Financial Statements Of Diageo Plc Accounting Essay

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Diageo Plc is engaged in the beverage alcohol business and has more than 1 brands of alcohol across its markets. It employs more than 20000 people in over 180 markets. Given that the United Nations have about 192 countries, then Diageos business cover almost 94% of the world and as such, it is one of the leading provider of beverages alcohol in the world. It is listed in both the London stock exchange and the New York Stock exchange and is registered in England and Wales (Reg: 23307). Because it is listed in the London and New York stock markets, it has been able to attract investors from different levels and this means it has a lot of shareholders. It started to exist in its current form in 1997. On the 1st May 2012, Diageo share price at the London Stock Exchange was 1,570.21p which represent 1.24% increase in share price (www.diageo.com). This means that the company can be attractive to investors if the share price is an important determinant of investment decisions. But investors may look at more than just the share price such as the liquidity, stock return rate and expected return (Holthausen et al, 992; Armstrong et al, 2010; Thinggaard et al, 2008 and Fischer, 2010). Additionally, external economic factors such as recessions can affect the share price if the level of sales falls or if expected returns are not promising (Rangvid, 2006; O'Keefe et al, 1985 and Collinson et al, 1993).

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The nature of financial report and the quality of information can be very important in informing all users of financial information to make valuable decisions. Because there is conflict of interest between managers trying to meet shareholders expectations and trying to raise finance through equity and borrowing, there is need for accounting standards to be set so that standardised reports can trusted. In the next sections, financial report of Diageo will be assessed to see whether it complies with accounting standards and where investors and lenders derive information from their financial statement.

2. Objectives of the paper:

The objective of this paper is to identify the type of information investors and lenders would require from the financial statement of Diageo so that they can make decisions about whether to invest and lend respectively. Second, we investigate the type of international accounting standard applied by Diageo will be presented and the emphasis will be on three components of the balance sheet. The International Accounting Standard Board (IASB) was set up in 2001 and is responsible for setting the international financial and accounting reporting standards. Many major international organisations such as Diageo Plc adopt the criteria set up by this board. Its objective is to ensure transparency and provide as much accurate and reliable information about a company as possible to all stakeholders especially investors, shareholders and creditors.

PART A:

3. Investors and lenders need for information in the financial statement of Diageo Plc

Financial reporting is basically a process in which a statement that entails all the necessary financial transactions of a company including all avenues of income, assets and liabilities, credit, sales, profits, meetings, auditing and so on are recorded (Chiappetta et al, 2009). Investor and lenders normally rely on information from the financial statement to decide whether to invest and whether the company is credit worthy respectively. What kind of information they need can depend on individual investors and lenders. However, based on the international financial reporting standards, all companies that are members are required to follow certain reporting system and standards and this has made it easier for all stakeholders to access information about the company in a common way (www.ifrs.co.uk ). Mirshekary et al (2005) found that the income statement, the balance sheet and auditors report are the most important part of a financial report for investors and other stakeholders looked at even though reliability of information in the report is not wholly trusted.

For investors and lenders, they can get important information from two main sections of the financial statement; the balance sheet and profit and loss account (income statement). The profit and loss account record all income and expenditure such as sales and purchases and profit. Investors need to know the profit and loss account because the nominal profit can help them determine the company earnings per share and how this compares with other companies and previous performance. If earnings per share are very low or zero, then investors will have little reasons to buy shares and this can reduce the expansion of the company. Earnings per share are how much of the profit goes to each share (Barth et al, 1996 and Rangvid, 2006) and can be found in the consolidated income statement of Diageo page 112. The balance sheet normally record the amount of cash the company has, its debt level, how much it spend on its different operations, assets and so on. Again, lenders may want to look at the consolidated balance sheet in page 114 to calculate the current ratio by dividing current assets by current liabilities to gauge ability to pay debt within a short period of time.

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Thus, detailed transparent financial report does enable investors and lenders to make good decisions. For example, if investors identify how shares are calculated using binomial or Monte Carlo model in the case of Diageo, then they would be able to know the strength of the method is matching their expectations (Armstrong et al, 2010and Omurgonulsen et al, 2009).

3.1. BALANCE SHEET:

The balance sheet contains records of assets, liabilities and equity. Assets consist of current and non-current assets. Current assets are those that can be convertible to cash at short notice and non-current assets are those which are convertible to cash for more than one year. The balance sheet also records current liabilities and non-current liabilities and equity levels, share and dividend payments and so on. Investor would want to carefully look at the balance sheet to see whether the company is financially sound before making any investment decisions. For example, the investor would want to know how much of the company revenue is used to finance debt because this would affect earnings per share if more of the profit goes to finance the debt. Looking at Diageos consolidated balance sheet, its total assets are higher than its total liabilities for both 2010 and 2011 and as such, one can assume that it would be able to pay its debt especially if some of the assets are liquid.

Lenders would also be interested in the level of total assets and liabilities because it helps them to forecast whether the company assets can pay for its debt. Lenders would want to know the profitability of Diageo and its ability to repay its debt. Perhaps, the current ratio (current assets divide by current liabilities which shows whether the company can pay for its debt in 1year) can be derive from the balance sheet on p114 and 147.

3.2. INCOME STATEMENT:

The income statement records the financial operations of the company and it includes sales, cost of goods, depreciations, interest expenses (receivable and payable), profits and share earnings (Penman, 2001). It is not clear from the income statement whether sales changes are real or nominal values and as such it would be useful to adjust sales for inflation in order to help investors determine whether increase in sales is due to inflation or not. The most important information that investors would want to know is earnings per share (basic or diluted) because this shows how much each share purchased will earn him money. Again, looking at the Diageo income statement, it is clear that earnings per share have been growing and this makes it attractive for investors.

Lenders would want to know profit after tax too because this can tell whether the company will finance its debt in the short and long term without having to sell any of its assets to do so. Armstrong (2010) has shown that many companies rely on debt to finance projects. For example, 95% of financed raised by USA corporations was debt and the decisions by lenders to lend mainly comes from the information they get from the accounting report. The other 5% comes from investors and they also relied on the accounting report to decide on investing.

However, it must be noted too that however much we rely on the financial report to make lending and investment decisions, unexpected economic circumstances can quickly change the information in the report. Therefore, the information should be a guide rather than an absolute criterion for decision making (Rangvid, 2006). But again, without financial report, it would be difficult to make any good decisions on investing or lending.

For example, Barth et al (1996) found that most investors in UK and Australia look at the trends in different earnings per shares before making investment decisions since EPS gives profitability details and future prospects on share prices.

PART B:

4. Balance sheet items and its compliance with international accounting standard

The objective of international accounting standard is to minimise the cost of asymmetric financial information for all users of financial information such as investors, lenders and other stakeholders by ensuring that certain governance and standards are met when reporting the balance sheet and income statement (Financial Reporting Council). Sufi (2007) highlighted that accounting quality is vital in lending and investment decisions and if there is asymmetric information, lenders are more likely to monitor borrowers. The idea it to make sure what is reported in the financial statement is as accurate and in compliance with the law as possible; and it is as transparent and easy to understand; and to follow a common approach to reporting so that differences in results does not emanate from differences in the method used to calculate the data (www.ifrs.co.uk ).

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For example, measurement methods of components of inventories should be the same across companies so that investors and users can make comparisons using common denominator. Fischer et al (2010) argued that differences in using certain standards of reporting and measurement can lead to different valuations and this makes it difficult for investors and lenders to make any comparisons. It is also a legal obligation for all listed companies like Diageo to do their financial statements based on the accounting standards and procedures. Additionally, managers may deliberately provide accounting reports to put the company in good light and this is why we have the accounting standards set (Armstrong et al, 2010).

This section will discuss three aspects of the balance sheet and identify which accounting standard is applied and how effective the information is for users. The International Accounting Standard (IAS) 39 is the one that determine what should constitute the balance sheet and what each item should include in order to providing as much information to users of financial information as possible. The fundamental objective of accounting standards is to ensure that financial statement is transparent, accurate and reliable. Therefore, we discuss IAS 38 which deals with intangible assets under the non-current assets section of Diageo's consolidated balance sheet; IAS 2 which deals with Inventories under current assets section and finally IAS 23 which deals with borrowings under current liabilities section.

4.1: IAS 38: Intangible assets

Intangible assets are non- monetary assets that do not have physical nature (ifrs). This includes brands, goodwill, computer software and patents, licences and copyrights. The standard deals with how the assets are identified, measured and controlled and required the company to provide a detailed description of what constitute its intangible assets. Control here means the company has the power to exert future benefit from the asset; identified means which aspects of intangible are covered in the standard while measured means being able to put a value on it so that in the future revenue can be gained from it and or its cost to the company is minimal. There are different sections of IAS 38 such as IAS 38.1 which deals with disclosure of intangible assets and IAS38.12 which deals with how to identify them.

Looking at the balance sheet in p.114, it is clear that intangible assets accounts for the majority of all Diagoe's assets. In page 78, Diageo has provided a detailed explanation of management judgement in determining intangible assets based on the life expectancy of that asset and its economic value. In addition, p.140-142 provided detailed description of all the intangible assets it has with their values and significance of each asset to the business especially the brands. Since IAS 38 required detailed statement of all intangible assets and the method used to measure its value, we can say that Diageo has followed this standard quite well if we read through page 78. For example, Diageo uses weighted average cost of its capital to generate discount for estimates of cash flow. This discount rate is then applied to estimate future operating cash flow which is then compared to the net carrying value of each acquired brand. What this does is to give investors the ability to identify which brands generate more income for the company so that they can make decisions on how to invest. Also, it gives management the ability to identify its cash cows. Indeed, in p.19, Diageo mentioned that its financial statement is reported in accordance with the IFRS. Thinggaard et al (2008) highlighted that financial information is relevant for investors and lenders decision making process which is why certain governance standards must be followed.

Therefore, if we look at p. 78, 114 and 140-142, it is clear that Diageo has provided detailed information on all its intangibles, the cost of acquiring some of them such as each brand and computer software.

4.2: IAS 2: Inventories

Inventories are assets that are used in the production process such as raw materials, other goods needed in the production process and the finished good that are ready for sale and resale. The standard requires that the company should record all the cost including transport, other overheads involved in the finished good production (IAS2.10) but should not include administrative overheads that are not related to production, storage cost, selling cost, foreign exchange cost and interest cost. The inventories are required to be stated at lower of cost and net realisable value (IAS 2.9) as mentioned in Diageo statement on p.119. Weighted average cost and first-in-first -out (FIFO) formulas are allowed to measure cost but not the LIFO after 2003. Therefore, Diageo used FIFO and cost based on actual usage basis to determine cost of inventories (see page 119).

If the IAS requires all cost related to the production process be reported, then one should expect borrowings that are directly used to purchase raw materials will be included. But since the standard stated that interest cost should not be included, Diageo did not include it under inventories. Rather, all borrowings are include in IAS 23.

Looking at page 114 and 146, inventories are the second most important asset for Diageo given its numerical value. We can argue that it is the production process that actually generates revenue and cash flow for the business in a sustainable way. Management can easily identify cost associated with each component of inventory so that they can forecast the expected revenue and pricing level required.

4.3: IAS 23: Borrowings

The objective of this standard is how to treat borrowing cost and this includes interest on overdrafts, premiums on borrowings, amortisation of discounts, exchange differences on foreign currency borrowings and finance charges in respect of finance leases recognised in IAS17. Borrowings that are directly attributed to acquiring, producing and constructing of assets and takes some time before it is ready for use or sale are considered part of that assets cost and should therefore be capitalised. However, inventories that are manufactured or produced in large quantities repetitively and takes time before they finish such as maturing whisky are not included in IAS 23 if part of the cost is borrowed and instead are recognised in IAS 23.8 even though they may have qualified for IAS 23. It was not surprising therefore that Diageo did not include cost of borrowing relating to purchase of inventories because the IAS mentioned so.

While p. 114 only gives the total value of borrowings by Diageo in the balance sheet, in p.74 and 148, Diageo defined what it has included in its borrowing cost and how it is measured using the effective interest rate and amortised cost. Also included is the various types of borrowings such as overdrafts, time of maturity and interest rate and currency hedging. This gives lenders adequate information to decide if the debt level of Diageo is sustainable and the level of risk so that it can upgrade or downgrade the premium charged. Similarly, it gives shareholders information about the net financial worth of the entire Diageo less all borrowings.

Watts et al (1990) argued that financial report can play an important part in reducing the conflicts between equity holders who may want higher dividend payments and lenders who want minimise probability of default. In the disclosure standard, IAS 23 required that the company identify which capitalisation rate is used and the amount of borrowing cost capitalised during a given period in addition to identifying the accounting policy adopted. As mentioned, page 74 and 148 gives all this information in detail. Importantly, Diageo does allow independent auditors like KPMG to audit and verify their accounts and ascertain if they comply with the standards. The KPMG report (page 111) has highlighted that the statement is accurate and they have been provided with all the relevant information they need to audit.

Therefore, in general, Diageo has complied with the standards set out and are aware of the reporting requirements of the standards.