3.3.4 Limitations of financial reports Flashcards
How can the use of financial reports be limited?
The usefulness of financial reports can be limited by factors such as the types of financial accounting methods used. Ratios are not precise diagnostic tools and business managers may require additional information.
Define and provide an example of Nomanised Earnings
Normalised earnings are earnings on the balance sheet that are adjusted to remove unusual or ‘one-off’ events. An example of this would be a situation where an accounting business sold a block of land that is owned in the central business district of a large city. The proceeds would be substantial and might give an unrealistic picture of profit for that business for that year. To ‘Normalise’ this event the proceeds of the sale are removed from the financial report.
What are capitalising expenses?
Expenses such as operating expenses are usually recorded in the income statement of a business.
What does it mean to capitalise an expense?
To capitalise an expense is to change the expense from a ‘one-off’ operating expense into a capital item which can then be depreciated over time. If a business is able to capitalise an expense, it becomes an asset and is then recorded in the balance sheet of the business.
What are the immediate impacts of capitalising an expense?
- Operating expenses will reduce, thus increasing the operating profit of the business
- The assets of the business will increase
- There will be a change to the liabilities of the business
What are some of the effects of capitalising effects?
The first effect of capitalising expenses will be to distort the financial reports of the business.
The second effect by changing the expense into a capital item the business can claim depreciation of the capital item as a tax deduction over a number of years.
Name one example of capitalising expenses
One example of capitalising expenses is the item of maintenance. Usually, maintenance would be an operating expense but if the Maintenace expense was to effect repairs to a kitchen in a preschool then the preschool business could list repairing as a capital item to claim depreciation over a number of years
Outline the two ways in which assets are valued
Historical costs and Value of intangibles
When valuing assets what is meant by historical costs?
Historical cost accounting values assets as equal to the cost of the asset at the time of the purchase. It assumes the value of the dollar and inflation rate is the same for the whole accounting period. This is a limitation as assets can increase in value over time and inflation can raise the level of prices
When valuing assets what is meant by the value of intangibles?
Intangible assets include goodwill, brand names, patents and copyrights. As these are not physical assets it is difficult to determine their real value and various interpretations can be placed on their value as stated in the balance sheet.
Define accrual-based accounting
Accrual based accounting records transactions in the period in which the transactions occur.
Define Cash-based accounting
A business, that uses cash-based accounting will record the transaction when it actually receives its cash. This cash-based method has the ability to produce misleading financial reports.
