What Keeps Firms from Misrepresentations of Financial Statements - Assignment Example

[Financial Analysis] [Saifullah shahid] [May 3, 2006] Question No a) Discuss the factors that keep the firms from misrepresenting their financial statements. (b) Describe the different types of "Costs" that companies can incur when financial information is disclosed. Solution What keeps firms from misrepresentations of financial statements The following factors keep the firms from misrepresentation of financial statements. - The reputation of the firm - The reputation of management - Third-party certification - Legal penalties (a) The Reputation of the firm: The firm has contractual and legal obligations with various other bodies, which are also called stakeholders of the firm. The following bodies for their decision-making processes rely upon the financial information provided by the firm. Investors in the firm Shareholders Bondholders Banks Business contacts Suppliers Customers Employees Other users Taxation agencies Government Local government Regulators Competitors Public Intermediaries Analysts Media The contents and timings of non-financial information in the financial information disclosures can adversely affect the usefulness of financial statements to the stakeholders of the firm. The misrepresentation in the financial statements can lead them to contingencies and then losses because of wrong decision-making and reliance on the financial information. If the firm is proved to be misrepresenting its financial statements later on, it will lose its confidence in the trust of its stakeholders, on which the whole business of the firm is based and it shall be difficult for the firm to survive for a lengthy period. (b) The Reputation of the Management The management of the firm is wholly responsible for the financial statements of the firm and thus any misrepresentation if found shall be the responsibility of the management. The individual managers are elected by the shareholders of the firm for the management of the business affairs of the firm. They have a vested interest in maintaining their own credibility in such regard so that the shareholders keep electing them every time the elections for the board of the management is held. In case of any kind of misrepresentation found in the financial statements, they shall be severely liable for not fulfilling their duties and the responsible individual managers are likely to penalize for not being reliable in dealings with the external parties. (c) Third Party Certifications The parties such as banks and financial institutions that are interested to provide funds to the firm and other individuals interested to invest in the firm or often require third parties to attest the financial statements served by the firm for reliance in the information provided. External audit firms, investment bankers and underwriting firms, provide these certification services. Various clients are served by these third parties and thus they are strongly interested in maintaining their reputation and credibility with the financial community. The report provided by these third parties serves as reasonable assurance in the true and fair disclosure of information in the financial statements. In case of any discrepancy found in the financial information provided by the firm, the reports on the financial statements shall not be clean. Thus adversely affects the credibility of the firm. (d) Legal Penalties In case of any fraudulent or misrepresentation of information found in the financial statements served by the firm, there are heavy penalties for the persons responsible for the fraud which may lead to even insolvency of the firm. Most juridical laws across the globe have severe civil and criminal liabilities for misrepresentation of financial information. Solution (b) Costs Associated with disclosure The various costs associated with the disclosure of financial statements can be classified as under: Collection and Processing costs Litigation Costs Political costs Competitive disadvantages costs. Collection and Processing costs These are the costs associated with the costs incurred for the certification of financial statements by the third parties such as by an external audit firm and other underwriting firms. Litigation Costs In case of any incorrect forecasts of earnings per share of the firm disclosed in the financial statements, the users of the financial information may incur losses for their investments in the firm based on the incorrect forecasts. They can then sue the firm on providing incorrect information that was vital for their correct decision-making for the investment in the firm. The firm shall be then liable to reimburse the aggrieved parties in such regard. Political Costs The Governments keep in view the financial statements of various firms and corporations to identify the highly profitable firms. In case of high profits, excess amounts of taxes are imposed on the firm and the government has also power interfere and expropriate wealth from the firm and redistribute it to other parties in the society for maintaining equal opportunities to low profitable firms currently in business in the society. For example, the government of United States of America involved in the business of Microsoft Corporation and forced them to separate their Software and hardware departments as different legal entities. Competitive disadvantages costs Firms having a research and development department often incur heavy expenses on the innovations in the products and introducing new products in their product range. They face difficulties while obtaining capital funds from other entities due to lack of confidence and contingency of the success of their new products in the market. Solution: Financial Distress: Financial distress is that state of the firm where it faces difficulties to make contractual payments in time due to insufficient cash flows of the firm. Identification Factors of Financial Distress: The various elements if found in the business affairs of the firm, leads to financial distress to the firm which are discussed below: Dividend Reductions The firm begins to offer low earnings per share on its share capital in continuity and fails to provide higher dividends during its consecutive financial periods. Plant Closures The firm reduces its operational departments and sells out one or more of the major operational parts of the firm. Losses The firm experiences continuous financial losses in consecutive financial periods without any indication of future progress in such regard. Management resignations The individual managers are interested to work in a company or firm where there are chances for further development in their designations. Where the management of the firm loses confidence in the firm, it tends to resign from its responsibilities. Labor Turnover High labor turnover of a company indicates financial distress due to lack of confidence of labor in their company. Decreasing Stock Prices The decreasing values of stocks and shares in the stock exchange market can be vital for identifying financial distress of the firm. Prediction of financial distress: Whether a company will suffer financial distress or not can be predicted by various techniques and methods which are individually described below: Use of Financial Ratios of the company Models for predicting financial distress Financial Ratios Financial ratios are helpful in finding the performance of the company immediately. It uses key figures from the financial statements and analyses by comparing the results of the ratios to the ratios of a successful business corporation. These ratios also help in identifying the areas experiencing problems and thus can be helpful in eliminating such factors which may be a problem for the firm. Categories of Financial Ratios The Financial ratios are divided into various categories, each identifying a key perspective of the business of the company. Liquidity ratios Efficiency ratios Gearing/Investment ratios Profitability ratios Liquidity ratios Current Ratio It is the ratio of current assets to current liabilities of the company and it should be about 2, indicating the current assets are twice the current liabilities. Care should be taken to seek that current assets are not unduly inflated by over valuation. Acid Test Ratio It is the ratio of current assets less stocks to current liabilities. Since stock lacks liquidity as compared to other current assets of a company. Efficiency ratios The ratios in this category identify the performance of the company in utilizing the resources efficiently. Stock turnover ratio It is the ratio of Average stock held to cost of sales multiplied by 365 days. It tells us about for how many days the stocks of the company are kept in stores from production till their sales. The lesser the days are, the better are the chances of reasonable cash flows. Fixed Asset Turnover Ratio It is the ratio of total sales revenue over fixed assets. It tells us how effective the assets of the business are in generating sales revenue. Debtor Turnover Ratio It establishes the relationship between credit sales and accounts receivable. A high debtor turnover ratio will mean that the debts are being collected efficiently. Creditor Turnover Ratio It establishes the relationship between credit purchases and accounts payable. It tells us about how long we take to pay our creditors. Gearing / Investment Ratios These are of two types. Capital based ratios and Income based ratios. Capital based ratios establish the relationship between the capital provided by proprietor and the other sources of funds whereas income based ratios establishes the relationship between the total revenue of the company its financial charges. Profitability ratios It is used as a performance meter of the company. Gross Profit Ratio It is the ratio of gross profit by sales of the company expressed in percentage. Net Profit Ratio It is the ratio of net profit by sales of the company expressed in percentage. Models for predicting financial distress There are two kinds of models in practice in the financial world. Univariate models of distress predictions. Multivariate models of distress predictions. Univariate model A univariate model makes use of a single ratio for predicting financial distress of any firm or company. The basis of predicting whether a firm is experiencing financial distress or not depends upon the following element. The average ratio of the non distressed firms will differ from the average of the same ratio of distressed firms. The difference shall be used for predicting financial distress of the firm. Multivariate model Multivariate model uses various ratios at a time to work out a certain figure on which the prediction is based upon. Most multivariate models uses a specific formula which gives out a figure which tells us whether the firm or company is in non distress zone, or distressed zone. The analysis of the figure on which the decision is made varies with the size of the company and the business which is carried out. Likewise univariate models of predicting financial distress, multivariate models chooses a point of score which is then compared with the score of the company calculated on the basis of a formula. Scores above the point are considered indicating a financially safe company while the score falling below the point is considered indicating a financially distressed company. An American academic, Altman, in 1968 worked out the first multivariate model which is also known as Altman's Z score. The Z score is calculated by the following formula: Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E Where A = Current assets - current liabilities Total Assets B = Retained earnings Total assets C = Profit before interest and taxation Total Assets D = Market value of preferred and ordinary shares Book value of total liabilities E = Sales Total assets The score calculated through the formula is known as Altman's Z score. According to his theory, the cut off point is 1.8, if the score of a company is above 2.99; it is predicted to be financially safe. If it is within 1.8 and 2.99 the company may or may not suffer from bankruptcy. If it falls below 1.8, the company is likely to suffer from financial distress and the lower it falls the higher are the changes of bankruptcy of the company. Financial distress Solutions The company experiencing financial distress may opt for the following solutions: Selling Major Assets: The company may opt for selling of its major assets for temporarily prevents the deficiency in its cash flow. Merger with another firm Merger with another firm combines the powers of two or more firm's altogether and small units can then form a single large unit in terms of finances and goodwill in the market. Moreover it regains the lost credibility of the firm experiencing financial distress. Reducing R&D Expenses Firms incur heavy expenses each year for their research and development department for the innovation of new products in the market. The firm can reduce these expenses temporarily for avoiding from deficiency in their funds. Issuing new securities Firm may opt for issuance of debentures of and stocks in the company to overcome its financial needs. Solution (b) Advantages of the tools used to predict financial distress: Financial ratios give the figures of the financial statements a meaning, these financial figures if used appropriately results in identifying key performance measures of the business. It ignores the element of size of the company. We can even compare a large firm with a small one for performance and efficiency. It enables us to gain vision of the company's business techniques and methodology. We can compare the ratios with the average of the industry of the business. We can analyze the whole financial position of a company by simply analyzing its ratios other than reading the detailed financial statements of the company. Whereas the models for predicting financial distress serves us as providing a simple figure on which the analysis is made. Financial distress indicating models have proved their consistency in the true predictions over a long length of time. Disadvantages of the tools used to predict financial distress: Financial ratios needs specific figures from financial statements which if missing will result in no meaningful result. Various figures in the financial statements are based on estimations and if used wont ignore the element of contingency in such regard. Non Standardized accounting results in the complications of finding the required specific information for use in calculating ratios. Negative numbers are often ignored by the ratio analysis. Whereas the financial distress predicting models were used in the past where the macroeconomic and market situations were far more different than that of today. The world has now being converted into a global village where companies from all parts of the world are competing hence the socio-economic conditions have been entirely changed. Question No. 2 (a) Discuss the problems encountered by analysts when comparing financial statements prepared in different countries. (b) Describe the steps being taken to overcome these problems. Solution (a) PROBLEMS INCURRED BY ANALYSTS WHEN COMPARING FINANCIAL STATEMENTS PREPARED IN DIFFERENT COUNTRIES: Various problems are faced by the analysts when comparing financial statements prepared in different parts of the world. The reasons behind these difficulties are different legal, economic, social, and religious and cultures of the parts of the world. Even though the differences are not too large at the current state of globalization but still due to lack of coordination among the financial giants of the world there are undeniable differences. The difficulties are due to the following elements, Disclosure requirements Though the International Financial Reporting Standards are currently in use by most parts of the world, but there are many countries which uses other financial and disclosure standards i.e. Generally Accepted Accounting Principles (GAAP). While comparing the financial statements of countries based on different standards, the components of the financial statements won't necessarily be the same. Moreover, the financial and non financial Information disclosed won't necessarily be the same either. Inland Laws Companies are formed on different legal formalities all over the world. These legal formalities do change the business techniques and methods of the companies in different parts of the world. Taxation rates, VAT and Sales Tax rules and their effect on profit While analyzing the financial ratios of companies in operation in different conditions, the Gross Profit Ratio and Net Profit Ratio changes due to the change in taxation rates in different countries. Exchange rates vary on daily basis Financial statements from different parts of the world are based on the different currencies being in use in that part of the world. The exchange rates of these currencies vary on daily basis thus creating problems for the analysts. Varied costs due to different charges and resources The customs duties and charges of other governing bodies differ in different countries thus affecting the costs and revenues of the companies. While analyzing the performance measures of companies these changes in resources and costs may lead to incorrect results. Financial Charges The financial charges in countries vary due to different interest rates being in use by different countries. Dividend paying policies The analysts should be careful when dealing with dividends declared by companies from various parts of the world because of different dividend paying policies such as some companies would be more interested in paying dividends off through cash while others prefer dividends through issuing bonus shares. (b)Describe the steps are being taken to overcome these problems Solution (b) Steps being taken to overcome problems faced by analysts while comparing financial statements prepared in various parts of the world Internationally Recognized Accounting and Disclosure Standards The Financial analysts and governing bodies from various parts of the world are now working upon the approval of a single financial reporting and disclosure standard to be used globally so that the differences due to different disclosure requirements may be overcome. For that, International Financial Reporting Standards (IFRS) has been applied to be recognized as the single standard to be followed by all the companies globally. Inland Laws Analysts should consider these laws while comparing financial statements from different countries so that they can be made the least influential on the decisions made. Taxation rates, VAT and Sales Tax rules and their effect on profit Analysts should consider different taxation rates, VAT and Sales Tax rules and requirements and their effects on the financial statements especially on profit, while comparing financial statements prepared in different countries. Exchange rates vary on daily basis Analysts should be able to convert the financial statements into a standard currency at the time of closure of the financial period so that the differences and variations due to constantly changing exchange rates can be eliminated. Solution (4): INTANGIBLES Solution (a): In reference to the given scenario of HIT Entertainment, it shows that they've not capitalized internally generated brand names. Due to that their asset base has been understated. And thus a gap has been generated between the market and book values of intangible assets in the financial statements of HIT Entertainment and other similar companies. IAS 38 which deals with recognition and capitalization of intangible assets emphasizes on capitalization of brand names if it falls within the criteria given below. Brands when purchased separately as a part of larger acquisition can be recognized if it can be measured reliably. Internally generated brand names may be recognized if they possess a readily ascertainable market value. Furthermore, the advantages and disadvantages relating to recognition and capitalization of brand names are listed below: Advantages: It increases the asset base of the company and in return has a healthy impact on the financial position of the company. It improves the gearing position of the company in terms of its related financial ratios. Third party reliability and confidence in the company increases if posses a larger asset base. It has a healthy effect on its credibility over its creditors and funds suppliers. Investors are more interested in investing in companies having higher debt equity ratios. Disadvantages: Since internally generated brand names are often measured by the company itself and there lies a possibility of overstated values. Companies may misuse the allowed accounting principle to induce investors to invest in the company. Since the valuation of brand names and intangibles are based on estimation on market values. These estimations are difficult to be challenged by financial analysts. Solution (b): Differences between brands and goodwill and their after-affects: Brands can be recognized when purchased from outside and also when generated internally, whereas goodwill can only be recognized when it is purchased hence it possesses a relatively higher ascertained value than brands. Brands are measured internally and are based on management's best estimate whereas goodwill is ascertained on its market value and it is tested annually for impairment. Goodwill included brand names earlier but now the International Financial Reporting Standards emphasizes on recognizing separately goodwill and other intangibles such as brands etc. Treatment by Financial Analysts: Financial analysts work out on the financial statements by choosing any of the following alternatives when analyzing financial statements having recognized goodwill and brand names. They may analyze by considering goodwill and other intangibles as a part of the total assets of the company. They choose this alternative on the basis of recognizing goodwill as a resource of the company which is capable of generating profits for the company till finite period. They may eliminate goodwill and brand names from the total assets of the company and later on subtract it from the retained earnings of the company. They choose this alternative on the following basis. The amount allocated to goodwill may be a result of paying greater than the market value of the intangible. Ignoring the value of internally generated goodwill due to complications relating to its valuation and recognition. Reference MC.Shukla, TS.Grewal. Advanced Accounts: financial ratios and goodwill: New Delhi, 1995 Read More