Page 4: Accounting standards
Several of the SSAPs and FRSs are detailed in the context of a fictional oil company (Global Oil). Further 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 Cashflow 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.