An Analysis of the Impact of Changed Economic Circumstances and an Evolving Regulatory - Case Study Example

An analysis of the impact of changed economic circumstances and an evolving regulatory [Students Name] [Course Title] [Tutor’s Name] 25th July, 2011 An analysis of the impact of changed economic circumstances and an evolving regulatory Executive Summary This report provides a review of the Downer group of companies (listed on the Australian Securities Exchange, ASX) based on its historical analysis, application of the accounting standards, and information derived from the economic environment within which the group operates. The methods used in the analysis include horizontal, vertical and trend analyses. The report shows that the future prospect of the economic health of the group is positive. The review also shows that the reaction by the group in relation to the economic issues it faces is worthwhile. It is shown in this report that Downer needs to hedge against exchange risk as currency exchanges have proved hard to predict in the present economy. There is however some weak areas the management of Downer needs to conduct some further investigation and take necessary action. In addition the report investigates the impact of the economic environment on the past and future prospects of the group. Significant economic issues such as inflation, interest rate, and recession and their effect on the performance of the group have been analyzed. This report has not provided forecasting figures as there are no enough monthly data details and the information is majorly based on past data rather than the present data. Analysis of Downer Group’s Announcements across the 5-year reporting period (2006-2010) General-purpose financial reports are intended to serve the needs of all external users of accounting information (Fess and Warren, 2004). However, all external users do not have the same needs and interests. For instance, a bank considering granting a three - months’ loan to Downer group of companies is primarily interested in the short run debt pay ability of the group. Whereas the long term investors in Downer shares is more concerned with earning capacity, potential growth in earning per share and the ability of the group to survive as a going concern. Because GPFRs serves a variety of users the needs of some of the users receives more emphasis than the needs of others. Downer Group’s Announcements therefore provides additional information that is helpful to any current or potential investor or creditor to the group. They use these announcements to monitor the trend and thus provide useful information for their decision making (Warren, 2009). The announcements by Downer with respect to completion of some millions funding means that the group can now demonstrate its credit worthiness, that is, its credit rating in the market has increased. This is very important for the growth of the business as it constantly needs finances to keep it operational and in its expansion. A company that its credit rating is good can easily get funding from many sources of finances (raises the market confidence of the company) and therefore be in a position to take full advantage of the available investment opportunities in the economy (Donald, et al., 2009). The announcement by the Downer group of companies that it has secured contracts is a welcome achievement for the company. Winning contracts means that the company is gaining recognition with time. It means that the group is getting business and thus there are prospects for the company registering some profits and thereby declare dividends to the shareholders. Contracts are awarded after a rigorous completion with other companies in the same industry. This can therefore be used as a tool to show the competitiveness of Downer group in the market. This can by extension help Downer achieve its objectives as well as increase its market share in the economy (Spiceland and Sepe, 2001). Downer frequently announces changes in its management with regard to appointment of directors, resigning of directors among others. Appointment of an able competent director means that the company’s management is keen on maximizing the wealth of the shareholders through achieving possible value of the firm. A director acts as an agent to the company and as such should always disclose any conflict of interest in the course of doing business. The announcement of resign of a director on the grounds of conflict of interest is important (Black, 2003). Announcement that Downer has acquired some other companies means that the firm is expanding through mergers and acquisitions. This helps the company to achieve synergism and at the same time fight competition. Acquisition of excel company which fits with Downer’s works division is an indication that there is an opportunity of expansion of its market segment. Downer must follow its constitution in all its operations. It is therefore important for Downer to make any announcements pertaining to its alteration or adoption of a new one. This will help the company to avoid any suit lodged as a result of ultra vires transactions. The Impact of Changed Regulations on the Downer Group’s (3) Primary Financial Reports Business enterprises operate under a conceptual framework that is guided through rules and regulations. This mainly comprises of the legal framework and other standards like the established accounting standards and other regulatory bodies. Any such changes will have either a favorable or unfavorable impacts on the financial reports of the company (Greuning, 2005). Generally, Downer groups of companies have three primary financial reports. Namely; income statement, statement of cash flow and the balance sheet (statement of financial position). Accounting standards Accounting standards are the established principles of accounting that govern the present accounting practice. Every company is required to strictly adhere to the set standards while making its financial reports. These standards are however subject to review from time to time so as to ensure that it addresses the needs of the dynamic field of business. When such a change is made there is some material change in the financial statements of the company (Hilton, 2004). Other regulatory changes Every business operates in a legal environment and is thus subject to the laws in existence in that country and any other law that is applicable internationally. A legal environment is an external factor that impacts on the business and which Downer cannot gain control over. It can only adapt to such an environment if it has to remain in business (Weygandt, et al., 2009). Legal regulatory changes involve duty to the government. Downer is required to; Pay corporation tax as and when they fall due Operate within the government development plan Operate within the legal system, that is, adhere to the industrial requirement and ensure safety standards to its employees. Downer group of companies is subject to corporation tax which is charged against the net profit after interest expense on any loan has been deducted. A change in corporation tax causes a change in the earnings after tax of the company shown in the income statement (Steven, et al., 2008). By extension, the BOD of Downer will declare dividends based on the profits made by the company and also the retained earnings will be made out of the same profits. Therefore the figures of the retained earnings and dividends in the balance sheet will as well change. A regulatory change requiring the company to pay high salaries and other privileges to its employees will mean a reduction in its profits since it constitutes a cost to Downer hence impacting on the financial statements of the company (Brown and Matysiak, 2007). Other regulatory changes may include internal control procedures, for instance, cash disbursements. Proper control of cash disbursement may be designed to prevent any unauthorized payment and to ensure that disbursements are recorded on the proper general ledger and subsidiary ledger accounts. Such an internal regulatory change might demand that all cash disbursements other than very small disbursements from petty cash should be made by cheque. This provides a permanent record for all disbursements. Note that this will impact on the amount of cash at hand and the amount of cash in the bank. However, it will not have any effect on the cash flow statement. The Impact of the Economic Environment on the Downer Group’s Past and Future Prospects Economic environment refers to the economic factors which impacts either negatively or positively to the operations of a business enterprise. They include such factors as interest rates, unemployment, recession, exchange rate, income, productivity, wealth, and inflation. They are exogenous factors to the business and Downer has to adapt to this kind of changing environment otherwise it can be wiped out of the market (Greite, 2007). Note that economic factors such as wealth and income affect the purchasing power of consumers and can also indicate the patterns of spending by the customers hence the need of the company to keep monitoring the economic environment on which it operates. Significant economic issues affecting the group There are various economic issues affecting the group but the significant issues include inflation, exchange rate, recession and rise in interest rates. The level of inflation has been increasing by day. When the inflation rate is high the purchasing power is reduced . This has meant that the cost of production for Downer group has gone up. This poses a problem to the group since this is a factor that cannot be anticipated well in advance meaning that the increased cost in production cannot be passed directly to the customers. Usually the Downer group is contracted to accomplish a certain task, for instance road construction. The contract price would normally be determined having considered the prevailing rate of inflation. Any anticipated rise in inflation would negatively affect the group performance. Once the consideration of a contract has been determined it cannot be changed and the failure of Downer to honor its obligation would result to breach of contract. Therefore, any effect of rise in inflation is absorbed by the group. Interest rates: Downer group relies heavily on external funding. This funding attracts periodic interest payment for servicing the loan. Increase in interest rates has been a problem to Downer since the cost of this loan amounts has gone up. The company has to honor these financial obligations which constitute a considerable expense on its income statements. The economic assumption of when the interest rate is high the investment goes down applies. The cost of investment goods goes up making it hard for Downer to continue with some of its investment projects. Exchange rate: this is an economic issue that also affects the group. This is mainly due to the fact that the group has its operations in countries outside Australia such as the UK, Asia and the New Zealand. Currency exchange rates keeps fluctuating thus posing a threat to the past and the future transactions of the group. A rise in the exchange rates depreciates the value of the home currency. Often when Downer secures a contract with a company outside Australia the contract price is set in Australian Dollar. Any future rise in exchange rate will reduce the dollar amount received by the Downer group when it exchanges the currency. Recession: this is an economic situation characterized by a fall in the real GDP. The recent economic crisis in the year 2008 left the group crumbling. During the recession the activities of the group was reduced below the minimum. The volume of sales was too low and the company made a huge loss (it recorded a negative change in revenue -21%). This period was also marked by a fall in the share price leading to decline in investment with the group. Potential investors monitor the trend of the share price of a company before deciding to invest in that company (Hilton, 2004). Low share price during this period scared away the potential investors. The group’s past performance in reaction to economic issues Economic environment factors are exogenous to a company. The company needs to react to these factors to mitigate their impact on the business performance since it does not have control over them. With increased levels of inflation the Downer has been forced to increase the cost of its services. This it did to cushion itself from the effects of inflation (Handerson, 2003). The contract price of most of its undertakings has been revised upwards. Due to increase in interest rates the group resulted to use other sources of finance that are less costly. This included issuing shares to the public and using its retained earnings to finance some of its investment projects. The group also completed most of its funding to offload the burden of paying periodic interests (DownerGroup, 2010). During the recession Downer company retrenched some of its employees as a measure to cut down on the operating cost. Some high ranking officials of the group like the directors have retired during this period all of which was aimed to trim the huge expenses of the group. The group also resulted to leasing some locomotives under an operating lease. This was a measure of furthering the activities of the group while at the same time boosting its revenue (Wright and Wright, 2007). The result was increased revenue in spite of the hard economic times the group was passing through. Overseas investment in bonds and stock can generate positive returns and create opportunities of diversifying the portfolio. However, they introduce an exchange rate risk. Downer considered hedging the risk as it impacts significantly on the returns of the portfolio. The company had invested in overseas assets and markets and because of a weaker Australian dollar Downer reaped the benefits. Exchange risk hedging was therefore not made since the group was holding assets in a foreign currency that was appreciating. The future economic health of the group Downer group has set up strategies that will ensure its economic health in the future. These measures include mergers and acquisition with companies whose operations fit with that of Downer, expanding its activities to countries outside Australia, and overseas investment in bonds and stocks. This ensures the group’s financial stability. From the group’s announcement it is evident that the company has cleared most of its loans hence offloading the many financial obligations (Oberuc, 2004). The comparative table below indicates that the total revenue for the Group has been increasing from 2006 to 2009. The corresponding ‘profit after tax’ has also been increasing. In addition, the company has been increasing its retained earnings thus it has adequate internal source of finance. This is a positive prospect for the future economic health of the Group. 30th June, 2010 30th June 2009 30th June 2008 30th June 2007 30th June 2006 Total Revenue 5,844,767 5,867,813 5,472,713 5,329,530 4,655,899 Profit After Tax 2,957 189,376 165,842 101,498 -24,929 Retained Earnings 231,974 336,721 241,794 154,861 121,905 Through acquisition of companies within its line of service the group will achieve to fight competition. There are other companies who offer the same services as does Downer group and thus acquisition forms a sure way of gaining command in the market and increase in the market share (Amenc and Le Sourd, 2003). Expanding its services in other countries enables the company to gain competitive advantage over its competitors. The company can take advantage of the low cost of production in that country. For instance, the activities of Downer group are capital intensive hence it will take advantage of the low cost of capital in the foreign country. The geographic location of its subsidiaries allows the company to take advantage of low labour cost since most of its employees come from within that locality. This will also be advantageous to the group since it interprets to creation of new market in the overseas countries and will result in profit in the long run. Overseas investments in bonds and stocks help the group to diversify its portfolio. This forms an additional investment that contributes positive returns to the group (Walter, 2001). Economic situations in an economic region may change but overseas investment will come in handy to boost the income of the group thereby counteracting any economic condition and preventing the chances of the group being declared insolvent. Downer group of companies is listed on the ‘Australian Stock Exchange’, ASX. Companies that are listed on ASX can raise capital through issuance of shares to the public (AASB (Australian Accounting Standards Board), 2004). This forms a reliable source of finance for the group since it is easily available from the shareholders (owners) of the company. Its cost is also low relative to other sources of finance, for instance, debenture issue. The reward of the shareholders is dividend payment. In the event that the group will not make profit in a certain financial year, it is not under any obligation to pay the dividends. This means that the group will use the funds available for other investment projects. Currently, the company is making good profit out of its operations and other investment projects. It has adequate assets in its retained earnings. The group therefore has enough internal sources of finance which it can use to meet its short term financial demands without negatively affecting its working capital (Picker, 2009). Conclusion This report reviewed the Downer group of companies which is listed on the Australian Stock Exchange, ASX. The review was based on the historic analysis of the group, application of the relevant accounting standards, and other vital information from the economic environment within Australia, the UK, Asia and the New Zealand where the has most of its operations. Information from the annual publication of the group formed a key element of the report. However, other external information was taken into consideration in the analysis to have a clear picture of the group in global economy. Specifically, the report looked at the impact of regulatory changes on the financial reports (income statement, balance sheet and cash flow statement) of the group. These regulatory environments include the Australian accounting regulatory environment, that is, corporation law and accounting standards. Changes in these regulatory environments have been shown to impact on the financial reports of the group. The change on the figures reported in the financial reports is interpreted differently by the different external users of the financial statement information. The report was also based on a five-year reporting period from the year 2006 to 2010 to enable a concise analysis since information from a single financial reporting period covers a short period that is not adequate to draw conclusion from. Issues affecting the valuation and the reporting of expenses, revenues, liabilities and assets of the group were identified and the reaction of the group towards these issues analysed. Downer group operates in an economic environment that is characterized by increased levels of inflation, recession, fluctuating exchange rate and uncertain interest rate levels. The group has demonstrated good performance despite the said economic issues. It reacted by applying necessary measures to counteract the possible impacts of these economic issues. This report however, concentrated on “general purpose financial reports”. These reports serve the needs of various users hence the possibility of emphasizing the needs of some users than others. References AASB (Australian Accounting Standards Board), 2004. Framework for the Preparation and Presentation of Financial Statements. Melbourne: Australian Accounting Standards Board. Amenc, N. and Le Sourd, V., 2003. Portfolio theory and performance analysis. New Jersey: John Wiley and Sons. Black, G., 2003. Students' Guide To Accounting and Financial Reporting Standards. London: Financial Times Prentice Hall. Brown, G.R. and Matysiak, G.A., 2007. Real Estate Investment: A Capital Market Approach. London: Financial Times. Donald, E., et al., 2009. Intermediate Accounting. New Jersey: John Wiley and Sons. DownerGroup, 2010. ASX Announcements. Retrieved 25th July, 2011< http://www.downergroup.com/Investors/ASX-Announcements/> Fess, E. and Warren, C., 2004. Accounting principles. 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