The impact of FRS 102 on medium sized companies

Abstract

Background IFRS for SMEs was published in 2009. Following a consultation by the European Commission, the majority opinion amongst EU member states was that its adoption should be provided for within the EU accounting legal framework. In the light of this discussion, the UK’s Financial Reporting Council decided to implement a new standard for medium sized companies (FRS102, effective 1st January 2015), based on the IFRS for SMEs but which avoided its conflicts with the EU Accounting Directives. FRS 102 is the cornerstone of a new financial reporting regime that represents the most significant change to UK GAAP in a generation. There are areas of key differences between the old UK GAAP and FRS 102 which, in turn, expected to have impacts on financial reporting and consequently on key financial ratios. Ormrod and Taylor (2004) argue that the change in accounting standards could have unexpected consequences for reported figures that were unrelated to changes in the company’s circumstances. The importance of this research area stems from how the application of new accounting regulation might affect financial reporting and then the decisions by the main stakeholders. Objective The objective of this Ph.D. thesis is to examine the impact of FRS 102 implementation on key financial ratios of liquidity, leverage, and return of medium-sized companies in the UK. The purpose of this is to inform different interested stakeholders, such as the adopting companies, lenders, regulators and member states of EU about the impact of the transition to FRS 102 on medium-size companies, as there is no previous evidence in this regard. Recognizing and understanding the effect of FRS 102 on financial reporting might affect making decisions by these stakeholders. Method Due to the lack of the relevant literature and, more specifically, no previous study about the impact of FRS 102 on medium-size companies, semi-structured interviews with highly experienced practitioners have been conducted to give some insight regarding the areas of impacts after the transition from old UK GAAP to FRS 102, and to help in identifying the types of companies that could be affected as a result. These interviews are complementary to the limited literature to narrow down the focus of the study in terms of the areas of impact and the likely affected companies as well as to help in developing the research hypotheses. Afterwards, I conduct my investigation using triangulation between two methods. Firstly, the ‘reconciliation statements’ method based on the financial reports for the year prior to FRS 102 implementation. In this year, financial statements are available under both old UK GAAP and FRS 102 which give a unique opportunity to examine the impact of FRS 102. Although the sample is relatively small, as the data are hand-collected, the changes reflect only the impact of FRS 102. In other words, there are no other factors involved except the transition to FRS 102 and then the effects are, for sure, caused by FRS 102. Secondly, I use the ‘difference-in-differences’ method using the year before and the year after the transition to FRS 102 to achieve the same research objective. The ‘difference-in-differences’ method is based on a large sample; however, I need to exclude the effects of other factors (economic effects). Both methods are commonly used in the research area and each method has strength and weakness. The weakness of each method is unique to that method and therefore is not replicated and therefore I take advantage of the using both methods as a form of ‘method triangulation’. Moreover, using both methods is considered as a contribution to the present study as the previous studies in the area use only either ‘reconciliation statements’ method or ‘difference-in-differences’ method. Results According to the interviews, transactions that are expected to have a significant impact on medium-size companies are investment properties, financial instruments, pension costs, capitalization of borrowing costs, intra group loans and deferred tax. Whereas transactions that are expected to have low/no impact on financial reporting are intangible assets, holiday pay, capitalization of development costs and leasing. Also, it is expected to be volatility in profit after the transition to FRS 102. Accordingly, the sample selection in chapter 4 (reconciliation statement-based analysis) and in the first section of analysis in chapter 5 (difference-in-differences analysis) is based on these areas of expected effect, namely, due to the type of transactions. The findings from chapter 4 are based on 368 medium size companies from Companies House in the year of transition (reconciliation statements in 2014). These are companies more likely to have similar transactions. The findings show that these companies have less liquidity, less performance, and more risk as well as more volatility in profits. Accordingly, the image of this group of companies seems worsened. This might affect the relationship with the main stakeholders especially banks. The findings from chapter 5 are based on the entire population of medium size companies, which are 6430 medium-sized companies for the years 2014 and 2015 taken from the FAME database. These findings show that the smaller medium-sized companies have less liquidity but better performance and less risk. This consequently, might create more tax to pay. As for the larger medium-sized companies have greater liquidity but poorer performance and more risk. This consequently, might make it more difficult to borrow more money from banks and/or might affect the debt covenants. In terms of industry effect, the findings suggest that the effect of FRS 102 spreads across different industries, and some industries look better than others. Finally, the reasons behind the changes are fair value accounting of investment property and financial instruments as well as the treatments of amortization, pension liabilities, deferred tax and group loans. The two methods used in chapter 4 and chapter 5 are totally different in terms of the source of data, sample size, statistical tests, time periods, the effect of transitional adjustments in chapter 4 and economic effect in chapter 5. However, the findings from both chapters (5 and 6) are generally consistent between companies likely to have similar transactions (in chapter 4) and the larger medium-size companies (in chapter 5) which are also expected to have more complex transactions. More specifically, both groups of companies (samples) have reductions in profitability and Interest Cover and an increase in leverage. Implication Why does it matter? Shareholders need to understand why reported figures might have changed. For banks, small changes might have critical effects on financial ratios and then on debt covenants. Other interested parties are Government, employees, suppliers, and competitors (see the general conclusion). Furthermore, the findings will be of interest to the member states of EU that might consider following (or not to follow) the UK as a first case that amended and applied IFRS for SMEs which is not permitted, to be adopted as it is, according to the incompatibilities with EU Accounting Directive. The present study contributes to the relevant literature (Callao et al., 2007; Asbitt, 2006; Stenka et al., 2008; Gastón et al., 2010; Lantto et al., 2009; Tsalavoutas and Evans, 2010 and Pálka and Svitáková, 2011) in terms of how changes in accounting regulations affect the way in which performance is reported, and how key financial ratios, which might have impacts on contractual obligations, could be affected. Ormrod and Taylor (2004) argue that the change in accounting standards could have unexpected consequences for reported figures that were unrelated to changes in the company’s circumstances. This research area is underrepresented in the academic literature for SMEs and more specifically for medium-sized companies. Moreover, there is no previous evidence about the impact of FRS 102 on financial reporting. Also, the findings are inconsistent with the Anglo-Saxon debate which suggests that UK companies are not expected to be affected by international accounting standards as they have a similar environment where these standards have been established. Another contribution is in terms of the research methodology, as two commonly used methods have been triangulated to achieve the same aim and to give the whole picture of the FRS 102 implementation on medium-size companies. This is considered as a contribution, as there is no previous study has conducted such triangulation. Furthermore, the findings of this study, after FRS 102 adoption, will give feedback to the regulators especially in the review of the standard as well as being of interest to the main users of financial statements of medium-sized companies regarding the recognizing and understanding the effect of the changes after the transition to FRS 102.