Limitations of Financial Reports p.323

Limitations

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 1] Normalised EarningsLimitation 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 2] Capitalising ExpensesLimitation Example

Capitalising Expenses

Expense capitalisation is common. The Commonwealth Bank capitalised $626 million in software and branch costs last financial year.

• Most commonly involves treating an investment in research and development as a non current asset on the balance sheet rather than an expense on the revenue statement because you believe you have created something of value that could be sold if so desired. Makes profits appear larger than they otherwise would be.

Limitation 2] Capitalising ExpensesLimitation 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.

My god we just spent

$30million on R&D!!!

Don’t you mean we created an asset worth $30million!

Accountants can do anything!

Limitation 3] Valuing AssetsLimitation 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?

Limitation 3] Valuing Assets

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 4] Timing Issues

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=_xIO731MAO4 56.38-59.30 - Timing fraud

http://www.youtube.com/watch?v=_xIO731MAO4 50.38- 52.44 - Debt hiding

Limitation 5] Debt Repayments

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 6] Notes to financials

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.

The notes to financial statements for Qantas go from page p55-p104 in their annual report....

Do I really

have to read

these for homework sir?!