FIFTH EDITION FIFTH EDITION Generally Accepted Accounting Practice in the United Kingdom Mike Davies, Ron Paterson and Allister Wilson ~ ill ERNST &Y OUNG MACMILLAN © Ernst & Young, 1997 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WIP 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. Fifth edition published 1997 by MACMILLAN REFERENCE LTD, 25 Eccleston Place, London SW1W 9NF, UK. Companies and representatives throughout the world. ISBN 978-1-349-13821-0 ISBN 978-1-349-13819-7 (eBook) DOI 10.1007/978-1-349-13819-7 Distributed by Macmillan Distribution Ltd, BruneI Road, Houndmills, Basingstoke, Hampshire RG21 6XS, UK. Macmillan Reference on the WWW http://www.macmillan-reference.co.uk A catalogue record for this book is available from the British Library. No responsibility for loss occasioned to any person acting or refraining from action as a result of the material in this publication can be accepted by the authors or publishers. Foreword to the fifth edition Seldom has a comprehensive and authoritative treatise on a country's accepted accounting practice been so readable and easily accessible to a wide audience that it can be recommended not only to accounting practitioners and finance directors but also to students, academics, and users of financial statements, both in the country and overseas. The authors' success at explaining a complex, technical subject in conversational prose is an impressive achievement. Numerical examples and graphs, as well as extracts from company annual reports, nicely complement the explanations and serve to illustrate applications. The authors supply useful historical background, and they draw on their firm's collective experience to breathe life into dry and sometimes arbitrary accounting standards, Companies Act provisions, and stock exchange rules. Consonant with the movement toward an international harmonisation of accounting standards, the authors make frequent comparisons with US standards as well as those issued by the International Accounting Standards Committee. In the chapter dealing with the conceptual framework, UK initiatives are compared with a selection of those proposed or adopted in the US, Canada, Australia and New Zealand, as well as with that of the lASe. The authors' analysis and criticism of particular standards and practices, as well as of the Accounting Standards Board's evolving conceptual framework, do much to stimulate the reader's critical faculty. The controversy stirred by these views is a lively addition to the literature on accounting standards and principle~. Throughout the book, the discussion is enriched by the authors' frequent arguments for improved standards and practices. At the close, the authors helpfully provide a complete set of specimen financial statements for a hypothetical group, as a guide to those concerned with preparing company accounts. At a time when accounting standards have become so detailed and complicated that they sometimes are not understood even by experts, a work that is at once authoritative and instructive is to be welcomed by all who have a stake in the soundness of company financial reporting. Since the publication of the first edition of UK GAAP in 1989, I have found it to be an indispensable reference work to the norms governing UK financial reporting. Through this foreword, I am pleased to commend the fifth edition to a wide audience. June 1997 Stephen A. Zeff Herbert S. Autrey Professor ofA ccounting Rice University Preface to the fifth edition UK GAAP has developed very significantly since we published the first edition of this book in 1989. Evidence of this can be seen in the progressive expansion of the book itself; this fifth edition is nearly twice the size of the original. The most important factor in this, of course, has been the creation of the Accounting Standards Board in 1990, which has had a profound effect on the shaping of accounting practice, as we have chronicled in each subsequent edition. In the 1989 Preface to the book, we promised to be forthright in our views as to how accounting practice could be improved. It is well known that since then we have often disagreed with proposals put forward by the ASB, and in particular that we have profound reservations about its draft Statement of Principles. The reason for this is not doctrinaire; we simply do not think that this framework provides a good foundation for practical standards that will generate understandable accounts, and this book discusses many examples which explain why that is the case. However, we also compliment the Board on some of its other achievements in enhancing the annual reporting package, such as the development of the cash flow statement and the Operating and Financial Review. More generally, through the distinctive leadership of Sir David Tweedie, the ASB has consistently provided strong advocacy for the best ideals of financial reporting, which we applaud and wholly support, even if we differ as to how these ideals should be advanced. In 1997, the new factor which may prove to have the most influence on the future development of UK GAAP is the IASC's bid to develop its standards to a level at which they will be accepted throughout the world's capital markets. If a truly global corpus of standards does emerge, it is bound to affect accounting in this country. We continue to record all the developments in this wider arena. As with all earlier editions, we are indebted to a number of our colleagues in Ernst & Young for their help with the publication of this book, most notably Joanne Brundish, Jan Collins, Matthew Curtis, Carla Jones, Leonie Moffat and Trevor Pijper, but also all the other members of the Technical Services Department, who contributed both directly and indirectly to the book's creation. As authors, however, we continue to take responsibility for all the opinions expressed in the book and the blame for all its faults. August 1997 Mike Davies Ron Paterson Allister Wilson List of chapters 1 The development of UK GAAP ............................................................................. 1 2 The quest for a conceptual framework for financial reporting ........................... .39 3 Revenue recognition .......................................................................................... 129 4 Corporate governance and the OFR ................................................................... 177 5 Consolidated accounts ....................................................................................... 225 6 Business combinations and disposals ................................................................ 269 7 Associates and joint ventures ............................................................................. 421 8 Foreign currencies .............................................................................................. 465 9 Financial instruments ......................................................................................... 589 10 Fi.xed assets and depreciation ............................................................................. 623 11 Investments ........................................................................................................ 717 12 Research and development. ................................................................................ 737 13 Capitalisation of borrowing costs ...................................................................... 755 14 Stocks and long-term contracts .......................................................................... 795 15 Capital instruments ............................................................................................ 845 16 Off balance sheet transactions ............................................................................ 923 17 Leases and hire purchase contracts .................................................................... 979 18 Government grants ........................................................................................... 1045 19 Segmental reporting ......................................................................................... 1059 20 Pension costs .................................................................................................... 1105 21 Taxation ........................................................................................................... 1185 22 Reporting financial performance ..................................................................... 1253 23 Earnings per share ............................................................................................ 1321 24 Post balance sheet events ................................................................................. 1377 25 Contingencies ............................................................................... : ................... 1407 26 Provisions ......................................................................................................... 1433 27 Cash flow statements ....................................................................................... 1467 28 Related parties .................................................................................................. 1531 29 Directors' and officers' loans and transactions ................................................ 1581 30 Directors' remuneration ................................................................................... 1615 31 Interim reporting .............................................................................................. 1705 Appendix: Specimen financial statements ........................................... , ..................... 1723 Index of extracts from accounts ................................................................................. 1795 Index of Statutes and Standards ................................................................................. 1803 Index ......................................................................................................................... 1815 Detailed contents CHAPTER 1 THE DEVELOPMENT OF UK GAAP 1 1 Definition of 'UK GAAP' ....................................................................................................... 1 1.1 'Principles' or 'practice' .......................................................................................... 1 1.2 What is 'generally accepted'? ................................................................................. 3 2 Accounting standards and the concept of 'true and fair' ......................................................... 3 2.1 The introduction of the true and fair concept .......................................................... 3 2.2 The interaction of accounting standards and the law ...•......................................... .4 2.3 The role of International Accounting Standards ..................................................... 7 2.4 The experience of other countries ........................................................................... 9 2.4.1 US ........................................................................................................ 9 2.4.2 Canada ............................................................................................... 14 2.4.3 Germany ............................................................................................ 15 3 The development of accounting standards ............................................................................. 16 3.1 I The Accounting Standards Committee .................................................................. 16 3.1.1 The creation of the ASC .................................................................... 17 3.1.2 The objects and terms of reference of the ASC ................................. 17 3.1.3 The Watts Report ............................................................................... 18 3.1.4 The McKinnon Report ....................................................................... 18 3.1.5 The Dearing Report .... :. ..................................................................... 18 3.1.6 The implementation of the Dearing proposals ................................... 21 3.2 The Accounting Standards Board .......................................................................... 22 3.3 Statements of Recommended Practice (SORPs) ................................................... 24 4 GAAP for small companies ................................................................................................... 25 4.1 The Big GAAP/Little GAAP debate ..................................................................... 25 4.2 The ASC's initiative on 'small companies' ........................................................... 26 4.3 The Financial Reporting Standard for Smaller Entities (FRSSE) ......................... 27 4.4 What is the small company solution? .................................................................... 29 5 Summary financial statements ............................................................................................... 30 5.1 The required form ofa summary financial statement ............................................ 30 5.2 The ICAEW survey ............................................................................................... 32 5.3 Commentary ...........................................................................................................3 3 viii Generally Accepted Accounting Practice in the United Kingdom 6 Conclusion ............................................................................................................................. 35 CHAPTER 2 THE QUEST FOR A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING 39 1 Introduction ................................................................................................................•.......... 39 1.1 What is a conceptual framework? ......................................................................... 39 1.2 Why is a conceptual framework necessary? .......................................................... 39 1.3 Early attempts to establish a framework ............................................................... .41 2 The AICPA's early initiatives in the United States ............................................................. .43 2.1 Accounting Research Studies ................................................................................ 43 2.2 APB Statement No. 4 ............................................................................................ 44 2.3 The Wheat and Trueblood Committees ................................................................. 45 3 The FASB conceptual framework ........................................................................................ 46 3.1 Introduction ........................................................................................................... 46 3.2 The objectives of financial reporting .................................................................... .47 3.3 The qualitative characteristics of accounting information ..................................... 50 3.3.1 The decision-makers .......................................................................... 51 3.3.2 The cost/benefit constraint. ................................................................ 51 3.3.3 Understandability .............................................................................. 52 3.3.4 Relevance and reliability ................................................................... 52 3.3.5 Comparability .................................................................................... 54 3.3.6 Materiality ......................................................................................... 54 3.3.7 Conservatism ..................................................................................... 55 3.4 The elements of financial statements .................................................................... 55 3.4.1 Assets ................................................................................................. 55 3.4.2 liabilities ........................................................................................... 56 3.4.3 Equity ................................................................................................ 57 3.4.4 InvestInents by owners ...................................................................... 57 3.4.5 Distributions to owners ...................................................................... 57 3.4.6 Comprehensive income ..................................................................... 57 3.4.7 Revenues, expenses, gains and losses ............................................... 58 3.5 Recognition and measurement .............................................................................. 59 3.6 Using cash flow information in accounting measurements (discounting) ............. 60 3. 7 Conclusion ............................................................................................................. 63 4 UK initiatives ......................................................................................................................... 64 4.1 SSAP 2: Disclosure of accounting policies ........................................................... 64 4.1.1 Fundamental accounting concepts ..................................................... 64 4.1.2 Accounting bases ............................................................................... 65 4.1.3 Accounting policies ........................................................................... 66