18 Analysis & Interpretation of FS

Question 1

How should consolidated financial statements be interpreted

Answer 1

• It may be necessary to consider both the overall situation of the group as a whole and where possible the individual performance of companies within the group
• The analysis may involve the calculation of goodwill, and gains or losses on disposal
• The group structure needs careful consideration
• Group companies may have been acquired or disposed of part way through the year
  o Or in the comparator year
  o So if a company was sold off last year the comparative figures will not be apples to apples

Question 2

How should accounts be interpreted if a subsidiary is acquired during the year

Answer 2

Statement of profit or loss
* Acquisition costs may impact group performance
o Some costs not capitalised, such as legal fees
* Results will only be consolidated from date of acquisition
* Income and expenses should increase after the acquisition
* Group margins may be altered

Statement of financial position
* 100%of the assets and liabilities of the subsidiary will be consolidated at the reporting date
* Working capital ratios may change and may be distorted
o Different credit terms
* Calculations of ROCE and net asset turnover may produce results that appear low
o Time apportioned profit but all assets and liabilities included

Question 3

How should accounts be interpreted in subsequent years to the subsidiary being acquired

Answer 3

• Costs of acquisition will not impact until reported performance in future years
• A full years results for the subsidiary will be included, and therefore there should be a more accurate impression of underlying performance

Question 4

How should accounts be interpreted if a subsidiary is disposed of during the year

Answer 4

Statement of profit or loss
* The results of the subsidiary may be consolidated up to the date of the disposal or shown as discontinued operations
* The previous years P/L would have shown full years result of disposed subsidiary
o Therefore, profit likely to be lower
* It may be necessary to separate out the gains or loss on disposal
* The SPL would include disposal costs in the year of disposal
o Professional fees, redundancy pay
* Margins are likely to be affected

Statement of financial position
* The current years SFP would contain none of the assets or liabilities of the subsidiary that has been disposed of
* The previous years SFP would have contained 100% of assets and liabilities of the disposed subsidiary
* The net cash position may have improved
o From disposal proceeds
* Working capital ratios, ROCE and net asset turnover may be distorted if P/L include subsidiaries figures
o Assets gone but profits came from sub for some portion of year

Question 5

How should accounts be interpreted in subsequent years to the subsidiary being disposed of

Answer 5

• There will not be distorted ratios
• It may be helpful to consider the impact of the investment proceeds of disposal

Question 6

What are the limitations of ratios analysis of financial statements

Answer 6

• Ratios are not predictive
• Based on historic cost accounting
  o So don’t reflect inflation
   Profits could be higher just as inflation has raised prices in a different ratio to cost inflation
• No comparatives if first year of trading
• Difficult to find external comparatives
  o N o two compass have identical financial and business risk profiles
• Ratios do not incorporate the potential impact of future actions by management
• Financial statements only reflect activities that can be expressed in monetary terms
• Ratios are not sufficient to be used in isolation
  o Business problems are usually too complex to be solved solely by using these ratios
• Different accounting policies may cause distortions in ratios:
  o IAS 16 allows cost model and revaluations
   Revaluations negatively impact ROCE
  o IAS 20 – 2 methods for allowed for rebounding government grants
  o IAS 40 – allows cost and FV models

Question 7

How can accounts become distorted

Answer 7

• Distortions may arise from creative accounting and window dressing
  o Delaying or advancing invoicing (revenue recognition)
• Purchase of NCA just before year end
  o Increases. NCA but decreases cash or increases debt
  o But income for NCA not fully materialised
   Adverse affect on ROCE
• In seasonal business, ratio results may be very dependent upon the choice of accounting year end date
  o Entity will tend to position their year end after a busy period
   Low trade payables and inventory
   High cash and trade receivables
• Make SFP look strong and solvent

Question 8

How can comparisons be made inter firm and inter sector

Answer 8

Care needs to be taken with regard to differences in:
* Accounting policies by comparator firm
* Formula used to calculate ratios
* The sizes of comparator firms
o While ratios allow comparisons larger companies are very different from small
* The markets served by companies in the same industry
o Primark vs Gucci (both sell cloths)

Question 9

What is historic cost accounting and how does it affect FS

Answer 9

• Allows the verification of the cost of everything
  o Information is reliable and verifiable
  o Have an invoice for it
• But cost comes less relevant over time
  o Due to depreciation and inflation
• Therefore old NCAs have low value
  o And if using reducing balance depreciation on old assets is low which could inflate profits, leading to over distribution of profits which could erode capital
  o FS not showing true cost of using NCA
  o If NCAs are replaced then sudden increase in costs
• Inventory held at historic cost during inflation
  o Sales revenue and new purchases keep pace with inflation
  o But if using FIFO would lead to understated COGS and overstated profits

Question 10

What is the factoring of receivables

Answer 10

• A company transfers it’s trade receivables to a factor (usually a bank) for management and collection of what is owed
• Only used if liquidity is poor

Question 11

What could cause low trade receivable days

Answer 11

Low trade receivables days could be from
* Using a factor to get advances on receivables
* A grocery store that receives cash only payments

Question 12

What additional financial information would be useful when analysing accounts

Answer 12

• Budgeted figures
• Management information
• Industry averages
• Figures for a similar business
• Figures for the business over a period of time

Question 13

What are the benefits to the company of factoring receivables

Answer 13

• Receives a % of the invoice value shortly after the invoice is raised
• Helps with cash flow
  o Especially companies which are overtrading
• Trade receivables days ratio will seem very low

Question 14

What are the disadvantages to the company of factoring receivables

Answer 14

o Expensive (essentially a loan against receivables)
o Balance is paid once the receivable pays minus factors fee
o Factor will usually require the company to repay the advance if they are unable to get payment from the receivable

Question 15

What non financial information would be of value when analysing accounts

Answer 15

• Market share
• Key employee information
• Sales mix
• Product range
• Size of order book
• Long term management plans
  o Larger companies often have senior management with short terms in roles
  o But small companies are owner operated and therefore top management has a longer focus
• Diversified or specialised

Question 16

What are some examples of non financial measures

Answer 16

Airlines
* Revenue per passenger mile
* Cost per available seat

House building
* Value of new orders
* Value of order backlog

Hotels
* Occupancy rate

Question 17

What are some other considerations that must be brought in

Answer 17

• How technologically advanced is the company
  o If poor
   Risk of being pushed out of the market
   Huge capital outlay to bring tech up to competitive standards
• Environmental policies
  o Is the company at risk of having to pay clean up costs if the law changes
  o Does it appeal to ethical investors
• Does the management team have a good reputation
  o Are they good at attracting and retaining talent
  o Are they a good employer
• What is the companies mission statement
  o Do they actually seem to be fulfilling it, or is it just rhetoric
• What is their market share
  o Do they operate domestically and / or internally
   More risk operating internationally
  o Single company or group
   Can get support from group
• How strong is the company’s competition
  o Are they a market leader
  o In a niche or mass market
  o Are they in danger of a takeover

Question 18

How can the FS of not for profit or public sector entities be evaluated

Answer 18

• Their aims are different from companies, as they do not usually have a profit motive.
  o Financial aim – to achieve value for money and/or provide a service
  o Management – accountable to trustees/government/public
  o Financed by – donations and government subsidies
• They may not have a profit motive but still have to account for their income and expenditure
• Have to account for their effectiveness, economy and efficiency
• Do not usually have to produce financial statements for the public but often still do
• Often have a regulatory authority which they report to e.g. The Charities Commission
• Many ratios used for companies are not relevant, e.g. EPS
• Have different mechanisms for measuring effectiveness:
  o Hospitals – patient bed occupancy rate, patient waiting times, number of missed appointments
  o Educational institutions – staff to student ratios, students’ results, drop-out rates, recruitment numbers, entry tariff, rankings
• Generic:
  o Number of complaints
  o Satisfaction rates
  o Staff turnover

Question 19

What is the importance of earnings

Answer 19

• Earnings are:
  o a measure of entity performance
  o widely reported
  o strongly linked to share value
  o frequently forecast
  o also known as profit, bottom line, net income.
• Earnings are used by different user groups
  o Shareholders (to assess prospects and stewardship)
  o Creditors (to assess risk)
  o Customers (long-term survival)
  o Employees (job security)

Question 20

What is earnings management

Answer 20

• Deliberate actions to influence reported earnings and their interpretation
• Earning management is the choice by a manager of accounting policies so as to achieve specific objective
• Earnings management can distort accounting information in the financial statements

Question 21

Why would you manage earnings

Answer 21

1. Benefits for the entity:
   a. To meet expectations and predictions
   b. To maximise share price and valuation
   c. To avoid breaching debt covenants
   d. To show underlying long-term value (short-term spikes can distort overall picture)
2. Managerial benefits:
   a. For their remuneration and bonuses (to meet short-term goals)

Question 22

What are some methods for managing earnings

Answer 22

• Accounting policy choice/change
  o E.g. Accounting methods, accounting estimates
• Accrual accounting
• Big bath write-offs
  o E.g. Restructuring costs (IAS 37 tries to prevent this)
• Cookie jar reserve
  o Reduce earnings (via reserves/provisions) in the good times to boost them in the bad times
• Income smoothing
  Accepted under GAAP:
• Inventory valuation e.g. LIFO versus FIFO
• Estimates
  o Depreciation
  o Bad debt provisions
• Revenue recognition policy
• Timing of transactions

Question 23

What is financial reporting quality

Answer 23

Financial reporting quality relates to the accuracy with which a company’s reported financials reflect its operating performance and to their usefulness for forecasting

Question 24

What is the quality of earnings

Answer 24

Earnings quality relates to how closely current earnings are aligned with future earnings

Question 25

How do businesses get their earnings

Answer 25

• Selling goods and services;
  o From investment; sale/disposal of assets (continued operation, discontinued operation, acquisition, etc.)
  o i.e. from operating activities and non-operating activities.
• Earnings can also be increased by reducing the cost of business
  o i.e. through cost savings measures.
• Some earnings are one-off (low quality) while other earnings are recurring (high quality).
• Earnings can be used to estimate future performance and are used to determine the share price.

Question 26

What are higher quality earnings

Answer 26

• Higher quality earnings are earnings where investors can assume the future performance of the firm from the current performance.
• According to Penman: ‘earnings are of good quality if they do not reverse in the future’ (2009:663).
• Earnings which investors think are sustainable and likely to grow in the future are considered high quality earnings.
• Earnings from operating activities are higher quality earnings (because they are of an on-going and recurring nature).

Question 27

What are lower quality earnings

Answer 27

• Earnings which mislead in forecasting or cannot be used in forecasting are considered to be earnings of poor quality.
• Gains and losses on trade investment or on financial assets are considered of lower quality because they are more volatile and less predictable
• Earnings from non-operating activities are lower quality earnings because they are not likely to be repeated in the future.