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Manufacturing
The future for UK automotive & aerospace industries under IAS
by Michelle Fisher
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Contents
Introduction
Executive Summary
Foreign Transactions
10
Revenue Recognition
12
Segmental Reporting
13
15
Business Combinations
20
Who to Contact
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Introduction
Convergence program
As indicated above, the ASB is developing UK standards
based on IAS. Since May 2002, the ASB has published
nine exposure drafts (FRED 23 30) as part of its effort to
achieve convergence between UK GAAP and IAS.
Many of these are expected to become standards in 2003.
The International Accounting Standards Board (IASB)
published an exposure draft in May 2003 called
Improvements to IAS. This proposes revisions to
twelve IAS.
As the IASB change existing standards, the ASB is
proposing that these are incorporated into UK GAAP.
As any new standards will apply to all companies in the
UK, the impact of IAS will affect non-listed companies
regardless of the Department of Trade and Industry (DTI)
consensus. The result of the convergence program may
mean that UK GAAP will equal IAS by 2005.
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Impact of IAS
Executive summary
Foreign exchange;
Revenue;
Foreign exchange
Segmental analysis
2002 Plan
Implementation of IAS;
2003 Implement
Business Combinations
2004 Comparatives
2005 Deadline
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Foreign exchange
and hedging
Overview
Large UK manufacturers usually have a significant global
presence and they are exposed to exchange rate
movements on many transactions and on the translation
of the net assets and profits of foreign subsidiaries.
To minimise this exposure, companies often have hedging
policies which involve the use of financial instruments,
generally forward contracts.
Under IAS, there are extremely complex rules and
guidance on accounting for financial instruments and
hedging. This chapter only gives a brief summary of the
key changes expected to foreign exchange transactions and
hedging of foreign currency risk under IAS.
Foreign transactions
Initial recognition of transactions
IAS and UK GAAP treat the following foreign currency
transactions by a single entity in the same way:
Foreign Operations
Temporal method
UK GAAP and IAS both require the financial statements
of foreign operations, which are integral to the operations
of the reporting enterprise, to be translated as if the
transactions are those of the reporting entity (see
transactions of a single entity).
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Financial instruments
and hedging
Accounting for forward foreign exchange
contracts
In the UK, there is no specific guidance on accounting for
derivatives, although detailed disclosures are required.
Under IAS, derivatives (which include forward foreign
exchange contracts, futures, currency swaps and options)
will initially be measured at cost. Derivatives, if not
designated as hedging instruments, are classified as held
for trading financial instruments under IAS 39, Financial
Instruments Recognition and Measurement. This means
they will be subsequently measured at fair value and gains
or losses will be taken to the income statement.
Hedging criteria
Under IAS, a hedging relationship qualifies for special
hedge accounting if and only if specific criteria are met. In
the UK, there is no comprehensive guidance on hedging,
so there are few restrictions on its use.
IAS 39 allows hedge accounting if the following conditions
are met (see text box at the end of this chapter for more
detail):
Impact of IAS
Net Investment method In practice, most companies
in the UK use the average rate to translate the income
statement so the restriction under IAS to the closing
rate is unlikely to have a strong impact on current
accounting treatments.
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Impact of IAS
There will be much stricter rules on hedge accounting
under IAS so many hedges will no longer be allowed
(e.g. simpler hedge strategies may not be effective).
The terms of derivatives will need to be considered
carefully to ensure they will make effective hedging
items and pricing agreements will need to be
structured so they fit with the derivatives which are
available for hedging. Businesses will need to develop a
thorough hedging and risk management strategy to
ensure the hedging criteria are met.
Proposals to remove the basis adjustment under IAS
will mean that keeping track of the effective part of the
hedge on particular assets will be difficult. Information
systems must be adapted to do this and address other
issues such as testing of effectiveness of a hedge.
In general, accounting for derivatives and hedges under
IAS is likely to lead to enhanced volatility in profits and
equity.
Recent UK developments
FRED 23 and 24 have been issued to bring the UK
treatment in line with current IAS treatment of foreign
exchange transactions and hedging.
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Research and
Development
Overview
Initial recognition
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Impact of IAS
Compulsory capitalisation of specific development
costs may increase the net assets of those entities who
would normally expense such costs. The income
statement will be affected over a number of years by
amortisation rather than in the year of expense. Extra
staff time will be required in order to review
expenditure against the criteria under IAS and to
review any impairment and amortisation of the costs
carried forward.
For those companies who already capitalise such cost,
the stricter IAS criteria will have to be met or the cost
will need to be expensed. All companies will need to
expense any prior year costs that have been reinstated.
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Company
Accounts
GKN plc
Year end
31 Dec 2001
Smiths
Group plc
Year end
31 July 2001
Tomkins plc
Year end
30 April 2001
Rolls-Royce plc
Year end
31 Dec 2001
Meggitt plc
Year end
31 Dec 2001
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Overview
Measurement of stock
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Recent UK developments
FRED 28 has been released based on IAS 11 Construction
Contracts, IAS 2 Inventories (including proposed
changes to LIFO and exchange differences) and some of
IAS 18, Revenue. A standard is expected at the beginning
of 2003 which will replace SSAP 9.
Impact of IAS
There will be little change in the treatment of stock
under IAS.
The main difference will be within long-term contracts.
Companies will need to consider the combination or
segregation of contracts. In addition, some
requirements over presentation and disclosures will
change under IAS, however, it is unclear how
significant the differences will be in the future.
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Revenue Recognition
Overview
Revenue is usually the largest balance in the accounts of
manufacturers. Sales and market share are two of the
most common statistics used in financial highlights given
by companies.
Guidance
Currently, UK GAAP has no general revenue recognition
criteria. The guidance followed in the UK is within the
ASBs Statement of Principles and FRS 5. An ASB
discussion paper on Revenue Recognition was published
in July 2001, as a first step towards an accounting
standard.
IAS 18 Revenue is a specific IAS on revenue recognition.
Under IAS, revenue recognition criteria is given for three
types of transactions:
Impact of IAS
There will be little difference in revenue recognition,
however IAS deals with some transactions in more
detail and this will need to be followed.
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Segmental Reporting
Overview
Large manufacturers usually have a significant global
presence and carry out many types of business. Segments
will have significantly different profitability rates,
opportunity for growth and degrees of risk.
Sometimes, the disclosure of segmental information can
be prejudicial. For example, where a company operates in
countries in which competitors are not required to provide
segmental analysis, they will be providing the competitors
with useful one way information about their results and
returns in different markets.
Scope
In the UK, the standard has requirements which apply to
all entities and additional requirements for public limited
companies, those with a public limited company as a
subsidiary and entities which exceed specific size criteria
(unless its parent provides segmental information).
Under IAS, the requirements only apply to entities whose
equity or debt securities are publicly traded or who are in
the process of going public. There are no requirements,
which apply to all entities. In group accounts, segment
information only needs to be given based on the
consolidated financial statements, as in the UK.
Both IAS and UK encourage all entities to apply the
provisions of the accounting standards. However IAS,
unlike UK GAAP, states that if an entity chooses to
disclose segment information voluntarily in its financial
statements, it must comply with the requirements in the
standard in full. This is likely to be off-putting to some
entities due to the extensive disclosures required.
However, it prevents entities from only showing selective
information.
Approach
Under UK GAAP, reportable segments are determined by
different returns, risks, rates of growth and future
development potential.
IAS adopts a slightly different approach and requires an
entity to identify segments using its internal reporting
structure. The basis for this is that risks and returns affect
how companies are organised and managed.
Both IAS and UK GAAP require business and
geographical segments to be disclosed. IAS requires one
of these to be reported in primary format and the other
secondary format depending on which segments have the
biggest impact on risks and returns.
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Disclosure
Result; and
Net assets.
Impact of IAS
Iiabilities;
Capital additions;
Depreciation; and
Revenue;
Assets; and
Capital additions.
Other differences:
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Overview
Impairment of assets
This project would examine some impairment issues
within the existing standards in various jurisdictions and
look to develop a common solution. Issues could include:
use of impairment triggers, definition of impairment, and
reversals of impairment losses.
Leases
This project would seek to improve the accounting for
leases by developing an approach that is more consistent
with the definitions of assets and liabilities in the
conceptual framework. This will build on an earlier
G4+1 Study. The G4+1 is an association of the accounting
standard-setting bodies including the ASB. The IASB
participate in the work of the G4+1 as an observer.
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Recent UK developments
Proposals from G 4+1 study
For lessees, the objective should be to record, at the
beginning of the lease term, the fair value of the rights and
obligations that are conveyed by the lease.
Leases that are presently characterised as operating leases
(and not on the lessees balance sheet) would give rise to
assets and liabilities, but only to the extent of the fair values
of the rights and obligations that are conveyed by the lease.
Thus, if a lease were for a small part of an assets economic
life, only that part would be reflected in the lessees balance
sheet.
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Subject
Current differences
Initial
measurement
of tangible
fixed assets
(TFA)
Subsequent
expenditure
on TFA
Revaluations
of TFA
Impairment of
TFA held at cost
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Subject
Current differences
Impairment of
revalued TFA
Depreciation of
TFA
Capitalisation
of borrowing
costs
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Subject
Current differences
Classification
of leases
(lessee only)
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Business
Combinations
Overview
Impact of IAS
This is not an area that is typical to the automotive and
aerospace industries. However, there will be a
considerable impact on larger groups due to the
amount of goodwill and frequency of acquisitive
activity. For example, on introduction of IAS,
impairment testing of goodwill and the recognising
more intangibles on the balance sheet could initially
cause significant amounts of goodwill to be written off.
This reaction was seen in the US when companies had
to adopt a similar accounting treatment to that under
IAS.
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Subject
Goodwill
general
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Negative
goodwill
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Intangible
assets
acquired in
business
combination
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Subject
Measurement
of assets and
liabilities on
acquisition
Restructuring
provisions at
acquisition
Cost of
acquisition
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Subject
Minority
Interests
Uniting of
Interests
(mergers)
Subsidiaries
excluded
from
consolidation
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Who to contact
UK Manufacturing Group Leader
Philip Johnson
prjohnson@deloitte.co.uk
asimmonds@deloitte.co.uk
mifisher@deloitte.co.uk
Deloitte & Touche would be pleased to advise on specific application of the principles set out in this publication.
Professional advice should be obtained as this general publication cannot be relied upon to cover specific
situations; application will depend upon the particular circumstances involved.
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