Sir David Tweedie
Chairman
Accounting Standards Board
FRED 19 - ACCOUNTING FOR DEFERRED TAX
I apologise for the late response to your Exposure Draft. It has taken some time for the implications of your proposals to filter through to our membership. The main areas of concern expressed to us may be summarised as follows:
1. the restriction, arising from changes in accounting treatment, in distributable reserves available to pay dividends and/or rearrange the capital structure of a business to improve shareholder value.
2. the impact on financial covenants in loan documentation from the resulting reduction in reported net worth.
3. the provision of meaningful information to investors and analysts. Clearly, unnecessary subjectivity in the preparation of accounts should be eliminated and a company's accounts should reflect the full tax implications of all transactions that have already taken place. However, accounts should not be made up of meaningless mathematical differences or include large, long-term liabilities which do not present a fair picture of a company's financial position. If these principles are followed then we believe that the three areas of concern mentioned above can be adequately catered for in accounting for deferred tax. On balance we believe that the flow-through method is the one that best follows these principles and is also closest to complying with your Statement of Principles.
Our second choice would be to maintain the status quo. SSAP 15 may be subjective, as discussed below, but in our view is preferable to the other alternatives.
In response to the specific issues set out on page 7 of the Exposure Draft our views are as follows:
1. We agree that SSAP 15 and the partial provision method should be replaced with a method that is less dependent on a subjective judgement. This is clearly less acceptable in the current international accounting environment. However, we do not agree that the full provisioning method proposed in FRED 19 is the appropriate approach to adopt, particularly if the objective is international harmonisation, since the approach proposed is still fundamentally different from that in FAS 103 and IAS 12. Full provisioning also fails to comply with the Statement of Principles.
2. The flow-through method offers significant advantages in terms of its clarity and objectivity. We believe that this approach, accompanied by rigorous disclosure of a company's tax position, is the one most likely to provide investors with the information they need (being closest to cash flow) while minimising balance sheet movements which would cause problems with financial covenants. It may prove difficult to defend in the international accounting community but could be justified by the differences in the calculation of UK taxable profits compared with most other countries. In addition many believe that the approach adopted by FAS 103 and IAS 12 is fundamentally flawed.
3. We believe that a company's accounts should reflect the full tax implications of all transactions which have already taken place but we do not believe that such liabilities should be anticipated by bringing them into the accounts before it is clear that they will become payable. We do not therefore support the approach proposed by FRED 19.
4. With regard to discounting, we believe that accounts should not include large, long-term liabilities at their full value, since this would lead to a distorted representation of a company's financial position. We are therefore supportive of discounting as a concept, should the FRED 19 approach be adopted. However we have considerable concern about the practicality of discounting. For many companies it will not be worth the time and effort expended even if the effect is material.
5. Further, we do not support the proposal that the discount element is charged or credited to the interest line in the Profit and Loss Account since this will mean that amounts relating to taxation will have an impact on the key figure of Profit Before Tax. In our view, the annual change in the discounting element should be treated as part of the current year tax charge in exactly the same way that changes in rates of taxation or a reassessment of the likelihood of rollover relief being available would be charged or credited through the current year tax charge.
We would like to make an additional comment on the impact of accounting changes on financial covenants, which applies, of course, not only to FRED 19 but a number of other proposals in the pipeline. Companies are coming under increasing pressure from banks to agree to their loans being transferable and we have already seen circumstances in which a borrower attempting to re-negotiate financial covenants has been "held to ransom" by holders of its debt. Banks themselves are coming under pressure to be more transactional and less relationship driven. The changes currently proposed by FRED 19 could cause a number of major borrowers to seek to re-negotiate their covenants in order to put borrowers and lenders in the same position as was initially intended. It can no longer be assumed that lenders will negotiate in good faith to achieve this position and some companies could be heavily penalised due simply to a change in accounting practice.
Similarly, on the issue of distributable reserves, we understand that under FRED 19 some companies may find their ability to pay dividends or buy back shares severely restricted or even totally eliminated. We expect that changes in accounting treatment that have such severe economic consequences will be heavily criticised, not least by investors.
We hope you find our comments of interest and, once again, apologise for the late response. If you have any queries, please do not hesitate to call me on 0207 213 0738 or via email at cbradley@treasurers.co.uk1.
Yours sincerely
Caroline Bradley
Technical Officer