Case Study Importance of Accounting Standards
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The importance of accounting standards
PricewaterhouseCoopers was created in July 1998 by the merger of two firms – Price Waterhouse and Coopers & Lybrand – each with historical roots going back some 150 years and originating in London. PricewaterhouseCoopers, the world’s largest professional services organization, helps its clients build value, manage risk and improve their performance. Drawing on the talents of more than 140,000 people in 152 countries, it provides a full range of business advisory services to leading global, national and local companies and to public institutions. These services include audit, accounting and tax advice; management, information technology and human resource consulting; financial advisory services including mergers & acquisitions, business recovery, project finance and litigation support; business process outsourcing services; and legal services through a global network of affiliated law firms. Five things you didn’t know about PricewaterhouseCoopers
1. To meet their growth targets they need to hire 1,000 people a week across the world. 2. They will be the largest professional services firm in critically important emerging markets: Russia and the Former Soviet Union, India, China, Singapore, Malaysia and Latin America. 3. The high technology practice will yield revenues in excess of $1 billion with over 2,500 technology clients. 4. Work with Financial Services clients will represent more than 20% of PricewaterhouseCoopers’ international revenues. 5. They are already investing $200 million a year in new technology. A global enterprise
The new, combined organization is the result of the continuing growth in the international economy. Companies are seeking to re-define themselves to thrive in the market-place where mergers and acquisitions are increasingly important and many companies now operate without geographical boundaries. A large-scale global enterprise such as PricewaterhouseCoopers needs a solid infrastructure to meet its clients’ expectations. One element is a powerful database developed by PricewaterhouseCoopers that shares ‘best practice’ information with all its offices around the world. PricewaterhouseCoopers is also harnessing all available technology to ensure any of their advisers can work with their clients anywhere in the world, allowing them to be fully effective in serving the clients’ needs immediately. They offer businesses around the world both a wider range of services and a more integrated service than has ever been possible. This service also provides a solution to business problems of a scale and complexity that are greater than ever before. An integrated team approach
They provide a fully integrated team to tackle a company’s diverse problems. At PricewaterhouseCoopers, there are six service lines or departments which cover different areas of specialization. They are: Assurance & Business Advisory Services
Management Consulting Services
Tax & Legal Services
Financial Advisory Services
Global Human Resource Solutions
Business Process Outsourcing.
PricewaterhouseCoopers may work on one of these areas and find that the client requires help and solutions to issues in other areas. They are able to provide an integrated team of experts to give advice and offer a range of possible solutions. The first and largest of these service lines, the Assurance & Business Advisory Service is now considered in more depth. ABAS – Assurance & Business Advisory Services
At PricewaterhouseCoopers the global practice they call ‘ABAS’ provides a broad range of services which fulfill three core business needs: 1. Assurance – They conduct audits and provide assurance to clients on the financial performance and operations of their businesses. 2. Global Risk Management Solutions – They help clients to manage their business risks and thereby improve financial performance. 3. Transaction Services – They offer advice to clients about their significant transactions such as mergers & acquisitions activity. Some of the most exciting organizations from the world of banking, commerce and government come to them for advice. The client list is dominated by household names, with particular strengths in communications, financial services, retail, energy and manufacturing sectors. Assurance
Assurance is the largest part of the UK practice for PricewaterhouseCoopers and generates income from a combination of audit and business advisory assignments. In addition to an audit, many clients require business advisory services. For example, they may provide advice on joint ventures or mergers, helping companies to ‘float’ their company on the Stock Exchange or assess whether the technology or systems in place provide an accurate means of reporting the financial data. Auditing
In order that shareholders and other interested parties can make informed judgments as to the financial health of a company, it is a legal requirement that all companies have their financial facts and figures checked. This is known as an audit and must be performed by an independent registered firm of auditors. The auditors use guidance from the Accounting Standards Board to state whether in their opinion the financial information presented by the company is a ‘true and fair’ representation of that company’s financial health. The primary reporting responsibility of the auditors is, however, to the shareholders, not to the company’s directors. It is interesting to note the difference between ‘true and fair’ and 100% accurate. It is not the role of the auditors to check every individual transaction performed by a company and therefore the auditors cannot state that the figures are 100% correct, merely that, in their opinion, they are ‘true and fair’. Legislation and regulation of companies
The accounts of a company are designed to show both the performance and its current financial position. All company accounts in this country need to be produced in accordance with: 1. The Companies Act, 1985 for UK, for Pakistan Companies ordinance 1984 and 2. Accounting Standards:
Statement of Standard Accounting Practice (SSAPs)
Financial Reporting Standards (FRSs).
In essence these standards set out:
What information should be included in a company’s accounts How this information should be presented.
The Companies Act / Ordinance, decrees that companies must produce accounts for publication. The Accounting Standards Committee devised SSAPs. In 1991 the Committee was replaced by the Accounting Standards Board, which develops FRSs. The Board is gradually replacing SSAPs with FRSs, which are issued when the Board identifies a need. These two sets of standards encourage greater clarity so that the reader can fully understand the information represented. Accounting standards
FRSs are expected as business becomes more complex. How these different standards are applied varies with the type of business conducted by a company. As for any company the shareholders’ interests must be protected. The following examples of SSAPs and FRSs demonstrate the consideration that must be given in drawing up financial accounts in order that interested individuals, such as financial analysts, can clearly judge a company’s performance and position. Key standards will be considered in this and the following section. SSAP 12 Accounting for depreciation
Companies invest in assets (such as machinery) in order to produce goods or services to sell. These are known as fixed assets. In the case of the gas or oil industry, an oil rig is a fixed asset – the company must own an oil rig to supply oil or gas. All companies have some form of fixed assets although the dependence on these assets varies with the type of business. Another example could be machinery for manufacturing a car, or a building in which employees work. In this example, Global Oil has built an oil rig for £50m. In its balance sheet, cash will be reduced by £50m and fixed assets will increase by £50m. In 20 years time (the ‘economic life’), the company knows that the oil rig will need to be replaced. By the 20th year, the value of the oil rig in the company’s balance sheet will be zero. Thus, the value of the oil rig will reduce each year by a set amount (£2.5m in this example). This is known as depreciation and the annual depreciation figure is shown in the profit and loss account. SSAP 12 states that the economic life of a fixed asset should be reviewed regularly and should be stated in the notes to the accounts, together with how the rate of depreciation was determined. FRS 11 Impairment of fixed assets and goodwill
FRS 11 is a new standard and deals with any loss in value to a fixed asset, for example through damage or downturn in the economy. This is known as impairment. For example, if a pipeline from Global Oil’s oil rig is damaged, the supply of oil or gas is reduced or stopped until repairs are made. Thus the ability of the oil rig to produce oil or gas is less than expected and the fixed asset’s value is reduced. Global Oil must therefore make a general reduction in the value of the asset and charge the loss to the profit and loss account. FRS 11 states that all companies must reassess the value of their fixed assets on a regular basis to establish whether the figure in the balance sheet is a ‘fair value’. FRS 1 Cash flow statements
There are three main statements in a company’s annual report and accounts – the profit and loss account, the balance sheet and the cash flow statement. For example, while Global Oil may be highly profitable, without any cash it will be unable to pay its employees or suppliers. Clearly, when Global Oil sells oil to its customers, it needs to ensure it receives prompt payment. Cash is the lifeblood of a business and it is therefore important for a company to issue a cash flow statement. FRS 1 sets out the format and contents of a company’s cash flow statement. Accounting standards continued…
FRS 3 Reporting financial performance
This is a highly complicated standard. Essentially FRS 3 serves to make sure the information presented in a set of accounts is clear. Companies must issue a report stating the financial performance for review by its shareholders. Consistency and ease of understanding these reports allows the reader to compare the data for similar companies. This would allow a potential investor to compare competing oil or gas companies before deciding which company’s shares to buy. In this example of Global Oil, there are three subsidiaries: International Gas, International Oil and International Petrochemicals. Each of these different companies or subsidiaries must also produce their own set of accounts as should the parent company, Global Oil.
FRS 3 states how a company must set out the financial reports and accounts, the type of information that should be provided and where it should be categorized in the company statement of accounts. FRS 3 Exceptional items
FRS 3 consists of several other sections including a note on ‘exceptional items’. These are one-off situations and may result in either a profit or loss to the company. These are included in a separate section in the profit and loss account. The reasons for incurring an exceptional item are various. Examples include the general costs involved in splitting up or de-merging a utility company, such as telecommunications or gas, into their separate components. In this case study, Global Oil decided to move its head office to Edinburgh. As this move is not expected to happen regularly in the normal course of business, the cost is regarded as an exceptional cost. Although this cost is included in the profit and loss account, it is clearly marked as exceptional so that shareholders realize that a marginal reduction in profit is not a result of a reduction in revenues. FRS 3 also states that exceptional charges must be shown separately in the profit and loss account and detailed in the notes to financial statements. SSAP 25 Segmental reporting
Segmental information gives a breakdown of the different industrial sectors in which a company is involved and allows the reader of the accounts a much better understanding of where the money is made within the different parts of the company. This information may also be provided on a geographical basis if this is relevant. This standard is mostly applicable to the biggest public limited companies or if the company has a banking or insurance division. So for Global Oil, the financial information should detail the amount of business generated in oil refining, gas and petrochemicals. It should also provide information on the different geographic areas in which it operates. SSAP 25 states that the annual report and accounts for a company needs to provide a geographical and industrial breakdown of the following information: Turnover
Operating profit and loss
SSAP 9 Stocks and long-term contracts
Stock is an asset on the balance sheet and is essentially the product that a company will sell. In the case of Global Oil, its stock is oil and gas. SSAP 9 deals with how to value this stock on the balance sheet. Typically the value on the balance sheet would be the cost to produce and refine the oil into a marketable state. However, if the price of oil drops to a value below these production costs, then Global Oil cannot sell the oil at a profit. In these circumstances, the value of the oil stocks on the balance sheet must be reduced to the sale price minus all transaction costs. This is known as the net realizable value. SSAP 9 states that a company must value its stock at whichever is the lower value – the cost to produce versus the net realizable value. Conclusion
The example of Global Oil demonstrates the financial reporting standards that must be considered when preparing a company’s accounts. More standards are expected as the complexities of business transactions grow and accounting practice adapts to keep up with these changes. Such changes already observed in business are the use of derivatives and financial ‘instruments’. At PricewaterhouseCoopers, the ABAS teams are experts in their field of knowledge and exercise their judgment in interpreting how these standards apply to different companies. The implementation of the standards can vary according to the type of industry and even between companies in the same industrial sector. In order to ensure the best possible interpretation, the ABAS teams need to have a good understanding of the client’s business and industry sector.