BACC482
BACC482
BACC482
Accounting (Honours)
Bachelor of Commerce in
Banking and Finance
(Honours)
Mount Pleasant
Harare, ZIMBABWE
ISBN: 978-1-77938-478-2
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
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.
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.
15
BLANK PAGE
Unit 1
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
• specify how financial accounting, cost accounting, management accounting and financial
management differ
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?
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.
Activity 1.2
What is the relationship between cost accounting and management accounting?
19
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).
• 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
22
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
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.
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.
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.
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
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.
• examine the trend of different cash flow components over time and their relationship to
related income statement items; and
Activity 1.4
Explain the usefulness of the statement of cash flows to an investor seeking to take over a
company?
31
Table 1.6: The format for the presentation of the statement of changes in equity
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.
34
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)
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?
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.
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.
• 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.
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.
(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.
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
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
43
d. taxation systems;
e. inflation; and
f. strength of the profession.
Activity 3.1
Under which legal system would you classify the Zimbabwean accounting system? Explain
why?
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.
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.
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.
3.14.1 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.
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
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
4.2.1 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.
4.2.5 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.
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.
4.3.3 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.
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)
4.3.10 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.
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.
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.
62
Unit 5
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
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.
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.
65
Activity 5.1
Outline the advantages and limitations of ratio analysis.
• profitability;
• liquidity; and
• gearing.
66
����� ������ �������� ��������
Gross profit margin = ��������
× ��� ����� ������
and ��� ������� ������
and
������� ��������
Operating ratios = × ���
��������
��������
Asset turnover = × ���
������� ��������
It is calculated as follows:
��� ������
ROCE = × ���
������� ��������
Profit before tax is used because interest figures are gross of any tax effect.
67
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)
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 =
������� �����������
����� �� ���
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.
69
������� (�����������)
Debtor turnover ratio = ������ �����
× ���
���� �� �����
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
Activity 5.3
Explain the importance of gearing ratio to holders of the ordinary shares of a company.
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.
72
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.
73
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.
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).
75
��� ������ ������ �������� ��� ���
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.
76
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
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.
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:
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
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:
(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.
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
Activity 6.1
a. What is valuation?
b. What is the logical criterion for choosing a valuation method?
Vo = P/E × E
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?
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?
Where
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
Ke = Cost of equity
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?
�� (���� )� (�� � �) �
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
(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?
97
6.14 Calculating value of the firm
��� ��
Value of the firm = ∑��� +
(���)� (���)�
Where;
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
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
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:
• 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
103
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.
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
106
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
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.
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
108
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.
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:
For period 1 CTU (Pvt) Ltd’s income statement would include (as other income) the following:
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
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
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.
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.
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.
8.6.1 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.
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:
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.
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.
�
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.
122
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.
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.
123
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.
• 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.
124
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)
125
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.
• The total future minimum lease payments under non-cancellable operating leases for
each of the following periods:
i. not later than one year;
126
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.
127
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.
128
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.
129
• 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.
131
Unit 9
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.
133
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.
Activity 9.1
Explain the two most common forecasting models in financial literature.
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.
134
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).
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.
135
in the light of the existing monetary policy or any other interest rate management techniques
which can be applied by the company.
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
137
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.
138
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.
139
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:
140
(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
141
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
142
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.
143
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
144
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
145
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
146
- 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.
147
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.
149
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
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.
150
10.3 Qualitative Approaches
Qualitative approaches will look at root causes of failure, attitudes and company failure and
argenti analysis among others.
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.
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.
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’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
154
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.
155
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.
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.
156
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.
157
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.
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.
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.
161
10.6 Avoiding Failure
Ross and Kami listed ‘Ten Commandments’ that should be followed by a company to avoid
failure:
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
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
Activity 11.1
Discuss creative accounting and motivations behinds its use.
• big bath;
• creative acquisition accounting;
• cookie jar reserves;
• materiality misapplication; and
• premature recognition of revenue.
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.
Activity 11.2
Explain the following creative accounting terms “Big Bath” and Cookie Jars”.
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.
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.
• 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.
• 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.
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.
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
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.
173
Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.
Alternative Proxies: