financial statement
Financial Statement Analysis
All financial statements are essentially historically historical documents. They tell what has happened during a particular period of time. However most users of financial statements are concerned about what will happen in the future. Stockholders are concerned with future earnings and dividends. Creditors are concerned with the company’s future ability to repay its debts. Managers are concerned with the company’s ability to finance future expansion. Despite the fact that financial statements are historical documents, they can still provide valuable information bearing on all of these concerns.
Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios.
Managers are also widely concerned with the financial ratios. First the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would ordinarily be used in a balanced scorecard approach. The specific ratios selected depend on the company’s strategy. For example a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio. Since managers must report to shareholders and may wish to raise funds from external sources, managers must pay attention to the financial ratios used by external inventories to evaluate the company’s investment potential and creditworthiness.
Although financial statement analysis is a highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometime makes it difficult to compare the companies’ financial data. For example if one company values its inventories by the LIFO method and another firm by average cost method, then direct comparisons of financial data such as inventory valuations are and cost of goods sold between the two firms may be misleading. Some times enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise may questions, but they rarely answer any question by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. They analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimism about the future, even though the past performance of the firm may have been mediocre.
Few figures appearing on financial statements have much significance standing by themselves. It is the relationship of one figure to another and the amount and direction of change over time that are important in financial statement analysis. How does the analyst key in on significant relationship? How does the analyst dig out the important trends and changes in a company? Three analytical techniques are widely used; dollar and percentage changes on statements, common-size statements, and financial ratios formulas.
Three Steps to Audited Financial Statements
Does your company need to present your stakeholders with an accurate report on your financial performance? The best way to prove your company’s financial credibility and accountability is to present your stakeholders with an audited financial statement.
There are three easy steps to obtain an audited financial statement for your company. First, contact an independent Certified Pubic Accountant (CPA). The CPA will then advise you on how to prepare for an orderly and efficient audit. Second, collect the information requested by the CPA and submit it to them. The CPA will examine documents which support figures within your company’s financial statements, assess the accounting principles used, and evaluate the financial statement presentation. From this information the CPA will create an audited financial statement for your company. The audit will give your stakeholders an unbiased opinion, either qualified or unqualified, regarding the nature of the financial statements and practices within your company. Lastly, review your audited financial statements, contact your CPA if you have any questions regarding the audit, and then submit the audited financial statements to your stakeholders.
An unqualified opinion indicates that the audit is found to be accurate, complete and fairly presented to meet the requirements of the US GAAP (Generally Accepted Accounting Principles). The audit provides the CPA a reasonable basis for their opinion that the financial statements are free of material misstatements or false/missing information. A qualified opinion indicates that the CPA is not in agreement with aspects of the financial statements and/or methods used to prepare their financial documents. A qualified opinion indicates that the CPA is not confident that the financial statements are correct or accurate. If no opinion is given, this usually indicates that a company needs to improve their accounting practices so they can meet the requirements of the US GAAP (Generally Accepted Accounting Principles) before an audit can be performed.
How Financial Statements Can Be Erroneously Prepared
The misuse or misunderstanding of the proper application of materiality can lead to manipulating reported income through “earnings management” techniques. This type of fraudulent financial reporting receives ample attention in the financial press. This is a subject relevant to the preparation and audit of all financial statements. SEC Staff Accounting Bulletin (SAB) no. 99, Materiality, helps advise preparers and independent auditors how to evaluate materiality misstatements in the financial reporting and auditing processes considering certain GAAP and the federal securities laws that relate to materiality.
Materiality is defined by the FASB as, “The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” The criteria for determining materiality by the FASB is that if the presentations of financial information are to be prepared economically on a timely basis and presented formally, then the concept of materiality is crucial. Misstatements occurring from clerical error or adjustments for missed invoices are not required to always be corrected as long as the error is identified in the audit process and management is notified.
Reliance on quantitative benchmarks to determine whether items are material to the financial statements is not acceptable. Qualitative, as well as quantitative factors, must be considered in determining the materiality of differences and/or omissions. Abuse of materiality, errors that are intentionally recorded within a defined percentage ceiling, and then dismissed as not enough to affect the bottom line, is not tolerated as well.
The SAB describes several qualitative factors that management and auditors can refer to when determining the materiality of misstatements. In a financial statement, a quantitatively small misstatement may become material if:
1) The misstatement came from an item that can be precisely measured.
2) It is from an estimate.
3) It disguises a change in earnings.
4) It covers up a failure to meet analysts’ expectations of the endeavor.
5) It changes a loss into income.
6) It involves a portion of the business that has been classified as a significant business segment regarding profitability.
7) It affects the business’s ability to adhere to regulations.
It affects the business’s ability to comply with contractual obligations.
9) It effects the management’s incentive compensation.
10) It involves the covering up of illegal activity.
The appropriate use of materiality should strengthen the effectiveness of financial reporting.1.
The American Institute of Certified Public Accountants’ (AICPA) Auditing Standards Board recently issued a new standard that requires CPAs to perform additional procedures to help detect potentially fraudulent actions. SAS No. 82, Consideration of Fraud in a Financial Statement Audit, meets the public’s expectations of assurance that financial statements are devoid of material misstatement caused by error or fraud. SAS no. 82 is designed to help define the responsibilities of the auditor in detecting fraud.
Errors that are unintentional can occur at any time or place causing unpredictable financial statement effects. A thorough internal control system can reduce the risk of material errors. Fraud, however, is intentional and is usually accomplished by avoiding internal controls. Fraud is difficult to detect using internal controls and requires the expertise of the auditor.
SAS No. 82 provides auditors with guidelines on how to address potential fraudulent situations in a financial statement audit. It describes the different types of fraud and advises the auditor of how to differentiate between the risk of material fraud, fraudulent financial reporting, and misappropriation of assets. SAS also requires auditors to record the risk factors identified and their response to them in both employee and management fraud.
Employee fraud usually involves the misappropriation of assets or improper record keeping. Employees are known to commit fraud due to or in combination with various factors:
1) Emotional duress
2) A perceived opportunity to get away with something
3) Resentment due to perceived pay inequity.
Management fraud usually involves manipulative financial reporting. There are several incentives for management fraud. They include:
1) Incentive to affect stock price
2) Expectations of investors
3) To avoid debt
4) To avoid tax liability
5) To meet budget
6) To influence creditors
7) To achieve bonuses
To avoid punishment.
To avoid the fraudulent activities of employees and management several things need to be implemented. Internal controls must be maintained to insure ethical practices are maintained. Top management’s support of internal control must be assured so as to not lose its effectiveness. Unusual or difficult transactions should be monitored thoroughly. Top management sets the tone for financial activity, if the ethical code is weak, a third party must become involved.
SAS No. 82 provides that the auditor accepts responsibility for detecting fraudulent practices and communicating with managers. It also contains performance guidelines to assess the risk of material misstatement due to fraud and how to respond to the risks involved. This standard raises public expectations and gives auditors greater responsibility in assuring that fraudulent practices no longer go undetected.2.
1. C. Terry Grant, “Earnings Management And The Abuse Of Materiality.” Journal of Accountancy (September, 2000)
2. Alan Reinstein; Gregory A. Coursen, “Considering The Risk Of Fraud: Understanding the Auditor’s New Requirements,” The National Public Accountant (March/April, 1999): 34-38
