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THE SIGNIFICANCE OF Powered By Docstoc
					THE SIGNIFICANCE OF
FINANCIAL
STATEMENTS TO
THE BUSINESSMAN
REPORT AT THE CULTURAL ASSOCIATION
CULTURE AND ARTS CLUB – ABU DHABI
FEBRUARY 1986



TABLE OF CONTENTS

Accountancy as an Information System
Users of the Published Financial Statements
Specifications of the Publisher Financial Statements
Shortcomings and Restrictions of the Audited Financial Statements
Approaches and Methods of Analyzing the Audited Financial Statements
Approaches of Analyzing the Audited Financial Statements
Interpretation of Financial Analysis
How to Develop the Published Financial Statements
Conclusion
References




INTRODUCTION

       Throughout history, the objectives, principles, and procedures of the
accountancy profession have developed in conformity with socio – economic
circumstances. Basically since inception, accountancy started as a book-keeping
system for safeguarding the owners’ equity. It currently changed into an information
system which provides businessmen/women with the economic data required for the
decision-making process.

       With time, auditing - the other facet of accountancy – has played a
complementary role. Both professions developed together and followed the same
trend. Whereas the purpose of accountancy was originally custodian, the role of
auditing was the detection of fraud and default in the financial statements. However,
as accountancy was later viewed as an information system, the main objective of
auditing turned into maintaining authenticity, fairness, and clarity of accounting
information.

        The growing role of accountancy as an information system was due to several
factors. The most important are the following:
1.    Emergence of shareholding companies (corporations), which was
accompanied by an expansion of owners’ equity. Independent management and hired
management.

2.      Establishment of the income tax system and tax departments. Accountancy as
an information system could be demonstrated.


Figure 1 Accountancy as an Information System:

Raw data (Inputs)     →       Processing            →       Information (Outputs)
                The accounting system is governed by           Outputs represented in
                a set of principles & procedures, with         data processed per users’
                which data is processed throughout the         objectives
                accounting cycle, utilizing:
                -Recoding
                -Classification
                -Summary
                -Communication

         Figure 1 above demonstrates that the accounting system is the data generating
source which rests, basically, on accounting information or figures registered in the
books and records. The data is later processed through the accounting system cycle
before being generated as an end product of the system.
         Through processing, the accounting system is governed by a group of
principles and procedures, aiming basically at supplying the required output
specifications, such as objectivity, clarity, authenticity, relevance, and punctuality,
which are altogether known as the Generally Accepted Accounting Principles
(GAAP). Though all principles should be inherent in accounting information, the
most important is the principle of relevance. The importance of data output basically
emanates from its relevance to users’ objectives. Data output could be mainly
categorized as follows:
1.       Detailed internal information which represents inputs or internal reports
passed to management regarding various firm activities.
2.       External general information which represents inputs or external reports
known usually as the firm’s published financial statements for the interest of other
parties.
         Our concern here is the published financial statements. The Accounting
Principles Board of the American Institute of Certified Public Accountants (AICPA)
defined the basic objectives of the published financial statements as follows:
  1.     Providing authentic and fair financial data on the firm’s economic resources
and obligations towards third parties and owners. This enables users of financial
statements to asses the firm’s weaknesses and strengths.
2.       Providing concerned parties with correct information on the changes in the
firm’s financial position due to profit-making activities.
3.       Providing financial information which enables users to derive some indicators
for forecasting the soundness of the firm’s profit earning position.
4.       Supplying users with adequate information of the significant accounting
policies and principles followed, while preparing statements, such as depreciation and
stock assessment methods. The above data could be transmitted through three basic
statements:
              (a) Balance Sheet
              (b) Profit and Loss
              (c) Source and Application of Funds


Users of Published Financial Statements
       Despite the variety of objectives and interested parties, users of the financial
statements could be generally categorized in four groups:

1.     Current promising investors, who use the audited financial statements for
investment decisions. In summary, this group seeks answers for the following:
                   Return on funds invested in the firm.
                   Success of the firm in accomplishing a competitive market
                      status.
                   Future trends, scope of continuity, and the anticipated growth
                      rate of activities.

2.      Lenders, including current and promising firm creditors, such as trade
creditors, bondholders, bank and other financial institutions.

        This group wants the economic information which would assist in short or
long-term decision-making. Hence, they look for answers to some queries such as:

              Liquidity position and whether the firm’s working capital is adequate
               for the settlement of short-term liabilities.
              Whether the firm would be capable, in case of liquidation or
               bankruptcy, of setting its long term liabilities. What are the risks
               encumbered by lenders in case of financial difficulties?
              Would the firm’s current net profits suffice for covering interests due
               on debts? If so, what are the available guarantees?



3.     Management of the Firm


        The firm’s management foresees on two categories. First, on data employed
for control, planning, appraisal, and decision-making purposes. This is mostly
detailed, estimated, or statistical in nature, and has originated from costing or
management accounting systems. Second, on general and historical information, that
could be included in the financial statements for deriving quantitative indicators on
performance as a whole.

       Through audited financial statements, management seeks answers to the
following:
              Success in managing funds in custody, and whether viable returns are
               realized compared to competitors within the same industry.
              Success of the applied financial policy in comparing inner and other
               sources of funds. Does it attract the suitable volume of funds at the
               proper cost and at the right time?
              Success in managing the firm’s assets and whether the credit, sales,
               and inventory departments perform successfully.

4.     Other Groups
        This group includes the firm’s staff, clients, and government establishments
such as planning boards, accounting bureaus, and tax departments. This is an addition
to research departments, financial analysts, and constancy offices.
        The concerns vary according to their interests, but they mostly voucher the
following:
             Continuity of the firm.
             Firm’s participation in national economy, and the social costs it
               encumbers.
             Whether the financial statements were prepared according to laws and
               regulations and to the Generally Accepted Accounting Principles and
               Standards. Are they authentic and objective for assessing the firm’s tax
               dues and preparing the national budget?



Specifications of the Published Financial Statements

        The success of the decision-making businessman/woman rests on two
principles:
    1. Whether decision inputs match targets. In other words, are the statements
        available to the decision-maker relevant, precise, authentic, and objective?
    2. Whether the decision model is correct; in other words, the success of the
        decision-maker in defining the basic hypotheses and variables.
         Any fault in one or both of the above result in the failure of the decision as
    demonstrated in the following:

DECISION


Decision inputs              Decision Model                Decision outputs

+                            +                             + (i.e. success)
_                            +                             _ (i.e. failure)
+                            _                             _
_                            _                             _
      Based on the above, specifications of the published financial statements,
which would be in conformity with the businessman/woman’s targets, are:

(1)    Relevance
         This is achieved when all users of the published financial statements get the
information required for making their decisions. The extreme difficulty of
establishing relevance is due to the disparity of users’ targets as its contradiction with
objectivity. The figures presented in the financial statements are historical in nature
and lack relevance. Decision-makers, therefore, prefer future forecasts on the firm’s
activities, since they can only have General Purpose Financial Statements, which
would in no way fulfill the targets of each and every group.


(2)    Objectivity

       Pursuant to the above, the abolished financial statements should quantitatively
present factual events supported by the required documents.

(3)    Reliability
        According to the accounting standards, absolute objectivity is a far fetched
objective. However, the published financial statements should be reasonably
accurate.

(4)    Completeness or full disclosure
       This means disclosure of all information required by the concerned parties,
without concealing any basic facts in conformity with the materiality concept.

(5)    Understandability
        This means the simplicity and clarity of the terms, presentation, and
classification of the published financial statements, easing understanding by all users
who are not necessarily accountants. The statements should be presented according to
the standards generally accepted by those who prepare, examine, or use them.

(6)    Comparability

       This is a basic factor for analyzing and interpreting the financial statements.
By comparability, the ratios and trends required could be deduced by the forecasting
decision-maker.      Consistency is closely correlated with comparability, and it
concerns the principles applied in each and every financial period.

(7)    Timeliness
        Timeliness is an important factor for the success of decision-making, because
financial information is of no use if it is not available at the right time.


The Audit Profession’s Role in Securing the Reliability of the
Published Financial Statements
               Most businessmen/women have some ambiguity over the auditor’s role
and the limit of his responsibility over any defaults or violations included in the
financial statements which he prepares. This ensued from mixing up two completely
independent tasks: preparing and issuing financial statements by the firm’s
management, and examining and attesting the financial statements by the auditor.

        The auditor’s responsibility for incorrectness falls within the framework of his
obligations to examine the financial statements in accordance with the Generally
Accepted Accounting Principles and professional conduct, and to express his/her
professional and independent opinion thereon. The auditor will only be responsible
for any defaults or arrogations correlated with his/her professional duties. Any other
premeditated or unpremeditated negligence by the management while preparing the
statements, or any information not disclosed to the auditor, will be the responsibility
of the firm.



         Due to the current importance of this issue, especially when considering the
extreme importance of the financial statements to businessmen/women, we shall deal
with it in detail, starting with the definition of auditing.
         The American Association of Accountants defined auditing as “a systematic
procedure which seeks objective testimonies to assert the firm’s economic incidents,
and thereby express an independent opinion to users of financial statements”. The
users therefore view the audited financial statements from two angles, namely content
and quality. While content is the firm’s management responsibility, quality is the
responsibility of the auditor, who plays an important role in providing data. By
following the audit procedures he/she deems fit, in accordance with the predetermined
and approved standards, he/she reaches a conviction that he/she examined the
financial statements present fairly and clearly the actual financial position of the firm
at the end of the period. The professional and independent opinion in the auditor’s
report represents his/her appraisal of the quality of the financial statements.

      Here below is a summary of the auditor’s role:
Figure 2: Auditor’s Role in conveying the Published Financial Statements to
Users




Statements to Users
Firm’s Economic
         ddsddddddddddfdd
   Incidents

                             Verified by testimonies ddjdsdsddfdd

Recorded in
documents and
accounting books
                                Checked and Verified



Summarized in
accounting reports                                                            Auditor
passed to                        Testifies to its
                                 Fairness




                                     Generally accepted
Accounting                                                               Auditor’s Report on the
Information Users                                                        financial Statements
                                       Auditing standards
                                        To
                 Concerning the presentation of reliable and independent financial statements
         to users, the auditor’s role complements rather than replaces that of the management.
         Management is responsible for the precision of the statements, after the auditor’s
         exertion of reasonable care in accordance with professional standards. The auditor’s
         responsibility for the quality is confined to whether the financial statements present
         fairly the results of operations and the firm’s financial position at the end of the
         period.
                 Being empowered by the shareholders and for the interest of other users,
         he/she will express in a special paragraph within his/her report, his/her opinion on the
         financial statements. To discharge himself/herself from responsibility, he/she also has
         to include the following in his/her report:
          1. His/her examination was in accordance with the Generally Accepted Auditing
         Standards, on the basis of which he/she will be responsible for any professional
         defaults. These standards are the following:
                         (a) General Standards:
                             Include personal and professional requirements for becoming an
                             auditor, and the efforts to be exerted during the auditing process.
                        (b) Reporting of Field Work:
                             Are the basic directives for setting any audit program or plan for
                             determining the type and nature of the procedures required for
                             examining or assessing the internal control system and accounting
                             records.
               (c) Cover reporting specifications and conditions and the expression of
                   an opinion on the fairness of the financial statements.


2.     That the firm initiating the financial statements keeps proper books of
accounts, and that the statements were prepared in conformity with the Generally
Accepted Accounting Principles applied on a basis consistent with that of the
preceding period.
           (a) Basic accounting principles and standards as directives during the
               recording and devaluation stage: Principles of realization, historical
               cost, accrual, continuity, conservatism, and consistency.
           (b) Accounting principles and standards as directives during the stage of
               presentation of financial statements: Principles of full disclosure.
               Materiality and relevance.
3.     In the case of a public shareholding company, the auditor has to maintain that
the financial statements give all the information required by the commercial
company’s law and the company’s by – laws.

4.      In light of the above, the auditor has to express an independent professional
opinion as to whether the financial statements present fairly the financial position of
the firm and the results of its operations at the end of the period.

5.      The American Institute of Chartered Public Accountants (AICPA) listed in its
releases, 4 types of opinions which could be expressed in the auditor’s report:
             (a) Clean opinion, which includes no qualifications.
             (b) Qualified opinion, in case of any important but not crucial
                 contraventions. For example, when the financial statements are not
                 prepared in conformity with Generally Accepted Accounting
                 Principles, or if inconsistency in applying such principles does not
                 crucially reflect on the presentation of the financial statements, or if
                 the management does provide the auditor with the information which
                 he deems adequate for his/her examination.
             (c) Disclaimer of Opinion, in case of crucial and basic qualifications. For
                 example, non-adherence to the Generally Accepted Auditing
                 Standards or the auditor’s abstention from examining the financial
                 statements.

           (d) Adverse Opinion, if the financial statements do not present fairly the
               firm’s results of operations or its financial position at the end of the
               period.


In summary the auditor’s responsibilities for the published financial statements are:

(1)      Exertion of reasonable due care as required by the examination. Within the
scope of his/her tasks, he/she will examine the internal control system and basically
express an independent professional opinion thereon.
        The firm’s management is responsible for the proper entry of financial
transactions in the record, precision of data presented in the published financial
statements, and any defaults or shortages disclosed therein.
(2)    To discharge himself/herself of responsibility for any possible defaults or
contraventions presented in the published statements, the auditor has to adhere, during
the normal examination process, to the Generally Accepted Auditing Standards and
professional conduct and has to exert reasonable and due care to detect such
contraventions or defaults.
   (3)      Sound and competent accenting and internal control systems restrict and
ease up the detection of defaults or fraudulent acts in the published financial
statements. The auditor’s responsibility is mainly to examine and appraise both
systems, through the tests he/she deems fit, before expressing his/her independent
professional opinion thereon.


Contents of the Financial Statements
      The audited financial statements include three main exhibits, together with
complementary schedules and notes:

1.        Balance Sheet:
          It discloses the firm’s assets compared to the corresponding liabilities at the
          end of the financial period. In other words, the balance sheet demonstrates the
          source of funds (liabilities and owner’s equity) and application of funds
          (assets). Balance sheet presentation varies from the traditional, which shows
          assets at the left against liabilities and owner’s equity at the right side, up to
          the current growing trend of presenting assets, liabilities, and owner’s equity
          at one side to correlate the sources of funds with corresponding applications.

                   Though traditional presentation facilitates comparison between assets,
          liabilities, and owner’s equity, it fails to clarify the correlation between the
          source of funds and their application. To show net working capital, the
          current presentation in list form overcomes this disadvantage, and it facilitates
          the correlation between the source and application of funds, whether long or
          short-term.


       Irrespective of the presentation, the following should be taken into
consideration, especially the materiality concept that should be applied regarding the
following:
       According to the nature of the firm, priority of classification shall be for
earning assets corresponding to the sources of financing such assets at the liabilities
side. In industrial companies the fixed earning assets have the priority over others,
while the owner’s equity has priority over liabilities. In financial companies, such as
commercial banks, priority is for the current assets and current liabilities.

To bring information loss to the minimum, aggregation of balance sheet captions
should be carefully done.


     2.      Profit and Loss Statement
    This presents realizable profits compared to expenditures during the financial
period, in addition to the net result of operations whether profit or loss. This would be
in different forms; some prefer the traditional account form while the growing
tendency prefers a list form.

(a)    Disclosure of revenues according to the source. This required the presentation
of income due from ordinary activities compared to realizable income from other
sources. This also requires disclosure of operational expenses independent from the
expenses and losses.

(b)      Disclosure of gross and net operational profit before the firm’s total net
profits.

   3.      Statement of Source and Application of Funds

       This presents the source of the firm’s funds and the way they were utilized
during the financial period. If prepared for successive financial periods, then this
statement provides useful information on investment and financing policies. But if
prepared in the form of a cash flow statement, it serves as a good credit analysis tool.


        The common three terms are:

        (a)    Statement of changes in the financial position, which shows the
changes in all balance sheet captions. This discloses all sources of funds and their
application together with effects on working capital. This is the form most often used
in the published financial statements.


       (b)     Sources and dispositions of working capital, which show only changes
in the working capital.


      (c)    Cash flow statement, which shows cash changes, concentrating on cash
flow and funds flow.

       Besides the above, the businessman/woman should enjoy some characteristics
which enable him/her to arrive at the indicators while reading the financial statements.
These are:

(1)     A general background on the principles and concepts of preparing the
financial statements.
(2)     Thorough knowledge of the causal relationship between the basic and all
balance sheet captions.
(3)     Full awareness of the expected shortcomings inherent in the audited financial
statements, and restrictions on their adoption in decision-making.
(4)     Thorough knowledge of financial analysis procedures.
(5)     The most important factor is the ability of the businessman/woman to interpret
quantitative indicators, properly evaluate the firm’s performance and financial
position, and to correlate that with his/her targets.
       Despite the importance of all the requirements listed above, we shall
concentrate on the last three.

     Shortcomings and Restrictions of the Audited Financial
Statements

       The financial statements are usually prepared on the basis of several
hypotheses and accounting principles. This reflects on the nature of these statements
and imposes restrictions on their use for decision-making by businessmen/women.
The major shortcomings are as follows:

1.      Arbitrariness of Accounting Measurement:
        The figures presented in the financial statements are finally the results of a
measurement process which is mostly subject to personal judgment and the scope of
adherence to the Generally Accepted Accounting Principles. For example, the net
profit for the period varies according to the procedure of measuring each item of
revenues and expenses. Hence, any change of views among accountants on fixed
assets depreciation procedures, inventory assessment, etc. or on applying the
conservative concept while setting provisions and reserves, will no doubt reflect
drastically on net profits and items of assets, liabilities, and owner’s equity. Hence,
the figures disclosed are closer to estimates rather than precise values.

2.      The published financial statements are prepared according to various
hypotheses. The most important are:
        Cash measurement, fixed currency rate, historical cost, and project continuity.
These no doubt affect the nature of information disclosed in the financial statements
and restrict their use in decision-making. Being historical in nature, decision-makers
prefer future statements which provide project tendency information. The fixed
currency rate postulate makes the financial statements misleading during inflation or
depression periods and improper for financial analysis during lengthy, comparable
periods. Meanwhile, though quantitative financial statements are important as
decision inputs, the qualitative are not far less, if not more, important. To succeed in
decision-making, the businessman/woman has to fulfill the qualitative aspect by
referring to other sources such as market and consultancy studies or direct contacts.

Approaches and Methods of Analyzing the Published Financial
Statements


       Financial analysis of financial statements is a procedure which enables
businessmen/women to extrapolate the information required on the firm’s activities.
The procedures are manifold depending on tendency. Nature and scope of
comparison are as follows:

1.      Vertical financial analysis, for comparison of figures within the same financial
period, such as net profit compared to sales. It could be also horizontal for the same
items within two or more financial periods, such as net profit for the current period
compared to the same for past periods, or current rations at the end of the period
compared to the same for past periods.

2.      Simple financial analysis for comparison between absolute values of items,
whether for one or several accounting periods, such as the comparison of working
capital at the end of the current and past financial periods. However, if the
comparison is between rations derived from absolute values, the financial analysis
would be of a complete nature, such as a comparison of liquidity at the end of the
current and rest periods.

3.      Financial analysis could be restricted to the firm’s figures or rations and this is
called internal analysis. Comparison is also possible between the figures and titans of
the concerned firm and similar competing firms, or market averages. This is called
Inter – firm Analysis.


       The Financial analyses mostly used by businessmen/women are the following:

   (1) Common Size Statements

        This corresponds to the vertical analysis mentioned above. Comparison
resulting in a percentage or ration is possible between figures within the same
accounting period, such as inventory over total current assets, or any two figures
having a casual relationship. For example, the current ration derived by comparing
the firm’s current assets to current liabilities at the end of the financial period.

        Due to the causal relationship between the items of the firm’s published
financial statements, businessmen/women could derive many ratios, which are also
indicators for appraising the firm’s performance in various fields.

       (a)     Profitability Ratios such as:

              Gross Profit/Sales
              Net Profit/Sales
              Return on Investment (ROI)
              Return on Equity (ROE)
              Return on Assets (ROA)

         (b)     Liquidity Ratios, as indicators for measuring the firm’s ability to
fulfill short-term liabilities such as the current ratio, liquidity ratio, stock turnover,
debtors turnover, and average collection period.
         (c)     Activity Ratios, as indicators for appraising competence in managing
assets such as: working capital turnover, assets turnover, fixed assets turnover, stock
turnover, and debtor’s turnover.

        (d)    Capital Structure Ratios, as indicators for appraising the firm’s
finance policy, and for estimating the risk borne by lenders and owners due to the
firm’s policy for trading in equity.

               Debts / Owner’s Equity or Leverage
                          Debts / Assets of Indebtedness Ration
                          Debts / Fixed Assets

            (e)    Market Ratios, as indicators for investors of the stock exchange
     market. For example:

                          Dividend Yield (DY)
                          Dividend per Share (DPS)
                          Pay out Ratio (FOR)
                          PRICE /EARNING Ration (PER)
                          Book Value per Share (BVPS)


     Common size statements facilitate the comparison between multi – size firms of the
     same industry, because absolute figures in this case are misleading and meaningless.
     This procedure is criticized as being static, because the figures demonstrate the firm’s
     status at a definite time, and the user is looking for trends that have a comprehensive
     and objective picture of the firm’s current and future activities.

     (2)      Trends Analysis

             To avoid a static character, as mentioned above, businessmen/women resort to
     trends analysis. This is possible by studying the movement of the item or the
     financial ratio for the period concerned. This secures the dynamism needed by the
     analyst and enables him/her of forming a more precise idea about the firm and its
     future trends. A trends analysis is usually in vertical form and for several financial
     periods of 5 – 10 years. The first would be considered a base year, and future years’
     items would be presented as percentages of the base year.

              Trends analysis could be restricted to major items as follows:

                                                   Schedule 3
                                            Absolute Value Trends Study

                            Value (000)                              TRENDS (%)
                            1981 1982        1983    1984    1985    1981  1982    1983 1984        1985
Sales                       1.000 1.2000     1.500   2.000   2.800   100   120     150 200          280
Gross Profit                400     540      690     980     1.400   100   135     173 245          350
Net Profit                  200     250      300     320     400     100   125     150 160          200
Current Assets              500     700      800     900     1.200   100   140     160 180          240
Fixed Assets                600     570      800     700     720     100   83      133 117          120
Current liabilities         200     370      450     550     800     100   185     225 275          400
Long – term Liabilities     -       -        150     50      120     -     -       Not Applicable
Shareholders’ Equity        900     900      1.000   1.000   1.000   100   100     111 111          111
Total Assets                1.100 1.270      1.600   1.600   1.920   109   109     145 145          175
Operation Capital            300    220      350     350     400     107   107     117 117          133
                                       Schedule 4
                            Study of the Major Ratio Trends

                                        Major Ratio Trends
                           1981         1982         1983           1984           1985
Gross Profit Ratio         40           45           46             48             50
Net Profit Ratio           20           21           20             16             14
Current Ratio              250          190          180            160            150*
Leverage Raito             22           33           60             60             92
Debts / Assets             18           25           38             38             48
Return on Assets           18           20           19             20             21
Assets Turnover            0.91 times   0.94 times 0.94 times       0.125 times    1.46 times
Working Capital Turnover   3.3 times    3.75 times 4.3 times        5.7 times      7 times




(1)     The firm’s absolute comparative figures are of more value to the
businessman/woman, if analysis is limited to one financial period that is in 1985.
That the firm’s total sales in 1985 amounted to KD 2.80.000 means nothing to the
analyst, if not compared with the same figures of previous years. This is in addition
to studying comparative figures of other captions such as current liabilities, current
assets, working capital, shareholders equity, and total assets.


(2)     Mostly, mere study of the general trend of absolute values which represent the
firm’s activities is misleading. For example, the absolute values of sales, gross profit,
and net profit have escalated in the first schedule, demonstrating good profitability
and improvement. This impression changes if the analyst concentrates on profitability
trends in the second schedule. Net profit, which is an important criterion for
measuring the firm’s profitability, was contradictory all through the period and
declined from 20% to 14%. This is contrary to the other profitability figures and was
contradictory all through the period and had declined from 40% to 50%; return on
assets which rose up from 18% to 20% and return on equity which increased from
22% to 40%. The analyst has to interpret the reasons by analyzing the trends.

(3)     To answer his/her queries, the financial analyst could extend the scope of
his/her study of the financial ratios to be within the framework of the casual
relationship among the firm’s activities. The accelerating trend of the gross profit
ration against decelerating net profits could be due to superior trading activities
emanating from a decrease in the cost of goods sold which is a trading success
resulting in continuous net profit decline.

         The analyst has to consider also the ratio trends disclosed in the second
schedule, in order to interpret the increase in Return on Assets (ROE), despite the fall
in net profits. The firm’s current ratio diminished all through the period, namely from
250% to 150%, despite the increase of the absolute value of working capital for the
same period. The leverage ratio doubled more than two times from 22% to 92%, and
this means that the management follows the critical path method, because it resorted
considerably to foreign financing sources. However, by studying the assets and
working capital turnovers which have increased as shown in the second schedule, we
note that the management has achieved considerable success in investing the available
liquidity whether in its normal activities or in foreign investment fields, making the
Return on Investment (ROI) considerably over their weighted costs. This interprets
the increase of the Return of Assets and Return on Equity ratios despite the net profit
ration decline. In other words, the management succeeded through trading in equity
and managing foreign investments in compensating the fall in profits to original
activities. This was possible by a squeeze in liquidity and a considerable rise in the
risk limit regarding the equity and lender’s rights.

(4)     Continuous adoption of a critical path method regarding equity trading should
raise the following queries:

              Till when would this policy continue and what risks would reflect on
               owners and lenders?

              Till when would the management be able to convince lenders to offer
               loans, while suffering liquidity and solvency squeezes?

              Based on the above, would the capital be increased? What is the
               increase required to achieve capital structure parity?



        The decomposition analysis of the published financial statements, based on the
modern information theory, is a modern financial analysis procedure. It aims at
measuring the media contents of the financial report from the user’s view. If properly
employed, it is the best procedure to forecast any future financial difficulties. The
decomposition analysis is a developed picture of the ratio analysis mentioned above.
But, it is characterized by dynamism and is a predictor for financial failure. It could
be applied to all published financial statements and mostly the balance sheet. Most
applied studies on the procedure demonstrated full efficiency in providing appropriate
indicators for appraising the firm’s ability to fulfill its short or long-term liabilities.
The indicators are usually in the form of “information measures” to evaluate the
trends from two angles, namely the relative size and stability over time. Balance
sheet information measures include:

   (1)     Items under each balance sheet caption.

   (2)     Items at the balance sheet level.
   (3)      Every caption at the balance sheet level.

   (4)      The balance sheet as one unit.

        The information measures values increase according to the users’ targets.
Partial analysis including items under current assets as liabilities would suffice for
assessing short-term liquidity. However, a comprehensive analysis including all items
of assets as liabilities is required for assessing the firm’s solvency or financial
structure, and for determining its ability to fulfill long-term commitments.



Approaches of Analyzing the Audited Financial Statements

        The approach differs from the method. Profitability, credit, and investment
analysis are examples for approaches; while trends, ratios, and cash flows are
methods. The approach or method of financial analysis is determined in the light of
the user’s target. Due to the importance of the steps of financial analysis to be
followed by a businessman/woman, we give the following example: A credit
manager receives a short-term loan borrowing request for financing stock purchases,
and an attached copy of the audit analysis. The credit manager should first study the
financial statements to ensure the fulfillment of certain basics – such as relevance,
authenticity, comprehension, etc. The statements are later analyzed in the light of the
following inquiries:

Q.1:     What is the basic target behind the analysis?
  1:     Assessing the customer’s ability to settle a short term loan due on _______
         ______. Hence, the approach is a short term credit analysis.
  2:     What are the factors which affect the customer’s ability to settle for the short-
         term loan?
A.2:     a)      Short-term       liquidity      during       (the     effective     loan)
         ______________________period.
         b) Source and application of funds during the effective loan period.
         c) Cash flows during the effective loan period.
         d) Other factors such as nature of activities and firm’s competence.
  3:     What are the quantitative indicators required for assessing the above factors?
A.3:     a) Working capital trends/consecutive periods.
         b) Working capital turnover/consecutive periods.
         c) Liquidity rations/consecutive periods.
         d) Stock turnover/consecutive periods.
         e) Debtors turnover/consecutive periods.
         f) Comparative statement of the source and application of funds for several
         financial periods.
         g) Comparative statement of cash flows and their application for several
         financial periods.
         h) Cash flow estimates up to the due date of the loan.
Q.4:     What is the proper method for reaching the said financial indicators?
  4:     a) Trends through absolute assessment of current assets and liabilities.
         b) Trends analysis concerning the ratios in 3 above.
         c) Analysis of financial (?) and cash flows.
Following the deduction of the quantitative indicators, the fifth question would be:

Q.5: What is the significance of every indicator after being compared with the
generally accepted industry standards, and what are their repercussions on the
customer’s short-term financial position? In the light of his/her answer to the final
question, the credit manager would make his/her decision.
Here below are the most important approaches and corresponding financial indicators
which could be adopted by a businessman/woman:


     1.         Investment Analysis

       This is employed by inceptors represented in current or promising
shareholders who require information on the following:

     (1)        The firm’s continuity chances and anticipated growth rates.
     (2)        Competence of the firm’s management in setting down its financial plans
                and utilization of the available economic resources (investment and
                management of assets).
     (3)        The firm’s investment risk indicators in case of liquidation or bankruptcy.

                To achieve the above objectives, the following are useful:
                (a) Profitability indicators
                (b) Leverage indicators
                (c) Performance indicators
                (d) Market indicators


2.         Credit Analysis
       Short and long-term creditors follow up this approach to have the following
information:

           a)      Firm’s ability to settle the principal and interest due thereon.
           b)      Applied finance policies and corresponding repercussions on the firm’s
                   capital structure.
           c)      Risks correlated with their debts due from the firm, and priority of
                   lenders to settle their rights in case of liquidation or bankruptcy.
           d)      Objectivity of the firm’s asset appraisal policies, especially those
                   placed as guarantees.


           The most important indicators in this regard are:


                   (1)     Short-term liquidity indicators
                   (2)     Long-term solvency indicators
                   (3)     Leverage indicators
                   (4)     Short and long-term cash flows
3.         Performance Analysis
       This is of utmost importance for the management because it concerns control,
planning, and performance appraisal targets. Performance analysis could not be fully
possible through the audited financial statements as mentioned before, and reference
should be made to cost accounting and management accounting records. However,
general indicators could be derived from the audited financial statements as follows:

     (1)      General indicators on activity regarding profitability, finance, and
              investment policies.
     (2)      Special indicators concerning the performance of some departments such
              as: Debtors turnover average, investments turnover average, stock turnover
              average, and working capital turnover average.


Interpretation of the results:

       The final and most decisive step for a businessman/woman is how to interpret
the results. Any interpretation errors will no doubt reflect on the corresponding
decision. The interpretation is based on three principles:
    1.      Based on the firm’s comparative statements for several successive periods,
            the trends including absolute values as derived ratios would be carefully
            examined.
    2.      Studying the casual relationship between ratios and indicators, which make
            the firm’s activities indivisible, since what reflects positively on some
            activity aspects could adversely affect others.
    3.      Comparing the firm’s ratios and indicators with those of competing firms
            or what is commonly known as industry averages.


     However, the following should be taken into consideration:

              (1) Trend Analysis

              (a) Profit and Loss Statements
               Studying the sales, sales returns, and sales discount indicators. Gross
                  sales could have increased, with a corresponding increase of returns
                  and discounts denoting default either in sales policies, product quality,
                  or both.
               Studying trends and indicators of gross profit and correlated cost of
                  goods sold. This is in addition to studying the indicators of net profit
                  and correlated expenses as extraordinary items.

               (b) Balance Sheet
          Studying the indicators concerning each and every current asset item rather
           than total value only. This is because the relatively increasing importance of
           the stock in case of the relative stability of cash as debtors is an indicator of a
           liquidity squeeze. However, the growing and relative importance of cash, if
       the other current items are relatively stable, could be a preliminary indicator
       for a default in the management of investments. In addition to that, studying
       current asset indicators should concur with finance source indicators or current
       liabilities.
      An increase in fixed assets at a rate higher than that of current assets indicates
       weak liquidity, unless associated with a corresponding increase in sales of
       profitable activities.
      If finance policies are to be appraised, liability trends should be studied
       together with equity trends. The growing importance of current liabilities
       indicates more reliance on short-term financing sources. Despite being an
       indicator of a possible liquidity squeeze, it could positively reflect on
       profitability if accompanied with concurrent growth in current assets and
       sales. A further study should be carried for long-term liability trends and their
       corresponding effects on long-term assets.
      While studying liability trends, considerations should be given to their effects
       on risk levels of creditors and owners as well. The safety margin available for
       each group is entirely dependent on capital structure equability. This is
       demonstrated in the following three different financial models that show the
       risks reflected on both the creditor’s and shareholder’s rights.


Schedule 6
Financial Structure of Company x
According to Three Models

                                      A                   B                      C
Trade creditors                       -                   100                    100
Ordinary bonds                        -                   300                    600
Shareholders equity                   1.000               1.000                  1.000
Total liabilities and shareholders    1.000               1.000                  1.000
Equity
Leverage                              ZERO                0.66                   2.3




Schedule 7
Profit and Loss Statement of Company x




                                       A                B                  C
Net profit before tax and interest     200              200                200
Less interest                          -                21                 42
       Profit before taxes                   200             179               158
      Income tax 50%                         100             89.5              79
                                             100             89.5              79
      Shareholders Equity                    1.000           600               300
      Return on equity                       10%             14.8%             26.3%


              The above schedule discloses the properly utilized high leverage which in turn
      accelerated the return on equity ratio up to 26.3% in the third period. However the
      analyst has to ask about the effects on the return on equity, if the company transcends
      the equity trading limit or when it is not competent to utilize the borrowed funds and
      consequently, costs exceed returns thereon. In this case and to the contrary, the high
      leverage firm would be exposed to the fall of the return on equity when profits
      fluctuate.



      Schedule 8
      Leverage Risk Appraisal

                   A                             B                           C
                   1           2        3        1         2         3       1       2          3
Near profit before 300         200      50       300       200       50      300     200        50
tax and interest
Less interest          -       -        -        21        21        21      42      42         42
Net profit before      300     200      50       279       179       29      129     79         4
tax income tax%
Net profit available   150     100      50       139       89.5      14.5    129     79         4
for distribution
Shareholders           1.0000 1.000 1.000 600              600       600     300     300        300
equity
Return on equity       15%     10%      2.5% 23.5% 14.8% 2.3% 43% 26% 1.3%
Leverage               Zero                  0.66             2.3
Standard deviation     7.3                   15               10.4


      The above schedule demonstrated the actual task of interpreting indicators and trends,
      which impose on a businessman/woman the need for reading between the lines before
      taking a decision. Indicators in schedule 7 demonstrate one facet of the rise in
      leverage ration which is positive for shareholders. A further step demonstrated in
      schedule 8 indicated the negative facet of the rise in the leverage ratio.

              Comparing risk limits with possible fluctuation of ROE shows that the model
      of the capital structure is the most risky for shareholders. This is because ROE
      fluctuates from 43% to 1.3 % with a standard deviation of 20.4 followed by model B
      whereby ROE fluctuates from 23.3% to 2.3% with a standard deviation of 15. Model
      A demonstrates minimum risk fluctuating from 15 to 2.5 %, with a standard deviation
      of 7.3.
(2) Casual Relationship Among Indicators

        The casual relationship among ratio indicators is very important. A
businessman/woman has to be aware of the important relationship between the firm’s
liquidity and profitability which is mostly divergent, and that between leverage and
risk which is mostly parallel. This importance is demonstrated while studying the
sudden change in the general trend of an activity throughout an accounting period.

        For example, a sudden drop in some profitability indicators such as ROE,
before interpreting ROE as an adverse indicator of the firm’s profitability, could be
correlated with sudden and massive capital growth during the same period. A causal
relationship is needed for interpreting liquidity ratios and indicators. Liquidity could
be appraised in the light of two factors:

(a)      Indicators regarding the quantitative constituents of operation capital that are
current assistant liabilities.
(b)      Indicators concerning the punitive constituents of operating capital, first
liquidity ratio and second turnover of individual items under current assets and current
liabilities. A businessman/woman should be alert for window dressing, since some
firms suffering from profitability or liquidity problems resort, at the end of the
financial period, to measures which aim at refining their financial position. For
example, a firm having massive stock would ease sale and credit trends to double its
sales volume. By doing so, the stock is liquefied and two objectives are fulfilled
namely.

   (1)     A substantial increase in annual sales and refining the profitability
           position.
   (2)     Liquefying stock in the form of debtors for improving the firm’s liquidity
           position. In this case, concern should be given to the provision that had
           debts, which could be considerable. To improve the liquidity ratio, firms
           change their policies concerning the settlement of current liabilities before
           the end of the financial periods as disclosed in the following schedule.




                                      Current Liabilities
Bank                  16.000                 Trade debtors                   5.000
Debtors                4.000                 Short term loans               15.000
Stock                  5.000
Total                 25.000                    Total                       20.000
        The current rate is 1.25 : 1 and working capital is 5.000. If the firm settles its
short-term loan both before the due date or the end of the financial period, the current
rate improves without affecting working capital as follows:

Schedule 10


                                       Current Liabilities
Bank                           1.000                          Trade debtors
       5.000
Debtors                        4.000
Stock                          5.000
Total                                   10.000                                      Total
5.000


       Current rate is 2:1 and working capital is 5.000. Hence, auditors and users
should give special concern to events prior or subsequent to the preparation of the
published financial statements.

(3)    Comparison with Industry Averages
        A businessman/woman comparing the firm’s indicators and ratios with
industry averages should be aware of any possible misleading conclusions. This is
because firms within the same industry adopt different accounting principles while
preparing financial statements. Hence, standard ratio differences could be due to
disparity of adopted principles and procedures and not due to performance.
        For example, Chrysler’s gross profit for 1979 was inflated to $81.4 billion.
This was because it appraised its stock according to the FIFO and not the LIFO
method adopted by most competing firms. Though, uppercase comparisons between
the firm’s indicators and ratios and industry averages are special cases, it can be
assumed we have three firms with identical performance and finance activities. All
appraise their stock and cost of goods sold through LIFO and average methods. The
following schedule demonstrates the stock and cost of goods sold for the three
companies:

Schedule 11



 Company   Method              Stock Value    Cost of Goods           Average
     Stock
                                               Sold Value             Turnover
A               LIFO              50              550                   11
B               FIFO             125             475                   3.8
C               AV              100             500                   5
       The standard average as a mathematical average is:


                             5+3+11
                            ________ = 6.6 times
                                3



The Standard Average as a Median is 5 Times

       In this case, neither 6.6 nor 5 are suitable for appraising the performance of the
three companies and any comparison would lead to biased results. It is improper to
compare the stock turnover of company A which is 11 with the industry average 6.6,
since the mathematical average represented by the industry average is the
combination of various stock appraisal methods which differ from that adopted by
company A.

       It is also improper to compare company A’s stock turnover which is 11 with
the industry average 5. This is because the 5 is the result of stock appraisal methods
followed by company C and contrary to that followed by A.


How to Develop the Published Financial Statements

        We stressed in the preface the accountancy profession’s developable nature.
When referring to the preparation of audit of financial statements towards more
efficiency as an accounting system, Arab accountants and auditors should cope with
international accountancy and audit developments manifested in three major fields:

1.      Cost of Human Assets, especially after their growing importance within
economic firms, to the extent which requires setting special accounting systems and
providing the corresponding financial data to decision-makers.
        This should urge Arab accountants and auditors to develop the required
principles and standards to assess human assets and the required procedures for
reviewing and disclosing the relevant costs in the financial statements.

2.      Social Costs and Benefits
        This was underlined following the socio – accounting system. Such a system
views a firm as a social unit which absorbs part of the economic resources of the
community and should, in return, shoulder some responsibilities. Hence, actual
performance should not be an appraisal in the light of profit and loss to owners, but
according to services extended to the community.
        This urges accountants to develop the required principles and to measure the
firm’s social performance through a comparison between its costs and services to the
community. Auditors should also develop social audit standards and a procedure for
passing fair social performance data to users.
.3.     Forecasting about firm activities, since users require information beyond
historical statements, in order to have a fair and objective view about the firm’s
continuity and anticipated growth rates; this arises within the published financial
statements, as well as the responsibility of the auditor for auditing the same.


SUMMARY

1.      Though accountancy is an information system which serves investors, lenders,
managers, competent authorities, and other parties, we should not forget that the data
it provides is for decision-making purposes.
2.      Relevance, objectivity, and reliability are the proper specifications of the
financial statements. This is because proper decisions are based on proper data.
3.      Both the firm’s management and the public accountant are responsible for the
disclosure of proper data. The auditor’s role follows that of the management, in
expressing an opinion on the fairness of the statements through procedures which are
according to Generally Accepted Auditing and Reporting Standards. The auditor is
responsible for his/her tasks according to the expected audit standards and ethics.
4.      The proper financial statements should include the company’s financial
position at the balance sheet; date the results of operations for the period they ended
and the source and application of funds or the changes in its financial position for that
period.
5.      Due to the arbitrariness of Accounting Measurement and several hypotheses,
the financial statements suffer unavoidable shortcomings such as historical costs, cash
basis, stable currency rates, and project continuity.
6.      The audited financial statements are used basically to deduce many ratios such
as profitability, liquidity, performance, capital structure, market indicators, and trend
analysis. All these enable a businessman/woman to appraise the firm’s activities and
forecast the future.
7.      The most important approaches for analyzing the audited financial statements
are investment and credit analysis. The businessman/woman should give special
concern to the causal relationship between indicators and ratios, such as that between
liquidity and profitability, leverage, and risks.
8.      Finally, if accountants and auditors want to cope with current developments,
they must give concern to future accountancy trends such as; cost of human assets,
social costs and benefits, and forecasting on project activities.



       In closing, the financial statements as a tool should be carefully set down. The
management should be responsible for proper issue and the auditor should examine
and express an opinion thereon with full competence and honest.                     The
businessman/woman should be aware of how to use it for achieving superior interests.

				
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