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 The tenth edition of Interpreting Company Reports and Accounts guides the reader through the many

Reports and accounts

Interpreting Company
conventions and complexities of company accounts, explaining how to assess the financial and trading position Tenth Edition
of a company from year to year, how to spot undue risk-taking and ‘cosmetic accounting’, and where to look

Interpreting
for clues on the quality of management.
This book is intended as a practical guide to the interpretation of reports and accounts. It contains frequent
reference to the legal and accounting requirements in the UK, both as regards to IFRS (International Financial
Reporting Standards) and UK GAAP (UK Generally Accepted Accounting Practice). This is done in the context of
interesting information to look out for, rather than how a set of accounts should be prepared.
Packed with relevant real world examples, this highly accessible book shows readers how to analyse company
reports and accounts, both qualitatively and quantitatively. The analysis is illustrated with numerous published
Company Reports
and accounts
accounts, extracts and examples and references to corporate websites.

Key Features
• Key points from company accounts are highlighted and explained throughout the book Geoffrey Holmes
• Each topic chapter examines the implications of adopting IFRS Alan Sugden
• The chapter ‘Putting it all together’ takes readers step by step through the reports, accounts
and press cuttings of an AIM company and Paul Gee
• 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

New to this edition

• Explains the key differences between UK GAAP and IFRS Tenth
• Analyses how companies present the impact of the transition from UK GAAP to IFRS Edition
• Coverage of small and medium-sized entities (SMEs) reporting
• Includes recent developments in narrative reporting: Operating and Financial Review
Developments; Business Review; and Corporate Social Responsibility Reporting

Holmes, Sugden and Gee

Interpreting Company Reports and Accounts is suitable for intermediate or advanced undergraduate accounting
and finance courses, as well as MBA courses. The book is recommended reading for several professional
examinations and will also be highly relevant to practitioners.

Geoffrey Holmes FCA, FTII was, for more than 20 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 a member of the National Assurance Technical
Group of Smith & Williamson and lectures widely in the UK on financial reporting.

Front cover image www.pearson-books.com

An imprint of © Getty Images

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Interpreting Company
Reports and Accounts

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Interpreting Company
Reports and Accounts
TENTH EDITION

Geoffrey Holmes
Alan Sugden
Paul Gee

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Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world

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First published 1979

Tenth edition published 2008

© Geoffrey Holmes and Alan Sugden 1979, 1983, 1986, 1990, 1994, 1997, 1999
© The Estate of Geoffrey Holmes; Alan Sugden and Paul Gee 2002, 2005, 2008

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, Saffron House, 6–10 Kirby Street,
London EC1N 8TS.

ISBN: 978-0-273-71141-4

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

Holmes, Geoffrey Andrew.
Interpreting company reports and accounts / Geoffrey Holmes, Alan Sugden, Paul Gee. --
10th ed.
p. cm.
ISBN-13: 978-0-273-71141-4
1. Financial statements. 2. Corporation reports. I. Sugden, Alan. II. Gee, Paul. III. Title.
HF5681.B2H63 2008
657′.3--dc22
2007049783

10 9 8 7 6 5 4 3 2 1
12 11 10 09 08

Typeset in 9.75/12 Times by 35

Printed and bound by Ashford Colour Press., Gosport

The publisher’s policy is to use paper manufactured from sustainable forests.

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 Brief contents

Contents vii
Preface xi
Publisher’s acknowledgements xii

1 Overview of the regulatory scene 1

2 International Financial Reporting Standards (IFRS) overview 8
3 Accounting principles 11
4 The annual report 22
5 Chairman’s statement and the operating and financial review 34
6 Corporate governance and the auditors’ report 43
7 The profit and loss account: overall structure 52
8 The profit and loss account: turnover and revenue recognition 55
9 The profit and loss account: further disclosure areas 62
10 The profit and loss account: interpretation, ratio analysis, segmental analysis and earnings per share 74
11 Equity statements, dividends and prior period adjustments 88
12 The balance sheet: an introduction 95
13 Tangible fixed assets 99
14 Intangible fixed assets 109
15 Fixed asset investments 116
16 Stocks and long-term contracts 122
17 Debtors and other receivables 131
18 Current asset investments; cash at bank and in hand 141
19 Creditors and provisions 145
20 Tax in the balance sheet 155
21 Bank loans and overdrafts 163
22 Loan capital 167
23 Derivatives and other financial instruments 185
24 Equity share capital and reserves 197
25 Balance sheet disclosures 209
26 Cash flow statements 217
27 Financial reporting for SMEs (small and medium-sized entities) 230
28 Group accounts, acquisitions and mergers 234
29 Joint ventures, associates and foreign operations 243
30 Historical summaries, ratios and trends 258
31 Inflation 269

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vi Brief contents

32 Half-yearly reports (interim reports) 273

33 UK GAAP and IFRS compared 278
34 Adopting IFRS for the first time 281
35 Putting it all together 290

Appendix 1 UK GAAP: Current Financial Reporting Standards and Exposure Drafts 296
Appendix 2 International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) 297
Appendix 3 Useful website addresses 298
Appendix 4 Present value 299
Appendix 5 Retail Price Indices since 1950 300
Appendix 6 Problems and solutions 300
Index 312

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 Contents

Page
Preface xi
Publisher’s acknowledgements xii

1 Overview of the regulatory scene 1

Purpose of the book. The regulatory structure in the UK. The annual report and accounts. The objective
of financial statements. The Financial Reporting Council’s role. International Financial Reporting
Standards (IFRS). UK company law. Categories of companies. Extracts from published accounts.

2 International Financial Reporting Standards (IFRS) overview 8

Introduction. Terminology. The Standards. Who must adopt IFRS? Convergence. Approach followed
in the book.

3 Accounting principles 11
What is UK GAAP? Accounting principles. The profit and loss account – UK GAAP. The balance
sheet – UK GAAP. Worked example – putting the accounts together. Format and terminology differences
– UK GAAP and IFRS compared. Accounting policies – UK GAAP. Accounting policies – IFRS.

4 The annual report 22

Information other than the financial statements. What is the annual report? The directors’ report. The business
review. The enhanced business review. Presenting the business review in practice. Annual review and
summary financial statements. Sequence of study of a report and accounts. The need to read the notes.

5 Chairman’s statement and the operating and financial review 34

Presenting the annual report in practice. Corporate social responsibility (CSR) report. Chairman’s statement.
Chief executive’s report. Enhanced business review. The operating and financial review (OFR).

6 Corporate governance and the auditors’ report 43

Corporate governance. The Combined Code. Directors. Directors’ remuneration. Accountability and audit.
Relations with shareholders. Going concern. The auditors’ report. Audit reports other than those which
are unqualified.

7 The profit and loss account: overall structure 52

Introduction. The format of the profit and loss account under UK GAAP. The format of the income
statement under International Financial Reporting Standards (IFRS).

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viii Contents

8 The profit and loss account: turnover and revenue recognition 55

Turnover and revenue. Revenue recognition under UK GAAP. Revenue recognition under IFRS.

9 The profit and loss account: further disclosure areas 62

Introduction. Basic disclosure areas. Directors’ and staff costs. Other expenses. Pension costs
(retirement benefits). Share option charges. Research and development expenditure. Exceptional items.
Discontinued and continuing operations. Comparative figures. Finance costs. Investment income.
Taxation. Segment reporting. Group issues.

10 The profit and loss account: interpretation, ratio analysis, segmental analysis and earnings per share 74
Interpretation and ratio analysis. Segment analysis. Earnings per share. Investment ratios.

11 Equity statements, dividends and prior period adjustments 88

Introduction. The statement of total recognised gains and losses (STRGL). Reconciliation of movement
in shareholders’ funds. Prior period adjustments. Equity dividends. Preference dividends. Equity statements
under IFRS.

12 The balance sheet: an introduction 95

Introduction. The format of the balance sheet under UK GAAP. International Financial Reporting Standards.

13 Tangible fixed assets 99

Tangible fixed asset categories. Depreciation. Revaluation of fixed assets. Sales and other disposals
of fixed assets. Investment properties. Government grants. Ratios.

14 Intangible fixed assets 109

Intangible fixed asset categories. Goodwill. Capitalised development costs. Computer software.
Other intangibles. Impairment. Revaluation.

15 Fixed asset investments 116

Fixed asset investment categories. UK GAAP. International Financial Reporting Standards.

16 Stocks and long-term contracts 122

Different classes of stock. UK GAAP. The inclusion of overheads in stock. Net realisable value.
Consignment stocks. The danger of rising stocks. Long-term contracts. Stock ratios. International
Financial Reporting Standards.

17 Debtors and other receivables 131

Categories of trade debtors and other debtors. Hire purchase and credit sales transactions.
Factoring and invoice discounting. Loans receivable. International Financial Reporting
Standards.

18 Current asset investments; cash at bank and in hand 141

Current asset investments – UK GAAP. Cash at bank and in hand. Disclosure requirements. Current
asset investments – IFRS. Cash at bank and in hand – IFRS.

19 Creditors and provisions 145

Creditors. Working capital and liquidity ratios. Provisions. Leases. IFRS.

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 Contents ix

20 Tax in the balance sheet 155

Introduction. UK GAAP – current taxation. UK GAAP – deferred tax. UK GAAP – the tax charge in
the profit and loss account. UK GAAP – accounting policies. UK GAAP – the tax reconciliation note.
UK GAAP – tax in the balance sheet. IFRS.

21 Bank loans and overdrafts 163

Bank facilities. Overdrafts. Bank loans. The big picture. Cash flow statements.

22 Loan capital 167

Company borrowings generally. Debentures, unsecured loan stock and bonds. Accounting for finance costs.
Share capital. Convertible loan capital. Financial instrument disclosure issues. Reporting the substance
of transactions, FRS 5. Gearing ratios. International Financial Reporting Standards.

23 Derivatives and other financial instruments 185

Introduction. UK GAAP. Definition of a derivative. Risk management and derivative trading. Narrative
disclosures. Common types of derivatives. Numerical disclosures. Counterparty risk. Concern about
derivatives. But why bother with derivatives? Benefits of disclosure. International Financial Reporting
Standards.

24 Equity share capital and reserves 197

Introduction. Share capital. Issue of further shares. Dividends. Reserves. Share-based payment
arrangements including share options. Purchase and reduction of shares. International Financial
Reporting Standards.

25 Balance sheet disclosures 209

Introduction. Related party disclosures. Operating leases. Contingent liabilities and contingent assets.
Capital commitments. Events after the balance sheet date.

26 Cash flow statements 217

Overview of the cash flow statement and related notes. Cash flow – definitions and ratios. International
Financial Reporting Standards.

27 Financial reporting for SMEs (small and medium-sized entities) 230

Introduction. Small companies and concessions available. The Financial Reporting Standard for Smaller
Entities (FRSSE). The International Financial Reporting Standard for SMEs. Medium-sized companies
and concessions available. Small and medium-sized groups.

28 Group accounts, acquisitions and mergers 234

Acquisitions of businesses. Group accounts. The consolidated balance sheet. The consolidated profit and
loss account. Acquisitions and mergers. Acquisition accounting. Merger accounting. International Financial
Reporting Standards.

29 Joint ventures, associates and foreign operations 243

Introduction. Joint arrangement that is not an entity. Joint venture. Associates. Foreign exchange.

30 Historical summaries, ratios and trends 258

Historical summaries. Ratios. Trends. International Financial Reporting Standards.

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x Contents

31 Inflation 269
Introduction. Historical cost (HC) accounting.

32 Half-yearly reports (interim reports) 273

Background. Practical issues. The new Disclosure and Transparency Rules (DTR).

33 UK GAAP and IFRS compared 278

Introduction. Where UK GAAP and IFRS are identical. Where UK GAAP is similar but where differences
remain. Where UK GAAP and IFRS are markedly different. The future.

34 Adopting IFRS for the first time 281

The impact of the change from UK GAAP to IFRS. Timing of IFRS implementation and different categories
of companies. The impact of IFRS 1, First-time adoption of IFRS. Explaining the impact on key ratios.
Making use of company websites. New disclosure opportunities under IFRS – some examples.

35 Putting it all together 290

Introduction. Charterhouse Communications. Question 1: What does the company do? Question 2: How large is
Charterhouse? Question 3: Recent history? Question 4: Does anyone have control? Any other information?
Summary. Conclusion.

Appendix 1 UK GAAP: Current Financial Reporting Standards and Exposure Drafts 296
Appendix 2 International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) 297
Appendix 3 Useful website addresses 298
Appendix 4 Present value 299
Appendix 5 Retail Price Indices since 1950 300
Appendix 6 Problems and solutions 300
Index 312
 Preface

The aim of this book IFRS

In the Preface to the first edition we wrote: In the UK, fully listed companies have had to start com-
plying with IFRS from 2005, whilst AIM-listed companies
‘Given a sound knowledge of the basic components of
were given a choice between early adoption (2005) or late
a balance sheet and profit and loss account, anybody
adoption (2007). It appears that relatively few unlisted
with a reasonably enquiring mind can learn a great deal
companies have yet adopted IFRS.
about a company by studying its report and accounts
and by comparing it with other companies. We have
written this book to provide the basic knowledge Narrative reporting
required . . .’
Corporate governance, business reviews and corporate
The aim remains the same, although there have been
social responsibility reporting are now a well-established
significant developments since the first edition was pub-
part of corporate life for bigger companies. This current edi-
lished in 1979.
tion addresses the fast-moving developments in this area.

UK GAAP
Approach
The Accounting Standards Board (ASB) set up in 1990
This edition seeks to provide a bridge between UK GAAP
has now issued 29 Financial Reporting Standards which,
and IFRS. The earlier chapters in the book examine vari-
together with earlier standards, are referred to as UK
ous topics, initially from the perspective of UK GAAP and
Generally Accepted Accounting Practice (or UK GAAP).
then conclude with the implications of adopting IFRS.
ASB’s main challenge is now to bring UK GAAP closer
Two chapters pull together the comparisons between UK
in line with International Financial Reporting Standards
GAAP and IFRS, and the conversion processes required.
(IFRS). Much progress has been made but the overall
The book concludes with an analytical chapter, ‘Putting it
process is likely to take several more years before the pro-
all together’, based on a real company. As with earlier
ject comes to final fruition.
editions, we use the Key Points symbol to help the reader
sort out the wheat from the chaff.

Alan Sugden
Paul Gee
 Publisher’s acknowledgements

We are grateful to the following for permission to First Choice Holidays PLC is no longer a public listed
reproduce copyright material: company; Chapter 19, page 150, from the Investors
Chronicle extract, 26 March 1993 (Investors Chronicle,
Chapter 1, page 4, a Wiggins Group article from the
1993); Chapter 23, page 185, extracts taken from the
Daily Telegraph, 8 March 2001 (Daily Telegraph, 2001);
Daily Telegraph, 6 October 1995 (Daily Telegraph, 1995);
Chapter 4, pages 26–27, Chapter 9, page 68, Chapter 14,
Chapter 35, pages 293–295, extracts from the Investors
page 113, Chapter 20, pages 161–162 and Chapter 34,
Chronicle, cuttings since 1998 (Investors Chronicle, 1998);
pages 285–287, extracts containing information on the
Chapter 35, pages 291–292, extracts from Charterhouse
Management Consulting Group, from Management
Annual Reports/data (Charterhouse Communications, 2002–
Consulting Group Director’s Report 2006, Management
2007).
Consulting Group Annual Report 2006, Management
Consulting Group Interim Report 2005, Management In some instances we have been unable to trace the owners
Consulting Group Annual Report and Accounts Year of copyright material, and we would appreciate any infor-
Ending 31 December 2005, reprinted with permission of mation that would enable us to do so.
Management Consulting Group PLC; Chapter 4, pages 28
and 31 and Chapter 9, pages 65–67, extracts containing We are grateful to the Financial Times Limited for
information on the Wilmington Group, from Wilmington permission to reprint the following material:
Group Director’s Report 2006 and Wilmington Group Chapter 6 Tomkins, © Financial Times, 1 July 2000;
Annual Report 2006 (Wilmington, 2006); Chapter 14, Chapter 8 Revenue recognition, © Financial Times, 9 July
pages 111, 113–114, Chapter 22, page 183 and Chapter 23, 2001; Chapter 8 PwC wins costs against Jarvis, ©
page 194, extracts containing information on First Choice Financial Times, 15 July 2000.
Holidays, from First Choice Holidays Annual Report 2006
We are grateful to the following for permission to use
(First Choice, 2006). These examples are taken from the
copyright material:
First Choice Holidays PLC Annual Report and reflect
the trading position at that time. However, First Choice Chapter 8 How accounting executives looked the wrong
Holidays PLC has since undergone a merger with the way from The Financial Times Limited, 13 August 2002,
tourism division TUI AG to form TUI Travel PLC, and © Robert Howell.
 CHAPTER 1 Overview of the regulatory scene

UK adoption of IFRS
Purpose of the book
Whether particular categories of company may or must
This book is intended as a practical guide to the inter-
adopt IFRS is referred in Chapter 2. Wherever applicable,
pretation of reports and accounts. In it frequent reference
the impact of IFRS (International Financial Reporting
is made to the legal and accounting requirements in the
Standards) is referred to throughout the book at the end each
UK, both as regards UK GAAP (UK Generally Accepted
relevant chapter, and in summary in Chapters 33 and 34.
Accounting Practice) and IFRS (International Financial
Reporting Standards). This is done in the context of inter-
esting information to look out for, rather than how a set of
accounts should be prepared. The annual report and accounts

The purpose of the annual report

The regulatory structure in the UK The report and accounts, normally produced annually, is
the principal way in which shareholders and others keep
Introduction themselves informed of the activities, progress and future
plans of a company. The style and content of the annual
What needs to be included in a set of financial statements report vary somewhat in line with the directors’ views on
is governed by a mixture of company law requirements its use as a public relations vehicle.
(presently the Companies Act 1985) and accounting stand-
ards. Companies that have a full listing on the London
What has to be included?
Stock Exchange are required to comply with additional
rules set by the Financial Services Authority (FSA), which
There is a minimum of information that must be disclosed
is the UK Listing Authority.
to comply with the law. In addition, the form and content
In the UK, reporting requirements are in a state of
of accounts are subject to Financial Reporting Standards.
flux. Companies listed on the London Stock Exchange
The detailed requirements of annual reports are dealt with
and the Alternative Investment Market (AIM) are required
in subsequent chapters.
to comply with International Financial Reporting Stand-
ards (IFRS). Other companies may choose between UK
GAAP (shorthand for UK Generally Accepted Account- The financial statements
ing Practice – see Chapter 3 for details) and IFRS. These
requirements are explained in this and the following The financial statements are a key part of a company’s
chapter. annual report. The annual report of the auditors to the
2 Interpreting company reports and accounts

company’s shareholders begins ‘We have audited the deal of important information on a wide range of issues,
financial statements on pages xx to yy, [i.e. the pages including the principal activities of the business, the names
containing the financial statements]’. The audit report of the company’s directors. Listed companies must give
then goes on to add a lot more detail before concluding details of their shareholdings and share option arrange-
(provided the auditors think all is well with the company) ment. It also contains a business review which should refer
with the opinion that ‘the financial statements give a true to business performance, principal risks and uncertainties,
and fair view . . .’ (see Chapter 6 for more detail, which and key performance indicators (KPIs). The directors’
includes the audit report on the financial statements of report is dealt with in Chapter 4.
Associated British Foods).
Under UK GAAP, the financial statements include four
Narrative reporting
primary financial statements:

n profit and loss account, In recent years ‘Narrative reporting’ has emerged as a
n statement of total recognised gains and losses, high-profile issue. Annual reports of larger companies
n balance sheet, contain information over and above that required by law
n cash flow statement. and accounting standards. Sometimes this information
has to be provided because the company is fully listed on
Financial statements also include: the London Stock Exchange – see the corporate govern-
ance and remuneration report requirements in Chapter 6.
n notes to the financial statements, Sometimes the information is provided as best practice by
n statement of accounting policies. companies whose shares are publicly-traded – see Chap-
ter 5. The quality of a company’s narrative reporting can
The notes and the primary financial statements form an
impact on its reputation within the financial community.
integrated whole, and should be read as such to obtain a
The various aspects of narrative reporting, including
complete picture. Chapter 4 refers in more detail to the
recent developments and trends, are dealt with in
content and structure of the annual report.
Chapters 4, 5 and 6.

The profit and loss account

The profit and loss account (referred to under IFRS as the The objective of financial statements
income statement) is a record of the company’s activities
over a stated period of time, usually a year. Chapter 3 Overall objective
explains how the profit and loss account is compiled and
prepared. More detailed requirements are dealt with in The key objective is to provide information about the
Chapters 8 to 10. financial position and performance of an entity that is
useful to a wide range of users for assessing the steward-
The balance sheet ship of management and for making economic decisions
(ASB’s Statement of Principles (StoP), Chapter 1).
The balance sheet is a statement of the company’s assets
and liabilities at close of business on a given date, referred Users and their information needs
to as the balance sheet date. Again, Chapter 3 explains
how the balance sheet is compiled and prepared. Later Financial information about the activities and resources of
chapters deal with specific issues in detail. an entity is typically of interest to many stakeholders.
Although some of them are able to command the prep-
The directors’ report aration of special purpose financial reports in order to
obtain the information they need, the rest – usually the vast
The Companies Act 1985 requires a company’s annual majority – will need to rely on general purpose financial
report to contain a directors’ report. This contains a great reports (StoP, para 1.1). As the StoP points out, annual
 Chapter 1 Overview of the regulatory scene 3

reports and accounts, and interim reports, are of interest In January 2003, the Secretary of State for Trade and
not only to investors, but also to: Industry announced that reform would be introduced in
three areas:
n lenders (although banks demand and get a lot more
timely and detailed information than is generally n raising standards of corporate governance;
available); n strengthening the accounting and auditing professions;
n suppliers and other trade creditors (to decide how much n providing for an independent system of regulation for
credit to allow a company); those professions.
n customers (e.g., a retailer who needs to assess the finan-
cial strength of a potential supplier); This reform was to be achieved by means of an enhanced
n employees (whether to buy some shares or to start look- role for the then existing Financial Reporting Council
ing for another job); (FRC) which was to become the ‘new, single, independent
n governments and their agencies; and regulator’.
n the general public (e.g. where a company makes a sub-
stantial contribution to a local economy by providing
employment and using local suppliers). The Financial Reporting Council (FRC)

The FRC has responsibility for:

What users look for
n corporate governance;
Economic decisions often require an evaluation of the n setting accounting and auditing standards;
entity’s ability to generate cash and the timing and cer- n proactively enforcing and monitoring them;
tainty of its generation. To do this, users focus on the n overseeing the self-regulatory professional bodies.
entity’s (i) financial position, (ii) performance, and (iii)
cash flows, and use these in predicting expected cash flows.
Two key bodies which report to the FRS are:
The financial position of an entity encompasses the
resources it controls, its financial structure, its liquidity
and solvency, and its capacity to adapt to changes in the n the Financial Reporting Review Panel (FRRP) and
environment in which it operates. Much, but not all, of the n the Accounting Standards Board (ASB).
information on financial position needed is provided by
the balance sheet.
The Financial Reporting Review Panel (FRRP)
The performance of an entity comprises the return
obtained by the entity on the resources it controls, includ-
The FRRP enquires into financial statements where it
ing the cost of its financing. Information on performance is
appears that the requirements of the Companies Act 1985
provided by the profit and loss account and the statement
(CA 85), principally that the financial statements show a
of total recognised gains and losses.
true and fair view, might have been breached. The FRRP
is autonomous in carrying out its function. Whilst large
private companies are within the Panel’s remit, the Panel
has announced that it intends to focus its resources on
The Financial Reporting Council’s role larger listed companies.
The role of the FRRP is to examine departures from the
Introduction accounting and disclosure requirements of both CA 85 and
applicable accounting standards, and if necessary to seek
The collapse of ENRON and WORLDCOM in the USA an order from the court to remedy such departures. This
led the government to undertake a wide-ranging review of may refer either to compliance with UK Financial
both accountancy regulation and corporate governance in Reporting Standards (UK GAAP) or with International
the UK. Financial Reporting Standards (IFRS).
4 Interpreting company reports and accounts

Until comparatively recently, FRRP did not actively Now isn’t that an interesting point of view?
scrutinise accounts unless they were brought to its atten-
The article ended ‘Wiggins shares fell 3/4 to 311/4p’, and
tion. It now has a proactive role and scrutinises accounts
they went on falling, as Figure 1.1 shows.
of larger companies on a sample basis. In Press Notice
88 (FRRP PN 88, www.frc.org.uk) FRRP noted that it
had ‘developed a more systematic approach to accounts
selection based on business sectors, accounting themes
and company-specific factors’. In December 2004, it
announced its 2005 Risk-based Proactive Programme,
which referred to monitoring activity focusing on five
industry sectors: Automobile; Pharmaceutical; Retail;
Transport; and Utilities. In December 2005, it announced
that it would continue to select accounts from the priority
sectors referred to above, but that ‘the strategy should be
widened to include some companies providing services to
these sectors.’
Further details of the Panel’s remit and activities are
available from the FRRP section of the Financial Report-
ing Council website (www.frc.org.uk).
Where a company has to revise its accounts, its repu-
tation can be seriously damaged. For example, WIGGINS
GROUP had to revise its accounts for the year to 31 March
2000, as the Daily Telegraph reported.

Figure 1.1 Wiggins Group: loss of confidence

The FRRP issued a Press Notice in March 2001 dealing

WIGGINS GROUP Extract from Daily Telegraph with the above company’s accounts (FRRP PN 65) avail-
8 March 2001 able from the FRRP section of the Financial Reporting
Council website (www.frc.org.uk), see also page 56.
Wiggins sees profit restated as £10m loss
Wiggins Group, the airport and property manager,
yesterday restated its accounts for the second time The Accounting Standards Board (ASB)
in six months after regulators intervened.
The new accounts show that the company made a
£9.9m pre-tax loss in the year to March 2000 instead
The ASB develops and issues UK accounting standards (UK
of a pre-tax profit of £25.1m. Generally Accepted Accounting Practice or UK GAAP)
The restatements mean that Wiggins incurred and keeps them up to date.
losses totalling £25.2m in the years 1995 to 2000 An important part of its role now is to help converge UK
rather than making profits of £48.9m as initially standards with standards developed by the International
recorded.
The Financial Reporting Review Panel said
Accounting Standards Board (IASB). The IASB’s stand-
Wiggins had mistakenly booked a £21.5m profit from ards are referred to as International Financial Reporting
redeveloping Manston airport, and failed to account Standards or IFRS (see Chapter 2).
for £3m losses from starting an international airport
network.
Oliver Iny, Wiggins chief executive, said ‘We did The Urgent Issues Task Force (UITF)
wrong, and we’ve admitted we did so, but it had no
impact on the fundamental value of the company . . .’ The UITF is a sub-committee of ASB. Its main role is to
assist the ASB on emerging issues where there is evidence
 Chapter 1 Overview of the regulatory scene 5

of unsatisfactory reporting practice. The UITF issues n Companies listed on the Alternative Investment Market
‘Abstracts’ to provide interim rules pending the issue of, or (AIM), are required to adopt IFRS for accounting
amendment to, an accounting standard. periods which start on or after 1 January 2007. For
periods starting before this date, AIM companies may
adopt either UK GAAP or IFRS.
Financial Reporting Standards (FRSs)
n All other categories of companies (including those listed
only on PLUS Markets) may presently adopt either UK
CA 85 includes the definition of ‘accounting standards’
GAAP or IFRS.
and requires that directors of companies preparing
accounts under UK GAAP follow standards issued by
the Accounting Standards Board. These include both
Financial Reporting Standards (FRSs) issued by ASB,
UK company law
Statements of Standard Accounting Practice (SSAPs)
issued by ASB’s predecessor body, and Abstracts issued
The Companies Act 1985 (CA 85) sets out relevant dis-
by the Urgent Issues Task Force. Current standards and
closure requirements for companies adopting UK GAAP.
Abstracts are listed in Appendix 1.
These do not apply to UK companies who adopt IFRS
Prior to issue of a standard in final form, ASB issues an
which has its own requirements.
exposure draft for comment and discussion (this is referred
Other parts of CA 85 apply to all UK companies,
to as a Financial Reporting Exposure Draft or FRED).
whether they adopt UK GAAP or IFRS. These include audit
FREDs do not have mandatory status until converted into
requirements, rules on distributable profit, filing accounts
an FRS.
at Companies House, duties of directors and so on.
Accounting standards concessions for small companies
The Companies Act 2006 (CA 2006) received Royal
are dealt with in Chapter 27.
Assent in November 2006. CA 2006 will eventually
replace most of CA 85. However, different parts of the Act
Statements of Recommended Practice (SORPs) come into force at different times, ranging from early 2007
to late 2008. Commencement procedures will be referred
SORPs are developed by bodies recognised by the ASB to to in the text wherever relevant. Details can be found on
provide guidance on the application of accounting stand- www.berr.gov.uk/bbf by clicking on Companies Act 2006
ards to specific industries for example, banking, insurance, on the left-hand panel.
investment trusts, charities and higher education. Informa-
tion about current SORPs and where these can be obtained,
may be found on www.frc.org.uk.
Categories of companies

Limited companies
International Financial Reporting Standards
(IFRS)
The key purpose of forming a company is to
These are issued by the International Accounting Standards limit the liability of its shareholders.
Board (IASB). The activities of IASB, and implications
for UK companies, are referred to in Chapter 2 and, where
applicable, throughout the remainder of the book. Before the first Companies Act in 1862 introduced the
The current position for UK companies is as follows: company as a separate legal entity, the proprietor of a
business (and his or her business partners) had unlimited
n Fully listed groups are required to adopt IFRS for their liability. If the business failed, the proprietor(s) were per-
group accounts for all accounting periods which started sonally liable for settling the debts of the business, even if
on or after 1 January 2005. this required selling the home and personal possessions.
6 Interpreting company reports and accounts

Companies limited by shares relations. These offer quick and easy access to public
documents such as annual reports, interim reports, and
Limited companies are usually formed as limited by shares corporate social responsibility and environmental reports.
(see below for companies limited by guarantee). If the Many larger companies post presentations to analysts and
shares are fully paid, the members’ liability is limited to conference calls.
the money they have put up: the maximum risk a share-
holder runs is to lose all the money he has paid for his
shares, and no further claim can be made on him for AIM listed
liabilities incurred by the company. In rare cases where
shares are issued only partly paid, shareholders can be AIM listed companies shares are traded and share prices
called upon to subscribe some or all of the unpaid part, but published in the financial press. However AIM listed
no more than that. companies vary greatly in size and the extent to which
Limited companies may be formed as either private shares are held by major shareholders, directors and
companies or public companies. financial institutions. Some AIM-listed companies are
effectively under the control of one person and family
members.
Private companies Useful information is available through the following
London Stock Exchange links.
Most UK limited companies are private – their constitu-
tion does not allow their shares to be traded. Many of n www.londonstockexchange.com/aim
these companies have only one or two shareholders. The n http://www.londonstockexchange.com/en-gb/
company name ends with the word limited (often abbre- pricesnews/statistics/factsheets/aimmarketstats.htm
viated to Ltd ).
PLUS Markets
Public companies
For many regulatory purposes, companies who trade
A public company is a company which is registered as solely on PLUS Markets are regarding as ‘unlisted’.
such. Its share capital must be at least £50,000 and its The market was previously referred to as OFEX. The
name must end either with the words ‘Public limited PLUS Markets website (www.plusmarketsgroup.com) is
company’ or with the abbreviation ‘PLC’ or ‘plc’. extremely comprehensive and gives details of companies
A public limited company does not automatically have whose shares are traded, their share prices and so on.
its shares listed on the London Stock Exchange despite
popular belief! Small and medium-sized enterprises (SMEs)
In practice, many PLCs are fairly large, and are listed
on a market such as the London Stock Exchange, the Small and medium-sized enterprises (SMEs) are defined
Alternative Investment Market or PLUS Market. A num- by the Companies Act 1985 – please refer to Chapter 27
ber of PLCs are companies which have de-listed due to for the special features of these companies and the finan-
acquisition of shares by private equity groups. Some PLCs cial information which has to be made available.
are fairly small and are privately-owned businesses.

Unlimited companies
Fully listed companies
By contrast with a limited company, the members have
Fully listed companies trade their shares on the London joint and several liability in the same way as a partnership
Stock Exchange and are subject to considerable public (each member can individually be held entirely respons-
scrutiny. These companies usually have sophisticated ible). The principal advantage of forming an unlimited
websites that feature important sections on investor company is that it is not required to file its accounts each
 Chapter 1 Overview of the regulatory scene 7

year at Companies House. This form of company is

Extracts from published accounts
relatively uncommon today.
The book includes practical examples of company
Companies limited by guarantee
accounts presented both in accordance with UK GAAP
and with IFRS. These are allocated within the appropriate
This method is used for charitable and similar organis-
sections of each chapter.
ations, where funds are raised by donations and no shares
are issued. The liability is limited to the amount each
member can personally guarantee, which is the maximum UK GAAP
amount each member may be called upon to pay in the
event of liquidation. This form of incorporation is not Most unlisted companies and a large number of AIM-listed
normally used for a commercial business. companies continue to use UK GAAP. (However, for AIM
listed companies this choice ceases to be available for
Limited liability partnerships (LLPs) accounting periods which started on or after 1 January
2007: they will be required to move over to IFRS.)
A limited liability partnership (LLP) is a relatively new Many UK GAAP illustrations taken from a few years
legal vehicle – the relevant legislation came into force in ago continue to be useful (most of these relate to fully
April 2001. Companies House described it as an ‘altern- listed companies which have now moved over to IFRS).
ative corporate business vehicle that gives the benefits of Where these illustrations give clear presentation and would
limited liability but allows its members the flexibility of still be acceptable if published today under UK GAAP, we
organising their internal structure as a traditional part- have retained them. UK GAAP is likely to be around for
nership. The LLP is a separate legal entity and, while the some time to come.
LLP itself will be liable for the full extent of its assets, the
liability of the members will be limited.’
The main difference between an LLP and a limited IFRS
company is that an LLP has the organisational flexibility
of a partnership and is taxed as a partnership. Apart from We have provided a large number of IFRS illustrations
this, an LLP is very similar to a company. Many large including reference to useful websites for those readers
accountancy and legal firms are now constituted as LLPs. who want to research further.
 CHAPTER 2 International Financial Reporting
Standards (IFRS) overview

modern) term is IFRS – this is the term we will use

Introduction
throughout the book.
We referred to the International Accounting Standards
Board (IASB) in Chapter 1. IASB is an independent body,
responsible for developing and setting Standards and The Standards
Interpretations.
For companies operating within the European Union The Standards referred to in the extract above are listed in
(EU) and producing accounts under IFRS, the Standards Appendix 1. ‘IFRS GAAP’ is effectively a combination of
used must have been officially approved (‘endorsed’) by International Accounting Standards issued by the former
the EU. Companies in their accounting policies usually International Accounting Standards Committee (these are
start referring to ‘basis of preparation’ and state words referred to as IAS 1, IAS 2, etc.) and International
similar to: Financial Reporting Standards issued by the current body,
‘These accounts have been prepared in accordance with the International Accounting Standards Board (these are
International Financial Reporting Standards (“IFRS”), referred to as IFRS 1, IFRS 2, etc.).
including International Accounting Standards (“IAS”)
and interpretations issued by the International Account-
ing Standards Board (“IASB”) and its committees, and
Who must adopt IFRS?
as adopted by the EU [emphasis added] . . .’
At present in the UK, the only two mandatory categories
are companies that are fully listed on the London Stock
Exchange and companies whose shares are traded on AIM
Terminology
(the Alternative Investment Market). This position is cur-
rently under review.
The terms ‘International Financial Reporting Standards’
(IFRS) and ‘International Accounting Standards’ (IAS)
are effectively interchangeable. Fully listed companies
The term IAS originates from the earlier standards
issued by the IASB’s (International Accounting Standard In June 2002, EU Member States adopted the Regulation
Board) predecessor body, the International Accounting on the Application of International Accounting Standards
Standards Committee. These standards are still applicable, (the ‘IAS Regulation’).
although several have been substantially revised in recent This requires companies governed by the law of a
years. member state to prepare their consolidated accounts in
The Companies Act 1985 and the relevant tax legisla- conformity with international accounting standards if their
tion refer to ‘IAS’. However, the more widely-used (and securities are admitted to trading on a regulated market of
 Chapter 2 International Financial Reporting Standards (IFRS) overview 9

any member state. In the UK, this applies to consolidated as an alternative to UK accounting standards. This option
accounts of fully listed companies. extends to SMEs as well as large unlisted companies.
The IAS Regulation applies to each financial year For unlisted companies, the choice between UK
commencing on or after 1 January 2005. For example, GAAP and IFRS is likely to remain an option for some
a fully listed group with a 31 March year-end first had years to come.
to apply IFRS to its full-year consolidated accounts to
31 March 2006.
The above requirement is only applicable to the consol- How does this affect different categories of
idated accounts (the accounts of the combined group). We companies?
refer to the concept of consolidated accounts in Chapter
28. The Companies Act 1985 permits the individual parent Examples of the possible impact are summarised in the
company and subsidiary company accounts to be prepared table below.
on the basis of either UK GAAP or IFRS. The Accounting Standards Board issued a Press Notice
on 10 May 2006 (ASB PN 289) setting out proposals for
However, it is the consolidated accounts that extending the mandatory categories that might be required
are used as the primary basis for analysts. to adopt IFRS including all public quoted and other pub-
licly accountable entities and UK subsidiaries of group
Alternative Investment Market (AIM) companies companies that applied IFRS in the group accounts. A fur-
ther announcement is awaited.
The Rules of the London Stock Exchange require all AIM
companies to adopt IFRS for financial years commencing
on or after 1 January 2007. Several AIM companies adopted Convergence
IFRS earlier, for example for 31 December 2005 year-
ends. What does ‘convergence’ mean?

The term ‘convergence’ may be used in two separate but

Unlisted companies
interlinked contexts:
For financial years commencing on or after 1 January n convergence of UK GAAP with IFRS,
2005, all British companies have the option of using IFRS n convergence of IFRS and US GAAP.

Type of company Application of IFRS

Traded on PLUS Markets For regulatory purposes, companies whose shares are traded on PLUS Markets are
(formerly OFEX) regarded as unlisted and there is therefore no mandatory date for transition to IFRS.
However, such companies should consider strategic issues such as how late adoption
of IFRS might be viewed in the marketplace, particularly for those companies
intending to move over to AIM or the full market.
UK listed parent company CA 85 offers a choice between adopting UK GAAP and adopting IFRS.
UK subsidiaries of UK fully All UK subsidiary companies within a group must adopt either UK GAAP or IFRS (see
listed groups above). In practice, many adopt IFRS in order to ease the preparation of consolidated
accounts under IFRS.
UK subsidiaries of foreign Although UK company law does not require these subsidiaries to adopt IFRS, the
listed groups that are overseas parent may require IFRS accounts from them so that it can itself prepare
adopting IAS IFRS consolidated accounts.
Unlisted companies These companies can for the moment choose whether and when they adopt IFRS. The
decision may be affected by a number of considerations, including the desires of the
major shareholder(s), whether the company has future plans for ‘going public’ and its
relations with suppliers and customers outside the UK.
10 Interpreting company reports and accounts

Convergence of UK GAAP with IFRS has been taking UK standards should be introduced with a common
place for a large number of years, for example the respec- effective date.
tive standards on accounting for provisions (FRS 12 and ASB issued a Press Notice on 10 May 2006 (ASB PN
IAS 37) are identical. More recent years have seen an 289), seeking views on the future application of reporting
acceleration of the convergence process, for example, the requirements for UK companies. This effectively proposes
areas of accounting for financial instruments and share- further extensions to the categories of companies for
based payment transactions such as accounting for share which IFRS would be mandatory.
option schemes. We will refer to the extent of convergence
in the chapters that follow. Transition from UK GAAP to IFRS
Convergence of IFRS and US GAAP is a relatively
recent development. It is hoped that bringing the two We refer to the ‘conversion process’ in Chapter 34, includ-
accounting frameworks closer together will eventually ing the extent to which invaluable information is available
mean that large UK companies with share listings in the in the investor relations and archive sections of corporate
USA will no longer have to publish tables reconciling websites.
their respective profits and assets between IFRS and US
GAAP.
Approach followed in the book

UK convergence strategy Whilst fully listed and many AIM companies are now
following IFRS, most UK companies are still using UK
The ASB’s Technical Plan, published on 22 June 2005, set GAAP. In the current edition of the book, each chapter
out a ‘phased approach’. The original plan was to bring will initially consider the relevant UK GAAP requirements
UK standards into line with IFRS by bringing a number (including those of the Companies Act 1985) and their
of standards on related topics into effect each year over implications for the interpretation of company accounts.
a three to four-year period (e.g. FRSs based on FREDs This will be followed by a concise summary of the key dif-
25 and 28 were originally planned to be brought into UK ferences for companies that adopt IFRS.
GAAP during 2005/06). Chapter 33 contains a summary of the key differences
At a public meeting held in January 2006, ASB pro- over the relevant profit and loss account and balance sheet
posed an alternative strategy whereby further changes to areas.
 CHAPTER 3 Accounting principles

n best practice – as adopted by leading UK companies

What is UK GAAP?
(e.g. leading FTSE companies) or sectors; UK GAAP
may also reflect best practice in particular industry
Terminology
sectors such as the construction industry;
n guidance from the leading professional bodies, for ex-
‘GAAP’ stands for Generally Accepted Accounting Practice
ample, guidance on revenue recognition (see Chapter 8)
(but it can also stand for Generally Accepted Accounting
issued by the Consultative Committee of Accountancy
Principles). UK GAAP is effectively a package of prin-
bodies (CCAB);
ciples, rules and guidance statements used by companies
n feedback from regulators such as the Financial Report-
to measure profits and assets, and also to determine what
ing Review Panel (FFRP) on appropriate company
disclosures must be given in the company’s annual
reporting practice.
accounts or financial statements.

Main components of UK GAAP

Accounting principles
In practice, in the UK, this set of rules and guidance
derives from a number of diverse sources, including: Statement of principles for financial reporting

n the Statement of Principles for Financial Reporting ASB issued its Statement of Principles for Financial
(StoP) – issued by the Accounting Standards Board Reporting (StoP) in 1999. In the words of ASB:
(ASB);
n Statements of Standard Accounting Practice (SSAPs) – ‘This Statement of Principles for Financial Reporting
issued by the ASB’s predecessor body; sets out the principles that the Accounting Standards
n Financial Reporting Standards (FRSs) – issued by the Board believes should underlie the preparation and pres-
ASB; entation of general purpose financial statements.
n Abstracts – issued by the Urgent Issues Task Force ‘The primary purpose of articulating such principles is
(UITF); to provide a coherent frame of reference to be used by
n Companies Act 1985 requirements (as subsequently the Board in the development and review of accounting
amended by the Companies Act 2006 and Regulations standards and by others who interact with the Board
expected to be issued during 2007); during the standard-setting process.
n Statements of Recommended Practice (SORPs) – issued
by ASB-recognised industry committees; ‘Such a frame of reference should clarify the concep-
n Reporting Statements, such as the guidance on the tual underpinnings of proposed accounting standards
Operating and Financial Review (OFR, see Chapter 5) – and should enable standards to be developed on a con-
issued by the ASB; sistent basis. . . .’
12 Interpreting company reports and accounts

StoP is a lengthy document consisting of eight chapters Comparability

over some 57 pages (excluding appendices). It was clearly
important in the development of the numerous Financial Users need to be able to able to compare an entity’s
Reporting Standards (FRSs) issued after its publication. financial information over time in order to identify trends
It is now rather less important as more recent FRSs in its financial performance and financial position. They
such as FRS 25, Financial Instruments – Disclosure and also need to be able to compare the financial information
Presentation (see Chapter 24) are based on standards of different entities in order to evaluate their relative finan-
issued by the International Accounting Standards Board cial performance and financial position.
following the policy of converging UK GAAP with When companies change their accounting policies,
International Financial Reporting Standards (IFRS) – see figures for the previous year will be restated in line with
Chapter 2. IASB has its own statement of principles the new policy so that current and previous year figures are
referred to as ‘The Framework’. comparable.
Comparability between companies can be distorted by:
FRS 18 – Accounting policies
n companies adopting different accounting policies, for
The term ‘accounting policies’ refers to the rules that the example, companies in similar business sectors depre-
company uses for dealing with particular transactions, for ciating similar equipment over different useful lives;
example, how they are recognised and presented in the n companies financing assets in different ways, for ex-
financial statements, and whether assets are stated at his- ample, a retailer that owns all its outlets cannot be fairly
torical cost or a current valuation figure. The application to compared with a similar retailer that rents all its outlets,
particular transactions and situations will be dealt with unless the analyst adjusts the figures to allow for the
in the chapters in the book that deal with individual finan- difference;
cial statement topics, for example, fixed assets, revenue n the effects of inflation (see Chapter 31).
recognition and stocks.
FRS 18 sets out principles to be followed in selecting Consistency
accounting policies and the disclosures required. An ex-
ample of a typical company accounting policy statement Consistency is viewed against the objective of compar-
under UK GAAP is included later in this chapter. ability, which can be achieved through a combination
FRS 18 does highlight two particular concepts that are of consistency and disclosure. The consistency concept
crucial in dealing with particular transactions and in assumes that accounting treatment of like items is con-
preparing and presenting financial statements. These are sistent from one period to the next.
the going concern assumption and accruals.

Going concern assumption Substance over form

Financial statements are usually prepared on the assump- This concept was introduced by FRS 5 but is now incor-
tion that the entity will continue in operational existence porated within the Companies Act 1985. It requires
for the foreseeable future. The going concern basis is not transaction to be accounted to reflect their commercial
used if the entity is being liquidated or has ceased trading, substance rather than their legal form, should these differ.
or if the directors have no alternative but to liquidate or For example, where a company may not technically be
cease trading. the legal owner of an asset but for practical purposes may
effectively have the risks and rewards of ownership of the
Accruals
asset. In this situation, the asset should be included in the
The accruals basis of accounting assumes that revenues company’s balance sheet. This could occur, for example,
and costs are accrued (accounted for) as they are earned or in a hire-purchase transaction where a company was
incurred, not as money is received or paid. Revenues are already deriving virtually all the commercial benefits from
matched with associated costs and expenses to determine an asset, and had an indefinite option to buy it from its
profit, by including them in the same accounting period. legal owner for a nominal sum.
 Chapter 3 Accounting principles 13

Materiality
TERMINOLOGY
Information is material if its omission or misstatement
could influence the economic decisions of users taken on UK GAAP: Profit and loss account
the basis of those financial statements. Materiality must be
judged in terms of its significance to the reporting entity. The profit and loss account is a monetary record of
the activities of a business during an accounting period,
which is normally one year. A balance sheet is drawn
Estimation techniques
up on the last day of the company’s accounting period.
Turnover (also called sales) is money received, or
Estimation techniques are the method a company adopts to to be received, by the business for goods or services
arrive at estimated monetary amounts – for example: sold during the year.
n depreciation charges; Expenses are costs incurred in producing those
n provisions for slow-moving or obsolete stock; goods and services, normally divided into:
n warranty provisions for expected returns. (i) Cost of sales, i.e. the cost of the goods them-
selves, e.g. raw materials and wages
Gross profit = Turnover – Cost of sales
The profit and loss account – UK GAAP (ii) Distribution costs, i.e. the cost of getting the
goods to the customer
The profit and loss account (also referred to in IFRS as the (iii) Administrative expenses, i.e. other expenses
income statement) is a record of the activities of a which cannot be or are not allocated to particu-
company for a stated period of time. This period, called the lar products (i.e. which do not form part of cost
accounting reference period, is normally a year. of sales) or appear under other headings.
Example 3.1 shows a typical profit and loss account; the Operating profit or trading profit
terminology box below explains the terms used. = Turnover − Expenses (i.e. (i) to (iii) above).
Where expenses (i) to (iii) above exceed turnover, the
difference is an operating loss.
Example 3.1 A typical profit and loss account (iv) Other operating income is income and expenses
Profit and loss account for the year ended which fall outside (i) to (iii) above, e.g. property
30 June 2007 income of a trading company, or patent income.
(v) Interest paid on borrowed money interest
£000 £000 received represents income from interest on
Turnover 7,200 money lent (e.g. deposits at the bank).
Cost of sales 3,600
Pre-tax profit = Operating profit + (iv) +/− (v)
Gross profit 3,600
Distribution costs 1,100 Depreciation is an expense appearing as part of (i) to
Administrative expenses 1,300 (iii) above, as appropriate.
The cost of each fixed asset is written off over its
2,400
expected life. Using the most common method of
1,200 depreciation, the straight line method:
Other operating income 95
Depreciation Cost of asset − Residual value
Trading or operating profit 1,295 =
for the year Expected useful life
Interest receivable 20
Corresponding figures or ‘comparatives’ are those
1,315 for the same item for the preceding accounting period.
Interest payable 100
Note: Dividends are distributions to the shareholders.
Pre-tax profit on ordinary activities 1,215 As dividends on equity (or ordinary) shares are not
Taxation 415
an expense of the business, they are not entered in
Profit for the year 800 the profit and loss account (see Chapter 24).
14 Interpreting company reports and accounts

Note
Accounts are required to include the figures
for two periods, normally those for the year Dividends paid are not entered in the profit and loss
being reported on and corresponding (or account, as they are not an expense of the company.
comparative) figures for the previous year. For Dividends paid are charged direct to reserves (see also
simplicity, at this stage we show only figures Chapter 24). The profit and loss account in last year’s
for the year being reported on. balance sheet at 30 June 2006 amounted to £600. The
profit for the year amounted to £800 (see Example 3.1).
The dividends paid during the year amounted to £560.
The balance sheet – UK GAAP The above figures may be reconciled to the closing
profit and loss reserves of £840 as follows:
The balance sheet is a statement of the assets and liabilities
of a company at the close of business on a given day, i.e. on
the balance sheet date. The balance sheet is always drawn
£
up on the last day of the company’s accounting period.
Example 3.2 shows a typical balance sheet; the termino- Profit and loss reserves at 1 July 2006 600
logy box below explains the main terms used in balance Profit for the year 800
Equity dividends paid (560)
sheets.
Profit and loss reserves at 30 June 2007 840

Example 3.2 A typical balance sheet

Balance sheet as at 30 June 2007

TERMINOLOGY
£000 £000 £000
Fixed assets UK GAAP: balance sheet
Freehold land and 950
buildings A balance sheet is a statement of the assets and
Fixtures and fittings 175 liabilities and ownership interest of an enterprise at
Motor vehicles 535 the close of business on the balance sheet date.
1,660 Assets are things which a business owns and on
Current assets which a book value can be placed.
Stock (of goods) 500
Debtors 1,040
Book value is cost less accumulated depreciation
Cash 5 or, if the asset has been revalued, it is the valuation
figure less any subsequent depreciation.
1,545
Less: Current liabilities: Liabilities are amounts owed by a business.
Creditors due within Net assets = All assets – All liabilities.
1 year: Fixed assets are assets (like land and buildings,
Trade creditors 860 plant and machinery) not held for resale but for use by
Taxation payable 415 the business.
Overdraft 90
Fixed assets can be either tangible, from the Latin
1,365 tango, I touch (e.g. motor vehicle, land and buildings)
Net current assets 180 or intangible, i.e. not susceptible to touch (e.g. patent
Net assets 1,840 rights and trademarks).
Current assets are cash and other assets that the
Capital and reserves
Ordinary share capital 1,000 company expects to turn into cash (e.g. stock).
Profit and loss account 840 Current liabilities, which are usually described as
Ordinary shareholders’ funds 1,840
Creditors due within one year, are the liabilities that
s

the company expects to have to meet within 12 months.

 Chapter 3 Accounting principles 15

The members (shareholders) of a company pro- credit). These suppliers become creditors of the company
vide some or all of the finance in the form of share – immediately following receipt of the goods, the amount
capital (that is, they subscribe for shares) in the owing to them is a liability.
expectation that the company will make profits, and No actual trading took place during the year, i.e. no
pay dividends. goods were sold and so the entire purchases of £200,000
Ordinary shareholders’ funds are made up of represent unsold stocks at the end of the year.
ordinary share capital and all accumulated reserves. The company’s cash position at the end of the first year
Financial statements is the term which covers the is as follows:
annual accounts as a whole, i.e. the profit and loss
account, balance sheet, cash flow statement and state-
£
ments forming part of the statutory accounts.
Initial cash introduced by the shareholders 300,000
Freehold shop (200,000)
Shop fittings (75,000)
Purchase of goods (50% × £200,000) (100,000)
Motor van (10,000)
Overdrawn bank account (85,000)

Worked example – putting the accounts

The balance sheet of the company at the end of the first
together
year as follows:
The initial transactions
£000 £000
A company is formed with a share capital of 300,000 ordi- Fixed assets
Freehold land and buildings 200,000
nary shares, each with a nominal value of £1. The director/ Fixtures and fittings 75,000
shareholders subscribe for these at par (= nominal value) Motor vehicles 10,000
by payment of cash.
285,000
At the same time, the directors of the company negotiate Current assets
with the bank and agree an overdraft facility of £150,000. Stock (of goods) 200,000
As the company is new, the bank requires personal securi- Current liabilities:
ties from the directors – for example against their personal Creditors 100,000
assets such as their properties. This facility enables the Overdraft 85,000
company to overdraw by up to £150,000. However, this 185,000
figure does not appear in the accounts.
Net current assets 15,000
300,000
Acquiring assets and getting started – the first year of
Capital
the business Ordinary share capital 300,000

The company:
Comment
1. buys a freehold shop for £200,000
2. acquires fixtures and fittings for £75,000 Fixed assets are held not for resale but for use by the
3. stocks the shop with £200,000 of goods business. Current assets are cash and other assets that
4. buys a van for £10,000. the company expects to turn into cash (e.g. stock). Current
liabilities (usually described as creditors due within one
The above are all acquired by payment of cash except for year, are all the liabilities that the company expects to have
the purchase of goods. Half of these are bought for cash to meet within 12 months. In balance sheets prepared and
and half are bought on credit terms requiring payment presented in accordance with UK GAAP, current liabilities
within four weeks following delivery (i.e. four weeks are deducted from current assets to arrive at a sub-total
16 Interpreting company reports and accounts

referred to as ‘net current assets’. Presentation under IFRS In our example, using the straight-line method, the
may be quite different from this (see Chapter 12). depreciation charges for the buildings, fittings and van are
set out below. Note that the land element of the land and
buildings (assumed to be £75,000) is not depreciated as
Trading transactions during the second year of trading
its life is assumed to be infinite and not subject to wear
and tear. The figures below show both the depreciation
The company:
expense in the profit and loss account (£12,000) as well
as the amount for fixed assets in the balance sheet
5. sells goods for £1,200,000
(£273,000).
6. buys goods for £850,000
Calculation of depreciation charge in the profit and loss
7. incurred expenses for wages and other expenses of
account using the straight line method (see Chapter 13):
£280,000.
Cost of asset
Depreciation for the year =
Expected useful life
Calculating profit for the year
For our company the depreciation charge for the year
To work out the profit for the year, further information is would be worked out as follows:
required:

Closing stock Fixed asset Cost Life Annual

depreciation
Some of the goods purchased were not actually sold, so £
the cost of these goods must be excluded from the profit Buildings 125,000 50 years 2,500
calculation. They will be included in the year-end balance Fittings 75,000 10 years 7,500
sheet as a current asset. Assume that the cost of these Motor van 10,000 5 years 2,000
goods amounts to £250,000. Depreciation 12,000
charge for the year

Depreciation

Allowance must be made for the wear and tear on fixed

assets during the year. This is done by means of a pro- Net book amount of fixed assets in the balance sheet
vision for depreciation. Depreciation is simply a way of
spreading the cost of the fixed asset over the period it is
being used. For example, assume a machine costs £5,000 Cost Accumulated Net book
and it will be used for ten years and at the end of this depreciation amount
period its value will be negligible. One way of calculating £ £ £
the depreciation charge would be to spread it evenly over Land 75,000 – 75,000
the ten years, charging an expense of £500 against the Buildings 125,000 2,500 122,500
profits of each year. 200,000 197,500
In practice, fixed assets will usually have some value at Fixtures and fittings 75,000 7,500 67,500
the end of their ‘useful lives’. This is referred to as resid- Motor vehicles 10,000 2,000 8,000
ual value (see also Chapter 13). 285,000 12,000 273,000
 Chapter 3 Accounting principles 17

The profit and loss account The balance sheet at the end of year 2

The profit and loss account for the second year is as This may now be completed:
follows:

£ £ £
Fixed assets
Sales (or turnover) 1,200,000 Freehold land and buildings 197,500
Less cost of goods sold (800,000) Fixtures and fittings 67,500
Motor vehicles 8,000
£
Opening stocks 200,000 273,000
Purchases 850,000 Current assets
1,050,000 Stock 250,000
Less: closing stock 250,000 Debtors 80,000
800,000 330,000
Current liabilities (or creditors due within 1 year)
Gross profit 400,000 Trade creditors 120,000
Wages and other expenses (280,000) Taxation payable 27,000
Depreciation (12,000) Overdraft 75,000
Profit before tax 108,000 222,000
Corporation tax 27,000 Net current assets 108,000
Profit for the year 81,000 Total assets less current liabilities 381,000

The bank account

The movement on the bank account is summarised as Capital and reserves

follows: £
Ordinary share capital 300,000
£ £ Profit and loss reserves 81,000
Overdrawn bank account at
beginning of year (85,000) 381,000
Receipts from sales 1,120,000

Sales during the year 1,200,000

Less amounts not yet received
(represented by debtors) (80,000)
Cash collected 1,120,000
Format and terminology differences – UK GAAP
and IFRS compared
Payments to suppliers for goods (830,000)
Some of the more common terminology differences are as
Owing at beginning of year 100,000 follows. Other differences will be referred to in specific
Purchases during the year 850,000
chapters later in the text.
950,000
Less amounts owing at end
of year (represented by
creditors) 120,000
UK GAAP term IFRS term
Cash paid 830,000
Profit and loss account Income statement
Wages and expenses (280,000) Turnover Revenue
Debtors Trade and other receivables
Overdrawn bank account at
Stocks Inventories
end of year (75,000)
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