Don’t let the bean counters bamboozle you

BY: STEVEN JONES

FOR THE novice investor who is trying to find out some information about the company in which they are considering an investment, the annual report containing the financial statements looks like a scary document filled with meaningless jargon designed to bamboozle the reader. To a certain degree, this is true.

However, help is at hand. This article will help you sift out the information that you need to know as a starting point to understanding your chosen company’s financial information, by outlining the main components of a set of financial statements and what they should be telling you.

STATEMENT OF COMPREHENSIVE INCOME
Back in the day, this part of the financial statements was known as the ‘profit and loss account’ (or ‘P and L’ for short). It was changed to ‘income statement’ in the late 1980s, and about 20 years later the accounting standard setters came up with the above mouthful. This statement (by whatever name it has been known over the years) is a summary of the company’s revenue and expenses over a particular reporting period, usually a year.

If the company’s revenue exceeds its expenses, it will show a profit. The other way round results in a loss.

While profits are important in the long term, readers of financial accounts need to understand the limitations of this statement. This is because accounts are normally drawn up using what is known as the ‘matching concept’, which basically means that revenue must be matched to the period in which they are earned, whilst expenses are to be matched to the period in which they are incurred.

An example of this in practice would be one’s Telkom bill. Telephone rentals are usually charged in advance, whereas the call charges are billed in arrears. Accordingly, a bill issued on 1 March 2021 would show line rental for March and call charges for February. If the company’s year-end is 28 February 2021, a correct application of the matching concept would include the call charges in the 2021 financial year, while the line rental would fall into the following financial year (i.e. 2022).

From a revenue perspective, sales invoices issued towards the end of the financial year would be recognised as income in that year—even if their customer only settles the invoice in the following year.

One can therefore see how an unscrupulous accountant could manipulate this process by (for example) issuing sales invoices towards the end of the financial year, thus inflating the company’s revenue. It was precisely this practice that eventually led to the Enron collapse a few years back.

STATEMENT OF FINANCIAL POSITION
The term ‘balance sheet’ has stood us in good stead virtually since double-entry accounting was developed in Persia in the 8th century CE, but you know … standards-setters. Either way, this section of the financial accounts is a ‘snap-shot’ of the company’s financial position as at a specific date, usually its financial year-end.

This statement is based on the so-called ‘accounting equation’, which comprises the following three components:

ASSETS: This is what the company owns. It is further broken down into three sections, namely fixed assets (property, plant, equipment, and intangible assets such as patents, trademarks, and goodwill); investments (shares in other companies); and current assets (debtors, cash in the bank).

LIABILITIES: This is what the company owes to providers of financing. It is broken down into long-term liabilities (debentures, mortgages) and current liabilities (trade creditors, bank overdrafts, and other short-term loans).

Finally, the EQUITY section shows the owners’ stake in the company. It includes share capital (funds contributed by the shareholders), and reserves (made up of retained profits and revaluation reserves). Also known as the net worth of the business, it is equal to total assets less total liabilities.

While the balance sheet can also be open to manipulation (e.g. where trade debtors is inflated due to the manipulation of sales), it is a bit more reliable than the income statement in that one would hope that (at the very least) the auditors will have verified physical as-sets, borrowings from financial institutions, and bank account balances.

STATEMENT OF CASH FLOW
The third leg of the accounting potjie, this is the only statement where the change in name has been an improvement in terms of what its purpose is (the old ‘source and application of funds’ name was a bit esoteric).

It is what it says on the tin—this statement tracks the cash flowing into and out of the business. The statement reconciles the movement in the cash balances from the previous financial year to the current one, clearly showing whether the cash that the business holds has gone up or gone down.

As already indicated, while income statement and (to a lesser extent) balance sheet items can be manipulated, this is far less likely when it comes to cash flow. It is relatively straight-forward for auditors to verify the major cash inflows from borrowings, the major cash out-flows where assets are purchased, and the opening and closing bank balances. It’s thus no surprise that one of the most reliable means of valuing a company is by measuring the present value of future cash flow.

Steven Jones is a registered SARS tax practitioner, a practicing member of the South African Institute of Professional Accountants, and the editor of Personal Finance and Tax Breaks.