Mind the GAAP

The way companies produce annual financial reports is undergoing a significant change. Property investment companies and developers may find their accounts show a different picture as new accounting standards begin to have an impact.

When a company produces its annual financial statements it has to follow a set of guidelines to ensure that they comply with generally accepted accounting principles (GAAP). These standards ensure that annual accounts are consistent, and that accounts from different companies can be compared. In theory they provide a level playing field.

However, in reality, a number of areas within the standards are open to interpretation. One example is the treatment of interest on loans that fund the construction of a property. Current UK GAAP allows companies to choose whether to charge the interest as an expense through profit and loss, or to carry it as work in progress on the balance sheet.

As a result, two companies building identical properties could report different levels of profit and loss depending on how they treat interest costs. In addition, the choice of accounting treatment could result in different levels of taxable profit. A company choosing to show its interest costs early will pay less tax at the beginning of a project as its profit will be lower than a company choosing to carry its interest costs forward as an item of work in progress.

Over recent years the impact of a globalising economy and scandals such as Enron has led the International Accounting Standards Board to issue a set of new International Accounting Standards aimed at ironing out the differences between UK GAAP and US GAAP, as well as other countries.

These International Accounting Standards have been compulsory for quoted companies in the UK since 1 January 2005. They also became compulsory for firms listed on the alternative investment market (AIM) on 1 January this year.

So what are the key changes introduced by the International Accounting Standards? Studies show that quoted companies adopting the new standards have reported an average increase of 35% in profits compared with accounts prepared under the old rules. One of the standards that has had a big impact is IAS40, which relates to investment properties, and affects all companies owning them. The key change is that, whereas previously any surplus or deficit on a revaluation of a property would be put through a “revaluation reserve” in the balance sheet, the new standard requires them to be shown on the face of the profit and loss account, thereby affecting reported profits.

Will these changes affect your business? International standards apply only to fully quoted and AIM-listed companies. However, the development of accounting standards is a continual process and there are plans in place for an international standard for small and medium-sized unquoted companies. So in the not-too-distant future we may see the impact of standards filtering down to a much broader group of businesses.

Studies show that those adopting the standards have reported an increase of 35% in profit compared with accounts prepared under the old rules

As the drive to iron out the differences between UK GAAP and US GAAP continues we will see further changes.

One proposed change is IAS23, which provides guidance on the treatment of borrowing costs. Under US GAAP, property developers must capitalise their interest costs on loans that are used to fund the construction of an asset, such as a property. If the option to write off interest costs is removed for UK firms it would have a significant impact on companies in the property sector.

IAS23 could result in many property developers having to report higher profit and as a consequence pay more in tax in the first year of applying the standard to a company’s accounts.

It is important that companies involved in the property sector are aware of the changes taking place. Directors of unquoted companies thinking of a possible flotation need to bear in mind that their financial statements will be prepared using a different set of standards and that these may have an impact on their reported profit.

Much will depend on how international standards evolve over the next couple of years, but we could see all UK companies, not just quoted companies, being affected.

The likelihood is these accounts will show significantly different levels of profit from those under UK GAAP.

Salvador Amico is a partner in the property department at Menzies Chartered Accountants. Contact him at samico@menzies.co.uk