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Financial Statements: Accuracy and Reliability

Introduction Financial statements are records of a business’ revenues/expenses and assets/liabilities. These statements are used by stakeholders to get an idea of the performance and state of affairs of an organisation over a period of time. The stakeholders of a company include its shareholders, tax authorities, banks, regulators, suppliers, customers and employees may also be interested in the financial statements. The important question is: What do stakeholders expect from financial statements in terms of qualitative characteristics? An immediate answer depends on the stakeholder and the information he/she is interested in. For example, a shareholder would expect to know about the future prospects of the company while a creditor will be interested in the existing solvency of the company.
Despite these variations in expectations, two characteristics everyone expects from the information in financial statements are accuracy and reliability. Therefore, all measures need to be taken to ensure that the financial statements are accurate and reliable.
What is Accuracy and Reliability of Financial Statements ‘Accuracy’ and ‘Reliability’ may mean different things to different people. Some seem to equate accuracy and reliability with precision while others view it principally in terms of verifiability. Financial information is accurate and reliable when it is free from material error and bias and can be depended upon by the users to represent faithfully in terms of valid description which it is reasonably expected to represent. For example, the representation of receivables in a balance sheet at a specified amount, net of any allowance for bad debts, contends that the stated amount is collectible. However, if the allowance is too small and many more of the receivables are uncollectible, that depiction would not be accurate or reliable because it would not be a faithful representation of the amount that is collectible.
Financial statements should faithfully represent real-world economic phenomena and changes in them. A good example could be the concept of fair value. Representations of fair values should change when the values change and the changes should reflect the degree of volatility in these changes.
In addition, information is accurate and reliable only if it is complete. An omission can cause information to be false or misleading.
Presentation of Accurate and Reliable Information in Financial Statements Accurate and reliable information is accounted for and presented in accordance with its substance and economic reality and not merely its legal form. Reliable and accurate information is neutral, that is, information is NOT selected or presented in a way as to influence the making of a decision or judgement in order to achieve a predetermined outcome.
Accuracy and reliability is affected by uncertainties associated with items recognised and measured in financial statements. These uncertainties are dealt with, in part, by disclosure and, in part, by exercising prudence in preparing financial statements. Prudence can only be exercised within the context of the other qualitative characteristics in the accounting framework, particularly relevance and the faithful representation of transactions in financial statements. Prudence does not justify deliberate overstatement of liabilities or expenses or deliberate understatement of assets or income, because the financial statements would not be neutral and, therefore, not have the quality of accuracy or reliability.
In order to ensure that financial statements give accurate and reliable information, these are governed by regulations. Regulations are meant to harmonise financial statement preparation in a way that they give a true and fair view of the state of affairs.
How Financial Statements are Regulated to Ensure Accuracy and Reliability Financial statements are governed by the requirements of companies’ legislation and pronouncements of professional accountancy bodies and local accounting standards. These directives and pronouncements/standards are meant to ensure accuracy and reliability of financial statements. Regulators apply rules for controlling how an operator reports its financial results. Preparers of accounts have to incorporate disclosures to bring in more clarity. Therefore, regulations prevent preparers of accounts from exercising much discretion in deciding on the accounting treatment of many of the major items in the accounts.
Accounting regulations assure the integrity of financial statements and provide accurate records for by identifying assets and asset values, earnings, benchmarking, monitoring performance on investment and transparency for investors.
Company Law Directives In the European Union (EU), the most important company law directive from an accounting point of view that ensures presentation of accurate and reliable financial statements is the EU Fourth Company Law Directives on annual accounts. Incorporation of the requirements of the Fourth Directive has had a significant impact on the presentation of the income statement and balance sheet in particular by prescribing formats and on the disclosures made therein. With the set formats and disclosures, these directives attempt to ensure accuracy and reliability. The requirement that accounts give a true and fair view comes from legislation. True and fair view can only happen when the information in accurate and reliable.
Accounting Standards Compliance with accounting standards is generally necessary if financial statements are to give a true and fair view. Accounting standards are authoritative statements of accounting practice on how particular transactions/events should be reflected in financial statements. They aim to reduce the variety of practices in the accounting treatment of the matters with which they deal. Implementation of standards has some legal backing in the UK. The authority of the standards derives from the fact that they represent the views of the accounting profession on the appropriate treatment of particular items if accounts are to give a true and fair view.
Accounting pronouncements show a direction where creative interpretations or variations in accounting practices could be inconsistent with the harmonisation objective. There are professional accounting requirements in Financial Reporting Standards (FRSs), Statements of Standard Accounting Practice (SSAPs) and International Accounting Standards (IASs) of the International Accounting Standards Board (IASB).
The IASB’s Framework for the Preparation and Presentation of Financial Statements describes the basic concepts by which financial statements are prepared. This framework serves as a guide to the Board in developing accounting standards and as a guide to resolving accounting issues that are not addressed directly in an IAS or IFRS or interpretation. The IASB and the Financial Accounting Standards Board (FASB) emphasize on qualitative characteristics of accuracy and reliability as being one of the key characteristics of financial reporting.
The FASB has Concepts Statement No 2, Qualitative Characteristics of Accounting Information to refer to, while the IASB has a framework to understand what the components of accuracy and reliability are. The Concepts Statement identifies as its components representational faithfulness, verifiability, neutrality, completeness and freedom from bias. Similarly, IASB framework identifies substance over form, neutrality, prudence and completeness as the components. Both Boards assert that accuracy/reliability and relevance are the key components in presenting decision-useful information to users of financial statements.
Preparers of accountants are guided by the accounting standards or interpretation statements. In the absence of one, management uses its judgement in developing and applying an accounting policy that results in information that is relevant, accurate and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Accounting Framework.
FRS18 also clarifies the legal disclosure requirements as particulars of any departure, reasons for it and its effect
Sarbanes Oxley Act 2002 US based companies and non-US international companies are subject to Sarbanes Oxley Act. The Act introduces more transparency and accountability into the financial management process and also aims at presenting accurate and reliable financial statements. The Act was introduced in 2002 in the US following accounting and financial scandals in the US. The Act has a stated objective to “protect investors by improving the accuracy and reliability of corporate disclosures made.”
Two main requirements of the act that ensure accuracy and reliability of financial information:
Section 302: Certification of Financial Reports
Section 302 requires that financial statements be complete and accurate. To ensure this, the Act makes Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) accountable for the accuracy and reliability of financial statements. The CEO, CFO and an attesting public accounting firm must certify the accuracy of financial statements and disclosures in the periodic report, and that those statements fairly present in all material aspects the operations and financial condition of the issuer.
Section 302 prescribes criminal penalties if CEOs or CFOs knowingly or willfully issue inaccurate statements. Section 302 also requires that material information that is used to generate periodic reports be retained and available to the public.
In most enterprises, information technology systems generate periodic reports and control tools for communicating this information internally. Chief Information Officers (CIOs) are being asked to ensure that these systems are secure and reliable. Because of the criminal penalties, CIOs also sign an internal attestation on their systems to further protect the enterprise in case of CIO negligence in maintaining these systems.
Section 404 – Management assessment of internal controls over financial reporting
The Act also requires that companies verify that their financial-reporting systems have the proper controls, such as ensuring that revenue is recognized correctly. The Act requires all financial reports to include an internal control report. This is designed to show that not only are the company’s financial data accurate, but the company has confidence in them because adequate controls are in place to safeguard financial data.
Ensuring Accuracy and Reliability through Financial Audits Accounting regulations require statutory independent financial audits for ensuring compliance to regulatory requirements. A financial audit is an audit of financial statements. It involves an independent examination by a third party of the financial statements of a company or any other legal entity resulting in the publication of an independent opinion on whether or not the financial statements are reliable, accurate, complete and fairly presented and in accordance with accounting requirements. An audit is designed to reduce the possibility of material misstatement (deliberate or otherwise)
In the UK, financial audits are conducted by the Registered Auditors including Chartered Certified Accountant (ACCA) and Chartered Accountant (CA or ACA). They provide reasonable assurance that the financial statements are free from material misstatement and give a true and fair view of the state of the company’s affairs and its income/loss. It also ensures that the financial statements have been properly prepared in accordance with the Companies Act 1985 or other relevant legislation.
Effectiveness of Regulations in Ensuring Accuracy and Reliability Despite the exhaustive accounting regulations and requirements of enhanced disclosures common concerns remain about the accuracy and reliability of financial statements. Some regulations such Section 404 of Sarbanes Oxley Act help in improving internal controls and therefore help sounder financial reporting by reporting more accurate and reliable information. The restrictions and penalties for misstatement of financial information, the Sarbanes Oxley legislation has made the communication of financial information by companies much more transparent. However, many stakeholders are unsure about the effect Sarbanes-Oxley has had on communication transparency, suggesting that many may not have an understanding of this legislation and its impact on businesses today.
Regulations can be effective in ensuring accuracy and reliability of financial statements only if regulatory compliance can be guaranteed. Regulatory compliance can only be verified through financial audits but cannot be guaranteed as financial audits have their own limitations.
The auditors follow the rules, but those rules are not always effective at uncovering information that is purposely disguised by a dishonest employee. In addition, auditors utilize sampling techniques to test certain transactions during the performance of an audit or review, since it would be nearly impossible and too expensive to test every single transaction. The sampling may be aimed at the largest items or the items on the financial statements that pose the most risk of misstatement. If material errors in the financial statements are discovered, the auditors will direct management to correct them.
Misstatements can be caused by either error or fraud. Auditors have some responsibility for the detection of both errors and frauds that are material, but this responsibility is not absolute. Auditors give reasonable assurance that material misstatements have been uncovered, but not total assurance.
Errors are much more likely to be discovered during an audit than are fraud. Fraud schemes manipulate the accounting system and controls, and therefore it is more difficult for an auditor to find them. In fact, auditors may never detect immaterial frauds. If a fraud is not large enough to make a difference in the financial statements, then it stands to reason that it most likely will not be detected. This will lead to inaccurate and unreliable financial information in the financial statements.
Besides limitations of financial audits, at times accounting standards themselves may pose limitations. Accounting standards are too slow in addressing a number of controversial and at times are too complex. So too are the financial transactions and structures to which they apply. In fact the existing accounting theory shows lot of resistance to change. Also, it is impossible to accurately describe the financial position of a business enterprise using traditional financial statements. The existing accounting standards offer possibilities of manipulation and window dressing of financial statements. This implies that the financial statements are not completely accurate and reliable.
Also, there may be a need for a trade-off between qualitative characteristics prescribed by accounting standards. For example, FASB Concept statement 2 states that, to be useful, financial information must be relevant as well as accurate / reliable and acknowledges that information may possess both characteristics to varying degrees. However, the accounting framework states constraints on information being both relevant and reliable in terms of timeliness. To be relevant information has to be reported without undue delay. This will impair reliability. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little relevance to users. Similarly, the balance between benefit and cost of reporting financial statement information is also one constraint on relevant and reliable information.
Conclusion In conclusion, financial statements may not be completely reliable and accurate and even the most meticulously prepared statement may not give a true, fair view of a business’s financial health. Though accounting regulations are important for financial statements to be accurate and reliable, it is equally important to ensure compliance to regulations. Accounting regulations have not been able to completely ensure accuracy and reliability of financial statements as there is still scope of some subjectivity in interpretation of regulations. Financial audits too do not give total assurance. One also needs to be mindful of the trade-offs and the unintended consequences.
References: International Accounting Standards Committee, International Accounting Standards Explained, Wiley
Henning Kirkegaard, Improving Accounting Reliability- Solvency, Insolvency and Future Cash Flows, Greenwood Publishing
Wikipedia, Financial Audit, Available from http://en.wikipedia.org/wiki/Financial_audit [Accessed 3 December, 2006]
Internal Control: The Coso Framework www.jeffersonwells.ca/News/COSO_May9_Presentation.ppt#13 [Accessed 2 December, 2006]
Out-law.com, U.K Version of Sarbanes Oxley in Force Today Available from: www.out-law.com/page-5505 [Accessed 2 December, 2006]
Dr. Archana Raheja

Cost Volume Profit Analysis: Advantages and Disadvantages

“Cost Volume Profit Analysis is not appropriate in an environment where companies produce many diverse products”.
Cost volume profit analysis is the study of the effects of output volume on revenue, costs and profit (Horngren, Sundem and Stratton). The most common use of cost volume profit analysis is to find break-even point in terms of number of units sold. In its simplest form cost volume profit analysis works for single product companies. But most of the companies produce more than one product. Sales mix is the relative proportion of quantities of different products that comprise total sales. When sales mix changes, break-even point changes and so does the profit.
Like any model, cost volume profit analysis is based on certain assumptions. This paper looks at the applicability of the assumptions, especially for a company producing more than one product. Most of the assumptions in cost volume profit model are based on the linearity of cost and sales with units. Major elements impacting cost are sudden increase in fixed costs, gain in worker efficiency and higher bargaining power of the company. Similarly revenues are non-linear because companies give varying discounts to different customers.
Assumptions made in cost volume profit analysis:
Unit selling price remains constant. This implies that the price of the product or service will not change as sales volume varies. In reality the situation is different as reduced selling prices are normally associated with increased sales volume and this supports the supply-demand hypothesis which states that lowering of price will result in higher sales and vice-versa. It is a common practice in the business world to offer different discounts to different customers based on the volume of purchase and the strategic importance of sale. Companies offer bulk discounts to larger customers. Managers often reduce prices as volume increases to attract more customers. Also stiff competition means selling product at discounts during lean periods or during festive times. Bigger companies producing more than one product have often more than one sales manager and they have their own targets. Each sales manager would adjust his sales volume and price to maximize his products profits and this may not result in ideal sales mix for the whole company. Hence the assumption of constant sales price is rarely applicable in today’s dynamic world.
The realistic sales-output relationship is more like a curve than a straight line. And when a company is selling more than one product, the analysis of break-even point under multiple non-linear relationships becomes more difficult.
The behavior of costs is linear (straight line) over the relevant range. This implies the following assumptions:
Costs can be categorised as fixed or variable. In a large organisation with multi-product it becomes very difficult to organize costs into fixed and variable. Not only there are a large number of costs involved but also there are a large number of cost drivers acting on those costs. Under such circumstances segregating costs into fixed and variable is a very tedious and time consuming job.
Unit variable costs are fixed and constant. It is possible that unit variable costs remain fixed under circumstances like where a company produces just one standard product. Most businesses enjoy benefits of economics of scale as their production increases in terms of
Higher trade discounts;
Better credit and financing terms.
The above benefits result in reduction of variable cost per unit with increase in number of units. The assumption of linear variable costs doesn’t hold true in reality and will result in a situation where the relationship between variable cost and output is a non-linear relation (Williamson).
Also when a company sells many products, unit variable costs can’t be identified properly and hence not known. It is hard to classify variable cost to each product. As an example, a superstore sells thousands of products at different prices. Calculating break-even point in terms of number of units sold would be meaningless. In such scenarios, companies can use total sales and total variable costs to calculate variable costs as a percentage of total sales.
Fixed costs remain fixed over a wide range of activity. Companies, based on their experience and studies, can analyse fixed cost over a range of activity. But it would be improper to assume that fixed costs would remain constant over a wide range of activity. In a multi-product company, different products will take different unit time of various production facilities. A change in sales mix may not be met by existing fixed capacity and involve setting up of further facilities resulting in higher fixed costs. Many times fixed cost has a step change and a particular fixed cost is applicable for a range of production only. Because of sudden change in fixed costs, unit costs can vary a lot just near the step change point. In case of multi product companies, because of change in sales mix, it becomes difficult to access which product has caused the change in fixed costs.
The efficiency and productivity of the production process and workers remain constant. Under economics of scale, efficiency of production processes increases with increase in production of units. Higher production levels should result in lower variable cost due to higher productivity. This means that assumption of constant unit variable costs doesn’t hold true when there is a change in productivity and efficiency. It is easier to calculate efficiency gains in a single product business. But for a company involved in multiple products, it becomes difficult to track efficiency gains in each process.
In multi-product organizations, the sales mix remains constant over the relevant range. It is hardly a scenario where all products perform as per budget expectations in terms of number of units sold. Let’s first examine the scenario where sales-output relationship is a straight line. If products have different contribution percentages, change in sales mix would change overall contribution. A change in sales mix is now basically a question of working out new contribution to sales ratio which is a weighted average based on the number and contribution percentage of each product sold. Change in sales mix would change the contribution ratio and hence the break-even point.
If now sales-output relationship is a non-linear one, it becomes much more difficult to calculate contribution percentage at different sales mix. The use of computer programming has made the task of calculations much easier but managers can miss the learning by just focusing on overall break-even point and profits.
Fearon (1960) reasoned that the problem of maintaining a constant product-mix in a multi-product company may not be that serious because of the following main points:
Break-even analysis is not just to give exact answer, it is more to throw light on the problem areas for management;
Break-even point should be used as approximation and as an area rather than a point;
Over time, multi-product companies reach a stable product mix which changes slowly. Hence constant product mix could be a good approximation for such scenarios; and
Also if company uses constant margin over the cost for all products, then it is much simpler to use cost volume analysis. For companies adopting this pricing strategy, sales mix is not a complex issue.
Ignores the time value of money. Cost volume profit analysis doesn’t take into account the time value of money. All cash flows are taken at face value. In real world, there are differences in timing of cash inflows and outflows. Companies have to pay for buying stock, workers salary, marketing and distribution before they can realize sales. Companies pay interest on any money borrowed to finance their working capital. Companies operating in high margin products can still manage to ignore the time value of money but companies with low-margin products have to take into account interest charges.
There is no change in inventory levels at the beginning and end of the period. This is hardly the case as most of the companies have work in progress at the beginning and end of a period. It can be a coincidence that the inventory levels are same at the beginning and end, but very rarely a company would plan inventory levels in such a way so that there is no net change in inventory during a period. The task of managing inventory with multiple products is even more difficult.
This is not a major issue as companies do stock taking at the end of a period for financial records. But the change in prices over the period and interest on working capital should be taken into account for proper cost volume profit calculations.
Fearon (1960) suggested some techniques to incorporate the product mix in a multi-product company for cost volume profit analysis. Though he suggested five different ways of adopting simple cost volume profit analysis in a multi-product company, he himself wasn’t fully satisfied with any of those solutions. But he mentioned that the sales mix could be approximated to benefit from the cost volume profit analysis.
With all its shortcomings and assumptions, cost volume profit analysis can be used to look at the profitability levels. Companies producing multiple products in today’s dynamic world should carry on the analysis with a view to look at the results as an approximation and not the definite answer. Management should use the results to highlight problem areas.
CONCLUSION Cost volume profit analysis is a common tool used to find break-even point in terms of number of units sold. Assumptions used in cost volume profit analysis are debatable because of linearity of cost and sales price. In real world, both cost and sales price remain fixed only over a narrow range and are impacted by elements like improvement in worker efficiency, bulk discounts both in purchasing and being offered to clients and competition.
When a company produces more than one product, a change in the relative proportion of quantities of different products changes the break-even point and profit. Because of the non-linearity and change in sales mix, cost volume profit analysis will not give a correct answer but could be a good approximation of what levels of production should a company target to break-even or to make certain level of profits. Management should use the analysis to look more at the problem areas and profitability of products rather than finding exact profit numbers.
BIBLIOGRAPHY
Fearon, H. E. (1960). “Constant product mix – A limiting assumption in B-E analysis”, National Association of Accountants, NAA Bulletin, July 1960, Pg. 61
Horngren, C.T., G.L. Sundem and W.O. Stratton. “Introduction to management accounting”. Prentice Hall International, Eleventh edition.
Williamson, D. “Cost Volume Profit Analysis: Its assumptions and their pitfalls”, (http://business.fortunecity.com/discount/29/cvpass.htm), date 21 January 2007

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