Financial statements are the main tool to support users’ investment and other business decisions. Financial statements that are not clear, curt and effective can have an adverse impact on the users’ interpretation of the current financial status of a company.
All too often, annual reports are peppered with overly optimistic jargon which paints a rosier picture than it actually is, thus not accurately reflecting the underlying economic substance of the company’s activities.
By way of an example, the spectacular collapse of Enron was attributed in part to financial reporting failures which attempted to create an erroneous image of financial health.
The primary responsibility of the published accounts being a fair and true representation of the financial health of the company lies with the Board of Directors.
Auditors also play a main part in ensuring that the accounting process is a true representation of the financial health of the company. Collective failures in delivering unbiased information to financial statement users’ will lead to distorted representations and is an ongoing concern for all stakeholders.
Listed below are a number of commonly accepted attributes that financial statements should include:
- information for understanding the entity’s financial position, performance, cash flows and prospects
- a disaggregation of the individual balances at a level of detail that enables the key components of primary financial statements to be understood
- information about significant business developments
- matters of importance to the business
- the specific financial risks to which the business is exposed, together with their context and management’s approach to those risks
- an explanation of the basis for recognition and measurement of line items in the primary financial statements, in particular when management exercised its judgement
- information relating to items not recognised in the statement of financial position that, if or when recognised, will have a significant effect on future cash flows.
Aswath Damodaran talks about the consequences of complexity in financial statements and how investors reflect the transparency (or the opacity) of a firm’s financial statements in its value.
He notes that complexity in financial reporting is exacerbated by “fuzzy” accounting standards allowing discretionary power in the measurement of income and capital. Accounting can be used to report higher earnings, lower capital invested, and higher returns on capital. He considers three examples:
(1) Firms have been inventive in their use of one-time and non-operating charges to move normal operating expenses below the operating income line. The appearance of these charges year after year essentially overstates operating income and can simultaneously reduce the book value of capital invested.
(2) Firms can also use accounting standards to move assets and debt off their books using, for example, off-balance-sheet vehicles.
(3) In addition, there are techniques to smooth earnings out over periods. Investors who look at earnings stability as a measure of equity risk are misled into believing that these firms are less risky than they truly are.
When financial statements are not transparent, we cannot estimate the fundamental inputs that we need to examine to value a firm. For instance, a firm’s expected growth should be a function of how much it reinvests (reinvestment rate) and how well it reinvests (its return on capital).
If firms funnel their investments through holding companies that are hidden from investors, we cannot assess either of these inputs. To evaluate a firm’s cost of capital, we need to know how much debt is owed by the firm, as well as the cost of this debt.
For firms that hide a significant portion of their debt, we will underestimate the default risk that the firm is exposed to, and consequently, its cost of capital.
Whilst accepting that financial statements are only part of the story, and users should not expect that they include everything they need to know, they are widely recognised to be the most important documents made available to the public.
The MFSA listing rules dictate that regulated debt issuers publish a financial analysis summary, which often includes pertinent information which is not available, or immediately clear in the Annual report published by a company.
Unfortunately since there is no such requirement for equity issuers, the decision on the level of disclosure rests with the company, and is often insufficient or unclear.
The “tick-the-box” approach when it comes to financial statement disclosure is often inadequate and disappointing to a user of financial statements. Companies should do more to provide the investing public with relevant and accurate information which is ultimately beneficial to all stakeholders.
Disclaimer: This article was issued by Simon Psaila, financial analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.