Select Committee on Treasury Minutes of Evidence

Note submitted by The Auditing Practices Board

  In the course of giving evidence to the Treasury Committee, I undertook to provide Mr Cousins with a brief note on the use of the true and fair override and special purpose vehicles (SPVs) in the UK financial reporting environment.

  In the UK, company accounts are required to show a true and fair view (s 226(2), Companies Act 1985). Section 226(5) permits departure from the requirements of the Act and of accounting standards in those rare circumstances where following those requirements would not result in financial statements showing a true and fair view. This provision is generally known as the "true and fair override".

  However, companies and their auditors have had no cause to use the true and fair override in relation to SPVs for two reasons:

    1.  The definition of subsidiary was broadened by Companies Act 1989 so that whether a company is a subsidiary does not depend only upon control through voting rights attaching to shares, but also applies where there is a right to appoint a majority of directors and/or where control over a company is achieved pursuant to an agreement amongst a number of shareholders; and

    2.  Even where a company is not a subsidiary (see above), the accounting standard which requires the substance of transactions to be reported (FRS 5), requires the economic implications of ownership to be reflected in the financial statements where the relationship between the company and the SPV is such that the reporting company is exposed to the risks and rewards inherent in the SPV.

  Consequently, compliance with FRS 5 achieves the necessary effect to ensure that a true and fair view is shown when assets and liabilities have been moved off-balance sheet to a SPV in a way which avoids that SPV being a subsidiary under the Companies Act definition.

  It may be helpful if I explain the use and accounting for SPVs. Sometimes assets and liabilities are placed in an entity or vehicle that is in effect controlled by the reporting entity but does not meet the legal definition of a subsidiary. Financial Reporting Standards (FRS) 5 "Reporting the Substance of Transactions" requires, inter alia, that where the commercial effect of a transaction is no different for a reporting entity from that which would result were the vehicle a subsidiary, the vehicle will be a "quasi-subsidiary" (see the definition set out below). In such circumstances, FRS 5 requires that the assets, liabilities, profits, losses and cash flows of that quasi-subsidiary be included in the consolidated financial statements of the group that controls it in the same way as if they were those of a subsidiary. In paragraph 100, FRS 5 expressly provides that the inclusion of quasi-subsidiaries in group (consolidated) financial statements is additional information that is necessary to give a true and fair view of the group as legally defined (thereby removing any argument that there would be a conflict with the consolidation rules if such information were to be provided).

  Whether an SPV is a quasi-subsidiary depends on an analysis of the facts of its relationship with the reporting entity, and particularly the extent to which the reporting entity is exposed to the risks and rewards inherent in the SPV. Where an auditor does not agree with a decision not to consolidate a company which, in his judgement, is in fact a quasi-subsidiary, then his proper course is to qualify his audit opinion and draw the situation to the attention of the reader of the accounts.

  It was against this background that I sought to explain that, in the UK, the use of the true and fair over-ride to ensure the consolidation of SPVs in accounts audited under the UK accounting regime simply does not arise (and, therefore, there are no instances of that course being taken).

  This contrasts with the situation in the USA where accounts are deemed to "present fairly" only if they comply with all US accounting standards. The US accounting standards dealing with vehicles such as SPVs rely mainly on a list of rules to determine ownership and are not based primarily on a test of economic control. Thus, if the vehicle in question has been structured to meet the rule-based tests for non-consolidation (ie off balance sheet treatment), and irrespective of whether economic control in fact exists, there is no mechanism by which the auditors can invoke a true and fair override. Certain assets and liabilities can thus be moved off balance sheet, even where the parent is exposed to substantial risk, and the auditor in the US has no mechanism by which he can draw the attention of the users of the accounts to the situation through qualification of his audit report. It is also appropriate to note that the US authorities are currently proposing to tighten the requirements relating to the accounting for SPVs, although they are unlikely to move to the fully substantive approach that we have in the UK.

  Finally, it may be relevant to point out that the relevant International Accounting Standards are not as strong as UK standards in this area. Consequently, unless the IASB reviews and amends its standards so that they are at least brought in line with UK standards, the current regime will be relaxed when and if harmonisation of accounting standards occurs (as is currently contemplated in the European Union with effect from 2005).

  I hope this is helpful.

R J H Fleck

Definition from FRS 5 "Reporting the Substance of Transactions"

  Quasi-subsidiary: A quasi-subsidiary of a reporting entity is a company, trust, partnership or other vehicle that, though not fulfilling the definition of a subsidiary, is directly or indirectly controlled by the reporting entity and gives rise to benefits for that entity that are in substance no different from those that would arise were the vehicle a subsidiary. (Paragraph 7).

23 July 2002

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