ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
Подождите немного. Документ загружается.
Chapter 21: Analysing and interpreting financial accounts
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 465
Limitations of interpretation techniques
Differences in accounting policy
Current cost accounts and current purchasing power accounts
Other limitations in the use of financial ratios
Using historical information
Creative accounting
Related party relationships and transactions
Using figures in the statement of financial position
Non-financial information
7 Limitations of interpretation techniques
There are several limitations or weaknesses in the use of interpretation techniques
for analysing the financial position and financial performance of companies. Some
of these are limitations of ratio analysis (the method of interpretation most often
used) and some are limitations of financial statements and financial information.
7.1 Differences in accounting policy
One of the uses of financial ratios is to compare the financial position and
performance of one company with those of similar companies for the same period.
Comparisons between companies might not be reliable, however, when companies
use different accounting policies, or have different judgements in applying
accounting policies or making accounting estimates. For example:
Entities might have different policies about the revaluation of non-current assets.
Entities might use different methods of depreciation.
Entities might use different judgements in estimating the expected profitability
on incomplete construction contracts.
Entities might use different judgements in assessing whether a liability should
be treated as a provision or a contingent liability.
IAS 8 states that an entity should not change its accounting policies unless the
change is required by an accounting standard or it will result in more relevant and
reliable information. Therefore changes should not happen often.
Where there has been a change in an accounting policy, IAS 8 also requires
comparative figures to be restated and information to be disclosed. However,
changes in accounting policies and accounting estimates can still make it difficult to
compare the financial statements of an entity over time, particularly if analysis is
based on extracts rather than the full published financial statements.
Paper F7: Financial reporting (International)
466 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
7.2 Current cost accounts and current purchasing power accounts
Historical cost accounts can also be misleading because they do not accurately show
the effects of inflation over time. They do not take into consideration changes in the
real value of money.
The biggest problem is the valuation of non-current assets. Companies have
different policies towards the revaluation of non-current assets. Some companies re-
value some categories of non-current assets regularly, and in particular land and
buildings. However, not all categories of non-current assets are re-valued.
When the rate of inflation is quite high, many non-current assets are probably
under-valued in the financial statements, in comparison with their current net
replacement value.
In addition, when the rate of inflation is high, the reported profit with historical cost
accounting will be higher than it would be using an ‘inflation accounting’ system
such as current cost accounting (CCA) or current purchasing power (CPP)
accounting.
With CCA and CPP accounting, particularly during a period of high inflation:
The reported profit will be less (or the loss will be higher) than with historical
cost accounting (HCA).
The asset turnover or asset utilisation will be lower, because asset valuations are
higher with CCA and CPP than with historical cost accounting (even when some
non-current assets are re-valued in HCA).
The return on capital employed will be lower, because the reported profit will be
lower and the value of capital employed will be higher.
7.3 Other limitations in the use of financial ratios
There are other problems with the use of financial ratios, particularly where these
are used to compare the performance and position of different entities or of an
entity with an industry average.
It is possible to calculate the same ratio in different ways. For example, there are
several variations of return on capital employed (ROCE) and gearing.
Comparisons can be misleading if different calculations are used.
Even where two entities operate in the same industry, comparisons can be
misleading. Entities can operate in different markets (for example, high
volume/low margin sales and low volume/high margin sales). The size of an
entity can affect the way it operates and therefore its ratios. For example, large
entities can often negotiate more favourable terms with suppliers than small
ones.
Financial statements are published infrequently. If ratios are used to study
trends and developments over time, they are only useful for trends or changes
over one year or longer, and not changes in the short term.
Ratios can only indicate possible strengths or weaknesses in financial position
and financial performance. They might raise questions about performance, but
Chapter 21: Analysing and interpreting financial accounts
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 467
do not provide answers. They are not easy to interpret, and changes in financial
ratios over time might not be easy to explain.
It can be argued that financial position and financial performance should be
analysed using market values rather than accounting values. For example, it can be
argued that investment yield is more relevant for the assessment of financial
performance than return on capital employed.
7.4 Using historical information
Financial statements are often used to predict the future performance of an entity.
Where comparative figures are available for several years it may be possible to
extrapolate trends and to base forecasts on these. If comparative figures are only
available for one or two years, predictions may be unreliable.
There may be some limited information about future transactions in the notes to the
financial statements. For example, details of contingent liabilities and non-adjusting
events after the reporting period must be disclosed. However, published financial
statements present historical information.
Generally, financial statements do not reflect future transactions or events. They do
not anticipate the effect of significant changes to the entity after the financial
statements have been authorised for issue. These may include events beyond the
control of management (for example, the liquidation of a major customer) or events
that could not possibly have been foreseen at the time the most recent financial
statements were issued.
It should also be remembered that financial statements are not normally published
until several months after the year end. The financial statements are often out of
date by the time that they become available.
7.5 Creative accounting
Management may use various forms of creative accounting to manipulate the view
given by the financial statements while complying with all applicable accounting
standards and regulations.
Some of the techniques that can be used have been discussed in earlier chapters.
They include:
Window dressing: an entity enters into a transaction just before the year end
and reverses the transaction just after the year end. For example, goods are sold
on the understanding that they will be returned immediately after the year end;
this appears to improve profits and liquidity. The only reason for the transaction
is to artificially improve the view given by the financial statements.
‘Off balance sheet’ finance: transactions are deliberately arranged so as to
enable an entity to keep significant assets and particularly liabilities out of the
statement of financial position (= ‘off balance sheet’). This improves gearing and
return on capital employed. Examples include sale and repurchase agreements
and some forms of leasing.
Paper F7: Financial reporting (International)
468 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
Changes to accounting policies or accounting estimates: for example, an entity
can revalue assets (change from the cost model to the revaluation model) to
improve gearing or change the way in which it depreciates assets to improve
profits.
Profit smoothing: manipulating reported profits by recognising (usually)
artificial assets or liabilities and releasing them to profit or loss as required.
Aggressive earnings management: artificially improving earnings and profits
by recognising sales revenue before it has been earned.
Capitalising expenses: recognising ‘assets’ which do not meet the definition in
the IASB Framework or the recognition criteria. Examples include: human
resources, advertising expenditure and internally generated brand names.
Most of these are now effectively prevented by accounting standards. However,
management may still attempt ‘creative accounting’, especially if the entity is
suffering falling profits or poor cash flow.
If directors’ salaries or bonuses are based on profits or on particular measures, (such
as earnings per share), they may try to manipulate that particular measure so that it
is as favourable to them as possible.
7.6 Related party relationships and transactions
A user of financial statements will normally expect the financial statements to reflect
transactions that have taken place on normal commercial terms (‘at arm’s length’).
The user of the financial statements would want to be informed if:
transactions have taken place that were not at ‘arm’s length’, or
there are parties that could enforce transactions on the entity that are not on an
‘arm’s length’ basis.
For example, an entity might sell an asset such as a property to another company
owned by one of its directors on more favourable terms than it would sell to a third
party.
In this situation, the financial performance or financial position reported by the
financial statements would be misleading. There is a special relationship between
the parties to the business transactions. This is referred to as a ‘related party
relationship’.
Related parties of an entity can include:
parents, subsidiaries and fellow subsidiaries
associates
key management personnel (such as directors)
close family members of any of the above.
A
related party transaction is:
a transfer of resources, services, or obligations between related parties
whether or not a price is charged.
Chapter 21: Analysing and interpreting financial accounts
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 469
Examples of related party transactions include:
purchases or sales of goods
purchases or sales of property and other assets
rendering or receiving of services
leases
finance arrangements (such as loans or contributions to equity).
Related party relationships and transactions are a normal part of business and there
is nothing wrong with entering into them. However, a related party relationship can
have an effect on the profit or loss, or on the financial position of an entity, because
related parties might enter into transactions with each other on terms that other
entities or individuals (unrelated parties) would not. For example, where an entity
sells goods to a related party, its profits may not be comparable with those of a
similar entity that only trades with third parties on normal commercial terms.
7.7 Using figures in the statement of financial position
In practice, ratio calculations are often based on figures in the year-end statement of
financial position. These may be very similar to average values for the period, but
this is not always the case.
Some businesses are seasonal and make a high proportion of their sales at a specific
time of year (for example, in the few months before a national holiday period).
Seasonal businesses often arrange their year-ends so that they fall when inventories
and receivables are at their lowest (probably just after the main period for sales).
Where this happens, ratios such as inventory turnover will be lower than they
would be if they were based on the average figure for the year. This means that
ratios may not be strictly comparable with those of other businesses or with
industry averages.
Major purchases of assets can have a significant effect on figures in the statement of
financial position and on ratios if they take place near the end of the accounting
period.
The carrying value of non-current assets is unusually high, because cost has
increased, but a full year’s depreciation has not been charged.
Return on capital employed and asset turnover are reduced, because assets have
increased but revenue and profits have not. New assets should generate
increased profits, but they have not yet been owned for long enough to do so.
7.8 Non-financial information
One of the most serious limitations of traditional financial statements is that they
only reflect the financial effects of transactions. Items are not recognised unless they
can be measured reliably in money terms.
Paper F7: Financial reporting (International)
470 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
There are two problems here:
Businesses and the transactions that they enter into are becoming increasingly
complex. Much information that is relevant to users cannot be expressed easily
in monetary terms or in numbers.
Businesses increasingly accept that they are not only accountable to investors
and lenders, but to a much wider group of people, or ‘stakeholders’.
Stakeholders can include customers, suppliers, employees, the local community
as a whole and (for some large public entities) society as a whole. These groups
are often more interested in the non-financial effects of an entity’s activities, (for
example, its effect on the natural environment), than in its financial performance.
Most large and listed entities now include a Business Review, an Operating and
Financial Review (sometimes called Management Discussion and Analysis) in their
published financial statements. This is a narrative report which sets out
management’s analysis of the business. Such a review is a legal requirement for
many companies within the European Union.
At present entities reporting under IFRSs do not have to publish any non-financial
information of this kind. The IASB is currently developing proposals for a standard
on non-financial information, but this is unlikely to come into force for several
years. However, companies will publish narrative reviews if they are required to do
so by national law.
Useful non-financial information
Useful non-financial information could include the following:
a description of the business, objectives and strategies of the entity
a narrative review of the performance of the business during the period
a description of the main risks and uncertainties facing the entity and the ways
in which these risks are managed
details of any significant factors or events that may have an impact on the
entity’s performance in future
details of any significant factors or events that may have an impact on the
entity’s cash flows in future
information about key relationships with other entities and transactions with
related parties, including management
a description of the entity’s research and development activities (if any) and of
any material intangible assets, including internally generated intangible assets
that have not been recognised in the balance sheet
additional explanations of amounts included in the financial statements, where
appropriate (for example, where these are based on estimates)
information about the entity’s policies in relation to environmental matters, in
relation to its employees and on social and community issues.
Chapter 21: Analysing and interpreting financial accounts
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 471
Specialised, not-for-profit and public sector entities
Interpretation and specialised entities
Users of the financial statements
The needs of users
Non-financial ratios
8 Specialised, not-for-profit and public sector entities
Specialised, not-for-profit and public sector entities were discussed in an earlier
chapter.
The main objective of these entities is not to make a profit, but to carry out a specific
activity.
8.1 Interpretation and specialised entities
All not-for-profit entities prepare financial statements. These may not be structured
and presented in the same way as those of a profit-making entity, but most of the
interpretation techniques described above are still relevant.
As usual, the starting point is the needs of the user.
What do they need to know?
What are they most interested in?
What decision (if any) do they need to make?
8.2 Users of the financial statements
Several different groups of people may be interested in the financial statements,
including:
members (of a club or society)
donors and potential donors (to a charity)
those who benefit or could benefit from the activities of the entity
lenders
the general public, as voters, as taxpayers or in some other capacity
central government (in the case of other public sector bodies)
employees and others involved in the work of the entity
pressure groups.
The most important users of the financial statements are likely to be either:
providers of finance or potential providers of finance; or
persons to whom the entity’s management are accountable for the way in which
money and other resources are used.
Paper F7: Financial reporting (International)
472 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
8.3 The needs of users
Users of the financial statements of a not-for-profit entity are almost always
interested in the way that the entity manages and uses its resources.
For example:
A charity may be managed by Trustees on behalf of its supporters and those
who benefit from its activities.
A public sector organisation is managed by elected officials on behalf of the
general public.
Typically, users will want to know whether:
the entity has enough finance to achieve its objectives
the money raised is being spent on the activities for which it was intended
the public are receiving value for money (in the case of a public sector entity)
services are being provided economically, efficiently and effectively (in the case
of a public sector entity)
the level of spending is reasonable in relation to the services provided.
8.4 Non-financial ratios
Most of the ratios covered earlier in this chapter could be relevant to a not-for-profit
entity.
However, a public sector entity may also use non-financial ratios. These measure the
efficiency with which services have been provided.
Examples include:
the average time that hospital patients wait for treatment
the number of schools built in an area
serious crimes per 1,000 of the population
number of complaints by members of the public in a given period
number of visits made to museums and art galleries in an area.
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 473
Paper F7 (INT)
Financial reporting
A
Answers to exercises
Chapter 5: The financial statements of a single company
Exercise 1
EntityRed
Incomestatementfortheyearended30June20X5
$000
Revenue 14,823
Costofsales 6,214
–––––
Grossprofiit 8,609
Otherincome 22
Distributioncosts (3,693)
Administrativeexpenses (3,901)
Otherexpenses (248)
–––––
Profitbeforetax 789
–––––
Exercise 2
EntityRed
Incomestatementfortheyearended30June20X5
$000 $000
Revenue14,823
Otherincome22
––––––
14,845
Changesininventoriesoffinishedgoodsandwork‐in‐
progress(reduction=expense,increase=negativeexpense)
(86)
Rawmaterialsandconsumablesused 5,565
Staffcosts(employeebenefitscosts) 4,926
Paper F7: Financial reporting (International)
474 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
Depreciationandamortisationexpense 1,533
Otheroperatingexpenses 2,118
–––––
14,056
––––––
Profitbeforetax789
––––––
Chapter 11: Financial assets and financial liabilities
Exercise 1
EntityGH $ $
Assets
Non‐currentassets
2,000,000
Currentassets
Inventories 56,000
Receivables 102,000
Taxbenefitreceivable 15,000
Cash((250,000at$3)–40,000issuecosts)lessformer
overdraft
610,000
–––––––
783,000
––––––––
Totalassets2,783,000
––––––––
Equityandliabilities
Equity
1,250,000ordinarysharesof$0.50 625,000
Sharepremium(240+(250×
$2.50)–25) 840,000
Retainedearnings 1,068,000
––––––––
2,533,000
Currentliabilities
Tradepayables 250,000 250,000
––––––––
Totalequityandliabilities2,783,000
––––––––