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Bachelor of Commerce in

Accounting (Honours)
Bachelor of Commerce in
Banking and Finance
(Honours)

Financial Statement Analysis


(Revised) 2013

Module BACC 402


Author: L. Kazunga
Master of Science in Finance and Investments (NUST)
Bachelor of Commerce in Finance (Honours) (NUST)
IOBZ Diploma

Content Reviewer: Patrick M. Paradza


Master of Accountancy Degree (Southwest Missouri State
University)
Bachelor of Accountancy (special) Honours (UZ)
Bachelor of Science Economics Degree (University of Rhodesia)
Associate member (ICSAZ)

Editor: Solomon T. Magumise


Master of Business Administration (ZOU)
Bachelor of Arts (UZ)
Grad CE (UZ)
Diploma in Personal Management (IPMZ)
Diploma in Training Management (IPMZ)

Revised by: (2013) Cuthbert Muza


Master of Commerce in Accounting (MSU)
Bachelor of Business Administration in Accounting (Solusi
University)
Certified Public Accountant (CPA (Z)) (ICPAZ)
Certified Professional Forensic Accountant (CPFAcct) (ICFA-
Canada)
Public Accountants and Auditors Board (PAAB) Registration
Certificate
Intermediate Certificate (ICSAZ)

Editor: (2013) Kenell Madzirerusa


Master of Science in Finance and Investment (NUST)
Bachelor of Commerce in Banking (Honours) (NUST)
IOBZ Diploma
Published by: Zimbabwe Open University

P.O. Box MP1119

Mount Pleasant

Harare, ZIMBABWE

The Zimbabwe Open University is a distance teaching and open


learning institution.

Year: July 2013

Reprinted: December 2013

Cover design: B. Pillay

Layout and design: D. Satumba Nyandowe

Printed by: ZOU Press

ISBN: 978-1-77938-478-2

Typeset in Times New Roman, 12 point on auto leading

© Zimbabwe Open University. All rights reserved. No part of this


publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without the prior permission of the Zimbabwe Open
University.
Foreword To the student
The demand for skills and knowledge
and the requirement to adjust and
academics, technologists
administrators of varied backgrounds,
and

change with changing technology, training, skills, experiences and personal


places on us a need to learn continually interests. The combination of all these
throughout life. As all people need an qualities inevitably facilitates the
education of one form or another, it has production of learning materials that
been found that conventional education teach successfully any student,
institutions cannot cope with the anywhere and far removed from the
demand for education of this tutor in space and time. We emphasize
magnitude. It has, however, been that our learning materials should enable
discovered that distance education and you to solve both work-related problems
open learning, now also exploiting e- and other life challenges.
learning technology, itself an offshoot
of e-commerce, has become the most To avoid stereotyping and professional
effective way of transmitting these narrowness, our teams of learning
appropriate skills and knowledge materials producers come from different
required for national and international universities in and outside Zimbabwe,
development. and from Commerce and Industry. This
openness enables ZOU to produce
Since attainment of independence in materials that have a long shelf life and
1980, the Zimbabwe Government has are sufficiently comprehensive to cater
spearheaded the development of for the needs of all of you, our learners
distance education and open learning in different walks of life. You, the
at tertiary level, resulting in the learner, have a large number of optional
establishment of the Zimbabwe Open courses to choose from so that the
University (ZOU) on 1 March, 1999. knowledge and skills developed suit the
career path that you choose. Thus, we
strive to tailor-make the learning
ZOU is the first, leading, and currently
materials so that they can suit your
the only university in Zimbabwe
personal and professional needs. In
entirely dedicated to teaching by
developing the ZOU learning materials,
distance education and open learning.
we are guided by the desire to provide
We are determined to maintain our
you, the learner, with all the knowledge
leading position by both satisfying our and skill that will make you a better
clients and maintaining high academic performer all round, be this at certificate,
standards. To achieve the leading diploma, undergraduate or postgraduate
position, we have adopted the course level. We aim for products that will
team approach to producing the varied settle comfortably in the global village
learning materials that will holistically and competing successfully with anyone.
shape you, the learner to be an all-round Our target is, therefore, to satisfy your
performer in the field of your own quest for knowledge and skills through
choice. Our course teams comprise distance education and open learning.
Any course or programme launched by ZOU is you may never meet in life. It is our intention
conceived from the cross-pollination of ideas to bring the computer, email, internet chat-
from consumers of the product, chief among rooms, whiteboards and other modern methods
whom are you, the students and your employers. of delivering learning to all the doorsteps of
We consult you and listen to your critical our learners, wherever they may be. For all these
analysis of the concepts and how they are developments and for the latest information on
presented. We also consult other academics what is taking place at ZOU, visit the ZOU
from universities the world over and other website at www.zou.ac.zw.
international bodies whose reputation in
distance education and open learning is of a Having worked as best we can to prepare your
very high calibre. We carry out pilot studies of learning path, hopefully like John the Baptist
the course outlines, the content and the prepared for the coming of Jesus Christ, it is
programme component. We are only too glad my hope as your Vice Chancellor that all of you,
to subject our learning materials to academic will experience unimpeded success in your
and professional criticism with the hope of educational endeavours. We, on our part, shall
improving them all the time. We are determined continually strive to improve the learning
to continue improving by changing the learning materials through evaluation, transformation of
materials to suit the idiosyncratic needs of our delivery methodologies, adjustments and
learners, their employers, research, economic sometimes complete overhauls of both the
circumstances, technological development, materials and organizational structures and
changing times and geographic location, in order culture that are central to providing you with
to maintain our leading position. We aim at the high quality education that you deserve.
giving you an education that will work for you Note that your needs, the learner ‘s needs,
at any time anywhere and in varying occupy a central position within ZOU’s core
circumstances and that your performance activities.
should be second to none.
Best wishes and success in your studies.
As a progressive university that is forward
looking and determined to be a successful part
of the twenty-first century, ZOU has started to
introduce e-learning materials that will enable
you, our students, to access any source of
information, anywhere in the world through
internet and to communicate, converse, discuss _____________________
and collaborate synchronously and Prof. Primrose Kurasha
asynchronously, with peers and tutors whom Vice Chancellor
The Six Hour Tutorial Session At
The Zimbabwe Open University
A s you embark on your studies with the Zimbabwe
Open University (ZOU) by open and distance
learning, we need to advise you so that you can make
This is where the six hour tutorial comes in. For it
to work, you need to know that:
· There is insufficient time for the tutor to
the best use of the learning materials, your time and
the tutors who are based at your regional office. lecture you
· Any ideas that you discuss in the tutorial,
The most important point that you need to note is originate from your experience as you
that in distance education and open learning, there work on the materials. All the issues
are no lectures like those found in conventional raised above are a good source of topics
universities. Instead, you have learning packages that (as they pertain to your learning) for
may comprise written modules, tapes, CDs, DVDs discussion during the tutorial
and other referral materials for extra reading. All these
· The answers come from you while the
including radio, television, telephone, fax and email
can be used to deliver learning to you. As such, at tutor’s task is to confirm, spur further
the ZOU, we do not expect the tutor to lecture you discussion, clarify, explain, give
when you meet him/her. We believe that that task is additional information, guide the
accomplished by the learning package that you receive discussion and help you put together full
at registration. What then is the purpose of the six answers for each question that you bring
hour tutorial for each course on offer? · You must prepare for the tutorial by
bringing all the questions and answers
At the ZOU, as at any other distance and open that you have found out on the topics to
learning university, you the student are at the centre the discussion
of learning. After you receive the learning package, · For the tutor to help you effectively, give
you study the tutorial letter and other guiding him/her the topics beforehand so that in
documents before using the learning materials. During cases where information has to be
the study, it is obvious that you will come across gathered, there is sufficient time to do
concepts/ideas that may not be that easy to understand so. If the questions can get to the tutor
or that are not so clearly explained. You may also at least two weeks before the tutorial,
come across issues that you do not agree with, that that will create enough time for thorough
actually conflict with the practice that you are familiar preparation.
with. In your discussion groups, your friends can bring
ideas that are totally different from yours and In the tutorial, you are expected and required to
arguments may begin. You may also find that an idea take part all the time through contributing in every
is not clearly explained and you remain with more way possible. You can give your views, even if
questions than answers. You need someone to help they are wrong, (many students may hold the same
you in such matters. wrong views and the discussion will help correct
The Six Hour Tutorial Session At The Zimbabwe Open University

the errors), they still help you learn the correct thing as the tutor may dwell on matters irrelevant to the
as much as the correct ideas. You also need to be ZOU course.
open-minded, frank, inquisitive and should leave no
stone unturned as you analyze ideas and seek
clarification on any issues. It has been found that Distance education, by its nature, keeps the tutor
those who take part in tutorials actively, do better in and student separate. By introducing the six hour
assignments and examinations because their ideas are tutorial, ZOU hopes to help you come in touch with
streamlined. Taking part properly means that you the physical being, who marks your assignments,
prepare for the tutorial beforehand by putting together assesses them, guides you on preparing for writing
relevant questions and their possible answers and examinations and assignments and who runs your
those areas that cause you confusion. general academic affairs. This helps you to settle
down in your course having been advised on how
Only in cases where the information being discussed to go about your learning. Personal human contact
is not found in the learning package can the tutor is, therefore, upheld by the ZOU.
provide extra learning materials, but this should not
be the dominant feature of the six hour tutorial. As
stated, it should be rare because the information
needed for the course is found in the learning package
together with the sources to which you are referred.
Fully-fledged lectures can, therefore, be misleading

The six hour tutorials should be so structured that the


tasks for each session are very clear. Work for each
session, as much as possible, follows the structure given
below.

Session I (Two Hours)


Session I should be held at the beginning of the semester. The main aim
of this session is to guide you, the student, on how you are going to
approach the course. During the session, you will be given the overview
of the course, how to tackle the assignments, how to organize the logistics
of the course and formation of study groups that you will belong to. It is
also during this session that you will be advised on how to use your
learning materials effectively.
The Six Hour Tutorial Session At The Zimbabwe Open University

Session II (Two Hours)


This session comes in the middle of the semester to respond to the
challenges, queries, experiences, uncertainties, and ideas that you are
facing as you go through the course. In this session, difficult areas in the
module are explained through the combined effort of the students and
the tutor. It should also give direction and feedback where you have not
done well in the first assignment as well as reinforce those areas where
performance in the first assignment is good.

Session III (Two Hours)


The final session, Session III, comes towards the end of the semester.
In this session, you polish up any areas that you still need clarification on.
Your tutor gives you feedback on the assignments so that you can use
the experience for preparation for the end of semester examination.

Note that in all the three sessions, you identify the areas
that your tutor should give help. You also take a very
important part in finding answers to the problems posed.
You are the most important part of the solutions to your
learning challenges.

Conclusion for this course, but also to prepare yourself to


contribute in the best way possible so that you
In conclusion, we should be very clear that six can maximally benefit from it. We also urge you
hours is too little for lectures and it is not to avoid forcing the tutor to lecture you.
necessary, in view of the provision of fully self-
contained learning materials in the package, to BEST WISHES IN YOUR STUDIES.
turn the little time into lectures. We, therefore,
urge you not only to attend the six hour tutorials ZOU
Table of Contents

MODULE OVERVIEW ........................................................................................................................ 15


Unit 1 .................................................................................................................................................... 16
Overview of Financial Accounting ........................................................................................................ 16
Activity 1.1 ....................................................................................................................................... 18
1.2.1 Cost accounting..................................................................................................................... 18
1.2.2 Financial management........................................................................................................... 19
1.2.3 External auditing ................................................................................................................... 19
Activity 1.2 ....................................................................................................................................... 19
1.3 Complete set of Financial Statements ........................................................................................... 20
1.4 Statement of Profit or Loss and Other Comprehensive Income (Statement of Comprehensive
Income) ............................................................................................................................................. 20
1.5 Arrangement of Statement of Comprehensive Income .................................................................. 20
Activity 1.3 ....................................................................................................................................... 24
1.6 Statement of Financial Position .................................................................................................... 24
1.7 Information to be Presented in the Statement of Financial Position ............................................... 24
1.8 Statement of Cash flows .............................................................................................................. 28
1.9 IAS 7: Statement of Cash flows ................................................................................................... 28
1.10 Cash Flow and Liquidity ............................................................................................................ 31
1.11 The Purpose of Statement of Cash Flows ................................................................................... 31
1.12 Cash Flow Trends ...................................................................................................................... 31
Activity 1.4 ....................................................................................................................................... 31
1.13 Statement of Changes in Equity ................................................................................................. 31
Activity 1.6 ....................................................................................................................................... 32
1.14 Notes ......................................................................................................................................... 32
1.15 Summary ................................................................................................................................... 33
References ......................................................................................................................................... 34
Unit 2 .................................................................................................................................................... 35
Regulatory Environment........................................................................................................................ 35
2.0 Introduction ................................................................................................................................. 35
2.1 Objectives.................................................................................................................................... 35
3
2.2 Regulation of Accounting Information ......................................................................................... 35
2.2.1 Regulation by market forces .................................................................................................. 35
2.2.2 Regulation by stakeholders .................................................................................................... 35
Activity 2.1 ....................................................................................................................................... 36
2.3 International Financial Reporting Standards (IFRS) Foundation ................................................... 36
2.4 The Conceptual Framework for Financial Reporting .................................................................... 37
2.5 Purpose........................................................................................................................................ 37
2.6 Scope of the Conceptual Framework ............................................................................................ 37
Activity 2.2 ....................................................................................................................................... 38
2.7 Objectives of Financial Reporting ................................................................................................ 38
2.8 Qualitative Characteristics of Useful Financial Information.......................................................... 38
2.8.1 Fundamental qualitative characteristics ................................................................................. 38
2.8.2 Enhancing qualitative characteristics ..................................................................................... 38
Activity 2.3 ....................................................................................................................................... 39
2.9 The Elements of Financial Statements .......................................................................................... 39
2.9.1 Financial Position.................................................................................................................. 40
2.9.2 Performance .......................................................................................................................... 40
2.10 The IASB .................................................................................................................................. 40
Activity 2.4 ....................................................................................................................................... 41
2.11 Summary ................................................................................................................................... 41
References ......................................................................................................................................... 42
Unit 3 .................................................................................................................................................... 43
International Aspects of Financial Statement Preparation ....................................................................... 43
3.0 Introduction ................................................................................................................................. 43
3.1 Objectives.................................................................................................................................... 43
3.2 The Development of Accounting.................................................................................................. 43
3.3 Causes of Accounting Differences Among Nations ...................................................................... 43
3.4 Legal Systems.............................................................................................................................. 44
3.4.1 Codified Roman Law Systems .............................................................................................. 44
3.4.2 Common Law systems .......................................................................................................... 44
Activity 3.1 ....................................................................................................................................... 44
4
3.5 Sources of Capital ........................................................................................................................ 44
3.5.1 Equity driven systems ........................................................................................................... 44
3.5.2 Bank driven financial systems ............................................................................................... 45
Activity 3.2 ....................................................................................................................................... 45
3.6 Theory ......................................................................................................................................... 45
Activity 3.3 ....................................................................................................................................... 45
3.7 Taxation ...................................................................................................................................... 46
3.8 Inflation ....................................................................................................................................... 46
3.9 Strengthening of the Accounting Profession ................................................................................. 46
Activity 3.4 ....................................................................................................................................... 46
3.10 Classification of Financial Reporting Systems ............................................................................ 47
3.11 A Two-group Classification of Accounting Systems................................................................... 47
Activity 3.5 ....................................................................................................................................... 48
3.12 Harmonisation of Financial Statements ...................................................................................... 49
3.13 The Need for Harmonisation ...................................................................................................... 49
3.14 How is Harmonization Achieved? .............................................................................................. 49
3.14.1 De Jure................................................................................................................................ 49
3.14.2 De Facto ............................................................................................................................. 49
3.15 Advantages of International Harmonisation ................................................................................ 50
3.16 Obstacles/Barriers to International Harmonisation ...................................................................... 50
Activity 3.6 ....................................................................................................................................... 51
3.17 Summary ................................................................................................................................... 51
References ......................................................................................................................................... 52
Unit 4 .................................................................................................................................................... 53
Characteristics of Financial Statements and Accounting Conventions .................................................... 53
4.0 Introduction ................................................................................................................................. 53
4.1 Objectives.................................................................................................................................... 53
4.2 Qualitative Characteristics of Financial Statements ...................................................................... 53
4.2.1 Understandability .................................................................................................................. 53
4.2.2 Relevance ............................................................................................................................. 54
4.2.3 Reliability ............................................................................................................................. 54
5
Activity 4.1 ....................................................................................................................................... 55
4.2.4 Comparability and consistency .............................................................................................. 55
4.2.5 Timeliness............................................................................................................................. 55
4.2.6 Balance between benefit and cost .......................................................................................... 55
4.2.7 Fair presentation.................................................................................................................... 55
4.2.8 Materiality ............................................................................................................................ 56
Activity 4.2 ....................................................................................................................................... 56
4.3 The Fundamental Accounting Concepts ....................................................................................... 56
4.3.1 Going concern concept .......................................................................................................... 57
4.3.2 Matching concept .................................................................................................................. 57
4.3.3 Consistency........................................................................................................................... 57
4.3.4 Prudence ............................................................................................................................... 57
4.3.5 Accrual concept .................................................................................................................... 57
4.3.6 Business entity concept ......................................................................................................... 58
4.3.7 Duality .................................................................................................................................. 58
4.3.8 Accounting period ................................................................................................................. 58
4.3.9 Realisation of revenue ........................................................................................................... 58
4.3.10 Materiality .......................................................................................................................... 58
4.3.11 Objectivity .......................................................................................................................... 58
4.3.12 Monetary measurement ....................................................................................................... 59
Activity 4.3 ....................................................................................................................................... 59
4.4 Measurement Bases ..................................................................................................................... 59
Activity 4.4 ....................................................................................................................................... 60
4.5 Accounting Policies and their Application.................................................................................... 60
4.5.1 Disclosure of accounting policies .......................................................................................... 60
Activity 4.5 ....................................................................................................................................... 61
4.6 Summary ..................................................................................................................................... 61
References ......................................................................................................................................... 62
Unit 5 .................................................................................................................................................... 63
Analysis of Financial Statements ........................................................................................................... 63
5.0 Introduction ................................................................................................................................. 63
6
5.1 Objectives.................................................................................................................................... 63
5.2 Definition of a Ratio .................................................................................................................... 63
5.3 Users of ratios .............................................................................................................................. 63
5.4 Types of Comparison ................................................................................................................... 64
5.4.1 Cross-sectional analysis ........................................................................................................ 64
5.4.2 Time series analysis .............................................................................................................. 64
5.4.3 Combined analysis ................................................................................................................ 65
5.5 Limitations of Ratios ................................................................................................................... 65
5.6 Important Points to Remember ..................................................................................................... 65
Activity 5.1 ....................................................................................................................................... 66
5.7 The Main Areas ........................................................................................................................... 66
5.8 Profitability Analysis ................................................................................................................... 66
5.8.1 Asset turnover ratios ............................................................................................................. 67
5.8.2 Finance ratios ........................................................................................................................ 67
5.9 Liquidity Analysis ....................................................................................................................... 68
5.9.1 Current ratio ................................................................................................................... 68
5.9.2 The quick ratio (or acid taste ratio) ................................................................................. 68
Activity 5.2 ....................................................................................................................................... 69
5.10 Fund Management Ratios (Activity Ratios) ................................................................................ 69
5.10.1 Receivables (Debtors ) turnover ratio................................................................................... 69
5.10.2 Payables (Creditors) turnover ratio ...................................................................................... 70
5.10.3 Inventory turnover (Stockturn) ............................................................................................ 70
5.11 Gearing ...................................................................................................................................... 70
5.11.1 Debt equity ratio.................................................................................................................. 71
5.11.2 Debt to capital ratio (Total gearing) ..................................................................................... 71
Activity 5.3 ....................................................................................................................................... 71
5.12 Investment Ratios ...................................................................................................................... 71
5.12.1 Definition of terms .............................................................................................................. 72
5.12.2 Earnings per Share (EPS) .................................................................................................... 72
5.12.3 Price Earnings Ratio (PER) ................................................................................................. 72
5.12.4 Diluted Earnings ................................................................................................................. 73
7
5.12.5 Diluted shares ..................................................................................................................... 74
5.12.6 Dividend cover .................................................................................................................... 74
5.12.7 Dividend yield..................................................................................................................... 75
5.12.8 Earnings yield ..................................................................................................................... 75
5.12.9 Interest cover....................................................................................................................... 75
Activity 5.4 ....................................................................................................................................... 76
Example 5.1: Ratio Analysis .............................................................................................................. 76
Activity 5.4 ....................................................................................................................................... 85
5.13 Accounting Policies and Financial Appraisal .............................................................................. 86
5.14 International analysis ................................................................................................................. 87
Activity 5.5 ....................................................................................................................................... 87
5.15 Summary ................................................................................................................................... 87
References ......................................................................................................................................... 88
Unit 6 .................................................................................................................................................... 90
Equity Valuation ................................................................................................................................... 90
6.0 Introduction ................................................................................................................................. 90
6.1 Objectives.................................................................................................................................... 90
6.2 Financial Statements and Valuation.............................................................................................. 90
6.3 Definition of Valuation ................................................................................................................ 90
6.4 Statement of Financial Position as a Valuation Tool ..................................................................... 91
6.5 Valuation through Expectations ................................................................................................... 91
6.6 Valuation through Market Values................................................................................................. 91
6.7 Perspective of an Investor Without Control .................................................................................. 91
6.8 Perspective of an Investor with Control ........................................................................................ 92
Activity 6.1 ....................................................................................................................................... 92
6.9 Price Earnings Multiple Approach ............................................................................................... 92
Activity 6.2 ....................................................................................................................................... 93
6.10 Net Asset Value (Balance Sheet Valuation) ................................................................................ 93
Activity 6.3 ....................................................................................................................................... 93
6.11 Dividend Valuation Models ....................................................................................................... 93
6.11.1 No Growth of Dividends ......................................................................................................... 94
8
Activity 6.4 ....................................................................................................................................... 94
6.11.2 Constant Growth (Myron Gordon) .......................................................................................... 95
Activity 6.5 ....................................................................................................................................... 95
6.12 Super (or Variable) Growth of Dividends ................................................................................... 95
Activity 6.6 ....................................................................................................................................... 96
6.13 Free Cash Flow Valuation Model ............................................................................................... 97
6.13.1 Calculation of free cash flows.............................................................................................. 97
6.14 Calculating value of the firm ...................................................................................................... 98
Activity 6.7 ....................................................................................................................................... 98
6.15 Summary ................................................................................................................................. 100
References ....................................................................................................................................... 101
Unit 7 .................................................................................................................................................. 102
Accounting for Business Combinations ............................................................................................... 102
7.0 Introduction ............................................................................................................................... 102
7.1 Objectives.................................................................................................................................. 102
7.2 Methods of Accounting for Business Combinations ................................................................... 102
7.2.1 Purchase Method ................................................................................................................. 102
7.2.2 Proportional consolidation................................................................................................... 105
Activity 7.1 ..................................................................................................................................... 106
7.2.3 Equity Method .................................................................................................................... 107
Activity 7.2 ..................................................................................................................................... 109
7.2.4 Pooling of Interest ............................................................................................................... 109
Activity 7.3 ..................................................................................................................................... 110
7.2.5 Cost Method ....................................................................................................................... 111
Activity 7.4 ..................................................................................................................................... 111
7.3 Summary ................................................................................................................................... 112
References ....................................................................................................................................... 113
Unit 8 .................................................................................................................................................. 114
Valuation of Non-Current Assets and Leases ....................................................................................... 114
8.0 Introduction ............................................................................................................................... 114
8.1 Objectives.................................................................................................................................. 114
9
8.2 Non-current Assets .................................................................................................................... 114
8.2.1 Tangible non-current assets ................................................................................................. 115
8.2.2 Intangible non-current assets ............................................................................................... 115
8.3 Concerns to be Addressed in Accounting for Non-current Assets ............................................... 116
Activity 8.1 ..................................................................................................................................... 116
8.4 Initial Recording ........................................................................................................................ 116
8.5 Costs Incurred Subsequent to Purchase (or Self Construction) .................................................... 116
8.6 Depreciation of Non-current Assets............................................................................................ 117
8.6.1 Amortisation ....................................................................................................................... 117
8.6.2 Reasons for depreciation ..................................................................................................... 117
Activity 8.2 ..................................................................................................................................... 118
8.7 Depreciation Methods ................................................................................................................ 118
8.7.1 Straight Line Method .......................................................................................................... 119
8.7.2 Declining charge method (reducing balance) ........................................................................... 119
Assumptions of the declining charge method ............................................................................... 120
8.7.3 Sum of digits method .......................................................................................................... 120
Activity 8.3 ..................................................................................................................................... 121
8.8 Leases (IAS 17) ............................................................................................................................. 122
8.8.1 Finance Lease ..................................................................................................................... 122
8.8.2 Subsequent measurement of finance leases (in the lessee’s books) ....................................... 123
8.8.3 Accounting for Finance Lease (In the Lessee Books) ........................................................... 123
Activity 8.3 ..................................................................................................................................... 124
8.8.4 Disclosures of finance leases in the financial statements of lessees ...................................... 124
Example 8.1 .................................................................................................................................... 125
Activity 8.4 ..................................................................................................................................... 126
8.9 Operating Leases ....................................................................................................................... 126
8.9.1 Disclosures of operating leases in the financial statements of lessees ................................... 126
Activity 8.5 ..................................................................................................................................... 127
8.10 Intangible Assets (IAS 38) ....................................................................................................... 127
8.10.1 Identifiability .................................................................................................................... 128
8.10.2 Control .............................................................................................................................. 128
10
8.10.3 Recognition of intangible assets ........................................................................................ 128
8.11 Research and Development ...................................................................................................... 129
Activity 8.6 ..................................................................................................................................... 130
8.12 Summary ................................................................................................................................. 130
References ....................................................................................................................................... 131
Unit 9 .................................................................................................................................................. 132
Forecasting Techniques and Models .................................................................................................... 132
9.0 Introduction ............................................................................................................................... 132
9.1 Objectives.................................................................................................................................. 132
9.2 Forecasting ................................................................................................................................ 132
9.2.1 Extrapolative models ........................................................................................................... 132
9.2.2 Permanent versus Transitory Components ........................................................................... 133
9.2.3 Index Models ...................................................................................................................... 133
9.3 Forecasting with Disaggregated Data ......................................................................................... 133
9.3.1 Quarterly data ..................................................................................................................... 134
9.3.2 Segment - based forecasts.................................................................................................... 134
9.3.3 Using statement of comprehensive income components ....................................................... 134
Activity 9.1 ..................................................................................................................................... 134
9.4 Forecasting Statement of Comprehensive Income (Extrapolative Approach) .............................. 134
9.4.1 Sales/turnover ..................................................................................................................... 134
9.4.2 Cost of sales ........................................................................................................................ 135
9.4.3 Operating expenses ............................................................................................................. 135
9.4.4 Interest expenses ................................................................................................................. 135
9.4.5 Corporate tax ...................................................................................................................... 136
Activity 9.2 ..................................................................................................................................... 136
9.5 Statement of Financial Position .................................................................................................. 137
9.5.1 Non-current assets ............................................................................................................... 137
9.5.2 Current assets ...................................................................................................................... 137
9.5.3 Current liabilities ................................................................................................................ 137
9.5.4 Long-term liabilities ............................................................................................................ 138
9.5.5 Shareholders equity ............................................................................................................. 138
11
9.5.6 Important areas to watch ..................................................................................................... 138
Activity 9.3 ..................................................................................................................................... 145
9.6 Application of Index Models...................................................................................................... 146
9.6.1 Statement of comprehensive income.................................................................................... 146
9.6.2 Statement of financial position ............................................................................................ 147
9.7 Assessment of Assumptions ....................................................................................................... 147
Activity 9.4 ..................................................................................................................................... 148
9.8 Summary ................................................................................................................................... 148
References ....................................................................................................................................... 148
Unit 10 ................................................................................................................................................ 150
Forecasting Company Failure .............................................................................................................. 150
10.0 Introduction ............................................................................................................................. 150
10.1 Objectives ................................................................................................................................ 150
10.2 Company Failure ..................................................................................................................... 150
10.3 Qualitative Approaches ............................................................................................................ 151
10.3.1 Root causes of failure ........................................................................................................ 151
10.3.2 Attitudes and company failure ............................................................................................... 151
Activity 10.1.................................................................................................................................... 152
10.3.3 Company pathology .......................................................................................................... 152
10.3.4 Argenti Analysis ............................................................................................................... 153
Argenti’s A Score ........................................................................................................................ 154
10.3.5 Limitations of Argenti Analysis ......................................................................................... 155
Activity 10.2.................................................................................................................................... 156
10.4 Quantitative Approaches (Statistical Modeling)........................................................................ 156
10.4.1 Univariate models ............................................................................................................. 156
10.4.2 Determining the cut-off point ............................................................................................ 156
10.4.3 Multivariate models........................................................................................................... 156
10.5 Z Scores and Discriminant Analysis ......................................................................................... 157
10.5.1 ‘Failure’ methodology ....................................................................................................... 158
10.5.2 The findings of discriminant analysis................................................................................. 159
10.5.3 Limitations of Z scores ...................................................................................................... 160
12
10.5.4 Adaptiveness of companies ............................................................................................... 160
10.5.6 Other factors ..................................................................................................................... 161
10.6 Avoiding Failure ...................................................................................................................... 162
Activity 10.3.................................................................................................................................... 162
10.7 Summary ................................................................................................................................. 162
References ....................................................................................................................................... 163
Unit 11 ................................................................................................................................................ 164
Important Aspects in Financial Reporting ............................................................................................ 164
11.0 Introduction ............................................................................................................................. 164
11.1 Objectives ................................................................................................................................ 164
11.2 Creative Accounting ................................................................................................................ 164
11.3 Purpose of Creative Accounting ............................................................................................... 164
Activity 11.1.................................................................................................................................... 165
11.4 Common Techniques of Creative Accounting .......................................................................... 165
11.4.1 Big Bath ............................................................................................................................ 165
11.4.2 Creative Acquisition Accounting ....................................................................................... 165
11.4.3 Cookie Jar Reserves .......................................................................................................... 166
11.4.4 Materiality misapplication ................................................................................................. 166
11.4.5 Premature recognition of revenue ...................................................................................... 166
Activity 11.2.................................................................................................................................... 166
11.5 Other Common Examples of Creative Accounting ................................................................... 166
Activity 11.3.................................................................................................................................... 167
11.6 Off-Balance Sheet (Statement of Financial Position) Transactions ............................................ 167
11.6.1 Leasing transactions .......................................................................................................... 167
11.6.2 Securitisation transactions ................................................................................................. 167
11.6.3 Creation of unconsolidated entities .................................................................................... 168
11.6.4 Buyback agreements ......................................................................................................... 168
11.6.5 Derivative contracts........................................................................................................... 168
11.7 Addressing the Dangers of Creative Accounting....................................................................... 168
11.8 Derivatives and Hedging Activities .......................................................................................... 169
Activity 11.5.................................................................................................................................... 170
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11.8.1 Derivative Hedging ........................................................................................................... 170
11.9 Notes to Financial Statements .................................................................................................. 170
Activity 11.6.................................................................................................................................... 171
11.10 Fundamental Analysis ............................................................................................................ 171
Activity 11.6.................................................................................................................................... 172
11.11 Summary ............................................................................................................................... 172
References ....................................................................................................................................... 173

14
MODULE OVERVIEW
Financial Statement Analysis is concerned with telling the story behind the numbers that we see in
financial statements. Whilst auditing is concerned with providing an external and independent check
on the activities of a business entity and on the financial statements and published reports, the
analysis aspect aims to bring out issues of viability in the various contexts of liquidity, profitability and
gearing.

In this module we outline the scope and purpose of financial statements, the context in which financial
statements are prepared, the regulatory framework, the accounting treatment of various business
aspects and use of financial statements in assessing the strength of business operations.

Financial statements have to be analysed in the context of the various stakeholders who make use
of the financial information contained therein. Different stakeholders have different needs in
terms of the detail that they require to make well-informed economic decisions (decisions with a
financial bearing). Managers, for example, will require more detail on the operations of the
company as compared to outside shareholders. Consequently the internal stakeholders (managers)
will have their own set of detailed accounts (management accounts) whilst external stakeholders
will wait for published financial reports which are thin on detail on the day-to-day operations of
the company. Financial managers, therefore, always play a delicate game in trying to satisfy the needs
of various external interested groups without exposing the company excessively to competitors.

In a nutshell, this course aims to equip you with the requisite analytical tools required in
Investment Analysis, Credit Analysis, Corporate Financial Analysis and in financial due diligence.
Consequently, this module is targeted at students who will undertake financial statements analysis
as one of their courses in satisfaction of their subjects particularly accounting, banking and finance.
A grasp of financial Accounting II is a prerequisite for a clear understanding of various aspects discussed
in this module.

The module will unfold as follows:


Unit 1 Overview of financial accounting, Unit 2 Regulatory environment, Unit 3 International
aspects of financial statement preparation, Unit 4 Characteristics of financial statements and
accounting conventions, Unit 5 Analysis of financial statements; Unit 6 Equity Valuation; Unit 7
Accounting for Business Combinations; Unit 8 Valuation of Non-Current Assets and Leases;
Unit 9 Forecasting Models; Unit 10 Forecasting Company failure; and Unit 11 Important
Aspects in Financial Reporting.

15
BLANK PAGE
Unit 1

Overview of Financial Accounting

1.0 Introduction

In this unit, we lay down the basics of Financial Accounting, preparation of financial statements,
purpose and the use of financial information. We will briefly look at the various financial
statements and try to differentiate among financial accounting, cost accounting, management
accounting, financial management and auditing.

1.1 Objectives

By the end of this unit, you should be able to:

• specify how financial accounting, cost accounting, management accounting and financial
management differ

• explain statement of comprehensive income, statement of financial position, statement of


cash flows and statement of changes in equity

• list the various stakeholders interested in financial statements

• discuss the elements of financial statements

1.2 Difference Between Financial and Management Accounting

Financial accounting is concerned with the preparation of financial information for use by a wide
range of users about the financial position of a company and changes there in, as well as the
financial results of the operations of the company. In preparing financial statements, the aim is
not to satisfy the needs of every possible user of the financial statements, but rather to meet at
least the basic needs of interested stakeholders such as:
 shareholders;
 board of directors;
16
 potential investors in shares or bonds;
 lenders and trade creditors (suppliers);
 government institutions;
 potential investors in shares or bonds;
 employees and their representative organisations;
 customers; and
 the general public.
Financial accounting is defined as “The classification and recording of monetary transactions
of an entity in accordance with established concepts, principles, accounting standards and
legal requirements and presentation of a view of those transactions during and at the end of
the accounting period” (Lucey, 1996). On the other hand, management accounting is concerned
with the preparation and presentation of accounting information in such a way as to assist
management in the formulation of policies, decision making, safeguarding the assets of
the company and in the planning and control of the operations of a business entity. The following
table summarises the differences between financial accounting and management accounting
under three broad categories, users, time horizon and regulatory compliance.
Table 1.1: Financial vs Management Accounting
Financial Accounting Management Accounting
Financial Accountant aims to report the Management Accountants aim to report
company’s affairs and transactions to external information exclusively to internal audiences
audience such as shareholders , debt providers, such as directors, project managers, department
government bodies managers.
Financial accounts are usually based on Management accounting information can often
historic data and are often reported some time be more forward looking and may use historic
(months) after the event to which they relate. data but will usually try to use it predicatively
Hence they are said to be backward looking. to make decisions about the future direction of
the company.
Financial accounts are used for stewardship Management accounts and reports do not have
purposes and as a basis for other calculations to suffer the same restrictions of legislation and
such as taxation liabilities. Hence there are IAS and IFRS and may not have the same level

17
expectations of precisions and accuracy to give of accuracy. The emphasis is on timely
a “true and fair view”. Therefore, they must production of information rather than accuracy
comply with detailed legislation and and compliance.
International Accounting Standards (IAS) and
International Financial Reporting Standards
(IFRS)

Activity 1.1
Consider the following groups: managers, investors, employees and government agencies.
Suggest the information they are likely to need from accounting statements and reports.
How easy is it to satisfy the needs of all these groups using one set of common
information?

1.2.1 Cost accounting


Cost accounting is “the establishment of budgets, standard costs and actual costs of operations,
processes, activities or products and the analysis of variances, profitability or the social use
of funds” (Lucey, 1996).
Table 1.2: Differences between Cost Accounting and Management Accounting
Basics Cost Accounting Management Accounting

1. Scope Cost accounting is limited to The main thrust is towards


providing technical cost determining policy and
information to management formulating plans to achieve
(primary emphasis is on cost desired management
and involves collection, objectives. It helps
analysis, relevance, management in planning,
interpretation and controlling and analysing the
presentation of cost of performance of the
production organisation for continuous
improvement.

2. Techniques employed Various techniques used by Management Accounting


cost accounting include also uses all these techniques
standard costing, variance but in addition also uses

18
analysis, marginal costing statistical analysis, operations
and cost volume profit research, quantitative
analysis and budgetary techniques and other
control branches of knowledge that
can help in most decision
making such as decision tree.

3. Data base It is based on data derived It is based on data derived


from financial accounts from cost accounting,
financial accounting and
other sources

4 Characterisation Cost accounting is mostly Management accounting is


quantitative in nature both quantitative and
qualitative, for example,
quality cost measurement and
reporting

1.2.2 Financial management


Financial management is concerned with the acquisition of and efficient utilisation of financial
resources. It involves financial analysis, planning and control and effective employment of funds
to maximise shareholder value.

1.2.3 External auditing


This is a control mechanism designed to provide an external and independent check of
the activities of the business, financial statements and reports published by the business to
external stakeholders.

Activity 1.2
What is the relationship between cost accounting and management accounting?

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1.3 Complete set of Financial Statements
According to IAS 1 a complete set of financial statements comprises:
(a) a statement of financial position as at the end of the period;
(b) a statement of profit or loss and other comprehensive income (statement of
comprehensive income) for the period;
(c) a statement of changes in equity for the period;
(d) a statement of cash flows for the period;
(e) notes, comprising a summary of significant accounting policies and other explanatory
information; and
(f) a statement of financial position as at the beginning of the earliest comparative period
when an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements, or when it reclassifies items in its
financial statements (IFRS, 2011).

1.4 Statement of Profit or Loss and Other Comprehensive Income (Statement


of Comprehensive Income)
The statement of comprehensive income gives a financial summary of the business entity’s
operating results during a specified period. The statement measures the flows of revenues
and expenses during an interval of time, usually one year or bi-annual periods. For more
detailed management accounts it can be on a monthly basis. This is a “period statement”,
explaining changes over time. The purpose of this statement is to give information on the
performance of an organisation over a given time frame.

1.5 Arrangement of Statement of Comprehensive Income


For easy of comprehension, the items to be disclosed in the statement of comprehensive income
are usually categorised on the basis whether they relate to:

• revenue;
• cost of sales;
• gross profit or loss;

20
• other income;
• distribution costs;
• administrative expenses;
• other operating income;
• income from shares in group undertakings;
• income from participating interests;
• income from other fixed asset investments;
• other interest receivable and similar income;
• amounts of written off investments;
• interest payable and similar charges;
• tax on profit or loss on ordinary activities;
• profit or loss on ordinary activities after taxation;
• extraordinary income;
• extraordinary charges;
• extraordinary profit or loss;
• other taxes not shown above; and
• profit or loss for the year.
According to Frank Wood and Alan Sangster (2002) the above items have to be displayed
in the order shown. If some items do not exist for the company in a given year, then
those headings are omitted from the published statement of comprehensive income. Some
income statements may differ in their form from the format shown above but the bottom line
is that the basis of preparation should comply with accepted local and international
accounting standards, principles, concepts and legal requirements.
Table 1.3 below shows a format of a statement of comprehensive income by function and by
nature.

21
Table 1.3

X Group Limited
Consolidated Statement of Comprehensive Income for the year ended 31 December 2012
(Illustrating the classification of expenses ‘by function’)
2012 2011
$ $
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other operating income X X
Distribution costs (X) (X)
Operating expenses (X) (X)
Finance costs (X) (X)
Other expenses (X) (X)
Share of profits/loss of associates X X
Profit/(loss) before tax X X
Income tax expense (X) (X)
Profit/(loss) for the year X X

Other comprehensive income


Exchange differences on translating foreign operations X X
Gain/(loss) on property revaluation X X
Gain/(loss) on available-for-sale financial assets X X
Share of other comprehensive income of associates X X
Other comprehensive income for the year X X

Total comprehensive income for the year X X

Profit/(loss) attributable to:


Owners of the parent X X
Non-controlling interests X X
X X
Total comprehensive income/(loss) attributable to:
Owners of the parent X X
Non-controlling interests X X
X X

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X Group Limited
Consolidated Statement of Comprehensive Income for the year ended 31 December 2012
(Illustrating the classification of expenses ‘by nature’)

2012 2011
$ $
Revenue X X
Other operating income X X
Changes in inventories of finished goods and work in progress (X) (X)
Work performed by the enterprise and capitalised X X
Raw materials and consumables used (X) (X)
Employee benefits expense (X) (X)
Depreciation and amortisation expense (X) (X)
Impairment of property, plant and equipment (X) (X)
Finance costs (X) (X)
Other expenses (X) (X)
Share of profit/(loss) of associates X X
Profit/(loss) before tax X X
Income tax expense (X) (X)
Profit/(loss) for the year X X

Other comprehensive income


Exchange differences on translating foreign operations X X
Gain/(loss) on property revaluation X X
Gain/(loss) on available-for-sale financial assets X X
Share of other comprehensive income of associates X X
Other comprehensive income for the year X X

Total comprehensive income for the year X X

Profit/(loss) attributable to:


Owners of the parent X X
Non-controlling interests X X
X X
Total comprehensive income/(loss) attributable to:
Owners of the parent X X
Non-controlling interests X X
X X

23
Note: A requirement of IAS 1 is that each entity must clearly identify whether the financial
statements are of an individual entity or a group of entities.

Other information that needs to be presented on the face of the income statement or the notes
include the following:
• depreciation;
• amortisation expense;
• staff costs; and
• dividends per share declared or proposed for the period.

Activity 1.3
List the main revenue and expense items for a:
(i) hotel business;
(ii) consultancy business; and
(iii) mining business.

1.6 Statement of Financial Position


A statement of financial position (balance sheet) is a summary statement of the business entity’s
financial position at a given point in time. The statement balances the business’ assets against its
financing which can either be debt or equity.

1.7 Information to be Presented in the Statement of Financial Position


At minimum, the statement of financial position shall include line items that present the
following amounts;
(a) property, plant and equipment;
(b) investment property;
(c) intangible assets;
(d) financial assets (excluding amounts shown under (e), (h) and (i));
(e) investments accounted for using the equity method;
(f) biological assets;
(g) inventories;
(h) trade and other receivables;
(i) cash and cash equivalents;
24
(j) the total assets as held for sale and assets included in disposal groups classified as held
for sale in accordance with IFRS 5 – Non-current assets held for sale and discontinued
operations;
(k) trade and other payables;
(l) provisions;
(m) financial liabilities (excluding amounts shown under (k) and (i));
(n) liabilities and asset for current tax;
(o) deferred tax liabilities and deferred tax assets;
(p) liabilities included in disposal groups classified as held for sale;
(q) non-controlling interests, presented within equity; and
(r) issued capital and reserves attributable to owners of the parent.
Assets are resources of the business, which may be current or non-current. Current assets are
assets that can be turned into liquid cash in one operating cycle or one year whichever is longer.
Non-current assets are assets that cannot be liquidated within one operating cycle (or
quickly). They are acquired with the intention of using them for a long period. Non-current
assets comprise physical and non- physical assets. Non-current tangible assets include land and
buildings, machinery and equipment, and furniture and fittings. Examples of non-current
intangible assets include goodwill, patents and trademarks.
The book value of tangible assets is reduced periodically by the amount of wear and tear
(depreciation). Book value is also known as the carrying amount. Accumulated depreciation is
the sum of depreciation calculated for physical assets of the firm over their expired life. There
are various methods of calculating depreciation. These are applicable depending on the nature of
the assets. The most common methods are:
• straight line method;
• reducing balance method; and
• sum of digits method.
Liabilities are obligations of the business. Liabilities can similarly be classified into current and
long term.
Shareholders equity is the ownership interest of the business and it is represented by ordinary
share capital, share premium and retained income. Preference share capital is quasi- equity

25
capital. It has some characteristics of equity and debt. Preference share dividends rank above
ordinary share dividends but below periodic payments to debt holders. Dividends on
cumulative preference shares can be passed but they accumulate, only to be paid when
the company is able to do so.
In practice, certain type of information is shown in the notes attached to the statement of
financial position. A reference to the note being made against any item actually included
in the statement of financial position will then give more information on the item. It is a
matter for the individual company’s discretion as to which item it will treat this way.

Table 1.4: Statement of Financial Position Format


X Group Limited
Consolidated Statement of Financial Position as at 31 December 2012

26
Non-current Assets
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investments in associates X X
Available-for-sale-investments X X
Other Assets X X
Total non-current assets X X
Current Assets
Inventories X X
Trade and other receivables X X
Other current assets X X
Cash and cash equivalents X X
Total current assets X X
Total Assets X X
EQUITY AND LIABILITIES
Equity attributable to owners of parent
Issued share capital X X
Reserves X X
Retained Earnings X X
Other components of equity X X
X X
Non-controlling interests X X
Total Equity X X
Non-current Liabilities
Long-term borrowings X X
Deferred tax X X
Long-term provisions X X
Total non-current liabilities X X
Current Liabilities
Trade and other payables X X
Short-term borrowings X X
Current portion of long-term borrowings X X
Current tax payable X X
Provisions X X
Total current liabilities X X
Total Liabilities X X
Total Equity and Liabilities X X
* A requirement of IAS 1 is that each entity must clearly identify whether the financial statements are of a
entity or a group of entities.

27
1.8 Statement of Cash flows
Financial statements should include a statement of cash flows in a format appropriate to the
circumstances of the business. The objective of a statement of cash flows is to provide
information concerning the source and use of all financial resources during the accounting
period. Cash flow information provides users of financial statements with a basis to assess the
ability of the entity to generate cash and cash equivalents and the needs of the entity to utilize
those cash flows.

1.9 IAS 7: Statement of Cash flows


The objective of IAS 7 is to require the provision of information about the historical changes in
cash and cash equivalents of an entity by means of a statement of cash flows which classifies
cash flows during the period from operating, investing and financing activities. The statement
should ideally disclose the following:
• cash flow from operating activities;
• cash flow from investment activities;
• cash flow from financing activities;
• changes in non-cash components of working capital;
• effect of taxation;
• effect of investing in fixed assets;
• effect of financing activities; and
• effect of distribution to shareholders.
The statement of cash flows is intended to help predict the firm’s ability to sustain current
operations.The classification of cash flows among operating, financing and investing activities
are essential to the analysis of cash flow data.
Cash flow from operating activities: -This measures the amount of cash generated or used by
the firm as a result of its production and sales of goods and services. One of the following
methods can be used to report the cash flows from operating activities:
• Direct method, whereby major classes of gross cash receipts and gross cash flow
payments are disclosed; or

28
• The indirect method, whereby profit or loss is adjusted for the effects of transactions of
a non-cash nature, any deferrals or accruals of the past or future operating cash receipts or
payments, and items of income and expense associated with investing or financing cash
flows.
Cash flow from investing activities - This reports the amount of cash used to acquire assets
such as plant and equipment as well as investments and entire businesses. These outlays are
necessary to maintain a firm’s current operating capacity and to provide capacity for
future growth. The cash flows represent the extent to which expenditures have been made for
resources intended to generate future income and cash flows. Only expenditures that result in a
recognised asset in the statement of financial position are eligible for classification as investing
activities. This section includes cash received from the sale or disposal of assets or segments of
the business. Dividends can also be classified as investing cash flows since they constitute a
return from earlier investment activities.
Cash flow from financing activities - Contains the cash flow consequences of the firm’s capital
structure decisions, including proceeds from the issuance of equity, returns to shareholders in the
form of dividends and repurchase of shares and the incurrence and repayment of debt. Cash
flows from financing activities is useful in predicting claims on future cash flows by providers of
capital to the entity.

29
Table 1.5: Format of a Statement of Cash Flows

X Limited Group

Consolidated statement of cash flows for the year ended 31 December 2012

2012 2011
$ $
Cash flows from operating activities
Cash generated from operations X X
Interest paid (X) (X)
Income tax paid (X) (X)
Net cash from operating activities X X
Cash flows from investing activities
Purchase of property plant and equipment (X) (X)
Acquisition of subsidiary net of cash acquired (X) (X)
Dividends received from associates X X
Proceeds from sale of property plant and equipment X X
Net cash used in investing activities X X
Cash flows from financing activities
Share issue X X
Dividends paid to non controlling interest (X) (X)
Dividends paid (X) (X)
Net cash used in financing activities X X
Net increase in cash and cash equivalents X X
Cash and cash equivalents at beginning of period X X
Cash and cash equivalents at end of period X X

Note: Reconciliation of profit before tax to cash generated from operations


Profit before tax X X
Finance cost X X
Depreciation charge X X
Amortisation charge X X
Loss on disposal of property plant and equipment X X
Share of profits from associates X X
Increase/(decrease) in inventories X X
Increase/(decrease) in trade and other receivables X X
Increase/(decrease) in trade and other payables X X
Cash generated from operations X X

30
1.10 Cash Flow and Liquidity
The cash flow statement provides information about the firm’s liquidity and its ability to finance
its growth from internally generated funds. It can highlight potential liquidity problems, such as
an increasing need for operating capital or lagging cash collections.

1.11 The Purpose of Statement of Cash Flows


The statement of cash flows is intended to disclose information that is not available from the
statement of comprehensive income and statement of financial position. They show how cash
was generated and how it was applied. This is very important since cash is the lifeblood of the
business. A statement of cash flows together with the statement of financial position provides
invaluable information on viability, liquidity and financial stability of a company at any given
point in time.

1.12 Cash Flow Trends


The data contained in the statement of cash flows can be used to:

• review individual cash flow items for analytic significance;

• examine the trend of different cash flow components over time and their relationship to
related income statement items; and

• consider the interrelationship between cash flow components over time.

Activity 1.4
Explain the usefulness of the statement of cash flows to an investor seeking to take over a
company?

1.13 Statement of Changes in Equity


A statement of changes in shareholders’ equity shows the value added to shareholders
from the internally-generated retained earnings or changes from new issues of shares. This is a
statement less frequently emphasised but nevertheless of paramount importance to the
shareholder.

31
Table 1.6: The format for the presentation of the statement of changes in equity

Share Share Revaluation Translation Accumulated Total


Capital Premium Reserve Reserve profits
Balance at 31 December 2012 x x x (x) x x
Changes in accounting policy (x) (x)
Restated balance x x x (x) x x
Surplus on revaluation of properties x x
Deficit on revaluation of investments (x) (x)
Currency translation differences (x) (x)
Net gains /losses not recognised in income statement x (x) x
Net profit for the period x x
Dividends (x) (x)
Issue of share capital x x x
Balance at 31 December 2013 x x x (x) x x
Deficit on revaluation of properties (x) (x)
Surplus on revaluation of investments x x
Currency translation differences (x) (x)
Net gains / losses not recognised in the income statements (x) (x) (x)
Net profit for the period x x
Dividends (x) (x)
Issue of share capital x x x
Balance at 31 December 2014 x x x (x) x x

Shareholders’ equity can be increased by any new capital issued. This can be in the form of
rights issues, private placements or initial public offers. Internally-generated earnings are added
to reserves but these have to be reduced by any deferred taxation and any deferred dividends.

Activity 1.6
Discuss the groups of stakeholders interested in the statement of changes in equity.

1.14 Notes
The notes shall:
(a) present information about the basis of preparation of the financial statements and the
specific accounting policies;
(b) disclose the information required by IFRs that is not presented elsewhere in the financial
statements; and
(c) provide information that is not presented elsewhere in the financial statements, but is
relevant to an understanding of any of them.

32
An entity shall present notes in a systematic manner. An entity shall cross-reference each item in
the statement of financial position and of comprehensive income, in the separate income
statement, and in the statement of changes in equity and of cash flows to any related information
in the notes.

1.15 Summary
In this unit we gave a brief analysis of the most important financial statements which are
of importance to stakeholders namely, the statement of comprehensive income, statement of
financial position, statement of cash flows, statement of changes in equity and notes, which we
normally find in published financial reports. These are the statements, which form the basis of
this course. It is assumed that the preparation of these statements is covered in financial
accounting 1 (BACC101). Illustration formats of various financial statements were given. A flip
through the various financial reports will show that financial statements could be presented in
different formats but have to show all the essential information as per the requirements of
acceptable accounting standards, principles, conventions and laws.

33
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Basson, N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.

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BLANK PAGE
Unit 2

Regulatory Environment

2.0 Introduction
The accounting environment has been changing dramatically over the past few years. The
regulatory environment has rapidly been globalised with the establishment of the International
Accounting Standards Committee (IASC) Foundation which was renamed International
Financial Reporting Standards (IFRS) Foundation in 2010. International Accounting Standards
(IAS) are fast becoming the common place of financial accounting treatment.

2.1 Objectives
By the end of this unit, you should be able to:
• explain the importance of regulation in accounting treatment
• outline the conceptual framework of financial statement preparation
• describe the mandate of the International Accounting Standards Committee (IASC)

2.2 Regulation of Accounting Information


Theory has provided two schools of thought with respect to the regulation of accounting
information which are (a) regulation by market forces and (b) regulation by stakeholders.

2.2.1 Regulation by market forces


Financial markets are assumed to be efficient, and consequently they reward those who provide
good quality and quantity of financial information. On the other hand, those who do not provide
quality information should be punished by finding it difficult and costly to raise finance in
money and capital markets.

2.2.2 Regulation by stakeholders


The assumption is that markets are not efficient and hence the regulation cannot be left to the
“invisible hand”. There is need for direct intervention by the government through laws and
regulations, the stock exchange and international organisations such as the International
Financial Reporting Standards (IFRS) Foundation and the International Organisation of Security

35
Commissions (IOSCO) which strive to achieve the harmonisation of the preparation of financial
statements to facilitate the comparison of financial results across national boundaries. The main
objective of both types of regulation is to protect the interests of investors.

Activity 2.1
The provision of accounting information can either be regulated by market forces or by
stakeholders such as the government. Which of the two methods of regulation do you think is
effective and why?

2.3 International Financial Reporting Standards (IFRS) Foundation


The International Accounting Standards Committee (IASC) later named IFRS Foundation in
2010 was set up in a bid to harmonise the preparation of financial statements internationally to
facilitate the comparison and assessment of financial information. Specifically the objectives of
IFRS Foundation are:
(a) to develop, in the public interest, a single set of high quality, understandable, enforceable
and globally accepted financial reporting standards based upon clearly articulated
principles. These standards should require high quality, transparent and comparable
information in financial statements and other financial reporting to help investors, other
participants in the world’s capital markets, and other users of financial information, make
economic decisions;
(b) to promote the use and rigorous application of those standards;
(c) to take account of the needs of a range of sizes and types of entities in diverse economic
settings; and
(d) to promote and facilitate adoption of International Financial Reporting Standards
(IFRSs), being the standards and interpretations issued by the International Accounting
Standards Board (IASB), through the convergence of national accounting standards and
IFRSs.

36
2.4 The Conceptual Framework for Financial Reporting
The conceptual framework for financial reporting sets out the concepts that underlie the
preparation and presentation of financial statements for external users. It is a constitution or a
coherent system of interrelated objectives and fundamentals that can lead to consistent standards
and that prescribes the nature, function and limits of financial accounting and financial
statements. The conceptual framework is not in itself a standard.

2.5 Purpose
The purposes of the conceptual framework is:
(a) to assist the Board in the development of future IFRSs and in its review of existing
IFRS;
(b) to assist the Board in promoting harmonisation of regulations, accounting standards and
procedures relating to the presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by IFRSs;
(c) to assist national standard setting bodies in developing national standards;
(d) to assist preparers of financial statements in applying IFRSs and in dealing with
topics that have yet to form the subject of an IFRS;
(e) to assist auditors in forming an opinion on whether financial statements comply with
IFRSs;
(f) to assist users of financial statements in interpreting the information contained in
financial statements prepared in compliance IFRSs; and
(g) to provide those who are interested in the work of the IASB with information about its
approach to the formulation of IFRSs.

2.6 Scope of the Conceptual Framework


The conceptual framework deals with:
(a) objectives of financial reporting;
(b) qualitative characteristics of usefulness of financial information;
(c) the definition, recognition and measurement of the elements from which financial
statements are constructed; and

37
(d) concepts of capital and capital maintenance.

Activity 2.2
Explain in detail the purpose and objectives of the International Financial Reporting Standards
(IFRS) Foundation conceptual framework for financial reporting.

2.7 Objectives of Financial Reporting


The objective of general purpose financial reporting is to provide information about:
• the financial position;
• performance; and
• changes in the financial position of the firm.
The critical assumptions are the accrual basis and that the firm is expected to continue
in operation for the foreseeable future.

2.8 Qualitative Characteristics of Useful Financial Information


These are the attributes that make the information provided in financial statements useful to
users. If information is to be useful, it must be relevant and faithfully represent what it purports
to represent. The usefulness of financial information is enhanced if it is comparable, verifiable,
timely and understandable.

2.8.1 Fundamental qualitative characteristics


The fundamental qualitative characteristics are relevance and faithful representation.
• Relevance: Information should be relevant to the requirements of interested stakeholders
for their decision making.
• Faithful representation – Financial reports represent economic phenomena in words and
numbers. To be useful, financial information must not only represent relevant
phenomena, but it must also faithfully represent the phenomena that it purports to
represent. To be a perfectly faithful representation, a depiction would have three
characteristics. It would be complete, neutral and free from error.
2.8.2 Enhancing qualitative characteristics
Comparability, verifiability, timeliness and understandability are qualitative characteristics that
enhance the usefulness of information that is relevant and faithfully represented.
38
• Comparability: Information presented should be prepared in such a way that it can be
comparable with previous information and also information from other entities.
• Verifiability means that different knowledgeable and independent observers could
reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation. Verification can be direct or indirect.
• Timeliness means having information available to decision-makers in time to be
capable of influencing their decisions. The older the information is the less useful it
is.
• Understandability: Information must be easily understood by financial statement
users who have got a fair accounting knowledge. Classifying, characterising and
presenting information clearly and concisely make it understandable.

• Reliability: Financial statement users should not be in doubt as to the accuracy and
fairness of the information provided.
It is important to note that some of the characteristics may be at variance. For example,
reliability and relevance tend to move in opposite directions. The historic cost convention is
reliable but would not be relevant during times of inflation.
To be reliable information must:
• be such that transactions are recorded according to their economic substance rather than
their legal form (substance over form);
• be free from bias, subject to the convention of prudence (neutrality); and
• be complete within the bounds of materiality and cost (completeness).

Activity 2.3
Neutrality is about freedom from bias. Prudence is a bias. It is not possible to embrace both
conventions in one coherent framework. Discuss.

2.9 The Elements of Financial Statements


Financial statements portray the financial effects of transactions and other events by grouping
them into broad classes according to their economic characteristics. These broad classes are
termed the elements of financial statements. We will look at the elements directly related to the

39
statement of financial position, statement of comprehensive income. The statement of changes in
equity looks at income statement elements and changes in financial position elements.

2.9.1 Financial Position


The elements directly related to the measurement of financial position are assets, liabilities and
equity. These are defined as follow:

(a) 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.

(b) A liability is 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.

(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

2.9.2 Performance
Profit is frequently used as a measure of performance. The elements directly related to the
measure of profits are income and expenses. The elements of income and expenses are defined as
follows:

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

(b) Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.

2.10 The IASB


The International Accounting Standards Board (IASB) is the standard-setting operation of the
IFRS Foundation. The IASB is selected, overseen and funded by the IFRS Foundation, and it has
complete responsibility for all IASB technical matters including the preparation and issue of
IFRSs. IFRSs are mandatory pronouncements and comprise:

(a) International Financial Reporting Standards

(b) International Accounting Standards

(c) International Financial Reporting Interpretations Committee (IFRIC) interpretations; and

(d) Standing Interpretations Committee (SIC) Interpretations.

40
Activity 2.4
Discuss the elements of financial statements and their recognition criteria in accordance with the
conceptual framework issued by the IASB.

2.11 Summary
The preparation of financial statements is becoming more critical in the global village because
of the internationalisation of businesses. Consequently, the International Financial Reporting
Standards (IFRS) Foundation was set up with a mandate to harmonise various accounting
treatments through the establishment of globally accepted International Financial Reporting
Standards (IFRSs).

41
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Basson N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Sibanda, A. (2001). Financial Statements Analysis Module.Finance Department. Bulawayo:
National University of Science and Technology publication.

42
Unit 3

International Aspects of Financial Statement Preparation

3.0 Introduction
The accounting profession as we know it today has evolved over time and space. There are
differences in the accounting treatment of various business aspects which the IFRS Foundation is
trying to harmonise. In this unit, we are going to focus on the development of accounting, causes
of accounting differences and the efforts being made to harmonise the differences.

3.1 Objectives
By the end of this unit, you should be able to:
• state the causes of disparities in financial statement preparation
• classify the major financial reporting systems
• assess the efforts being made to harmonise the preparation of financial statements

3.2 The Development of Accounting


Historical events that influenced the preparation of financial statements include the following:
• a fairly sophisticated single entry system developed by the Romans;
• the double entry system which was developed by the Medieval Northern Italy;
• Holland came up with share capital subscriptions;
• the profession of accountancy as we know it today was perfected in Scotland;
• the standardised formats of financial statements came from Germany; and
• the United States Of America gave us consolidated accounts and management
accounting.

3.3 Causes of Accounting Differences Among Nations


The development of accounting has generally been influenced by the following factors:
a. legal systems;
b. sources of capital;
c. theory;

43
d. taxation systems;
e. inflation; and
f. strength of the profession.

3.4 Legal Systems


Generally the preparation of accounts can fall under (i) the Codified Roman Law systems or (ii)
the Common Law systems.

3.4.1 Codified Roman Law Systems


Company Law and commercial codes are the basis for financial accounting and reporting.
Continental Europe follows the Codified Roman Law systems. Under this system, the state plays
an important part in influencing and shaping the accounting systems through various statutes.
Such systems are usually dominated by debt as a source of capital other than equity, and as a
result, the lenders seek protection through the law other than in equity driven systems where
financiers have the ability to influence management through the appointment of directors.

3.4.2 Common Law systems


Common Law influences Company Law other than statute. Company Law is not all-
encompassing and consequently a number of accounting rules and procedures are derived from
common law. Countries falling under this system include United Kingdom, Ireland, USA,
Australia and New Zealand.

Activity 3.1
Under which legal system would you classify the Zimbabwean accounting system? Explain
why?

3.5 Sources of Capital


Financial systems can be categorised according to their main sources of capital.

3.5.1 Equity driven systems


These are basically capitalist systems dominated by private individuals or institutional investors
who provide equity capital to businesses, occasionally supplemented by debt capital. In such
systems there are well developed stock exchanges. Countries with such systems include United
44
Kingdom, United States of America, Japan, Australia, South Africa and Canada. Zimbabwe
can also be classified under this system as it is influenced more by British systems. Because of
the agent/principal conflict in such systems, there is more pressure for the accounting function to
adhere closely to the requirements of disclosure, audit standards and the provision of fair
information.

3.5.2 Bank driven financial systems


These are systems dominated by debt capital provided by banking institutions. The debt capital is
supplemented by equity from affluent families and banks. Stock markets in such systems are
small and are usually not effective in raising equity capital through Initial Public Offers (IPOs).

Activity 3.2
Given the two classifications of equity driven and bank driven systems, explain how the
equity driven system may bring about a more efficient accounting system?

3.6 Theory
The theory of accounting is fairly young. Accounting theory started to develop in the last thirty
years and that is when it took its place in institutions of learning such as colleges and
universities. Prior to that, accounting was taught and examined by professional bodies such as
CIMA, ACCA, and CIS. Currently there is a battle for supremacy between the two camps
(accounting bodies and institutions of higher learning) but the accounting field will definitely
benefit more from research and new conclusions from the institutions of higher learning.

Activity 3.3
1. List countries which rely on bank driven financial systems?

2. List the professional accounting bodies that exist in Zimbabwe and try to examine whether
they emphasise on cost, management, financial or public accounting.

45
3.7 Taxation
There exists among different countries a difference between taxation rules and accounting rules.
In countries such as Germany and Italy where the tax rules are the accounting rules the problem
is less pronounced. For example, where the tax treatment for depreciation differs from the
accounting treatment, the timing differences will give rise to a tax liability called deferred tax.
Such problems have given rise to a considerable amount of accounting standards documentation
in trying to harmonise the treatment of such items in order to make the comparison of financial
performance more objective.

3.8 Inflation
Hyper inflation levels experienced in Latin America during the eighties led to inflation
adjustment of accounts. Inflation adjustment is now being treated in compliance with IAS 29
Financial Reporting in Hyperinflationary economies. Zimbabwe has adopted IAS 29 for all
companies listed on the Zimbabwe Stock Exchange because of the hyper inflation experienced
since 2000.

3.9 Strengthening of the Accounting Profession


The strength, size and competence of the accounting profession may help to shape the type of
financial reporting being followed within a country. In Zimbabwe the local professional bodies
include the following:
• Southern Africa Associates of Accountancy (SAAA)
• Institute of Chartered Accountants in Zimbabwe (ICAZ)
• The Institute of Chartered Secretaries and Administrators in Zimbabwe (ICSAZ)
• Chartered Institute of Management Accountants (CIMA)
• Institute of Certified Public Accountant Zimbabwe (ICPAZ)
• Public Accountants and Auditors Board (PAAB)

Activity 3.4
1. Discuss the contribution of the above mentioned bodies to financial reporting in
Zimbabwe.

46
2. To what extent do differences in professional bodies within different countries constitute
a hindrance to the harmonisation of accounting standards among countries.

3.10 Classification of Financial Reporting Systems


There are two main financial reporting systems that we can identify.
• Micro/fair/judgmental/commercial driven systems: Such systems are dominated by
private enterprises. The firm is at the centre of the economic system and not the state. The
development of accounting therefore is initiated at the enterprise level.
• Macro/uniform/government driven tax dominated systems: The state dominates business
and the development of accounting

3.11 A Two-group Classification of Accounting Systems


Anglo Saxon Continental
Background
-English Common Law -Roman Law
-Large, old, strong profession -Small, young, weak profession
-Large stock exchange -Small stock exchange.
General Accounting Features
-Fair -Legal
-Shareholder – orientation -Creditor – oriented
-Disclosure -Secrecy
-Tax rules separate -Tax dominated
-Substance over form -Form over substance
-Professional standards -Government rules
Specific Accounting Features
-Percentage of completion method -Completed contract method
-Depreciation over useful lives -Depreciation by tax rules
-No legal reserves -Legal reserves
-Finance leases capitalised -No lease capitalisation
-Cash flow statements -No cash flow statements

47
-No earnings per share disclosed -Earnings per share disclosed
-No secret reserves -Secret reserves
-No tax induced provisions -Tax induced provisions
-Preliminary expenses expensed -Preliminary expenses capitalised
-Taking gains on unsettled foreign -Deferring gains on unsettled
currency monetary items foreign currency monetary items.
Examples of Countries
-United Kingdom -France
-Ireland -Germany
-United States -Austria
-Canada -Sweden
-Australia -Spain
-New Zealand -Italy
-Hong Kong -Portugal
-Singapore -Japan
-Denmark -Belgium
-Netherlands -Greece
Globalisation and integration of international capital markets have resulted in the shrinking of
the gap between the two extremes. Zimbabwe naturally falls in the first group because of the
influence of British and more recently American literature on accounting.

Activity 3.5
International differences in financial reporting are related to the relative importance of the
different countries. Discuss.

48
3.12 Harmonisation of Financial Statements
Harmonisation is the process of trying to improve the compatibility of accounting practices,
processes and procedures among different nations or regions. This is basically achieved by
setting bounds to the degree of variation of the various accounting practices.

3.13 The Need for Harmonisation


The following are some of the reasons for harmonizing:
a. the need by multinational corporations to consolidate comparable financial accounts;
b. the need by international investors to appraise foreign investments;
c. the need by the accounting profession to facilitate the standardization of procedures and
d. facilitate the mobility of staff;
e. calculation of tax where double taxation treaties exist between countries;
f. the need to protect investors by multinational groupings such as the European Union; and
g. the need by investment analysts to be able to assess performance of investment
opportunities across regions.

3.14 How is Harmonization Achieved?


Harmonisation is achieved as follows:

3.14.1 De Jure
This is harmonisation achieved through imposition of rules and standards which should be
complied with.

3.14.2 De Facto
This is harmonisation brought about by free market forces. The requirements of investors,
analysts, labour unions, economic bodies, for example, will force those producing financial
statements to meet certain minimum accounting standards if they are to enjoy continued support
in their operations. For example, the requirement by the Zimbabwe Stock Exchange for listed
companies to publish inflation-adjusted financials for them to continue enjoying the benefit of
being listed.

49
3.15 Advantages of International Harmonisation
i. Investors have greater comparability of financial statements which enables easier
investment decisions. This is important in the context of global investing which has
become more significant in the last decade.
ii. Governments will have reduced funding requirements as they will not have to develop
accounting standards for their own country.
iii. Accounting firms with international practices will find it easier to deal with staff
resourcing in countries experiencing boom or recessionary times due to common
accounting standards allowing staff transferability between countries with no major
impact on services delivered.
iv. Companies:
• management control of foreign subsidiaries will be easier;
• consolidation of financial statements of subsidiaries will be easier as they will
operate under the same standards;
• easier to comply with stock exchange reporting requirements; and
• investment more likely as investors will have greater knowledge and reliance
on the financial statements.

3.16 Obstacles/Barriers to International Harmonisation


i. Different purposes of financial reporting. In some countries the purpose is solely for tax
assessment, while in others is for investor decision-making.
ii. Nationalism – possible unwillingness to accept another countries standards.
iii. Different legal systems whereby some countries require certain accounting practices and
policies and other countries do not.
iv. Different users of financial statements. Countries have different ideas about who the
relevant user groups are and their respective importance. In the USA investor and creditor
groups are given prominence, while in Europe employees enjoy a higher profile.
v. Lack of strong accountancy bodies. Many accountancy bodies in various countries are
not independent or strong enough to press for harmonisation of accounting standards in
their jurisdiction.

50
vi. Language and cultural differences. Both of these can cause difficulties in the adoption of
accounting standards.
vii. Needs of developing countries. Developing countries are obviously behind in the
standard setting process and they need to develop the basic standards and principles
already in place in most developed countries.
viii. Unique circumstances. Some countries may be experiencing unusual circumstances
which affect all aspects of everyday life and impinge on the ability of companies to
produce proper reports, for example, hyperinflation, civil war, currency restrictions and
so on.

Activity 3.6
1. Explain both the main advantages and obstacles/barriers to the international
harmonisation/convergence in financial reporting.
2. Explain De Jure and De Facto harmonisation.

3.17 Summary
Disparities in accounting systems have been caused by a number of historical events and also the
development of the accounting profession itself in different parts of the globe. We basically have
two accounting systems, that is, the micro and macro systems which international bodies such as
the IFRS Foundation is trying to harmonise into one viable system by the introduction of
universally acceptable accounting standards.

51
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Basson N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Sibanda, A. (2001). Financial Statements Analysis Module.Finance Department. Bulawayo:
National University of Science and Technology publication.

52
Unit 4

Characteristics of Financial Statements and Accounting Conventions

4.0 Introduction
There is a minimum acceptable standard of financial statements, and there are important
attributes of financial statements that make them more informative and comparable over time
and space. These are basically achieved if the preparation of accounts is done adhering to the
recognised accounting standards and conventions, principles and laws.
4.1 Objectives
By the end of this unit, you should be able to:
• discuss the fundamental qualitative characteristics of financial statements
• identify the important concepts in financial statement preparation
• apply accounting policies followed in the preparation of financial statements

4.2 Qualitative Characteristics of Financial Statements


Qualitative characteristics are the attributes of financial statements which increase suitability in
providing useful information to users for decision making. The most important qualitative
characteristics that financial statements should have are:
• understandability;
• relevance;
• reliability;
• comparability and consistency;
• timeliness;
• balance between benefit and cost;
• fair presentation; and
• materiality.

4.2.1 Understandability
Information provided in financial statements should be readily understandable by a user with a
reasonable knowledge of business and economic activity as well as accounting. Some

53
phenomena are inherently complex and cannot be made easy to understand. Excluding
information about those phenomena from financial reports might make the information in those
financial reports easier to understand. Those reports will be incomplete and misleading.

4.2.2 Relevance
Only that information which has the capacity to influence the economic decisions of users by
helping them evaluate past, present and future events should be included in the financial
statements. Financial information is capable of making a difference in decisions if it has
predictive vale, confirmatory value or both. Financial information has predictive value if it can
be used as an input to processes employed by users to predict future outcomes. Financial
information has confirmatory value if it provides feedback about previous evaluations. The
predictive value and confirmatory value of financial information are interrelated. Information
that has predictive value often also has confirmatory value.

4.2.3 Reliability
Information in financial statements should be free from material error and bias. The elements
ensuring reliability include:
i. Faithful representation
Information can only be a faithful representation of transactions and other events if it clearly
and faithfully represents the economic substance or economic realities. The criteria for
recognition, measurement and presentation must at all times correspond in essence with the
financial consequences of the transactions and events it represents.
ii. Substance over form
Transactions and other events must be accounted for and presented in accordance with their
substance and economic reality and not merely their legal form. Capitalisation of leased assets
held under lease agreement is a good example of illustrating the impact of applying substance
over form.
iii. Neutrality
Information is neutral, if it does not, by choice or presentation, unduly influence a user in order
to achieve a predetermined result or outcome.

54
iv. Prudence
Uncertainties inevitably forming part of many transactions should be recognised and prudence
exercised in the preparation of financial statements. However, the exercise of prudence does not
justify the creation of hidden reserves or excessive provisions.
v. Completeness
Only such information which, within the constraints of materiality and cost, accounts for the
financial consequences of all transactions and events, can qualify as being reliable.

Activity 4.1
Write short notes on the five elements that ensure the reliability of financial information.

4.2.4 Comparability and consistency


All like transactions and events ought to be accounted for on a consistent basis during a period as
well as from period to period. In addition, for different companies all similar transactions should
as far as possible be consistently accounted for on a uniform basis. Accordingly, consistency in
the choice, disclosure and application of generally accepted accounting policies in the
preparation of financial statements is essential.

4.2.5 Timeliness
Information in financial statements is only useful if it is made available to the users in time. The
need of users of financial statements is the ultimate consideration in achieving a balance between
reliability and time.

4.2.6 Balance between benefit and cost


A consideration of the benefit derived from including specific information in financial statements
as opposed to the cost of its inclusion, is necessary.

4.2.7 Fair presentation


Financial statements must fairly present the financial position, results and changes in the
financial position of the company. To be perfectly faithful representation, a depiction would have
three characteristics:

55
i. Complete- a complete depiction includes all information necessary for a user to
understand the phenomenon being depicted, including all necessary descriptions and
explanations.
ii. A neutral depiction is without bias in the selection and or presentation of financial
information. Neutral information does not mean information with no purpose or no
influence on behaviour. The information should not be crafted to be favourably or
unfavourably received by users.
iii. Free from error – means there are no errors or omissions in the description of the
phenomenon, and the process used to produce the reported information has been selected
and applied with no errors in the process.

4.2.8 Materiality
Information is material if omitting it or misstating it could influence decisions that users make on
the basis of financial information about a specific reporting entity. Materiality is an entity-
specific aspect of relevance based on the nature or magnitude, or both, of the items to which the
information relates in the context of an individual entity’s financial report.

Activity 4.2
Discuss the qualitative characteristics of financial statements.

4.3 The Fundamental Accounting Concepts


Accounting conventions are the broad basic assumptions which underlie the periodic preparation
of financial statements. These are contained in IAS 1 Presentation of Financial Statements, and
must be followed. In this section we will examine the following concepts:
• Going concern
• Matching
• Consistency
• Prudence
• Accrual
• Business entity
56
• Duality
• Accounting period
• Realization of revenue
• Materiality
• Objectivity
• Monetary measurement

4.3.1 Going concern concept


In the absence of evidence to the contrary, it is assumed that the business will continue in
operation for the foreseeable future. (Foreseeable future is normally assumed to be the next
twelve months).

4.3.2 Matching concept


Costs and revenues are accrued and are matched with one another as far as their relationship can
reasonably be established for the period to which they relate.

4.3.3 Consistency
Items should be treated in the same way from one period to the next, unless there is a significant
change in the nature of the operations.

4.3.4 Prudence
Revenue is not anticipated but is recognised by inclusion in the income statement only when
realised in the form of cash (or other assets whose realisable cash value can be ascertained).
Provision is made for all known liabilities, whether the amount of these is known with certainty
or is the best estimate in the light of available information.

4.3.5 Accrual concept


The effects of a financial transaction are recorded and accounted for in the financial statements
when they occur, irrespective of the cash flow timing.

57
4.3.6 Business entity concept
A business has an identity and existence which is separate from its owners. It is a legal persona.
Ownership is claimed through owners’ equity which comprises capital and reserves in the
statement of financial position.

4.3.7 Duality
In any transaction there are two aspects recorded in the accounts, that is:
• the source of wealth; and
• the application (or the form it takes).
Hence double entry system of accounting (Debit and Credit)

4.3.8 Accounting period


The time period for determination of profit must be defined (for example, one year, semi-
annually or quarterly).

4.3.9 Realisation of revenue


Revenue is recognised as soon as it is allocated to the period in which it is capable of objective
measurement, and the asset value receivable in exchange is reasonably certain. Possible dates of
revenue realisation depending on the tradition of the industry are:
• date of sale agreement;
• invoice date; or
• delivery date.

4.3.10 Materiality
Insignificant items should not be given the same emphasis as significant items because the cost
of disclosing them will exceed the benefit derived from their disclosure when they are of no
influence.

4.3.11 Objectivity
Information included in financial statements should permit qualified and experienced individuals
working independently to develop similar conclusions from the same information.

58
4.3.12 Monetary measurement
Only facts that can be expressed in monetary terms need to be recorded in financial
statements. Those aspects, which cannot be expressed in monetary terms, should not be included.

Activity 4.3
1. Give examples of accounting treatment based on the going concern concept.
2. Outline business aspects which cannot be expressed in monetary terms.
3. Explain intangible assets which, under certain conditions, are expressed in monetary
terms.

4.4 Measurement Bases


Measurement is the process of determining the monetary amounts at which the elements of
financial statements are to be recognised and carried in the statement of financial position
(balance sheet) and statement of comprehensive income (income statement). This involves
selection of the particular basis of measurement. The different measurement bases include the
following:
(a) Historical cost
Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances, at the amounts of cash or cash equivalents expected to be paid to satisfy
the liability in the normal course of business.
(b) Current cost
Assets are carried at the amount of cash or cash equivalents that would have to be paid if
the same or an equivalent asset was acquired currently. Liabilities are carried at the
undiscounted amount of cash or cash equivalents that would be required to settle the
obligation currently.
(c) Realisable (settlement) value

59
Assets are carried at the amount of cash or cash equivalents that could currently be
obtained by selling the asset in an orderly disposal. Liabilities are carried at their
settlement values.
(d) Present value
Assets are carried at the present discounted value of the future net cash inflows that the
item is expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of the future net cash outflows.
Historical cost basis is the most common in the preparation of financial Statements. This
is usually combined with other measurement bases.

Activity 4.4
Discuss why the Zimbabwe Stock Exchange introduce the requirement that listed companies
publish inflation adjusted financials.

4.5 Accounting Policies and their Application


Accounting policies encompass the principles, bases, concepts and procedures applied by
management in preparing and presenting financial statements. Accounting policies to be
followed in the preparation of financial statements should be flexible and take into account the
interests of the stakeholders or the principal users of the financial information. Sound judgment
is of paramount importance in the selection and application of the policy which is best suited to
present the financial position of the company and the results of its operations objectively, fairly
and reliably. Application of accounting policies should be consistent from year to year.

4.5.1 Disclosure of accounting policies


It is important for a company to adequately disclose the accounting policies that it follows in the
preparation of financial statements. Different facets of accounting policies should be
systematically grouped and disclosed. The following are examples of general areas in which
different accounting policies may be applied and where the policy actually selected should be
disclosed.
• consolidation policy;

60
• conversion or translation of foreign currencies including the disposition of exchange
gains and losses;
• overall valuation policy;
• events after the reporting period;
• operating leases, finance leases, hire purchase or instalment transactions;
• taxes (including deferred tax);
• long term contracts;
• franchises; and
• capitalisation of interest.
An entity shall disclose in the summary of significant accounting policies or other notes:
• the measurement basis (or bases) used in preparing the financial statements;
• the other accounting policies used that are relevant to an understanding of the financial
statements; and
• the judgments, apart from those involving estimations, that management has made in the
process of applying the entity’s accounting policies and that have the most significant
effect on the amounts recognised in the financial statements.

Activity 4.5
List areas in which accounting policies need to be disclosed with respect to assets, liabilities,
revenues and expenses.

4.6 Summary
It is of paramount importance for the user or analyst of financial statements to understand how
the financial statements are prepared. The financial statements should comply with the generally
accepted qualitative characteristics that should be evident in a good set of accounts. Accounting
conventions (concepts) have to be followed in the preparation of the accounts and the policies
derived from the conventions and the measurement bases should be adequately disclosed.

61
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Basson N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Sibanda, A. (2001). Financial Statements Analysis Module.Finance Department. Bulawayo:
National University of Science and Technology publication.
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

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Unit 5

Analysis of Financial Statements

5.0 Introduction
Users of financial statements require information for different purposes. Ratios are used to
interpret financial information. Ratio analysis involves the methods of calculating and
interpreting financial ratios to assess the firm’s performance and status. The basic inputs to ratio
analysis are the firm’s statement of comprehensive income and statement of financial position
for the periods to be examined. For comparison purposes information may also be gathered from
without (outside) the firm, such as industry averages or ratios on comparable firms within the
same industry. A number in isolation is not a very helpful piece of information.

5.1 Objectives
By the end of this unit, you should be able to:
• classify the different types of ratios
• calculate different types of ratios
• apply profitability, liquidity, valuation and international analysis
• outline the strengths and weaknesses of comparisons and ratio analysis

5.2 Definition of a Ratio


A ratio is the quantitative relation between two amounts showing the number of times one value
contains or is contained within the other. A ratio is a number divided by another. Ratio analysis
is a tool used by individuals to conduct a quantitative analysis of information in a company's
financial statements. Ratios are calculated from current year numbers and are then compared to
previous years, other companies, the industry, or even the economy to judge the performance of
the company. Ratio analysis is predominately used by proponents of fundamental analysis.

5.3 Users of ratios


The following are users of ratios:
• Management:

63
a. to analyse past results
b. to plan for future (for example, preparation of budgets)
c. to control their business
• Investors: to compare their investments with alternative forms of investment
• Bankers and finance houses: to assess the credit worthiness of businesses
• Financial analysts working for the financial press, trade associates, trade unions, for
example
• Government statisticians: to compile tables of national statistics.

5.4 Types of Comparison


When interpreting ratios it is important to understand that they cannot be analysed in isolation.
The interpretation depends upon the business environment, which encompasses the economic
environment, intensity of competition, the influence of suppliers and customers. Ratios can be
analysed over time or between firms.

5.4.1 Cross-sectional analysis


This involves the comparison of different firms’ financial ratios at the same point in time. Often
the firm’s performance will be compared to that of the industry leader or industry averages. The
comparison of a particular ratio to the standard is made in order to isolate any deviations from
the norm. The size of the firm can have an important effect on ratios. For example, it will be
irrational to compare the results of a single supermarket business with a group such as OK
Zimbabwe even though they may be in the same business. Ratio analysis directs the analyst to
the potential areas of concern, it does not provide conclusive evidence as to the existence of a
problem.

5.4.2 Time series analysis


Time series analysis involves evaluating the firm’s financial performance over time using ratio
analysis. The theory behind time series analysis is that the company must be evaluated in relation
to its past performance, developing trends must be isolated and appropriate action taken to direct
the firm towards immediate and long-term goals.

64
5.4.3 Combined analysis
The most informative approach to ratio analysis is the one that combines cross sectional and time
series analysis. A combined view permits assessment of the trend in the behaviour of the ratio in
relation to the trend in the industry.

5.5 Limitations of Ratios


• Ratio analysis is based on historical data
• Different companies use different accounting policies and this reduces the benefit of
comparing one company against another.
• Ratios are not definitive measures; they only provide clues to a company’s performance
or situation.
• Ratios only show the results of carrying on business; they do not indicate the causes of
poor performance. Further investigation is required.
• The accuracy of ratios depends upon the quality of the information from which they are
calculated; the required information is not always disclosed in accounting statements and
account headings may be misleading.
• Ratios can only be used to compare like –with-like.
• Ratios tend to ignore the time factor in seasonal business, for example, widely fluctuating
stock levels and debtor levels.
• They can be misleading if accounts are not adjusted for inflation.

5.6 Important Points to Remember


• A single ratio does not provide sufficient information from which to judge the overall
performance of a firm.
• Be sure that the dates of the financial statements being compared are the same.
• Preferably use audited financial statements for ratio analysis.
• Be certain that the data being compared have been developed in the same way (that is,
using the same accounting treatments).

65
Activity 5.1
Outline the advantages and limitations of ratio analysis.

5.7 The Main Areas


When attempting to analyse the financial statements of a company, there are several main areas
that should be looked at as follows:

• profitability;

• liquidity; and

• gearing.

5.8 Profitability Analysis


Shareholders are interested in the return on the money that they will have invested in a business.
Profitability ratios are integral in the assessment of their return. Profitability can be analysed
using activity ratios and finance ratios. The main ratio to measure profitability in an organisation
is return on capital employed (ROCE), which can be sub-analysed into:
• net profit margin – if ROCE indicates poor performance then the net margin would
indicate if it is due to low margin or poor overhead control and further ratios can be
calculated to investigate.
• asset turnover – if this indicates poor performance then fixed assets utilisation and
working capital management may be further examined.
��� ������
ROCE = × ���
������� ��������

Where capital employed = equity + long-term debt


ROCE = net profit margin × asset turnover

��� ������ ��������


Net profit margin = × ��� Asset turnover = × ���
�������� ������� ��������

Net profit margin can be investigated Asset turnover can be investigated


by finding: by finding:

66
����� ������ �������� ��������
Gross profit margin = ��������
× ��� ����� ������
and ��� ������� ������

and
������� ��������
Operating ratios = × ���
��������

5.8.1 Asset turnover ratios


These are ratios, which show the efficiency in the utilisation of assets (hence they can be
identified as efficiency ratios). The assets considered can be total assets, net assets (that is, fixed
assets plus net current assets) or fixed assets alone. These could be related with, for example
turnover, gross profit, net profit or net operating profit.

��������
Asset turnover = × ���
������� ��������

5.8.2 Finance ratios


(a) Return on owners’ equity (ROOE)
��� ������
ROOE =
����� ������� ��� ��������

Net profit can be taken after tax or before tax.

(b) Return on Capital Employed (ROCE)


This ratio is used in assessing the efficient usage of the resources provided to the business.
Capital employed is the owners’ equity plus the long-term borrowings of the business.

It is calculated as follows:
��� ������
ROCE = × ���
������� ��������

Profit before tax is used because interest figures are gross of any tax effect.

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5.9 Liquidity Analysis
A number of ratios can be calculated which compare short-term assets with current liabilities.
Each ratio shows the extent to which the particular definition of short term assets would allow
the repayment of the current liabilities in existence at that date. Liquidity is the ability of an
organisation to pay its debts when they fall due. There are two main measures of liquidity ratios:
• the current ratio
• the quick ratio (or acid taste ratio)

5.9.1 Current ratio


Current ratio is sometimes called the working capital ratio. This ratio shows how many times
current liabilities are covered by current assets. The current liabilities should always be
expressed as a unit in this ratio. A ratio between 1.5:1 and 2:1 may generally be considered
reasonable. A current ratio in excess of 2:1 may indicate poor management of resources with
capital tied up in inventory, accounts receivables or lying idle in the bank instead of being put to
work to earn profit.
Current ratio = Current assets ÷ Current liabilities
Various factors must be considered when commenting on this ratio:
• the nature of the business. The business may require large stocks to be carried.
• the working capital of a seasonal business will fluctuate more than non seasonal business
which has a steady working capital; and
• The various components of working capital.
5.9.2 The quick ratio (or acid taste ratio)
The ratio can be referred to as liquid ratio. Liquid assets are those in the form of cash and those
which can readily be converted into cash. The least liquid form of current assets is inventory
whether of materials, work in progress or finished goods. The quick ratio tastes the ability of the
current assets other than inventory to meet the current liabilities. The quick ratio can be
calculated as follows:
����� ������ (�������������)
Quick ratio = ������� �����������

A quick ratio of 1:1is generally considered satisfactory but it may be considered to fall to 0.9:1 if
the debtors pay promptly and there is regular inflow of cash from them. A business which sells

68
almost wholly for cash but enjoys normal credit terms for its purchase may well have a quick
ratio of 0.5:1 or even less.
Other ratios to consider in liquidity analysis are as follows:
���� ���� ������ ����������
Cash ratio =
������� �����������

����� �� ��� ���������


Holding period of raw materials = × ���
���������

����� �� ���
Work-in-progress (WIP) period = × ���
���� �� �����
����� �� �������� �����
Finished goods period = ���� �� �����
× ���

Activity 5.2
1. Comment on the significance of the following ratios:
a. Cash ratio;
b. Holding period of raw materials;
c. Work-in-progress(WIP) period; and
d. Finished goods period in a manufacturing industry.

5.10 Fund Management Ratios (Activity Ratios)


Constituent elements of working capital such as inventory, receivables (debtors) and payables
(creditors) are compared with the flow related to it. Frequently the amount is taken from the
closing statement of financial position (balance sheet), but a more theoretically sound ratio is
obtained by using the average amount of each item in existence over the trading period.

5.10.1 Receivables (Debtors ) turnover ratio


Arguably cash sales should be excluded from the denominator but such information may not be
readily available especially when one is using published information other than management
accounts. When information on sale is not readily available, the calculation can be based on
turnover. The debtor turnover ration is generally calculated as follows:

69
������� (�����������)
Debtor turnover ratio = ������ �����
× ���

5.10.2 Payables (Creditors) turnover ratio


This ratio relates trade creditors with annual purchases. Information on cost of sales may not be
readily available, the sales or turnover figure can be considered as explained above. The
creditors’ turnover ratio is calculated as follows:
��������� (��������)
Creditors’ turnover ratio = × ���
������ ��������

5.10.3 Inventory turnover (Stockturn)


The inventory turnover ratio indicates the time inventory remains in the business between
purchases and sale (on the average) or simply it indicates how many times during a year
inventory is turned over. Since inventory is evaluated at cost, it should ideally be compared with
cost of sales rather than sales.

���� �� �����
Inventory turnover =
������� ������

NB: The decision on whether to use sales or cost of sales depends to a larger extent on the
availability of information. Published accounts usually place a limitation on the amount of
information available for ratio analysis and there may be need to make use of the available
information if detailed information is not readily available.

5.11 Gearing
The relationship between owner’s equity and long-term borrowings is known as gearing
(leverage). Lenders are interested in gearing ratios which they use in assessing the ability of an
organization to take on more debt on their statement of financial position (balance sheet). There
are two common ways of calculating gearing ratio, debt equity ratio and debt to capital ratio.

70
5.11.1 Debt equity ratio
The debt to equity ratio considers the long term debt that the company has on its statement of
financial position (balance sheet) and the shareholders equity. The ratio is given by the following
formular:
���� ����� ���� �������
������ (����� ����������������) ������
Debt equity ratio = or

Where;
Fixed cost capital = long term loans + preference shares, if any;
Total capital = fixed cost capital + equity.
Equity = issued ordinary shares + reserves

5.11.2 Debt to capital ratio (Total gearing)


Total gearing considers the total amount of capital (financing) as the denominator. The formula
is as follows:

���� ����� ���� �������


Debt to capital ratio = or
���� � ������ ����� �������

Activity 5.3
Explain the importance of gearing ratio to holders of the ordinary shares of a company.

5.12 Investment Ratios


Investment ratios consider items inside and outside the accounts from the outside equity
investor’s perspective. The connection between an investor and the business is obviously through
the medium of a share. These are ratios that are of importance to outside stakeholders such as
shareholders or potential investors in shares. The holders of the ordinary shares of a company
(equity) are interested in their return on their investments and the value of their shares. Their
interests, however, takes third place to the interests of the providers of long term loans (usually

71
debenture holders) and the preference shareholders. Debenture holders are entitled to interest on
their loans whether a company makes a profit or not, the preference shareholders entitlement to
dividends has priority over ordinary shareholders. The interests of ordinary shareholders may be
at risk if their company’s long term capital is provided by debenture holders and/or preference
shareholders.

5.12.1 Definition of terms


Book value per share
The book value per share is the value attributable to each ordinary share if the assets and
liabilities of the company were sold or settled at the figures shown in the published statement of
financial position (balance sheet).
Earnings
“Earnings” is generally the net profit after tax and extraordinary (or unusual) items.

5.12.2 Earnings per Share (EPS)


Earnings per share are the net profit after tax and extraordinary items per share. They are
calculated as follows:

������ ����� ��� ���� ���������� ��������� �������� (�� �����)


Basic EPS = ������ �� �������� ������ �� �����
or ������ �� �������� ������

Investors regard EPS as a convenient measure of the success of a company.

5.12.3 Price Earnings Ratio (PER)


The Price Earnings Ratio may be regarded as the number of years’ earnings that investors are
prepared to pay for in the purchase price of the company’s shares. The PE ratio is a useful
indicator of how the stock market assesses the company. It is also useful when a company
proposes to issue new shares, in that it enables potential investors to better assess whether the
expected future earnings make the share a worthwhile investment. A higher PE ratio is usually
interpreted as confidence in the future prospects of the company. The PE ratio relates the market
price of a share to the earnings per share and is calculated as follows:
������ ����� �� �����
Price Earnings Ratio =
�������� ��� �����

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5.12.3 Calculating the number of shares
The weighted average number of ordinary shares outstanding during the period is calculated
based on the following principles:
• The number of shares outstanding at the beginning of the period is adjusted by those
bought back or issued during the year multiplied by the time factor.
• Shares are included in the calculation from the date that consideration was received.
• Partly paid shares are treated as fractions.
• Business combination rules:
1. Acquisition: From acquisition date
2. Uniting of interest: For all periods presented
• Adjust number of shares of current and all previous periods presented for changes in
shares without corresponding change in resources, for example, bonus issues and share
splits. Note that the number of shares is not weighted for these events.
Diluted earnings per shares are calculated taking into account the dilution effect of any additional
shares such as share options. Earnings would increase by the amount of interest on any loan that
is convertible to equity less the extra tax payable as a result of the removal of the tax expense.

5.12.4 Diluted Earnings


The earnings are adjusted for after tax effects of the following items associated with dilutive
potential ordinary shares:
- Dividends for the period.
- Interest for the period.
- Other changes in income or expense that would result from a conversion of those
shares.
These adjustments are necessary as, after the potential ordinary shares have been converted to
ordinary shares, the relevant items will no longer be incurred. The conversion of some potential
ordinary shares may lead to consequential changes in other income or expenses, for example, the
savings on interest related to these shares may lead to an increase in the expense relating to non-
discretionary employee profit sharing plan.

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5.12.5 Diluted shares
• The weighted average number of shares, for basic earnings per share, plus the weighted
number of shares to be issued on conversion of all dilutive potential ordinary shares.
• Dilutive potential ordinary shares are deemed to have been converted into ordinary shares at
the beginning of the period or, if issued later, the date of the issue of the shares.
• The number of dilutive shares to be issued is determined from the terms of the shares. The
computation assumes the most advantageous rate of conversion or exercise price from the view
of the holder of the shares, that is, the worst case scenario for the company.
• Contingently issuable shares are included as at the beginning of the year or the date of the
contingent shares agreement, if later.
• Dilutive potential shares issued by a subsidiary, associate or joint venture are included if they
have a dilutive effect on the consolidated earnings per share of the reporting entity.
• Options and share purchase arrangements are dilutive when they would result in the issue of
ordinary shares for less than their fair value. The difference between the number of shares
issued and that which would have been issued at fair value is treated as an issue for no
consideration- they are dilutive.
• Potential ordinary shares that have been converted into ordinary shares during the reporting
period are included in the calculation of diluted earnings per share for the full period. From the
date of conversion, the resulting ordinary shares are also included in basic earnings per share.
• Potential ordinary shares that were cancelled or allowed to lapse during the reporting period
are included in the computation of diluted earnings per share only for the portion of the year
during which they were outstanding.

5.12.6 Dividend cover


This is the number of times that a company can pay the intended dividend out of the available
profits of the current year. Dividend cover is calculated as follows:

�������� ������ ��������� �� ��� �������� ��������


Dividend Cover = ����� �������� �� ��� �������� ������ or �������� �������� ����

74
This is the same as dividing the EPS by the dividend paid per share. A high dividend cover may
be indicative of a conservative dividend policy; but it also suggests that the company should be
able to maintain the present level of dividend to the ordinary shareholders even if profits should
decline temporarily. Low dividend cover indicates that a relatively small reduction in profit may
put the ordinary dividend at risk. The earnings generated by the company should have the
potential to cover the declared dividend. Whether the cover is favourable or not, depends on the
industry average (cross sectional analysis) or the previous cover (time series analysis).

5.12.7 Dividend yield


The ratio indicates the rate of return in terms of profit distribution if an investor buys one share at
the current market price. We would need the trading price of the share for us to accurately
calculate the dividend yield. The price can be an average of the prices for the whole period under
consideration or the closing price at the accounting date. Dividends are declared either as a
percentage of the nominal value of a share or as an amount in cents per share. Yield expresses
the dividend as a percentage of the market price of the share. Dividend yield is calculated as
follows:

�������� ��� ����� ������� ����� �� �����


Dividend yield = or �������� ���� �� �������� × ������ ����� ��� �����
������ ����� ��� �����

5.12.8 Earnings yield


Companies have different dividend policies which make it difficult to compare them on the basis
of dividends paid. There is need to examine the earnings yields of companies comparatively. The
earnings of the company are expressed as a percentage of the market price of the shares.

Earnings yield = Dividend yield × dividend cover


��������
Or =
������ ����� ��� ����� ������ �� ������

5.12.9 Interest cover


Interest cover measures the ability of a company to pay for its long term borrowing out of current
year profit. Interest cover can be calculated as follows:

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��� ������ ������ �������� ��� ���
Interest cover = �������� �������

Activity 5.4
Your manager is not familiar with ratio analysis and has recently attended a meeting where he
came across this statement “It is important to note that there is no ideal ratio. The favourability of
a ratio depends on the context in which it is being analysed. Basically, the ratio has to be
compared with those from other comparable companies or from past financial information
making sure that the financial statement was prepared in more or less similar way”. The manager
approached you as an accountant for advice pertaining the meaning and significance of the
statement. Using suitable ratios, advise or comment on the statement explaining its significance
to your manager.

Example 5.1: Ratio Analysis


Milkshire Limited is a company which is involved in the retail trade with a number of shops in
prime city centre locations. The following are their results for the last two years.
Milkshire Limited Statement of Comprehensive Income for the year ended 31 December
2010.
2010 2010 2009 2009
$000 $000 $000 $000
Sales 23 200 15 960
Cost of sales 16 492 11 452
Gross Profit 6 708 4 508
Distribution costs 356 298
Admin costs 872 504
Profit before Interest & Tax 5 480 3 706
Taxation 432 484
Interest 752 1 184 772 1 256
Net Profit for the year 4 296 2 450
Dividends 200 200

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Profit Retained 4 096 2 250

Milkshire Limited Statement of Financial Position for the year ended 31 December 2010
2010 2010 2009 2009
$000 $000 $000 $000
Non – Current Assets 14 040 13 304
Current Assets
Inventory 2 784 1 860
Trade Receivables 2 084 1 000
Cash and cash equivalent 800 600
Total current Assets 5 668 3 460
Total Assets 19 708 16 764
Equity & Liabilities
Equity
Share capital 4 000 4 000
Retained Earnings 6 308 2 212
Total Equity 10 308 6 212
Non – current Liabilities
Long term debt 5 750 8 000
Total non–current liabilities 5 750 8 000
Current liabilities
Trade payables 1 600 1 368
Bank overdraft 1 196 48
Taxation 432 484
Dividends 200 200
Accruals 222 452
Total Current Liabilities 3 650 2 552
Total Equity & Liabilities 19 708 16 764

Notes:
77
i. The Opening Inventory for 2009 was $2 000 000.
ii. The number of shares in issue is 4 000 000 for both years.
iii. Current share Price per share 2010 2009
$25 $8
Required.
(a) Calculate for both years the following ratios in relation to Milkshire Limited.
1. Gross profit percentage
2. Net profit percentage
3. Quick Ratio
4. Trade receivable days
5. Trade payable days
6. Interest cover
7. Earnings Per Share
8. Price Earnings Ratio
(b) Draft a Report to the Board of Directors of Milkshire Limited in which you provide a
commentary on the Company’s position and performance. Use the ratios calculated in (a)
above as the basis for your commentary.
Solution
(a) 2010 2009
Gross Profit Percentage 6,708/23,200=28.91% 4,508/15,960=28.25%
Net Profit Percentage 4,296/23,200=18.52% 2,450/15,960 = 15.35%
Quick Ratio (5,668-2,784)/3,650=0.79:1 (3,460-1,860)/2,552=0.63:1
Trade Receivable Days 2,084/23,200×365=33days 1,000/15,960×365=23Days
Trade Payable Days 1,600/16,492×365=35 Days 1,368/11,452×365=44Days
Interest Cover 5,480/752=7.29 Times 3,706/772=4.80Times
Earnings per share 4,296/4,000=$1.07 2,450/4,000=$0.61
Price Earnings Ratio $25.00/$1.07=23.36 $8.00/$0.61=13.11

(b) Report
78
To: Board of Directors

From: Financial Accountant

Re: Commentary on Company’s Position and Performance

Date: September 2011

Gross Profit Percentage


The gross profit percentage has increased from 28.25% to 28.91%, an increase of over 2.34% on
the percentages year on year which is a positive trend for the company. This is also positive for
the fact that the company revenue increased by over 45%. An increase of this magnitude
presented a challenge for a company and the company, has in the main, responded positively to
this challenge. The increase resulted from the fact that revenue increased faster than cost of sales
(44%). However, this increase in cost of sales is masked to a degree by the increase in closing
inventory. If we look at purchases, these have increased from $11.312million to $17.416 million
which is an increase of 53.96%. This increase is greater than the increase in revenue and for the
company’s point of view; we must hope that this increase is due to ordering inventory close to
year–end to meet further demand for its products rather than poor ordering or purchasing at a
poor price. If it is the latter, then this could easily affect the 2011 results unless price increases
can be passed on.

2010 2009 %Increase


Opening Inventory 1,860 2,000 -7.00%
Purchases(Balancing Figure) 17,416 11,312 53,96%
Closing Inventory 2,784 1,860 49.68%
Cost of sales 16,492 11,452

Net Profit Percentage


The Net Profit % has increased from 15.35% to 18.52% which is an increase of nearly 21% year
on year on the percentages. This is an extremely good performance. The main reason for the
increase is due to the increase in revenue which has meant that the gross profit has increased

79
from $4.508 million to $6.708 million an increase of $2.2 million. This increase has been
enhanced by the decrease in taxation and interest for the year. However, the increase has been
offset to a degree by the increase in Admin Expenses of $368,000 which is an increase of just
over 73%. This increase is high, so the company needs to watch this cost going forward.

Quick Ratio

This ratio has increased from 0.63:1 to 0.79:1 this year which is an improvement of over 25%
year on year percentage wise. The main reason for the increase is the fact that current assets
minus inventory increased by over 80% driven mainly by the increase in trade receivables over
108% year on year. Current liabilities increased by only just over 43% driven mainly by the huge
increase in the bank overdraft. This was a good result overall as the company has increased its
revenue significantly which can put some strain on working capital. Yet the quick ratio has
increased this year and the company has also purchased some extra non-current assets and paid
off a significant amount of non –current debt (decreased by over 28%). Some of this decrease in
debt may have been funded through the bank overdraft so Milkshire Limited should ensure that
their source of funding is appropriate from a time point of view. Milkshire should reduce some
of its cash and cash equivalents in current assets in order to reduce the bank overdraft and
ultimately save on bank interest costs.

Trade Receivable Days


This has increased from 23 to 33 days, an increase of over 43% year on year which is not a great
result. Revenue has increased by over 45% but Milkshire should have tried to ensure that there
was no deterioration in trade receivables days. The company needs to try and ensure that the
increase in revenue is not being fuelled by having customers who are demanding longer credit
before they would purchase goods from Milkshire. Another possible reason could be that the
credit department was not efficient in collecting debts. However, given the increase in
administrative expenses, one would expect that this is a department which was adequately staffed
to cope with the increased workload in collecting debts from having more revenue and therefore,
there has to be more focus on managing their trade receivables in the coming year.

80
Trade Payable Days
This decreased from 44days to 35days which is a deterioration of over 20%.This is not a good
result given the fact that the company should be aiming for closer to 45-60 days. The increase in
purchases probably ensured that some of the supplier company’s set limits on the amount of
inventory they would sell before getting paid and therefore, this meant that the trade payable
days decreased. If we compare to 2009, the difference between when money was received in
from trade receivables and paid out to trade payables has decreased from 21 days to 2 days
which has obviously put pressure on the cash flow of the company and probably has contributed
to increase in the bank overdraft.
Earnings per share
This has increased from 61 cents per share to 107 cents per share, which is an increase of over
75%. This is a positive trend and is driven by the increase in profit which the company has
gained in 2010. Given that the dividend has stayed the same, the company is obviously keeping
much of the profit with the company to fuel current and future growth.
Price Earnings Ratio
This ratio has increased from 13.11 to 23.36, an increase of over 78% year on year. This
increase is primarily due to the increase in the share price which has increased by nearly 213%
year on year. As we saw in previous section, the earnings per share increased by a sizeable
percentage this year but the share price really changed during the course of the year. A P/E ratio
of over 23 is on the upper scale when compared to the average P/E ratio for companies and
obviously investors are seeing this company as a ‘buy’ which primarily must be due to the sales
and profit growth from 2009 to 2010.
Conclusion
Overall, the results and trends for Milkshire are positive when comparing 2010 to 2009
particularly in relation to the increase in sales and profit. The share price has increased markedly
in the year as investors took note of the increased performance of the company. This significant
increase in sales has obviously put increased pressure on the working capital of the company and
this is an area where management must focus on so as to ensure that the company continues to
grow in a planned and managed way and that the company has the necessary finance in place to
ensure this growth occurs.

81
I hope that the above responses are of benefit to your company and the management of same. If
you have any further queries, please do not hesitate to contact me.

Yours sincerely,

Financial Accountant
Example 5.2
A Ltd and B Ltd are both hardware retailers in a large town. You are given the following
summarised information.
Statement of comprehensive income for the year ended 31 March 2008
A Ltd B Ltd
$'000 $'000
Revenue: Sales 4,300 3,024
Less cost of sales 2,860 2,296
Gross profit 1,440 728
Less
Sundry expenses -500 -380
Operating profit 940 348
Interest on debentures -40 -120
Net profit before tax 900 228
Taxation -200 -60
700 168
Dividends -400 -160
Retained profit 300 8
Statement of financial position for the year ended 31 March 2008
A Ltd B Ltd
Non-Current Assets $'000 $'000 $'000 $'000
Machinery at cost 5,000 5,920
Less depreciation to date 1,800 3,200 4,640 1,280
Office equipment at cost 260 720
Less depreciation to date 80 180 328 392
Motor vehicles at cost 240 200
Less depreciation to date 80 160 80 120
3,540 1,792
Current Assets
Inventory 840 680

82
Trade receivables 1,600 1,200
Sundry 200 160
Bank 80 2,720 0 2,040
6,260 3,832
Equity and Liabilities
Issued share capital 2,400 4,00
Retained earnings 1,940 152
4,340 552
Long-term liabilities
10% Debentures 400 1,200

Current liabilities
Trade payables 400 560
Sundry including taxation 320 240
Bank overdraft 400 1,120
Dividends 400 1,520 160 2,080
6,260 3,832
Required
(a) Calculate the following ratios for both companies:
i. Current ratio
ii. Quick ratio/acid test ratio
iii. Debtors’ collection period in days
iv. Return on capital employed
v. Return on owners’ equity (before taxation)
vi. Gearing ratio
vii. Interest cover
viii. Dividend cover
ix. Gross profit percentage on sales
x. Operating profit percentage on sales
(b) Comment briefly on the relative profitability, liquidity and risk of the two companies.

Solution

83
(a) A Ltd B Ltd
1 Current ratio (2,720/1,520) 1.79 (2,040/2,080) 0.98
2 Quick ratio (1,880/1520) 1.24 (1,360/2,080) 0.65
3 Debtors' collection period (1,600/4,300) 136 days (1,200/3,024) 145 days
4 ROCE (940/4,740) 20% (348/1,752) 20%
5 Return on equity (900/4,340) 21% (228/552) 41%
6 Gearing ratio (400/4,340) 9.20% (1,200/552) 217%
(400/4,740) 8.40% (1,200/1,752) 68.50%
7 Interest cover (940/40) 23.5 times (348/120) 2.9 times
8 Dividend cover (700/400) 1.75 times (168/160) 1.05 times
9 Gross profit margin (1,440/4,300) 33.50% (728/3,024) 24.10%
10 Operating profit margin (940/4,300) 0.22 (348/3,024) 0.12
(b) Profitability
Both companies show a profit, although A Ltd’s profit margins exceed those of B’s by a
significant amount. Return on capital employed is virtually identical for both companies but B
Ltd yields a much higher return on owners’ equity than A Ltd (30.4% against 16.1%). This
reflects the fact that B Ltd is much more highly geared than A Ltd (68.5% against 8.4%)
Liquidity
A Ltd exhibits a very comfortable liquidity position, with current and quick ratios at normal
levels for manufacturing company. B Ltd appears to be in a less healthy position, with ratios
below the industry norm. However, this is primarily due to the fact that B ltd has such a large
bank overdraft. If this is removed from the calculations, B Ltd’s current and quick ratios fall to
2.13:1 and 1.42:1 respectively, which are perfectly acceptable levels. Excluding the bank
overdraft from the calculations is justified on the basis that it may be regarded as medium-term
source of finance.
Risk
A Ltd exhibits healthy profit margins, a comfortable liquidity position and low level of gearing.
It may therefore be considered a low risk company. B Ltd, on the other hand, is highly geared,
indicating quite a high degree of risk. Interest costs will be high, reflecting the cost of the
overdraft. If profits decline, the company could find itself in trouble. Furthermore, machinery is
almost fully depreciated, suggesting that capital investment in fixed assets will be required in the
not too distant future. This will put further demands on resources.

84
Activity 5.4
X Ltd and Y Ltd are both computer component manufacturers in Harare. You are provided with
the following summarised information in relation to both companies:

Statement of comprehensive income for the year ended 31 December 2012

X Ltd Y Ltd
$'000 $'000
Revenue 1,500 2,000
cost of sales 1,000 1,600
Gross profit 500 400
Operating expenses 150 200
Operating profit 350 200
Interest on debentures 100 50
Net profit before tax 250 150
Taxation 50 30
Profit after tax 200 120
Dividends 70 100
Retained profit 130 20

Statement of financial position for the year ended 31 December 2012

X Ltd Y Ltd
Non-Current Assets $'000 $'000 $'000 $'000
Machinery at cost 4,000 4,830
Less depreciation to date 1,000 3,000 3,500 1,330
Buildings at cost 3,000 2,200
Less depreciation to date 1,140 1,860 600 1,600
Motor vehicles at cost 800 600
Less depreciation to date 350 450 550 50
5,310 2,980
Current Assets
Inventory 150 330
Trade receivables 160 370
Bank 240 550 0 700
5,860 3,680
Equity and Liabilities
Issued equity shares 3,000 2,000
Retained earnings 1,600 550

85
4,600 2,550
Non-current liabilities
10% Debentures 1,000 500

Current liabilities
Trade payables 140 310
Bank overdraft 50 220
Dividends 70 260 100 630
5,860 3,680

Required:

(a) Calculate the following ratios:


i. Gross profit margin
ii. Operating profit margin
iii. Current ratio
iv. Acid test ratio
v. Inventory days
vi. Receivable days
vii. Payable days
viii. Return on capital employed
ix. Gearing ratio
x. Interest cover

(b) Comment on the performance of both companies in terms of profitability and liquidity, using
the ratios that you calculated and any other relevant information in the question.

5.13 Accounting Policies and Financial Appraisal


The market may rely partly on an analysis of accounting information to establish its value. This
leads to ratio analysis for which a number of limitations can be cited.
• Differences in accounting policies
• The historical nature of accounting statements
• Changes in the value of money
• Hidden short-term fluctuations between financial statements
• The absence of comparable data
• Differences in the environments of the periods or firms being compared
• Non-monetary factors

86
5.14 International analysis
General analysis of financial statements is hard enough within one country, because of the
complexity of the economic world and the incentives that some preparers of accounting
information have to mislead the users. When trying to compare companies internationally, the
difficulties multiply, including differences under the following headings:
• Language problems
• Differences in financial culture
• Interpretation difficulties
• Availability of published accounting data
• Extent and type of audit
• Valuation of assets
• Measurement of profits
• Formats of financial statements
• Frequency of reports
• Quantity of data disclosed
• Different currencies
• Biases in the accounting data
• User- friendliness of annual reports

Activity 5.5
“General analysis of financial statements is hard enough within one country, because of the
complexity of the economic world and the incentives that some preparers of accounting
information have to mislead the users”. Discuss.

5.15 Summary
Ratio analysis is one of the most important and powerful tools in financial statement analysis.
Various ratios can be calculated from the statement of comprehensive income and statement of
financial position which include, profitability, efficiency, liquidity and gearing. The emphasis on
which ratios to calculate depend on the specific user interested in the financial statements. There
are many reasons for analysts to try to carry out international comparative analysis. However, it
has all the problems of domestic analysis plus several others. Multinational companies can make
87
several types of adjustment to assist international analysis. However, it is necessary for the
analyst to do further work before international comparison of financial statements.

References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
88
Basson N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
th
Company Financial Statements. 7 Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Sibanda, A. (2001). Financial Statements Analysis Module.Finance Department. Bulawayo:
National University of Science and Technology publication.
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

89
BLANK PAGE
Unit 6

Equity Valuation

6.0 Introduction
While it may be difficult to ascertain the monetary returns on certain types of assets such
as works of art, the fundamental characteristic of business assets is that they give rise to income
flows. Sometimes these flows are easy to determine, but most of the times we have to estimate
them. Irrespective of the difficulties of measuring income flow, it is the prospective income from
business assets that give rise to value.

6.1 Objectives
By the end of this unit, you should be able to:
• define valuation
• determine valuation methods to apply in specific cases
• apply the following valuation methods
­ price-earnings based valuation
­ book value-based method
­ dividend valuation models
­ free cash flow valuation model

6.2 Financial Statements and Valuation


Figures in financial statements are by themselves meaningless if we do not have an objective
standard to compare them to. The comparison, however, has to be carried out in the context of
the operating environment of the firm. Hence it is necessary to come up with valuation figures
using the information from the company’s financial statements which we can use to compare, for
example, with the share price, if the company is a listed company.

6.3 Definition of Valuation


Valuation is the process that links risk and return in order to determine the worth of an asset. The
numbers in financial statements and reports have to tell a story about what an asset is really
worth in its present state. Valuation may also be defined as the estimation of an asset’s value
90
based on variables perceived to be related to future investment returns, on comparison with
similar assets, or, when relevant, on estimates of immediate liquidation proceeds.

6.4 Statement of Financial Position as a Valuation Tool


A statement of financial position (balance sheet) is a summary statement of the business entity’s
financial position at a given point in time. It shows the resources of the business, as well as
sources of finance. If viewed as a complete financial picture of the business, a statement of
financial position suffers from the following drawbacks:
• absence of non-monetary items (for example, risk);
• historical valuation of items (the backward looking nature of accounts);
• effect of matching convention; and
• flexibility of accounting policy (for example, on depreciation and provisions).
Within the limitations inherent in the above discussion, the statement of financial position figures
usually known as book values can be used as partial indicators of the business size and financial
strength.

6.5 Valuation through Expectations


The correct theoretical approach to the valuation of a share in a business is to consider some
defined future flows and to discount the anticipated figures to give the present value, using the
principles of discounted cash flow (DCF). Possible flows to use would include:
• stream of future earnings, from the income statement;
• stream of future net cash flows from statement of cash flows; and
• stream of future dividends.

6.6 Valuation through Market Values


Value is derived from the market value of shares as quoted on the stock exchange. The price of a
share on the stock exchange on any particular day is influenced by all kinds of factors, which are
extraneous to the particular business under consideration.

6.7 Perspective of an Investor Without Control


These are investors who are shareholders, but have no control or influence over the operational
or financial policies of the business and also do not form part of the management of the
91
company; as such valuation of investments for such investors should be based on expected future
distribution of income.

6.8 Perspective of an Investor with Control


When an investor buys majority interest, she also buys a stream of future dividends. But in
addition to the stream of future cash flows, she is also buying the ability to influence the level of
these future cash flows hence she should be prepared to pay more for this influence over the
company’s decisions.

Activity 6.1
a. What is valuation?
b. What is the logical criterion for choosing a valuation method?

6.9 Price Earnings Multiple Approach


Price earnings ratio is an indicator of investor’s confidence in the growth prospects of the
company. The higher the ratio, the better is the confidence in the company’s prospects.
Value of a business Vo is determined as follows:-

Vo = P/E × E

Where Vo = Value of a business

P/E = Price earnings ratio

E = Expected earnings of the company.

Example 6.1
Fairmile (Pvt) Limited is not listed on the stock exchange, however, a similar company Prett
(Pvt) Limited which is similar to Fairmile in all respects is trading at a price earnings ratio of 10.
If Fairmile expects earnings per share of $2.00, what is the fair value of its shares?
Solution
P/E × e.p.s

92
=10× $2
=$20
NB: The p/e ratio of the surrogate firm is used.

Activity 6.2
Shuttle Pvt. Ltd is expected to earn $2.50 per share next year. This expectation is based on an
analysis of the firm’s historical earnings which have been growing annually by an average 25%.
The average price earnings ratio for firms in the same industry is 7.
a. What are the earnings per share for the current year?
b. What is the fair value of a share?

6.10 Net Asset Value (Balance Sheet Valuation)


Net asset value is the amount to be received if all assets are to be liquidated for their exact
accounting value and if all the liabilities are paid out in full. This method is too simplistic
because of its reliance on historical balance sheet data. It ignores the future earning capacity of
the assets. This is the reason why most listed shares trade above their net book value, even
though some trade below because of the pessimistic view of investors on the future earning
potential of the assets.

Activity 6.3
Shuttle Pvt. Ltd as at 31 December 2012 has an asset base of $10 million, total liabilities
including preference share capital of $3.9 m and 1000 000 ordinary shares in issue.
a. What is the net asset value per share?
b. Why is this method of valuation inferior?

6.11 Dividend Valuation Models


Dividend valuation models depend on the dividends that are expected to be declared by
companies in the foreseeable future in order to come up with the current fair value of the
company or a share. These models assume either:
1. no growth;
2. constant growth or
3. supernormal growth of dividends.
93
6.11.1 No Growth of Dividends
This model assumes that the declared dividend will neither grow nor shrink. It will remain
constant during the life of the company. The value of a company is given by the following
formular:
��
Vo =
��

Where

Vo = value of the company

Do = current dividend

Ke = cost of equity

Example 6.2
XYZ Private Limited has just paid a dividend of $3 per share which is expected to be constant
indefinitely. If the company’s cost of capital is 20% what is the fair value of a share?

Solution
��
Vo =
��


Vo =
�.�
= $15

Activity 6.4
Last year Shuttle (Pvt) Ltd declared a dividend totaling $20 million and the required rate of
return on equity is 37%. What is the value of this company assuming that the dividend will not
grow for the foreseeable future?

94
6.11.2 Constant Growth (Myron Gordon)
This model assumes that the dividend will grow at a constant rate indefinitely. The value of the
company is given by the following formula:
�� (���)
Vo =
�� ��

Where

Vo = Value of the company

Do = Current total dividend

Ke = Cost of equity

g = Growth rate of dividend

Activity 6.5
Shuttle (Pvt) Ltd’s fortunes have changed due to positive developments brought about by the
monetary policy statement and the dividend of $20 million is expected to grow by a constant rate
of 10% per annum. Assuming the required rate of return of 37%, what is the value of this
company given the improved operating environment?

6.12 Super (or Variable) Growth of Dividends


This model assumes that dividends will grow at varying rates during the life of the company.
For simplicity, the variation in growth is assumed to take place during the earlier years
and during the later years constant or no growth is assumed. Value of a company is given
by the following formula:

�� (���� )� (�� � �) �
Vo = (��� )�
+ ���
× �(���)� �

In other words
Vo = Present value of dividends during supernormal growth period + value of share price at
end of supernormal growth period discounted back to present.
Where:

95
Do = current dividend

gs = supernormal growth rate


g = normal growth rate
n = period of supernormal growth
Example 6.3
Because competitors have bowed out, Shuttle (Pvt) Ltd is now enjoying monopoly status and is
expected to have a super growth of dividend of 30% for the next 3 years, after which the growth
rate is expected to stabilize at 5% for the foreseeable future. Shuttle expects to pay a dividend of
$50 at the end of year one. Assume a cost of equity of 20%. What is the value of the company?
50
Year 1 = 42
1.2

(1.3)50
Year 2 = 45
(1.2) 2

(1.3) 2 50
Year 3 = 49
(1.2) 3

(1.3) 2 50(1.05)
Year 3 = 342
(0.2 − 0.05)(1.2) 3

Total = 478
Vo = 478

Activity 6.6
Assume the following:-
i. Shareholders’ capitalisation rate of 16%
ii. Growth rate of 27.5% for ten years and 8% there after
iii. Current dividend of $2 per share
a. What is the fair value of the share?

96
b. Assuming that the company has 10 000 000 shares outstanding, what is the value of the
company?
c. What are the drawbacks of the dividend growth models?

6.13 Free Cash Flow Valuation Model


When an investor buys majority interest, she is buying a stream of future dividends. In addition
to the stream of future cash flows she is also buying the ability to influence the level of these
future cash flows hence she will be prepared to pay more for this influence over the company’s
decisions. Cash flows associated with majority interest are called free cash flows (FCF). Free
cash flows are cash flows beyond what a firm requires to invest in all available positive net
present value investments.

6.13.1 Calculation of free cash flows


Table 6.1
Operating profit before tax xxx
+add back depreciation xxx
-less interest (xxx)
-less tax (xxx)
-less increase in working capital (xxx)
-less investment in fixed assets (xxx)
net of proceeds from disposed of fixed assets.
+ add financing: change in debt xxx
change in preference shares xxx
change in minority interest xxx

Free Cash Flow FCF xxx

97
6.14 Calculating value of the firm
��� ��
Value of the firm = ∑��� +
(���)� (���)�

Where;

FCF = Free cash flow

Vt = Terminal value of the firm

K = Cost of capital

t = Period of operation

The logic behind this valuation model is that the investor who is buying control has to discount
all the cash flows that she will be able to control using the required rate of return (cost of capital)
so as to come up with a fair value of the firm. Unlike a minority shareholder who is not able to
control cash flows and is only entitled to distributions such as dividends, the majority or
controlling shareholder can basically determine the direction of the company by virtue of control
of cash flows.

Future cash flows have to be estimated using the various forecasting techniques some of which
are described latter on in this unit. Forecasting of cash flows is the most challenging part and it
needs to be approached with extra caution, as flawed cash flows will also give an
unrepresentative value. Cost of capital (the required rate of return) can be estimated using the
Myron Gordon model or the Capital Asset Pricing Model (CAPM).

Activity 6.7
JTM (Pvt) Ltd Statement of financial position for the year ended 31 December 2012
Non Current Assets $ $
Property 60 900
Plant 13 500
74 400
Current Assets
Stock 246 200
Debtors 85 800
98
Cash 3 600
332 000
Total Assets 410 000
Equity and Liabilities
Equity
Share Capital 80 000
Reserves 120 000
200 000
Liabilities
Long term debt 50 000
Creditors 160 000
210 000
Total Equity and Liabilities 410 000

Statement of Comprehensive Income for the year ended 31 December 2003


$
Revenue 2 241 600
Cost of sales 1 591 800
Gross profit 649 800
Operating Expenses 541 800
Operating Profit 108 000
Interest payable -12 000
Profit before tax 96 000
Tax at 25% - 24 000
Profit after tax 72 000

Additional information
• Current asset management ratios are to be maintained
• Depreciation valuation is $10 200
• Number of months sales debtors 15½

99
• Number of months cost of sales in inventory is 2.
• Number of months operating expenditure in payables (creditors) is 1.
• Expenses on non-current assets during 2013, $34 300.
Required
Calculate the projected free cash flow for 2013 given the above detail.

6.15 Summary
Valuation is critical to financial statement users. The users of financial statement should be able
to tell a story from the figures beyond the mere growth in profit, sales and financial position
(balance sheet) size. In this unit, we have been laying the foundation for deriving values from the
available information with the financial statements acting as the basis for valuation. Valuation
methods should be put in their proper context, for example, price earnings based valuation and
dividend-based models are used by minority investors while majority investors should go for the
free cash flow valuation models. Forecasting is integral to valuation. Earnings and cash flows
used in valuation are forecasted and the accuracy of the forecasted value will actually depend on
the accuracy of the forecasted cash flows.

100
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Basson, N., et al. (2003). Accounting Standards. 10th Edition. Cape Town: Juta & Co.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Frank, W., and Alan, S. (2002). Business Accounting 2.9th Edition.England: Prentice Hall.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Miller, M.,Modigliani,H., and Franco.(1961). Dividend Policy, Growth and the
Valuation of Shares. Journal of Business 34 pp 411-433.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Sibanda, A. (2001). Financial Statements Analysis Module.Finance Department. Bulawayo:
National University of Science and Technology publication.
Walter, L.E. (1967). Dividend Policy and Enterprise Valuation. Wadsworth, Wales: Belmont
Cadif.
Wendt, P.F.( March-April 1985). Current Growth Stock Valuation Methods.Financial
Analysis Journal No 33
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

101
Unit 7

Accounting for Business Combinations

7.0 Introduction
After merger terms have been agreed upon, the financial manager must be familiar with the
accounting treatment of the financial results of the merger that reflect the initial effect on the
earnings of the surviving firm. In this unit, we will dwell on the accounting treatment of business
combinations and reorganisations.

7.1 Objectives
By the end of this unit, you should be able to:

• explain the different methods of accounting for business combinations


• apply the purchase method of accounting for business combination
• discuss the merger method of accounting for business combination
• compute the equity method of accounting for business combination
• conduct proportional consolidation of accounting for business combination
• apply the cost method of accounting for business combination

7.2 Methods of Accounting for Business Combinations


Business combinations involve the acquisition of one business by another, partially or wholly, or
the combining of two or more businesses entities on a more or less equal footing. Acquisition is a
business combination in which one of the entities (the acquirer) obtains control over the net
assets and operations of another entity (the acquiree) in exchange for the transfer of assets,
incurrence of liabilities or issue of equity.

7.2.1 Purchase Method


A purchase involves:

• new owners;
• an appraisal of the acquired firm’s physical assets and a restatement of the financial
position (balance sheet) to reflect these new values;

102
• the possibility of an excess or deficiency of consideration given up with respect to the
book value of equity (this refers to goodwill); and
• recognition of previously unrecognised contingencies and off-balance sheet items.
Examples include lawsuits and employment benefit plans.

Example 7.1

Assume ZOU Corporation acquires the whole of the issued share capital of Little Hope (Pvt) Ltd
at a price of $1.50 per share for cash at 31 December 2012 at which date their respective
statement of financial position are shown. As at this date the estimated fair values of Little Hope
(Pvt) Ltd assets were:
Assets $
Land and Buildings 15 000 000
Plant 11 000 000
Sundries 7 500 000
33 500 000

Little Hope (Pvt) Ltd Statement of Financial position (Actual SFP)


Assets $
Land and Buildings 12 500 000
Plant 10 000 000
Sundries 7 500 000
30 000 000
Assuming that ZOU Corporation pays $37 500 000 for Little Hope, the statement of financial
position can appear as follows, assuming that the $37.5 million is taken as an investment.
Assets $
Land and Buildings 50 000 000
Plant 20 000 000
Investment in Little Hope Pvt Ltd 37 500 000
Sundries 10 000 000
117 500 000

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Equity and Liabilities
Ordinary Share Capital 75 000 000
Reserves 42 500 000
117 500 000
To reflect the substance over form relationship between the parent and the subsidiary, the
published results of ZOU Corporation must incorporate the resources and results of the
subsidiaries which it controls as follows:
• assets and liabilities of Little Hope at the Statement of financial position (Balance Sheet) date
are added to those of ZOU Corporation;
• the difference between resources at fair value and investment at cost should be attributed to
goodwill;
• only the parent company’s share capital is shown as the capital of the group.
The consolidated statement of financial position is as follows:
Assets $
Land and Buildings (50m + 15m) 65 000 000
Plant (20m + 11m) 31 000 000
Goodwill (37.5m-33.5m) 4 000 000
Sundries (10m + 7.5m) 17 500 000
117 500 000
Equity and Liabilities $
Ordinary Share Capital 75 000 000
Reserves 42 500 000
117 500 000

The application of the purchase method of accounting to the statement of financial position can
be summarised as follows:
• the purchase price is allocated to assets (including intangibles) and liabilities are restated
at their fair market value;
• the restated net fair value is compared with the purchase price. Any excess is attributed to
goodwill;

104
• if the restated net fair value exceeds the purchase price, then the write-up of property is
reduced until equality is achieved; and
• the ordinary share capital of the acquired firm is eliminated and replaced with the market
value of acquirer shares issued.

7.2.2 Proportional consolidation


This method basically involves calculating the principal company’s proportionate interest in the
various components of the controlled company’s statement of financial position (balance sheet)
and adding them to the corresponding components of the principal company’s statement of
financial position.
Example 7.1
Delo Holdings Limited acquires 50% of Switchtech Pvt Ltd which it jointly controls with
Lorenzo (Pvt) Ltd for cash at 31 December 2012. Their Statement of financial position is as
follows:
Switchtech (Pvt) Ltd Statement of financial position for the year ended 31 December 2012

Non-Current Assets $
Plant and Machinery 20 000 000
Sundry 30 000 000
50 000 000
Equity and Liabilities
Ordinary Share Capital 40 000 000
Reserves 10 000 000
50 000 000

Delo Holdings consolidated statement of financial position for the year ended 31 December
2012

Non-Current Assets $
Plant and Machinery 250 000 000
Investment in Switchtech (pvt) Ltd 30 000 000
105
Sundry 143 000 000
423 000 000
Equity and Liabilities
Ordinary Share Capital 200 000 000
Reserves 223 000 000
423 000 000
Required:
Using proportional consolidation, construct the statement of financial position for Delo Holdings
Limited.
Solution
Delo Holdings limited Statement of financial position for the year ended 31 December 2012

Non-Current Assets $
Plant and Machinery (note 2) 260 000 000
Goodwill (note 1) 5 000 000
Sundry (note 3) 158 000 000
423 000 000
Equity and Liabilities
Ordinary Share Capital @$1/share 200 000 000
Reserves 223 000 000
423 000 000
Notes to Financial Statements
1. Goodwill [$30 000 000 – 0,5 ($40 000 000 + $10 000 000)] = $5 000 000
2. Plant and Machinery [$250 000 000 + 0,5 ($20 000 000)] = $260 000 000
3. Sundry [$143 000 000 + 0,5 ($30 000 000)] = $158 000 000

Activity 7.1
Gift (Pvt) Limited acquired the total shareholding in Jinks (Pvt) Ltd for a consideration of $100
million. The statement of financial position for Jinks (Pvt) Ltd and Gift Pvt Ltd as at 31
December 2012 was as shown below:
Jinks (Pvt) Jinks(Pvt) Ltd Gift(Pvt) Ltd
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Estimated Actual
$ $ $
Non-current assets 50 45 500
Current Assets 30 30 400
Investment in Jinks 100
Other 10 10 50
Total Assets 90 85 1 050

Equity and Liabilities


Ordinary Share Capital 80 80 700
Reserves 10 5 300
90 85 1 050

Gift accounted for the shareholding in Jinks as an investment and its statement of financial
position appeared as shown above in the last column.
Required:
Using the purchase method of consolidation, construct the statement of financial position for Gift
Pvt Ltd for the year ended 31 December 2012.

7.2.3 Equity Method


The equity method of accounting is founded on the basis that the investor company should
furnish prescribed additional information in respect of its interest in an associated investee
company in which its voting rights is of such interest that the operating results, assets and
liabilities of the associated company are of particular interest to the shareholders of the relevant
investor company.
Example 7.2
First Private Limited acquires 6 million ordinary shares in Second Private Limited which is 30%
of the company at a price of $1,50 on 31 December 2012 at which date the profit and loss
reserve of Second Private Limited was $800 000.
First Limited
Statement of financial position for the year ended 31 December 2012
107
$’000
Non-current assets 15 000
Investment in Second Pvt Ltd 900
Current Assets 1 000
16 900
Equity and Liabilities
Share Capital 8 000
Reserves 8 900
16 900

Second Limited
Statement of financial position for the year ended 31 December 2012

$’000
Non-current Assets 3 200
Net Current Assets 1 800
5 000
Equity and Liabilities
Share Capital 2 000
Reserves 3 000
5 000
Required:
Prepare the consolidated statement of financial position for First Private Limited for the year
ended 31 December 2012.
Solution:
First Limited
Consolidated statement of financial position for the year ended 31 December 2012
$’000
Non-current Assets 15 000
Investment Assets in Second (note 1) 1 560
Current Assets 1 000
17 560
Equity and Liabilities
Ordinary Share Capital 8 000
Reserves (note 2) 9 560
17 560
Notes
1. Investment in Second Pvt. Ltd at cost 900
First share of profit (3m – 0.8m) × 30% 660
1 560
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2. Reserves of First Pvt. Ltd 8 900
Group’s share of post acquisition profit 660
Reserves of Second Pvt. Ltd 0.3 x (3m – 0.8m) 9 560

The equity method must be applied when the investor exercises significant influence on the
management, operations, investing and financing decisions of the investee. The investor must
report its proportionate share of the investee’s net assets and recognise a proportionate share of
the income of the investee, regardless of whether it is received as a dividend or is re-invested.
In practice, the equity method has been applied to holdings as low as 10% when significant
influence has been demonstrated. If the amount paid is greater than the proportionate share of the
investee’s book value, as is generally the case, then goodwill is created. When the subsidiary has
losses, the equity method requires a write-down of the carrying value of the investment.
However, the carrying value cannot be written down below zero.

Activity 7.2
Explain where the equity method of consolidation would be preferable to the other methods of
accounting for consolidations.

7.2.4 Pooling of Interest


Under pooling of interest, the accounting treatment is simply to combine the statements of
financial position (Balance Sheet) of the companies. Goodwill will not ordinarily arise in the
consolidation. This method is applicable where two businesses are coming together on more or
less equal basis. Shareholders of the combined entity must achieve a continuous mutual
relationship of sharing of risks and benefits attached to the business entity. The basis of the
transaction must be an exchange of voting ordinary shares of the companies involved. With
pooling of interest, shares issued in the share for share exchange are recorded at nominal value,
that is, no share premium is created. Pooling of interest method is similar to consolidation of a
previously unconsolidated subsidiary. Fair market values are irrelevant to recording the
combination. The actual market price and premium paid for the acquired firm are suppressed
from both statement of financial position and statement of comprehensive income.

109
Activity 7.3
Statements of financial position of two companies Hammond & Loyds are shown below.

Hammond
Statement of financial position for the year ended 31 December 2012
$’000
Non-Current assets 100 000
Current Assets 50 000
Other 20 000
170 000
Equity and Liabilities
Ordinary Share Capital 70 000
Preference Shares 50 000
Reserves 50 000
170 000
Loyds
Statement of financial position for the year ended 31 December 2012

$’000
Non-current assets 30 000
Current Assets 25 000
Other 10 000
65 000
Equity and Liabilities
Ordinary share Capital 50 000
Reserves 15 000
65 000
The two companies are coming together on a more or less equal basis. Show the consolidated
Statement of financial position of the combined entity using the pooling of interest method of
accounting.

110
7.2.5 Cost Method
Under the cost method an investor records an investment in the shares of an investee company at
cost. Where there is a sustainable decline in value, there should be an appropriate recognition of
such decline. Assets are reported at their amortized cost. Market value changes are recognised
until there is an actual transaction (sale).
Example 7.3
At acquisition CTU (Pvt) Ltd reports the purchased asset on its statement of financial position at
the acquisition cost as follows:

Investment in Toddler (Pvt) Ltd $ 1 000

For period 1 CTU (Pvt) Ltd’s income statement would include (as other income) the following:

Dividend received $100

At the end of period 1 CTU (Pvt) Ltd does not record the increase in the market price of the
shares of Toddler Pvt Ltd. When the share is sold, CTU recognises the realised gain or loss equal
to the difference between the proceeds of the sale and the original cost.

For example, $1 200 - $1 000 = $200 yielding a total two period return (Dividend + Capital gain)
of $300 on the investment.

In the absence of a dividend, sale or write down of the investment, the operating, financing and
investment activities of Toddler have no impact on the financial statements of CTU. The
carrying amount remains $1 000 until the investment is sold.

A write down of the investment to its estimated market value is required only when CTU
determines that it has been permanently impaired (for example, due to financial problems of
Toddler).

Participation in the equity income or loss of the investee company subsequent to the date of
acquisition is recognized only to the extent that dividends are distributed by the investee
company or provisions are made for losses.

Activity 7.4
Maurin has a number of wholly owned subsidiaries and 28% holdings of the issued share capital
of Game. The shares were acquired years ago. The Consolidated Statement of Comprehensive
Income of Maurin Group and the Statement of Comprehensive Income of Game for the year
ended 31 December 2012 were:

111
Maurin Games
$ $
Revenue 18,000 7,000
Cost of sales (9,500) (2,000)
Gross profit 8,500 5,000
Expenses (2,900) (1,400)
Profit from operations 5,600 3,600
Finance income 1,010 -
Finance costs (700) (300)
Profit before tax 5,900 3,300
Income tax (2,000) (1,000)
Profit after tax 3,900 2,300

Dividends of $1,500 and $400 respectively have been proposed.

Maurin has not accounted for the dividend from Game which was proposed prior to the year end.

Required:

Prepare the Consolidated Statement of Comprehensive Income for the Maurin Group
incorporating the results of Games.

7.3 Summary
In this unit, we have been laying down the basics of accounting for business combinations. Each
method of accounting should be appropriately applied in the context of the relevant accounting
guidelines or international accounting standards. The basic intention of the current accounting
treatment of business combinations is to reflect the economic resources under the control of the
company (the investor company).

112
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Ashton, D.J., and Atkins, D.K. (March 1984). “ A Partial Theory of Takeover Bids” Journal of
Finance; 39 pp 167-183.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Ellert, J. C. (May 1976). “Mergers, antitrust Law Enforcement and Stockholder Returns”
Journal of Finance pp 715-732.
Fama E .(April 1980). “Agency Problem and the Theory of the Firm ” Journal of Political
Economy pp 288-307.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Miller, M.,Modigliani,H., and Franco.(1961). Dividend Policy, Growth and the Valuation of
Shares. Journal of Business 34 pp 411-433.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Stapleton, R. C. (1992). Mergers and Acquisitions. LexingtonUS: Mass DC Heath.
Walter, L.E. (1967). Dividend Policy and Enterprise Valuation. Wadsworth, Wales: Belmont
Cadif.
Wendt, P.F.(March-April 1985). Current Growth Stock Valuation Methods. Financial Analysis
Journal No 33
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

113
Unit 8

Valuation of Non-Current Assets and Leases

8.0 Introduction
Valuation of non-current assets has a bearing on reported profits. Just like the valuation of
inventory, the various methods applicable in the depreciation of assets give accountants a lot of
leeway in determining the amount of profit to be reported. Similarly, the treatment of leases has a
bearing on the gearing ratios of a firm. In this unit, we will look at the valuation of assets and
leases and their accounting treatment.

8.1 Objectives
By the end of this unit, you should be able to:
• explain the basic valuation methods that could be used for the presentation of non-current
assets in the statement of financial position
• distinguish between the benchmark and allowed alternative treatment for non-current assets,
leased non-current assets, intangible assets and research and development
• Outline depreciation methods
• Explain disclosure requirements in accounting for leases
• Discuss intangible assets in accordance with IAS 38.

8.2 Non-current Assets


Non-current assets (fixed assets) are property, plant, equipment and intangibles that will provide
an economic benefit to an enterprise for a number of future periods. There are two important
aspects that should concern an accountant and the analyst with respect to the treatment of non-
current assets:
• determining the appropriate cost at which to record the assets initially; and
• determining the appropriate methods to be used to allocate the cost or other recorded
values over the periods when benefits are enjoyed.

114
The benchmark treatment for recording long-lived assets, at the onset is historic cost but under
hyper-inflationary conditions it may be recommended that revalued costs be used. Long-lived
non-current assets can be categorised into tangibles and intangibles.

8.2.1 Tangible non-current assets


These are assets that have physical substance and can be categorised as follows:
• depreciable assets (for example, motor vehicle);
• depletable assets (for example, mineral resource); and
• other tangibles.

8.2.2 Intangible non-current assets


These are assets that have no physical substance. The value of such assets is derived from rights
or privileges that their ownership conveys to the business enterprise. According to IAS38 an
intangible asset is an identifiable non-monetary asset without physical substance. Intangibles can
be categorised into two, that is:
• identifiable; or
• unidentifiable.
The definition of an intangible asset requires an intangible asset to be identifiable to distinguish
it from goodwill. Examples of identifiable intangibles include:
• patents;
• copyrights;
• brand names;
• customer lists;
• trade names; and
• other specific rights that can be conveyed by an owner without necessarily also
transferring related physical assets.
Goodwill on the other hand is an unidentifiable asset that cannot be meaningfully transferred to a
new owner without also transferring related physical assets.

115
8.3 Concerns to be Addressed in Accounting for Non-current Assets
The initial recording and further treatment of non-current assets is subject to a lot of
complications. The following are some of the major concerns that need to be addressed:
• The amount at which the non-current assets should be recorded initially on acquisition.
• How value changes subsequent to acquisition should be reflected in the accounts, if need
be.
• The rate at which the amount of the assets is recorded should be allocated to future
periods.
• The recording of subsequent disposals of the assets.

Activity 8.1
1. Explain the essential criterion to distinguish a non-current asset from a current asset.
2. “The definition of an intangible asset requires an intangible asset to be identifiable to
distinguish it from goodwill”. Discuss the identifiability of an intangible asset.

8.4 Initial Recording


The cost of the non-current asset should include all costs involved in getting the asset into a
location and condition where it can be productive. The total cost should include the following:
• purchase price;
• delivery charges;
• any duties paid;
• installation costs;
• legal fees, architects fees, clearing fees; and
• labour, material and production overheads that have been used or incurred in construction
of non-current assets.

8.5 Costs Incurred Subsequent to Purchase (or Self Construction)


A cost can be added to the carrying amount of the related asset only when it is probable that
future economic benefits, beyond those originally anticipated for the asset will be received by the
business entity. The improvement costs can include the following:
• modifications made to the asset to extend its useful life;
• modifications to improve the asset’s capacity;
116
• modifications to improve the quality of the product; and
• modifications that result in the reduction of other input costs.
These costs should be capitalised. Repairs and maintenance should be expensed as they are
incurred. Such costs include those incurred to maintain the anticipated productive capacity and
those incurred to restore productive capacity to anticipated levels.

8.6 Depreciation of Non-current Assets


Depreciation is the allocation, in a systematic manner of the cost of the non-current asset so as to
match the expense with the revenue it generates for the duration of its useful life. IAS 16 defines
depreciation as the systematic allocation of the depreciable amount of an asset over its useful
life.

8.6.1 Amortisation
Amortisation is the depreciation of intangible non-current assets such as research and
development costs and goodwill. IAS 38 (Intangible assets) defines amortization as the
systematic allocation of the depreciable amount of an intangible asset over its useful life. In the
case of an intangible asset, the term ‘amortisation’ is generally used instead of ‘depreciation’.
The two terms have the same meaning.

8.6.2 Reasons for depreciation


Non-current assets are used up for a number of reasons which can be categorised into two.
Physical reasons – this is deterioration or wearing out with use, for example, the expiration of
a lease or patent or the exhaustion of a mine.
Economic reasons – this is obsolescence of the asset or the product, or could be as a result of the
expansion of a business causing an asset to be inadequate in size or performance.
In a nutshell, depreciation is the allocation of the depreciable amount of an asset over its
estimated useful life. Depreciation is not a valuation technique. Although provisions for
depreciation are deducted from the cost of non-current assets to arrive at net book value on the
statement of financial position, net book value is not supposed to represent the net realizable
value of the non-current assets at the balance sheet date. Net book value is merely the cost of an
asset that has so far not been allocated to the profit and loss account.

117
It is also important to note that depreciation is not a mechanism for the replacement of the
depreciating asset when it reaches the end of its useful life.
The accounting entries are as follows:-
Debit: Depreciation expense
Credit: Provision for depreciation
It is crystal clear from the above entries that there is no direct effect on cash.
For the replacement of an asset that is being depreciated there is need to open a sinking fund
account whose accounting entries will be as follows:-
Debit: Sinking fund provision for depreciation
Credit: Cash
A bank account can be opened for the sinking fund, but this may not be enough to replace the
asset for the following reasons:
• hyper inflation; or
• the firm may want to replace with a different asset because of technological changes or
may want to replace with a different size of asset.
Nonetheless, depreciation may help firms with replacement of assets in general because it helps
in maintaining the original capital (in monetary terms) by reducing profit available for
distribution.

Activity 8.2
Explain in layman terms, the significance and/or meaning of the following Journal entries in
relationship to depreciation of non-current assets:

1. Debit: Depreciation expense


Credit: Provision for depreciation
2. Debit: Sinking fund provision for depreciation
Credit: Cash

8.7 Depreciation Methods


IAS 16 (Property, Plant and Equipment) states that the depreciation method used by a company
should reflect the pattern in which the asset’s future economic benefits are expected to be
consumed by the entity. The depreciation method applied to an asset shall be reviewed at least at
each financial year-end and, if there has been a significant change in the expected pattern of
118
consumption of the future economic benefits embodied in the asset, the method shall be changed
to reflect the changed pattern.

A variety of depreciation methods can be used to allocate the depreciable amount of an asset on a
systematic basis over its useful life. These methods include the straight line method, the
diminishing balance method and the units of production method.

8.7.1 Straight Line Method


Straight-line depreciation results in a constant charge over the life if the asset’s residual value
does not change. This is applicable where maintenance costs are not incurred, for example,
depreciation of intangibles.
������������� �����
Straight-line depreciation =
��������� ������ ���� �� �����/�������

This method of depreciation allocation is systematic but its rationale is questionable. The straight
line depreciation method is more appropriate where assets require depreciation because of lapse
of time, for example, when leases and patents expire because the term of contract expires.
Some assets have repair and maintenance costs that increase with time, which when added to
straight line depreciation would cause the total charge for the asset’s service potential to also
increase with time. Under such circumstances, if a constant total charge for the asset’s service
potential is to be put to profit and loss, a declining depreciation charge may be appropriate.

8.7.2 Declining charge method (reducing balance)


This method is referred to as diminishing balance method in IAS16. The diminishing balance
method results in a decreasing charge over the useful life. This is appropriate where assets incur
increasing repair and maintenance costs. The declining depreciation charge plus the increasing
maintenance per year should result in constant total charge for services rendered by the asset.

d = 1- ��/�
Where d = depreciation rate
n = life of asset
s = scrap value
k = gross cost
NB: S = k [1 + d] n
Example 8.1
119
Suppose the cost of an asset whose life is estimated to be five years is $100 000 and the scrap
value at the end of five years is estimated to be $10 000.
Calculate the depreciation charge percentage rate and the depreciation charge for the first three
years.
Solution
Please note that in our example scrap value is already given, we do not need to calculate it.

d = 1- �S/K

d = 1- �10000/100 000
d = 0.37
d = 37%
Depreciation charge for the first three years
Year 1 $100 000 × 37% = $37 000
Year 2 ($100 000 - $37 000) × 37% = $23 310
Year 3 ($63 000- $23 310) × 37% = $14 685
Implied maintenance costs
Year 1 $37 000 - $23 310 = $13 690
Year 2 $37 000 - $14 685 = $22 315
Year 3 $37 000 - $[(39 690-14685) × 37%] = $27 748.15

Assumptions of the declining charge method


• The benefits generated by the asset are going to be more or less equal.
• It will be rational to charge the same depreciation rate each year.
• The asset is going to incur increasing maintenance costs, hence to achieve a constant
amount for services rendered each year the depreciation charge should decline.

8.7.3 Sum of digits method


IAS 16 refers to this method as the units of production method. The units of production method
result in a charge based on the expected use or output. This is another way of producing
systematically declining charges for depreciation. Assuming that the useful life of a project is
five years.
Sum of digits = 5 + 4 + 3 + 2 + 1 = 15
120
�(���) �(���)
Or = = 15
� �


1 = = 33%
��

2 = ��
= 27%

3 = ��
= 20%

4 = ��
= 13%

5 = = 7%
��

100%

Activity 8.3
1. A company borrows money at 15% interest in order to finance the building of a new
factory. Suggest arguments for and against the proposition that the interest costs should
be capitalised and regarded as part of the “cost” of the factory.
2. Outline three methods of depreciation and appraise them in the context of the definition
and objectives of depreciation.
3. The following payments have been made during the year in relation to non-current asset
bought at the beginning of the year. $
Cost as quoted by supplier 24 000
Less discount 2 000
22 000
Delivery charge 200
Erection charge 400
Maintenance charge 800
Additional component to increase capacity 1 000
Replacement parts 1 200
(a) Distinguish figures which should be used as the basis for the depreciation charge.
(b) Explain your answer on (a) above.
4. The following actual and estimated figures are available.
Cost $20 000
Useful life 5 years
Scrap value $4 000

121
a. Calculate annual depreciation under the straight line method. Under what circumstances
would you use this method?
b. Calculate the depreciation for each of the five years under the reducing balance method
using depreciation charge of 40%. What is the implied maintenance cost in each of the
years?
c. If the estimated scrap value turns out to be correct and the asset is sold on the first day, list
and contrast the effect on reported profit for each of the five years under each method.

8.8 Leases (IAS 17)


A lease is an agreement whereby a lessor conveys to the lessee in return for a payment or series
of payments the right to use an asset for an agreed period of time. The lease term is the non-
cancelable period for which the lessee has the option to continue to lease the asset, with or
without further payment, when at the inception of the lease it is reasonably certain that the lessee
will exercise the option. A lease is classified as finance lease or operating lease.

8.8.1 Finance Lease


A finance lease is a lease that transfers substantially all the risks and rewards incidental to
ownership of an asset. Title may or may not eventually be transferred. Risks related to ownership
include the following:
• possibility of losses from idle capacity;
• technological obsolescence; and
• variation in returns due to changing economic conditions.
Rewards incidental to ownership of an asset include:
• expectation of profitable operations over the asset’s economic life; and
• expectation of gain from appreciation in value.
At the commencement of the lease term, lessees shall recognise finance leases as assets and
liabilities in their statement of financial position at amounts equal to the fair value of the lease
property or, if lower, the present value of the minimum lease payments. The discount rate to be
used in calculating the present value of the minimum lease payment is the interest rate implicit in
the lease or the lessee’s incremental borrowing rate. The lessee’s incremental borrowing rate of
interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not

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determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a
similar term and with a similar security, the funds necessary to purchase the asset. Any initial
direct costs of the lessee are added to the amount recognised as an asset.

8.8.2 Subsequent measurement of finance leases (in the lessee’s books)


Minimum lease payments shall be apportioned between the finance charge and the reduction of
the outstanding liability. The finance charge is allocated to each period during the lease term to
produce a constant periodic rate of interest on the remaining balance of liability. Contingent rent
shall be charged as expenses in the periods in which they are incurred.

A finance lease gives rise to depreciation expense for depreciable assets as well as finance
expense for each accounting period. If there is reasonable certainty that the lessee will obtain
ownership by the end of the lease term, the period of expected use is the useful life of the asset;
otherwise the asset is depreciable over the shorter of the lease term and its useful life.

8.8.3 Accounting for Finance Lease (In the Lessee Books)


If any one of the following criteria is met, the risks and benefits of ownership are deemed
transferred.
• The ownership of the leased item is transferred to the lessee at the end of the lease term.
• The lease contains a bargain purchase option and it is reasonably certain that the option
will be exercised.
• The lease term is almost equal to the useful life of the leased asset.
• Present value, at inception of lease of minimum lease payments is greater than or equal to
substantially all of the fair value of the leased asset.
At inception of lease capitalise the lease as follows:
Debit: Fixed assets (Present value of minimum lease payments or future value whichever is
lower)
Credit: Obligation under lease agreement
The above entries are meant to record the economic substance of the transaction rather than its
legal form.
At the end of each financial year:
Debit: Obligation under lease agreement
Credit: Cash
When recording payments under the lease agreement

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Debit: Finance charge
Credit : Cash
To record the portion of payment attributed to interest on lease agreement
Debit: Depreciation (over the shorter of lease term or useful use of asset)
Credit: Provision for depreciation
If the economic substance is not captured in the books of the lessee, this will result in off balance
sheet financing, that is, obligations which have a bearing on gearing are not reflected in the
statement of financial position.
Debit: Profit and loss (to close the depreciation account)
Debit: Profit and Loss (finance charge)
Credit: Depreciation
Credit: Finance charge

Activity 8.3
1. Explain subsequent measurement of finance leases in the lessor’s books
2. Give possible journal entries when accounting for finance lease in the lessor’s books.

8.8.4 Disclosures of finance leases in the financial statements of lessees


Lessees shall make the following disclosures for finance leases:

• for each class of assets, the net carrying amount at the end of the reporting period
• a reconciliation between the total of the future minimum lease payments at the end of the
reporting period, and their present value.
• an entity shall disclose the total of the future minimum lease payments at the end of the
reporting period, and their present value, for each of the following periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years.
• Contingent rents recognised as expenses in the period
• The total of future minimum sublease payments expected to be received under non-
cancellable sublease at the end of the reporting period.
• A general description of the lessee’s material leasing arrangements.

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Example 8.1
The expected useful life of a lease is three years. The equipment reverts to the lessor on
expiration of the lease agreement. The fair value of the equipment is $135 000 and lease
payments in arrears are $50 000 per annum for three years. The asset has a guaranteed residual
value of $10 000. The lessee’s incremental borrowing rate is 10%.
i. What type of a lease is this?
ii. Apportion the lease payments between capital and interest.
iii. Show the accounting entries at inception of the lease and after inception in the
books of the lessee.
Solution:
i. This is a finance lease. The useful life period is equal to the lease period.
ii. Present value of minimum lease payments (PV of MLP)
PV of rentals $50 000 × 2.4869 = $124 345
PV of residual value $10 000 × 0.7513 = $ 7 513
Total $131 858
Fair value of leased asset = $135 000
We consider the lower of the two, that is, $131 858
Apportionment of capital and interest
Year Opening balance Interest Premium Closing balance
1 131,858 13,185.80 (50,000) 95,044
2 95,044 9,504 (50,000) 54,548
3 54,548 5,454.80 (50,000) 10,000
(Residual value)

iii. Journal entries


At inception
Dr: Fixed asset
Cr: Obligation under lease agreement
To record the economic substance of the lease
Year 1
Dr: Obligation under lease ($50 000)
Cr: Cash ($50 000)

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To record the premiums under the agreement
Dr: Finance charge ($13 185.80)
Cr: Obligation under lease ($13 185.80)
Dr: Depreciation ($40 619)
Cr: Provision for depreciation ($40 619)
Depreciation is calculated on a straight line basis, that is, ($131 858 – 10 000) ÷ 3
= $40 619

Activity 8.4
A three-year lease on an asset with a useful life of five years required payment of $104 000 in
advance. The lessor pays $4 000 per year for insurance on equipment. The lessee’s incremental
borrowing rate is 10% and fair value of equipment is $280 000, the lessee can exercise a bargain
purchase option of $20 000 at the end of the lease term.
i. What type of a lease is this?
ii. Show the journal entries in the books of the lessee.
iii. Apportion the lease payments between capital and interest.

8.9 Operating Leases


A lease is classified as an operating lease if it does not transfer substantially all the risks and
rewards incidental to ownership. It does not meet any of the criteria of the finance lease. Leases
in the financial statements of lessees stipulates that lease payments under an operating lease shall
be recognised as an expense on a straight-line basis over the lease term unless another systematic
basis is more representative of the time pattern of the user’s benefit.
Accounting entries are very simple:
Dr: Profit and Loss
Cr: Cash

8.9.1 Disclosures of operating leases in the financial statements of lessees


Lessees shall make the following disclosures for operating lease:

• The total future minimum lease payments under non-cancellable operating leases for
each of the following periods:
i. not later than one year;
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ii. later than one year and not later than five years;
iii. later than five years.
• The total of future minimum sublease payments expected to be received under non-
cancellable subleases at the end of the reporting period.
• Leases and sublease payments recognised as an expense in the period.
• A general description of the lessee’s significant leasing arrangements.

Activity 8.5
Outline the disclosure requirements of finance lease and operating lease in the financial
statements of the lessor.

8.10 Intangible Assets (IAS 38)


An intangible asset is an identifiable non-monetary asset without physical substance. Examples
of intangible resources include:
• scientific or technical knowledge;
• design and implementation of new processes;
• systems, licences, intellectual property;
• market knowledge; and
• trade marks.
Common examples of items encompassed by these broad headings include:
• computer software;
• patents;
• copyrights;
• motion picture films;
• customer lists;
• mortgage servicing rights;
• fishing licenses;
• import quotas;
• franchises;
• customer or supplier relationships; and
• market share and market rights.
An intangible asset should meet the following criteria:
• identifiability;
• control over a resource; and
• existence of future economic benefits.
If an item does not meet the above criteria it should be expensed.

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8.10.1 Identifiability
An intangible asset needs to be identifiable to distinguish it from goodwill. Goodwill recognised
in a business combination is an asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identifiable and separately
recognised. Goodwill is the residual cost of a business acquisition that cannot be assigned either
to tangible assets or to identifiable intangibles. Under international financial reporting standards
it is defined as the excess of the cost of acquisition over a group’s interest in the fair value of the
identifiable assets and liabilities of a subsidiary, associate or jointly controlled entity at the date
of acquisition. Goodwill is recognised as an asset.
An asset is identifiable if it either:

(a) is separable, that is, capable of being separated or divided from the entity and sold,
transferred, licensed , rented, or exchanged either individually or together with related
contract, identifiable asset or liability, regardless of whether the entity intends to do so; or
(b) arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.

8.10.2 Control
An entity controls an asset if the entity has the power to obtain the future economic benefits
flowing from the underlying resources and to restrict the access of others to those benefits. The
capacity to control intangible asset would normally stem from legal rights that are enforceable in
a court of law. It is difficult to demonstrate control without legal rights. Legal enforceability of
rights is not necessarily a condition of control because an entity my control future economic
benefits in some other way. For example, market and technical knowledge may give rise to
future economic benefits, the benefits may be controlled by protecting knowledge through legal
rights such as copyrights, patents, restrain of trade agreement, and legal duty by employees to
maintain confidentiality.

8.10.3 Recognition of intangible assets


An intangible asset shall be recognised if, and only if:
(a) it is probable that the expected future economic benefits that are attributable to the asset
will flow to the entity; and
(b) the cost of the asset can be measured reliably

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8.11 Research and Development
IAS 38 defines “research and development” not as a singe word but separately as follows:

Research
This is original and planned investigation undertaken with the prospect of gaining new scientific
or technical knowledge and understanding.
No intangible asset arising from research or research phase shall be recognised. Expenditure on
research shall be recognised as an expense when it is incurred.
Examples of research activities are:
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of research findings or other
knowledge;
(c) the search for alternatives for materials, devices, products, processes, systems or services;
and
(d) the formulation, design, evaluation and final selection of possible alternatives for new or
improved materials, devices, products, processes, systems or services.

Development
This is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.
International Accounting Standards requires costs to be currently expensed presumably because
future benefit is uncertain. Hence it would be prudent to expense. All development costs which
meet the following criteria ought to be capitalised and amortised.
• The product or process is clearly defined and the costs attributed to the product or process
can be separately identified and measured reliably
• The technical feasibility of the product on process can be demonstrated
• The enterprise intends to produce and market or use the product or process.
• The existence of a market for the product or process or if it is to be used internally rather
than sold, its usefulness to the enterprise can be demonstrated.

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• Adequate resources exist or their availability can be demonstrated to complete the project
and market the production process.
Examples of development activities are:
(a) The design, construction and testing of pre-production or pre-use prototypes and models;
(b) The design of tools, jigs, moulds and dies involving new technology
(c) The design, construction and operation of a pilot plant that is not of a scale economically
feasible for commercial production; and
(d) The design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services.

Activity 8.6
1. The idea of substance over form supports the recording of a finance lease as an asset even
though there is no legal ownership. Discuss.
2. Research expenditure by its nature, gives no reasonable expectation of future related
revenue and must be treated as an expense under the prudence convention. Development
expenditure which satisfies the five criteria, clearly gives a reasonable expectation of
future related revenues and must be treated as an asset and amortised under the matching
convention. Discuss.

8.12 Summary
The allocation of depreciable amounts to specific periods is of paramount importance. It is
important to note that depreciation is not a valuation technique, neither is it a sinking fund.
Leases also have a bearing on reported profits. The recording of lease transactions should take
into account the economic substance of a transaction other than its form.

130
References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
Ashton, D.J., and Atkins, D.K. (March 1984). “ A Partial Theory of Takeover Bids” Journal of
Finance; 39 pp 167-183.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Ellert, J. C. (May 1976). “Mergers, antitrust Law Enforcement and Stockholder Returns”
Journal of Finance pp 715-732.
Fama E .(April 1980). “Agency Problem and the Theory of the Firm ” Journal of Political
Economy pp 288-307.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Miller, M.,Modigliani,H., and Franco.(1961). Dividend Policy, Growth and the Valuation of
Shares. Journal of Business 34 pp 411-433.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Stapleton, R. C. (1992). Mergers and Acquisitions. LexingtonUS: Mass DC Heath.
Walter, L.E. (1967). Dividend Policy and Enterprise Valuation. Wadsworth, Wales: Belmont
Cadif.
Wendt, P.F.(March-April 1985). Current Growth Stock Valuation Methods. Financial Analysis
Journal No 33
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

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Unit 9

Forecasting Techniques and Models

9.0 Introduction
Forecasting is integral to the valuation of businesses. Free cash flow methods of valuation solely
depend on the ability to forecast future levels of activity. The concept of garbage- in-garbage out
applies very well to the use of forecasted information. The bad the information used in
forecasting, the bad the result of any output from the forecasted information. It is important
therefore to grasp the basics of forecasting.

9.1 Objectives
By the end of this unit, you should be able to:
• apply extrapolative and index approaches to forecasting
• forecast statement of comprehensive income and statement of financial position
• explain the difficulties in forecasting

9.2 Forecasting
Forecasting is a scientific and systematic way of predicting future variables. Valuation depends
to a large extent on the ability to forecast earnings and filter out their transitory and permanent
components. Generally, there are two classes of forecasting models in the financial literature:
• the extrapolative models; and
• index models.

9.2.1 Extrapolative models


These models use the previous time-series of earnings to forecast the future level of earnings. To
extrapolate is to extend. In our context, we are finding the future level of a variable by extending
the previous observed variable and how it is affected by some economic phenomena. Basically
the future variable is dependant on the past movement of the variable in response to some
economic factors such as inflation, economic growth and movement in the exchange rate. The
forecast of next period’s variable is defined as:
E (Yt + 1)
(Assuming that we are forecasting the future level of income)
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E (Yt + 1) is a function of past history of earnings
Where Yt represents variables that are dependant on previous time series and E is the level of
earnings.
E (Yt + 1) = ƒ (Yt, Yt – 1 ,………Y1)

9.2.2 Permanent versus Transitory Components


It is important to separate the permanent and transitory components when using time series of the
firm’s earnings in forecasting. The permanent component is expected to persist into the
foreseeable future. The permanent component however can be altered by random events
affecting the firm or its operating environment. The permanent earnings stream includes all prior
permanent random events.
Non-permanent (transitory) events (mean reverting processes) do not affect the permanent
earnings stream. The recorded income is a sum of permanent and transitory components. The
goal of time-series analysis is to identify the firm’s permanent earnings stream.

9.2.3 Index Models


Index models use independent variables or indices to forecast earnings. The earnings forecast is
described as:
E(Yt + 1) = ƒ (Z1t, Z2i,……Znt)
Where Z1 represent independent variables. These variables are not dependant on any previous
time series. These models apply in environments which are highly uncertain. You cannot rely on
past data to predict the future. You cannot use a rear view mirror to guide you forward.

9.3 Forecasting with Disaggregated Data


Forecasts of annual earnings can be based on data disaggregated along three dimensions as
follows:
i. quarterly data;
ii. using segment-based data; and
iii. using statement of comprehensive income components.

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9.3.1 Quarterly data
Such forecasts usually sum the individual quarterly forecasts. These forecasts have been
generally found to outperform forecasts based on annual models.

9.3.2 Segment - based forecasts


These are forecasts based on predicting individual segment earnings first and then combining
those results to forecast firm’s earnings. However, if the various industries that make up the
segments are influenced by similar factors, then the forecast based on the consolidated data
should be just as good as a forecast based on the segment data.

9.3.3 Using statement of comprehensive income components


These models use statement of comprehensive income or statement of financial position
components to help forecast earnings. These are the most commonly applied by a lot of finance
managers.

Activity 9.1
Explain the two most common forecasting models in financial literature.

9.4 Forecasting Statement of Comprehensive Income (Extrapolative


Approach)
Forecasting a statement of comprehensive income involves the prediction of key independent
variables that are affected by outside economic factors. Other dependant variables such as profit
will be calculated from the independent variables.

9.4.1 Sales/turnover
Sales are forecast using past data (linear regression) for example, if the sales figure for the recent
past is $20 million and over the past five years the growth rate in sales averaged 25%, it can be
reasonably assumed that the sales figure of $20 million will grow to $25 million in the coming
year. Where volumes (in terms of number of units) are constant and growth in sales is
attributable to price adjustments, the rate of inflation can be used as a guide in forecasting
growth in sales. The estimated sales figure can be forecasted to grow in line with the anticipated
rate of inflation. Sales can also be forecasted on the basis of the projected increase in sales
volume plus the element of price adjustment.

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9.4.2 Cost of sales
Usually past margins help in estimating the level of cost of sales (percent of sales method). Cost
of sales can also be estimated using the ruling rates of inflation. For example, if the current
figure for cost of sales stands at $1 000 and the rate of inflation is forecast to be 24%, it can
reasonably be assumed that the costs will also rise by, more or less, the same magnitude.

Costs can also be forecasted using the previous growth rates (linear regression). In a nutshell,
cost of sales can be forecasted using at least three bases namely:
• established margins (relationship between turnover and costs);
• inflation rates (as measured by the consumer or producer price indices); and
• previous growth rates (geometric or arithmetic).

9.4.3 Operating expenses


Operating expenses such as selling expenses and administrative expenses can similarly be
forecasted using established margins, the general rise in the level of prices or extrapolation from
previous growth rates.

Depreciation can be established with certainty. The figure of depreciation for the forecasted
period can be calculated from the statement of financial position balances using the applicable
depreciation methods which include among others the following:
• straight line method;
• reducing balance method; and
• sum of digits method.
Where there are any additions to non-current assets, they have an effect of increasing the
depreciation charge. Unlike other expenses, it is important to note that depreciation can actually
be calculated from the statement of financial position.

9.4.4 Interest expenses


Interest expenses can easily be estimated using the current levels of debt and any anticipated new
debt and the applicable rate of interest. Where the interest rate is variable, it has to be forecasted

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in the light of the existing monetary policy or any other interest rate management techniques
which can be applied by the company.

9.4.5 Corporate tax


From the forecasted profit before tax, corporate tax can be calculated using the applicable
corporate tax rate taking into account any loss carry-overs. A loss carry over is the amount of
loss that a firm is allowed to carry over to the next period and deduct it from income before
calculating taxable income.

Activity 9.2
Mc Millan Pvt Ltd is a retail business that has the following statement of comprehensive income
for the year ended December 31 2012
$’000 $’000
Turnover 1 700
Cost of sales 1 000
Gross profit 700
Operating expenses
Selling expenses 80
Administrative expenses 150
Depreciation 100
Total operating expenses 330
Operating profit 370
Interest expenses 70
Profit before tax 300
Tax (25%) 75
Net profit after tax 225

Assume the following:


i. Inflation rate of 25% per year forecasted for 2013
ii. Gross margins remain as they are.
iii. Volume is remaining constant in terms of units sold.
iv. There are no additions to non-current assets and straight line depreciation method is used
v. The current level of debt and the applicable interest rate is not changing in 2013
vi. The applicable corporate tax rate in 2013 will be 30%
On the basis of the above information, prepare a forecasted statement of comprehensive income
for Mc Millan for the year ending 31 December 2013.
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9.5 Statement of Financial Position
A statement of financial position is not very easy to forecast, since the statement of financial
position items are affected by a plethora of both internal and external variables. In this section,
we will explain the simple guidelines in forecasting specific statement of financial position
items.

9.5.1 Non-current assets


Non-current assets are affected by depreciation and this can be ascertained with a reasonable
degree of certainty. Where there are no additions to non-current assets, the forecasted non-
current assets figure could be estimated by calculating the applicable depreciation amount and
subtracting it from the current balance of non-current assets. Any potential new additions to non-
current assets have to be included in the forecasted non-current assets figure, bearing in mind
that this will affect the depreciable amount and the liabilities side of the statement of financial
position if the assets are bought on credit. Different methods of depreciation may be applicable
to different types of non-current assets.

9.5.2 Current assets


Current assets are the most difficult part to deal with and in most cases are used as the fudge
factors (balancing factors). If the assets and the liabilities are not balancing, current assets such
as cash, debtors, and stocks may be manipulated until a balance has been achieved. However
where working capital management ratios have been established and it can be assumed that they
will hold, they will be applied in coming up with current asset levels depending on the forecasted
levels of activity.

9.5.3 Current liabilities


Similarly, current liabilities are also difficult to forecast. Individual items may also be used as
fudge factors in order to make the statement of financial position balance. Established working
capital ratios can also be used to forecast individual current liabilities items in line with the
forecasted level of activity.

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9.5.4 Long-term liabilities
Long term liabilities such as long term debt are easy to forecast. If there is debt in the existing
capital structure, it will either increase, remain at current levels, decrease or be paid off
completely. The desired level will be determined by management, hence it can be ascertained
with a good level of certainty.

9.5.5 Shareholders equity


Shareholders equity is usually in the following forms:
• ordinary share capital;
• preference share capital;
• share premium; and
• retained earnings.
Ordinary share capital can be increased by new injection of capital by way of issue of cash,
rights issue, private placement or bonus issue and these can be ascertained with a reasonable
degree of certainty. The same would apply to preference share capital. Share premium which is
the amount in excess of the nominal value of shares can be forecasted by taking into account the
likely market conditions when shares are anticipated to be issued. Retained earnings are taken
from the statement of comprehensive income taking note of any distributions.

9.5.6 Important areas to watch


The following statement of financial position items need to be cautiously dealt with when
forecasting the statement of financial position.
• depreciation (it also affects statement of comprehensive income);
• accounts receivables (debtors);
• inventory (stocks);
• accounts payables (creditors);
• accruals;
• deferred tax; and
• retained earnings.

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Example 9.1
You are a consultant working for a company called MMCS, which started trading four years ago
in 2003 and which manufactures plastic rainwater drainage goods. You have the following
information.
(a) Revenue and cost of sales are expected to increase by 10% in each of the financial years
ending 31 December 2007, 2008 and 2009. Operating expenses are expected to increase
by 5% each year.
(b) The company expects to continue to be liable for tax at the marginal rate of 30%. You
can assume that tax is paid or refunded 12 months after the year end.
(c) The ratios of receivable to sales and trade payables to cost of sales will remain the same
for the next three years.
(d) Non-current assets comprise land and buildings, for which no depreciation is provided.
Other assets used by the company, such as machinery and vehicles, are hired on operating
leases.
(e) The company plans for dividends to grow at 25% in each of the financial year 2007, 2008
and 2009.
(f) The company plans to purchase new machinery to the value of $500,000 during 2007, to
be depreciated straight line over ten years. The company charges a full year’s
depreciation in the first year of purchase of its assets. Tax allowable depreciation at 25%
reducing balance is available on this expenditure.
(g) Inventory was purchased for $35,000 at the beginning of 2007. The value of inventory
after this purchase is expected to remain at $361,000 for the foreseeable future.
(h) No decision has been made on the type of finance to be used for the expansion
programme. The company’s directors believe that they can raise new medium-term
secured bonds if necessary.
(i) The average P/E ratio of listed companies in the same industry as MMCS is 15.
The company’s objectives include the following.
(a) To earn a pre-tax return on the closing book value of shareholders’ funds of 35% per year
(b) To increase dividends per share by 25% per year
(c) To obtain a quotation on a recognised stock exchange within the next three years.

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A summary of the financial statements for the year to 31 December 2006 is set out below.
MMCS
Summarised statement of comprehensive income for the year to 31 December 2006
$'000
Revenue 1,560
Cost of sales 950
Gross profit 610
Operating expenses 325
Interest 30
Tax liability 77
Net profit 178
Dividends declared 68

MMCS
Summarised statement of financial position at 31 December 2006
$'000
Non-current assets (net book value) 750
Current assets
Inventories 326
Receivables 192
Cash at bank 50
Total assets 1,318
Financing
Ordinary share capital (Ordinary shares of $1) 500
Retained profits to 31 December 2005 128
Retentions for the year to 31 December 2006 110
10% loan note redeemable 2020 300
1,038
Current liabilities
Trade payables 135
Other payables (including tax and dividends) 145
Total equity and liabilities 1,318
Required
Using the information given:

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(a) Prepare forecast statements of comprehensive income for the years 2007, 2008 and 2009,
and calculate whether the company is likely to meet its stated financial objective (return
on shareholders’ funds) for these three years.
(b) Prepare cash flow forecasts for the years 2007, 2008 and 2009 and estimate the amount of
funds which will need to be raised by the company to finance its expansion.
Notes
1. You should ignore interest or returns on surplus funds invested during the three year
period of review.
2. You may ignore the timing of cash flows within each year and you should not discount
the cash flows.
Solution
(a)
MMCS
Statement of comprehensive income for the years 2007, 2008 and 2009

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Actual Forecast
2006 2007 2008 2009
$'000 $'000 $'000 $'000
Revenue (increase 10% pa) 1,560 1,716 1,888 2,076
Cost of sales (increase 10% pa) (950) (1,045) (1,150) (1,264)
Gross profit 610 671 738 812
Operating expenses (increase 5% pa) (325) (341) (358) (376)
Depreciation (10% pa × $500,000) - (50) (50) (50)
Profit from operations 285 280 330 386
Interest (assumed constant) (30) (30) (30) (30)
Profit before tax 255 250 300 356
Taxation ( see working) (77) (53) (77) (101)
Net profit 178 197 223 255
Dividends (25% growth pa) (68) (85) (106) (133)
Retained profit 110 112 117 122
Reserves b/f 128 238 350 467
Reserves c/f 238 350 467 589
Share capital 500 500 500 500
Year end reserves 238 350 467 589
Year end shareholders' funds 738 850 967 1,089
Pre-tax return on shareholders' funds 34.6% 29.4% 31.0% 32.7%

On the basis of these figures, the financial objective of a pre-tax return of 35% of year-end
shareholders/ funds is not achieved in any of the years.
Working
It is assumed that the company does not account for deferred taxation.
Actual Forecast
2006 2007 2008 2009
$'000 $'000 $'000 $'000
Profit before tax 255 250 300 356
add back Depreciation - 50 50 50
Less tax allowable (25% reducing balance) - (125) (94) (70)
Taxable profit 255 175 256 336
Tax at 30% 77 53 77 101

(b) Cash flow forecast


The 2006 statement of financial position figure for ‘other payables (including tax and
dividends)’ is simply the sum of tax and dividends in the statement of comprehensive

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income. It is assumed that this will continue to be the case in the following three years.
The annual change in net current assets can be computed as follows.
Actual Forecast
Changes in net current assets 2006 2007 2008 2009
$'000 $'000 $'000 $'000
Inventories (scenario note (7)) 326 361 361 361
Receivables (12.31% of sales)* 191 211 232 256
Trade payables (14.21% of cost of sales)* (135) (148) (163) (180)
Tax and dividends payable (sum of the figures) (145) (138) (183) (234)
Net current assets 237 286 247 203
Increase/(decrease) net current assets 48 (39) (44)

*Alternatively receivables and payables can be computed as a 10% increase each year.
The cash flow forecasts can then be constructed.

Cash flow forecast 2007 2008 2009


$'000 $'000 $'000
Retained profit for the year 112 117 122
add back depreciation 50 50 50
(Investment in net current assets)/release of net current
assets (see working) (48) 39 44
Expenditure on non current assets (500) - -
Surplus/(deficit) for the year (386) 206 216
Cash/(deficit) b/f 50 (336) (130)
Cash/(deficit) c/f (336) (130) 86

Alternative presentation of a cash flow forecast include:


• A detailed statement of cash receipts and payments, or
• A cash flow statement in IAS 7 Cash flow statement format
1. Cash receipts and payments

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2007 2008 2009
Receipts $'000 $'000 $'000
Cash from sales (revenue + opening receivables -
closing receivables) 1,697 1,867 2,053
Payments
For purchase (cost of sales + opening payables +
closing payables) 1,032 1,135 1,248
Operating expenses 341 358 376
Additional inventory purchases 35 - -
Machinery 500
Interest (current year) 30 30 30
Tax (previous year) 77 53 77
Dividends (previous year) 68 85 106
2,083 1,661 1,837
Net cash flow (386) 206 216
cash/(deficit) b/f 50 (336) (130)
cash/(deficit) c/f (336) (130) 86

2. IAS 7 format

2007 2008 2009


$'000 $'000 $'000
Net cash flow from operations (see working) 290 373 429
Interest paid (30) (30) (30)
Dividends paid (68) (85) (106)
Tax paid (77) (53) (77)
Net cash inflow 115 205 216
Investing Activities
Non-current assets: Machinery (500)
Net cash flow before financing (385) 205 216

Working: net cash inflow from operations

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2006 2007 2008 2009
$'000 $'000 $'000 $'000
Inventory 326 361 361 361
Receivables 192 211 232 256
Payables (135) (149) (163) (180)
383 423 430 437
Incremental working capital (40) (7) (7)
Gross profit before depreciation 671 738 812
Less: Operating expenses (341) (358) (376)
Net cash inflow from operations 290 373 429

Activity 9.3
Using information on activity 9.2 (forecasting statement of comprehensive income for Mc
Millan Pvt. Ltd) and making any reasonable assumptions about current assets and current
liabilities, forecast the 2013 statement of financial position for Mc Millan Pvt Ltd given the 31
December 2012 statement of financial position below.
Mc Millan Pvt Ltd
Statement of financial position for the year ended 31 December 2012.
2012 2011
$’000 000 $’000 000
Assets
Non-current Assets
Land and Buildings 1 200 1 050
Machinery and equipment 850 800
Furniture and Fittings 300 220
Vehicles 100 80
Other 50 50
Total non-current 2 500 2 200
Accumulated depreciation 1 300 1 200
Net non-current 1 200 1 000
Current assets
Cash 400 300
Marketable securities 600 200
Accounts receivables 400 500
Inventory 600 900
Total current assets 2 000 1 900
Total assets 3 200 2 900
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Equity and Liabilities
Equity
Preference share capital 100 100
Ordinary share capital 120 120
Share premium 380 380
Retained earnings 600 500
Total equity 1 200 1 100

Current liabilities
Accounts payable 700 500
Accruals 700 900
Total current liabilities 1 400 1 400
Long term debt 600 400
Total liabilities 2 000 1 800
Total equity and liabilities 3 200 2 900

Ordinary shares 12 cents per share.

9.6 Application of Index Models


Index models are more appropriate where the environment is highly volatile or where past
information is not available.

9.6.1 Statement of comprehensive income


Where there is no past information, we cannot use extrapolative models or linear regression.
Information has to be constructed using available data. In this instance, data has to be gathered
on variables such as the following:
- number of units to be produced;
- anticipated price at which products or services will be sold;
- cost of labour, rentals, electricity;
- estimated overheads;
- applicable depreciation methods and amounts;

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- dividend policy;
- finance raising activities; and
- applicable tax rates.
The desired activity level will determine the costs that will be incurred and consequently the
operating profit, operating expenses payable, corporate tax and profit after tax. This information
is built up from management budgets which are also constructed on an index basis.

9.6.2 Statement of financial position


A statement of financial position can be constructed from scratch starting from the shareholders’
capital, and then recording the assets as the shareholders’ funds are applied to the purchase of
assets. Other items such as retained income will be taken from the statement of comprehensive
income and where it is anticipated that some of the assets will be financed using debt, the debt
levels can be forecasted with a reasonable level of certainty.

9.7 Assessment of Assumptions


The cornerstone of forecasting is making reasonable assumptions about the likely movement of
each and every item in the financial statements.
• Assumptions must be reasonable. For example, growth figures should be in line with
growth rates in the particular industry and the economy in general. The same applies to
price adjustments. Any price increases way above the forecasted rates of inflation must
be explained.
• Assumptions must be manageable. A lot of assumptions about everything may defeat the
whole purpose of coming up with reasonable forecasts. A lot of detail can confuse hence
it is advisable to keep the number of assumptions within manageable limits. Too little
detail may also not be adequate to come up with reasonable forecasts.
• It is better to be conservative rather than being overly optimistic. The future is uncertain
hence it is far better to be prudent rather than try to impress with unachievable forecasts.
• Lastly, but not least, assumptions must be flexible. Any analyst should be able to
understand the assumptions and vary them without necessarily changing the basis on
which the forecasts have been made.

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Activity 9.4
1. Explain the application of extrapolative and index models to forecasting statement of
comprehensive income.
2. Discuss the benefits of forecasting using disaggregated data from statement of
comprehensive income.
3. Explain the most difficult areas of the statement of financial position to forecast.

9.8 Summary
Forecasting financial statements needs to be approached systematically. Extrapolative and index
models are the most common models used in forecasting financial statements. Forecasting is
essential for planning and also for valuation of businesses. The statement of financial position is
the most difficult statement to forecast and more often some items especially current assets and
current liabilities are used as fudge factors (balancing items.) It is important to make sound,
reasonable and manageable assumptions when forecasting financial statements.

References
Alan, P.(2001). Accounting and Finance: A Firm Foundation.5th Edition. London: Continuum
148
Ashton, D.J., and Atkins, D.K. (March 1984). “ A Partial Theory of Takeover Bids” Journal of
Finance; 39 pp 167-183.
Cilliers, H.S., Rossouw,R., Grobbelaar, A.F., Mans,K.N., and Van Den Berg,F.N. (1992).
th
Company Financial Statements. 7 Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
Ellert, J. C. (May 1976). “Mergers, antitrust Law Enforcement and Stockholder Returns”
Journal of Finance pp 715-732.
Fama E .(April 1980). “Agency Problem and the Theory of the Firm ” Journal of Political
Economy pp 288-307.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Miller, M.,Modigliani,H., and Franco.(1961). Dividend Policy, Growth and the Valuation of
Shares. Journal of Business 34 pp 411-433.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Stapleton, R. C. (1992). Mergers and Acquisitions. LexingtonUS: Mass DC Heath.
Walter, L.E. (1967). Dividend Policy and Enterprise Valuation. Wadsworth, Wales: Belmont
Cadif.
Wendt, P.F.(March-April 1985). Current Growth Stock Valuation Methods. Financial Analysis
Journal No 33
White, G.I., Sondhi, A.C., and Fried, D. (2003). The Analysis and Use of Financial Statements.
USA: John Wiley and Sons.

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Unit 10
Forecasting Company Failure

10.0 Introduction
Stakeholders in a company such as shareholders, creditors and employees are principally
concerned about the survival of a firm. As published financial statements are often used to
evaluate a business’ performance, the analysis can reasonably be extended to assess or measure
the future viability or survival of a firm.

10.1 Objectives
By the end of this unit, you should be able to:
• define company failure
• apply qualitative approaches to asses the likelihood of company failure
• explain the logic behind quantitative approaches to forecasting company failure

10.2 Company Failure


There is a semantic problem in defining company failure. A working definition, however, is
possible by substituting financial distress for company failure. Financial distress is severe
liquidity problems that cannot be resolved without a significant re-scaling of the entity’s
operations or structure, Foster (1986). It is what is generally referred to as financial difficulties.
Normally, a company in such difficulties would require a substantial restructuring or injection of
funds in-order to survive such difficulties in its present state.

There are several approaches that have been developed of forecasting company failure. For the
purposes of this course, we will focus on three, two of which are qualitative in nature and the
other one quantitative. The first one involves studying the root causes of failure. The second
involves the identification of symptoms and the third one focuses on quantitative data. Rather
than building a logical case, the quantitative approach centres on what has been termed “brute
empiricism”, that is, the combining of data from published accounts to develop financial
indicators of a company’s well being. As such it appears a natural extension of the work
developed in ratio analysis.

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10.3 Qualitative Approaches
Qualitative approaches will look at root causes of failure, attitudes and company failure and
argenti analysis among others.

10.3.1 Root causes of failure


Barmash I (1973) identified one factor, “greed”, as the root cause of company failure. Bill
Houston (1989) pointed at two factors as causes of company failure: commercial misjudgment
leading to cash outflows and the business cycle. It is crystal clear that companies are likely to
face serious financial problems during recession than during a boom and it is equally obvious
that a major commercial mistake can lead to very serious financial problems. What is less
obvious though is how to identify companies that are likely to fail before they fail.

To reduce the risk of company failure, Houston identified and suggested areas where
management should exercise particular care. These include, adequate internal financial systems,
attention to pricing policy, reliance on a single customer, the avoidance of overtrading, that is,
attempting to support increasing levels of sales from an inadequate capital base and major
acquisition and diversification and investment decisions. The problem with these identified areas
is that most, if not all, will only be known to the internal manager and they may be difficult for
external stakeholders to quantify their relative importance.

10.3.2 Attitudes and company failure


Clutterbuck and Kernaghan (1990) came up with a different approach to forecasting company
failure. They attempted to identify attitudes which lead to company failure by matching a sample
of failed companies against a control group of surviving firms. They were basically concerned
about the attitudes of management and employees towards controls, risk and the vision of the
company and they identified five attitudes which they thought to be integral to company
survival.
• Attitudes towards the management team - included leadership styles, how other staff
members perceived their roles and responsibilities and the quality and nature of
communications.
• Attitudes towards customers, towards winning and losing and towards learning were also
identified. They also identified attitudes towards investors.
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They concluded that companies run by entrepreneurs appeared to collapse because of a failure to
create working relationships with providers of finance.
From their analysis, Clutterbuck and Kernagham produced a listing of failure indicators. Areas
identified included the following:
• poor management;
• lack of planning;
• lack of financial control;
• over reliance on one product;
• over reliance on one customer;
• lack of reaction to economic and environmental change;
• inexperienced management (particularly in dealing with growth, acquisitions and
international markets);
• dissension within the management team;
• inappropriate pricing;
• preoccupation with short term results;
• high cost structures; and
• over-expansion, over leverage and over diversification.
The problem with the above factors is that it is not clear at times whether they are symptoms or
causes.

Activity 10.1
Identify a failed Zimbabwean bank or company of your choice and apply Clutterbuck and
Kernagham’s analysis in explaining the causes of its failure.

10.3.3 Company pathology


County Natwest Woodmac produced a company pathology report after a study of 45 quoted
companies which appointed administrators or administrative receivers between 1989 and 1990.
Six major contributory factors were identified in the company collapses:
• fast aggressive expansion whether organically or by mergers and takeovers;
• being in an inherently risky sector;
• companies fully listed on stock exchange are less likely to fail than those which are not;
• dominant personalities are associated with companies which fall into difficulties,
particularly where the chairman has a significant shareholding and is also the Chief
Executive Officer;
• creative accounting and relegation of important information to notes; and
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• companies which do not appear to have long-term relationships with banks or financial
advisors appear vulnerable than those with established relationships.
Whilst the above listing does not separate cause from symptom, the factors are much clearer to
outsiders and can be assessed more objectively. However, it is illogical to conclude that all
companies with the listed qualities will fail. The analysis does not attempt to rank the relative
importance of the factors identified.

10.3.4 Argenti Analysis


Argenti (1976) attempted to explain the various stages of financial distress and rank the relative
importance of the different indicators.
Inherent Defects

Argenti identified three areas of inherent corporate weakness which are


(a). company’s management;
(b). accounting systems; and
(c). the business’ response to change.
(a) Company management

One important aspect that was singled out on management is the presence of a domineering chief
executive officer who is also the chairman surrounded by unquestioning fellow directors who
have got limited business skills.
(b) Accounting systems

Poor accounting systems and lack of accounting skills was also identified as a separate defect
which has an impact on the survival of the firm.
(c) Business response to change

Finally there is the company’s failure to recognise change and the need to respond. This is often
associated with an ageing board of directors. Signs of failure to recognise and respond to change
include outdated products and production techniques, run-down factories and insufficient
attention to modern techniques of production and marketing.
Mistakes associated with company failure

Argenti identified three mistakes associated with company failure:


• over-gearing;
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• overtrading; and
• emphasis on “the big project”.
The implications of gearing or leverage are fairly obvious. In times of shrinking sales and
profitability, the effect of gearing is to magnify the losses. Companies with an autocratic chief
executive are usually prone to this problem.
Overtrading usually results in huge requirements for capital which is usually financed through
short term debt financing rather than equity. The debt is often acquired without strong
justification for that type of financing.
Then, there is the big project which usually brings down the whole company if it fails. Such
projects take various forms such as expansion, takeovers, new product ranges or a single big
project such as highway construction (for a company that may be in that industry).
Symptoms

The mistakes identified above usually start to manifest themselves in:


1. deteriorating financial ratios;
2. development of creative accounting;
3. freezing of capital expenditure and management salaries including a cutting back on
overheads; and
4. senior staff members start leaving the company and rumours start to circulate.

Argenti’s A Score
Argenti developed a model that looked at non-accounting variables. He produced a list of
possible defects, mistakes, and symptoms of failure with a mark against each. If the defect, for
example, exists, then it scores the full mark. If it does not exist then it scores zero. There is a pass
mark for each section of the list, and an overall, total, pass mark.
Defects:
Chief executive is an autocrat 8 marks
Chief executive is also the chairman 4 marks
Passive board of directors 2 marks
Lack of skills balance in the board 2 marks
Lack of management depth 1 mark
No budgets or budgetary controls 3 marks
No cash flow plans 3 marks
No costing systems 3 marks

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Poor response to change 15 marks
(Products, processes, markets, employee practices)
The pass mark for this section is 10 marks (that is a mark of less than 10 is satisfactory)
Mistakes:
High gearing 15 marks
(Loans imprudently high)
Overtrading 15 marks
(Expanding faster than cash funding)
Too much reliance on one big project 15 marks
(Project failure jeopardising company)
The pass mark for this section is 15 marks
Symptoms:
Financial signs (such as the Z score) 5 marks
(Deteriorating ratios)
Creative accounting 4 marks
(Signs of manipulation of figures)
Non-financial signs 3 marks
(Decline in morale, quality, and market share)
Terminal signs 1 mark
(Writs, rumours, resignations)
There is no separate pass mark for this section

The overall total pass mark is 25, and it is suggested that a score in excess of this is cause for
concern, as is a score above the pass mark in the first two individual sections. Points should only
be awarded by the user if the particular feature is confidently felt to exist. If a particular feature
is absent then a zero score should be awarded. No intermediate scores are allowed. A score of 25
and below suggest a company that is not in danger of failing. If points are more than 25 then the
company is more likely to fail within five years. A company with more than 10 points in the
defects section is a warning that it might make a major mistake. Similarly, although the total
points may be less than 25, more than 15 points for mistakes but less than 10 for defects imply
that management is running the company at some risk.

10.3.5 Limitations of Argenti Analysis


• The three stage-processes cannot be rigorously tested as features such as autocratic chief
executive cannot be objectively measured.
• There is need for a control group of non-failed companies to verify that the features were
unique to failed companies. It also ignores the possibility that the path to financial failure
might lie along a route other than that of defects, mistakes and symptoms.
• Lack of explanation and objectivity for the awarded points within the A scores.

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Activity 10.2
Identify an existing company of your own choice and apply the Argenti A Scores in trying to
predict the likelihood of it failing. Comment on the validity of the approach in coming up with
accurate results.

10.4 Quantitative Approaches (Statistical Modeling)


Statistical models make use of financial data provided in financial statements to forecast
company failure. These approaches reject the qualitative approaches as subjective and they
instead utilise financial ratios based on data taken from published audited accounts.

10.4.1 Univariate models


These involve the use or a single variable of financial ratio to predict failure. The assumptions
are that the distribution of the variable for distressed firms will differ systematically from that in
non-distressed firms and this difference can be used to predict future company failure.

10.4.2 Determining the cut-off point


Statistically, two types of errors are possible. A type one error would predict a failed company as
a non failed company. A type two error would predict a non failed company as having failed.
There are therefore three possible cut off points. One would minimise first the total type one
errors, then second the number of type two errors, and third the total number of errors.

10.4.3 Multivariate models


One limitation to the univariate model is that a firm might be ranked as a prospective ‘failure’
under one ratio but the survivor using another. At the very least, this would involve a user having
to make judgments to relative importance of the different ratios.

A second difficulty is that it is easier for a company to distort a single ratio by creative
accounting than a whole series of ratios. For example, a company might immediately write-off
the goodwill relating to the acquisition. If the possibility of failure is being judged by the single
ratio of return on capital employed, such a policy will have the effect of improving the ratio.
Using more than one ratio, however, may bring out negative aspects of the policy. Gearing, for
example, will be negatively affected by the immediately written off of goodwill.

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A third limitation of the univariate approach is that not all the potential useful data is being used
when a single ratio is emphasised.
Multivariate models attempt to combine several financial variables within a single forecasting
model. Models take many forms. They may be linear or non-linear. They may attempt to
estimate the probability of failure or they may attempt to classify companies into one or two
groups. Whichever the approach, choices have to be made about the ratios to be included and
their relative importance or weighting.

10.5 Z Scores and Discriminant Analysis


Discriminant analysis is a technique most often associated with multivariate modeling of
company failure. It assumes a linear and additive relationship between several variables which
enables the result to be expressed as a single figure known as the Z score. This can then be
compared with a cut-off point to determine whether or not the company is likely to fail. The
result is an equation which takes the following form:
Z = aR1 + bR2
Where R1 and R2 are financial ratios chosen for their ability to forecast financial failure and a
and b are weights reflecting their relative importance. The most dramatic presentation of Z
scores was presented by Taffler and Tisshaw. They developed the idea of solvency thermometer
similar to the one reproduced in figure 10.1.
Figure 10.1: The solvency thermometer

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Source: Taffler, R., and Tisshaw, H. (1977).

Of the 46 non-failed companies in their sample, the Z score thermometer accurately forecast
every single one as being solvent. Of the 46 failed companies made up of the famous failures of
the late 1960s and early 1970s, only one was incorrectly forecast. But, even that was excusable
as subsequent events showed.
The one error- shown as the one failed company within the solvent region of the thermometer –
related to the collapse of Rolls Royce. However, all of its outstanding debts, including the
debenture holders, were repaid on liquidation along with a partial payment to the equity holders.
As such, Rolls Royce may not have been really insolvent in the first place. The Z score within
the solvency thermometer correctly forecast 96% percent of the failed companies from their last
published accounts even though only 22% of the accounts had ‘going concern’ qualifications of
their audit reports. Moreover, the model was able to predict 70 % of the failure from the accounts
of two previous years. As well as being accurate, the model is also claimed to be simple to apply.

10.5.1 ‘Failure’ methodology


One difficulty faced by all attempts to forecast failure is defining what is meant by the term.
Simply relating it to companies which call in the receiver (undergo reconstruction) would omit
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those companies which avoid such a fate by merging with other companies or rearranging their
capital. No simple answer is possible. Care therefore has to be taken in interpreting the results of
differing Z values.
Having defined what is meant by failure, the next stage involves statistical testing to ensure that
any differences between failed and non failed samples are due to differences in the population
rather than random error (noises).

10.5.2 The findings of discriminant analysis


This was the approach taken by Altman (1968), one of the first observers to estimate the Z
values. As a result of the iterative process involved in discriminant analysis, he derived the
following model:
Z =1.2R1 + 1.4R2 + 3.3R3 + 0.6R4 + 1.0R5
Where:
R1 = working capital ÷ total assets
R2 = retained earnings ÷ total assets
R3 = earnings before interest and tax ÷ total assets
R4 = market value of preference and ordinary shares ÷ book value of debt
R5 = sales ÷ total assets
His sample comprised 33 US manufacturers that had filed for bankruptcy and these were paired
with firms of similar size and industry which did not go bankrupt. He originally started with 22
ratios which were chosen on the basis of popularity in the literature and their potential relevance
to the field of study. By a process of iteration, these were whittled down to the five outlined
above. When applied to the estimation sample, Altman found a five percent misclassification.
He then used two validation samples: the first consisting of 25 bankrupt companies gave a 4%
error rate; the second, comprising 66 non-failed companies which had suffered ‘temporary
probability difficulties’ predicted 52 out of the 66 as non-bankrupt. From his model he was able
to forecast that a company with a Z value above 3 would be safe. If however, it fell below 1.8, it
was a potential failure. Taffler and Tisshaw omitted a validation sample when developing their
solvency thermometer. Given that the solvency thermometer is describing the original data from
which the Z value was developed, it is only to be expected that the success rate should be high.
The Z model they developed and the ratios were:
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Z = C0 + C1R1 + C2R2 + C3R3 + C4R4
Where C1 to C4 are weightings given to ratios R1 to R4 and C0 is a constant. The four ratios are:
R1 = profit before tax ÷ current liabilities
R2 = current assets ÷ total liabilities
R3 = current liabilities ÷ total assets
R4 = the no–credit intervals
The no-credit interval was defined as immediate assets less current liabilities divided by
operating costs excluding depreciation. Unfortunately, although Taffler and Tisshaw disclosed
the ratio derived from the discriminant analysis, they did not disclose their coefficients and so
their findings cannot be verified.

10.5.3 Limitations of Z scores


Much of the research undertaken on Z scores is of an ex-post nature. To demonstrate the
relevance of the scores requires ex-ante predictions both about failures and timings. Further there
is only a meagre theoretical base for the inclusion of the variables. Altman, for example partly
chose his initial ratios because of their popularity in the literature.

10.5.4 Adaptiveness of companies


The analysis takes data as given and from that suggests that the results are inevitable.
Companies, however, consist of people and people are adaptive. They react to danger signals. On
the other hand, if investors and others take note of the Z values and act on them, failure could
become a self-fulfilling prophecy.
10.5.5 Benchmarks of success
A further problem is the standard or benchmark against which the model’s success should be
judged. Many models use a 50:50 relationship between failed and non failed firms. Random
prediction therefore will, on average, give a 50 percent success rate. Equally the alternative pure
strategy approach of accepting or rejecting all companies as failures will also give 50 percent.
However, both of these are naïve standards as they assume ignorance on the part of the decision
makers, namely, that they cannot judge when a firm is more likely to go into liquidation.
Choosing a proportion other than 50:50 will change the bench-mark against which the accuracy
of the Z scores has to be measured. If 99 percent of companies do not fail, then assuming no

160
company fails will be correct 99 percent of the time. Certainly there are far less failed than non-
failed companies and so there is a danger that the individual characteristics of the model’s failed
companies will excessively affect the estimated discriminant function.
Some models try to avoid the problem of misclassification by developing a corridor rather than a
boundary. Only if a company lies on either side of this wide band would a forecast be made.
Appealing as this is, the danger is that it merely segregates companies into three sections:
• the obviously healthy ;
• the obviously distressed; and
• the balance in the middle.
And yet it is to the companies in the middle where human judgment is insufficient and where
extra information would be of most benefit.

10.5.6 Other factors


The Z scores methodology tends to concentrate on established firms using a paired sample
design to match failed and non-failed companies. However, this excludes the three variables of
age, industry and size. Failure may be signified by different ratios or different values of different
ratios between industries. Supporting this was the acknowledgement by Taffler and Tisshaw that
a different Z value was derived for unquoted companies and quoted companies. If there are
significant differences between quoted and unquoted companies, how much greater might the
differences be between industries.

Finally, there is the validity of accounting numbers. Historical accounts convey costs which may
not be current values. Similarly, creative accounting may attempt to disguise the underlying
reality. Although there is tentative evidence that forecasting ability shows little difference
whether reports are compiled under the current purchasing power or historical cost accounting,
the findings are not conclusive. Certainly investors and analysts increasingly scrutinise accounts
for unusual transactions and treatments. A failure to do the same for Z scores may well weaken
their usefulness.

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10.6 Avoiding Failure
Ross and Kami listed ‘Ten Commandments’ that should be followed by a company to avoid
failure:

• you must have a strategy;


• you must have controls;
• the board must participate;
• you must avoid one-man rule;
• there must be management in depth;
• keep informed of, and reach to change;
• the customer is king;
• do not misuse computers;
• do not manipulate your accounts; and
• organise to meet employees’ needs

Activity 10.3
Discuss the factors that have led to the corporate collapse of three companies which you are
familiar with. Describe Altman’s Z score model and how it may have been used to predict such
collapse.

10.7 Summary
Forecasting of company failure can basically be approached in two ways. The first approach
looks at qualitative aspects and the second approach focuses on statistical data. Argenti
expanded the qualitative approach by coming up with a three staged process of defects, mistakes
and symptoms. Discriminant analysis is the most common statistical model used in forecasting
company failure. A univariate or multivariate approach can be taken in discriminant analysis.

162
References
Argenti, J. (1977). Corporate Collapse.McGraw Hill.
Barmash, I. (1973). Great business Disasters. Ballantine Books
Beaver, W. H. (1966). Financial Ratios as Predictors of Failure, Emperical
research into accounting. Supplement to Journal of Accounting Reseach.
Clutterbuck, D., and Kernagham, S. (1990). The Phoenix Factor: Lessons for Success from
Management Failure. Weidenfeld & Nicolson.
County NatWest, W. (1991). Company Pathology, Equity Briefing. Paper 7
Foster, G. (1989). Financial Statement Analysis, 2nd Edition. Prentice Hall.

163
Unit 11

Important Aspects in Financial Reporting

11.0 Introduction
Very often financial statements may mislead the users. This arises from the agency problem.
Those who run companies are not necessarily the owners and consequently the objectives of
managers differ from the objectives of other stakeholders. In this unit, we will examine some of
the common techniques applied by financial managers in misleading the external users of
financial statements.

11.1 Objectives
By the end of this unit, you should be able to:
• assess the impact of creative accounting on reported financials
• discuss the manipulation of financial statements through off-balance sheet transactions
• determine the importance of financial notes using financial information in fundamental
analysis

11.2 Creative Accounting


Creative accounting is unconventional and questionable accounting treatment that is legal, but
designed to mislead financial statement users about the real financial standing of the company. It
is not necessarily consistent with “substance over form” convention. Substance over form
convention is very critical in accounting, and requires following an accounting treatment that is
most appropriate in a particular situation in order to present fair financial statements.
If a company fails to provide meaningful disclosure to investors about where it has been, where
it is and where it is going, the value of the company may be eroded, and shareholders will lose
confidence in the company.

11.3 Purpose of Creative Accounting


Company management manipulates earnings in order to increase equity value and subsequently
get bigger perks (perquisites) if based on share price performance. It is important to note that
creative accounting is more prevalent in listed companies than in private companies primarily
164
due to the market that is unforgiving of companies that miss their estimates. The pressure to
“make numbers” often results in earnings manipulation by management and a consequent decline
in the quality of financial information reported. Companies try to meet or beat expectations of
analysts in order to grow market capitalisation.

Activity 11.1
Discuss creative accounting and motivations behinds its use.

11.4 Common Techniques of Creative Accounting


Common techniques of creative accounting include the following:

• big bath;
• creative acquisition accounting;
• cookie jar reserves;
• materiality misapplication; and
• premature recognition of revenue.

We will explain these techniques in detail.

11.4.1 Big Bath


Companies sometimes set up large charges associated with restructuring. These charges help
companies “clean up” their statement of financial position giving them a so called “big bath”.
This is done so that next year’s earnings will look improved. A restructuring causes some assets
to lose value because they no longer fit in the company’s strategic plans, so the charges are made
against those assets or the whole amount of the assets is written off. The controversy is that
companies exercise considerable discretion in determining the amount of a restructuring charge.

11.4.2 Creative Acquisition Accounting


In the purchase price allocation procedures, companies classify a large portion of the acquisition
price as “in process” research and development, which can be written off in a “one-time” charge
removing any future earnings drag. Sometimes large liabilities for future operating expenses are
created to protect future earnings.

165
11.4.3 Cookie Jar Reserves
This involves, basically, using unrealistic assumptions to estimate liabilities for such items as
sales, returns, loan losses or warranty costs. In doing so, they stash accruals in “Cookie Jars”
during the good times and reach into them when needed in the bad times.

11.4.4 Materiality misapplication


Some companies misuse the concept of materiality. They intentionally record errors within a
defined percentage ceiling. This is justified on the basis that the effect on the profit is too small
to matter. In the case of discovery, management simply puts the matter to rest on the basis of
immateriality. Materiality requires consideration of all relevant factors that could impact on
investors’ decisions.

11.4.5 Premature recognition of revenue


This involves recognising revenue before sale is complete, before product is delivered to the
customer or at the same time when the customer still has options to terminate, void or delay the
sale.

Activity 11.2
Explain the following creative accounting terms “Big Bath” and Cookie Jars”.

11.5 Other Common Examples of Creative Accounting


• Subtracting payroll taxes on employee share options in earnings per share numbers.
• Increasing earnings by assuming the company would pay less into its pension fund with
the implication of decreasing current expenses but the rate of return on pension
investments declining, requiring bigger future contributions (larger future expenses).
• Boosting sales by lending huge sums to customers.
• Capitalising expenses instead of immediate expensing.
• Piling up inventories. Outdated or damaged items are included in inventory of good items
while they have to be written down to their current value.
• Options cost. Companies do not have to deduct the cost of options from their income.
• Using complicated, hard to understand language of financial disclosure.
• Extending an expected life of an asset to reduce depreciation charges.

166
• Playing with estimates. For example, assuming that a company will have fewer bad debts.
• Back door bargains. Promoting sales by buying a customer’s stock or granting cheap
warrants.
• Disguising pension costs by lumping them with other retirement benefit costs.
• Convoluted but permissible use of derivative accounting which allows future profits from
certain contracts to be booked in the present period. It is called “front-loading” profits.

Activity 11.3
Identify a failed financial institution of your own choice and examine the creative accounting
techniques which were applied to the published financial accounts to disguise the true financial
position of the firm.

11.6 Off-Balance Sheet (Statement of Financial Position) Transactions


Off-balance sheet transactions are ways by which management obscure the economic substance
of the company’s financial position by removing assets and (or) liabilities from the statement of
financial position. The most common off-balance sheet transactions are explained below.

11.6.1 Leasing transactions


A company that owns an asset and finances that asset with debt, reports an asset and a liability
(the debt). A company that operates the same asset under an operating lease reports neither the
asset nor the liability. Imagine a statement of financial position that presents a train operating
company (such as NRZ) without any train, that is certainly not a faithful representation of
economic reality.
This matter is now being addressed internationally, and there is a possibility that companies will
be required to recognise assets and related lease obligations for all leases, both finance and
operating.

11.6.2 Securitisation transactions


Assets are transferred through a securitisation transaction and the transaction is recognised as a
sale which removes the amounts from the statement of financial position. Securitisation involves
the transfer of a company’s receivables into another vehicle [usually identified as Special
Purpose Vehicles (SPV)] and then issuing out new securities out of the special purpose vehicle

167
with the receivables being the underlying assets. When the receivables are transferred to the
special purpose vehicle, they will be removed from the statement of financial position of the
company.
Some securitisations are appropriately accounted for as sales, but many continue to expose the
transferor to many of the significant risks and rewards inherent in the transferred assets and
should not be removed.

11.6.3 Creation of unconsolidated entities


A company that transfers assets and liabilities to a subsidiary company must consolidate that
subsidiary in the parent company’s financial statements. However in some cases, the transferor
may be able to escape the requirement to consolidate.

11.6.4 Buyback agreements


These are most common in financial institutions. Financial instruments such as treasury bills or
bankers’ acceptances are sold to counterparty and consequently removed from the statement of
financial position but with an implied agreement to buy them back on a certain day (maturity
date). In this way, the financial institution is able to remove from its statement of financial
position all the unwanted financial instruments on the accounting date but take them on there
after.

11.6.5 Derivative contracts


The full amount of liability on contracts such as futures, options and forwards is difficult to
quantify accurately. Companies can structure their obligations using derivatives such that the
liabilities are not fully represented in the statement of financial position since they are contingent
or potential liabilities.

11.7 Addressing the Dangers of Creative Accounting


The dangers of creative accounting may be addressed by any of the following:

• putting pressure on the auditors to pick up any creative accounting aspects and qualify the
statements;
• strengthening the company audit committee;

168
• need for a cultural change for analysts so that they punish those who rely on deception
rather than the practice of openness and transparency; and
• the technical rule changes by standard setters will improve the transparency of financial
statements and will certainly address the creative accounting techniques.
Activity 11.4
Assess the extent to which off-balance sheet transactions have undermined the integrity of
financial reporting by financial institutions in Zimbabwe and the world at large. Quote relevant
cases in your answer.

11.8 Derivatives and Hedging Activities


Derivatives are financial instruments or other contracts with three distinguishing features:
• One or more underlying assets and one or more notional amounts or a payment provision
or both.
• No initial investment or a relatively low initial investment, similar response to changes in
market factors.
• Net settlement is required or permitted.
Derivatives are generally used to manage the following risks:
• Interest rate risk: This is the chance of incurring a loss on a long or short position as a
result of fluctuations in interest rates.
• Foreign currency risk: This is the chance of incurring a loss as a result of fluctuations in
exchange rates.
• Commodity risk: This is a risk caused by the unavailability or shortage of a particular
commodity.
• Market risk: This type of risk is caused by fluctuations in the prices of marketable
securities.
• Event risk: This is the likelihood of a loss emanating from a particular event or
occurrence.
The most common types of derivatives are:

• options;
• forwards;
• futures; and

169
• economic hedges.

Activity 11.5
1. Giving examples, explain the above mentioned financial risks.
2. Differentiate between a futures contract and a forward contract.
3. When would you prefer using an option contract other than a futures contract?
4. Explain economic hedge.

11.8.1 Derivative Hedging


International Accounting Standards 39 (Financial Instruments: Recognition and measurement)
guides the accounting for derivative hedging.
The most significant provisions are:
• All derivatives must be recognised in the financial statements.
• All derivatives must be measured at fair value.
• Changes in the market value of derivatives must be recognised in the net income for
those derivatives that are considered to be part of a hedge.
• The accounting for the hedged item in the designated hedge is affected by that of the
derivative (directly).
• When a derivative is not fully effective as a hedge, the ineffective portion of changes in
the derivatives market value must be included in the net income.
• Derivatives can be used to hedge the following risk exposures
­ Fair value hedges: changes in the fair market value of the recognised assets and
liabilities or of firm commitments
­ Cash flow hedges: variations in future cash flows related to recognised assets and
liabilities or of forecasted transactions
­ Foreign currency hedges
• Embedded derivatives such as the conversion feature of a convertible bond, must be
separated from the host contract and accounted for as if it were a stand-alone transaction.

11.9 Notes to Financial Statements


Financial statements also contain notes and supplementary schedules and other information.
They may contain additional information that is relevant to the needs of users about the items in
170
the statement of financial position and statement of comprehensive income. They may also
include disclosures about the risks and uncertainties affecting the enterprise and any resources
and obligations not recognised in the statement of financial position. Information about
geographical and industry segments and the effect of inflation on the business may also be
provided in the form of supplementary information.

Many potential liabilities are usually disclosed in the financial notes and the majority of financial
statement analysts over look such important information. All notes should be read and all the
elaborate financial jargon broken down to bring out the hidden meaning. An analyst worth her
salt should never be out-witted by creative accountants.

Activity 11.6
Explain how some creative accountants attempt to obscure the economic substance of some
transactions by using notes to financial statements.

11.10 Fundamental Analysis


Information contained in financial statements form the basis for fundamental analysis of a
business. What analysts try to do is basically to ascertain the viability of a business using all the
relevant information at their disposal and the most important of the information comes from
financial statements.
The bottom-up approach of fundamental analysis starts from the company specific information
which basically comes from company reports and then it looks at the industry, sector, economy
and the global factors that affect the operations of a company. Alternatively, one can take the
top-down approach, coming from global factors down to company-specific factors. The aim of
fundamental analysis is basically to ascertain the lucrativeness of an investment before
commitment of resources. It must be emphasised that at the core of fundamental analysis are
financial statements.
When analysing the performance of a company, all types and sources of information should be
considered. The following sources of information are integral:
• annual report and accounts;
• interim accounting statements;

171
• official filings;
• prospectuses;
• aggregate financial data;
• share price performance;
• index price performance;
• financial analysts forecasts;
• production and consumption statistics;
• official industry statistics;
• audit reports;
• environmental and employee reports;
• management comments and news announcements;
• analysts’ comments and recommendations;
• credit assessment reports;
• financial and trade press comment;
• independent valuations;
• personal contacts; and
• previous dealings.

Activity 11.6
Explain the significance of business fundamental analysis by an analyst to a potential investor.

11.11 Summary
Creative accounting is a cancer that has gripped financial reporting. Accountants have used a
number of techniques to manipulate figures and misrepresent information. Analysts need to
watch out for off-balance sheet transactions used to reduce statement of financial position size
and consequently not reflecting the true state of a company at the accounting date. Much of the
creative accounting is glossed over in financial notes and these need to be read and understood.
Objective financial statements which give a fair representation of the financial status of a
company form the core of fundamental analysis.

172
BLANK PAGE
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Company Financial Statements. 7th Edition. Durban: Butterworths.
David, H., and Wayne, W. M. (1996). Accounting: What the numbers mean. 3rd Edition. USA:
Irwin/McGraw Hill.
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Journal of Finance pp 715-732.
Fama E .(April 1980). “Agency Problem and the Theory of the Firm ” Journal of Political
Economy pp 288-307.
Fred Weston, J., and Copeland. T.E .(1989). Managerial Finance. 8th Edition. Florida: Dryden
Press Orlando.
Gitman. L.J.(1988). Principles of Managerial Finance. 5th Edition. New York: Harper Collins
Publishers.
IFRS. (2011). A Guide through IFRS: Part A. London: IFRS Foundation Publications.
Lucey, T .(1996). Costing. 5th Edition. Great Britain: DP Publications.
Miller, M.,Modigliani,H., and Franco.(1961). Dividend Policy, Growth and the Valuation of
Shares. Journal of Business 34 pp 411-433.
Owler, L. W. J., and Brown, J. L.(no year).Wheldon’s Cost Accounting and Costing Methods.
14th Edition. London: MacDonald and Evans.
Randall, H. (1995). Advanced Level Accounting. Great Britain: DP Publications.
Stapleton, R. C. (1992). Mergers and Acquisitions. LexingtonUS: Mass DC Heath.
Walter, L.E. (1967). Dividend Policy and Enterprise Valuation. Wadsworth, Wales: Belmont
Cadif.
Wendt, P.F.(March-April 1985). Current Growth Stock Valuation Methods. Financial Analysis
Journal No 33
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USA: John Wiley and Sons.

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