TABLE OF CONTENTS
Accountancy as an Information System
Users of the Published Financial Statements
Specifications of the Publisher Financial Statements
Shortcomings and Restrictions of the Audited Financial Statements
Approaches and Methods of Analyzing the Audited Financial Statements
Approaches of Analyzing the Audited Financial Statements
Interpretation of Financial Analysis
How to Develop the Published Financial Statements
Conclusion
References
INTRODUCTION
Throughout history, the objectives, principles, and procedures of the accountancy profession have developed in conformity with socio – economic circumstances. Basically since inception, accountancy started as a book-keeping system for safeguarding the owners’ equity. It currently changed into an information system which provides businessmen/women with the economic data required for the decision-making process.
With time, auditing - the other facet of accountancy – has played a complementary role. Both professions developed together and followed the same trend. Whereas the purpose of accountancy was originally custodian, the role of auditing was the detection of fraud and default in the financial statements. However, as accountancy was later viewed as an information system, the main objective of auditing turned into maintaining authenticity, fairness, and clarity of accounting information.
The growing role of accountancy as an information system was due to several factors. The most important are the following:
1. Emergence of shareholding companies (corporations), which was accompanied by an expansion of owners’ equity. Independent management and hired management.
2. Establishment of the income tax system and tax departments. Accountancy as an information system could be demonstrated.
Figure 1 Accountancy as an Information System:
Raw data (Inputs) → Processing → Information (Outputs)
Outputs represented in data processed per users’ objectives
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The accounting system is governed by a set of principles & procedures, with which data is processed throughout the accounting cycle, utilizing:
-Recoding
-Classification
-Summary
-Communication
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Figure 1 above demonstrates that the accounting system is the data generating source which rests, basically, on accounting information or figures registered in the books and records. The data is later processed through the accounting system cycle before being generated as an end product of the system.
Through processing, the accounting system is governed by a group of principles and procedures, aiming basically at supplying the required output specifications, such as objectivity, clarity, authenticity, relevance, and punctuality, which are altogether known as the Generally Accepted Accounting Principles (GAAP). Though all principles should be inherent in accounting information, the most important is the principle of relevance. The importance of data output basically emanates from its relevance to users’ objectives. Data output could be mainly categorized as follows:
1. Detailed internal information which represents inputs or internal reports passed to management regarding various firm activities.
2. External general information which represents inputs or external reports known usually as the firm’s published financial statements for the interest of other parties.
Our concern here is the published financial statements. The Accounting Principles Board of the American Institute of Certified Public Accountants (AICPA) defined the basic objectives of the published financial statements as follows:
1. Providing authentic and fair financial data on the firm’s economic resources and obligations towards third parties and owners. This enables users of financial statements to asses the firm’s weaknesses and strengths.
2. Providing concerned parties with correct information on the changes in the firm’s financial position due to profit-making activities.
3. Providing financial information which enables users to derive some indicators for forecasting the soundness of the firm’s profit earning position.
4. Supplying users with adequate information of the significant accounting policies and principles followed, while preparing statements, such as depreciation and stock assessment methods. The above data could be transmitted through three basic statements:
(a) Balance Sheet
(b) Profit and Loss
(c) Source and Application of Funds
Users of Published Financial Statements
Despite the variety of objectives and interested parties, users of the financial statements could be generally categorized in four groups:
1. Current promising investors, who use the audited financial statements for investment decisions. In summary, this group seeks answers for the following:
· Return on funds invested in the firm.
· Success of the firm in accomplishing a competitive market status.
· Future trends, scope of continuity, and the anticipated growth rate of activities.
2. Lenders, including current and promising firm creditors, such as trade creditors, bondholders, bank and other financial institutions.
This group wants the economic information which would assist in short or long-term decision-making. Hence, they look for answers to some queries such as:
· Liquidity position and whether the firm’s working capital is adequate for the settlement of short-term liabilities.
· Whether the firm would be capable, in case of liquidation or bankruptcy, of setting its long term liabilities. What are the risks encumbered by lenders in case of financial difficulties?
· Would the firm’s current net profits suffice for covering interests due on debts? If so, what are the available guarantees?
3. Management of the Firm
The firm’s management foresees on two categories. First, on data employed for control, planning, appraisal, and decision-making purposes. This is mostly detailed, estimated, or statistical in nature, and has originated from costing or management accounting systems. Second, on general and historical information, that could be included in the financial statements for deriving quantitative indicators on performance as a whole.
Through audited financial statements, management seeks answers to the following:
· Success in managing funds in custody, and whether viable returns are realized compared to competitors within the same industry.
· Success of the applied financial policy in comparing inner and other sources of funds. Does it attract the suitable volume of funds at the proper cost and at the right time?
· Success in managing the firm’s assets and whether the credit, sales, and inventory departments perform successfully.
4. Other Groups
This group includes the firm’s staff, clients, and government establishments such as planning boards, accounting bureaus, and tax departments. This is an addition to research departments, financial analysts, and constancy offices.
The concerns vary according to their interests, but they mostly voucher the following:
· Continuity of the firm.
· Firm’s participation in national economy, and the social costs it encumbers.
· Whether the financial statements were prepared according to laws and regulations and to the Generally Accepted Accounting Principles and Standards. Are they authentic and objective for assessing the firm’s tax dues and preparing the national budget?
Specifications of the Published Financial Statements
The success of the decision-making businessman/woman rests on two principles:
- Whether decision inputs match targets. In other words, are the statements available to the decision-maker relevant, precise, authentic, and objective?
- Whether the decision model is correct; in other words, the success of the decision-maker in defining the basic hypotheses and variables.
Any fault in one or both of the above result in the failure of the decision as demonstrated in the following:
DECISION
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Decision inputs
|
Decision Model
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Decision outputs
|
|
+
_
+
_
|
+
+
_
_
|
+ (i.e. success)
_ (i.e. failure)
_
_
|
Based on the above, specifications of the published financial statements, which would be in conformity with the businessman/woman’s targets, are:
(1) Relevance
This is achieved when all users of the published financial statements get the information required for making their decisions. The extreme difficulty of establishing relevance is due to the disparity of users’ targets as its contradiction with objectivity. The figures presented in the financial statements are historical in nature and lack relevance. Decision-makers, therefore, prefer future forecasts on the firm’s activities, since they can only have General Purpose Financial Statements, which would in no way fulfill the targets of each and every group.
(2) Objectivity
Pursuant to the above, the abolished financial statements should quantitatively present factual events supported by the required documents.
(3) Reliability
According to the accounting standards, absolute objectivity is a far fetched objective. However, the published financial statements should be reasonably accurate.
(4) Completeness or full disclosure
This means disclosure of all information required by the concerned parties, without concealing any basic facts in conformity with the materiality concept.
(5) Understandability
This means the simplicity and clarity of the terms, presentation, and classification of the published financial statements, easing understanding by all users who are not necessarily accountants. The statements should be presented according to the standards generally accepted by those who prepare, examine, or use them.
(6) Comparability
This is a basic factor for analyzing and interpreting the financial statements. By comparability, the ratios and trends required could be deduced by the forecasting decision-maker. Consistency is closely correlated with comparability, and it concerns the principles applied in each and every financial period.
(7) Timeliness
Timeliness is an important factor for the success of decision-making, because financial information is of no use if it is not available at the right time.
The Audit Profession’s Role in Securing the Reliability of the Published Financial Statements
Most businessmen/women have some ambiguity over the auditor’s role and the limit of his responsibility over any defaults or violations included in the financial statements which he prepares. This ensued from mixing up two completely independent tasks: preparing and issuing financial statements by the firm’s management, and examining and attesting the financial statements by the auditor.
The auditor’s responsibility for incorrectness falls within the framework of his obligations to examine the financial statements in accordance with the Generally Accepted Accounting Principles and professional conduct, and to express his/her professional and independent opinion thereon. The auditor will only be responsible for any defaults or arrogations correlated with his/her professional duties. Any other premeditated or unpremeditated negligence by the management while preparing the statements, or any information not disclosed to the auditor, will be the responsibility of the firm.
Due to the current importance of this issue, especially when considering the extreme importance of the financial statements to businessmen/women, we shall deal with it in detail, starting with the definition of auditing.
The American Association of Accountants defined auditing as “a systematic procedure which seeks objective testimonies to assert the firm’s economic incidents, and thereby express an independent opinion to users of financial statements”. The users therefore view the audited financial statements from two angles, namely content and quality. While content is the firm’s management responsibility, quality is the responsibility of the auditor, who plays an important role in providing data. By following the audit procedures he/she deems fit, in accordance with the predetermined and approved standards, he/she reaches a conviction that he/she examined the financial statements present fairly and clearly the actual financial position of the firm at the end of the period. The professional and independent opinion in the auditor’s report represents his/her appraisal of the quality of the financial statements.
Here below is a summary of the auditor’s role:
Figure 2: Auditor’s Role in conveying the Published Financial Statements to Users
Statements to Users
Concerning the presentation of reliable and independent financial statements to users, the auditor’s role complements rather than replaces that of the management. Management is responsible for the precision of the statements, after the auditor’s exertion of reasonable care in accordance with professional standards. The auditor’s responsibility for the quality is confined to whether the financial statements present fairly the results of operations and the firm’s financial position at the end of the period.
Being empowered by the shareholders and for the interest of other users, he/she will express in a special paragraph within his/her report, his/her opinion on the financial statements. To discharge himself/herself from responsibility, he/she also has to include the following in his/her report:
1. His/her examination was in accordance with the Generally Accepted Auditing Standards, on the basis of which he/she will be responsible for any professional defaults. These standards are the following:
(a) General Standards:
Include personal and professional requirements for becoming an
auditor, and the efforts to be exerted during the auditing process.
(b) Reporting of Field Work:
Are the basic directives for setting any audit program or plan for determining the type and nature of the procedures required for examining or assessing the internal control system and accounting records.
(c) Cover reporting specifications and conditions and the expression of an opinion on the fairness of the financial statements.
2. That the firm initiating the financial statements keeps proper books of accounts, and that the statements were prepared in conformity with the Generally Accepted Accounting Principles applied on a basis consistent with that of the preceding period.
(a) Basic accounting principles and standards as directives during the recording and devaluation stage: Principles of realization, historical cost, accrual, continuity, conservatism, and consistency.
(b) Accounting principles and standards as directives during the stage of presentation of financial statements: Principles of full disclosure. Materiality and relevance.
3. In the case of a public shareholding company, the auditor has to maintain that the financial statements give all the information required by the commercial company’s law and the company’s by – laws.
4. In light of the above, the auditor has to express an independent professional opinion as to whether the financial statements present fairly the financial position of the firm and the results of its operations at the end of the period.
5. The American Institute of Chartered Public Accountants (AICPA) listed in its releases, 4 types of opinions which could be expressed in the auditor’s report:
(a) Clean opinion, which includes no qualifications.
(b) Qualified opinion, in case of any important but not crucial contraventions. For example, when the financial statements are not prepared in conformity with Generally Accepted Accounting Principles, or if inconsistency in applying such principles does not crucially reflect on the presentation of the financial statements, or if the management does provide the auditor with the information which he deems adequate for his/her examination.
(c) Disclaimer of Opinion, in case of crucial and basic qualifications. For example, non-adherence to the Generally Accepted Auditing Standards or the auditor’s abstention from examining the financial statements.
(d) Adverse Opinion, if the financial statements do not present fairly the
firm’s results of operations or its financial position at the end of the period.
In summary the auditor’s responsibilities for the published financial statements are:
(1) Exertion of reasonable due care as required by the examination. Within the scope of his/her tasks, he/she will examine the internal control system and basically express an independent professional opinion thereon.
The firm’s management is responsible for the proper entry of financial transactions in the record, precision of data presented in the published financial statements, and any defaults or shortages disclosed therein.
(2) To discharge himself/herself of responsibility for any possible defaults or contraventions presented in the published statements, the auditor has to adhere, during the normal examination process, to the Generally Accepted Auditing Standards and professional conduct and has to exert reasonable and due care to detect such contraventions or defaults.
(3) Sound and competent accenting and internal control systems restrict and ease up the detection of defaults or fraudulent acts in the published financial statements. The auditor’s responsibility is mainly to examine and appraise both systems, through the tests he/she deems fit, before expressing his/her independent professional opinion thereon.
Contents of the Financial Statements
The audited financial statements include three main exhibits, together with complementary schedules and notes:
1. Balance Sheet:
It discloses the firm’s assets compared to the corresponding liabilities at the end of the financial period. In other words, the balance sheet demonstrates the source of funds (liabilities and owner’s equity) and application of funds (assets). Balance sheet presentation varies from the traditional, which shows assets at the left against liabilities and owner’s equity at the right side, up to the current growing trend of presenting assets, liabilities, and owner’s equity at one side to correlate the sources of funds with corresponding applications.
Though traditional presentation facilitates comparison between assets, liabilities, and owner’s equity, it fails to clarify the correlation between the source of funds and their application. To show net working capital, the current presentation in list form overcomes this disadvantage, and it facilitates the correlation between the source and application of funds, whether long or short-term.
Irrespective of the presentation, the following should be taken into consideration, especially the materiality concept that should be applied regarding the following:
According to the nature of the firm, priority of classification shall be for earning assets corresponding to the sources of financing such assets at the liabilities side. In industrial companies the fixed earning assets have the priority over others, while the owner’s equity has priority over liabilities. In financial companies, such as commercial banks, priority is for the current assets and current liabilities.
To bring information loss to the minimum, aggregation of balance sheet captions should be carefully done.
2. Profit and Loss Statement
This presents realizable profits compared to expenditures during the financial period, in addition to the net result of operations whether profit or loss. This would be in different forms; some prefer the traditional account form while the growing tendency prefers a list form.
(a) Disclosure of revenues according to the source. This required the presentation of income due from ordinary activities compared to realizable income from other sources. This also requires disclosure of operational expenses independent from the expenses and losses.
(b) Disclosure of gross and net operational profit before the firm’s total net profits.
3. Statement of Source and Application of Funds
This presents the source of the firm’s funds and the way they were utilized during the financial period. If prepared for successive financial periods, then this statement provides useful information on investment and financing policies. But if prepared in the form of a cash flow statement, it serves as a good credit analysis tool.
The common three terms are:
(a) Statement of changes in the financial position, which shows the changes in all balance sheet captions. This discloses all sources of funds and their application together with effects on working capital. This is the form most often used in the published financial statements.
(b) Sources and dispositions of working capital, which show only changes in the working capital.
(c) Cash flow statement, which shows cash changes, concentrating on cash flow and funds flow.
Besides the above, the businessman/woman should enjoy some characteristics which enable him/her to arrive at the indicators while reading the financial statements. These are:
(1) A general background on the principles and concepts of preparing the financial statements.
(2) Thorough knowledge of the causal relationship between the basic and all balance sheet captions.
(3) Full awareness of the expected shortcomings inherent in the audited financial statements, and restrictions on their adoption in decision-making.
(4) Thorough knowledge of financial analysis procedures.
(5) The most important factor is the ability of the businessman/woman to interpret quantitative indicators, properly evaluate the firm’s performance and financial position, and to correlate that with his/her targets.
Despite the importance of all the requirements listed above, we shall concentrate on the last three.
Shortcomings and Restrictions of the Audited Financial Statements
The financial statements are usually prepared on the basis of several hypotheses and accounting principles. This reflects on the nature of these statements and imposes restrictions on their use for decision-making by businessmen/women. The major shortcomings are as follows:
1. Arbitrariness of Accounting Measurement:
The figures presented in the financial statements are finally the results of a measurement process which is mostly subject to personal judgment and the scope of adherence to the Generally Accepted Accounting Principles. For example, the net profit for the period varies according to the procedure of measuring each item of revenues and expenses. Hence, any change of views among accountants on fixed assets depreciation procedures, inventory assessment, etc. or on applying the conservative concept while setting provisions and reserves, will no doubt reflect drastically on net profits and items of assets, liabilities, and owner’s equity. Hence, the figures disclosed are closer to estimates rather than precise values.
2. The published financial statements are prepared according to various hypotheses. The most important are:
Cash measurement, fixed currency rate, historical cost, and project continuity. These no doubt affect the nature of information disclosed in the financial statements and restrict their use in decision-making. Being historical in nature, decision-makers prefer future statements which provide project tendency information. The fixed currency rate postulate makes the financial statements misleading during inflation or depression periods and improper for financial analysis during lengthy, comparable periods. Meanwhile, though quantitative financial statements are important as decision inputs, the qualitative are not far less, if not more, important. To succeed in decision-making, the businessman/woman has to fulfill the qualitative aspect by referring to other sources such as market and consultancy studies or direct contacts.
Approaches and Methods of Analyzing the Published Financial Statements
Financial analysis of financial statements is a procedure which enables businessmen/women to extrapolate the information required on the firm’s activities. The procedures are manifold depending on tendency. Nature and scope of comparison are as follows:
1. Vertical financial analysis, for comparison of figures within the same financial period, such as net profit compared to sales. It could be also horizontal for the same items within two or more financial periods, such as net profit for the current period compared to the same for past periods, or current rations at the end of the period compared to the same for past periods.
2. Simple financial analysis for comparison between absolute values of items, whether for one or several accounting periods, such as the comparison of working capital at the end of the current and past financial periods. However, if the comparison is between rations derived from absolute values, the financial analysis would be of a complete nature, such as a comparison of liquidity at the end of the current and rest periods.
3. Financial analysis could be restricted to the firm’s figures or rations and this is called internal analysis. Comparison is also possible between the figures and titans of the concerned firm and similar competing firms, or market averages. This is called Inter – firm Analysis.
The Financial analyses mostly used by businessmen/women are the following:
(1) Common Size Statements
This corresponds to the vertical analysis mentioned above. Comparison resulting in a percentage or ration is possible between figures within the same accounting period, such as inventory over total current assets, or any two figures having a casual relationship. For example, the current ration derived by comparing the firm’s current assets to current liabilities at the end of the financial period.
Due to the causal relationship between the items of the firm’s published financial statements, businessmen/women could derive many ratios, which are also indicators for appraising the firm’s performance in various fields.
(a) Profitability Ratios such as:
Gross Profit/Sales
Net Profit/Sales
Return on Investment (ROI)
Return on Equity (ROE)
Return on Assets (ROA)
(b) Liquidity Ratios, as indicators for measuring the firm’s ability to fulfill short-term liabilities such as the current ratio, liquidity ratio, stock turnover, debtors turnover, and average collection period.
(c) Activity Ratios, as indicators for appraising competence in managing assets such as: working capital turnover, assets turnover, fixed assets turnover, stock turnover, and debtor’s turnover.
(d) Capital Structure Ratios, as indicators for appraising the firm’s finance policy, and for estimating the risk borne by lenders and owners due to the firm’s policy for trading in equity.
Debts / Owner’s Equity or Leverage
Debts / Assets of Indebtedness Ration
Debts / Fixed Assets
(e) Market Ratios, as indicators for investors of the stock exchange market. For example:
Dividend Yield (DY)
Dividend per Share (DPS)
Pay out Ratio (FOR)
PRICE /EARNING Ration (PER)
Book Value per Share (BVPS)
Common size statements facilitate the comparison between multi – size firms of the same industry, because absolute figures in this case are misleading and meaningless. This procedure is criticized as being static, because the figures demonstrate the firm’s status at a definite time, and the user is looking for trends that have a comprehensive and objective picture of the firm’s current and future activities.
(2) Trends Analysis
To avoid a static character, as mentioned above, businessmen/women resort to trends analysis. This is possible by studying the movement of the item or the financial ratio for the period concerned. This secures the dynamism needed by the analyst and enables him/her of forming a more precise idea about the firm and its future trends. A trends analysis is usually in vertical form and for several financial periods of 5 – 10 years. The first would be considered a base year, and future years’ items would be presented as percentages of the base year.
Trends analysis could be restricted to major items as follows:
Schedule 3
Absolute Value Trends Study
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Value (000)
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TRENDS (%)
|
|
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1981
|
1982
|
1983
|
1984
|
1985
|
1981
|
1982
|
1983
|
1984
|
1985
|
|
Sales
|
1.000
|
1.2000
|
1.500
|
2.000
|
2.800
|
100
|
120
|
150
|
200
|
280
|
|
Gross Profit
|
400
|
540
|
690
|
980
|
1.400
|
100
|
135
|
173
|
245
|
350
|
|
Net Profit
|
200
|
250
|
300
|
320
|
400
|
100
|
125
|
150
|
160
|
200
|
|
Current Assets
|
500
|
700
|
800
|
900
|
1.200
|
100
|
140
|
160
|
180
|
240
|
|
Fixed Assets
|
600
|
570
|
800
|
700
|
720
|
100
|
83
|
133
|
117
|
120
|
|
Current liabilities
|
200
|
370
|
450
|
550
|
800
|
100
|
185
|
225
|
275
|
400
|
|
Long – term Liabilities
|
-
|
-
|
150
|
50
|
120
|
-
|
-
|
Not Applicable
|
|
Shareholders’ Equity
|
900
|
900
|
1.000
|
1.000
|
1.000
|
100
|
100
|
111
|
111
|
111
|
|
Total Assets
|
1.100
|
1.270
|
1.600
|
1.600
|
1.920
|
109
|
109
|
145
|
145
|
175
|
|
Operation Capital
|
300
|
220
|
350
|
350
|
400
|
107
|
107
|
117
|
117
|
133
|
Schedule 4
Study of the Major Ratio Trends
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|
1981
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Major Ratio Trends
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|
1982
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1983
|
1984
|
1985
|
|
Gross Profit Ratio
|
40
|
45
|
46
|
48
|
50
|
|
Net Profit Ratio
|
20
|
21
|
20
|
16
|
14
|
|
Current Ratio
|
250
|
190
|
180
|
160
|
150*
|
|
Leverage Raito
|
22
|
33
|
60
|
60
|
92
|
|
Debts / Assets
|
18
|
25
|
38
|
38
|
48
|
|
Return on Assets
|
18
|
20
|
19
|
20
|
21
|
|
Assets Turnover
|
0.91 times
|
0.94 times
|
0.94 times
|
0.125 times
|
1.46 times
|
|
Working Capital Turnover
|
3.3 times
|
3.75 times
|
4.3 times
|
5.7 times
|
7 times
|
(1) The firm’s absolute comparative figures are of more value to the businessman/woman, if analysis is limited to one financial period that is in 1985. That the firm’s total sales in 1985 amounted to KD 2.80.000 means nothing to the analyst, if not compared with the same figures of previous years. This is in addition to studying comparative figures of other captions such as current liabilities, current assets, working capital, shareholders equity, and total assets.
(2) Mostly, mere study of the general trend of absolute values which represent the firm’s activities is misleading. For example, the absolute values of sales, gross profit, and net profit have escalated in the first schedule, demonstrating good profitability and improvement. This impression changes if the analyst concentrates on profitability trends in the second schedule. Net profit, which is an important criterion for measuring the firm’s profitability, was contradictory all through the period and declined from 20% to 14%. This is contrary to the other profitability figures and was contradictory all through the period and had declined from 40% to 50%; return on assets which rose up from 18% to 20% and return on equity which increased from 22% to 40%. The analyst has to interpret the reasons by analyzing the trends.
(3) To answer his/her queries, the financial analyst could extend the scope of his/her study of the financial ratios to be within the framework of the casual relationship among the firm’s activities. The accelerating trend of the gross profit ration against decelerating net profits could be due to superior trading activities emanating from a decrease in the cost of goods sold which is a trading success resulting in continuous net profit decline.
The analyst has to consider also the ratio trends disclosed in the second schedule, in order to interpret the increase in Return on Assets (ROE), despite the fall in net profits. The firm’s current ratio diminished all through the period, namely from 250% to 150%, despite the increase of the absolute value of working capital for the same period. The leverage ratio doubled more than two times from 22% to 92%, and this means that the management follows the critical path method, because it resorted considerably to foreign financing sources. However, by studying the assets and working capital turnovers which have increased as shown in the second schedule, we note that the management has achieved considerable success in investing the available liquidity whether in its normal activities or in foreign investment fields, making the Return on Investment (ROI) considerably over their weighted costs. This interprets the increase of the Return of Assets and Return on Equity ratios despite the net profit ration decline. In other words, the management succeeded through trading in equity and managing foreign investments in compensating the fall in profits to original activities. This was possible by a squeeze in liquidity and a considerable rise in the risk limit regarding the equity and lender’s rights.
(4) Continuous adoption of a critical path method regarding equity trading should raise the following queries:
· Till when would this policy continue and what risks would reflect on owners and lenders?
· Till when would the management be able to convince lenders to offer loans, while suffering liquidity and solvency squeezes?
· Based on the above, would the capital be increased? What is the increase required to achieve capital structure parity?
The decomposition analysis of the published financial statements, based on the modern information theory, is a modern financial analysis procedure. It aims at measuring the media contents of the financial report from the user’s view. If properly employed, it is the best procedure to forecast any future financial difficulties. The decomposition analysis is a developed picture of the ratio analysis mentioned above. But, it is characterized by dynamism and is a predictor for financial failure. It could be applied to all published financial statements and mostly the balance sheet. Most applied studies on the procedure demonstrated full efficiency in providing appropriate indicators for appraising the firm’s ability to fulfill its short or long-term liabilities. The indicators are usually in the form of “information measures” to evaluate the trends from two angles, namely the relative size and stability over time. Balance sheet information measures include:
(1) Items under each balance sheet caption.
(2) Items at the balance sheet level.
(3) Every caption at the balance sheet level.
(4) The balance sheet as one unit.
The information measures values increase according to the users’ targets. Partial analysis including items under current assets as liabilities would suffice for assessing short-term liquidity. However, a comprehensive analysis including all items of assets as liabilities is required for assessing the firm’s solvency or financial structure, and for determining its ability to fulfill long-term commitments.
Approaches of Analyzing the Audited Financial Statements
The approach differs from the method. Profitability, credit, and investment analysis are examples for approaches; while trends, ratios, and cash flows are methods. The approach or method of financial analysis is determined in the light of the user’s target. Due to the importance of the steps of financial analysis to be followed by a businessman/woman, we give the following example: A credit manager receives a short-term loan borrowing request for financing stock purchases, and an attached copy of the audit analysis. The credit manager should first study the financial statements to ensure the fulfillment of certain basics – such as relevance, authenticity, comprehension, etc. The statements are later analyzed in the light of the following inquiries:
Q.1: What is the basic target behind the analysis?
1: Assessing the customer’s ability to settle a short term loan due on _______
______. Hence, the approach is a short term credit analysis.
2: What are the factors which affect the customer’s ability to settle for the short-term loan?
A.2: a) Short-term liquidity during (the effective loan) ______________________period.
b) Source and application of funds during the effective loan period.
c) Cash flows during the effective loan period.
d) Other factors such as nature of activities and firm’s competence.
3: What are the quantitative indicators required for assessing the above factors?
A.3: a) Working capital trends/consecutive periods.
b) Working capital turnover/consecutive periods.
c) Liquidity rations/consecutive periods.
d) Stock turnover/consecutive periods.
e) Debtors turnover/consecutive periods.
f) Comparative statement of the source and application of funds for several financial periods.
g) Comparative statement of cash flows and their application for several financial periods.
h) Cash flow estimates up to the due date of the loan.
Q.4: What is the proper method for reaching the said financial indicators?
4: a) Trends through absolute assessment of current assets and liabilities.
b) Trends analysis concerning the ratios in 3 above.
c) Analysis of financial (?) and cash flows.
Following the deduction of the quantitative indicators, the fifth question would be:
Q.5: What is the significance of every indicator after being compared with the generally accepted industry standards, and what are their repercussions on the customer’s short-term financial position? In the light of his/her answer to the final question, the credit manager would make his/her decision.
Here below are the most important approaches and corresponding financial indicators which could be adopted by a businessman/woman:
1. Investment Analysis
This is employed by inceptors represented in current or promising shareholders who require information on the following:
(1) The firm’s continuity chances and anticipated growth rates.
(2) Competence of the firm’s management in setting down its financial plans and utilization of the available economic resources (investment and management of assets).
(3) The firm’s investment risk indicators in case of liquidation or bankruptcy.
To achieve the above objectives, the following are useful:
(a) Profitability indicators
(b) Leverage indicators
(c) Performance indicators
(d) Market indicators
2. Credit Analysis
Short and long-term creditors follow up this approach to have the following information:
a) Firm’s ability to settle the principal and interest due thereon.
b) Applied finance policies and corresponding repercussions on the firm’s capital structure.
c) Risks correlated with their debts due from the firm, and priority of lenders to settle their rights in case of liquidation or bankruptcy.
d) Objectivity of the firm’s asset appraisal policies, especially those placed as guarantees.
The most important indicators in this regard are:
(1) Short-term liquidity indicators
(2) Long-term solvency indicators
(3) Leverage indicators
(4) Short and long-term cash flows
3. Performance Analysis
This is of utmost importance for the management because it concerns control, planning, and performance appraisal targets. Performance analysis could not be fully possible through the audited financial statements as mentioned before, and reference should be made to cost accounting and management accounting records. However, general indicators could be derived from the audited financial statements as follows:
(1) General indicators on activity regarding profitability, finance, and investment policies.
(2) Special indicators concerning the performance of some departments such as: Debtors turnover average, investments turnover average, stock turnover average, and working capital turnover average.
Interpretation of the results:
The final and most decisive step for a businessman/woman is how to interpret the results. Any interpretation errors will no doubt reflect on the corresponding decision. The interpretation is based on three principles:
1. Based on the firm’s comparative statements for several successive periods, the trends including absolute values as derived ratios would be carefully examined.
2. Studying the casual relationship between ratios and indicators, which make the firm’s activities indivisible, since what reflects positively on some activity aspects could adversely affect others.
3. Comparing the firm’s ratios and indicators with those of competing firms or what is commonly known as industry averages.
However, the following should be taken into consideration:
(1)Trend Analysis
(a) Profit and Loss Statements
· Studying the sales, sales returns, and sales discount indicators. Gross sales could have increased, with a corresponding increase of returns and discounts denoting default either in sales policies, product quality, or both.
· Studying trends and indicators of gross profit and correlated cost of goods sold. This is in addition to studying the indicators of net profit and correlated expenses as extraordinary items.
(b) Balance Sheet
- Studying the indicators concerning each and every current asset item rather than total value only. This is because the relatively increasing importance of the stock in case of the relative stability of cash as debtors is an indicator of a liquidity squeeze. However, the growing and relative importance of cash, if the other current items are relatively stable, could be a preliminary indicator for a default in the management of investments. In addition to that, studying current asset indicators should concur with finance source indicators or current liabilities.
- An increase in fixed assets at a rate higher than that of current assets indicates weak liquidity, unless associated with a corresponding increase in sales of profitable activities.
- If finance policies are to be appraised, liability trends should be studied together with equity trends. The growing importance of current liabilities indicates more reliance on short-term financing sources. Despite being an indicator of a possible liquidity squeeze, it could positively reflect on profitability if accompanied with concurrent growth in current assets and sales. A further study should be carried for long-term liability trends and their corresponding effects on long-term assets.
- While studying liability trends, considerations should be given to their effects on risk levels of creditors and owners as well. The safety margin available for each group is entirely dependent on capital structure equability. This is demonstrated in the following three different financial models that show the risks reflected on both the creditor’s and shareholder’s rights.
Schedule 6
Financial Structure of Company x
According to Three Models
|
|
A
|
B
|
C
|
|
Trade creditors
|
-
|
100
|
100
|
|
Ordinary bonds
|
-
|
300
|
600
|
|
Shareholders equity
|
1.000
|
1.000
|
1.000
|
|
Total liabilities and shareholders
|
1.000
|
1.000
|
1.000
|
|
Equity
|
|
|
|
|
Leverage
|
ZERO
|
0.66
|
2.3
|
Schedule 7
Profit and Loss Statement of Company x
|
|
A
|
B
|
C
|
|
Net profit before tax and interest
|
200
|
200
|
200
|
|
Less interest
|
-
|
21
|
42
|
|
Profit before taxes
|
200
|
179
|
158
|
|
Income tax 50%
|
100
|
89.5
|
79
|
|
|
100
|
89.5
|
79
|
|
Shareholders Equity
|
1.000
|
600
|
300
|
|
Return on equity
|
10%
|
14.8%
|
26.3%
|
The above schedule discloses the properly utilized high leverage which in turn accelerated the return on equity ratio up to 26.3% in the third period. However the analyst has to ask about the effects on the return on equity, if the company transcends the equity trading limit or when it is not competent to utilize the borrowed funds and consequently, costs exceed returns thereon. In this case and to the contrary, the high leverage firm would be exposed to the fall of the return on equity when profits fluctuate.
Schedule 8
Leverage Risk Appraisal
|
|
A
|
B
|
C
|
|
|
1
|
2
|
3
|
1
|
2
|
3
|
1
|
2
|
3
|
|
Near profit before tax and interest
|
300
|
200
|
50
|
300
|
200
|
50
|
300
|
200
|
50
|
|
Less interest
|
-
|
-
|
-
|
21
|
21
|
21
|
42
|
42
|
42
|
|
Net profit before tax income tax%
|
300
|
200
|
50
|
279
|
179
|
29
|
129
|
79
|
4
|
|
Net profit available for distribution
|
150
|
100
|
50
|
139
|
89.5
|
14.5
|
129
|
79
|
4
|
|
Shareholders equity
|
1.0000
|
1.000
|
1.000
|
600
|
600
|
600
|
300
|
300
|
300
|
|
Return on equity
|
15%
|
10%
|
2.5%
|
23.5%
|
14.8%
|
2.3%
|
43%
|
26%
|
1.3%
|
|
Leverage
|
Zero
|
0.66
|
2.3
|
|
Standard deviation
|
7.3
|
15
|
10.4
|
|
|
The above schedule demonstrated the actual task of interpreting indicators and trends, which impose on a businessman/woman the need for reading between the lines before taking a decision. Indicators in schedule 7 demonstrate one facet of the rise in leverage ration which is positive for shareholders. A further step demonstrated in schedule 8 indicated the negative facet of the rise in the leverage ratio.
Comparing risk limits with possible fluctuation of ROE shows that the model of the capital structure is the most risky for shareholders. This is because ROE fluctuates from 43% to 1.3 % with a standard deviation of 20.4 followed by model B whereby ROE fluctuates from 23.3% to 2.3% with a standard deviation of 15. Model A demonstrates minimum risk fluctuating from 15 to 2.5 %, with a standard deviation of 7.3.
(2) Casual Relationship Among Indicators
The casual relationship among ratio indicators is very important. A businessman/woman has to be aware of the important relationship between the firm’s liquidity and profitability which is mostly divergent, and that between leverage and risk which is mostly parallel. This importance is demonstrated while studying the sudden change in the general trend of an activity throughout an accounting period.
For example, a sudden drop in some profitability indicators such as ROE, before interpreting ROE as an adverse indicator of the firm’s profitability, could be correlated with sudden and massive capital growth during the same period. A causal relationship is needed for interpreting liquidity ratios and indicators. Liquidity could be appraised in the light of two factors:
(a) Indicators regarding the quantitative constituents of operation capital that are current assistant liabilities.
(b) Indicators concerning the punitive constituents of operating capital, first liquidity ratio and second turnover of individual items under current assets and current liabilities. A businessman/woman should be alert for window dressing, since some firms suffering from profitability or liquidity problems resort, at the end of the financial period, to measures which aim at refining their financial position. For example, a firm having massive stock would ease sale and credit trends to double its sales volume. By doing so, the stock is liquefied and two objectives are fulfilled namely.
(1) A substantial increase in annual sales and refining the profitability position.
(2) Liquefying stock in the form of debtors for improving the firm’s liquidity position. In this case, concern should be given to the provision that had debts, which could be considerable. To improve the liquidity ratio, firms change their policies concerning the settlement of current liabilities before the end of the financial periods as disclosed in the following schedule.
Bank 16.000 Trade debtors 5.000
Debtors 4.000 Short term loans 15.000
Stock 5.000
Total 25.000 Total 20.000
The current rate is 1.25 : 1 and working capital is 5.000. If the firm settles its short-term loan both before the due date or the end of the financial period, the current rate improves without affecting working capital as follows:
Schedule 10
Bank 1.000 Trade debtors 5.000
Debtors 4.000
Stock 5.000
Current rate is 2:1 and working capital is 5.000. Hence, auditors and users should give special concern to events prior or subsequent to the preparation of the published financial statements.
(3) Comparison with Industry Averages
A businessman/woman comparing the firm’s indicators and ratios with industry averages should be aware of any possible misleading conclusions. This is because firms within the same industry adopt different accounting principles while preparing financial statements. Hence, standard ratio differences could be due to disparity of adopted principles and procedures and not due to performance.
For example, Chrysler’s gross profit for 1979 was inflated to $81.4 billion. This was because it appraised its stock according to the FIFO and not the LIFO method adopted by most competing firms. Though, uppercase comparisons between the firm’s indicators and ratios and industry averages are special cases, it can be assumed we have three firms with identical performance and finance activities. All appraise their stock and cost of goods sold through LIFO and average methods. The following schedule demonstrates the stock and cost of goods sold for the three companies:
Schedule 11
Company Method Stock Value Cost of Goods Average Stock
A LIFO 50 550 11
B FIFO 125 475 3.8
The standard average as a mathematical average is:
5+3+11
________ = 6.6 times
3
The Standard Average as a Median is 5 Times
In this case, neither 6.6 nor 5 are suitable for appraising the performance of the three companies and any comparison would lead to biased results. It is improper to compare the stock turnover of company A which is 11 with the industry average 6.6, since the mathematical average represented by the industry average is the combination of various stock appraisal methods which differ from that adopted by company A.
It is also improper to compare company A’s stock turnover which is 11 with the industry average 5. This is because the 5 is the result of stock appraisal methods followed by company C and contrary to that followed by A.
How to Develop the Published Financial Statements
We stressed in the preface the accountancy profession’s developable nature. When referring to the preparation of audit of financial statements towards more efficiency as an accounting system, Arab accountants and auditors should cope with international accountancy and audit developments manifested in three major fields:
1. Cost of Human Assets, especially after their growing importance within economic firms, to the extent which requires setting special accounting systems and providing the corresponding financial data to decision-makers.
This should urge Arab accountants and auditors to develop the required principles and standards to assess human assets and the required procedures for reviewing and disclosing the relevant costs in the financial statements.
2. Social Costs and Benefits
This was underlined following the socio – accounting system. Such a system views a firm as a social unit which absorbs part of the economic resources of the community and should, in return, shoulder some responsibilities. Hence, actual performance should not be an appraisal in the light of profit and loss to owners, but according to services extended to the community.
This urges accountants to develop the required principles and to measure the firm’s social performance through a comparison between its costs and services to the community. Auditors should also develop social audit standards and a procedure for passing fair social performance data to users.
.3. Forecasting about firm activities, since users require information beyond historical statements, in order to have a fair and objective view about the firm’s continuity and anticipated growth rates; this arises within the published financial statements, as well as the responsibility of the auditor for auditing the same.
SUMMARY
1. Though accountancy is an information system which serves investors, lenders, managers, competent authorities, and other parties, we should not forget that the data it provides is for decision-making purposes.
2. Relevance, objectivity, and reliability are the proper specifications of the financial statements. This is because proper decisions are based on proper data.
3. Both the firm’s management and the public accountant are responsible for the disclosure of proper data. The auditor’s role follows that of the management, in expressing an opinion on the fairness of the statements through procedures which are according to Generally Accepted Auditing and Reporting Standards. The auditor is responsible for his/her tasks according to the expected audit standards and ethics.
4. The proper financial statements should include the company’s financial position at the balance sheet; date the results of operations for the period they ended and the source and application of funds or the changes in its financial position for that period.
5. Due to the arbitrariness of Accounting Measurement and several hypotheses, the financial statements suffer unavoidable shortcomings such as historical costs, cash basis, stable currency rates, and project continuity.
6. The audited financial statements are used basically to deduce many ratios such as profitability, liquidity, performance, capital structure, market indicators, and trend analysis. All these enable a businessman/woman to appraise the firm’s activities and forecast the future.
7. The most important approaches for analyzing the audited financial statements are investment and credit analysis. The businessman/woman should give special concern to the causal relationship between indicators and ratios, such as that between liquidity and profitability, leverage, and risks.
8. Finally, if accountants and auditors want to cope with current developments, they must give concern to future accountancy trends such as; cost of human assets, social costs and benefits, and forecasting on project activities.
In closing, the financial statements as a tool should be carefully set down. The management should be responsible for proper issue and the auditor should examine and express an opinion thereon with full competence and honest. The businessman/woman should be aware of how to use it for achieving superior interests.