of transaction be dealt with by the FRSSE. Some IASB members indicated that they had been unaware that the requirements of the FRSSE were not as comprehensive as they had thought, given that the FRSSE did not prescribe the accounting for derivatives and share-based payment transactions, and that there was no fall-back to full UK GAAP should these transactions occur. IASB members stated a concern about issuing a standard that omits guidance on important transactions given the fact that the IASB's standard would be applied globally. It was pointed out that the FRSSE included guidance on transactions that were expected to occur within the target group of entities. Some Board members certain concerned that some small entities enter into derivatives and share-based payment transactions that would not be accounted for if the FRSSE was applied. Instead some disclosures of the transaction would be required together with the accounting treatment adopted, if any. In addition, some IASB members expressed concern about the basis for assessing a 'true and fair view' if the standard does not prescribe guidance on the accounting for derivatives and share-based payment transactions. Other Board members drew the Board's attention to the fact that the UK had no standard dealing with financial instruments until very recently, but this did not affect the assessment of 'true and fair view', therefore the Board should not seek to provide guidance in the SME standard for every conceivable transaction.
- The FRSSE is based on objectives for financial statements that primarily focus on stewardship of the entity's management and secondarily for making economic decisions. Some IASB members expressed their concern on this issue as they believe financial statements should be 'forward looking' by providing information with predictive value.