CASE STUDY SOLUTIONS

Part 1
(1a) The phrase “the financial statements give a true and fair view” is not defined in law. According to
the Financial Reporting Council:

“True and fair is not something that is merely a separate add on to accounting standards. Rather the
whole essence of standards is to provide for recognition, measurement, presentation and disclosure
for specific aspects of financial reporting in a way that reflects economic reality and hence that
provides a true and fair view.”
www.frc.org.uk/FRC-Documents/FRC/Paper-True-and-Fair.pdf

True, therefore, suggests the financial statements are factually correct and free from any material
misstatements which would make a difference to the decisions of users. Fair suggests the information in
the financial statements is unbiased and reflects the economic substance rather than legal form of
transactions.

(1b) It is not the aim of the statutory audit to detect fraud. According to the ICAEW:

“The purpose of the statutory audit is to provide an independent opinion to the shareholders on the
truth and fairness of the financial statements, whether they have been properly prepared in
accordance with the Companies Act 1985, and to report by exception to the shareholders on the
other requirements of company law such as where, in the auditors’ opinion, proper accounting
records have not been kept.”
www.icaew.com/~/media/Files/Technical/Audit-and-assurance/audit-quality/audit-quality-
forum/meeting-notes-2006/july-2006-audit-purpose.pdf

Responsibility for the prevention and detection of fraud rests with the Board of directors, not with the
auditors.

(1c) The directors (agent) have a fiduciary responsibility to manage the company for the benefit of the
shareholders (principal). This responsibility means that the directors are accountable to the shareholders.
The role of the audit is to monitor the performance of the directors and management by carrying out an
independent review of the financial statements and to ensure that the directors are properly accountable
to shareholders.

(1d) The Conceptual Framework for Financial Reporting (2010) defines faithful representation as follows:

“A faithful representation is complete, neutral and free from error. Information is complete if a user
can understand the phenomenon being depicted. This may require descriptions and explanations as
well as a numerical depiction. Information is neutral if it is without bias in its selection or
presentation. In other words, it is not intentionally overstated, understated, emphasised or de-
emphasised. Neutral information does not mean the information does not have an impact on
decisions. By definition, useful information affects decisions. Likewise, free from error does not
mean perfectly accurate. It means that there are no errors in the process used to produce the
information and no errors in its description.”

The important thing to recognise here (highlighted in bold) is what faithful representaion does not
mean- it does not mean that the information in the Annual Report is 100% accurate. The need for
“judgements, estimations and assumptions” means that such accuracy is impossible but that does not
mean that the principles set out in the above definition have not been followed.

(1e) Collier (pp. 86-87) refers to Understandability, Relevance, Reliability and Comparability as the
qualitative characteristics which make accounting information useful to users. The Conceptual
Framework for Financial Reporting (2010) approved by the IASB in September 2010 identifies two
fundamental qualitative characteristics - Relevance and Faithful Representation - and four enhancing
qualitative characteristics - Comparability, Verifiability, Timeliness and Understandability.

For more information on these characteristics go to: www.iasplus.com/en-gb/standards/other/framework

The examples available in the Annual Report to illustrate these characteristics are numerous and varied,
so it would be impossible to give a comprehensive list here. Some suggestions are as follows:

• Relevance - to decision making – ten year history showing trends in performance.

• Faithful Representation – defined in (1d) – this is something it is impossible for an
outsider to assess, but we have some reassurance on this from the report of the
auditor.
• Comparability - the figures for the previous year (2011) are given alongside the
current figures.
• Verifiability – apart from obvious figures such as the dividend paid and the share price,
it may be difficult for the outsider to verify the content of the financial statements but
again the audit report suggests that the auditor has been able to do this.
• Timeliness – the annual report is published within 3 months of the year end date.
• Understandability – key figures and highlights for the year are summarised at the
beginning of the report and graphs and tables are used to show trends.

If you are in any doubt about the examples you have chosen post your ideas on the forum so everyone
can discuss them.
CASE STUDY SOLUTIONS
Part II
(2a) Sales have increased by over 50% in the decade, but the growth has not been consistent throughout
the period with falls in revenue experienced in the years to January 2009 and to January 2011. The
profile of profits – on trading, after interest and tax, and after dividends – reflects this substantial growth
with slight dips from 2005 to 2006 and 2008 to 2009. The absolute level of dividends is misleading
because Next’s repurchases have reduced the number of shares by over 40%. In relative terms (that is on
a per-share basis), dividends have consistently risen apart from in 2009.

(2b)

Capital Employed = Fixed Assets + Current Assets – Current liabilities

= 714m + 1,140m – 742m
= 1,112m

Or

Capital Employed = Long term liabilities + Capital and Reserves

= 889m+ 223m
= 1,112m

Comparative figure for 2011 was £959m (£727m + £232m)

Capital employed is stable and has risen slightly.

(2c) Shareholders’ funds are the accumulated wealth of the shareholders as reflected on the Statement
of Financial Position. It is the total of capital and reserves, and as such includes:

• The original capital issued by the company at the price at which it was issued.
• The share premium account.
• The accumulated retained profits (i.e. the annual profit left after distribution of the
dividend).
• Accumulated reserves.

Accumulated reserves can reflect many things, but include gains or losses not passed through the
Income Statement, but shown instead in the Statement of Other Comprehensive Income. This could arise
through the disposal of an asset (e.g. a building) for a price that differs from its book value. It can also
arise where book values are continually updated to reflect their realisable value in the market (e.g.
financial investments).

(2d) A share premium arises when shares are issued by the company at a price greater than their face
value. The nominal value of a Next plc share is £0.10. Let’s assume 1000 shares are issued at a price of
£1. The company would receive £1000, which would be a DR to cash. The nominal value of the shares
issued, £100, would be a CR to Share Capital and the remaining £900 would be a CR to Share Premium.

(2e) In Next’s case, there is a significant negative balance on “other reserves” of £1.5 billion.
Investigation of the Notes to the accounts shows that most of this arose in 2002 when a capital
reconstruction was carried out to facilitate the ongoing programme of share repurchase. The buyback of
shares at market price will reduce reserves because the difference between the nominal value of the
share (10p) and the price paid will be deducted from reserves, in Next’s case from Retained Earnings. For
example: if shares have been issued at face value (10p) and, at a later date, are repurchased at a market
price of £5.00, the book-keeping entries for the repurchase would be:

CR Cash £5.00

DR Share Capital £0.10

DR Reserves £4.90

Since the balance on capital and reserve accounts are normally credits, this debit to reserves will result in
a reduction in the reserve balance.

(2f) The immediate cash position of a company should take account of any bank overdraft because this is
recallable without warning. For Next, it has cash and short term deposits of £56m with an overdraft of
£7m, and thus net cash of £49m. In 2011, the bank overdraft was higher (£10m) and the net position
was £39m. In addition to which there was a £115m bank loan which had been repaid by January 2012.

(2g) Assets are items that are expected to bring future economic benefit. Pre-payments are costs paid in
advance of the period in which the benefit for that payment is received. For example if we pay a
quarterly rental for the use of premises on the 1st January and our year end is the 31st January, the
economic benefit for two thirds of this payment will be received in the following accounting period.
Therefore, two thirds of the rental payment is a current asset in the Statement of Financial Position at the
31st January.

(2h) In most cases, a non-current liability is an obligation to make payments after a year into the future;
it is for this reason often termed a long-term or non-current liability. The property lease incentives are
cash received in advance, which cannot be credited to the income statement until the future period to
which they relate. Until such time as it can be recognised, it remains repayable and is therefore a non
current liability.

(2i) Under the historical cost convention, fixed assets are recorded at the price paid for them at the time
of purchase and then depreciated over the life of the asset.

Property prices tend to rise – and have done so dramatically in the UK over the long term. Given the cost
of freehold premises is stated as £74m (Note 11) and that acquisition could have been made 20 years
ago, it is possible that the value shown is understated and that the sale of those premises could add
substantially to shareholders’ funds. A policy that depreciates freehold buildings by 2% per annum is
likely to lead to a further understatement of the realisable value of retail premises.

(2j) Next plc has cash in hand, current assets that cover current liabilities, and fixed assets that cover the
debt finance (i.e. the bond). The growth in fixed assets and stock is adequate to keep pace with the
growth in sales, and there is no sign of under-capitalisation (i.e. insufficient capital to fund productive
investment for the future). The shareholders’ funds figure of £223m is low for a £3.4bn turnover
business, but this is a result of the share buy back strategy which has been pursued since 2000. Providing
retained profits sustain their current level, there appears to be no problem in meeting the longer-term
liabilities and the balance sheet looks strong.
CASE STUDY SOLUTIONS
Part III
(3a) The following notes might emerge from a quick review:

• Sales have grown by just under 4.5% which is the highest rate since 2007 and justifies
the CEO’s comment that faced with an “economic storm [...] NEXT has performed
remarkably well”.
margin
• Operating profit is almost 17.5% and has risen by slightly more than sales (5.7%), so
some costs must have decreased disproportionately,
• Unusually in a retail clothing business in such difficult trading conditions, there is no
evidence of price discounting as the costs of goods sold has risen by only 2.7%.
• Depreciation is unchanged and lease rentals have fallen slightly even though additional
space has been acquired during the year.
• There are no anomalous increases in interest or tax, and so earnings are marginally up.
• The cashflow statement shows a managed position – £10m movement in a £3.4bn
turnover business; the free cashflow of £456m after re-investing in operations has been
used to repay the bank loan, pay dividends and repurchase shares; payment of
dividends and repurchase of shares are both discretionary activities.
• In reviewing the detail of cashflows, note the expected increases in stock, debtors, and
creditors (because of business growth), but reference to the balance sheet’s opening
and closing levels suggests the almost 12% rise in debtors is excessive – perhaps
management have granted more lenient credit terms. ?? where 12 comes from ?
• The repayment of a £115m bank loan (current liability) is evident from the cashflow
statement, but the balance sheet shows that £181m additional corporate bonds (non-
current liabilities) have been issued during the year.
• No other inconsistent movements are evident in the balance sheet.

(3b)

Operating Profit
Net Margin =
Sales

Use Note 3 to get data

Next Retail

324
= 14.7%
2,198

Next Directory

263
= 24.2%
1,089

Next International

8
= 10.5%
76

Next Sourcing

21
= 4.0%
519

By far the highest margin is achieved by Next Directory, which may be a result of lower overhead costs in
online trading. Alternatively, gross margins on home sales (80% of which were through online
shopping) may be higher than on clothing. (The Chief Executive has commented on the effect of soaring
cotton prices in his review.) The results for Next Sourcing are not reliable because almost all of its sales
are internal and therefore subject to artificially set transfer prices.

It is evident that Next Directory is the fastest growing and most profitable part of the business helping to
offset the very difficult UK retail trading environment faced by Next Retail. These two segments account
for nearly 95% of the total revenues and 96% of the capital expenditure.

(3c) Measures:

Debtors
Debtors Settlement Period = x 365
Sales

609
x 365 = 65 days (2012)
3,441

545
x 365 = 60 days (2011)
3,298

Current Assets – Stock

Acid Test =
Current Liabilities

1,140 – 372
742
= 768:742 = 1.04 (2012)

1,067 – 368
833
= 699:833 = 0.84 (2011)

Debt
Gearing =
Debt + Equity

652 652
= = 74.5% (2012)
652 + 233 875

471 + 115 586

= = 71.6% (2011)
(471 + 115) + 232 818

Profit before Interest and Tax (Operating Profit)

Interest Cover =
Interest

598
= 21 times (2012)
28

566
= 24 times (2011)
23
 Profit after Tax (Earnings)
Return on Equity =
Shareholders’ Funds

427
= 191.5% (2012)
233

393
= 169.4% (2011)
232

Earnings (Profit after Tax)

Earnings per Share =
Numbers of Shares in Issues

427
= £2.53 (2012)
169

393
= £2.17 (2011)
181

The first two measures are indicators of liquidity. The average settlement period of Next’s customers has
extended since 2011, but the acid test has improved. The acid test is strictly an examination of monetary
assets and liabilities and more would need to be known about the nature of other creditors, accruals,
and liabilities due within the year. In the context of the clothing industry, stock can be more readily
converted into cash through discounting. With the increased cash in hand and the repayment of the
unsecured bank loan, liquidity is unlikely to present a problem for Next plc.

The second pair of measures relate to risk. Gearing has risen, but although it has fallen slightly, the cover
for interest on debt is generous. Equity has been artificially reduced by the repurchasing policy of
management, and the asset base of the balance sheet can support more debt if necessary. Technically,
gearing is high but the risk is being controlled by Next’s management.

The final pair represent shareholder returns and it is in these that the benefit of the repurchase policy is
evident. ROE is high and increasing as earnings rise and shareholders funds fall. Similarly, the persistent
reduction in the number of shares in circulation automatically puts upward pressure upon EPS.

3d) The proposed final dividend has not been accrued in the accounts because it “is subject to approval
by shareholders at the Annual General Meeting” (Note 9). In the past the proposed final dividend would
have been shown as a Current Liability because it was expected to be paid in the coming year. However,
under FRS 21 effective from 2005, the dividend can only be included as a liability if it has been approved
by the shareholders at the year end. The ICAEW explains the treatment as follows:

“For dividends ‘paid’ after the year-end, reference needs to be made to accounting standards on
provisions. These state that for it to be provided at the year-end there must be an obligation at the
year-end.
A history of paying dividends does not generate an obligation; neither does a declaration of a
dividend after the year-end. For a dividend to be provided at the year-end, it must be approved by
the shareholders before the year-end.”
www.icaew.com/en/members/practice-resources/icaew-practice-support-
services/practicewire/news/dealing-with-dividends
CASE STUDY SOLUTIONS
Part IV
(4a) UK listed companies have been required to use IFRS since 2005. Like UK accounting standards, IFRS
are principles based rather than rules based and are an important tool for achieving comparability of
financial statements. The global economic crisis has reinforced the need for transparent and consistent
information to be made available for decision making by investors and other users of accounting
information.

The use of IFRS means that:

• Multinationals can prepare reports to a single standard rather than incurring the cost of
reporting according to different standards in different countries.
• It is easier to compare a UK company and its foreign competitors because reports are
prepared on the same basis.
• It is easier to raise capital abroad because of the greater comparability and
transparency.
• Where there are foreign subsidiaries the same accounting methods and disclosures are
used across the business.
• It is easier to evaluate a business in a takeover or merger situation.

(4b) Going-concern is an accounting convention explained in Section 2. It is the presumption that there
is no known impediment to the business continuing to trade in the future – fundamentally, that there is
no risk of insolvency. This means that asset values are justified by their potential to generate future
commercial returns and liabilities that would arise in the event of difficulty are not recognised.

The liquidation value of a business is likely to be much less than even its historic cost as many of its
assets are specific to the business context. In Next’s case, its fixed assets include high street property and
vehicles which have general utility and, in the case of the owned property, would probably fetch a value
greater than historically reported. However, as with any ‘fashion’ business, the carrying value of its stock
is vulnerable and could require heavy discounting to liquidate – though there is a readily available
market. Its debtors are its customers and include store card finance – they are not going to be
susceptible to a write down any greater than is usual through consumer credit risk. If Next were not a
going-concern, the major implication would be on liabilities related to closure.

(4c) The following list is not exhaustive:

• “Comply or explain” principle – Next have ‘complied’.

• Going-concern declaration.
• Three independent review committees.
• Non-executive meetings without any executive influence.
• Separation of role of chairman and CEO.
• Affirmation of reasonable effectiveness of internal controls.
• Considered use of auditors beyond compliance work (not compliant with SOX).
• Demonstration of shareholder communication.
• Evidence of a coherent strategic planning framework.
• Fair treatment of shareholders in the selectivity and timing of announcements
(avoidance of insider trading).
• Transparency of governance practices (through the website).
 • Formal review of Board effectiveness.
• Various risk management dimensions (this point is enlarged in Question 4d).

(4d) COSO Framework steps:

(1) Control Environment:

• “The Board is responsible for major policy decisions whilst delegating more detailed
matters to its committees and officers”. (p. 25)
• “The Board promotes the development of a strong control culture within the
business”. (p. 28)
• “The Board sets guidance on the general level of risk which is acceptable and has a
considered approach to evaluating risk and reward”. (p. 28)
• “The system of internal control is designed to manage, rather than eliminate, the
risk of failure to achieve business objectives and can only provide reasonable and
not absolute assurance against material misstatement or loss”. (p. 25)

(2) Risk Assessment:

• “During the year the Board addressed the business risks which had been identified
as key, taking into account any changes in circumstances over the period”. (p28)

(3) Control Activities:

• The NEXT Brand meetings “cover risk management of all business areas in respect
of the NEXT Brand, including product, sales, property, warehousing, systems and
personnel”. (p27)
• “[...] the Group’s management structure and timely and continuous monitoring of
key performance indicators provide the ability to identify promptly any material
areas of concern. Business continuity plans, procedures manuals, and codes of
conduct are maintained in respect of specific major risk areas and business
processes”. (p28)

(4) Information and Communication:

• “Key performance indicators are monitored daily and weekly” (at the NEXT Brand
meeting). (p27)
• “The Board communicates with its shareholders in respect of the Group’s business
activities through its Annual Report, yearly and half yearly announcements, interim
management statements and other regular trading statements. […] This
information is also made publicly available via the Company’s website.” (p28)

(5) Monitoring:

• “The Board confirms that it has carried out a review of the effectiveness of the
Group’s system of internal control covering financial, operational, compliance and
[…] risk management”. (p28)
• “The Audit Committee has reviewed the level of internal audit resource available
within the Group and believes that it is adequate for the size, structure and
business risks of the Group and is supplemented with appropriate external
resources where needed for specific projects.” (p28)


(4e) The forum – is purely internal. To be genuinely engaging in social responsibility, participating
external representatives of stakeholder groups, including environmental advisors and pressure groups,
would be expected.

The aspects – suppliers, customers, employees, environment and community- represent an appropriate
range of CRR dimensions.

The key facts and figures – only headline information is contained in the online material and therefore
the following critique is limited to the selection of data that has been highlighted by Next plc.

Economic – no comment is made regarding Next plc’s contribution to the countries in which it operates.

FTSE4GOOD – whilst a listing is commendable, the index is essentially designed to exclude corporate
investments in unethical areas (e.g. tobacco, defence, etc.).

Suppliers – the presence of a Code of Practice is commendable but hardly unusual for a high-profile
company. There is a substantial programme of audit of suppliers and some have been disengaged for
non compliance. The team of staff involved in this work has been increased, which is perhaps an
indication of an awareness of the negative publicity which can arise when problems are brought to light
by the press.

Customers – are these volume-based criteria really measures of responsibility toward customers?

People – the illustrative statistics on membership of pension schemes are encouraging.

Environment – Next plc has a range of initiatives relating to reducing the impact of its business
operations on the environment. During the year, it reduced its carbon footprint, the amount of waste
going to landfill and its fuel emissions.

Community – that Next plc engages in supporting communal projects is commendable. Taken together,
the financial contribution amounts to over £3m.

Next plc evidently recognises a responsibility toward society and the environment. Whether the data
demonstrates an adequately socially responsible attitude is a matter of individual opinion.

(4f) Agency theory defines the primary external relation of a company with its shareholders. It asserts
that management acts as the agent of shareholder interest and suggests measures by which managerial
interest is aligned, incentivised, and constrained by various mechanisms (e.g. share option
arrangements).

Stakeholder theory advocates a wider duty to all who affect or are affected by the aims and operations
of the company. Its advocacy is either based on the ethical conduct of business relations with society, or
that engaging stakeholders is instrumental in delivering financial rewards to all, including shareholders.

Next plc defines its stakeholders very narrowly – suppliers, customers, employees – but these do
represent Michael Porter’s ‘chain’, through which value is created. They are therefore the ‘instruments’ of
financial reward for shareholders: sales, margins, productivity, profit, dividends. Whether acting in an
ethical manner towards suppliers, building the trust of customers, and recognising employees as a
valuable asset is a minimum condition or a motivating force for their engagement is arguable. Moreover,
whether these aspirations are sufficient “to bring value to all our stakeholders, including our
shareholders” is highly questionable.

It is suggested that, from the balance of policies and statements made throughout their published
reports, Next plc are very shareholder centred.
CASE STUDY SOLUTIONS
Part V
(5a) Share price is the market price of the share; exercise price is the price provided by an option to
purchase a share over some future period; face value is the original denomination of the share capital,
and is represented on the balance sheet in the value of ordinary share capital.

(5b) Market capitalisation is the market value of the ordinary share capital – it is the total market value of
equity. It is calculated by multiplying earnings by the p/e ratio or, as in this case, the number of shares in
issue by the share price (see Figure 5.3)

169,000,000 x £27 (approx.) = £4.6 billion

(5c) Value of debt capital is £652m

Therefore:

652
Gearing = = 12.4%
652 + 4,600

This contrasts with a gearing based on book values of 74.5% and would lead to an entirely more relaxed
conclusion about the financial risk of Next plc’s capital structure.

(5d) Using Figure 5.3 we can see that the share price has risen from about £18, to just over £36, so there
is a gain of £18 over five years. In addition, Figure 5.2 shows that dividends of (90 + 78 + 66 + 55 + 55
=) 344 pence have been declared. In total a return of £21.44 on an investment of £18, or 119%. This can
be annualised by taking the fourth root of 2.19, which is 1.216 or 21.6% pa.

(5e) The £652m debt costs 4%, the £4.6bn equity costs 21.6%. The weighted average is:

(652 x 4) + (4,600 x 21.6) 101,986

= = 19.4%
(652 + 4,600) 5,252

(5f)

2012 2011 2010 2009 2008 2007 2006 2005 2004 2003

Dividends (£m) 135 130 109 107 109 104 104 94 89 86

Share buybacks (£m) 290 205 120 54 514 316 218 57 209 392

Total returned to
425 335 229 161 623 420 322 151 298 478
shareholders

Total returned
£3.4 billion
2003 - 2012

(5g) There is a very significant alignment between the package and the characteristics of financial
performance. One incentive, the annual bonus, specifically targets earnings per share. A long term
incentive targets shareholder return relative to a peer group of 20 companies and there is a share
matching plan designed to encourage more share ownership by directors The package has obviously
been designed to fit the financial objectives of Next plc but, with its singular pursuit of eps growth, is it
possible the financial strategy has fitted the package?