FOOL SCHOOL
Balance Sheet Basics - Part II

September 2, 2005

In Part I, we looked at the top half of tobacco firm Gallaher's (LSE: GLH) balance sheet as at 31 December 2003. Here, we explain what makes up the bottom half of a balance sheet.

Reserves

After presenting the balance sheet items, annual accounts then have to show how the company's net assets (or liabilities) 'balance' with shareholders' interests. Gallaher's 'reserves', which effectively reflect how the company has been funded, match the balance sheet's £276m net liability:

Year to December 31st	2003 (£m)	2002 (£m)
Capital and reserves:
Called up share capital	65	65
Share premium account	125	117
Capital redemption reserve	8	8
Merger reserve	146	146
Other reserve	(911)	(911)
Profit and loss account (including retirement benefits reserve)	260	213
Equity shareholders' deficit	(307)	(362)
Equity minority interests	31	25
	(276)	(337)

Here's what the most popular entries mean within the 'reserves' part of the balance sheet:

Called-up share capital plus share premium: The total money given by shareholders to allow the company to trade. Reflects the original start-up capital and subsequent sums raised from rights issues etc.

Profit and loss reserve: The cumulative amount of post-tax profits and losses, after dividend payments, since the company's formation. Dividend payments can only be taken from this reserve, and only if it contains a sufficient 'distributable' sum.

Capital redemption reserve: Reflects the value of shares redeemed or purchased by the company from distributable profits.

Revaluation reserve: Any surplus (or shortfall) following a revaluation of tangible assets (usually land and property) is credited to (or debited from) the company's revaluation reserve.

Minority interests: Occurs when the company has one or more controlled subsidiaries that are not wholly owned. Assets relating to part-owned subsidiaries are apportioned to the minority and separated from shareholders' interests. Read more on minorities.

Gallaher's reserves also include a merger reserve and an other reserve.

The former can be created in certain obscure circumstances when shares are issued to fund an acquisition. Details of other reserves will be found in the relevant accounting notes. In Gallaher's case, its other reserve resulted from 'a capital reorganisation that included a purchase of own shares out of capital' on the demerger from Fortune Brands in 1997.

Reconciliation

Finally, annual accounts have to reconcile how the company's final net asset (or liability) value has altered over the period under review. This next table explains the movements within Gallaher's shareholders' deficit, which went from £362m to £307m during 2003:

Year to December 31st	2003 (£m)	2002 (£m)
Profit for the financial year	247	255
Dividends	(193)	(179)
Actuarial loss recognised on retirement benefits	(4)	(108)
Movement on deferred tax relating to actuarial loss on retirement benefits	1	30
Exchange adjustments on foreign currency net investments	(4)	(22)
Amounts deducted from profit and loss reserve in respect of shares issued to the Qualifying Employee Ownership Trust	-	(5)
Issue of ordinary shares	8	12
Net decrease/(increase) in equity shareholders' deficit	55	(17)
Opening equity shareholders' deficit	(362)	(345)
Closing equity shareholders' deficit	(307)	(362)

Common reconciliation entries include:

Reported profits and dividends: The former minus the latter equals the retained earnings for the year, which accumulate in the profit and loss reserve. Retained earnings (or losses) will usually be the dominant figure in the reconciliation.

Foreign exchange movements: Overseas assets are translated into sterling at the exchange rate prevailing on the balance sheet date. Differences arising from the translation at the previous year-end are accounted for in the profit and loss reserve.

Revaluations: Unrealised profit (or deficit) from fixed asset revaluations made during the year.

Issue of new shares: Amounts raised from rights issues etc., which accumulate in the called-up share capital and share premium accounts.

Prior year adjustments: Amendment to the previous year's balance sheet following a change in accounting policy during the latest period.

Retirement benefits: The net change to the 'actuarial' value of the company's FRS17 pension scheme.

Limitations

That concludes the main points and definitions to balance sheet accounting. In fact, Gallaher presents a good example of the difficulties of evaluating a company solely by its balance sheet. The tobacco group has net liabilities of £276m -- a seemingly precarious financial position -- yet it continues to churn out regular profit and dividend growth.

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