A financial reporting is a formalrecord of the financial activitiesof the business, person or otherentity.(Wikipedia Dictionary)The process of preparing thecorporations financial statementin accordance with generallyaccepted accounting principles(GAAP). The statement preparedincludes: an income statement, abalance sheet, and a statement ofcash flows.(Real Estate Dictionaries)
Annual Report for a CompanyFor legal and necessity reasons,companies publish a formal report at theend of each financial year. This annualdocuments has three broad sections:Directors report, financial statementsand audit report.Director’s Report FinancialStatements Audit Report
The first section of the annual report, called Directors Report, is a narrative , often in theform of a letter from the company’s chairman to it’s share holders giving three importantpieces of information:Firstly, a comment on the performance of the company during the year to which the reportrelates. This part is often referred to as OFR, i.e. operational and financial review.Secondly, an assessment of what lies in the immediate future .Thirdly, a statement about the company’s policies, principles and strategies developed tomeet the challenges of the future.
Narrative Part of Annual Report:The narrative part of annual report is prepared with great care.Professional writers and designers are hired to touch it up to ensure its acceptability andappeal to the shareholders.A number of graphs , charts and photographs are inserted.Only those issues are talked about which the management feels will be of interest of andappreciated by the shareholders.Sadly, over recent era this report has become to lose a considerable part of its credibility.As more and more investors tend to look at it as a public relations exercise rather than aserious attempt to give meaningful information to shareholders.
The second section of the report comprises of four financial statements, namely;A Balance SheetAn Income StatementA Funds Flow StatementA Statement showing movement in equityEach statement is accompanied with a large number of notes providing explanations Of itemstherein.Notes of accounts are considered in to be as important as the account themselves as they providean insight into the companys accounting policies and manner of treating various financial items.
Example:The method of computing and providing depreciation on fixed assets is avery important issue as it can have a significant impact on profit for the period underreview. Hence, financial Analyst go through these notes as minutely as the financialstatements themselves.
1.INCOME STATEMENT:This statement shows the profit or loss made by the company in the yearunder report. While the statement may not be so clearly demarcated, it iscommon for an Income Statement to have the following three distinctparts;1. Trading Accounts:This part shows the sales revenue earned by the company, the total ofdirect costs incurred to earn that revenue, and the resultant grossprofit earned by the company.
1.INCOME STATEMENT: (Cont…)2. Profit & Loss account:This starts with the figures for gross profit to which are added allincidental incomes, arriving at the figure of gross operating profit. Fromthis figure is deducted the total of all other expenses (overheads) to arriveat the year’s net profit figure.3. Profit & Loss Appropriation Account:This part show how the profit earned during the year is being used. Fromthe figure of net profit for the year, deductions of applicablecorporation tax is shown to arrive at the Profit After Tax for the year.
1.INCOME STATEMENT: (Cont…)To this figure is added the un-appropriated profit brought forward fromthe previous year to arrive at the profit available for appropriation .Theappropriations made in the year (e.g transfer to reserves, write off ofintangible assets, recommendations to proposed dividends, payments ofinterim dividends etc) are then listed, totaled and the total deducted fromthe figure of profit available for appropriation, to arrive at the un-appropriated profit carried forward to the next financial year.Profit & Loss Appropriation Account
2. CASH FLOW STATEMENT:The statement show movement in funds, generally taken to mean cash and near cashitems, over the year. It should be appreciated that definition of accounting net profit is“an increase in net assets (or equity) of a company arising out of its operations”. Anincrease in net asset does not necessarily mean an increase in cash. A number ofexpenses not even paid in cash (e.g. Depreciation), or may have been booked but not yetpaid (e.g. accruals). On the other hand, a number of incomes may not be received in cash(e.g. appreciation in value of fixed assets, or accrued incomes) and may yet be creditedto the year’s profits. At the same time, a part of cash earned out of the year operationsmay have been used to increase the level of certain assets (e.g. increase in stocks), or toretire debt , while some cash may have been received (e.g. from shares issues or loanproceeds) without passing through the income statements.
2. CASH FLOW STATEMENT:KFCStatement of Cash flowDec 31, 2011Cash Cash1. Operating Activities:Cash collection from customers 2,50,000Cash payments to suppliers (85,000)Cash payments for salaries (45,000) 1,20,000Net cash flow provided by operating activities 1,20,0002. Investing Activities:Sale of equipment 30,000Purchase of equipment (36,000) (6,000)Net cash flow used by investing activities (6,000)3. Financing Activities:Cash payment of dividend (35,000)Retirement of Common Stock (25,000) (60,000)Net cash flow used by financial activities (60,000)Total Net change in cash 54,000
3. Balance Sheet:This statement shows the assets and liabilities of the company at the end of the financial year. It iscustomary in the Pakistan to first show the Liabilities side and then the Asset side. The Liabilities sideshows the equity and long term liabilities. The Asset side shows the total of fixed assets, intangibleassets, investments and working capital. Hence, each side of the balance sheet shows the total of capitalemployed.Capital Employed:= Equity + Long term Liabilities= (Fixed Assets + Intangible Assets+ Investments) +Working Capital= Noncurrent assets + Working CapitalEquity: The total of equity of a company comprises of it’s paid up share capital, reserves andun-appropriated profits.
3. Balance Sheet: (Cont…)Long Term Liabilities: These are obligation of a company that are payable afterconsiderable time, at least one year after the date of the current balance sheet.Fixed Assets: These are assets that a company uses to conduct its business with e.g. Land,Buildings, Plant, Machinery, Equipments, Vehicles, furniture and fittings etc.Non-Tangible Assets: These assets have no physical form but have value to the company,as they are capable of improving its profitability. e.g. copyrights, goodwill, trademarks,franchise, licenses, royalties, etc.Investments: These are financial assets held by the company. A company may own sharesand bonds of other company or organization. It could be of two types•Long-term Investments•Short term investments
3. Balance Sheet: (Cont…)Working Capital: This is the excess of current assets over current liabilities at any givenmoment of time. It is shown on the assets side of the balance sheet.Current Assets: These are the assets that are expected to be sold, consumed or convertedinto cash during the normal operating cycle of a company or within one year if the operatingcycle of the company is shorter than one year.Current Liabilities: It is an obligation that must be discharge by a company within normaloperating cycle or within its normal operating cycle, or within one year whichever is longer.Capital Employed: Total of each side of balance sheet represents company’s capitalemployed.
3. Balance Sheet:
4. Statement of Owners Equity:Equity of a company comprise of three parts: Paid up share capital,Reserve and un-appropriated profit. Statement shows how theseitems increased and decreased over a financial year under report.Increase in share capital come from fresh issue of shares, whiledecrease come from redemption of shares.
Notes to the Financial Statements:Notes accompanying the set of financial statements published by acompany provide the following additional information:1.An explanation of accounting methods or policies used. For example,companies are generally free to choose the method of computingdepreciation on their fixed assets. While Ali Ltd. calculate depreciation onits plant and machinery using the staright line method, Bakr Ltd. may wellopt to write down its plant and machinery using the diminishing balance.
2. Greater details regarding certain figures in the financial statements. Forexample, In income statement only one figure of cost of goods sold is given.Details of the various figures making up the cost of good sold during the year aregiven in Notes to the accounts.3. Statutory disclosures. The law require company to disclose certaininformation in their annual accounts. For example, details of remuneration paidto directors and senior managers must be disclosed.4. Changing in accounting policies, methods or nature of business during theyear. If a company changes any of its accounting policies, or start a new line ofbusiness , or abandons a part of its operations, or if there is any significantchange in the manner in which company conducts its business, informationabout such changes must be given in the Notes to the accounts.
5. Details of off-balance sheet items. Certain information may beimportant for the users of the financial statements but it may not have arightful place within the body of any particular financial statement.
The Need for Publishing Financial Statements;Financial statements published by a company at the end of every financial year servethree main purposes:1. The Information Function:A large number of people have an interest in the affairs of company. The persons arecalled stakeholders and include shareholders, lenders, suppliers, customers, managers,employees, prospective investors, relevant governmental departments and the public atlarge. Their only source of information about the financial performance and health of thecompany is the annual report published by the company. These statements thereforeserve to provide vital information to all those who have an interest in the well being ofthe company.
2. The Control Function:On the basis of information contained in the financial statements, shareholders cancontrol the conduct of directors who manage the company. These financial statementswhen compared with others from similar companies can also help the investors setimportant benchmark for measuring the efficiency of the managers.3. The Planning function:Financial statements of one year provide a basis on which to plan or budget for the nextone or next few years. Detailed analysis of financial statements helps to set target andmake attainable plans in light of already achieved standards.
Limitation of Financial Statements:Financial statements are very useful source of information to all those people who havean interest, or stake in the company. However, financial statements suffer from someinherent defects. These are briefly discussed below, along with some adviice on how tominimize the impact of these problems.1. Most balance sheets show values of assets, in particular the fixed assets, at cost lessaccumulated depreciation. These values may be vastly different from the prevailingmarket value of these items.2. Accounting policies of companies differ even within an industry. e.g. one companymay not treat a sale as a sale till the goods are paid for by the customer, whileanother company may book a sale as soon as items are delivered to the customer.
Limitation of Financial Statements: (Cont…)3. Financial statements contain absolute figures. For the purpose of evaluating financialperformance or position, it is often necessary to compare one company’s figures withthose of other companies, or the average of the industry.4. Certain assets and/or liabilities may not be shown in the financial statements. E.g.Contingent liabilities are often shown only in notes to the accounts. Similarly, a companymay opt not to show a disputed receivable amount in its balance sheet till it is actuallyreceived.
Stakeholders interest in financial statements:1. Shareholders use them for deciding how they should vote at the various issues put up forvoting at the annual general meeting. These include approval of dividends, approval ofdirectors remuneration etc.2. Investor use them for making investment decisions like should they continue to hold theshares of this company, should they sell them off, or buy more of them.3. Investment analysts use them for rating the company as well as its instruments likeshares and bonds.4. Major investor use them for making acquisitions, merger or de-merger decision.5. Creditors particularly the long term lenders, use them for assessing the credit worthinessor risk-weight of the company.6. Employees use them for negotiating better terms of employment with the company.7. Management use them as a basis of planning for the future.8. Government, particularly its various tax departments, use them for computing thecompany’s tax liability for income tax, capital gains tax, sales tax etc.
Qualities of Financial Statements:A good set of financial statements should have the following qualities:1. Each statement should be clear and understandable.2. The statements should be reliable.3. The statements should be honest.4. The statements should contain all the disclosures required by the various regulatorybodies.
Responsibility for the health of financial Statements:The parties related to and sharing responsibility for financial statements are;1. The management, who keeps the books, chooses the accounting policies, maintainsthe books of accounts, prepares the financial statements and facilitates the externalauditor.2. The board who oversee the preparation of accounts, prepare the directors report,ensure that all due legal disclosures are made, present the financial statements to theshareholders, and file them with KSE and SECP.3. Audit committee who liaises with the internal and external auditors and recommendsthe financial statements to the Board.4. External Auditor who examines the accounting and related records as well as thefinancial statements and gives a formal opinion on them.
Audit Committee’s Role:The audit committee is the part of Board of directors. It is assigned the specificresponsibility by the board to ensure that financial statements produced by themanagement and audited by the external auditors are worthy of board’srecommendation for approval by the shareholders. In order to achieve thisobjective , the audit committee takes the following steps;1. It review the internal control processes of the company. It approves all of thecompany’s procedure manuals which provides them the opportunity tounderstand how the company carries out its various activities.2. It review the reports of the internal auditor. In this way, committee is able tounderstand and evaluate the efficiency of company’s accounting systems andpolicies.3. It plays the pivotal role in selection of external auditor, carrying out the vettingprocess, and negotiating their terms and conditions.
Audit Committee’s Role: (Cont…)4. It maintain liaison with the external auditors and reviews all his communication withthe company.5. It can go direct to the chairman or the shareholders if it feels that executive directorsare in any way impeding its work.
Misleading Financial statements:Statements are said to be misleading if;1. They are not consistent with the accounting records on which they are purportedlybased.2. They are not based on accounting policies.3. They do not comply with applicable accounting standards and GAAP.4. They do not disclose the true profit or loss made by the company, meaning they donot include all the expenses and incomes, or state them at correct accounts.5. They do not include all the assets and liabilities in the balance sheet.6. They do not value the assets and liabilities of the company correctly.7. They do not provide adequate information or disclosure to help a user understand orevaluate them meaningfully.
Consequences of unreliable Financial Statements:As stated earlier, a lot of people related with the company make a number of their decisionson the basis of its financial statements. For Example:1. Creditors make decision about extending more term or calling back their existing loanson the strength of the financial statements.2. Investors decide about buying more shares, or selling off their present holding in light ofthe information contained in the financial statement.3. Shareholders approves the dividends or expansion program according to what thefinancial statements say.4. Management draws their future plans and employees make their long term decisionsunder the influence of financial results.All these decisions would prove wrong if the financial statements are not reliable,accurate or honest. It is therefore important that the financial statements have the highestdegree of integrity.
Misleading financial statements:There are essentially three aspects of misstatements:1. Over-statement of Profits:a. To meet the expectation of general public or investors.b. To maintain the share price. A decline in profits often leads to reduction in shareprice at the stock exchange.c. To meet contractual obligations with creditors. Some lender lay down very strictconditions in the loan agreements.d. To maintain its image of rising profit.e. To prepare the company for a higher price if a merger or sale of the company is inthe offing.
Under-statement of Profits:a. To save corporation tax.b. To avoid having to pay dividends.c. To smoothen the earnings trend. Hence, a company may under-state its profit bycreating unnecessary provisions, or writing off some non-tangible assets.Misstatement of Financial Position:This means stating assets or liabilities at incorrect values. Assets may over-stated inbalance sheet through provision of inadequate depreciation, stocks may be over-valued,insufficient provisions for doubtful debts may be made to overstate the trade debtors etc.Some assets may be deliberately misclassified, i.e. a fixed asset may be show as currentassets or vice versa. Similarly, some liabilities may be understated or not shown in thebalance sheet at all.
Creative Accounting:“A systematic and intention misrepresentation of the true income and financial position of anentity to achieve certain objectives.” This involves using such accounting policies andtechniques that assist in misstating the financial statements.The Role of External Auditor:Stakeholders attach a lot of importance to external auditor’s report because;1. External auditor is appointed by shareholders, not management.2. He is independent, not a part of the company’s management.3. He is competent to examine the accounts and financial statements and give an opinionthere-on. Only professionally qualified persons can get a license to act as externalauditors to a company.4. He is believe to have a high degree of integrity as he belongs to a profession that isstrictly regulated by a professional body.
The Audit Report:This report is given by the external auditors after they have examined the accountingrecords, supporting evidence and financial statements prepared on the basis of suchrecords at the end of year. It essentially gives the auditors opinion on the financialstatements, generally covering the following areas:a. Step taken by the external auditor to form his opinion on the financial statements;b. Auditor’s opinion on whether or not:o The book of account have been properly kept and are complete in all necessary aspects;o The financial statements are in accordance with the accounting records;o The financial statements give a true and fair view of company’s profit for the yearended and its financial position at the end of the year;o The financial statements provide all the disclosures required by relevant laws.
Types of Audit Reports:1. Unqualified Report: If the external auditor is fully satisfied with the state of affairs, hegives a clean or unqualified repot which indicate that the financial statements are by andlarge very much in order.2. Qualified Report: If the external auditors find some minor irregularities in the accountsor the financial statements which do not materially affect the year’s profit or financialposition at the year end, he may give a qualified report, indicating areas about which heis dissatisfied.3. Adverse Report: If the external auditors finds too many errors and misstatements inthe accounts, or if the accounts have not been properly kept, and the financial statementsgive materially incorrect profit and financial statements are not reliable.4. Disclaimer: If the external Auditors finds hat the book of accounts or supportingdocuments are inadequate for the purpose of preparing meaningful financial statements,he may give a disclaimer., which indicates that he was not able to form any opinion onthe accounting records and/or financial statements due to inadequate records andevidence.
Independence of External Auditor:Financial statements are used by various stakeholders for making a number of decisions. Thedecisions would not prove to be correct if the financial statements are not accurate. With thatmuch importance being attached to the audit report, it is essential that that external auditormust be independent and allowed to do his work independently.The following are some of the means used to ensure the independence of external auditors:1. The firm performing the external audit should not be given any other professional work.If an audit firm earns a large percentage of its total revenue from a particular companythrough fees for audit, accounting, tax, procedure consultancy, financial advisoryservices etc. It is likely that its independence may be impaired.2. Auditor should be rotated frequently so that familiarity does not lead to loss ofindependence.3. There should be no relationship between the partners of an audit firm and company’sdirectors.
Membership of External Auditors:1. All the external auditors are members of Pakistan Institute of Charted Accountants(ICAP).2. This body strictly regulate the conduct of its members, providing them withcomprehensive code of conduct and monitoring their work.3. In addition, SECP also monitor the conduct of audit firms in Pakistan.4. There are also several international professional bodies which issues standards/guidelines for accounting and auditing practices.5. ICAP is a member of most of these international professional bodies and makes itcompulsory for its own members to follow the internationally recognized standardsand guidelines.
International Bodies:Some of these international bodies/ standards are:1. Accounting standards from IFAC2. Ethical Standards for ESB3. Audit Standards from APB (UK)4. Accounting and Audit Review Board (UK)5. Public Company Accounting Oversight Board (Sarbanes-Oxley Act) in USA