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  • Financial reporting

Financial reporting

Since the result of the referendum was confirmed back in June 2016, businesses have been grappling with how to communicate the possible effects of Brexit to stakeholders. The starting point when drafting such disclosures should be to focus on the questions that boards are asking themselves when considering the possible effects of Brexit and the subsequent actions that are being taken or considered. This is more obvious when preparing the more forward-looking narrative in the front end of an annual report but there are equally important implications for the more historically focused financial statements.

Initially, companies tended to give only very limited and generic information on the potential effects of Brexit in their annual reports. However, as Exit Day approaches and more detail has emerged about a proposed exit deal and, more importantly, what the consequences of a no-deal scenario may be, companies should be providing more detailed disclosures in their interim and annual reports. While the uncertainty continues, this may mean covering different Brexit scenarios in order to provide meaningful information to allow stakeholders to assess the risks to which they give rise. Given the importance of this matter, the FRC has announced that it will be undertaking a Thematic Review of Brexit disclosures in 2019.

The uncertainty caused by Brexit effects the accounting estimates that are used in various areas of financial reporting, such as fair values, impairment assessments and going concern forecasts. It also affects narrative reporting on the principal risks and uncertainties.

Principal risks and uncertainties

All companies, other than those that are ‘small’, are required to prepare a strategic report. In accordance with s414C(2)(b) of the Companies Act 2006, the strategic report should include a description of the principal risks and uncertainties facing the company. Given the level of inherent risk and uncertainty created by Brexit, it is likely that boards will need to include a discussion of them in the strategic report in order to meet these legal obligations and enhance shareholders’ understanding of the development, performance, position and future prospects of the business.

In doing this, the board should distinguish between the specific and direct challenges to operations and those challenges that result from boarder economic circumstances. Examples of direct challenges include a potential disruption of supply chains, changes in import/export taxes and the removal of licences to operate. More general threats might include those that arise from a general economic downturn that may follow, in particular, a disorderly exit. Where specific principal risks are identified, it is important to investors that directors outline any risk management and mitigation steps they are taking and/or how they are monitoring the ongoing situation.

If it is expected that no specific challenges will arise as a result of Brexit, then it would be helpful to include a statement to that effect, together with an explanation on why that conclusion has been reached.

Going concern and viability statement

The directors must assess whether circumstances exist that would make the adoption of the going concern basis of accounting in the entity’s financial statements inappropriate. They should consider a period of at least twelve months from the date of approval of the financial statements. In undertaking this assessment, the board should take into account how Brexit might affect the ability of the business to continue as a going concern. The forecasts may need to be amended as circumstance and expectations change and should include appropriate sensitivity analysis. Other considerations could include whether financing arrangements or covenant compliance could be affected and whether there is sufficient headroom within the financing facilities to cover any uncertainties.

For UK Corporate Governance Code-adopting companies, the longer-term viability statement should also take into account the possible effects of Brexit. The FRC has encouraged boards to apply a two-stage process to the viability statement. Firstly, assessing the future prospects of the company and secondly, stating whether directors have a reasonable expectation that the company will be able to continue to operate and meet its liabilities as they fall due (potentially over a shorter period), drawing attention to any qualification or assumptions as necessary. Examples of how this has been applied by companies are included in the Financial Reporting Lab’s Implementation Study issued in October 2018. There is an expectation of more detailed disclosure of stress and scenario testing; not just the fact that it is done but also how it is done, what is considered and its results.

Clearly, this forward looking information is at a significant risk of looking out of date if it is not revisited and potentially revised close to the reporting date to take account of the most up-to-date information available to the directors. This should be born in mind when considering reporting timetables.

Estimates and judgements

This significant amount of uncertainty increases the importance of the judgements and estimates disclosures required by IAS 1 (and FRS 102, section 8). These disclosures are already a high-priority for the FRC and investors and they are likely to be subject to increased scrutiny as the stakeholders attempt to assess the risk and impact of Brexit on the business.

As a result of Brexit, Companies should generally be considering a wider range of reasonably possible outcomes when performing sensitivity analysis on their cash flow projections; these should be disclosed and explained. Judgements made should be clear and transparent and, where relevant, the disclosures should highlight the potential effect of possible alternative judgements. Not all companies will require extensive disclosures, but where sensitivity or scenario testing indicates significant issues, relevant information and explanation should be reflected in the appropriate parts of the annual report and accounts, for example in the impairment disclosures.

The fluid nature of the Brexit process may create challenges in this area. For example, it may be difficult to decide whether facts and circumstances that become apparent post-balance sheet were in existence, or could reasonably have been envisaged, at the balance sheet date. These should be factored into the year-end calculations whereas discretely post-balance sheet events should be considered for disclosure but would not be included in the year-end calculations.

The key message here is that the directors should ensure that the disclosures are clear where Brexit might reasonably be expected to have an effect on amounts recognised in the financial statements. This may affect several transactions and balances; we consider some of those specifically below.

Impairment testing and credit losses

The impairment of financial and non-financial assets is an area that will be particularly affected by Brexit uncertainty.

Impairment tests on non-financial assets should factor in cash flows that reflect reasonable and supportable expectations based on the conditions that existed at the balance sheet date. Any discount rates that are used should be both consistent with the cash flow assumptions used and reflect the risks associated with those cash flows. It may be appropriate to include a higher range of possible outcomes through sensitivity analysis or the use of probability-weighted scenarios.

Considering how uncertain economic events, such as Brexit, could affect credit risk is a core element of the IFRS 9 Expected Credit Loss (ECL) model. The multiple economic scenarios being used in the ECL calculations and their respective probabilities need to take into account the various Brexit possibilities that might arise. For shorter maturity assets, such as trade receivables, the effect of Brexit would likely have a lesser impact than it would on longer-term assets such as contract assets because they would likely be settled before the full effects of Brexit are felt.

It should be noted that FRS 102 still uses the “incurred loss model”, meaning that possible Brexit outcomes are much less likely to have an influence on balance sheet measurement.

Other financial statement areas

The potential effects of Brexit can influence other areas of the financial statements such as:

  • If the directors consider that a restructuring plan needs to be implemented as a result of Brexit, there are strict conditions that must be met before related provisions can be recognised – there has to be a present obligation which would generally occur once a restructuring plan has been formalised and announced.
  • Any changes in tax status or rules that crystallise on Brexit must only be taken into account at the date the tax status changes (this is likely to be no earlier than Exit Day: ie no earlier than 31 October 2019 at the time of writing). Where there is uncertainty over the income tax treatments that arise from Brexit, IFRS-adopting companies must follow IFRIC 23 when accounting for current and deferred tax. In addition, a potential fall in future profits may restrict the ability to recognise deferred tax assets.
  • Considerations about whether and how much revenue should be recognised (for example, decisions that require the estimate of variable consideration, the commercial substance and enforceability of contracts and whether future economic benefits are expected to flow to the entity) should be based on balance sheet date conditions.

Dividends

Directors have a duty to consider the effects of paying dividends on the on-going liquidity of a company. This means that, even if the relevant accounts contain sufficient distributable profits to support a dividend, directors will need to consider the effect of any post balance sheet events and uncertainties of Brexit on the forecasts. The board may want to exercise a degree of caution before paying a dividend, particularly if Brexit is likely to have a significant effect on the business.

UK and EU company law

Finally, a number of changes in the law that underpins financial reporting will be necessary to reflect the fact that the UK is no longer a member of the EU. The Department for Business, Energy and Industrial Strategy (BEIS) has produced a useful guidance note detailing a number of different factors that will need to be considered in the event of a ‘no-deal’ Brexit.

UK incorporated subsidiaries and UK parents of EU businesses will continue to be subject to the UK’s corporate reporting regime. However, certain exemptions in the Companies Act 2006 relating to the preparation of individual accounts will no longer be extended to companies with parents or subsidiaries incorporated in the EU. These include:

  • A UK company is currently exempted from having to prepare and file individual accounts if it is dormant and part of a group of companies with an EU parent company that prepares group accounts (s394A and s448A). This exemption will only continue to apply after exit if the parent company is established in the UK.
  • A UK company with an EEA parent could claim an exemption from the preparation of consolidated accounts under s400. This will no longer be applicable and instead a UK company may be able to claim a similar exemption under s401.