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7 CHAPTER Further features of company accounts ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● Investments Associates and subsidiaries Accounting for associates Accounting for subsidiaries Funding Debt Equity Revaluation reserves Statement of recognised gains and losses Note of historical cost profits and losses Intangible fixed assets Leases Corporation tax Exchange gains and losses Fully diluted earnings per share Summary In our review of Wingate’s accounts we have covered the majority of the things you will see in the accounts of a small- to medium-sized company. However, most of the companies in which you might want to invest your spare cash, Tom, are rather larger than Wingate. These companies tend to have somewhat more complex accounts. In fact, at first glance, their accounts can be quite daunting. Don’t be intimidated! In the next couple of hours, we can get a good enough understanding of the main features that cause these complexities for you to be able to read such 121 ACCOUNTS DEMYSTIFIED accounts with considerable confidence. I do not propose to go into the accounting in detail, but merely to explain the principles of the relevant accounting rules. Investments One of the first things you will notice about many larger companies’ annual reports is that the main statements are described as ‘consolidated’. To understand this, we need to discuss investments and how we account for them. What are investments? Broadly speaking, an asset that is not used directly in the operation of a company’s business is classified as an investment. This definition would include, for example: ● Antique furniture or paintings held in the hope of a rise in value, rather than simply for use in the business. ● Shares in other companies bought as an alternative to putting some spare cash in the bank. ● Shares in other companies bought for strategic reasons, i.e. they form part of the company’s long-term strategy. Such investments are known as trade investments. Many companies own 100 per cent of the shares of other companies, but trade investments can be of much smaller shareholdings as well. Companies whose shares can be bought and sold through a recognised stock exchange are described as listed. Company accounts have to distinguish between listed investments and unlisted investments. Are investments current or fixed assets? 122 F U R T H E R F E AT U R E S O F C O M PA N Y A C C O U N T S That depends on the type of investment. If you expect to sell the investment in the coming year, then you classify it as a current asset. Otherwise, it is a fixed asset. Accounting for investments All investments, regardless of the type, are included on the balance sheet at the lower of the following: ● The cost of the investment, ● The market value of the investment, i.e. what you would get if you were to sell the investment. There is a difference, however, between fixed asset investments and current asset investments. In the case of fixed assets, we only reduce the value on the balance sheet if there has been a permanent diminution in value of the investment. In the case of current assets, we apply the rule at each balance sheet date. So if I buy some shares on the stockmarket and they triple in value, I would still record them on the balance sheet at what I paid for them, but if they go down in value, I would have to include them at the lower value? I’m afraid so. That doesn’t seem very sensible – what’s the logic behind it? The logic is simply that you shouldn’t include a gain in your accounts until you have realised the gain; in other words, until you have sold the investment. This is because the investment’s value may go back down again before you sell the shares. Similarly, if the investment’s value falls, we pessimistically assume it is not going to go up again. The rules are different for companies whose business is investing in shares. 123 ACCOUNTS DEMYSTIFIED Associates and subsidiaries As you just pointed out, Tom, the way we account for investments means that, if the investment does well, we don’t show the benefit of that in the accounts of the investor company. Many companies, however, carry on a large percentage of their business through investments in other companies. This may be because they have bought the companies (in total or just substantial stakes in them) or because they have started new businesses through separate companies. The way we account for investments means that you wouldn’t get a very meaningful picture of such an investor company. We therefore define certain investments as either associated undertakings or subsidiary undertakings. They are usually just known as associates and subsidiaries and there are special rules by which we account for them. So how are associates and subsidiaries defined? The rules are actually quite complex, but very generally: ● A company is a subsidiary of yours if you own more than 50 per cent of the voting rights or you are able to exert a dominant influence over the running of that company. ● A company is usually an associate of yours if it is not a subsidiary, but you own 20 per cent or more of the voting rights. However, if you own less than 20 per cent but still exert a significant influence over the company’s affairs, then it is an associate. Similarly, if you own more than 20 per cent but don’t exert a significant influence, it is not an associate. Let’s now look at how we account for each of these in turn. 124 F U R T H E R F E AT U R E S O F C O M PA N Y A C C O U N T S Accounting for associates Accounting for associates is very simple, in principle. The investor company, rather than putting just the cost of the investment on its balance sheet, instead recognises its share of the net assets of the associate. By ‘its share’ I mean the percentage of the associate’s share capital that the investor company owns. This is known as the equity method. So if, during a year, the associate makes a profit (thereby increasing its net assets), the investor company would make the following double entry on its balance sheets: ● Increase Share of net assets of associate. ● Increase Retained profit. Since the investor company’s retained profit has gone up, its P&L must naturally reflect this. In fact, the investor’s P&L shows its share of the associate’s profit before tax, tax charge, extraordinary items and retained profit. So not only is the performance of the associate reflected in the investor company’s accounts, but you are actually given some details about that performance. This information is not sufficient to enable you to analyse the associate properly, however; for that you need a copy of the associate’s own annual report. Goodwill Up to now, we have been learning about accounting on the basis that the net assets of a company (which are equal to the shareholders’ equity) represent the value of the shares to the shareholders. Thus, if an investor company was going to buy 20 per cent of a company, we would expect it to pay 20 per cent of the net asset value of the company. For all sorts of reasons, investors (both companies and individuals) often pay more than net asset value for shares in companies. We will go 125 ACCOUNTS DEMYSTIFIED into why they do this later. For now, we can think of companies as having various assets that are not included on their balance sheets. Such assets might include: ● An organisation of skilled employees with procedures, culture, experience, etc. ● Relationships with customers and suppliers ● Brand names These ‘hidden’ assets lead investors to pay more than net asset value. The difference between what an investor company pays and net asset value is known as goodwill. Think of it as representing the goodwill of the associate’s customers and suppliers towards the company. Accounting for goodwill So is the goodwill shown on the balance sheet? Yes. So if a company invests, say, £12m to buy 25 per cent of a company which has total net assets at the time of £20m, then the investor company would have less cash assets by £12m but higher ‘share of net assets of associates’ by £5m (being 25 per cent of £20m) and higher goodwill by £7m (being the £12m cash invested less the £5m that is represented by the actual recorded net assets of the associate). So in the jargon, we are ● Crediting cash £12m ● Debiting share of net assets of associates £5m ● Debiting goodwill £7m Yes. There is a further twist on this, however. The investor company is required to treat the goodwill like any other fixed asset and depreciate it over its useful life. This is usually called amortisation rather than depreciation but it is the same thing. So if the investor company decides 126 F U R T H E R F E AT U R E S O F C O M PA N Y A C C O U N T S the useful life of the investment is 15 years, it would have to reduce the value of the goodwill by £467k each year for 15 years. The double entry for this is, inevitably, retained profit, so the investor company has a cost of £467k in its P&L every year for 15 years as a result of making this investment. How do you decide what the useful life of an investment in an associate is? With difficulty. Many investor companies would argue that the useful life is infinite and that there should therefore be no annual goodwill amortisation. This is allowed under the rules but the investor company has to subject the investment to an ‘annual impairment review’. In fact, this applies to all investments a company has where the goodwill amortisation period is greater than 20 years. If the annual impairment review shows the value of the investment to be lower than the value in the investor company’s balance sheet, the investor company has to writedown the investment (i.e. reduce the value of the goodwill in its balance sheet and reduce retained profit accordingly). Accounting for subsidiaries In principle, accounting for subsidiaries is even easier than accounting for associates. The objective is simply to present the accounts as if the investor company (usually known as the ‘parent’) and the subsidiaries were all actually part of the same company. This gives you the consolidated accounts, which make it very easy for someone interested in the company to get the full picture. In practice, ‘doing consolidations’ is not as easy as my description suggests. Since you’re never likely to want to do one, it doesn’t matter. To interpret a set of consolidated accounts, there are just a few additional things you need to know. 127 ACCOUNTS DEMYSTIFIED Company vs consolidated balance sheets Any company which produces consolidated accounts produces a consolidated version of each of the three main financial statements. In addition, the company’s unconsolidated balance sheet will also be provided. Generally, this will not be of much interest to you. The consolidated statements are what you should concentrate on. Goodwill As with associates, goodwill rears its ugly head where subsidiaries are concerned. The same accounting policies apply. There is an additional complication. On making acquisitions of subsidiaries, companies have to include the assets of the new subsidiary on their balance sheet at the ‘fair value’, which is often different from the value in the books of the subsidiary. The goodwill is then the difference between what the investor company paid for the subsidiary and the fair value of the subsidiary’s assets. Minority interests When an investor company owns less than 100 per cent of a subsidiary, it still consolidates the accounts as if it owned 100 per cent. The investor’s accounts are then adjusted to take account of the proportion it does not own. This proportion is known as the ‘minority interests’. You will find ‘minority interests’ adjustments on all three main consolidated statements. Funding When SBL started up, it obtained its funding (or capital, as it is often known) from two sources – Sarah and her parents. The cash Sarah put in was ordinary share capital. It was a long-term investment which could only pay a dividend if the company did well. The better the com- 128 F U R T H E R F E AT U R E S O F C O M PA N Y A C C O U N T S pany did, the better would be Sarah’s return (i.e. the profit on her investment). This form of funding we call equity or share capital. The cash Sarah’s parents put in was a loan. This was different from Sarah’s investment in that the length of the loan (the term) was known and the return (the interest rate) on the loan was not only known but had to be paid, unlike dividends on share capital. This kind of capital is known as debt. There are many different forms of both equity and debt, often called instruments, and it can actually be difficult sometimes to tell one from the other. I will run through some of the more common types you are likely to encounter. Debt Wingate had two types of debt – an overdraft and a loan. Both of these were provided by the bank. Most of the debt of small- and mediumsized companies is provided in one of these two forms by banks. Larger companies, however, often ‘issue’ debt to individual investors or big institutions such as pension funds or insurance companies. This means that the investor provides cash to the company in return for a certificate saying that the company will pay a certain interest rate on the loan and will repay the loan on a certain date. There are often other conditions attached. This kind of debt has many different descriptions, the most common being loanstock, notes, or bonds. Don’t worry about the word used, they are all essentially the same; it is the particular conditions of the debt that are important. Usually these types of debt can be traded; in other words, once the company has issued the debt, investors can buy and sell the certificates from one another, just as they would buy and sell shares. 129 ACCOUNTS DEMYSTIFIED Let’s look at some examples of different types of debt. Unsecured loanstock As we saw when we looked at Wingate’s accounts, many loans are secured by a charge. This means that, in the event that the company is unable to pay the interest on the loan or to make the agreed repayments of principal, the lender has the first claim on any proceeds from selling assets which are charged. Unsecured loanstock is a loan which has no such security. If the company goes bust, then the holders of the unsecured loanstock will have the same rights to any proceeds as the other ordinary creditors of the company. Investors typically require a higher rate of interest on such debt to compensate them for the higher risk they are taking. Subordinated loanstock Some loans are subordinated to the other creditors of the company. This means that, in the event of a liquidation of the company’s assets, the subordinated lenders do not get anything until the other creditors of the company have been paid in full. Such loans are therefore even more risky than unsecured loans and carry a higher interest rate. Debentures These are loans which carry a fixed rate of interest for a fixed term. Usually, they are secured on the company’s assets. Fixed rate notes A fixed rate note is exactly what it says: a loan at a fixed rate of interest. Usually, it will have a specified date on which it will be repaid. Floating rate notes A floating rate note is a loan which has an interest rate linked to one of the interest rate standards – such as the Base Rate, which is the rate set 130