The accounting policies of Marks and Spencer - Essay Example

The accounting policies of Marks and Spencer Index: Introduction 2 Accounting Policies of Tangible Fixed Assets 2 Depreciation 2 Capitalisation of Interest 4 Accounting Policies of Intangible Assets 5 Goodwill 5 Transition to IFRS 7 Conclusion 11 References 13 Introduction Bringing accounting policies to single standard has become a basis of free competition. When financial statements of every company is prepared in accordance to same standards, it easier for investors to analyse the current performance of the company and to forecast its future. With national markets merging into global, the number of companies operating internationally grows rapidly. Today the global market is a subject of competition at the same level as national ones. Therefore, today we need to talk about the international standards of accounting policies in order to place all the companies in the fair conditions of competitiveness. This report analyses the accounting policies of Marks and Spencer from two sides: in order to assess their usefulness, and to determine the degree of transition towards international financial reporting standards (IFRS). The first part of the report analyses the development of two accounting policies regarding tangible fixed assets and intangible one. To make the analysis more critical, comparisons with the main competitors of Marks and Spencer are drawn illustrating the controversial development of the selected policies. The second part of the report deals with the analysis of transition from UK GAAP to IFRS with specific respect to the following issues: treatment for property, property leases, employee benefits, share-based payments, intangible assets, and financial instruments. Accounting Policies of Tangible Fixed Assets Depreciation During their lifetime companies acquire property, which should be treated as assets according to the accounting standards. Meanwhile most of the property types have a ‘lifetime’ span, a time period, called useful economic life, during which an asset is used. To reflect the useful economic life in financial statements, profit and loss account receives regular portion of the cost of an asset. This expense is known as depreciation. In other words, depreciation represents the extent to which economic value of an asset has been consumed by the business. There are different accounting policies on depreciation, but the most commonly used two are straight line depreciation and reducing balance. The one that is used by Marks and Spencer is the straight line depreciation. “Depreciation is provided to write off the cost or valuation of tangible fixed assets, less residual value, by equal annual instalments” (Marks and Spencer, 2005a, p. 33). That means the company pays the cost of an asset minus its value after its useful economic life expires by equal portions annually. Thus, fixtures fittings and equipment as a type of property has useful economic life of 3–15 years in the accounting policy of Marks and Spencer — that means, during that time the company annually pays its cost less residual value divided into 3–15 equal portions. Another popular policy of depreciation is reducing balance. In this case the depreciation in each year is calculated as the percentage of the un-depreciated value. For instance, if the purchase cost of an asset is £100 and the reducing balance rate is 20% then the first year depreciation is £100*0.2=£20 and the second year depreciation is (£100-£20)*0.2=£16. The reducing balance rule is used to reflect the fact that the value of some assets falls more rapidly in the first years of use than in the last ones. As can be seen in theory the reducing balance policy can go on forever, with annual portions reducing ad infinitum. Generally, after 95% of the initial cost has been depreciated all the rest is written off in the next portion. The difference of these two methods is as follows: while the straight line depreciation is the simplest of all methods, the reducing balance allows taking the advantage of larger tax deductions in early years. Therefore, the reducing balance method can be used to smooth the financial performance by shifting greater expenditures to successful years from the unsuccessful ones. Meanwhile, the use of straight line depreciation by Marks and Spencer instead of accelerated methods, which write off depreciation costs more quickly, can be seen as an attempt to boost the bottom line, and consequently to increase the net asset value which s considered to be a precise valuation metric by investors. As a result, straight line depreciation gives a company bigger book value than the value a faster rate would give (McClure, 2004). The attempt to increase earnings through the use of straight-line depreciation along with the reports of the analysts, indicating the low performance of Marks and Spencer, can be reasonable. The company tries to extend the success of previous years on future to buy time. Capitalisation of Interest Another interesting issue concerning managing tangible fixed assets is the policy of capitalisation of interest. Generally, when acquiring some significant assets (e.g. construction) loans are taken by the company. Of course, loans have some interest to be paid. In this case if the interest is included into the value of an asset this is called the capitalisation of interest. The accounting policy of Marks and Spencer states that the interest is not capitalised (Marks and Spencer, 2005a, p. 33). Such policy is not typical for the retail sector, and the main competitors of Marks and Spencer, such as NEXT and Tesco, capitalise interest on a gross basis (NEXT, 2005, p. 30 and Tesco, 2005, p. 38). What causes such differences in accounting policies? Interest capitalisation means adding interest payments to the principal of the loan. The positive effect of capitalisation is that it relieves the pressure on the cash flow statement of the company. However, the negative side is that the cost of the loan is substantially increased, as the future interest obligations will be calculated on an escalating debt. From this viewpoint, the policy of Marks and Spencer can be seen as putting greater pressure on their current cash flow and saving costs in their future. Accounting Policies of Intangible Assets Goodwill When one company buys another one it pays the purchase price. However, this purchase price differs significantly from the real value of the subject of acquisition. This occurs because of goodwill. Generally, the most commonly used definition of goodwill dates back to 19th century, when goodwill reflected the difference between the purchase price of a company and its book value. According to this definition, goodwill is a ‘leftover’ amount. Consequently, goodwill is an intangible asset of a company that cannot be sold without selling the company itself. Goodwill can only be acquired as a part of acquisition of another company. There were and there are now a lot of debates about treating goodwill in accounting. Consequently, its treatment has evolved over years. “Goodwill was first treated as a deduction from the stockholders' equity section at the acquisition date. Next, capitalization without amortization occurred. Finally, current treatment requires capitalization and amortization.” (Johnson, 1993) While writing off, simply means deduction of goodwill from stockholders’ equity section, capitalisation observes goodwill as an intangible asset. It is not permitted to capitalize goodwill without amortisation in the UK. The amortisation simply represents the acquired cost of the goodwill spread over several years. However, there is one problem with the goodwill: its life period cannot be determined. Current treatment of goodwill requires capitalisation and amortisation of goodwill over a period not exceeding twenty years. This term is still a subject of debates. On the one hand, the goodwill acquired has borne a cost to shareholders and that cost should impact profits. But on the other hand, goodwill acquired should in reality never decrease in value. Moreover, it should increase in value if a company is managed properly. The reasonable assumption on limiting the useful economic life of goodwill is that over time purchase goodwill becomes replaced with internally generated goodwill, which should not be capitalized according to FRS 10. The main problem with goodwill is that while in some countries like the UK and USA, goodwill is required to be capitalised and amortised, companies in many other countries do not have to amortise goodwill against income. Compared to non-amortising company or the one that is permitted a tax deduction for amortisation, the business that has to amortise goodwill without tax deduction loses its competitiveness. As there are no cash flow differences in accounting of goodwill in the US and the UK, therefore none of these sides is placed into disadvantage. However, some other countries, like Japan or Canada, place their companies at the advantageous position. The accounting policy of Marks and Spencer for goodwill states its capitalisation and amortisation over its useful economic life. However, this refers only to acquisitions made after March 31, 1998. The goodwill from all the previous acquisitions is simply written off to reserves and is not reinstated in the balance sheet. Such policy is permitted by FRS 10, which came into operation as an obligatory standard only on accounting periods ending December 23, 1998 or after. It is allowed not to reinstate goodwill from previous acquisitions in the balance sheet. According to FRS 10, goodwill is neither an asset nor an immediate loss in value. Instead it forms a transition between the cost of the investment shown as an asset in the acquirer’s own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements. (Robins, 2000) Transition from SSAP 22 to FRS 10 puts more pressure on Marks and Spencer and on every other UK company. Previously businesses had the opportunity to writer off goodwill, or use tax deduction for capitalisation and amortisation of goodwill, but FRS 10 makes capitalisation and amortisation of goodwill obligatory. On the one side it makes the UK companies closer to US financial accounting standards; on the other side, as it was stated before, competitors from other countries receive an advantage over Marks and Spencer, which is forced to more strict accounting standards. Still, FRS 10 makes troubles for investors, allowing companies either to write off previous goodwill to the balance sheet as an asset, or merge the goodwill reserve and profit and loss reserve. As can be seen Marks and Spencer has chosen the second path without stating the goodwill clearly in the balance sheet. Most of the companies did the same, still some of Marks and Spencer’s competitors (NEXT for instance) chose to reinstate goodwill as an asset in the balance sheet, which brings previous operations in line with the FRS 10. Transition to IFRS Transition to IFRS from UK GAAP presents challenges for Marks and Spencer. Since the beginning of 2005 the company has taken steps to adopt new international standards of accounting. The main issues of the transition were identified in the Annual Report: “For the next financial year, the Group will be required to adopt International Financial Reporting Standards. We have identified that the greatest impact on the Group arises from changes in the accounting treatment for property, share-based payments, financial instruments and software.” (Marks and Spencer, 2005a, p. 10). Changing from UK GAAP to IFRS has reflected on financial measures. Evidently, the turnover has not changed, but the operating profit before exceptional items has changed from 709.4 £m to 689.2 £m; profit before tax and exceptional items has changed from 618.5 £m to 596 £m; adjusted EPS has fallen from 21.9 p to 21.0 p; and the net assets at April 2, 2005 have risen from 521.4 £m to 938.6 £m — the largest change in reported financial statements (Marks and Spencer, 2005a, p. 10). The following analysis examines the differences in the UK GAAP and IFRS with specific reference to issues that rose before Marks and Spencer. As can be seen from the data given in previous paragraph, changes in the net value of assets were significant: assets have risen in net value on 80 per cent, because of revaluation of properties included as an exemption into IFRS 1. Because of differences in classification of assets under UK GAAP and IFRS some complex assets had to be accounted by components. Additionally, revaluation required to decide if values would have needed to be split between land and buildings. Previously property has been stated at historical cost. A property revaluation was prepared on an existing use basis by external valuers DTZ Debenham Tie Leung as at 2 April 2004. The Group has elected under IFRS 1 to reflect this valuation, in so far as it relates to freehold land and buildings, as deemed cost on transition at 4 April 2004. (Marks and Spencer, 2005b). Thus, in order to adopt IFRS Marks and Spencer has used the exemption of revaluation. The adoption of a valuation of freehold land and buildings as deemed cost increased net assets at 2 April 2005 by £388m net of tax. Hence such a significant change in the net assets reported under IFRS. As a result, the cost of freehold land and buildings is restated and depreciated. Changes in property leases have also influenced net assets. Due to reclassification of assets, some operating leases of buildings were recognized as finance leases in accordance with IAS 17. The main impact of this international standard was to treat land and buildings as separate leases. Therefore, lands and buildings had to be assessed separately, and then divided into different leases. According to IAS 17, leasing of buildings should be treated as finance leases. It is reflected in the changes of net assets of property leases (from 121.3 £m in 2004 to 95.2 £m in 2005). Unfortunately, Marks and Spencer still has not provided data on finance leases to check this transition: “The Group currently recognises finance leases under the recognition criteria set out in SSAP 21… The adjustments are to include the fair value of these leased buildings within fixed assets...” (Marks and Spencer, 2005b). Meanwhile, under IAS 17 leasehold land should normally be treated as an operating lease. Consequently, payments made to acquire leasehold land, previously treated as fixed assets, have been re-categorised as prepaid leases and amortised over the life of the lease. The revaluation previously attributed to the land has been derecognised. Next, the changes in accounting for employee benefits have become an important step towards the IFRS accounting policy. International accounting standard 19 utilises the principle of recognizing the cost of providing employee benefits in the period in which benefit is earned by the employee, rather than whet it is paid or payable. Using the IFRS 1 exemption on employee benefits, Marks and Spencer continued to recognize all cumulative actuarial gains and losses in equity at the transition date. Now significant changes were made here, as the company previously recognized them in equity under FRS 17 of UK GAAP. Pensions have also been treated similarly in the FRS 17 and IAS 19, so there were little changes made. The most important step of moving towards accounting for employee benefits under IFRS was made in share-based payments. Under previous UK GAAP share-based incentive schemes implemented by Marks and Spencer were treated under UITF 17, according to which charge to the profit and loss account should be based on the difference between the market value of shares at the date of grant and the exercise price spread over the performance period. Under the requirements of IFRS 2 all shares and options awarded to employees as remuneration are valued at fair value at grant date and charged against the profits over the period between grant date and vesting date, forming the vesting period. Marks and Spencer applied this treatment not only to awards made after November 7, 2002 (which was offered as an exemption of IFRS 1) but to all awards that were not fully vested at the date of transition in order to maintain consistency across the accounting periods. As far as other employee benefits are concerned, the most important change here was the set up of holiday pay provision in accordance with IAS 19. Under IAS 19 the expected cost of compensated short term absences must be recognised when employees render the service that increases their entitlement. As a result an accrual has been made for holidays earned but not taken (Marks and Spencer, 2005b). As a result, under IFRS, there was an additional charge to profit and loss account of Marks and Spencer for the last reported year. Thus the inclusion of a fair value charge in respect of outstanding share-based awards for employees of Marks and Spencer has reduced the operating profit and profit before tax by 23 £m in 2004/05. Intangible assets also have presented a challenging transition, especially in the aspect of software capitalisation. Software expenditure has been capitlaised in accordance with international accounting standard 38 on intangible assets. The cost of developing software is currently written off as incurred in Marks and Spencer. IAS 38 on intangible assets requires capitalising internally generated intangible assets. To meet this requirement Marks and Spencer had to adjust the results, with expenses that were previously charged into the profit and loss account have been brought to the balance sheet as intangible software assets and amortised over their estimated useful lives. The exceptional profit from sales of M&S Money was restated under IFRS in order to reflect the value of their capitalised software at the point of disposal. As it was stated in the first part of the essay goodwill is capitalised and amortised over its useful economic life. Further use of IAS 38 implied separate identification of brands and other intangible assets instead if including them as parts of goodwill. As a result the goodwill recognised under UK GAAP on the acquisition of Per Una of 125.5 £m has been split between brand (80 £m) and goodwill (45.5 £m). Using the exemption of IFRS 1 Marks and Spencer has not restated comparatives for IAS 32 (Financial Instruments: Disclosure and Presentation) and IAS 39 (Financial Instruments: Disclosure and Presentation). Financial instruments in the year 2005/06 will be presented in the existing UK GAAP basis. The use of IAS 32 benefits the company in the following ways: clarifies the classification of a financial instrument as a liability or as equity; prescribing the accounting for treasury shares (a company's own repurchased shares; prescribes strict conditions under which assets and liabilities may be offset in the balance sheet; and requires a broad range of disclosures about financial instruments, including information as to their fair values. A companion standard, IAS 39, deals with initial recognition of financial assets and liabilities, measurement subsequent to initial recognition, impairment, derecognition, and hedge accounting. Marks and Spencer has chosen the exemption not to restate comparative fro these accounting standards. This will lead to the following impact: interest rate swaps will be reflected on the balance sheet under IAS 39; the company will meet the hedge accounting criteria for the majority of forward exchange contracts, enabling profit and loss volatility to be kept at a minimum; and finally non-equity shares will be treated as a liability rather than equity. IFRS is not a clear list of unbreakable rules. Instead, it is also a subject of debates, which also imposes difficulties for the company. For instance, leases that contain predetermined, fixed rental increases should be accounted in such way that the predetermined fixed rental payments should be recognized over a straight-line basis over the life of the lease. “The impact of this change is a reduction in profit before tax of 4.5 £m for the 52 weeks ended 2 April 2005.” (Marks and Spencer, 2005c) Such a quick reaction to changes in IFRS indicates the importance of these standards for Marks and Spencer. Conclusion In this report the transition of Marks and Spencer from UK GAAP towards IFRS has been analysed. Although the company shows the willingness to adopt new accounting standards with its preparation and changes in the accounting policy, further work requires to be done in the policies of reporting on financial instruments, and property leases. The situation is complicated with the debates and constant changes over IFRS. Nevertheless, the analysis indicates that Marks and Spencer has adopted most of the IFRS policies in a decent way. Future forecast may be made that the company will be able to perform a successful transition to IFRS this year. References Johnson, J.D. (1993). Goodwill - an Eternal Controversy. The CPA Journal Online. Retrieved March 8, 2006 from http://www.nysscpa.org/cpajournal/old/14152806.htm Marks and Spencer. (2005a). Annual Report and Financial Statements 2005. Retrieved March 8, 2006 from http://www2.marksandspencer.com/thecompany/investorrelations/annual_review05/index.shtml Marks and Spencer. (2005b). Marks and Spencer Group plc Adoption of International Financial Reporting Standards. Retrieved March 8, 2006 from http://www2.marksandspencer.com/thecompany/mediacentre/pressreleases/2005/fin2005-05-24-01.shtml Marks and Spencer. (2005c). Marks and Spencer Group Plc Adoption Of International Financial Reporting Standards. Retrieved March 8, 2006 from http://www2.marksandspencer.com/thecompany/mediacentre/pressreleases/2005/fin2005-10-11-00.shtml McClure, B. (2004). Appreciating Depreciation. Published by Investopedia on September 8. Retrieved March 8, 2006 from http://www.investopedia.com/articles/fundamental/04/090804.asp NEXT. (2005). Annual Report and Accounts 2005. Retrieved March 8, 2006 from http://www.next.co.uk/pdfs/Jan2005.pdf Robins, P. (2000). Goodwill and Intangible Assets. Student Accountant. Retrieved March 8, 2006 from http://www.accaglobal.com/publications/studentaccountant/30993 Tesco. (2005). Annual Report and Summary Financial Statements 2005. Retrieved March 8, 2006 from http://www.tescocorporate.com/images/Tesco_review.pdf Read More