The balance sheet, the profit and loss account, and the statement of cash flows provide information in a condensed form for ease of comprehension. Readers of these statements, however, may be interested in additional details. Firms are therefore required to provide details for many of the items reported in the condensed financial statements. These details are given in various supporting schedules.
The annual report also contains explanatory notes which elaborate on certain items presented in the financial statements. In additional, there is a statement that spells out the significant accounting policies followed in preparing the financial statements.
Report of auditors:
The annual report contains a report of the auditors on the financial statements. Inter alia, the report of the auditors certifies whether the company has kept proper books of accounts as required by the law and whether the balance sheet gives a true and fair view of the financial position and the profit and loss account presents a true and fair view of the financial performance.
If the report of auditors has qualifying remarks, you must do further investigation to understand the implications of the same.
Report on corporate governance:
SEBI has issued a corporate governance code that has to be compiled with listed companies. The code deals with issues like board composition, audit committee, remuneration committee, investor grievance committee, and board remuneration. The report on corporate governance provides information on the compliance with the code.
Management analysis and discussion:
Firms are now required to include a management analysis and discussion section in the annual report. This section reviews the financial results of the firm, discusses the performance of different businesses the firm is engaged in, explores the opportunities and challenges ahead, presents the outlook for the future, highlights the risks faced by the firm, and provides information on internal controls in place.
Manipulation of the bottom line:
Financial statements reflect revenues, expenses, assets, and liabilities. Corporate managements have some discretion in influencing the occurrence, measurement, and reporting of these items. They often use this latitude to manipulate the reported profits referred to as bottom line. The devices commonly employed for this purpose are:
* Inflate the sales for the current year by advancing the sales from the following year.
* Alter the other income figure by playing with non operational items like sale of fixed assets.
* Fiddle with the method and rate of depreciation.
* Capitalize certain expenses like research and development cost and products promotion costs that are ordinarily written off in the year of incurrence.
* Defer discretionary expenditures to the following year.
* Make inadequate provision for certain known liabilities and treat certain liabilities as contingent liabilities after getting suitable legal opinion from obliging lawyers.
* Make extra provision during prosperous years and write them back in lean years.
* Revalue assets to create the impression of substantial reserves.
* Lengthen the accounting year in an attempt to cover poor performance.
Secured loans are loans that are secured by a charge on the assets of the firm. The charge may be created in the form of pledge or hypothecation of movable assets such as inventories and debtors and/or in the form of mortgage (usually equitable mortgage) of immovable assets such as land, buildings, plant and machinery (which are embedded to earth).
Why do companies manipulate/ smoothen earnings?
A variety of motives prompt firms to manipulate earnings.
* To project an image that the company is a low risk company
* To enhance managerial compensation if the same is linked in some way to reported earnings.
* To promote a perception that the management of the firm is competent.
* To communicate more meaningfully about the long term prospects of the firm.
What Can you do
What can you do to read in between the lines when corporate managements tends to manage the â€˜bottom lineâ€™ by employing a variety of ingenious devices? Our suggestion are as follows:
*Acquire greater knowledge of how accountants prepare financial statements and what are the current financial reporting practices.
* Carefully peruse the notes to accounts in order to: (a) discover changes in accounting policies; and (b) learn about the nature and magnitude of contingent liabilities.
* Read the auditorsâ€™ report and understand the implications of the qualifications in that report.
* Look at the performance of the company over a period of time and do not attach much importance to the figures for one year. Remember that while manipulation may pay for a year or two, it tends to be a self defeating exercise in the long run. This may be a good safeguard against corporate accounting gimmickry.