Download Limitations of Financial Reports


Caution needs
to be exercised
when reading
financial reports
as there are
some issues
regarding how
the data is
collected and
treated that
you need to be
aware of.
Limitation
Example
Normalised Earnings
• Normalising earnings suggests that accountants have
removed one off influences that distort from the normal
earnings of a company. In short, normalised earnings refer to
a situation where earnings are adjusted to remove unusual or
one-time influences.
• An example would be choosing to exclude the inflow of cash
that comes from the once-off sale of land. Obviously the
inflow of cash would be a lot greater than actually shown on
the statements.
Is this activity
normal? Should it
be included?
Ultimately its a
judgement call to some
degree.
Limitation
Example
Capitalising Expenses • Most commonly involves treating an investment in research
and development as a non current asset on the balance sheet
Expense
rather than an expense on the revenue statement because
capitalisation is
you believe you have created something of value that could
common. The
be sold if so desired. Makes profits appear larger than they
Commonwealth Bank otherwise would be.
capitalised $626
million in software
and branch costs last
financial year.
Limitation
My god
we just
spent
$30million
on R&D!!!
Example
•Imagine that a pharmaceutical company undertakes $30
million worth of research and development into a new drug.
• Usually would be considered an expense but accounting
procedures can allow this to be placed as a future asset on
the balance sheet rather than an expense on the revenue
statement. This is because that $30 million has been used to
generate a new drug that has value to the business. If this
company sold the patent to another firm it would be worth
$30 million.
Don’t you mean we
created an asset
worth $30million!
Accountants can do
anything!
Limitation
Example
Valuing Assets
- How should you value a businesses assets?
1] What if a business owns shares in Apple and the share price
dives 20% the day before the balance sheet is produced but
then rises 30% the day after. What price do you report your
shares at?
2] You bought a property for $7 million in Sydney at the
height of the property boom. It is estimated today to be
worth only $3million. What price do you record it on the
balance sheet at?
3] The value associated with the McDonalds brand has been
estimated at $26.4bn. Is this accurate?
4] You bought a $1million machine used in your factory in
1998. How much is it worth today? What rate have you
depreciated its value at? Is it accurate?
The general idea is that you should not take the value of the assets as
gospel. It is a product of a lot of estimation.
Limitation
Example
Timing Issues
- Businesses can exploit timing of financial statements to give
a misleading impression of their financial position.
- Revenues could be delayed or accelerated ahead of time to
force them into this years revenue statement. Managers
could delay certain expenses from appearing until the next
period. This is an example of fraudulent activity.
http://www.youtube.com/watch?v=_xIO731M
AO4 56.38-59.30 - Timing fraud
http://www.youtube.com/watch?v=_xIO731M
AO4 50.38- 52.44 - Debt hiding
Limitation
Example
Debt Repayments
- It may not be clear when exactly debt must be repaid and
as a result distort the meaning and usefulness of financial
reports.
- A business may have relatively little debt but if the
conditions require all the debt to be repaid all at once it may
actually be more unstable than a business with larger
amounts of debts with credit terms that are more favourable.
Qantas debt....But what are
the conditions associated?
Who knows?
Limitation
Example
Notes to financials
- Notes to financial statements are attached to help the
reader get more information about the processes undertaken
to determine the amounts you see on actual statements.
- The notes are not regulated by law and therefore may be
potentially misleading as they tend to be more subjective in
nature. It will require a sophisticated analyst to determine
whether the methods and advice provided are sound.
I love educating people about the
accounting methods I used to create my
financial statements! I get angry when
investors say they don’t read my
complex methods of determining
figures.

Do I really
have to
read these
for
homework
sir?!
The
notes to
financial
stateme
nts for
Qantas
go from
page
p55p104 in
their
annual
report....