Analysis of Frosted Plc Income Statement - Essay Example

TASK The qualitative characteristics of information as d in the International Accounting Standards Board Framework are understandability, relevance, materiality, reliability, substance over form, and comparability (Tiffin 2004, p. 205-206). Understandability means that information should be presented in a way that is easily understandable by users who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently (IASB framework n.d.). This means that how the company derives the earnings and the number of shares has to be understandable. If there was no clear definition of what comprises "earnings" the amount of earnings (profit) would be open to varying interpretations. Also it is possible to take differing views on the number of shares to be used in the denominator, example should it be the number of shares in issue at the balance sheet date or the average number of shares in circulation during the year (Tiffin 2004, p. 135). To be understandable, the company has to distinguish between basic earnings per share and diluted earnings per share. Basic earnings per share should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders, by the weighted average number of ordinary shares outstanding during the period. For the purpose of calculating diluted earnings per share, the net profit attributable to ordinary shareholders and the weighted average number of shares outstanding should be adjusted of the effects of all dilutive potential ordinary shares. If the number of ordinary or potential ordinary shares increases as a result of capitalisation, bonus issue, share split or other reasons, the calculation of earnings per share and diluted earnings per share should be re-calculated retrospectively (Tiffin 2004, p. 137). Materiality means that insignificant amounts should be ignored. For example, when the stock-take figure totals 89,000 and the stock records show 92,000, the 3,000 is not material and the lower stock-take figure should be used. The earnings per share should therefore reflect the 3,000 as loss (Tiffin 2004, p. 206). Information in financial statements is relevant when it affects the economic decisions of users. To do so, it should be able to (a) help them assess past, present, or future events and to (b) confirm or amend past assessments they have made (IASB framework n.d.). Disclosure of relevant information is closely related to the concept of materiality - what is material is likely to be relevant. Relevant information also includes changes in number of shares in issue during the year and the dilution of earnings per share caused by the conversion of potential ordinary shares to ordinary shares (Tiffin 2004, p. 138). Reliability is influenced by the use of estimates and by uncertainties in the recognition and measurement of items. These uncertainties are dealt with by disclosure and by practicing prudence in preparing financial statements (IASB framework n.d.). An enterprise should disclose (a) the amounts used as the numerators for any earnings per share figures and a reconciliation of the amounts to the reported net profit or loss for the period and (b) the weighted average numbers of ordinary shares used as the denominator of any earnings per share figure. A reconciliation among the differing numbers of ordinary shares should be given where appropriate. Basic and diluted earnings per share should be presented, with equal prominence, on the face of the income statement. If an enterprise discloses additional earnings per share figures, example excluding a one off, exceptional cost, then the calculations should be as for basic or diluted earnings per share figures. All earnings per share figures should be disclosed with equal prominence (Tiffin 2004, p. 137). Substance over form means that the underlying business position matters rather than the legal form. For example, equipment may be leased over 5 years-60 monthly installments being paid; ownership of the equipment legally remains with the bank financing the equipment; but the substance of the transaction is that the equipment is owned, that is the economic benefits of ownership flow to the lessee. Equally the bank does not really consider it owns equipment-it has lent money to be repaid in 60 installments. Hence, where the substance is that the company owns the equipment, depreciation should be recognised to arrive at the earnings per share (Tiffin 2004, p. 206). Users should be able to compare the financial statements of a business over time so that they can see the trends in its financial position and performance. Users should also be able to compare the financial statements of different businesses. Disclosure of accounting policies is imperative for comparability (IASB framework n.d.). The reporting of earnings per share under International Accounting Standards may be less comparable than Generally Accepted Accounting Standards because businesses adopting International Accounting Standards are not required to determine the impact of contingently issued shares and would not be prohibited from using alternative bases for making that determination (SEC concept release: International Accounting Standards 2000). TASK 2 Frosted Plc Income Statement for the Year Ended 31st December 2006 Sales Less: Cost of Goods Sold Opening stock Add: Purchases Less: Closing stock Gross profit Less: Operating Expenses Depreciation Freehold property Plant and machinery Motor vehicles Directors' remuneration Fees Audit Legal fees Heating, light and power Hire charges Insurance Interest Bank loan Debentures Overdraft Maintenance and repairs Miscellaneous expenses Motor expenses Postal and telephone charges Salaries Wages Net profit for the year before corporation tax Less Corporation tax paid Net profit for the year after corporation tax before dividends Less Dividends paid Net profit for the year after corporation tax after dividends $'000 5,034 34,550 39,584 6,022 161 5,011 572 248 188 60 123 25 240 187 40 195 3,100 35 2,120 210 3,200 6,592 $'000 72,000 33,562 38,438 22,307 16,131 5,421 10,710 600 10,110 Frosted Plc Balance Sheet as at 31st December 2006 Shareholders' Equity Issued share capital Retained earnings (76,492 + 10,110) This is represented by: Fixed Assets Freehold land Freehold buildings Less Depreciation (1,775 + 161) Motor Vehicles Less Depreciation (1,386 + 572) Plant and Machinery Less Depreciation (1,145 + 5,011) Current Assets Cash Accounts receivable Stock Less Current Liabilities Bank overdraft Provision for corporation tax Trade payables Working capital Less: Long-Term Liabilities Bank loan (secured on property) Debentures $'000 16,100 1,936 2,860 1,958 50,110 6,156 653 9,027 6,022 511 425 5,024 $'000 38,000 14,164 902 43,954 15,702 5,960 10,010 150 $'000 10,000 86,602 96,602 97,020 9,742 106,762 10,160 96,602 Frosted Plc Cash Flow Statement for the Year Ended 31st December 2006 Cash flows from operating activities Net profit before taxation Adjustments for: Depreciation Freehold property Plant and machinery Motor vehicles Interest Bank loan Debentures Overdraft Operating profit before working capital changes Decrease in accounts receivables Increase in stock Increase in trade payables Cash generated from operations Corporation tax (740 + 5421 -425) Net cash from operating activities Cash flows from investing activities Purchase of freehold land Cash flows from financing activities Interest Bank loan Debentures Overdraft Dividends Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at the end of the period (653 - 511) $'000 16,131 161 5,011 572 187 40 195 22,297 443 (988) 47 21,799 (5,736) (187) (40) (195) (600) $'000 16,063 (14,000) (1,022) 1,041 (899) 142 Assumptions: 1. Depreciation has not yet been provided for the year ended 31st December 2006. 2. Bank overdraft stays at the same level as 2005 year end. TASK 3 The possible cost of the legal dispute with the former employee cannot be recognised. In accordance with IAS 37, a provision should be made only when an enterprise has a present obligation as a result of a past event and where it is probable that the provision will have to be settled and a reliable estimate can be made of the amount. If these conditions are not met then no provision should be recognised (Tiffin 2004, p. 80). Since it is not probable (40% chance) that the provision will have to be settled, the legal cost should not be recognised. Therefore, this does not impact the financial statements. However, Frosted Plc should report it as a contingent liability and disclose an estimate of the financial effect, an indication of the uncertainties in amount and timing, and the possibility of any reimbursement (Tiffin 2004, p. 81). A contingent liability is either an existing obligation that is not recognised because it is unlikely that anything will have to be paid to settle the liability, or the amount of the obligation cannot be measured with sufficient reliability-it is impossible to determine an amount to provide, or a possible future obligation that arises from past events and whose existence will be confirmed by the occurrence or non-occurrence, of one or more uncertain future events not wholly within the control of the enterprise (Tiffin 2004, p. 80). The purpose of this Standard is to eliminate creative accounting. To legally move profits from one accounting period to another would be a very useful facility. Reported results could be in line with promised results, profits could be smoothed, losses minimised, tax charges managed and so on. The setting up and releasing of ill defined provisions could facilitate such practices. The Standard therefore accepts the business and commercial need for provisions but brings definition as to when and how provisions should be sanctioned. The Standard demands a high degree of certainty as to cause and amount before provisions can be made. The objective of the Standard is to ensure appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets, and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount (Tiffin 2004, p. 78). The goodwill cannot be recognised. Therefore, this does not impact the financial statements. The "customer goodwill" developed since the company started trading is internally generated goodwill because IAS 38 demands that only purchased goodwill can be shown in the balance sheet. Internally generated goodwill cannot be capitalised and shown in the balance sheet. The argument is that it will inevitably be impossible to measure the cost reliably (Tiffin 2004, p. 64). However, Frosted Plc. can declare goodwill and give indications of its value in a Financial Review included in the financial statements. Frosted Plc. should also consider the value of goodwill in internal management accounts. Being aware of the return that is made on brands is a very important issue for many businesses (Tiffin 2004, p. 65). The fire took place after the balance sheet date and therefore does not impact the financial statements. However, this piece of information is significant as it results in a loss of $215,000 ($250,000 - $35,000) that will affect future periods. IAS 2 states that stock should be included in accounts at cost or a lower figure, net realizable value, if they are worth less. This is in accordance with the prudence concept (Tiffin 2004, p. 57). This should be reported as "events after the balance sheet date" in accordance with IAS 10. Post balance sheet events are those events, both favorable and unfavorable, which occur between the balance sheet date and the date on which the financial statements are approved by the board of directors-"the date of sign off". The fire is a non-adjusting event because it concerns conditions that did not exist at the balance sheet date. Financial statements should be prepared on the basis of conditions existing at the balance sheet date. A material post balance sheet event should be disclosed where it is a non-adjusting event of such materiality that its non-disclosure would affect the ability of users of financial statements to reach a proper understanding of the financial position (Tiffin 2004, p. 127-128). TASK 4 Purchasing 75% of the ordinary share capital of Tinted plc on the 1st July 2007 would result in a controlling stake in Tinted plc. In this case, Frosted plc is the parent and Tinted plc is the subsidiary. In accordance with IAS 27, the financial statements of Frosted plc and Tinted plc should be consolidated. The concept of consolidation is that the sales, costs, assets, liabilities and cash flows of Frosted plc and Tinted are combined or consolidated (eliminating any inter company transactions and balances) to give the overall position in the income statement, balance sheet and cash flows statement (Tiffin 2004, p. 161). Acquired assets should be disclosed at "fair value" on acquisition (Tiffin 2004, p. 155). The assumption is that none of the following is true (a) the group is small or medium-sized (as defined by the Companies Act) (b) the subsidiary is merely held for resale (c) the parent is itself a subsidiary (d) severe long-term restrictions substantially hinder control (e) there would be disproportionate expense and undue delay (f) the subsidiary's activities are so different from the rest of the group's activities. If any of the above is true, financial statements should not be consolidated. In Frosted plc's separate financial statements investments in subsidiaries should be carried at cost, accounted for using the equity method, or accounted for as an available for sale financial asset as described in IAS 39 Financial Instruments. Apart from the fact that they are the accounts of the company in which external shareholders invest, the accounts of the parent are really not normally of great significance. Carrying the investments in subsidiaries at historical cost is all that is needed. The consolidated accounts will reveal the latest carrying value of the component subsidiaries. A list of all significant subsidiaries including their name, country of incorporation or residence, the method of accounting for the combination, the effective date of combination, the cost of the acquisition, how this is to be paid (in cash, shares, etc.) and proportion of ownership interest should be disclosed (Tiffin 2004, p. 157, 162-163). Minority interests should be presented in the consolidated balance sheet separately from liabilities and parent shareholders' equity. Minority interests in the income of the group should also be separately presented (Tiffin 2004, p. 162-163). The goodwill paid by Frosted plc is $1,500,000 ($9,000,000 - 75% X $10,000,000). In accordance with IAS 22, goodwill should be recognised in the balance sheet. Goodwill is then amortised to income over its useful life (Tiffin 2004, p. 155). Goodwill should be amortised on a systematic basis which reflects the best estimate of the period during which economic benefits related to the goodwill are expected to flow to the enterprise (Tiffin 2004, p. 156). The period over which goodwill is amortised should be disclosed. A reconciliation, with analysis of movements between opening and closing goodwill balances should be given (Tiffin 2004, p. 157). Purchasing 25% of the ordinary share capital of Tinted plc on the 1st July 2007 would result in influence in Tinted plc. In this case, Frosted plc would be expected to have some rights with respect to the management, dividend payment and the use of assets of the associate (Tiffin 2004, p. 165). In accordance with IAS 28, associates should be accounted for using the equity method. The equity method is a method of accounting whereby the investment is initially recorded at cost (25% X $8,000,000 = $2,000,000) and adjusted thereafter for the post acquisition change in Frosted plc's share of net assets of Tinted plc. The profit or loss of Frosted plc includes 25% of the profit or loss of Tinted plc (Tiffin 2004, p. 168). As each ordinary share carries an equal number of voting rights in Tinted plc, there is no restricted influence (in which case Tinted plc is unlikely to be an associate and should be carried under the cost method in accordance with IAS 27 Consolidated and Separate Financial Statements). Another assumption is that Tinted plc is not to be acquired and held exclusively with a view to its subsequent disposal within twelve months from acquisition. If so, the purchase should be accounted for in accordance with IAS 39 Financial Instruments, at fair value with changes in fair value included in the profit or loss of the period of the change (Tiffin 2004, p. 166). Lastly, it is assumed that Frosted plc does not have effective control even though the percentage of share ownership is 25%. Otherwise, consolidation is required (Tiffin 2004, p. 163). Investments in Tinted plc under this case should be disclosed as long-term fixed asset investments as a separate line on the balance sheet. The investor's share of profits or losses of associates should be disclosed as a separate line on the income statement. The fair value of Tinted plc ($10,000,000 X 25% = $2,500,000) should be disclosed. There should be summarised financial information regarding the associates (Tiffin 2004, p. 166). Frosted plc should also disclose its share of any contingent liabilities of Tinted plc and in particular contingent liabilities that arise if it is severally liable for all the liabilities of Tinted plc (Tiffin 2004, p. 167). Purchasing 10% of ordinary shares of Tinted plc on 1st October 2007 requires only the recognition of dividends from Tinted plc (Tiffin 2004, p. 165). REFERENCES IASB framework n.d. Retrieved November 9, 2006, from http://www.iasplus.com/standard/framewk.htm SEC concept release: International Accounting Standards n.d. Retrieved November 10, 2006, from http://www.sec.gov/rules/concept/34-42430.htm Tiffin, R 2004, Complete guide to international financial reporting standards: including IAS and interpretation, Thorogood, London. Read More