There is a little bit of legislation that has brought us all together and I think Chicane sums it up quite well int his cartoon. Some of the tasks you have are a bit hair raising. Many of you, as elected Trustees may not have been previously exposed to some of the responsibilities you now have.
Today I am going to give you an overview of the financial governance role which you all take on board as Trustees of Energy Trusts. I will discuss:- the role which shareholders have to play in the financial management of a company The unique position which Trustees of Energy Trusts have as shareholders The interaction between governance, and the Operating & Financial review I will give you a brief insight into what the International financial Reporting Standards are. I will also outline what you should expect to see included in Financial Statements, and additional information which you may find, and how you could bring more information into the Annual Report. I will then spend some time showing you how to find hidden information within the Financial Statements which will help you as shareholders to better understand what is happening financially within the companies you own.
I thought, at this point it might be useful to give you a definition of accounting. This definition will help you to understand this role, as it differs from your role as one of the users of financial information. Accounting is:- The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information It recognises that accounting is a process concerned with capturing business events, recording their financial effect, summarising and reporting the result of those effects and interpreting those results It is concerned with economic information: while this is predominantly financial, it also allows for non-financial information Its purpose is to support “informed judgements and decisions” by users: this emphasises the decision usefulness of accounting information and the broad spectrum of “users” of that information. Users of accounting information include all those who may have an interest in the survival, profitability and growth of a business: shareholders, employees, customers, suppliers, financiers, government and society as a whole.
Shareholders have few direct rights in relation to the conduct of a business. Their main powers are to elect or appoint the , in accordance with the constitution of the company, and appoint the auditors in an annual general meeting of shareholders. They are also entitled to an annual report containing details of the company’s financial performance.
Companies obtain funds raised from shareholders – this is called equity, and Borrowings from financiers – this is called debt. Both of these constitute the “Capital employed” in the business. Later in this presentation I will refer to a term known as “WACC” or Weighted Average cost of Capital. For now I will ask you to remember that Capital is made up of both Debt and Equity.
Trustees as owners of businesses have a role which is somewhat different to the normal shareholder. Trustees, in accordance with Trust Law have a duty to “maintain and enhance the value of the Trust Fund”. The rights of Beneficiaries of the Trust to elect Trustees may influence the decision making process of Trustees, despite their obligation to make decisions as would a “prudent man of business”. This influence may from time to time introduce decision making which does not fit with the “Prudent man of Business” requirement. In other words it may be irrational. The terms of the Trust Deed that Trustees operate under may also affect the ability of Trustees make sound decision in relation to their investments, particularly if the Deed requires them to only invest in one particular investment, such as an Electricity Network Business. Because the Electricity Network System is vital to the economic structure of New Zealand, Central Government past and present and left and right, has had a history of interference in in both the electricity businesses themselves, and the role of Energy Trusts as shareholders of Electricity Network Businesses.
Send your memories back a few years. You may remember these cartoons, or ones very similar. Enron changed financial reporting forever. Listed companies, and reporting entities are now required to produce Annual Reports which meet the requirements of the International Financial Reporting Standards (IFRS).
In New Zealand the requirement to report under the new IFRS standards if effective for all balance dates after 31 March 2006. For most companies this will mean that the 31 March 2006 Balance Sheet will need to be restated in the 2007 Financial Statements. The emergence of IRFSs has in part been due to the globalisation of capital markets, but also in part a response to the failure of accounting standars to provide early warning of corporate collapses. Although the highest profile failure such as Enron and WorldCom, have been in the US, New Zealand also has its failures, such as Feltex.
IFRS has changed the names given to the financial reports back from “Statement of Financial Performance” to “Income Statement” and from “Statement of Financial Position” back to the far more understandable “Balance sheet”. Information about the financial position of the company, at the reporting date, is found in the Balance sheet, and information about the performance of the company during the period being reported is in the Income Statement. The Cash flow Statement provides information about the movement of “Cash” in and out of the company.
The “Framework” sets out the concepts underlying the preparation and presentation of financial statements for external users. The “Framework” is concerned with: The objective of financial statements The qualitative characteristics that determine decision usefulness The definition, recognition and measurement of the elements from which the financial statements are constructed Concepts of capital maintenance.
The underlying assumptions of financial statements are that they are prepared on an accruals basis and as a going concern. There are also qualitative characteristics that make the information useful to users. These are: Understandability – Users are assumed to have a reasonable knowledge of business and exonomic activities and accounting Relevance : Information must be relevant to the decision-making needs of users. The nature of relevance of the information is affected by its nature and materiality. Information is material if its omission or mis-statement could influence the economic decisions of users taken on the basis of financial statements Reliability: That is is free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent. Transactions must be accounted for and presented in accordance with their substance and economic reality and not merely their legal form, which may be contrived (this is called substance over form). It should also be noted that information may lose its relevance and reliability if there is undue delay in reporting. Comparability : this is really important for today’s exercise – Users must be able to compare the financial statements of an entity through time and be able to compare the financial statements of different entities in order to evaluate their relative financial position, performance and changes in financial position. Measurement and presentation must, therefore, be consistent throughout an entity and over time. Importantly, users must be informed of the accounting policies employed in the preparation of financial statements, and any changes in these policies and the effects of those changes. However it is not appropriate for a company to leave it accounting policies unchanged when more relevant and reliable alternatives exist. Although the term “True & Fair View” is no longer included in the Framework, it is considered that the application of the Framework with result in a “True & Fair View”.
Financial transactions are portrayed by grouping them into broad classes according to their economic characteristics. These broad classes are the elements of Financial Statements. The elements related to the measurement of the financial position in the Balance sheet are Assets, Liabilities and Equity. The elements related to the measurement of performance in the Income Statement are income and expenses.
Recognition is the process of incorporating in the Balance sheet or Income Statement an item that meets the definition of an element. Recognition depicts an item in words and a monetary amount and the inclusion of that figure in the Balance Sheet or Income Statement totals. An item that meets the definition of an element should be recognised if: It is probable that any future economic benefit associated with the item will flow from or to the entity; and The item has a cost or value that can be measured with reliability. An item that has the characteristics of an element, but does not meet the criteria for recognition should usually be disclosed in a note to the Financial Statements. An assets is not recognised in the Balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. This should be treated as an expense. A liability is recognised in the Balance sheet when it is probable that an outflow of resources which have economic benefit will result from the settlement of the obligation.
Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the Balance Sheet and Income Statement. There are four basis of measurement: Historical cost – Assets are recorded at the cash or fair value consideration given at the time of their acquisition. Current cost – Assets are carried at the cash that would have to be paid if the same or equivalent assets was acquired currently Realisable value – Assets are carried at the cash that could currently be obtained selling the asset. Present value – Assets are carried at the present discounted value of the future cash inflows that the item is expected to generate. The most common measurement basis is historical cost. However: Inventories are usually carried at the lower of cost or net realisable value Marketable investments may be carried at market value Pension liabilities are carried at present value.
The financial concept of capital comprises invested money, being equal to net assets or the equity of the company. Capital maintenance provides the linkage between concepts of capital and profits because it provides the point of reference as to how profit is measured. Under financial capital maintenance, a profit is earned only if the financial amount of net assets at the end of a period exceeds the financial amount of net assets at the beginning of a period, excluding distributions to shareholders (usually dividends) and contributions from shareholders (such as share issues).
It is the role of the Directors of a company to provide entrepreneurial leadership within a framework of prudent and effective controls, which enables risk to be assessed and managed. The board should set the company’s strategic aims and ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance. Although in practice these functions are delegated to a company’s management the responsibility can not be delegated by the Board. In New Zealand Electricity companies owned by Energy Trusts, a unique document known as the Statement of corporate Intend is agreed between the directors and shareholder. The Board also has a responsibility to ensure that a satisfactory dialogue with shareholders takes place, and the board should use the Annual General Meeting to communicate with investors and encourage participation
There is no substitute for reading the Annual Report from cover to cover before doing any other analysis. Often the Chairman’s report will allude to events which have taken place during the past 12 months, and have been accounted for in a specific way in the financial statements. Make a note of anything which comes to your attention from this review. Look for things which stand out, or may possibly be an understatement of the full story. This review will often highlight topics for questioning of the board and management at the Annual General Meeting. Specifically look for references to the creation or use of reserves. Reserves are often used by management and boards to spreads profits from good years to years in which it is expected profits may decline. The reverse can also be true. The types of reserves which you might find are: Assets revaluation – Look for the basis of the revaluation, and the events surrounding it Contingent expenses – Here you might find an accrual for anticipated costs of litigation in progress. You would expect to see a reference in the Chairman’s report to any significant litigation in progress, and the Board’s opinion on the likely outcome. It is not uncommon for a Board to considerably understate the outcome of court action. Read through the Notes to the Financial Statements. Look once again for movements in reserves and significant changes to Assets and Liabilities. Also look carefully at the note which reconciles the reported profit back to the cash received from operations. This note is quite important as it will give an indication of significant changes in debtors or creditors at balance date, which have impacted on the profit. It may also indicate a potential problem with uncollectible debtors or a rising problem with not being able to meet creditor payments on time. A single year of information is not enough. You will need several years to form an opinion of the direction a ratio is heading in.
The interpretation of any ratio and the selection of ratios depends on the industry. In particular, the ratio needs to be interpreted as a trend over time, or by comparison to industry averages. I will talk a little about this shortly. These comparisons help determine whether performance is improving and where improvement is needed. Based on the understanding of the business environment and conditions, and the information provided by ratio analysis, shareholders can make judgements about the pattern of past performance and prospects for the future. When considering the movement in a ratio over two years or more, it is important to look at possible causes for the movement. These can be gained by understanding either the numerator (top number in the ratio) or denominator (bottom number in the ratio) or both can influence the change.
Profitability ratios look at the relationship between earnings and assets and equity. Changes in these ratios can happen because of either movements in the earnings, or the capital. Interestingly an increase in sales may result in a higher profit, but not necessarily in a higher rate of profit as a percentage of sales. A change in the gearing of a business can change the Return on Assets Ratio, without changing either sales or profitability. An improvement in profit margin can be achieved by a reduction in costs, without increasing sales, indicating some improvement in business efficiency. Further investigation would be needed to ensure that short term cost reductions were not going to result in longer term reductions in turnover, or the inability in increase turnover.
The current ratio gives an indication of the ability of the company to meet its short term commitments. It should generally be in the range of 1:1 to 2:1. Too high a current ratio indicates excessive and inefficiently managed stocks, debtors and cash. Too low a current ratio may imply financial weakness, possibly an inability to meet short term commitments. The acid test is often used to measure the ability for a company to quickly meet it’s immediate commitments. It is expected that this ratio will always be around 1:1. As with working capital too high a ration implies under utilsation of cash.
These ratios are used to assess the financing or gearing structure of a company. The Debt to Equity Ratio relates to the long-term funds provided by outsiders and on which interest must be paid as a percentage of the finance provided by the owners through their capital. The gearing ratio should be compared with the average for the industry. The Debt Ratio is a measure of the relationship between total commitment of the business and total assets. The proportion of assets financed by creditors is important to shareholders, since the creditors will have a prior interest on the assets in case of liquidation. Therefore the greater the proportion of assets contributed by shareholders, the greater the protection. The Equity Ratio attempts to measure the long-term financial stability of the business and is sometime calculated to compare with the Debt Ratio. The Equity Ratio, sometime known as Proprietorship ratio , examines the relationship between Shareholders’ Equity and total Assets. The Capitalisation Ratio is another useful variation of the Debt Ratio and the Equity Ratio. As with the Debt and Equity Ratios the Capitalisation Ratio is often expressed as a true ratio, i.e. 2:1. Trends with the ratio over time and comparison with the ratios of other Network companies will provide useful information about the long-term financial stability of the business and about the degree of risk involved in financing assets with long-term debt.
Investor ratios are primarily used by shareholders or prospective shareholders of companies listed on the Stock Exchange. Of the 29 Electricity Network businesses, only Vector and Horizon are listed on the NZX, but it is worthwhile exploring these ratios. The dividend policies of the unlisted Network companies means that it is not realistic to compare these ratios between listed and non listed companies.
Cash sufficiency ratios evaluate the adequacy of cash flows to meet the company’s cash needs. Based on the Statement of cash Flows, the cash sufficiency ratios evaluate whether the cash flows are sufficient for the payment of debt, acquisition of assets and payment of dividends etc.
Cash flow efficiency ratios measure the company’s performance in terms of its efficiency in generating cash flows. Cash flow efficiency ratios assess the relationship between items in the Income account with cashflows, thus reviewing the efficiency of the company in turning accrued items into cash flows.
The cost of capital is the target return that is required to satisfy the providers of finance; both shareholders and financiers. Determining the cost of capital is important to decision makers because it establishes a minimum required return for evaluating investment proposals and similarly a target return for those investment proposals. The overall cost of capital consists of the weighted average cost of capital. This means that the relative costs of both debt and equity capital sources are considered when attempting to optimise the capital structure. The objective is minimise the overall cost of capital, which in turn should maximise the profits and returns to shareholders.
Examine the Annual Reports and financial Statements, computations and trends to identify the financial strengths and weaknesses of your company. Look for linkages, trends and opportunities to improve performance in the future. Where it is appropriate bring the KPI’s into the Statement of corporate Intent.
Collecting information is absolutely a waste of time and money if you don’t do anything as a result of the exercise. You have the mechanism to make your Directors accountable. Do not be afraid to make KPI’s part of your Director appraisal process.
Interpretation of Financial Statements ETNZ Conference 3 May 2007 Toni Owen
Governance & the Operating & Financial Review (OFR)
International Financial Reporting Standards (IFRS)
What is included in Financial Statements
Interpreting Financial Statements
Accounting is: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information “ American Accounting Association 1966”
Framework for the Preparation and Presentation of Financial Statements
The objective of the financial statements
The qualitative characteristics
Definition, recognition & measurement
Concepts of capital maintenance
The objective of the financial statements To provide information about the financial position, performance and changes in financial position of a company that is useful to a wide range of users in making economic decisions