INTERPRETING COMPANY REPORTS and ACCOUNTS NINTH EDITION Geoffrey Holmes Alan Sugden and Paul Gee Holmes, Sugden and Gee An imprint of Interpreting Company Reports and Accounts guides the reader through the conventions and complexities of company accounts, explaining how to assess the financial and trading position of a company from year to year, how to spot undue risk taking and ‘cosmetic accounting’ and where to look for clues on the quality of management. Packed with interesting real world examples, this is a highly practical book which shows readers how to analyse company reports and accounts, both qualitatively and quantitatively. The analysis is illustrated with over 200 extracts/examples from published accounts. Interpreting Company Reports and Accounts is suitable for intermediate/advanced undergraduate accounting and finance courses and for MBA courses. The book is recommended reading for several professional examinations and will also be relevant to practitioners. The late Geoffrey Holmes FCA, FTII was, for more than twenty years, the highly regarded and much respected Editor of Accountancy, the Journal of the Institute of Chartered Accountants. Alan Sugden is a Sloan Fellow of the London Business School and a retired director of Schroder Investment Management. He spent nearly 20 years in the City as an Analyst and fund manager, running the £100 million Schroder Recovery Fund for several years. Paul Gee BA (Econ) FCA is Technical Director of Bristol based accountants Solomon Hare, and lectures widely in the UK on financial reporting. ‘That it is known as “The Analysts Bible” says much about this book. It shows how to crunch the numbers and what to look for buried in the notes to the accounts and suggests how to read the director’s reports for the signs of business turning sour.’ “We still love it” 2004 Investors Chronicle ‘The book is wholly successful in its aim of providing a guide for ‘anybody with a reasonably enquiring mind’ on how to take to pieces a set of company reports.’ Financial Times ‘If I wanted to give my mother a book to help her make sense of company accounts I could hardly think of a better book. For business people or potential investors… I would say this book is ideal.’ Michael Thompson: University of Ulster 9 780273 695462 ISBN 0-273-69546-0 www.pearson-books.com Key Features Key points from company accounts are highlighted and explained throughout the book. Chapter 32: Putting it all Together takes readers step-by-step through the reports, accounts and press cuttings of an interesting AIM company. The authors comment as well as inform – previous editions highlighted the serious weaknesses of both Polly Peck and Maxwell Communications Corporation well ahead of their collapse. Very well written, engages students and brings the subject to life. New Features A chapter detailing the differences between International and UK accounting standards, and how the ASB plans to close the gap. New chapter on ‘Accounting Practices – Cause for Concern?’ A critique on Corporate Governance. NINTH EDITION Cover image © Taxi/Getty Images INTERPRETING COMPANY REPORTS and ACCOUNTS Holmes ppr 18/08/2005 3:05 PM Page 1 Interpreting Company Reports and Accounts We work with leading authors to develop the strongest educational material in business, finance and marketing, bringing cutting-edge thinking and best learning practice to a global market. Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work. To find out more about the complete range of our publishing please visit us on the World Wide Web at: www.pearsoned.co.uk Interpreting Company Reports and Accounts NINTH EDITION Geoffrey Holmes Alan Sugden Paul Gee Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 1979 Ninth edition published 2005 ©Geoffrey Holmes and Alan Sugden 1979, 1983, 1986, 1990, 1994, 1997, 1999 ©The Estate of Geoffrey Holmes; Alan Sugden and Paul Gee 2002, 2005 The rights of Geoffrey Holmes, Alan Sugden and Paul Gee to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. ISBN-10: 0-273-69546-0 ISBN-13: 978-0-273-69546-2 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress 10 98765432 09 08 07 06 05 Typeset in 9.75/12pt Times by 35 Printed and bound by Ashford Colour Press, Gosport The publisher’s policy is to use paper manufactured from sustainable forests. Publisher’s Acknowledgements vi Full Contents vii Preface xiii 1 Company reports and accounts – an introduction 1 2 Financial reporting standards and principles 7 3 Forming a company 15 4 Admission to listing 17 5 Share capital and reserves 20 6 Loan capital 34 7 Intangible fixed assets 50 8 Tangible fixed assets 54 9 Fixed asset investments 67 10 Stocks and work in progress 71 11 Debtors 81 12 Current asset investments; cash at bank and in hand 89 13 Bank loans and overdrafts 92 14 Derivatives and other financial instruments 99 15 Creditors, provisions, contingent liabilities and contingent assets 106 16 Profit and loss account 118 17 Taxation 138 18 Profit after tax, dividends and earnings per share 146 19 Cash flow statements 163 20 Subsidiaries and group accounts 175 21 Acquisitions and mergers 184 22 Associates, joint ventures and related parties 191 23 Foreign exchange 201 24 Historical summaries, ratios and trends 210 25 Chairman’s statement, operating and financial reviews and directors’ report 221 26 Corporate governance and the auditors’ report 231 27 Interim reports 239 28 Other sources of information 242 29 Inflation 249 Brief contents 30 Accounting practices – cause for concern? 253 31 International accounting comparisons 258 32 Putting it all together 263 33 Developments in accounting 269 Appendix 1 – Current Financial Reporting Standards and Exposure Drafts 274 Appendix 2 – Present value 276 Appendix 3 – Retail Price Indices since 1950 278 Appendix 4 – Problems and solutions 279 Appendix 5 – International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) 301 Index 302 Publisher’s acknowledgements We are grateful to the following for permission to reprint copyright material: Financial Times for: Financial Times extract from article on accountants by Barry Riley, © Financial Times, 8 December 1990; Financial Times extract from LEX column, © Financial Times, 1 July 2000; Financial Times extract from the LEX column, © Financial Times, 9 July 2001; Financial Times extract from accounting article by Robert Howell, © Financial Times, 13 August 2002; Financial Times article of 15 July 2000 by Charles Batchelor, © Financial Times, 15 July 2000; Marks & Spencer for a page from their 1945 Annual Report; HS Financial Publishing for the Body Shop International figures on page 247 © HS Financial Publishing. vi Brief contents Page Preface xiii INTRODUCTION 1Company reports and accounts – an introduction 1 The purpose of this book. The report and accounts. The directors’ report. The profit and loss account. The balance sheet. The accounts of a newly-formed company. 2Financial reporting standards and principles 7 The present structure. The regime prior to 1990. The present regime. The Financial Reporting Council (FRC). Financial Reporting Review Panel (FRRP). The Accounting Standards Board (ASB). The Urgent Issues Task Force (UITF). Financial Reporting Standards (FRSs). Statements of Recommended Practice. International accounting standards. Principles of financial reporting. Need for a conceptual framework. Fundamental accounting concepts. FRS 18 Accounting policies. Statement of Principles for Financial Reporting. What financial statements comprise. The need to read the notes. The objective of financial statements. Users and their information needs. What users look for. Recognition. Accounting policies. FORMATION 3Forming a company 15 The limited company. Incorporation of a company. Memorandum of Association. Articles of Association. Members’ (shareholders’) liability. Public company. Private company. Chartered company. Small and medium-sized companies. 4Admission to listing 17 Stock Exchange listing – ‘quoted companies’. Requirements for listing. Listing Particulars (prospectus). Minimum size of issue. Keeping the public informed. Continuing Obligations. Methods of obtaining a listing. Alternative Investment Market. Full contents THE BALANCE SHEET: CAPITAL EMPLOYED 5 Share capital and reserves 20 Share capital. Authorised and issued share capital. Types of share capital. Preference shares. Golden shares. Ordinary shares. Partly paid shares. Ordinary stock. Non-voting shares. Another substantial shareholder. Deferred shares. Warrants. Exercise rights. Accounting for warrants. Warrant price behaviour. ADRs. Share schemes for directors and employees. Granting of options. Executive share option schemes. Unapproved share option schemes. Enterprise Management Incentives (EMI). Save-As-You-Earn (SAYE) share options. All employee share ownership plans (AESOPs). Performance share plans. Phantom share schemes. Summary of schemes. The investor’s viewpoint. Effect of inflation. The issue of further equity. Rights issues. Placing and open offer. Scrip issues. Share splits. Scrip (stock) dividends. Further information on shares. Company purchasing its own shares. Reduction of share capital. Arrangements and reconstructions. Reserves. Where reserves come from. Capital and revenue reserves. Share premium account. Revaluation reserve. Capital redemption reserve. 6Loan capital 34 The advantages of borrowing. The risk of borrowing. Types of borrowing. Security given to the lender. Typical characteristics of debentures and ULS. The trust deed. Accounting for finance costs. Repurchase of debt. Deep discount issues. Sinking funds. Yields. Bonds. Notes and loan notes. Commercial paper (CP). The amount a company can borrow. Capital and income covers. Convertible loan capital. Terms of a convertible loan. Convertibles with ‘put’ options. Warrants. Mezzanine finance. Complex capital issues. Off balance sheet financing. Substance over form. FRS 5 Reporting the substance of transactions. Quasi-subsidiaries. Sale and leaseback. Linked presentation. Other aspects of FRS 5. Gearing ratios. Financial gearing. Leverage effect. Interest rate sensitivity. Operational gearing. Profit/volume chart. Aggravating the problem. Fixed charges cover. ASSETS: FIXED ASSETS 7Intangible fixed assets 50 Intangible fixed assets. Capitalised development costs. Rights. Copyright and similar publishing rights. Licences. Patents and trademarks. Purchased goodwill. Purchased goodwill – old rules. Purchased goodwill – FRSs 10 and 11. Impairment. 8Tangible fixed assets 54 Tangible fixed assets. Depreciation. Companies Act requirements. Rates of depreciation. Subnormal depreciation charges. Useful economic life. Where depreciation is shown in the accounts. Depreciation methods. The straight line or fixed instalment method. The reducing balance method. The sum of the years’ digits method. Comparison of methods. The renewals method. Change in expected useful life. Writing down of asset values. Changing method. Freehold land and buildings. The revaluation of assets. Background. The arguments for and against valuations. FRS 15 Tangible fixed assets. Sales and other disposals of fixed assets. Investment properties. Government grants. Ratios. 9Fixed asset investments 67 Types of investment. Investment in subsidiaries. Investment in associates. Investments in joint ventures. Other fixed asset investments. Disclosures on significant holdings. Balance sheet presentation. Points to watch. Interlocking holdings. viii Full contents CURRENT ASSETS 10 Stocks and work in progress 71 Different classes of stock. Subclassification. The matching principle. Dead stock. Consistency. The importance of stock valuation. Problems in valuing stock. Stocks in a large retail business. Stocks in a manufacturing business. Methods of pricing issues from stock. Taxation of stock profits. Requirements of the Companies Act 1985 and of SSAP 9 on stocks and WIP. Consignment stocks. The danger of rising stocks. Long-term contracts. SSAP 9 requirements on long-term contracts. Stock ratios. Stocks/Turnover ratio. Stocks/Cost of sales ratio. Cost of sales/Stock ratio. 11 Debtors 81 Trade debtors and other debtors. Introduction. Bad debts and doubtful debtors. The importance of debtors. Debt collection period. What we would like to know. Factors affecting the debt collection period. Debtors due after more than one year. Assets held for resale. Hire-purchase and credit sale transactions. Definitions. Timing of profit taking. The rule of 78. Hire-purchase information given in accounts. Factoring. The provision of finance. Service charge. Bad debt protection. International factoring. Invoice discounting. Factoring in the accounts. Linked presentation. 12 Current asset investments; cash at bank and in hand 89 Types of investment. Types of current asset investment. Accounting for current asset investments. Current asset investments in practice. Significance of short-term investments. Availability of short-term investments. Cash at bank and in hand. Disclosure requirements. CURRENT LIABILITIES 13 Bank loans and overdrafts 92 Bank facilities. Overdrafts. The cost of borrowing on overdraft. Fluctuations in amount. Vulnerability. Bank loans. Security. Flexible loan facilities. Bills of exchange. Definition. Primary purpose. Balance sheet presentation. Discounting. Acceptance credits. The big picture. Cash flow statements. 14 Derivatives and other financial instruments 99 Introduction. Derivatives can seriously damage your wealth. Definition of a derivative. Risk management and derivative trading. Disclosure requirements. Common types of derivative. Commodity related derivatives. Reducing the risks of trading in derivatives. Financial derivatives. Currency swaps. Interest rate swaps. Interest rate caps. Numerical disclosures. Counterparty risk. Concern about derivatives. But why bother with derivatives? Benefits of disclosure. Recognition and measurement. 15 Creditors, provisions, contingent liabilities and contingent assets 106 Creditors. Presentation. Types of creditor. Working capital and liquidity ratios. Comment on The Body Shop’s ratios. Liquidity ratios. Current ratio. Quick ratio or acid test. Provisions. Background. Definition. When to make provisions. Annual review and disclosure. Provisioning – the main areas. Other accounting standards on provisions. Other uses of the term ‘provision’. What does all this mean to the investor? Contingent liabilities and contingent assets. Definition. Examples of contingent liabilities. The significance of contingent liabilities. Capital commitments. Other financial commitments. Leases. Operating leases. Full contents ix [...]... report; a profit and loss account; a balance sheet; and an auditors’ report The form and content of accounts are also subject to Financial Reporting Standards, about which we will have more to say in Chapter 2, and which add to the list of required contents For example, FRS 1 requires all companies (other than small companies) to include a cash flow statement 2 Interpreting company reports and accounts In... business 3 4 Interpreting company reports and accounts Net assets = All assets − All liabilities Fixed assets are assets (like land and buildings, plant and machinery) not held for resale but for use by the business Fixed assets can be either tangible, from the Latin tango, I touch (e.g motor vehicles, land and buildings) or intangible, i.e not susceptible to touch (e.g patent rights and trademarks)... rely on general purpose financial reports (StoP para 1.1) As the StoP points out, Annual Reports and Accounts and Interim Reports are of interest not only to investors, but to: n n n n n n lenders (although banks demand and get a lot more timely and detailed information than is generally available); suppliers and other trade creditors (to decide how much credit to allow a company) ; customers (a retailer... as well as the International Accounting Standards Board (IASB) But ‘if the Board is to participate meaningfully and credibly in international debates about financial reporting, it must move closer to the conceptual frameworks of other leading standard-setters’ 10 Interpreting company reports and accounts For a comparison of UK and International Accounting Standards, see Chapter 31 Principles of financial... stimulated requirements for more and more disclosure, some of which have been met by what Sir David Tweedie calls ‘boilerplating’, the use of standard wording that provides no useful information, and tends to clutter up company reports Key points Because of the sheer increase in the volume of information contained in annual reports and accounts we have, in this edition, expanded the inclusion of ‘Key Points’... wheat from the chaff Alan Sugden Paul Gee CHAPTER 1 Company reports and accounts – an introduction The purpose of this book DIAGEO Extract from 2003 Annual Review This book is intended as a practical guide to the interpretation of reports and accounts In it frequent reference is made to the legal, accounting and UK Listing Authority’s requirements that accounts have to meet, but this is done in the context... flow Snippets of information 163 Full contents xi THE GROUP 20 Subsidiaries and group accounts Interests in another company Buying some shares in company B Making a takeover bid for company B FRS 6 Acquisitions and mergers Holding companies, subsidiaries and groups Some definitions Group accounts Additional information Consolidated Accounts The consolidated balance sheet Goodwill on consolidation arising... land, over their expected useful lives Stocks Stocks are valued at the lower of cost and net realisable value Net realisable value is based on estimated selling price less further costs to completion and disposal The Body Shop International Employee Share Trust The Company is deemed to have control of the assets, liabilities, income and costs [of the Trust] 14 Interpreting company reports and. .. Incorporation is issued and the company assumes a legal identity separate from its shareholders Before incorporation can take place, a Memorandum of Association and Articles of Association have to be drawn up and filed with the Registrar of Companies in England and Wales or with the Registrar of Companies in Scotland The Memorandum lays down the rules which govern the company in its relations with the... to be supplied for approval prior to listing, and which have to be included in The UKLA also has to ensure that the general public will be kept satisfactorily informed of the company s activities and progress in the future, and that the shareholders’ interests will be adequately protected: this is done by requiring an 18 Interpreting company reports and accounts applicant for listing to accept ‘Continuing . INTERPRETING COMPANY REPORTS and ACCOUNTS NINTH EDITION Geoffrey Holmes Alan Sugden and Paul Gee Holmes, Sugden and Gee An imprint of Interpreting Company Reports and Accounts guides. analyse company reports and accounts, both qualitatively and quantitatively. The analysis is illustrated with over 200 extracts/examples from published accounts. Interpreting Company Reports and Accounts. Corporate Governance. NINTH EDITION Cover image © Taxi/Getty Images INTERPRETING COMPANY REPORTS and ACCOUNTS Holmes ppr 18/08/2005 3:05 PM Page 1 Interpreting Company Reports and Accounts We work with leading authors