Chapter 7 - Published financial statements

Since 1980, the law governing financial reporting in the United Kingdom (now contained in the Companies Act 1985 and related legislation) has reflected membership of the European Union (EU) and the work of regulators across the EU to harmonize aspects of financial reporting. There are many similarities between these documents because the UK ASB benefited from the earlier work of the IASB. A comparison of primary statements in the IASB and UK ASB systems is shown in Table 7.1.

Key: * can be shown on the front page of the statement of capital movements or in the notes. You can't read about ﬁnancial statements for long without coming across the phrase 'bottom line'. Companies that do not use the IASB accounting system must comply with the requirements of the Companies Act 1985 and the UK ASB standards.

Descriptions in the balance sheet

When reading a balance sheet, the first thing you should look at is its overall structure to see where the major components of assets, liabilities, and ownership interests are placed. You take a step back to first look at the overall impression of the landscape and its most important features. Then you step forward to look at some details in different parts of the painting.

Finally, if you're really excited, you zoom in and start studying the details of texture, brush strokes, and shading.

Subtotals

Illustration

The following illustration presents the balance sheet of Safe and Sure Group plc for the year 7 with comparative amounts against the previous year.

Discussion

The balance sheet follows the accounting equation and this company has helpfully laid out the key elements of the equation in the left margin. There are some phrases on the balance sheet that you are encountering for the first time, but you shouldn't feel intimidated by new titles if you can figure out what they mean when you think about the common meanings of words. Tangible fixed assets is another term that you will encounter here for the first time, but here too you can find out its meaning.

So you would not be surprised to find that note 2 to the accounts gives more details about land and buildings, plant, equipment, vehicles and office equipment. The provisions relate to future liabilities caused by: treatment of a contaminated site; reorganization of part of the company; and future tax payable. This phase of the balance sheet ends with the net assets, defined as all assets minus all liabilities.

Drawing a total at this point is not a requirement of any format, but is used by many companies as the point that creates a pause in the balance sheet before turning to the owner's equity. The ownership interest in a company is specified in company law as the claim created by the shares owned by the various equity holders (shareholders) and the claim representing additional reserves of wealth accumulated since the company began. The owner's equity is the part of the balance sheet that causes the most confusion for most readers.

To add to the potential confusion, company law is happy to find names for different types of ownership shares. They are all part of the accounting terminology which becomes important to a corporate lawyer when there is a dispute about how much dividend may be declared, but is less important to the investor who says 'How much is my total claim?'.

Income statement (profit and loss account)

What items must be reported?
What formats are used?
Illustration
Discussion

This is a consolidated income statement (income statement) that brings together the results of the activities of all companies in the group during the year. A very common subtotal is the gross profit calculated as revenue minus the cost of the goods or services sold as revenue. Starting at the top of the income statement, we see that the word revenue is used to describe the sale of goods or services.

The cost of sales is the total of the cost of materials, labor and overhead directly related to earning the sales. The gross profit is sometimes referred to as the gross margin and is closely monitored by those who use the ﬁnancial statements to make judgments about the operations of the company. On the other hand, it is not a particularly significant component of the overall picture and the users may show little interest.

The profit from operations is the end of the first stage of the profit and loss account, where the story of the business operations is completed. The rest of the profit and loss account is concerned with the cost of financing the company. Next comes the corporation tax, which all companies must pay as a percentage of pre-tax profit.

The loss is part of the performance of the period, but investors can see that the bad news from this operation will not continue in the future. They don't see any mention here of a reward in the form of a dividend that gives them back some of the wealth the company has created over the period.

Cash flow statement

What items must be reported?

Finally, the equity holders (common shareholders) see the profit for the period attributable to them. This information will appear on a statement of changes in equity, which is explained in Chapter 12.

Illustration

Cash flow from operating activities

Discussion
Group structure of companies

Defining a group
The importance of control
The parent company’s balance sheet
Acquisition

Group financial statements

The parent company’s balance sheet
The group’s consolidated balance sheet
The group income statement (profit and loss account)
Goodwill on acquisition
Associated companies

Beyond the annual report

Preliminary announcements
Interim reports
Prospectus
Small and medium-sized companies
Avoiding information overload

The consolidated income statement (income statement) brings together all income and expenses for the companies in the group. The investment in the subsidiary is reported by the parent company as a single item, but the consolidated balance sheet shows all assets and all the group's liabilities under each separate item. This section explains how the purchase of a subsidiary affects the parent company's balance sheet.

In the consolidated balance sheet of the group, the assets and liabilities of the parent company are added to the assets and liabilities of the subsidiaries. The subsidiary's assets and liabilities take the place of the parent company's investment in the subsidiary. In the illustration shown in Figure 7.6 and Exhibit 7.7, the subsidiary's net assets are shown as the same size as the investment amount.

In these circumstances, the price paid for the investment in the subsidiary will be greater than the amount of the subsidiary's net assets. The amount of the cost of the investment in S exceeds the net assets of S plc. The shaded area equals the difference between the amount of the investment in S and S's net worth.

This treatment of an investment in an associated company is called equity accounting because it reports the parent's and the group's share of the investment in the ownership interest (also referred to as the equity). Company law does not prescribe the content of the preliminary announcement or the interim report. The Stock Exchange requires the company's auditors to agree to the release of the preliminary announcement.

It could be that in the longer term the advance announcement will increasingly take over the role of the annual report.

7.9.6 ‘Pro forma’ financial statements

Electronic publication of documents

The March 2005 White Paper confirmed that a document provided in electronic form will be validly delivered if that form has been consented to by the intended recipient (or the intended recipient has not responded when asked for a preference). However, shareholders and others who have the right to receive information will be able to ask for a paper copy of a document.

Summary

One conclusion of the Review was that the law allows financial reporting to be a slow process.

QUESTIONS

A consolidated cash flow statement contains the total cash flows of the group of companies, after eliminating any cash flows between the group companies. l Goodwill arising from the acquisition is calculated by comparing the fair value of the consideration for the subsidiary with the fair value of the net assets acquired. It represents future economic benefits arising from assets that are not able to be individually identified and recognized separately. l Goodwill is recognized as an asset on the balance sheet and tested annually for impairment. l Beyond the annual report there is a range of corporate communications – often most easily found by visiting a company's website. l Special disclosure rules apply to small companies to reduce the burden of disclosure. If you cannot find them again in the text, they are defined at the end of the book.).

A7.9 What are the key items found in most corporate profit and loss accounts? A7.11 Why does depreciation appear as a line in the reconciliation of operating income with cash flow? A7.15 Using the accounting equation, explain the effect on the parent company's balance sheet of a cash payment for an investment in a subsidiary.

A7.16 Using the accounting equation, explain the effect on the parent company's balance sheet of a share issue in exchange for shares in the subsidiary. A7.19 In addition to the annual report, what other documents do companies use to communicate accounting information to investors, creditors and other users of annual accounts.

B Application

C Problem solving and evaluation

Activities for study groups

An exception to the scope for interim control, retained in the first version of 2003, was removed from IFRS 5 issued in March 2004, see BC 14. 1 uses the description 'acquisition method' but the exposure draft amending IFRS 3 , issued in 2005, uses the description 'acquisition method'. In this section, the explanations assume that the fair value is equal to the book value of the subsidiary's net assets.

Information to be presented on the balance sheet as required by IAS 1.

Information to be presented on the face of the Balance sheet, as required by IAS 1

Supplement to Chapter 7.1

Balance sheet format 1, as prescribed by the Companies Act 1985

Supplement to Chapter 7.2

K Capital and reserves I Called share capital II Share premium account III Revaluation reserve IV Other reserves. Note: Where minority interests are relevant, they should be attached as a letter. Information to be presented on the face of the Income Statement as required by IAS 1.

Information to be presented on the face of the Income Statement as required by IAS 1

UK Companies Act

Profit and loss account format 1 – list of contents