New Law Journal – 5 January 2018
Rakesh Kapila offers some helpful insights into understanding financial statements
- Key aspects can affect the value of a set of financial statements to the user.
- It may be important for solicitors to consult forensic accountants for their expertise in interpreting and investigating financial statements before deciding on the extent to which such statements can be relied upon.
Financial statements summarise the performance of a business over an accounting period, usually a year, and its financial position at the end of that accounting period. They are prepared by the management of a business or others, such as accountants, acting on their behalf. It is common for financial statements to be referred to colloquially as ‘accounts’, but ‘financial statements’ is the technical term used by the accounting profession.
Limited companies and limited liability partnerships (LLPs) must comply with detailed statutory requirements covering the form and content of financial statements. There are no such requirements in relation to sole proprietorships and other types of partnership. Financial statements for an unincorporated business are therefore prepared solely for the benefit of the proprietors of the business, but are often made available to the tax authorities and to providers of finance.
This article highlights key factors which will affect the value of a set of financial statements to the user.
Audit & Review
The financial statements of private companies and LLPs which exceed certain size limits or which operate in certain sectors are generally subject to audit, i.e. an independent review by professional accountants who will report on them to the members. Small companies’ financial statements are not normally subject to audit but may be accompanied by an accountants’ report: the scope of this report, however, is likely to be restricted. Companies House may reject financial statements if they do not comply with the disclosure requirements of the Companies Act 2006.
The reliance which users can place on audited financial statements will depend upon whether the auditors’ report is unqualified or not. Even if financial statements are accompanied by an unqualified audit report and have been accepted by Companies House, it is important to obtain access to the auditors’ working papers as part of any financial investigation as these will show whether the auditors’ opinion can be supported by the work which they undertook and may also identify areas in which the auditors experienced difficulty in obtaining adequate evidence or areas in which they disagreed with the company. It is also useful to review correspondence between the business and the tax authorities as, for example, taxable profits may have been adjusted to take account of such issues as private expenditure ‘put through the business’ or queries may have been raised about the level of declared turnover.
Finalisation & Filing
It is essential to obtain the final signed set of financial statements of a business rather than any draft statements, which may not include adjustments made before finalisation. Failure to comply with the time limits set by Companies House for filing financial statements may result from one or more causes such as inefficiency, deliberate delay, problems with the accounting system or disagreements between the company and its auditors, or may suggest that the company is in financial difficulties.
Even if a company is complying with its filing obligations, its most recent financial statements may not provide useful information about its current financial position. As a private company currently has nine months from its year end to file its financial statements, the most recent information available before 31 December 2017 for a company with a year end of 31 March may be the financial statements for the year ended 31 March 2016.
Errors in such basic matters as page numbers and cross-referencing and more substantive mistakes such as inconsistencies between the data summarised in the balance sheet or profit and loss account of a business and the notes to the financial statements will reduce confidence that the financial statements have been properly prepared.
It is important to ascertain whether the relationships between certain key components of the financial statements have followed a consistent pattern over the most recent years: for example, the relationship between stock and turnover for a retailer may be important so that if stock forms a particularly high proportion of turnover in one year when compared with others, the reason for the discrepancy will need to be investigated. Other important relationships include those between debtors and turnover, trade creditors as a percentage of the cost of sales (i.e. the direct costs associated with a business’s turnover), profits and cash flows and borrowings and interest payable.
The extent to which the financial statements of a business can be taken at face value depends on several factors. As the financial characteristics of businesses vary considerably, it is necessary to review the information provided in financial statements in the light of knowledge and experience of the relevant sector.
This article was first published by New Law Journal on 05/01/18, and is reproduced by kind permission.
The information contained in our Articles is provided as general information only. It does not constitute professional advice and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. In addition, since the Articles were published in recent years, the information contained in them may not be applicable at the current time.