Question

Ratih, a financial analyst found that PT Mentari changed its accounting policy in preparing financial reports every year even though it was not due to new standard provisions. PT Mentari voluntarily changed its acquisition policy. For these changes, PT Mentari has followed the provisions in IAS 8 regarding changes in accounting policies. Ratih is one of the users who uses financial statements to determine the value of a company.

Give advice to Ratih what things to consider in analyzing the financial statements?
What provisions in the conceptual framework that might be violated by PT Mentari so that the financial statements are reduced in quality?

Answer 1

Steps to analyze the financial statements

For any financial professional, it is important to know how to effectively analyze the financial statements of a firm. This requires an understanding of three key areas:

1. The structure of the financial statements
2. The economic characteristics of the industry in which the firm operates and
3. The strategies the firm pursues to differentiate itself from its competitors.

There are generally six steps to developing an effective analysis of financial statements.1. Identify the industry economic characteristics.

First, determine a value chain analysis for the industry—the chain of activities involved in the creation, manufacture and distribution of the firm’s products and/or services. Techniques such as Porter’s Five Forces or analysis of economic attributes are typically used in this step.

2. Identify company strategies.

Next, look at the nature of the product/service being offered by the firm, including the uniqueness of product, level of profit margins, creation of brand loyalty and control of costs. Additionally, factors such as supply chain integration, geographic diversification and industry diversification should be considered.

3. Assess the quality of the firm’s financial statements.

Review the key financial statements within the context of the relevant accounting standards. In examining balance sheet accounts, issues such as recognition, valuation and classification are keys to proper evaluation. The main question should be whether this balance sheet is a complete representation of the firm’s economic position. When evaluating the income statement, the main point is to properly assess the quality of earnings as a complete representation of the firm’s economic performance. Evaluation of the statement of cash flows helps in understanding the impact of the firm’s liquidity position from its operations, investments and financial activities over the period—in essence, where funds came from, where they went, and how the overall liquidity of the firm was affected.

4. Analyze current profitability and risk.

This is the step where financial professionals can really add value in the evaluation of the firm and its financial statements. The most common analysis tools are key financial statement ratios relating to liquidity, asset management, profitability, debt management/coverage and risk/market valuation. With respect to profitability, there are two broad questions to be asked: how profitable are the operations of the firm relative to its assets—independent of how the firm finances those assets—and how profitable is the firm from the perspective of the equity shareholders. It is also important to learn how to disaggregate return measures into primary impact factors. Lastly, it is critical to analyze any financial statement ratios in a comparative manner, looking at the current ratios in relation to those from earlier periods or relative to other firms or industry averages.

5. Prepare forecasted financial statements.

Although often challenging, financial professionals must make reasonable assumptions about the future of the firm (and its industry) and determine how these assumptions will impact both the cash flows and the funding. This often takes the form of pro-forma financial statements, based on techniques such as the percent of sales approach.

6. Value the firm.

While there are many valuation approaches, the most common is a type of discounted cash flow methodology. These cash flows could be in the form of projected dividends, or more detailed techniques such as free cash flows to either the equity holders or on enterprise basis. Other approaches may include using relative valuation or accounting-based measures such as economic value added.

The next steps

Once the analysis of the firm and its financial statements are completed, there are further questions that must be answered. One of the most critical is: “Can we really trust the numbers that are being provided?” There are many reported instances of accounting irregularities. Whether it is called aggressive accounting, earnings management, or outright fraudulent financial reporting, it is important for the financial professional to understand how these types of manipulations are perpetrated and more importantly, how to detect them.

An alternative system to using a conceptual framework is a rules based one, whereby detailed rules govern and guide the preparation of financial statements.

This type of system is open to abuse as management may try ‘creative accounting’ methods to provide biased information whilst still complying with the relevant accounting standards and regulations. It is more difficult to evade wide-ranging principles than detailed rules.

Another disadvantage of having a rules-based system is that the creation of accounting rules may be influenced by certain parties, such as large companies or lobby groups. Influence is harder to exert when using a principles-based system guided by a conceptual framework.

Despite these problems, some countries prefer to use a rules-based system as it allows for less management judgement, which may result in mistakes.

Following a conceptual framework can be difficult and lead to overly complex accounting standards which may be hard for the end users to understand and apply. That said, a system of overly complex and detailed rules is also hard to apply.

Occasionally, an accounting standard may conflict with the Conceptual Framework, although this is rare. When this happens the requirements of the accounting standard override the requirements of the Conceptual Framework.

The main reasons for developing an agreed conceptual framework are that it provides:

• a framework for setting accounting standards;
• a basis for resolving accounting disputes;
• fundamental principles which then do not have to be repeated in accounting standards.

  With a sound conceptual framework in place the FASB is able to issue consistent and useful standards. In addition, without an existing set of standards, it isn’t possible to resolve any new problems that emerge.

  The framework also increases financial statement users’ understanding of and confidence in financial reporting and makes it easier to compare different companies’ financial statements.