Analysing Financial Statements for Non-Specialists

Jim O'Hare

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317247012
• Edition: 2
• Topic: Business
• Subtopic: Business General
• Index: Business

All business organizations produce financial statements, and the information communicated (or hidden) in these is relevant to a wide range of users. After a number of recent financial scandals from banks to supermarkets, the need to fully understand financial statements has never been so imperative, and the topic itself so pertinent.

With updated examples to reflect the current business environment, including new material on the ethical considerations, and a wider array of business examples, from retail to services and banks, O'Hare continues to demist financial statements for non-specialists. In this new and refreshed edition, he once again covers the topic in an accessible way and assumes no prior training or study in accounting.

Offering a range of extra resources, including end of chapter questions, topics for further discussion and brimming with real-world examples, this concise new edition provides a comprehensive resource that will be welcomed by lecturers and instructors charged with delivering classes on financial statements.

Chapter 1
Why is analysing financial statements necessary?

1.1 Why do companies have to prepare and publish their accounts?

For many years, limited liability companies have been owned and managed by two different groups of people. The owners are the shareholders who provide finance to set up companies and to help them to grow. The managers are the directors of the companies and they are responsible for running the companies on a day-to-day basis. Because of this separation, it is necessary that financial information be produced by the managers and reported to the owners. This reporting is needed to demonstrate how well the management has looked after the investment of the owners, how well it has fulfilled the “stewardship” role. The report produced is what we now refer to as the “annual report and accounts” or “financial statements”.

There has been a need for such reports for hundreds of years, and the need for accurate and honest reporting was highlighted as early as the eighteenth century by the first great financial scandal – “The South Sea Bubble”.

The South Sea Company was formed in 1711 to trade, mostly in slaves, with Spanish America. Following what turned out to be overly optimistic forecasts of growth, in 1720, the stock in the company boomed and the company grew to the extent that it actually overtook the national debt. The market then collapsed with stock prices falling from over £1000 to less than £100. There was an enquiry by the House of Commons that discovered that three ministers had accepted bribes. The company directors were disgraced.

The scandal brought Robert Walpole to power as prime minister and led to increased regulation of companies. The South Sea Company actually survived this crisis and continued to trade until 1853.

From that time until very recently, the financial statements produced by the management of a company were seen as only being relevant to that company’s shareholders. It is only in very recent times that it has been accepted that groups and individuals other than the owners make important decisions based on the information in those financial statements.

This acceptance has led the International Accounting Standards Board (IASB) to recognising this change in the way it defines the objective of financial statements.

Previous attempts by various bodies to define the purpose and objective of company financial statements always referred to the need to give information to shareholders and only shareholders. It was not until late in the twentieth century that it was formally recognised that there were many other users of the financial statements.

In recent years a lot of time and effort has been put into developing a “framework of principles” to guide the development of preparing company financial statements. This framework aims to answer the questions that relate to:

• What is the objective of financial statements?

• Who are the users of financial statements?

• What are the important qualitative characteristics of financial statements?

• What should financial statements contain, and how should the contents be defined and measured?

The first “framework” was probably the one developed by the Financial Accounting Standards Board (FASB) in the United States of America in 1973, and in 1975 in the United Kingdom the Institute of Chartered Accountants in England and Wales (ICAEW) produced “The Corporate Report”, which “aimed to be the starting point for a major review of the users, purposes and methods of modern financial reporting”.

The more recently formed IASB drew on the work previously done in both the UK and the USA when it produced the “Framework for the Preparation and Presentation of Financial Statements”, which defined the objective of financial statements as:

to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions

The framework was first published in 1989 but not adopted by the IASB until 2001. It is very important that anyone who prepares financial statements now recognise the range of those who may use them to make economic decisions. If the information in the financial statements turned out to be incorrect, it is now thought that any of the users could make a claim for damages if a loss was suffered as a result of such inaccuracies. Previously it was considered that only shareholders could take such an action.

1.2 Who are the users of financial statements, and what economic decisions do they need to make?

Some of the user groups are:

1 Shareholders – both existing and potential shareholders need information to enable them to make decisions relating to buying or selling shares in a company. The financial statements of a company will contain information that will help with this decision. For example, they will give information about the amount of dividend paid to shareholders; if the dividend is high, this will suit shareholders who need income but may not suit those who want growth in their investment.

2 Lenders such as banks need to be able to assess whether any loans they have made or are about to make are safe. The financial statements can be used to see if the company is generating sufficient profits to meet the repayments on a loan or if it has sufficient assets for the lender to hold as security for the loan.

3 Suppliers to a company will usually supply goods and services on credit. They may deliver their goods or provide a service several weeks before they get paid. The financial statements will enable these suppliers to assess whether the company that they are about to supply is likely to have the funds available to pay for the goods and services when that payment falls due.

4 Customers need to know if they are being overcharged for what they are buying and whether they can rely on receiving goods or services into the future. The financial statements may show if the company they are buying from is making excessive profits and whether it might fail in the future.

5 Employees and trades union groups will also use financial statements. Existing employees need information to be able to make realistic claims for a pay rise, and potential employees will be concerned about the potential failure of the company.

6 The government will use data in company financial statements for many purposes, not least the need for the tax authorities to assess the amount of tax payable on profits made.

The above list does not cover all of the potential users nor does it refer to all of the potential economic decisions that may be made by those users. We can only conclude that there is a very wide range of users who make different types of economic decisions. The following chapters will address the ways in which the users can analyse the financial statements in order to make their decisions.

1.3 What are the required characteristics of useful financial information?

All of the user groups will need to be able to understand the content of the financial statements, be able to compare different entities and be able to rely on the data in those statements. The IASB framework describes the following “qualitative characteristics of useful financial information”:

1 Relevance – the information given in the financial statements should be capable of affecting the decisions made by the users. For this to be possible, the information should be useful in making predictions or confirming values or both.

2 Faithful representation – the information reported in the financial statements should be complete, unbiased and free from error.

3 Comparability – the information will be of more use if it can be compared to similar information about other entities and from other time periods. This should allow the user to identify and understand differences, and similarities, between entities and over time.

4 Verifiability – the information should faithfully represent the financial performance and position of the entity. Verifiability means that if a number of qualified and independent users reviewed the information they could reach a consensus that the information gives a faithful representation.

5 Timeliness – It is important that users receive the information in time for it to have an impact on any decisions to be made.

6 Understandability – Presenting the information in a clear and concise way will help to make it more understandable. Some of the information disclosed in financial statements will be complex. It would be misleading to omit this complex information; therefore, it must be assumed that users of financial statements will have a reasonable knowledge of business and will take care when analysing the information.

1.4 The content of financial statements

The financial statements produced by an entity represent all of the financial transactions that have occurred in a period – usually a year. The effects of these transactions can be grouped together, and these “groups” are referred to as the “elements of financial statements”. There are five elements in financial statements. Three of these elements, assets, liabilities and equity, help to describe the financial position of a company and are represented in a “balance sheet” or “statement of financial position” (two different names for the same thing; this happens a lot in accountancy). The other two elements, income and expenses, are related to financial performance and are represented in an “income statement” or “statement of profit or loss”.

The framework defines the elements as follows:

• Asset – An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

An example of an asset is a machine that a company has bought. As the owner (the past event would be the purchase of the machine), the company would control its use, and the machine may be used to produce goods that could be sold to create an economic benefit (or profit).

As the definition uses the word “control” and not “own” we would also include as assets resources that are not legally owned. For example, a machine that is on a long lease and will spend most of its useful life with the entity but is legally owned by the lessor is treated as an asset of the lessee. This is an example of accounting for the “substance” of a transaction over its legal form, an important concept in accountancy.

• Liability– A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

An example of a liability is a bank loan. As the entity has been given funds by a bank in the past it now has an obligation to repay it. The outflow is the cash used to repay it.

The outflow to settle a liability will not always be cash. If a customer has paid in advance for some service from an entity that has not yet been provided then the entity will have an “obligation” to provide that service in the future, and that obligation would be classified as a liability.

• Equity – Equity is the residual interest in the assets of the entity after deducting all of its liabilities.

Equity can also be referred to as the “ownership interest” in an entity. And it links to the assets and liabilities in the “accounting equation”

ASSETS – LIABILITIES = EQUITY

The accounting equation is represented by a statement of financial position. On one side we have Assets minus Liabilities, which “balances” with the other side, Equity.

• Income – Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.

The sales a company makes are its main source of “income”. They result, usually, in an inflow of cash to the entity.

A discount received by a supplier will also be “income” as it will result in a reduction of the amount owed to that supplier (decrease in a liability). If a company issues some shares to generate cash, then that cash is not classified as “income” as the shareholder is an “equity participant”.

• Expense – Expenses are decreases in economic benefits during an accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

If a company pays an electricity bill, this results in an “expense” as a result of the reduction of the asset of cash. An expense will also reduce profits, and this in turn will reduce equity. Depreciation of assets (see chapter 2) also results in an “expense”. However, when a company pays a dividend to its shareholders we do not classify ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• 1 Why is analysing financial statements necessary?
• 2 What information is provided in company financial statements?
• 3 Analysing profitability
• 4 Analysing liquidity
• 5 Analysing financial gearing
• 6 Analysing shareholder interests
• 7 Predicting corporate failure
• 8 Using other information in company annual reports
• 9 Corporate governance
• 10 Business valuations
• 11 What do financial statements not tell the users?
• Bibliography
• Index