EU Gives Small Co. Accounting An Overhaul

A logjam of opaque financial reporting structures has long dammed up economic growth among the European Union’s vast realm of small businesses, family-owned or otherwise. Now, new legislation intends to overhaul reporting rules, drive down the cost of capital, and galvanize the small- and medium-sized business sector there.

As in the United States, SMBs are the backbone of the EU economy: They comprise an estimated 23 million companies, providing 110 million jobs and accounting for 99 percent of all enterprises. Still, according to a recent Eurobarometer survey, 40 percent of SMBs say their development would be enhanced by easier access to capital.

Wright

EU officials have targeted financial reporting as a prime way to improve that access to the financial markets, and to clarify investment risks to investors, says David Wright, director of financial services in the European Commission. In particular, the EU plans to amend the 4th and 7th Company Law Directives, which govern financial statements and reporting in the EU. The 4th Directive applies to the financial statements from individual companies, the 7th Directive applies to consolidated accounts for groups (see box at right for details).

Large businesses already listed on EU exchanges can usually just follow International Financial Reporting Standards because IFRS is more comprehensive, but SMBs are regulators’ immediate worry.

Schaub

“While satisfactory disclosure exists for listed companies under International Accounting Standards, requirements for non-listed companies should be improved,” says Alex Schaub, the just-retired director of the European Commission’s Internal Market Directorate General. (That directorate is responsible for introducing a great swath of EU financial legislation in recent years.)

The revisions to company law, which are being processed as a legislative amendment, introduce two main principles. One is disclosure of companies’ related-party transactions, such as with company managers or their family members, although “only where such transactions are material and not carried out at arm’s length,” Schaub says. The other principle is disclosure of off-balance sheet transactions in financial statement footnotes. Other elements in the revised legislation confirm that all board members should have collective responsibility for company financial statements.

FAQs

The excerpt below is from a list of "frequently asked questions" regarding the European Commission proposal for amending the Accounting Directives:

Off-Balance Sheet Arrangements

What kind of off-balance sheet arrangements will fall under the new disclosure requirements proposed by the Commission?

In essence the Commission’s proposal follows the “true-and-fair-view” principle, in other words that financial statements must present a true and fair view of the financial position of a company. No specific definition of such arrangements is given in the proposed amendments to the Directives, because sticking to a principles-based approach makes it difficult to circumvent transparency rules. However, the Commission considers that investors, shareholders and users of financial statements should be informed about a company's material interests in unconsolidated entities, such as special purpose entities (SPEs) or offshore entities. SPEs may be used efficiently, for example to spread risk, to raise finance or for similar objectives. But when a company decides to use SPEs or other arrangement to spread risks or raise financing and keep this off the balance sheet, shareholders and other users of financial statements should be informed about this.

Who will be affected by the new requirements?

Listed EU companies applying IAS would have to comply with these additional disclosure requirements, to the extent that they go beyond what is currently required under international accounting standards.

Related Party Transactions

Who is a related party?

Since the Commission is committed to global accounting standards, it prefers to align the Accounting Directives with the existing definitions under IAS 24, which were generally recognised as satisfactory during the public consultation. This could be achieved by referring in the amended Accounting Directives to the definition in the relevant International Accounting Standard, which has already been endorsed by the Commission under the IAS Regulation.

What about small non-listed companies?

Under the proposal, Member States could exempt from the requirements small non-listed companies, defined as those with fewer than 50 employees, a balance sheet total of less than €3.65 million and a turnover of less than €7.50 million. Already the present Accounting Directives give an option to Member States to allow such small companies not to disclose transactions with affiliated undertakings - which is one type of related party. Therefore, the Commission considered that the same logic should apply in the case of an extension of the transparency rules to other kinds of related parties.

Source

European Commission Proposal For Amending The Accounting Directives—Frequently Asked Questions (Oct. 28, 2004)

“Such transactions or arrangements can make it difficult for investors to assess the real risk of investing in a company,” Schaub says. Instruments such as special-purchase vehicles, for example, could be used to evade accounting rules to the detriment of investors. “Generally, the measures were to help investors assess the real risk of investing in the unlisted sector,” he says.

Lehne

Klaus-Heiner Lehne, a German member of the European Parliament who nursed through the upgrade, also emphasizes the need to avoid overkill in accounting requirements for small firms. “We are providing benefits to investors without too much regulatory burden on the companies themselves,” he told Compliance Week.

The enhanced company law legislation is nearly done rumbling through the Brussels institutional machinery; the EC’s proposals went to the European Parliament at the end of last year, which agreed to its version at first reading.

It is now with the Council of Ministers, the body that brings together the government ministers from the EU’s 25 member states. The Council signed the formal text to amend the 4th and 7th directives in May. Now the legislation is waiting on another delay as it is translated into the European Union’s 20 different official languages, according to Ralph Pine, an EU parliamentary official. (In each piece of EU legislation, lawyers trained in languages agonize over whether all versions mean exactly the same thing.)

The final language that emerges from Brussels will be modifications to national laws, which then have to be implemented in each of the member states. The countries will be given two years to upgrade their own rulebooks. Lack of consistent implementation could be a problem.

Will It Work?

Regardless, the current revisions may not have much effect on investments, at least not for the small investor. In Europe most non-family finance for SMBs comes from banks rather than equity. According to Saskia Slomp, technical director at the European Accountants Federation, banks can be strict with their cash, demanding full collateral backing, especially those banks in southern Europe.

Another source of finance is venture capital for startups, but in Europe that plays only a small role. According to an EC spokesperson, overall EU early-stage venture capital last year was 2.1 billion euros, or about 0.02 percent of GDP—far less than in the United States.

Spurring that anemic amount of investment activity is what the 4th and 7th directive reforms are all about. The EC ultimately wants to generate more risk capital investments, to develop bank finance for innovation, and to make existing financing systems more SMB-friendly. The Commission also wants to step up early-stage investment from 2 billion euros annually to 6 billion ($2.5 – 7-6 billion) by 2013.

Another important step could be an exposure draft from the International Accounting Standards Board, the international body behind the IFRS, on accounting rules for small and mid-sized enterprises. Its draft is eagerly awaited in early autumn, although particulars of what IASB might address are unclear. And still another possible event in the pipeline, but not yet announced, is still more action from the EC to reform the 4th and 7th company law directives.

Details on the directives can be found in the box above, right.