The Usefulness of Financial Information in Diageos Annual Report - Case Study Example

?To The Board of Directors Diageo Plc From Wilson & Wilson Management Consultants Report on Usefulness of Financial Information in Diageo’s Annual Report The Annual Report of Diageo Plc. has been analyzed with reference to the IASB’s Conceptual Framework document 2010 as advised with a view to improve the reporting standards by the company in future and the findings are given below. IASB’s Conceptual Framework The IASB’s Conceptual Framework document covers conceptual framework in respect of financial reporting, Qualitative Characteristics of Decision-useful Financial Reporting, Recognition and Measurement of the elements of the financial statements with the objective that the financial reporting should encompass all decisions made by capital providers of a reporting entity in their capacity as capital providers. The Objective of Financial Reporting The major elements of the financial statements are the Asset, Liabilities, Equity, Income and Expenses. The financial statements are prepared on the accrual basis of accounting and ‘going concern’ concept both being the fundamental principles for recognition, measurement and reporting. The objective of financial reporting could be achieved only if the decision-usefulness aspect maintaining the principle of stewardship is fulfilled in financial reporting. The information provided should be useful to the existing investors and the other stakeholders and relevant in decision making. Qualitative aspects should enhance the financial statements’ usefulness in predicting the future while confirming the fair and true view of the current status of the company and the statements are required to be understandable and comparable. A - Decision Usefulness Stewardship information is historical in nature and they are subjected to various types of analysis to assess the performance during a particular year for taking decisions. The comparison of the information over a period of time reveals the trends in the operations and the business. But, in most of the cases these could not be extrapolated to assess the future of the company as they are dependent on various internal and external environmental factors. The other statements and the reports like Chairman’s Report or Directors’ Report to the shareholders would be useful in assessing the future performance. Information regarding Stewardship objective The data available from the Income Statement and the Balance Sheets are useful for working out various financial ratios for the purpose of analysis with reference to various parameters such as efficiency in performance, profitability, leverage, interest cover or return on capital employed. For example we can work out operating margin from the Consolidated Income Statement as below: 2011 2010 2009 Sales 13,232 12,958 12,283 Operating Profit 2,595 2,574 2,418 Operating Margin 19.61% 19.86% 19.68% The comparison for the past three years suggests that though there is increase in sales during 2011 by 2.11% in 2011 and 5.5% in 2010 over the previous years it is not reflecting in gross margin. This is mainly because there has been slowdown in the economy during this period and there has been increase in excise duties, marketing and other operating expenses. Similarly, we work out the current ratio from the balance sheet. 2011 2010 Current Assets 7161 6952 Current Liabilities 4915 3944 Ratio 1.46 1.76 Though the current ratio is better than the generally accepted level of 1, the ratio has come down during 2011. This is mainly because of the increase in overdraft from 587 in 2010 to 1447 in 2011. Stewardship oriented cash flow statement would indicate the movement of cash in the operations of the business. The details given in the Annual Report serves the decision useful objective in the areas such as efficiency in working capital management or plough back of profits accrued for long term capital investments. Elliott and Elliott (p. 16) state “Cash flow accounting provides objective, consistent and prudent financial information about businesses transactions. It is stewardship-orientated and oilers a means of achieving accountability over cash resources and investment decisions.” Support for Decision usefulness objective Apart from the decision useful information from the Income Statement and the Balance Sheet for the past year(s), the Annual Report furnishes several other details which are very useful for the investors or creditors for taking decisions. Key performance indicators such as Operating margin, Return on invested capital, free cash flow, details of volume, Earnings per share, market share of the company and performance by the reportable segments (p. 4-7) given by the company serve the decision usefulness objective effectively. Information about the future The chairman’s forward looking statement reflects optimism in future business prospects. The Chief Executive has outlined the companies strategies in organic growth and acquisitions and expansion into the international markets with growth potential. The opportunities for growth in the industry as well as challenges faced by the company in various fronts including Corporate Social Responsibilities and the risks involved in the business as outlined in the Business Review, Trend Information and Directors’ Report are the important pointers to the future growth of the company. The increase in the dividend payout reflects the confidence of the management in the future prospects of the company. Post balance sheet events furnished in the Annual Report (p. 76) are the useful indicators about the future course of actions undertaken by the company and there is no off balance sheet item which materially affects the performance of the company. Critical accounting policies discussed in the Annual Report (p. 78) reflects transparency in accounting. The company’s policies with regard to intangible assets are analyzed separately in this report. The financial statements are prepared in accordance with the IFRS and in compliance with the FSA Disclosure and Transparency Rules as confirmed by the independent auditors’ report and the US Sarbanes-Oxley Act of 2002 (SOX). B – Analysis of the important issues relating to decision usefulness Cash flow The focus on cash flow is important in the back drop of squeeze in operating margin, muted revenue growth and imbalances in the current ratio. Elliott and Elliott (p. 15) state “The cash flows can be verified for completeness provided there are adequate internal control procedures in operation.” ?in million. Equity dividends paid during the year = 973 Net investment in property, plant and equipment and software = 372 The above outflows need to be analysed with reference to the borrowings of the company during the year. 2011 2010 Inc./Dec. Borrowings due within one year -1447 -567 -880 Borrowings due between one and three years -2441 -2189 -252 Borrowings due between three and five years -1741 -2732 991 Borrowings due after five years -2566 -3256 690 Net cash from operating activities 2091 2298 -207 The management needs to focus its attention for efficiency in working capital management and capital investment plans. It could be observed that the borrowings due within a year and one to three years have been increased by 1132 and borrowing due beyond three years have been reduced by 1681. The company has made capital investment to the tune of 372 and the outgo on account of dividends has increased by 59. It means the short term borrowings of the company has been effectively used for long term capital investment and repayment of long term loans and payment of additional dividend which obviously is not a sound business strategy, considering the proposed acquisitions and expansions. The increase in short term borrowings increases the interest burden and it should be used on temporary basis. Apart from the borrowings, the following are the important changes in the working capital during the year. Inventories 3473 3281 192 Trade and other receivables 1977 2008 -31 Trade and other payables 2838 2615 223 The management attention is called for in the case of increase in inventory. The increase in payables may be due to the tight short term financial situation. The dividend payment is a management decision. However, when there are short term financial constraints and future investment plans the increase in dividend payout is not justified. Intangible Assets Under IAS 38 “ Intangible assets meeting the relevant recognition criteria are initially measured at cost, subsequently measured at cost or using the revaluation model, and amortised on a systematic basis over their useful lives (unless the asset has an indefinite useful life, in which case it is not amortised)” (Deloitte, 2012). After initially measuring at cost, a company can adopt either cost or valuation model which is suitable for application. Nobes and Parker (p. 346) state “IFRS allows subsequent fair valuation...largely because the standard-setters are not yet able to decide between reliable costs and relevant fair values.” Identifiability, control and future economic benefits are the important attributes essential in the accounting of the intangible assets. The various brands are clearly identifiable with the markets and most of which had been created more than 100 years ago. Impairment losses on account of full impairment of the brand value in the case of Ursus brand has been charged to the operating expenses. When the cost of acquisition is more than the fair value the difference has been treated as goodwill by the company. The intangible assets with limited useful life have been amortized over this period. The review of the assets for impairment is carried out at least annually or when required. The policies adopted by the company are in line with the standards. “Internally generated goodwill shall not be recognised as an asset...Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets.” (IFRS.org, 2012). It is important to note that the valuation of internally generated brand will lead to complications as it involves estimation and judgment on the part of the management as in the case of goodwill. “The importance of internally generated intangibles has been reflected in the increasing proportion of the company’s market value attributable to the existence of intangibles” (Austin, 2007). However, the brand value is relevant and gets precipitated at the time of stake sale or transfer of rights to a third party. Gowthorpe and Amat (2005) state “Under the FASB concession earnings will be affected only if there is an impairment in the value of goodwill...given that goodwill valuation is such a subjective and difficult area, it seems likely that American corporations will be able to use the requirement as quite an effective way to manage their earnings.” With reference to adoption of different methods for accounting and amortization, Gore et al (2000) state that goodwill accounting distorts comparisons between companies that have grown by acquisition and those which have grown by internal means. Finance costs attributable to the acquisition, construction or production of a qualifying asset, being an asset that necessarily takes a substantial period of time to get ready for its intended use or sale, are added to the cost of that asset. All other finance costs are recognised as charges in the income statement for the period in which they are incurred. (p. 118 and 143) IAS 38 applies to all intangible assets and as such the same principles are adopted for capitalization and amortization in the case of development of software and R&D. Computer software is amortised on a straight-line basis to estimated residual value over its expected useful life or up to 5 years. R&D expenditure is capitalised and amortised on a straight-line basis over the period of the expected benefit, if meets the recognition criteria. (p. 117) It is important to note that the impairment tests are based on the estimates or judgment of the management which are subject to changes. Under IFRS, the company is not under obligation to disclose the valuation methods adopted in respect of intangible assets. However, Diageo has chosen to give the details of working for the impairment charges which enhances the level of transparency. Changing perspective of the reporting guidelines Bartov et al (2001) stated “investors reward firms whose earnings meet or beat analysts’ estimates.” Earnings management is also correlated to public issues by the companies. The international accounting and reporting bodies are concerned about the earnings management by the companies and its impact on the stock prices. Accountants face “ethical issues of simultaneously complying with their duties for faithful service and loyalty to their employer or client while respecting their responsibilities to other stakeholders” (Verschoor, 2011). The US subprime crisis and the European financial crisis have made the international bodies to revisit the accounting and reporting norms to eliminate or bring down earnings management by the companies, especially where the management discretion plays an important role as in the case of revaluation of the assets, provision for bad and doubtful debts and accrual earnings management by shifting the income or expenses to the next accounting period. Conclusion It is stated that the boards are continuing their efforts to achieve a single set of high quality, global accounting standards, within the context of an independent standard-setting process. (IASB and FASB, 2012, p. 2) The risks associated with non compliance of the accounting and reporting standards will be detrimental to the growth of the business apart from earning disapproval of the statutory bodies. Alexander et al (p. 35) state “The schemes for balance sheet and profit and loss account put forward by the Fourth and Seventh Directives of the European Union are more detailed than the layout presented by the IASB.” In view of the regulatory agencies’ attitude towards earnings management, the companies need to be cautious in using their discretionary powers in respect of estimations and judgements while preparing the financial statements to avoid controversies. References Alexander, D., Britton, A. and Jorissen, A., 2011. International financial reporting and analysis, 3rd Ed. Thomson Learning, London. Austin, L., 2007. Accounting for Intangible Assets. Business Review. Vol. 9(1) 63-72. Bartov, E., Givoly, D. and Hayn, C., 2002. The rewards to meeting or beating earnings Expectations. Journal of Accounting and Economics 33 (2002) 173–204. Deloitte, 2012. IAS 38 – Intangible Assets. [online] Available at: [Accessed 1 January, 2013]. Diageo Plc, 2001. Annual Report 2011. Elliott, B. and Elliott, J., 2011. Financial Accounting and Reporting. 14th Edition. Pearson Education Limited, Harlow. Gore, P., Taib, F. M. and Taylor, P. A., 2000. Accounting for goodwill: An examination of factors influencing management preferences. Accounting and Business Research, Vol. 30. No, 3. 213-225. Summer 2000. Gowthorpe, C. and Amat, O., 2005. Creative Accounting: Some Ethical Issues of Macro- and Micro-Manipulation.  Journal of Business Ethics. 57 (1):55 - 64 (2005). IASB and FASB, 2012. Joint Update Note from the IASB and FASB on Accounting Convergence: Note from IASB on Governance Enhancements. [online] Available at: [Accessed1 January, 2013]. Nobes, Christopher and Parker, R., 2008. Comparative international accounting. 10th Ed. Pearson Education Ltd., Harlow. Verschoor, C. C., 2011. Did Ernst & Young Really Assist Financial Fraud?  Strategic Finance. March 1, 2011. Read More