Uses and limitations of published accounts
We have now explained and illustrated the balance sheet and profit and loss account. It is now time to see how these financial accounts are used and what information can be derived from them, while highlighting their limitations.
Uses of published accounts
This will be examined in depth when we look at ratio analysis in the next section. In more general ways, investors (shareholders) and potential investors will use the accounts to examine the follows:
- Profit utilisation - firms have to give their shareholders an acceptable return on their investment, otherwise they will sell their shares and the market value of the firm will fall. Investors will be interested in the ratio between dividends and retained profits.
- Profit quality - identify any changes in profit and ask where any profit comes from. For instance, identifying whether the profit generated is from improved trading or from the sales of assets.
- Balance sheet strength - to look at the balance between assets and liabilities. What is the cash position and how is cash used? What are the levels of debt and how strong is the liquidity position of the firm? How easily can the firm pay its bills?
- Trends with time - what do a series of accounts, representing several years, say about the business? What trends for sales (turnover) and profits can be identified?
Limitations of published accounts
Accounts are documents required by law, and are open for all to see. Their value is limited, however, as they are prepared with this knowledge in mind. Although, in theory, there can be no secrets in these accounts the accounts show the 'headline figures' rather than the specific detail.
- A series of accounts is needed to be able to compare the firm's performance with others. One account, say a single balance sheet, is of virtually no value. It is like one still picture from a 1.5 hour movie. It may be good for advertising, but provides little information that can be used. The investor should have the full set of accounts and notes for a number of years.
- Accounts are in terms of money, and tell you nothing about non-financial matters. This can be vitally important when making decisions. For instance, they tell you nothing about the firm's technology or the ability and skill of the staff in using this.
- The major asset of many firms, its personnel, is not included. This is crucial when looking a firm where the creativity of staff is important. With an advertising agency, for example, its strength depends on its key creative staff. If they leave, the prospects for the firm are poor, even though the accounts (which are historic) may not show this until it is too late.
- Accounts for other firms in the industry are required to enable judgements and comparisons to be made.
- Accounts will be a 'potted truth'; they will not tell all the truth. Firms want to avoid putting too much detailed information in the public domain, as it then becomes available to their competitors.
- Accounts are backward looking (historic). They report what has happened, not what is going to happen. Accounts, when issued, may be up to 6 months out of date. Only management accounts, which are intended for internal use, look forward. These accounts are used as planning and navigation documents for the management and are not available to the general public.
Window dressing is presenting the accounts of a business in the best possible, or most, flattering way. In public companies, this type of "creative accounting" can amount to fraud.
There are several 'tricks of the trade' - some legal and others not - whereby companies try to make their businesses look more successful than they are. Remember accounts are produced on a single day at the end of the financial year. The position may be different the day before or the day after! The timing of various transactions can be manipulated to influence the appearance of the accounts just before they are prepared.
Why massage the accounts?
- Managers may be on performance bonuses
- To minimise tax liability
- To increase share values - especially if the directors are shareholders
- To disguise the fact that the business is close to insolvency
- To use as a bargaining tool in negotiations with suppliers, customers and employees.
- Treating revenue expenditure as capital expenditure. Revenue expenditure, like rent is payable in the present year. Capital expenditure, e.g. spending on machinery, can be spread over several years through the process of depreciation. Spreading a payment will increase profit in the current year.
- Selling assets just before the end of the financial year to make it appear that the business is more liquid than it is, e.g. Sale and leaseback where a firm sells some property and then rents it back. This releases funds for the business and improve liquidity, but incurs a long-term liability for the rent. If this is done just before the accounts are due, the firm may seem to have a good cash, or liquidity position, but it now has an additional long-term expense. As a result, long-term profits may be lower.
- Encouraging early debt payments through discounts before the end of the financial year, whilst delaying payment of debts, to improve liquidity. This can be achieved also by delaying purchases for even a week, so this cost does not appear in the present year's accounts.
- Loans may be taken out just before the date of the accounts to improve the liquidity position, but may be repaid a few days later.
- Firms may change the way that they account for items from one year to the next - this may be hidden in the notes to the accounts.
- Inflating the value of intangible assets, such as brands, just after purchase.
Window dressing can amount to fraud if the accounts are simply 'made up'. One of the most notorious business failures of recent years was Enron, which went into receivership when its accounts were discovered to be fraudulent. Its accounting company, Arthur Anderson, which verified the accounts, was also closed down and several of their senior managers were imprisoned.