Annual reports and financial statements

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MODULE 7 UNIT 3 Evaluation of financial statements

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Table of contents 1. Introduction 3 2. How investors evaluate a business 3

2.1 Ratio analysis 3 2.2 Vertical and horizontal analysis 4 2.3 Year-to-year change analysis 4

3. Red flags in financial statement analysis 5 4. Creative accounting 6 5. The risk of over- or understating financial results 7 6. Conclusion 8 7. Bibliography 8

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Learning outcomes:

LO5: Identify the limitations of ratio analysis.

LO6: Explain the impact that pressure exerted on management might have on the accuracy of financial statements.

LO7: Describe how management can mitigate the risk of fraud and misrepresentation in financial statements.

LO8: Analyse the financial statements of a business to determine its financial performance.

1. Introduction By now, you should be familiar with the financial ratios that can be used to analyse and interpret the financial statements of a business. To gain a proper understanding of a business’s activities, it is necessary to take a more holistic view of the business, rather than focusing only on financial ratios.

In this set of notes, you will learn what to look out for when analysing a business’s annual report, and how to identify potential weaknesses or fraudulent activities. This may come in handy should you ever have to decide whether or not to invest in another business. It will also provide you with more insight into the expectations a business’s shareholders have, and how they view financial results.

2. How investors evaluate a business It is good practice for a potential investor to evaluate the financial position of a business and compare its performance with that of other potential investments before taking the step to buy shares. The main objective when analysing financial information is to identify changes in trends, amounts, and relationships between amounts, and to investigate why these changes occurred.

It is a good idea to integrate different methods when analysing financial performance, as one method might not provide enough information to base a decision on. Investors can use the following methods to analyse the financial performance of a business.

2.1 Ratio analysis In Module 5, and in Unit 2 of this module, you learnt how an investor can calculate different financial ratios. When conducting ratio analysis, an investor can compare the current year’s ratios with the ratios of the previous year, with the ratios of competitors, with industry averages, or with company standards (such as the gross profit margin that should ideally be in line with the standard set by the business).

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While ratio analysis is a useful tool to identify a company’s strengths and weaknesses, it does have some limitations, including the following:

• Every business is unique, which means that comparing the financial ratios of one business with that of another does not always provide an accurate picture. For instance, a manufacturing business will probably invest in more assets than a service business, and this will influence all ratios that include assets as one of the components.

• Different businesses may use different methods to value their fixed assets, or to calculate depreciation. This will result in differences in their ratio calculations, making it difficult to determine which businesses are financially more stable.

• Ratios are useful for identifying potential problems, but do not provide any background. For example, imagine that the dividend ratio of a business decreased significantly from one year to the next. If an investor took these numbers at face value, it would appear as though the business is struggling financially and is therefore paying out less dividends to shareholders. However, upon further investigation, it might transpire that shareholders agreed to lower dividend payments so that the business can use the extra funds to finance an exciting new opportunity.

(Weetman, 2016)

When basing decisions on the results of ratio analysis, you should consider these limitations and ensure that you also use other sources of information to inform your decisions.

2.2 Vertical and horizontal analysis With this method, information is compared by making use of percentages. This allows the comparison of businesses that vary in size, as changes in amounts are expressed in percentages instead of absolute values. Watch the interactive video included in this unit to learn how to conduct vertical and horizontal analysis.

2.3 Year-to-year change analysis This method is used to identify trends over a period of time. For example, you can analyse the growth in revenue and net profit across a few consecutive years. Year-on-year growth in these two figures is a positive sign, especially if they have grown at the same rate. If the revenue figure grows at a faster rate than net profit, it might be an indication that the business is not managing its expenses effectively. If the net profit is growing at a faster rate than revenue, it might be an indication that the business has taken effective steps to reduce expenses, but has failed to increase sales – a kind of growth that is not sustainable over the long term. However, it could also indicate that the business has moved into a different area (such as delivering services), or started selling new products that earn less revenue, but are not as costly as other products. Each case should therefore be investigated based on the unique circumstances present.

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3. Red flags in financial statement analysis There are certain things you should look out for when evaluating the financial statements of a business, and when you spot one of these things, you should immediately question the business’s decisions. The more familiar you become with evaluating financial statements, the easier it will be to identify these red flags.

Watch Video 1 to learn more about some of the red flags that investors should be able to recognise to protect their investments.

Video 1: Red flags to look out for when analysing a business. (Source: https://www.youtube.com/watch?v=lwp6i4Kd4RA)

In addition to the aspects mentioned in Video 1, there are other red flags an investor should look out for, including the following:

• Revenue has been in decline for three or more consecutive years: This indicates that the business is failing to increase its sales for a prolonged period of time, meaning that it may become unsustainable.

• The inventory or accounts receivable figures increase at a higher rate than sales: This means that the business has less cash on hand, as its money is tied up in inventory that is not being sold, or in debtors that have to settle outstanding amounts.

• The number of shares issued increases significantly year on year: This decreases the value of shares, because, as you will recall, the dividend declared is divided between the shares. The more shares there are, the smaller the portion of the dividend each shareholder will get.

• Large amounts appearing under the heading “Other” on the income statement or statement of financial position: This might be an attempt to hide

https://www.youtube.com/watch?v=lwp6i4Kd4RA

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certain transactions. Significant expenses or incomes must be specified and presented separately in the statements.

There are many other issues in financial statements that may also raise concerns, but the ones identified are the main things to look out for. If your business is considering investing in another business, it is important to identify any potential problems, and to investigate these further before committing to investing.

4. Creative accounting Creative accounting is when a business records its financial transactions in such a way that it adheres to accounting standards, but manipulates information to make the business appear to perform better than it actually is. This is typically done by overstating revenue and assets, or understating liabilities and expenses.

A business might use this practice to get more shareholders to invest, or to convince a bank to offer them a loan or a low interest rate on a loan. This practice is also sometimes a result of the payment of performance-related bonuses, as these may serve as an incentive for management to inflate results. Other times, it is done to cover up fraudulent transactions.

Enron is one of the best-known instances of how creative accounting was used to manipulate shareholders and lenders. Read more about the “fuzzy” rules of accounting and Enron, and watch Video 2 to see how creative accounting led to Enron’s downfall.

Video 2: The impact of the Enron scandal. (Source: https://www.youtube.com/watch?v=Mi2O1bH8pvw)

Further reading:

http://www.nytimes.com/2002/01/30/business/enron-s-many-strands-the-accounting-fuzzy-rules-of-accounting-and-enron.html

https://www.youtube.com/watch?v=Mi2O1bH8pvw

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If you are interested, have a look at several other famous cases of creative accounting.

Seeing as individuals who commit fraudulent activities often take great care to hide them, it might be difficult to spot creative accounting practices. However, it is possible to identify instances of creative accounting by carefully analysing financial statements and questioning amounts that do not make sense. For example, inventory that increases at a higher rate than that of sales might indicate that inventory is being overstated in the financial statements.

5. The risk of over- or understating financial results There are various reasons why people might commit fraud when reporting financial information. The fraud triangle, developed by criminologist Donald Cressey, aims to explain why fraudulent activities take place, and presents three elements that must be present for fraud to occur.

Figure 1: The fraud triangle.

These elements are discussed in more detail here:

• Pressure or incentives: As mentioned before, managers might be prone to misstating financial information if they stand to gain something from doing so, such as getting a performance bonus. If they are under a lot of pressure from shareholders or lenders to post positive results, the risk of fraud taking place also increases.

http://www.businessinsider.com/infographic-the-10-worst-corporate-finance-scandals-2012-11

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• Opportunity: Businesses that rely heavily on estimates when compiling financial statements are more open to risk, as there is more opportunity to manipulate figures. A lack of proper accounting procedures also increases the risk of fraud.

• Rationalisation: The attitude that senior management has when it comes to financial reporting may influence the risk that the business is exposed to. If senior management does not foster a culture of honesty and trust, managers may feel justified in their attempts to present financial results in a better light.

Read more about the Tesco fraud trial, and try to identify the elements of the fraud triangle that were present and may have resulted in the overstatement of financial results.

As a business manager, you must ensure that you balance the need to keep shareholders happy with the need to report financial information that is accurate and free from bias. As you discovered in these notes, anyone who takes the time to properly analyse a set of financial statements will likely be able to spot red flags that might be indicators of fraud. Fraudulent financial reporting has far-reaching consequences, not only for the individuals directly involved, but also for the business, as is evident from the Enron scandal discussed in this module.

A business can mitigate the risk of fraudulent financial reporting by having their annual reports audited by an independent auditor, and by appointing an audit committee that oversees the internal auditors and is responsible for establishing processes to identify and address any risks that might lead to inaccurate financial reports.

6. Conclusion In these notes, you discovered that, by looking at financial statements in a holistic way, you can identify trends and red flags that may require further investigation. The risk of fraudulent presentation of financial information may increase when managers are under pressure to deliver results, or if the business has a culture of disregarding good financial practices.

An increased awareness of these risks may prevent you from making investment decisions that could be detrimental in the long term. It also gives you a better understanding of the fears and concerns that investors might have about investing in your business – fears and concerns that you can address by presenting your business’s financial results in a comprehensive and transparent way.

7. Bibliography Enron scandal [Video file]. 2013. Available:

https://www.youtube.com/watch?v=Mi2O1bH8pvw [2017, October 18].

Gibson, C.H. 2013. Financial reporting and analysis: using financial accounting information. 13th ed. Mason, OH: South-Western Cengage Learning.

http://www.independent.co.uk/news/business/news/tesco-fraud-trial-bosses-accused-cooking-the-books-accounting-scandal-chris-bush-carl-rogberg-john-a7974056.html

https://www.youtube.com/watch?v=Mi2O1bH8pvw

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Harrison, W.T., Horngren, C.T., Thomas, C.W. & Tietz, W.M. 2017. Financial accounting. 11th ed. Edinburgh Gate: Pearson Education Limited.

MoneyWeek. 2011. Ten signs a company's in trouble - MoneyWeek investment tutorials [Video file]. Available: https://www.youtube.com/watch?v=lwp6i4Kd4RA [2017, October 18].

Pietersz, G. n.d. Creative accounting. Available: https://moneyterms.co.uk/creative- accounting/ [October 12, 2017].

Weetman, P. 2016. Financial accounting: an introduction. 7th ed. Edinburgh Gate: Pearson Education Limited.

https://www.youtube.com/watch?v=lwp6i4Kd4RA

https://moneyterms.co.uk/creative-accounting/

MODULE 7 UNIT 3

Evaluation of financial statements

Table of contents
1. Introduction
2. How investors evaluate a business

2.1 Ratio analysis
2.2 Vertical and horizontal analysis
2.3 Year-to-year change analysis

3. Red flags in financial statement analysis
4. Creative accounting
5. The risk of over- or understating financial results
6. Conclusion
7. Bibliography