Findings of the Financial Reporting Review Panel in respect of the accounts of Liberty International PLC for the period ended 31 December 2000

FRRP PN 73 26 February 2002 The Financial Reporting Review Panel has had under consideration the report and accounts of Liberty International PLC for the period ended 31 December 2000 and has discussed them with the company’s directors. The single matter at issue was the company’s accounting treatment of its acquisition, in November 2000, of the minority interest of shares in a 75% owned subsidiary, Capital Shopping Centres PLC (“CSC”), a property company specialising in the ownership, management and development of prime regional shopping centres. The Panel has accepted the accounting treatment adopted by the company but only on the basis that there were ‘special circumstances’ attaching to the acquisition which justified the invocation of the true and fair override (Section 227 (6) of the Companies Act 1985) on which it needed to rely. In the December 2001 financial statements published today, the directors have made certain restatements of the 31 December 2000 accounts and given certain additional disclosures in response to the Panel’s view. They have (a) presented a revised fair value table, in which property assets are brought in at a fair value which is £193.2 million higher than previously reported; (b) as a consequence, recognised negative goodwill of £193.2 million which did not arise in the figures previously reported, and then credited it to reserves; and (c) restated certain notes to the accounts to include the disclosures required when the true and fair override is invoked. The restatement involves no change to (a) the profit and loss account; (b) the balance sheet (save for the reclassification of group reserves); (c) distributable profits; (d) earnings or net assets per share; or (e) cash flows. The Panel welcomes the action taken by the directors and regards its enquiry into the company’s 2000 accounts, initiated in December 2001, as complete. Detailed analysis The transaction The acquisition was a share for share exchange, with a small cash inducement designed to bring the market value of the consideration (0.714 Liberty International share plus 40 pence) to a modest premium over the market value of each CSC share acquired. In common with many quoted property companies, both Liberty International’s and CSC’s shares were trading at a significant discount to their published net asset values, reflecting the fact that the market price takes account of such items as contingent capital gains tax which are not included in the accounts but which are significant for both companies. Financial Reporting Standard (FRS) 2, ‘Accounting for Subsidiary Undertakings’, specifies the treatment that is to be adopted where a group increases its interest in an undertaking that is already its subsidiary undertaking. In these cases, the identifiable assets and liabilities of the subsidiary undertaking should be revalued to fair value and goodwill arising on the increase in interest should be calculated by reference to those fair values (paragraph 51). The goodwill then falls to be accounted for in accordance with FRS 10, ‘Goodwill and Intangible Assets’. The accounting treatment adopted in the 2000 accounts The directors had a range of concerns about goodwill arising from acquisition of a minority interest in a company that holds, manages and develops investment properties. First, the question was raised whether the acquisition of a property investment company could give rise to any goodwill as it is common practice to treat such acquisitions as ‘asset deals’. It was argued that the acquisition of CSC was, in substance, the purchase of a portfolio of property assets rather than a trading business to which goodwill could attach. The Panel held however that paragraph 51 was applicable to the transaction. Secondly, application of FRS 2, paragraph 51, appeared to give rise to a substantial negative goodwill balance of £193.2 million, the directors having satisfied themselves that they had included all identifiable net assets in accordance with FRS’s 7 and 10. FRS 10 attributes negative goodwill either to a bargain purchase or to future costs or losses that do not represent identifiable liabilities at the balance sheet date. The directors do not believe that the purchase of the minority shareholding in CSC could reasonably be described as a bargain purchase. The transaction was designed to ensure that the minority shareholders had the same interest in the net assets of CSC after the transaction as they had before, although now held through Liberty International’s shares. Moreover, the market value of the minority shareholders’ interest after the transaction was virtually unchanged from the value of their shareholding before it took place. Thirdly, under FRS 10, negative goodwill is to be recognised in the profit and loss account in the periods in which the non-monetary assets are recovered, whether through depreciation or sale. As investment properties are exempt from the need to depreciate, and the directors have no intention of selling the underlying properties which are not easily replaceable, they could envisage negative goodwill being retained indefinitely on the balance sheet. The directors believed the ‘negative consolidation difference’ (Companies Act 1985, paragraph9 of Schedule 4A) to stem from a fundamental disparity between the basis of valuation adopted for the consideration and that for the net assets acquired. They were of the view that most of the difference represented the potential capital gains tax and purchaser’s costs of property acquisition, both of which they considered were reflected in the acquired company’s discounted share price. Neither liability however could be recognised as part of the fair value process of the identifiable net assets under UK GAAP. Further, and consistent with UK GAAP, the company does not have a policy of recognising purchaser’s costs or contingent capital gains tax on assets that are not due for sale. In the circumstances, the directors considered it a more appropriate accounting treatment to consider the fair value of net assets acquired as equating to the fair value of the consideration. Note 13 to the 2000 accounts gave details of the transaction and included a fair value table as required by FRS 6 (paragraph 25) and Schedule 4A to the Companies Act 1985 to show the book values of CSC’s identifiable assets and liabilities before the acquisition and their fair values at the date of acquisition, with an explanation of any significant adjustments made. The note showed a fair value for net assets at the date of acquisition of £395.6 million, after a net credit adjustment of £197.3 million, £193.2 million of which was taken against investment properties. The net fair value of £395.6 million was the same amount as the fair value of the shares and cash given as consideration for the minority interest. Hence, no goodwill, either positive or negative, was deemed to have arisen from the transaction. The Panel enquiry Under SSAP 19, investment properties are carried at their market value. Hence, the ‘book value’ of the portion of the investment property assets acquired by the company in September 2000, £807.1 million, approximately represented the market value of the properties at that date, an acceptable basis for the determination of fair value of tangible assets. The Panel queried the substance of the £192.3 million ‘fair value’ credit adjustment against the investment properties which had the effect of bringing the fair value of the net assets acquired into equilibrium with the net value of the consideration. At 31 December 2000, the value of the investment properties was brought back up to market value through the usual annual revaluation process, required by SSAP 19, which included a reversal of the £193.2 million downwards adjustment. Had the fair value table retained the carrying value of the properties as the fair value of the net assets acquired, negative goodwill of £193.2 million would have arisen which, under FRS 10, would have been classified as a negative amount under purchased goodwill in the balance sheet. This negative goodwill, up to the value of the non-monetary assets acquired, would fall to be recognised in the profit and loss account in the periods in which the non-monetary assets are recovered through depreciation or sale (FRS 10, paragraph 49). In the meantime, it would reduce the apparent net assets of the group for accounting purposes. The Panel considered that paragraph 51 of FRS 2 should be applied to the transaction. However, it agreed that to account for the goodwill in accordance with paragraph 49 of FRS 10 would not be compliant with the requirement to give a true and fair view. The true and fair view override Section 227(6) of the Companies Act 1985 requires directors to depart from the provisions of the Act, including applicable accounting standards, where compliance with any of those provisions would be inconsistent with the requirement to give a true and fair view. This is expected to happen only rarely and must be supported by ‘special circumstances’. Having considered the issue very carefully, the Panel came to the view that, in accordance with section 227(6) of the Companies Act 1985, the directors should override the requirements of FRS 10 with respect to the negative goodwill arising from this transaction for the following reasons. As investment properties are exempt from the need to depreciate under FRS 15, the company is not able to recover the property values through depreciation, as envisaged by FRS 10. The property assets of CSC , being shopping centres, are not easily replaceable. The directors have no intention of selling them, either in the long or short term and CSC is therefore not likely to recover the property values through disposal, the alternative method envisaged by the standard. The balance described as negative goodwill reflects a fundamental difference in the valuation bases of the consideration and the identifiable net assets acquired, including the fact that certain contingent liabilities are reflected in the share price but may not be recognised in the fair value process. It is not appropriate to carry this balance on the balance sheet indefinitely. The net assets of CSC before acquisition represented some 90% of the net assets of the group. The effect of the acquisition ought not, economically, to result in an apparent reduction of the group net assets, which would be the result of recognising negative goodwill in accordance with paragraph 49 of FRS 10. There was a slight change in the relative proportional interests of the shareholders of CSC in the group assets before and after the transaction. However, in substance, the acquisition was similar to that of a group re-organisation as described in FRS 6 as the interest of the former minority in the group net assets was not substantially altered by the transfer and the same overall body of shareholders continued both before and after the transaction. This argument is dependent on the transaction being a share deal rather than a purchase for cash or cash equivalent The Panel accepted that a true and fair view would be shown in the circumstances of this acquisition if the negative goodwill arising on consolidation were transferred to reserves. This treatment reflects the unrealised nature of the gain, is not inconsistent with the requirements of the Companies Act 1985 and was the accounting policy adopted by the company before FRS 10 introduced a different treatment. Notes to Editors The remit of the Financial Reporting Review Panel is to examine the annual accounts of public and large private companies to see whether they comply with the requirements of the Companies Act 1985. Within this framework a main focus is material departures from accounting standards where such a departure results in the accounts in question not giving a true and fair view as required by the Act. Where a company’s accounts are defective the Panel will wherever possible endeavour to secure their revision by voluntary means, but if this approach fails it is empowered to make an application to the court under section 245B of the Companies Act 1985 for a order compelling their revision. To date no court applications have been made, though in some instances, the necessary steps have been at an advanced stage. The Panel does not itself monitor or actively initiate scrutinies of company accounts for possible defects, but acts on matters drawn to its attention, either directly or indirectly. The Panel’s responsibilities do not extend to the directors’ report, summary financial statements or interim statements. The Chairman of the Panel is Richard Sykes QC and the Deputy Chairman Ian Brindle FCA. There are currently 18 other Panel members drawn from a broad spectrum of commerce and the professions. Individual cases are normally dealt with by specially constituted Groups of 5 or more members. END Press Enquiries: Ann Wilks, Secretary to the Panel, on 020 7611 9750.