Understanding Financial Statements: Consolidation and Presentation in Large PLCs

1. Chapter 6 Financial Statements

2. Financial Statements as Financial Photographs Financial Information Analysis

3. Consolidation • Most large plc’s are business combinations • i.e., various companies under one parent: • wholly-owned subsidiaries • partly-owned subsidiaries • associates • investee • These combinations require consolidated (group) accounts to be prepared Financial Information Analysis

4. Group a/cs • Consolidated (Group) accounts comprise accounts of parent and: • wholly-owned subsidiaries: incorporate fully • partly-owned: incorporate fully, then identify minority interest share of profits and assets • associates: include share of profits and net assets • investee: show as investment and source of dividends • See Chapter 11 for more detail Financial Information Analysis

5. Format of financial statements • Impact of EU Directives on presentation • IAS 1, Presentation of Financial Statements, the principal standard for large plcs • Overall principles: • “Fair presentation” [NB: “True & Fair”] • Compliance with IFRS must be stated • Offsetting generally not allowed • Each material class of item to be presented • Basic accounting concepts continue Financial Information Analysis

6. Financial Statements in AR • Financial statements are core of AR • Controlled by statute, standards, etc. • Under IAS 1 financial statements include: • balance sheet; • income statement; • cash flow statement; • statement of changes in equity; • notes to the accounts Financial Information Analysis

7. Balance Sheet • Format not rigid • But, Assets and Liabilities must be divided between “current” and “non-current” • “Current” if: • Realisable within normal operating cycle, or • Held primarily for trading purposes, or • In form of cash (or a ‘cash equivalent’ item), or • Expected to be realised with 12 months after B/S date • Otherwise, B/S may follow any one of a number of structures Financial Information Analysis

8. IAS 1 includes this example of B/S presentation Other formats acceptable – see Tesco B/S ASSETS Non-Current Assets X Current Assets X X LIABILITIES Equity X Non-Current Liabilities X Current Liabilities X X IAS 1 Format Financial Information Analysis

9. B/S: minimum disclosure • See p.175 for minimum disclosures based on IAS 1, para. 68. • Additional line items allowed where necessary to “fairly present entity’s financial position” • Following slides deal with some of the B/S items specified Financial Information Analysis

10. Property, Plant & Equipment • IAS 16: ‘Tangible assets held for use in production or supply of goods … for more than one period.’ • Recognise at cost or revalued amount if future economic benefits expected to flow • Cost includes all attributable costs • Revaluation based on fair value • Usually done by ‘class’ of asset • Revaluation increases directly to Equity • All subject to depreciation/impairment (IAS 36) • Assets not to be carried at more than recoverable amount • Detailed disclosures required in notes Financial Information Analysis

11. Investment Property • IAS 40: ‘land or buildings held to earn rentals or capital appreciation’ • Cost or Fair Value model may be used • Cost: • Carry at cost less depreciation/impairment • Fair value must also be disclosed • Fair value: • Any movements recognised in Income Statement Financial Information Analysis

12. Intangible Assets • IAS 38: ‘identifiable non-monetary assets without physical substance’ • e.g.: intellectual capital, customer loyalty, etc • To qualify, asset must be: • ‘identifiable’ – separable • ‘controlled’ – rights to future economic benefits • Classify as • ‘Indefinite’ life: subject to impairment tests • ‘Finite’ life: can be valued using fair value and amortised • Internally generated intangibles with demonstrable feasibility may now be recognised Financial Information Analysis

13. Inventories • IAS 2: Inventories shown in B/S at lower of Cost and Net Realisable Value (NRV) • Determining cost can be problematic • Raw materials, Work-in-Progress, Finished Goods • FIFO, LIFO, Weighted Average • Long-term contracts - % of completion (IAS11) • Accounting policies in relation to Inventories must be disclosed Financial Information Analysis

14. Provisions & Contingencies • IAS 37: Provision recognised when: • Entity has legal or constructive liability • Outflow of resources probable • Reliable estimate can be made • Contingent Liabilities: more subjective and less certain that outflow will result • e.g.: pending legal action against entity • Disclose details by way of note Financial Information Analysis

15. Financial Assets & Liabilities • IAS 39: recognition and measurment • Recognise on B/S including underlying instruments etc (e.g. derivatives) • Measure initially at ‘fair value’ (usually = cost) • Subsequent measurement: • Non- trading Loans etc – amortised cost • Held-to-maturity investments – amortised cost • Derivatives etc – fair value; changes to Income Statement • Other – fair value; changes to equity • Instruments used for hedging – ‘hedge accounting’ • Changes recognised in Income Statement • Significant additional disclosures Financial Information Analysis

16. Financial Assets & Liabilities • IAS 32: Disclosure & Presentation • Intended to address Off-Balance Sheet issues • Requires that financial istruments be classified on the basis of substance • if obliged to make future transfer = Liability • otherwise = Equity • Significant disclosure requirements: • Fair value • Risk exposure Financial Information Analysis

17. Capital and Reserves • Share Capital: • Authorised: indicated in Memo of Association • Issued: element of Authorised offered to public • Allotted: allocated to purchasers • Called-up: payment demanded by company • Fully paid: amount of called-up that has been paid • Share values: • Nominal (Par): arbitrary initial value, e.g., £1 • Issue price: amount at which available to public • share premium: excess of issue price over par value • Market price: price commanded on open market Financial Information Analysis

18. Capital and Reserves • Reserves arise from retention of profits or events such as issue of shares at a premium • Distributable reserves: can be used to fund dividends or other distributions • Undistributable Reserves: • Share Premium: excess of issue price over par • Revaluation Reserve: increase in asset value • Capital Redemption Reserve • Reserves nominated in Memo of Association • IAS 1 imposes significant disclosure requirements Financial Information Analysis

19. Income Statement (IS) • IAS 1 imposes certain minimum required headings: • Revenue • Finance costs • Share of profits from associates and joint ventures • Tax expense • Allocation of profit between Minority Interest and Equity • Dividends recognised as distributions during period must also be disclosed • Additional items may be required for purposes of ‘fair presentation’ • Where material, income and expense should be disclosed separately Financial Information Analysis

20. Income Statement (IS) • Expenses can be analysed by: • Nature: materials, staff costs, etc., or • Function: cost of sales, administration, etc. • Choice will impact IS structure • IFRS 5 requires that results of Discontinued Operations be shown on face of IS • Problems of definition of income, etc • calls for ‘Comprehensive Income’ like US Financial Information Analysis

21. Statement of Changes in Equity • Replaces Statement of Total Recognised Gains and Losses • Intended to track and disclose changes to Equity • IAS 1 requires disclosure of: • Profit or loss for period • Income and expense recognised in Equity • Impact of changes in Accounting Policy on Equity • Capital transactions with owners • Opening and closing reconciliations Financial Information Analysis

22. Cash Flow Statement (CFS) • CFS allows an assessment of ability to generate and apply cash (or cash equivalents) • Reflects critical role of cash in commercial life • IAS 7 requires presentation under three headings: • Operating – principal trading activity • Investing – e.g. acquisitions, dividends received • Financing – cash movements relating to Equity or borrowings • Additional information should be disclosed by way of notes Financial Information Analysis

23. Notes to Financial Statements • Integral part of reporting process • Cross-referenced to primary statement • Disclose: • Basis of preparation • Additional information, often in narrative form • Typically, AR has separate section dealing with Accounting Policies (IAS 8) • Outlines policies, judgements, etc, used • Prior period adjustments made by restating comparative prior period amounts Financial Information Analysis

24. Post-Balance Sheet Events • Arise because AR issued after year-end • IAS 10 envisages two categories: • Adjusting events: ‘provide additional evidence of conditions existing at balance sheet date’ • e.g., confirmation of amount of a bad debt •  record in period under review • Non-adjusting events: ‘concern conditions which did not exist at balance sheet date’ • e.g., acquisition of subsidiary after balance sheet date •  where material, disclose by way of note • Dividends proposed or declared after year end now viewed as contingent liability • Disclose by way of note Financial Information Analysis

25. Summary • Financial statement presentation heavily regulated • Increasing emphasis on greater disclosure and supplementary information in notes • Continuing change likely in future due to: • changing reporting culture • new technologies and media • Fair value represents significant change Financial Information Analysis