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  • UK becomes Europe’s test-bed for new regulation, but are we remembering to ‘think small first’? Posted on 19 October 2016

    This is a story for anyone interested in the regulation of small and medium-sized companies, promoting business investment, and the effects of Brexit on UK regulations. If that sounds interesting, I’d better be honest and tell you the story is about a rather technical subject. Some might even say it’s boring - but how wrong they would be! It concerns the financial accounting treatment of leases. Trust me, the bigger issue at stake more than makes up for that!

    The UK’s accounting regulator, the Financial Reporting Council (FRC), recently published a consultation as part of its triennial review of UK and Ireland accounting standards called “Approach to changes in IFRS”.

    Page 18 is where the action is. The FRC is proposing that the principles of the new international accounting standard for leases, IFRS 16, should be applied to FRS 102, the accounting standard for incorporated small and medium-sized enterprises (SMEs) in the UK.

    The FRC’s proposal is a live example of how SMEs can end up being regulated by the back door, without regulators properly assessing the costs and benefits. Let’s look at how this happens, because it's more about a fault of the regulatory system than about blaming an individual regulator.

    Effects analysis

    The regulator that sets the new international accounting standards is the International Accounting Standards Board (IASB). Based in London, the IASB is overseen by the International Financial Reporting Standards Foundation, an American not-for-profit company. The IASB write the accounting rules that are used by ‘publicly accountable companies’. That means companies listed on a stock exchange and financial institutions such as banks. So, in most cases, large companies.

    When it published the new lease accounting rules, IFRS 16, in January the IASB also provided a lengthy ‘effects analysis’. This reviewed the costs and benefits of the new rules based on the expected users, i.e. large companies. Having spent almost ten years to develop its new leasing rules, it was no great surprise the IASB concluded the effects would be beneficial.

    The IASB’s effects analysis didn’t look at SMEs, as the IASB noted that: The vast majority of European SMEs will not be required to apply IFRS 16”. The IASB did however go on to say: The IASB acknowledges that a change in IFRS might subsequently result in a similar change in national [accounting standards] applied by smaller companies when preparing financial statements”.

    If that sounds like a problem, don’t worry, because the IASB assured us it would continue working with national standard-setters to raise awareness of potential issues so that they can be addressed on a timely basis.”

    European ‘public good’

    Once the IASB publishes a new Standard, the European Commission must check it out to see if it is in the European ‘public good’. Until a new standard is endorsed by the European Union it can’t be used. The Commission obviously cares a great deal about European SMEs, so can we rely on the endorsement process to help avoid the “potential issues” that the IASB talked about?

    The problem in Brussels is that the endorsement process only looks at the direct effects of the new rules, which means only the effects on a few thousand SMEs that, for various reasons, use international accounting rules (not every listed company is large, of course). In its request for advice to its technical advisers EFRAG, the Commission asks for: “A comparison between the options in terms of their effectiveness and efficiency (benefits and costs), including for SMEs where relevant”.

    The EU endorsement process doesn’t usually look at any potential ‘knock-on’ effects on the other 99% of European SMEs. That’s the job of national standards setters, not the EU. As a result, there’s a risk that the European endorsement process might not consider the most significant effects of the new rules on Europe’s SMEs. Hopefully the EC will consider that the wider impacts on SMEs are indeed relevant to the European ‘public good’ test but it’s already clear that’s not how EFRAG is interpreting the Commission’s request for advice.

    Brexit

    In some ways it’s odd that the Financial Reporting Council has already published its intention to make UK SMEs follow IFRS 16.  Perhaps the FRC has taken the view that the EU is bound to endorse IFRS 16. True, that’s a fairly safe bet, but it’s not terribly diplomatic! Alternatively, the FRC might consider that Brexit means there’s no longer any need to wait for Brussels. Whatever the reason, the UK regulator is the first in Europe to announce that IFRS 16-type rules will be extended to SMEs.

    The UK can actually claim credit for being at the forefront of an international movement amongst regulators to ‘think small first’. It means regulators must consider the impacts on SMEs early in their work, even if the effects are indirect. We’ve already seen the IASB hasn’t done it. It’s not yet clear whether the European Commission will. How does the FRC score?

    Consistency

    The FRC justifies proposing to make SMEs follow IFRS 16 on the basis that once the rules have been implemented for large companies, the market will expect consistent information from smaller companies. The FRC says: “Indeed, it is possible that once IFRS 16 has been implemented, some users, for example lenders, will be expecting similar information from any entity…”. It goes on to note: “consistency with IFRS 16 would improve the information available to the users of financial statements regarding leases.”

    In effect, the FRC is saying that by the time they started looking at the new rules, it’s too late, as it would be inefficient to have one method of accounting for leases for large companies and another for SMEs.

    Business investment

    This isn’t just a theoretical problem about regulation that’s designed specifically for large companies being extended to SMEs without “thinking small first” about the costs and benefits of regulation.

    It may seem that changes to the financial accounting rules can’t possibly matter that much. In many respects, that is right. Investors and lenders are often more interested in management accounts, forecasts and models, and non-financial information about the business than they are in historical financial accounting information. Most SMEs now don’t even need to file their full accounts at Companies House.

    But actually these changes really do matter for SMEs. Like most regulation, the enemy here is sheer bureaucracy. IFRS 16 delivers that in spades. The new rules are a lot more complicated and will generate a significant extra administration burden for businesses with shorter (‘operating’) leases in particular.

    That’s before proposed changes to the tax rules that could make matters worse, as three of the four proposals in another consultation from HM Revenue and Customs would make it harder for many SMEs to benefit from existing tax incentives for business investment. The remaining option is actually a technical simplification to parts of the current tax rules, but it’s not at all clear yet whether SMEs would find it any easier to follow.  

    The IASB suggested in its effects analysis that if companies don’t lease assets they will pay cash for them instead. There’s plenty of research to suggest otherwise. Lease finance can sometimes be the only form of finance available to SMEs, and it is very often the lowest cost finance available making more investment projects viable than would otherwise be the case. In short, businesses that lease invest more.

    With the proposals for new accounting and tax rules for SMEs published before IFRS 16 is even approved for use in the EU, the UK is becoming Europe’s test bed for new accounting regulation and perhaps in other fields too. It’s time for the UK regulators to once again lead the way in ‘thinking small first’.

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