SESSION 15–REPORTING FOR NON-FOR-PROFIT ENTITIES & SME
1.REPORTING FOR NON-FOR-PROFIT ENTITIES
DEFINITIONS
The not-for-profit sector includes public sector entities and private not-for-profit entities such ascharities. Not-for-profit entities have different goals from profit making entities, but they still need to be properlymanaged and their accounts need to present the information fairly.There are the most obvious examples:
(a)Central government departments and agencies
(b)Local or federal government departments
(c)Publicly-funded bodies providing healthcare (in the UK this would be the NHS) and social
housing
(d)Further and higher education institutions
(e)Charitable bodies
The first four are public sector entities. Charities are private not-for-profit entities. Not-for-profit entities have different goals and purposes to profit-making entities and are responsible to different stakeholders.
CONCEPTUAL FRAMEWORK FOR NON-FOR-PROFIT ENTITIES
The IASB and the FASB are currently in a project to produce a new, improved conceptual framework for financial reporting, entitled: The Objective of Financial Reporting and Qualitative Characteristics ofDecision-Useful Financial Reporting Information.Phase G is entitled Application to not-for-profit entities in the private and public sector. The following issues exist regarding application of the proposals to not-for-profit entities:
Accountability/stewardship
Not-for-profit entities are not reporting to shareholders, but it is very important that they can account for funds received and show how they have been spent. In some cases, resources may be contributed for specific purposes and management is required to show that they have been utilised for that purpose.
Users and user groups
The primary user group for not-for-profit entities is providers of funds. In the case of public bodies, suchas government departments, this primary group will consist of taxpayers. In the
case of private bodies such as charities it will be financial supporters, and also potential future financial supporters. There is alsoa case for saying that a second primary user group should be recognised, being the recipients of the goods and services provided by the not-for-profit entity.
Cash flow focus
The new Framework emphasises the need to provide information which willenable users to assess an entity's ability to generate net cash inflows. Not-for-profit entities also need to generate cash flows, but other aspects are generally more significant – for instance, the resources the entity has available to deliver future goods and services, the cost and effectiveness of those it hasdelivered in the past and the degree to which it is meeting its objectives.
Budgeting
The IASB has decided to leave consideration of whether financial reporting should include forecast information until later in the project. However, for not-for-profit entities, budgets and variance analyses are more important. In some cases, funding is supplied on the basis of a formal, published budget.
REGULATORY FRAMEWORK FOR NON-FOR-PROFIT ENTITIES
The IASB and the FASB are working on a framework for reporting, which includes not-for-profit entities.The International Public Sector Accounting Standards Board (IPSAB) is developing a set of InternationalPublic Sector Accounting Standards based on IFRS.Regulation of public not-for-profit entities, principally local and national governments and governmentalagencies, is by the International Public Sector Accounting Standards Board (IPSAB), which comes under the International Federation of Accountants (IFAC).
CHARACTERISTIC OF NON-FOR-PROFIT ENTITIES
As part of its preliminary report on the new ConceptualFramework, the IASB sets out some of the characteristics of not-for-profit entities as follows.
Private sector
(a)Their objective is to provide goods and services to various recipients and not to make a profit
(b)They are generally characterised by the absence of defined ownership interests (shares) that can be
sold, transferred or redeemed
(c)They may have a wide group of stakeholders to consider (including the public at large in some
cases)
(d)Their revenues generally arise from contributions (donations or membership dues) rather than
sales
(e)Their capital assets are typically acquired and held to deliver services without the intention of
earning a return on them
Public sectors
(a)Their objective is to provide goods and services to various recipients or to develop or implement
policy on behalf of governments and not to make a profit
(b)They are characterised by the absence of defined ownership interests that can be sold,
transferredor redeemed
(c)They typically have a wide group of stakeholders to consider (including the public at large)
(d)Their revenues are generally derived from taxes or other similar contributions obtained through
the exercise of coercive powers
(e)Their capital assets are typically acquired and held to deliver services without the intention of
earning a return on them
PEFORMANCE MEASUREMENT FOR NON-FOR-PROFIT ENTITIES
Not-for-profit and public sector entities produce financial statements in the same way as profit-makingentities do but, while they are expected to remain solvent, their performance cannot be measured simply by the bottom line.A public sector entity is not expected to show a profit or to underspend its budget.
Public sector entities
These will have performance measures laid down by government. The emphasis is on economy, efficiency and effectiveness. Departments and local councils have to show how they have spent public money andwhat level of service they have achieved. Performance measurement will be based on Key PerformanceIndicators (KPIs).Examples of these for a local council could be:
(a)Number of homeless people rehoused
(b)% of rubbish collections made on time
(c)Number of children in care adopted
Private sector entities
While charities must demonstrate that they have made proper use of whatever funds they have received, their stakeholders will be more interested in what they have achieved in terms of their stated mission. People who donate money to a relief fund for earthquake victims will want to know what help has beengiven to survivors, before enquiring how well the organisation has managed its funds. Although it must be said that any mismanagement of funds by a charity is taken very seriously by the donating public.
Some charities produce 'impact reports' which highlight what the charity set out to achieve, what it has achieved and what it has yet to do. Stakeholders should know what the organisation is aiming to achieve and how it is succeeding. Each charity will have its own performance indicators which enable it tomeasure this.
2.REPORT FOR SMALL AND MEDIUM SIZED ENTITIES
BIG GAAP / LITTLE GAAP
In most countries the majority of companies or other types of entity are very small. They are generally owned and managed by one person or a family. The owners have invested their own money in the business and there are no outside shareholders to protect.
Large entities, by contrast, particularly companies listed on a stock exchange, may have shareholders who have invested their money, possibly through a pension fund, with no knowledge whatever of the company. These shareholders need protection and the regulations for such companies need to be more stringent.
It could therefore be argued that company accounts should be of two types.
(a)'Simple' ones for small companies with fewer regulations and disclosure requirements
(b)'Complicated' ones for larger companies with extensive and detailed requirements
This is sometimes called the big GAAP/little GAAP divide
Possible solutions
There are two approaches to overcoming the big GAAP/little GAAP divide:
(a)Differential reporting, ie producing new reduced standards specifically for smaller companies,
suchas the UK FRSSE or the IFRS for SMEs (see below.)
(b)Providing exemptions for smaller companies from some of the requirements of existing standards.
Other standards always have an impact. In particular, almost all small companies will be affected by theIFRSs on:
Property, plant and equipment
Inventories
Presentation of financial statements
Events occurring after the reporting period
Taxes on income
Revenue
Provisions and contingencies
IFRS FOR SMALL AND MEDIUM-SIZED ENTITIES
Published in July 2009, the IFRS for Small and Medium-sized Entities aims to simplify financial reportingfor SMEs by omitting irrelevant topics, reducing guidance and disclosure and eliminating choice. It alsosimplifies some of the recognition and measurement principles.
The IFRS for Small and Medium-Sized Entities (IFRS for SMEs) was published in 2009. It is only 230pages, and has simplifications that reflect the needs of users of SMEs' financial statements and cost-benefit considerations. It is designed to facilitate financial reporting by small and medium-sized entities ina number of ways:
(a)It provides significantly less guidance than full IFRS.
(b)Many of the principles for recognising and measuring assets, liabilities, income and expenses in
full IFRSs are simplified.
(c)Where full IFRSs allow accounting policy choices, the IFRS for SMEs allows only the easier
option.
(d)Topics not relevant to SMEs are omitted.
(e)Significantly fewer disclosures are required.
(f)The standard has been written in clear language that can easily be translated.
Scope
The IFRS is suitable for all entities except those whose securities are publicly traded and financial institutions such as banks and insurance companies. It is the first set of international accounting requirements developed specifically for small and medium-sized entities (SMEs). Although it has been prepared on a similar basis to IFRS, it is a stand-alone product and will be updated on its own timescale.
The IFRS will be revised only once every three years. It is hoped that this will further reduce the reporting burden for SMEs.
There are no quantitative thresholds for qualification as a SME; instead, the scope of the IFRS is determined by a test of public accountability. As with full IFRS, it is up to legislative and regulatory authorities and standard setters in individual jurisdictions to decide who is permitted or required to use the IFRS for SMEs.
Effective date
The IFRS for SMEs does not contain an effective date; this is determined in each jurisdiction. The IFRS willbe revised only once every three years. It is hoped that this will further reduce the reporting burden forSMEs.
Accounting policies
For situations where the IFRS for SMEs does not provide specific guidance, it provides a hierarchy for determining a suitable accounting policy. An SME must consider, in descending order:
The guidance in the IFRS for SMEs on similar and related issues.
The definitions, recognition criteria and measurement concepts in Section 2 Concepts andPervasive Principles of the standard.
The entity also has the option of considering the requirements and guidance in full IFRS dealing with similar topics. However, it is under no obligation to do this, or to consider the pronouncements of other standard setters.
Overlap with full IFRS
In the following areas, the recognition and measurement guidance in the IFRS for SMEs is like that in the full IFRS.
Provisions and contingencies
Hyperinflation accounting
Events after the end of the reporting period
Omitted topics
The IFRS for SMEs does not address the following topics that are covered in full IFRS.
Earnings per share
Interim financial reporting
Segment reporting
Classification for non-current assets (or disposal groups) as held for sale
Examples of options in full IFRS not included in the IFRS for SMEs
Revaluation model for intangible assets and property, plant and equipment
Choice between cost and fair value models for investment property (measurement depends on the circumstances)
Options for government grants
Principal recognition and measurement simplifications
(a)Financial instruments: Financial instruments meeting specified criteria are measured at cost or
amortised cost. All others are measured at fair value through profit or loss. The procedure for derecognition has been simplified, as have hedge accounting requirements.
(b)Goodwill and other indefinite-life intangibles: These are always amortised over their estimated
useful life (or ten years if it cannot be estimated).
(c)Investments in associates and joint ventures: These can be measured at cost, but fair value must
be used if there is a published price quotation.
(d)Research and development costs and borrowing costs must be expensed.
(e)Property, plant and equipment and intangibles: There is no need to review residual value,
useful life and depreciation method unless there is an indication that they have changed since the most recent reporting date.
(f)Defined benefit plans: All actuarial gains and losses are to be recognised immediately (in profit
or loss or other comprehensive income). All past service costs are to be recognised immediately in profit or loss.To measure the defined benefit obligation, the projected unit credit method must be used.
(g)Income tax: When published, the IFRS for SMEs said to follow the ED Income tax, which
simplified IAS 12. ThisED has been withdrawn, but it is likely that the treatment of income tax will be simpler in the IFRSfor SMEs when this is replaced.
(h)Available-for-sale assets: There is no separate available-for-sale classification; holding an asset
or group of assets for sale is an indicator of impairment.
(i)Biological assets: SMEs are to use the cost-depreciation-impairment model unless the fair value
is readily determinable, in which case the fair value through profit or loss model is required.
(j)Equity-settled share-based payment: If observable market prices are not available to measure the fair value of the equity-settled share- based payment, the directors' best estimate is used.
CONSEQUENCES: GOOD OR BAD ?
There is no perfect solution to the Big GAAP/Little GAAP divide. It remains to be seen how well the IFRSfor SMEs will work in practice.
Advantages:
(a)It is virtually a 'one stop shop'.
(b)It is structured according to topics, which should make it practical to use.
(c)It is written in an accessible style.
(d)There is considerable reduction in disclosure requirements.
(e)Guidance not relevant to private entities is excluded.
Disadvantages
(a)It does not focus on the smallest companies.
(b)The scope extends to 'non-publicly accountable' entities. Potentially, the scope is too wide.
(c)The standard will be onerous for small companies.
(d)Further simplifications could be made. These might include:
(i)Amortisation for goodwill and intangibles
(ii)No requirement to value intangibles separately from goodwill on a business combination (iii)No recognition of deferred tax
(iv)No measurement rules for equity-settled share-based payment
(v)No requirement for consolidated accounts (as for EU small and medium-sized entities currently)
(vi)All leases accounted for as operating leases with enhanced disclosures
(vii)Fair value measurement when readily determinable without undue cost or effort.
3.ENTITY RECONSTRUCTION
Most of a Study Text on financial accounting is inevitably concerned with profitable, even expanding businesses. It must of course be recognised that some companies fail. From a theoretical discounted cash flow viewpoint, a company should be wound up if the expected return on its value in liquidation is lessthan that required. In practice (and in law), a company is regarded as insolvent if it is unable to pay its debts.
Going concern
Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation forthe foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations.
It is generally assumed that the entity has no intention to liquidate or curtail major operations. If it did, then the financial statements would be prepared on a different (disclosed) basis. Indications
INTERNAL RECONSTRUCTION
A company may be able to enter into any type of scheme regarding either its creditors or its shareholdersas long as the scheme does not conflict with general law or any particular statutory provision.
For a reconstruction of this type to be considered worthwhile in the first place, the business must have some future otherwise it might be better for the creditors if the company went into liquidation.
Example 1: Reconstruction scheme
Boswell Co has been making losses over the last few years. Its statement of financial position at31 December 20X1 showed the following.
$ $
Ordinary capital 50,000 Plant 40,000
Retained earnings (70,000) Inventory 10,000
Loan stock (secured) 50,000 Receivables 20,000
Payables 40,000
70,000 70,000
On liquidation, the assets would realise the following.
Plant 15,000
Inventory 6,000 Receivables 18,000
39,000
If the company continued to trade for the next four years, profits after charging $10,000 per annum depreciation on the plant would be as follows.
20X2 2,000
20X3 10,000
20X4 13,000
20X5 14,000
39,000
Assuming that there would be no surplus cash to repay the creditors and loan stock holders until afterfour years and that inventory and receivables could then be realised at their book values, you are requiredto prepare a reconstruction scheme. Ignore taxation.
Solution:
If liquidation took place now only $39,000 would be raised which would be given to the loan stock holders leaving them with a deficiency of $11,000. There would be nothing for the creditors and shareholders. However, if trading continues for the next four years and estimated results are achieved, the cash available would be as follows.
Profits 39,000 Depreciation 40,000
Inventory and receivables: full value 30,000
109,000
$90,000 would enable the loan stock holders and creditors to be paid in full leaving $19,000 available forthe ordinary shareholders.
Everyone will be better off if the company is allowed to continue trading. However, the loan stock holders probably have the right to appoint a receiver and would insist on some compensation for not enforcingtheir right. The creditors might also expect something for having to wait four years before receiving some payment.
There is no unique solution to such a question but one that might be acceptable would be for the loan stock holders and creditors to waive the amounts owed to them in exchange for ordinary shares, so that they will have full participation in the future profitability of the company. Terms of such an exchange mightbe as follows.
(a)37,500 $1 ordinary shares to the loan stock holders (3 $1 ordinary shares for every $4 of loan
stock)
(b)20,000 $1 ordinary shares to the creditors (1 $1 ordinary share for every $2 due)
(c)12,500 $1 ordinary shares to the old ordinary shareholders (1 $1 ordinary share for every 4 of
the old $1 ordinary shares)
The creditors might prefer to receive loan stock as they would then have a legal right to repayment of nominal capital and could also insist on payment of interest.
The reconstructed statement of financial position of Boswell Co at 31 December 20X1 would then be asfollows.
$ $ Ordinary capital 70,000 Plant 40,000
Inventory 10,000
Receivables 20,000
70,000 70,000
EXTERNAL RECONSTRUCTION
A court may make orders for the transfer of all the company's assets and liabilities and for its dissolution. Such a scheme might provide for the formation of a new company to take over the undertaking of the old company, or an amalgamation, to acquire the undertakings of a number of companies, the members and creditors of which accept shares or loan stock in the new company in exchange for their former rights.
Example 2: Reconstruction scheme
Extracts from the statement of financial position of Brave World Co are as follows.
Debit Credit
$ $
Ordinary $1 shares, fully paid 70,000
Payables 32,100
Inventory 29,000
Receivables 16,000
Cash 100
Patents 30,000
Preliminary expenses 2,000
Retained earnings 25,000
102,100 102,100
A scheme of reconstruction was agreed by the shareholders and creditors of the company.
(a)The company to go into voluntary liquidation and a new company, New Brave World Co, to
beformed with an authorised share capital of $50,000 which will take over the assets and liabilities of the old company.
(b)The inventory, receivables and cash of the old company to be taken over at book value. The
patents are subject to adjustment.
(c)Creditors are to receive settlement as follows.
(i) Preferential creditors to be paid in full 2,100
(ii) $20,000 of unsecured creditors to be discharged for
a cash compensation of 80c in the $ 20,000
(iii) $10,000 of unsecured creditors to accept $12,000
6% loan stock in the new company 10,000 Book value 32,100
(d)50,000 $1 ordinary shares in New Brave World Co to be issued, 50c already paid up
toshareholders in the old company and 50c payable on application and allotment to make the shares fully paid up.
(e)Costs of liquidation amounting to $1,000 will be paid by the new company as part of the purchase
consideration.
Required
Prepare the statement of financial position of the new company.
Solution
NEW BRAVE WORLD CO STATEMENT OF FINANCIAL POSITION
$ $ Authorised, issued and fully paid Inventories 29,000 Ordinary share capital Receivables 16,000 50,000 shares of $1 each 50,000 Cash (W3) 6,000 6% loan stock 12,000 Patents, at cost (W2) 11,000
62,000 62,000 Workings
1 Purchase consideration
Cash
To pay off creditors ($2,100 + 80% of $20,000) 18,100
Liquidation expenses 1,000
19,100 Loan stock 12,000
Paid up part of new shares 25,000
56,100
2 Assets
Inventories 29,000
Receivables 16,000
Cash 100
45,100 Patents at cost (balance) 11,000
56,100
3 Cash balance
Cash from shareholders 25,000
Cash acquired from old company 100
25,100 Less cash payments in purchase consideration 19,100
Cash balance held 6,000
TRANSFER OF ASSETS TO A NEW COMPANY
Another form of reconstruction is by means of voluntary liquidation whereby the liquidator transfers the assets of the company to a new company in exchange for shares or other securities in the new company. The old company may be able to retain certain of its assets, usually cash, and make a distribution to the shareholders of the old company who still have an interest in the undertaking through their shareholdingin the new company. There may be various rules governing the protection of non-controlling shareholders.
Such a procedure would be applied to the company which is proposed to be or is in course of being wound up voluntarily. A company in liquidation must dispose of its assets (other than cash) by sale in order to pay its debts and distribute any surplus to its members. The special feature of this kind ofreconstruction is that the business or property of Company P is transferred to Company Q in exchange for shares of the latter company which are allotted direct or distributed by the liquidator to members of
Company P. Obviously the creditors of Company P will have to be paid cash.
Finding the cash to pay creditors and to buy out shareholders who object to the scheme is often the major drawback to a scheme of this kind. It is unlikely to be used much because the same result can be more satisfactorily achieved by a takeover: Company Q simply acquires the share capital of Company P, which becomes its subsidiary, and the assets and liabilities are transferred from the subsidiary to the newholding company. In this situation usually no cash has to be found (although obviously there is no guarantee of success).
The advantage of transferring a business from one company to another (with the same shareholders in the end) is that by this means the business may be moved away from a company with a tangled history toa new company which makes a fresh start. As explained above this procedure can also be used to effect a merger of two companies each with an existing business.