MA526 Limitations of Accounts

(ActEd Ch. 13)

Limitations of Accounts
SYLLABUS OBJECTIVES
Interpret the accounts of a company or a group of companies and discuss the limitations of such interpretation. Discuss the shortcomings of historical cost accounting. Discuss the limitations in the interpretation of company accounts. Discuss the ways that reported figures can be manipulated to create a false impression of a companys financial position.

Limitations of Accounts
WHAT WE ARE GOING TO COVER
The shortcomings of historical cost accounting Limitations in the interpretation of accounts Manipulation of reported figures

The shortcomings of historical cost accounting

Inflation distorts profits Overstates because: ignores the higher cost of stock (replacement). underestimates the depreciation charge

The shortcomings of historical cost accounting

Inflation distorts profits Overstates because: ignores the higher cost of stock (replacement). e.g. item bought for 2, sold for 3 Profit = 1 Cost of replacing item now 2.5 say So real profit only 50p

The shortcomings of historical cost accounting

Inflation distorts profits Overstates because: underestimates the depreciation charge e.g. 10% pa charge on item depreciated over 10 years (straight line basis) With inflation, cost of item increases, charge pa increases with each new purchase. Charge on older purchases underestimated.

The shortcomings of historical cost accounting (contd)

Understates because:With inflation, real value of capital falls Interest on loans part offsets this fall but not treated like that in accounts Whole interest is shown in accounts so profits understated. With inflation, real value of loan falls, interest less in real terms. So borrower gains but not reflected in accounts profits understated.

The shortcomings of historical cost accounting (contd)

FINAL POINT Difficult to separate the effect of inflation from the real increase in the scale of a business when profits and assets increase in money/nominal terms.

Limitations in interpretation of accounts

Subjectivity (are the figures correct?) Appropriateness (correct for what purpose?) Comparison between firms Ratio analysis Accuracy of the figures

Limitations in interpretation of accounts: Subjectivity

Different methods used Stock valuation (LIFO, FIFO, realisable value) Depreciation Revaluation of assets Intangibles

Limitations in interpretation of accounts: Appropriateness

Figures may not be the most appropriate for the purpose for which they are to be used.
Going concern basis Present values Depreciated cost not economic value Accuracy End of year figures

Limitations in interpretation of accounts: Comparisons between firms Comparability - use of different methods Creative accounting Format for presentation Level of aggregation

Limitations in interpretation of accounts: Ratio analysis

Diverts attention from actual accounts

Company size Notes to accounts

Comparisons may not be appropriate

Different accounting methods Exposure to different risks.

Limitations in interpretation of accounts: Ratio analysis (contd)

Different industries
some industries have specific features eg property company will have low ROCE due to continually revaluing assets.

Creative accounting
to reflect managements requirements

Limitations in interpretation of accounts: Accuracy of the figures Out of date when published Window dressing

Forecasting

Manipulation of reported figures

Value of stock Value of property Value of intangible assets Depreciation Accruals Company pension funding provision Value of future liabilities

Manipulation of reported figures

Mechanisms for Manipulation
Inappropriate depreciation of tangible assets Inappropriate amortisation of intangible assets Inappropriate valuation of inventories (stocks) Inappropriate valuation of future liabilities & provisions (including pension provisions) Unwarranted revaluation of tangible assets Creating intangible assets of questionable value pre-booking of anticipated sales revenues
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