However, there are other significant limitations to the value of the information in a set of financial statements. Comparisons over time between the accounts of the same company may prove to be invalid or only partially valid because significant changes have taken place in the company. For example, German, French and Spanish accounts are traditionally prepared in accordance with tax law (so, for example, the depreciation allowances set out in the financial statements are exactly those allowed for tax purposes).
These effects can have the result that the comparability of the financial statements of two companies located in different countries is reduced.
Limitations of ratio analysis
Major listed entities have tended, in recent years, to provide more non-financial information in their financial statements and it is increasingly common to find disclosures related to, for example, environmental issues. In Section 14.5.2, for example, we encountered two perfectly valid approaches to calculating gears. For example, suppose an artificial Christmas tree business starts building its stock from a low point in early February, gradually building up the stock to build up to a peak in early November.
If the company closes the fiscal year on January 31 (which would make sense since there isn't much going on at that time of year), inventory levels will be at their lowest. The opening stock closing stock)/2 will certainly provide an average stock figure, but will not be representative of the company's activity level. Sometimes textbooks and teachers try to set standards for ratios: for example, the current ratio should ideally be around 2, or 1.5, or 2.5. Not all ratios are useful or applicable in all business situations, and the analyst must exercise care in selecting which ratios to use.
For example, a business may have a mix of cash and credit sales, but it will not normally be possible to distinguish between them using only the information included in the annual financial statements. In fact, the relationship would be meaningless, and the analyst could be seriously misled by it. The analyst might calculate that a business's gross profit percentage is 14.3 percent for a particular year.
Creative accounting
Methods employed by creative accountants
Some people consider this type of "manipulation" to be outside the definition of creative accounting. This approach involves the exploitation of the optional elements that exist in the accounting regulations. The use of provisions has been exploited in the past as a way to manage reported earnings.
However, by issuing IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the IASB effectively stopped many of the abuses of provisions that had occurred previously. One of the gray areas that persists in accounting is the classification of debit items either as current year expenses or as non-current assets. One of the most famous cases of misclassification in recent years occurred at the American long-distance telephone company WorldCom.
In this particular case, the scale of the irregularities has been so great that senior officers are currently being prosecuted for fraud. Other areas of financial accounting that allow for creative accounting via classification include the categorization of costs and revenues as exceptional or non-recurring items, and decisions about classification as reportable segments where the entity is required to undertake segment reporting. When the company then continues to deliver a better-than-expected result, the market's view of the shares may improve.
The motivation to use creative accounting
INTERPRETATION OF FINANCIAL STATEMENTS . were excluded from the group accounts, so that their obligations had no impact on the activities) off-balance sheet financing remains a possibility. This last category of manipulation has nothing to do with massaging the figures of an entity, but with the way the entity presents itself to the world. Reporting by listed entities, especially in the US market, is strongly determined by analyst expectations.
It may be easier to massage their expectations rather than improve reported results using creative accounting techniques. CEOs of listed entities meet with analysts in short meetings where they have the opportunity to influence analysts' expectations by predicting rather bad numbers. If managers perceive that all other units in their sector are using creative accounting practices, they may feel obligated to do the same.
Sometimes lenders insist on special covenant agreements as a condition for granting a loan: for example, they may stipulate that an entity's current ratio may not fall below 1.5:1, or that gearing may never exceed 35 percent. In such cases, if the entity cannot meet the terms it has agreed to, the lender may insist on immediate repayment or liquidate the entity. When an entity is in danger of defaulting on its covenants, there is a clear incentive for managers (especially if they genuinely feel that the difficulty is short-term in nature) to massage the numbers so that the covenant is apparently effective . Met.
Special problems in analysing financial obligations
During the financial year ended 31 December 20X4, CY acquired 80% of the issued share capital of DZ. An earn-out arrangement was included in the contract whereby, if total audited profit before distributions for the two full financial years ended 31 December 20X6 exceeded $600,000, CY would be required to pay a further $0.4 million to shareholders pay. from whom she bought the DZ shares. How should CY account for this potential liability in its financial statements for the year ended December 31, 20X5.
There is a legal obligation as a result of a past event and the extent of the obligation can be measured reliably. The only question in dispute is whether or not the expiration of funds in connection with the obligation can be considered probable. If it is probable (and a reasonable estimate of probability is feasibly given that DZ's results will exist), a provision will be made in the group accounts or the year ended 31 December 20X5.
If the outflow is not likely, it will probably be listed as a contingency. As with other contingent liabilities, the analyst should read the financial statements thoroughly so that he is aware of all noted contingent liabilities. If the liability has not yet been recognized, it may be worthwhile to investigate the effect of the earn-out payment on the group's cash flow and statement of financial position.
Summary
Earn-out arrangements are a special form of contingency that can arise when a group company is purchased. Having recently received the company's accounts for the financial year ended 31 July 20X6, your friend, who has some basic knowledge of accounting, has asked you to clarify certain points for him and give him a brief account of the company's position . The income statement, equity statement and statement of financial position are together with comparative figures as follows:.
I have looked up IAS 31 Interests in Joint Ventures, which mentions proportionate consolidation and equity accounting as possible methods of accounting for joint ventures. Apparently, one of the model home kits supplied by SDB has a tendency to collapse in adverse weather conditions, and $10 million is the sum claimed by the litigants in a case that will be heard within the next 18 months. How likely it is that the entity will have to pay and how bad the effect will be.
I can see that the profitability of the business has suffered during the year, but if anything I am more concerned that the cash balance has fallen by more than.
Question 2
FD has asked you to review the entity's most recent financial statements as a preliminary step. The copyright of the games is owned by PJ, but no value is attributed to them in the financial statements. During the year, DM directors undertook a reassessment of the useful life of non-current tangible assets.
However, it is also possible that directors wish to avoid increasing, for example, liabilities by including those under common control because this would provide a less positive view of the entity. This exceeded profit for the period for the year ended 31 July 20X5 and it is likely to be difficult for the company to maintain the dividend at this level unless profitability improves significantly. DCB's pre-tax profit as a percentage of sales and return on equity are both better than those of other entities.
The value of the software titles generated over the lifetime of the business is likely to be a significant sum. A more detailed breakdown of certain elements of the income statement would be useful in analyzing the company's results. In the case of PJ, complete sets of financial statements since the company was founded would be useful.
It is noticeable that Target's gross profit margin is towards the bottom of the comparison range, while the net margin is towards the bottom. Perhaps most of the investment in new stores was made during 20X3.
Summary
