20 Limitations of financial statements and interpretation techniques Flashcards
Financial statements are affected by the obvious shortcomings of historical cost information and are also subject to manipulation. Give examples
Problems of historical cost information
Explain Problems of historical cost information
Historical cost information is reliable and can be verified, but it becomes less relevant as time goes by. The value shown for assets carried in the statement of financial position at historical cost may bear no relation whatever to what their current value is and what it may cost to replace them. The corresponding depreciation charge will also be low, leading to the overstatement of profits in real terms. The financial statements do not show the real cost of using such assets.
Explain Creative accounting
Listed companies produce their financial statements with one eye on the stock market and, where possible, they like to produce financial statements which show analysts what they are expecting to see. For instance, a steady rise in profits, with no peaks or troughs, is reassuring to potential investors. Companies could sometimes achieve this by using provisions to smooth out the peaks and troughs. This has been largely outlawed by IAS 37 (see Chapter 13), but companies can still achieve similar effects by delaying or advancing invoicing or manipulating cut-offs or accruals. Directors who are paid performance bonuses will favour the steady rise (enough to secure the bonus each year, rather than up one year, down the next) while those who hold share options may be aiming for one spectacular set of results just before they sell.
Explain Intragroup transactions
It is common for entities to carry on activities with or through subsidiaries and associates, or occasionally to engage in transactions with directors or their families. The point is that such transactions cannot be assumed to have been engaged in ‘at arm’s length’ or in the best interests of the entity itself, which is why investors and potential investors need to be made aware of them. Transfer pricing can be used to transfer profit from one company to another and inter-company loans and transfers of non-current assets can also be used in the same way.
Explain Seasonal trading
This is another issue that can distort reported results. Many companies whose trade is seasonal position their year end after their busy period, to minimise time spent on the inventory count. At this point in time, the statement of financial position will show a healthy level of cash and/or receivables and a low level of trade payables, assuming most of them have been paid. Thus the position is reported at the moment when the company is at its most solvent. A statement of financial position drawn up a few months earlier, or even perhaps a few months later, when trade is still slack but fixed costs still have to be paid, may give a very different picture.
Explain Asset acquisitions
Major asset acquisitions just before the end of an accounting period can also distort results. The statement of financial position will show an increased level of assets and corresponding liabilities (probably a loan or lease payable), but the income which will be earned from utilisation of the asset will not yet have materialised. This will adversely affect the company’s return on capital employed
Explain Acquisitions and disposals
A company may have acquired or disposed of a subsidiary or division during the year and the effect of this will need to be isolated in order to assess the underlying performance. See Chapter 19 for more details on this
Accounting policies and the limitations of ratio analysis. Explain The effect of choice of accounting policies
Where accounting standards allow alternative treatment of items in the accounts, then the accounting policy note should declare which policy has been chosen. It should then be applied consistently. You should be able to think of examples of how the choice of accounting policy can affect the financial statements eg whether to revalue property in IAS 16, or how to account for government grants in IAS 20.
Explain Changes in accounting policy
The managers of a company can choose accounting policies initially to suit the company or the type of results they want to get. Any changes in accounting policy must be justified, but some managers might try to change accounting policies just to manipulate the results.
Limitations of ratio analysis The consideration of how accounting policies may be used to manipulate company results leads us to some of the other limitations of ratio analysis
In a company’s first year of trading there will be no comparative figures. So there will be no indication of whether or not a ratio is improving. Comparison against industry averages may not be that revealing. A business may be subject to factors which are not common in the industry. Ratios based on historic cost accounts are subject to the distortions described in 1.1 above. In particular, undervalued assets will distort ROCE and exaggerate gearing. Ratios are influenced by the choice of accounting policy. For instance, a company seeking to maintain or increase its ROCE may choose not to revalue its assets. Financial statements are subject to manipulation and so are the ratios based on them. Creative accounting is undertaken with key ratios in mind. Inflation over a period will distort results and ratios. Net profit, and therefore ROCE, can be inflated where FIFO is applied during an inflationary period. No two companies, even operating in the same industry, will have the same financial and business risk profile. For instance, one may have better access to cheap borrowing than the other and so may be able to sustain a higher level of gearing.
Other issues Are there other issues which should be looked at when assessing an entity’s performance? Factors to consider are:
How technologically advanced is it? If it is not using the latest equipment and processes it risks being pushed out of the market at some point or having to undertake a high level of capital expenditure. What are its environmental policies? Is it in danger of having to pay for cleanup if the law is tightened? Does it appeal to those seeking ‘ethical investment’? What is the reputation of its management? If it has attracted good people and kept them, that is a positive indicator. What is its mission statement? To what degree does it appear to be fulfilling it? What is its reputation as an employer? Do people want to work for this company? What are its labour relations like? What is the size of its market? Does it trade in just one or two countries or worldwide? How strong is its competition? Is it in danger of takeover?
