Making sense of statements
Ash Chandarana demystifies financial statements with eight important answers for IP professionals.
Financial statements – such as profit and loss accounts, balance sheets and cashflow statements – are widely regarded as the “language” of business. Used properly, they provide a unique insight into the financial performance of a company and can be a vital resource for experts working in the IP arena by articulating the value of trade marks and other intangible assets.
However, they can also seem impenetrable unless you understand the jargon and the principles behind their presentation. Reading the answers to these key questions is a good place to start.
Is there a single format for financial statements?
No. Financial statements can take many forms, depending on the business structure involved. The financial statements of an unincorporated entity are usually only for internal and tax purposes and can be presented in a variety of ways.
By contrast, incorporated companies and limited liability partnerships (LLPs) are required to file their financial statements at Companies House and must follow some strict disclosure requirements and rules as to how the accounts are presented.
It is also worth noting that an LLP and a limited company will have different terminology and various differing disclosure notes.
Can you rely on a financial statement?
Check to see what type of report has been prepared, as this will determine the level of assurance you take from the financial statement. Three of the most common types are:
- Accountant’s report. This informs the reader that the financial statements have been prepared by the accountant, but no tests or checks have been done on the numbers and no opinion is given on whether the financial statements provide a “true and fair view” of the company’s affairs.
- ISRE 2400 report. Here, the accountant performs a limited review of the financial statements to state whether anything has “come to their attention”. However, no opinion is given as to whether the financial statements provide a “true and fair view” of the company’s affairs.
- Audit report. This confirms that various tests have been performed to check the reliability of the financial statements. As a result, the report is able to provide an opinion on the financial statements and whether they offer a “true and fair view” of the company’s affairs.
Do all businesses need to be audited?
No. Small companies are typically exempt from having their financial statements audited if they meet two out of the three following criteria, for two consecutive years:
- Turnover is not more than £10.2m;
- The balance sheet total (gross assets) is not more than £5.1m; and/or
- The average number of employees for the year is not more than 50.
However, certain companies (such as banks and subsidiaries that are in the same group as a bank) are always subject to statutory audit, regardless of their size, to ensure their transparency to the public eye.
A business can voluntarily undertake an audit, to provide assurance to its stakeholders regarding its financial statements. Even if a company is exempt from an audit, it must still undertake an audit if requested by 10 per cent or more of its shareholders.
What are the rules around accounting for intangible assets?
There are specific rules around accounting for intangible assets such as trade marks or other intellectual property. Principally, the intangible asset should only be recognised if it is probable that the expected future economic benefits attributable to the asset will flow to the company and the cost can be measured reliably.
Internally generated brands, logos, publishing titles, customer lists and goodwill cannot be recognised as intangible assets.
Research and development expenditure has a two-stage treatment. While in the research phase, all expenditure must be taken to the profit and loss account, as expenditure is incurred. In the development phase, provided all the following criteria are met, the expenditure can be considered an intangible asset:
- It must be technically feasible to complete the intangible asset so that it can be either used or sold.
- The company must have the intention to complete the intangible asset so that it can be used or sold.
- The company must have the ability to use or sell the intangible asset once it is completed.
- The intangible asset must be able to generate probable future economic benefits and prove its usefulness.
- Adequate resources must be available to the company to complete the development of the intangible asset; and
- The costs incurred can all be measured reliably.
How are intangible assets valued?
Intangible assets are capitalised to the balance sheet at cost, which includes any directly attributable costs necessary to produce and prepare the asset for use (legal fees, for example). Where assets have already been capitalised, the revaluation model can be applied, revaluing the asset each year going forward.
When can the value of goodwill be recognised?
Internally generated goodwill cannot be recognised on the balance sheet. However, if a company is purchased for £10m, with all net assets (including any intangible assets attributable to the acquired company) being valued at £7m, the remaining £3m is recognised as ‘goodwill’ in the group financial statements. Goodwill can also arise on the purchase of a business, rather than a company.
What is amortisation?
Amortisation is accounting terminology for the depreciation of an intangible asset and is a measure of the impairment and reduction of its value. Amortisation should spread over the useful life of an asset. If you are unable to determine the asset’s useful life, the UK Generally Accepted Accounting Principles (GAAP) state that a maximum of 10 years should be used.
Do the accounts use UK GAAP or IFRS?
It is always worth checking the basis of preparation of the financial statements. We have noted all our points above using a convention called FRS 102, under UK GAAP. However, it is possible that the financial statements could be prepared under International Financial Reporting Standards (IFRS) instead. One difference between IFRS and UK GAAP for intangibles is that under IFRS intangibles must be capitalised in the development phase if certain criteria have been met, while under UK GAAP companies can opt to capitalise intangibles once the criteria (similar but not the same as those under IFRS) have been met.
Note: This article is intended as a general guide. No responsibility for loss occasioned to any person acting or refraining from action as a result of this material can be accepted by the author or publisher. This information is in accordance with legislation in place as of 1st February 2020.
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