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Introduction to Financial Statements

This document provides a brief introduction to the structure, content and format of company accounts.

1. The legal framework The shareholders of most publicly listed companies do not have any involvement in the day-to-day management of the business. The directors run the business but are required by law to prepare a report to the shareholders to show how they are managing the company and its assets. This report to the shareholders is known as the 'annual report' or 'annual report and financial statements'. The content and presentation of annual reports is controlled in the following ways: The Companies Act 1985 provides standard formats for the content and presentation of accounts. The Statements of Standard Accounting Practice (SSAPs) and, more recently, Financial Reporting Standards (FRSs) set out detailed rules for accounting for a wide range of transactions. In addition, where shares are quoted on the London Stock Exchange, companies are required to comply with the rules of the London Stock Exchange. Amongst other things these rules stipulate certain information to be included in the accounts.

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The Companies Act also permits companies to produce an 'annual review and summary financial statement' for those shareholders who do not wish to receive a full annual report. This is a much shorter document, which omits much of the legal and technical matter contained in the full report, but in summary form still enables shareholders to be informed about a group's performance. 2. Company accounts Company accounts contain three key financial statements, the balance sheet, the profit and loss account and the cash flow statement. 2.1 The balance sheet A company's balance sheet is a snapshot of its assets and liabilities at a single point in time. It can help answer two basic questions about a company: a) Where did the money necessary to fund the business come from? b) What did the money acquire? A simple fictional balance sheet format is set out below: Millstream plc balance sheet as at 31 December 2002 m share capital + 222 fixed assets + reserves + 1,089 working capital + loan capital 33 investments provisions 1,344 m 1,742 781 56 (1,235) 1,344

The total of the components on the left hand side must always equal the total of those on the right - hence the term 'balance' sheet. Let's have a look at the different components in more detail. There are three sources of money for a business: 2.2 Share capital This is money permanently invested by the owners of a business. In return for their investment they get 'shares' in the company and, hopefully annual dividends. 2.3 Reserves This includes the balance of any profit that has been generated and put back into the business. This profit balance is often referred to as 'retained earnings', but is shown on the balance sheet as 'profit and loss account' reserve. There are also other reserves which are mentioned later. 2.4 Loan capital This is money that has been borrowed from someone else, such as a bank, and which at some stage will be repaid. You may also hear it described as 'debt' or 'borrowings'.

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Having looked at the sources of finance, we will now look at where that money has been spent or invested. Broadly speaking, a business will spend or invest its money on the following: 2.5 Fixed assets These are items or 'assets' that the company means to keep and use on a continuing basis. Examples include land and buildings, fixtures and fittings, and equipment. 2.6 Working capital Working capital is the money tied up in the businesses' trading cycle - for Centrica the cycle includes buying gas and transportation, materials and other goods and services, paying salaries and collecting receipts from customers. The working capital section of the balance sheet is a snapshot of this trading cycle at the balance sheet date. It shows: The value of goods in warehouses and in stores - stock How much money customers owe the company for goods they have received but not yet paid for - debtors How much cash is sitting in the bank account - cash How much money the company owes to suppliers for products or services it has received but not yet paid for - creditors.

In a company's balance sheet, the stock, debtors and cash are grouped together under the heading 'Current assets' - being assets which the company intends to convert into cash in the near future or which are already in the form of cash. The working capital in Millstream plc is the total of all these elements: working capital 781m = stock + debtors + cash m 168 2,117 18 - creditors 1,522m

2.7 Investments Apart from investing in fixed assets and working capital, a company may also place money in deposit accounts or acquire shares in other companies. Investments will appear in the balance sheet as fixed assets if the intention is to hold them for the long-term and as current assets if it is intended to convert them into cash in the short-term.

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2.8 Provisions Provisions, like creditors are a form of liability. Provisions are used to set aside, or provide, for costs that relate to past performance but which cannot be easily valued, usually because they are subject to some uncertainty. 2.9 Different formats The above balance sheet format (often called the 'horizontal format') clearly shows the division between 'sources' of financing and 'uses' of funds invested. In practice however, companies, including Centrica, produce balance sheets in a 'vertical format', an example of which is shown below: Net Assets fixed assets + current assets creditors due within one year creditors due after more than one year provisions m 1,742 2,359 (1,462) (93) (1,235) 1,311 Total shareholders' funds = share capital + reserves m 222 1,089 1,311

As you can see, this format is not merely a vertical representation of the one we saw earlier, since the components have been ordered in a slightly different way. Instead of including loan capital with share capital and reserves as part of the sources of finance, it is deducted from the top half of the balance sheet and included within creditors. The top half of the balance sheet now represents the 'Total assets minus total liabilities' of the company. This may be referred to as 'Net Assets'. Meanwhile, all we have left in the bottom half of the balance sheet is the share capital and reserves, which is often described as 'Shareholders' funds'. The columns still balance with the Net Assets equal to the Shareholders' funds. 2.10 Profit and loss account The profit and loss account is the second main financial statement. It sets out what a company has earned from selling its goods and services in a period and deducts the costs directly related to producing and selling these items as well as other overheads. Millstream plc underlying profit and loss account before exceptional items for the year ended 31 December 2002 Turnover (sales) Cost of sale Gross profit Operating costs Operating profit Other income Net interest receivable Profit on ordinary activities before taxation Taxation Profit attributable to shareholders m 7,842 (6,631) 1,211 (1,036) 175 (2) 39 212 (168) 44

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Gross profit is turnover less the direct costs of buying goods or providing services which have been sold. Operating profit is gross profit less the other costs (including marketing and administration) of operating the business. A profit and loss account is usually prepared to cover transactions in a period, typically a month or a company's financial year. Companies whose shares are quoted on the London Stock Exchange also publish 'interim' profit and loss accounts for the first six months of each year and a few publish quarterly accounts. Centrica prepares monthly profit and loss accounts for its own internal monitoring purposes and publishes results to the Stock Exchange and shareholders half yearly. In the UK, the order of the items shown in the profit and loss account is specified by statute (the Companies Act 1985). 2.11 Cash flow statement Cash flow is of critical importance to all businesses. To give users of accounts the information they require about the company's historical cash flow a third financial statement, the cash flow statement, is produced. This shows where the cash in the business has come from and where it has been spent. It starts by showing the cash that has been generated by the business from its day-to-day trading activities. Then it shows in turn, cash inflows and outflows relating to interest, dividends received, taxation, investments in fixed assets, acquisitions and disposals of subsidiaries and associated undertakings, dividends paid, current asset liquid investments and cash flows relating to financing, such as increases in share capital or loans. Millstream plc cash flow statement for the year ended 31 December 2002 Cash inflow from operating activities before exceptional payments Exceptional payments Cash inflow from operating activities Returns on investments and servicing of finance Taxation Capital expenditure and financial investment Acquisitions and disposals Equity dividends paid Cash inflow before use of liquid resources and financing Management of liquid resources Financing Increase in cash m 1,028 (653) 375 45 (112) (87) 3 224 (44) (178) 2

The bottom line of the cash flow statement shows the increase or decrease in cash balances. Cash is defined as 'cash in hand, overnight deposits and overnight borrowings'. Surplus cash is invested in short-term deposits to maximise interest receipts. In 2002, Millstream plc generated 224 million of cash in excess of its immediate business requirements, of which 44 million was invested in short-term deposits and 178 million was used to repay borrowings. It is important to understand the fundamental difference between the profit and loss account and the cash flow statement.

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The cash flow statement, as its name suggests, is only concerned with the cash that comes into, and goes out of, the business. The profit and loss account brings together all the income receivable and expenses payable relating to the year, regardless of whether or not cash has been received or paid for those transactions. For example, the cash flow statement would only reflect the cash that has been received for goods sold in the year whereas the profit and loss account shows all the sales made in the year whether the cash has been received or not. 3 Group accounts Most large businesses consist of a number of companies and businesses which trade as a group. These businesses prepares a group balance sheet, a group profit and loss account and a group cash flow statement combining or 'consolidating' the results of all the companies in the group for each financial period. 3.1 Group structures A group of companies involves a holding or 'parent' company and one or more 'subsidiary' companies. In the case of Centrica, the holding company is Centrica plc. This company owns shares either directly or indirectly through a subsidiary holding company (in Centrica's case, GB Gas Holdings Limited) in each of the other Centrica companies. In most cases 100% of the share capital of subsidiaries is held. 3.2 Types of investment The way in which a holding company discloses its investments in other companies in its accounts depends on the level of shareholding and degree of 'control' it has over the other companies. Company law recognises three levels of investment which a company may have in other companies: Investments in subsidiaries A subsidiary (strictly, a 'subsidiary undertaking') is a company in which the holding company is said to have a 'dominant influence'. Usually, this means that the holding company owns the majority (i.e. more than 50%) of the voting shares of the other company. Alternatively, the holding company may have a dominant influence because it has the power to control the board of directors or it can influence the operating decisions in some other way. A subsidiary may be wholly-owned (i.e. 100% of the shares are owned) or partially-owned (less than 100% but greater than 50%). In both cases, all of the assets and liabilities of the subsidiary are included in each asset and liability category (line-by-line) of the group balance sheet. Hence, the assets of the group are the total of those of the holding company and its subsidiaries. Where a subsidiary is only partly-owned, we still show all the assets and liabilities in the consolidated balance sheet. The value of the proportion of the

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net assets owned by third parties is shown as 'minority interests in equity' in the financing part of the balance sheet. Consolidation reflects control not ownership. The results of a subsidiary are included in the profit and loss account for a group in a similar way. Results for the subsidiary are added to those of the holding company to arrive at the group figures, although sales from one company to another within the group are excluded. Again, if the subsidiary is not wholly-owned we include the total figure for sales and profit but then deduct, as 'minority interest', the equity portion that belongs to the outside shareholders. Investments in associates An associate (strictly, an 'associated undertaking') is a company in which the holding company has a 'participating interest'. A participating interest is not the same as a dominant influence. It means that the holding company participates in the operating policies of the associate, but does not control those policies. The most common method of achieving a participating influence is by owning 20% or more (but less than 50%) of the voting shares in another company. Associates are accounted for differently from subsidiaries in group accounts. The group's share of the net assets of the associate is brought into the group balance sheet as one figure. Similarly, in the profit and loss account, the group's share of the profit or loss of the associate is brought in as a single figure, shown separately on the face of the statement. This is known as equity accounting. Other investments in companies Companies in which the investing company holds less than 20% of the voting share capital and/or has no influence over operating policies are called 'other investments'. These are shown in the balance sheet as fixed asset investments providing it is the company's intention to hold them for the long-term. Otherwise they would be shown as current assets. 3.3 Presenting group accounts Looking at Millstream plc's balance sheet, you will notice that there are two balance sheets covering the position at the end of 2001 and 2002 for both the Group and the Company. As explained earlier, the group balance sheet includes the assets and liabilities of the holding company, Millstream plc, as well as the assets and liabilities of all its subsidiaries. The company balance sheet shows the assets and liabilities of the holding company as they appear in the books of Millstream plc itself. This presentation of a balance sheet for both the 'Group' and the 'Company' is a requirement of Company Law. There is an exemption from the requirement to publish a company profit and loss account and therefore only a group statement is published, as you can see in the Annual Report & Accounts. There is a similar exemption for publishing a company cash flow statement.

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4 Fundamental accounting concepts 4.1 Going concern Almost invariably it is assumed that a business will continue to operate for the foreseeable future (usually by looking forward at least a year from the date that the annual accounts are signed). This is very important as it particularly affects the valuation of the assets and liabilities of a company. If the company is going to cease trading, the assets should be valued at realisable or scrap value. 4.2 Consistency Assets, liabilities and transactions must be accounted for consistently from one accounting period to the next. 4.3 Accruals (or matching) The accruals concept means that transactions are recognised as they are incurred rather than when cash is received or paid. Revenues (otherwise known as sales income or turnover) must be matched, as far as possible, with their associated costs and should be included in the profit and loss account for the period to which the sales relate. 4.4 Prudence This is a common-sense approach suggesting that accounts should be prudent in recognising profits and losses. Accounts should only include profits when it is reasonably certain that they have actually arisen. On the other hand, provision should be made for all known liabilities whether the amount is known with certainty or is merely the best estimate available. 5 Principal accounting policies In addition to the above concepts, accounts are prepared using other policies which are consistently applied. These main policies can usually be found in the Notes to the financial statements section of the Annual Report.

Centrica plc, registered in England and Wales no. 3033654. Registered office: Millstream, Maidenhead Road, Windsor, Berks. SL4 5GD

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