Tell me a story

Analysing financial statements is a key area for the Financial Reporting (FR) exam, and is the area of the syllabus that is used to help prepare FR candidates for the Strategic Business Reporting (SBR) exam. It is also the area of the syllabus where performance varies most between students; a well prepared candidate can often score extremely high, in contrast to those candidates who have not prepared properly and so score very low, or even zero marks.

A well-rounded accountant must always be so much more than a number-crunching machine. The ability to step back, to discuss and to analyse has always been important to the profession. This is the purpose of the inclusion of this type of question in the FR exam, and it is vital that candidates master this skill in order to perform well.

This article will look at what the FR exam is looking for in the answer to an interpretation question, along with the key weaknesses that are consistently noted in candidate answers. It will then examine some of the different types of scenario that candidates might face in the FR exam, and some key recommendations of items to consider for each. Finally, these recommendations are applied to an example to show the difference between a good and a bad answer.

What the examiner is looking for

Candidates are required to combine the information in the scenario with the numbers that they have been given to produce a coherent understanding of the business and why items have moved. This is the specific skill that prepares candidates for SBR. Their answer needs to give succinct, key reasons for the movements rather than stating that performance has improved because sales or profits have moved.

Think of how a business would be analysed in the real world. If you were looking at the financial statements of a large company (for example Netflix) and noted that revenue had increased year on year, you wouldn’t simply state that this was good and leave your answer at that. You would talk about the subscriber numbers or developments into new territories. You could talk about successful programmes, any recent film developments or any significant promotional offers. All of these would contribute to the underlying increase in revenue and should be discussed.

Similarly, in the FR exam, candidates must use the scenario. The exam will give you information in the question, which is there to support you. Just as an analyst commenting on the increased Netflix revenue would be expected to mention the factors outlined earlier, a candidate is expected to use the information in the question to explain the changes in performance or position. Any candidate who does not use this information is likely to score poorly.

A candidate’s answer must be balanced. Often, the requirement may have separate elements to it, such as commenting on performance and position, or asking for further information. It is vital that candidates attempt all of the requirements. If 15 marks are available for analysing performance and position, a good answer should attempt to make 7 or 8 points on both the statement of profit or loss and statement of financial position. An answer that focuses solely on profitability is not sufficiently dealing with the requirement and will not score highly.

Key weaknesses

The examiner’s reports often detail the same weaknesses over and over, and these are essential reading to ensure that candidates do not make any of these common mistakes:

Lack of depth – Candidates often  identify movements in accounting numbers without ever attempting to discuss the reasons why there has been a movement. Candidates sometimes comment that profitability has increased because the profit margins have improved. This is too brief and does not give any meaningful analysis, which should always seek to explain the underlying reason for the movement.

Lack of use of the scenario – Too many candidates are attempting to rote learn what ratios could mean and apply them to the numbers without any consideration for the information provided. A recent example is where an exam question dealt with a company that had acquired a new subsidiary and formed a group during the year. This meant that candidates were presented with consolidated financial statements for the current year and financial statements for a single entity for the previous year. A significant number of candidates attempted to answer the question without even mentioning the acquisition or that they were comparing financial statements that were not comparable (ie group versus single entity).

Calculations without workings – Candidates are often producing ratio calculations without providing workings behind them. This means that candidates are potentially missing out on numerous marks through the application of the ‘own figure’ rule. The June 2018 examiner’s report contains a large amount of detail on this and should be carefully reviewed by candidates.

Types of scenario

1. Comparison of one entity over two periods

This could examine extracts from the financial statements for the same entity over two time periods. The key things to consider here are any developments or changes in the business between the two years, and whether the performance and position of the entity has improved or deteriorated. As stated above, this always needs to be supported with the reason (or potential reasons) for the improvement or deterioration.

Candidates should also consider one-off events that could skew comparison. If these exist, the question will normally ask you to strip these out of the accounting numbers and recalculate ratios to show the underlying position for comparison. Candidates should also be considering the impact of any new products, or changes in customers or entries into new markets.

2. Comparison of two entities in the same period

These types of question might be based on two competitor firms and ask candidates to compare their performance or decide which is more suitable to target for acquisition. Candidates should consider if there any differences in accounting policies which might skew the comparison. There may also be useful information about which areas of the market the company targets or information about significant customers.

If the question includes an acquisition, candidates should look at the liquidity of the companies and any possible synergies that could be made through purchasing either of the entities

3. Comparison of an entity with the sector averages

In a scenario such as this, candidates should give consideration to the fact that different entities in the sector will have different margins as they target different ends of the market. Also firms may have different year ends, which could skew the comparison. Finally, consider if the entity in question has different accounting policies to the rest of the sector.

4. Analysis of consolidated financial statements – acquisition of a subsidiary

If a candidate is asked to analyse consolidated financial statements, they must consider group-related issues, rather than treating it the same as the analysis of a single entity. Consideration of the fact that there may be different entities with different margins is necessary, as well as the fact that some transactions such as intra-group sales or unrealised profits will need to be eliminated. There may also be issues to deal with such as goodwill impairment which would not incur in individual financial statements. Finally, analysis of consolidated financial statements could involve either an acquisition of a subsidiary or a disposal of a subsidiary.

In a situation with the acquisition of a subsidiary, it is important to note that the results will not be comparable year-on-year. The current year will have consolidated the results of the subsidiary , whereas, the previous year would not. The subsidiary may be in a different market, with different margins and payment terms, so this could have a significant impact across all of the ratios.

Consideration should also be given as to when the subsidiary was acquired during the year; there may be a mid-year acquisition in which case there will be an impact on both the consolidated Statement of Financial Position (SOFP) and the Statement of Profit or Loss (SOPL). The results in the SOPL will include the profits of the subsidiary since acquisition. The statement of financial position will include the full assets and liabilities of the subsidiary. This means that ratios using elements of both performance and position will present a complex picture for candidates to analyse. For example, if a subsidiary is acquired six months into the year, then only six months revenue will be included, but the entire receivables balance will be included within the statement of financial position. This would give a false impression of the receivables collection period if this was used to calculate this ratio.

If the subsidiary was purchased at the year-end there will only be an impact on the SOFP (but not the SOPL). There may also be elements of one-off costs incurred associated with the acquisition of the subsidiary. These are unlikely to be repeated, so candidates should consider these and consider calculating ratios excluding these figures.

5. Analysis of consolidated financial statements – disposal of a subsidiary

If a subsidiary has been disposed during the year, then the consolidated SOPL will only contain the results of the subsidiary up until the date of disposal, rather than for the full period. The SOFP will not contain any assets or liabilities of the subsidiary since it has been disposed. Therefore, similar to as noted above, any ratios combining information from the SOPL and the SOFP may not show an accurate picture due to this mismatch. Candidates would be expected to spot this and talk about the limitations of this comparison.

There are also likely to be one-off items relating to the disposal. These might include gains or losses on disposal, any potential closure or redundancy costs, and any professional fees associated with the disposal.

6. Analysis of cash flow information

In questions that require the analysis of cash flow statements, tThe first key figure to discuss is the cash generated from operations. This shows how much cash the business can generate from its core activities, before looking at one-off items such as asset purchases/sales and raising money through debt or equity. The cash generated from operations figure is effectively the cash profit from operations.

Candidates should then consider other cash inflows and outflows from the remainder of the cash flow statement. Consider these in/outflows are one-off items (such as purchases or sales of non-current assets), or regular in/outflows such as interest paid or tax paid.

Candidates should not simply comment on the overall movement in the total cash and cash equivalents figure in the year. An increase in this figure will not simply mean that the entity has performed well in the year. A situation could easily arise where an entity is struggling to generate cash in a period and is forced to sell its owned premises and rent them back in order to continue to trade. This may mean that the entity’s overall cash position increases in the period, but is clearly not a sign that the entity has performed well. This should cause significant concern, as the entity cannot sell the premises to raise cash again in the future.

Example

The following financial statement extracts are for Janssen Co for the years ending 31 December 20X7 and 20X8.

 

20X8

20X7

 

$000

$000

Revenue

35,100

42,300

Cost of sales

(24,200)

(27,400)

Gross profit

10,900

14,900

 

 

 

Trade receivables

2,400

1,500

The following information is also relevant.

Janssen Co is a manufacturer of confectionary, selling through supermarkets and small convenience stores. In recent years there has been a decline in demand following concerns over the level of sugar in confectionary products. To combat this, in July 20X8 Janssen Co rebranded some of its chocolate bars as health food supplements and began to sell them to chains of gyms and hotels, in addition to the existing confectionary lines.

Janssen Co reduced the selling price on other items by 10% to combat the falling demand. Janssen Co also outsourced its packaging to a third party, whereas previously Janssen Co had packaged its own goods.

Answer tips

In the exam, most candidates would calculate ratios correctly, as these are pretty straightforward. This would give the following:

 

20X8

20X7

Gross profit margin

31.0%

(10,900/35,100)

35.2%

(14,900/42,300)

 

 

 

Receivables collection period

25 days

(2,400/35,100 x 365)

13 days

(1,500/42,300 x 365)

Remember to provide workings for your ratios as demonstrated above (unless the spreadsheet answer space is used where cell formula might be used to calculate ratios).

The most common errors in the analysis would be to comment on the numbers above without a single consideration of the scenario. Based on these figures, there would be many comments such as:

  • Gross profit margin is down, meaning Janssen Co is generating less profits from the core product
  • Janssen Co may be managing costs poorly
  • Janssen Co may have changed supplier
  • Janssen Co may have a risk of irrecoverable debts

These answers do not have sufficient depth to score significant marks. Candidates cannot simply learn what a decrease in the ratios could mean, and apply these generic reasons across each exam diet. None of these bullet points really consider what we know about the entity, and will score poorly because of that. Typically many candidates fail to even comment on the movement in revenue because there is no ratio to calculate. Therefore they would omit it from their analysis, despite it being a key accounting number.

A much better answer would consider what we know about the business, and what we would expect to see happen to the figures. The answer below shows how candidates should be combining the information in the narrative with the figures calculated to come up with the key reasons why accounting numbers have moved.

Revenue – decrease of $7.2m, which is a fall of 17%.

The fall in revenue is likely to be driven by the decreased consumer demand following the concerns over sugar.

We would potentially have expected an underlying decrease in the confectionary revenue as Janssen Co cut the price by 10%. This suggests that the reduction in sale price has not resulted in the increase in volume that Janssen Co may have hoped for.

It may also mean that the move into the new market has been unsuccessful, as the demand for the sports food supplement may not be there.

It is also important to note that the product was only launched in July 20X8 so may not have had time to generate significant sales yet.

A candidate who has commented on the items above is likely to score 4 marks. All of those points are using the scenario, telling the reader a story which is derived directly from the question. This will significantly outscore the student who states that the decline in revenue is a poor sign for the business and not much else.

Gross profit margin – fall of 4%

Whilst the fall in gross margin is a poor sign, this is surprising as Janssen Co has cut the price by 10%, so a fall in gross profit margin of greater than 4% may have been expected.

We are told that Janssen Co has outsourced its wrapping department. This move may have led to a reduction in cost of sales, enabling Janssen Co to offset some of this price reduction.

The new products launched may have a higher gross profit margin than the remaining confectionary products, as they are aimed at a different market.

Candidates who produce comments like those noted above will score significantly higher than those making generic comments regarding cost management. These comments are based around the scenario and are bringing in sensible commentary based on what would be expected to be seen. This is what the exam is looking for, rather than simply stating that a decrease in the margin is a negative thing.

Receivables collection period – increase of 12 days

Previously Janssen Co made the majority of its sales via retail outlets, meaning that there would have been almost no credit terms on the majority of its sales.

The increase in receivables is likely to be due to the new contracts with gyms and hotels, as these are likely to have negotiated credit terms with Janssen Co.

A high proportion of Janssen Co’s sales are likely to remain as retail sales, which would aid Janssen Co’s cash flows even with this introduction of new credit terms.

These are the kind of comment that will score marks. Comments referring to ‘ideal’ receivables collection periods of 30 days are likely to not score anything. These are rote learned and not what the examiner is looking for.

Summary

The analysis question is likely to be one that continues to divide candidates. By taking a step back, making sensible points and basing these points on the scenario, candidates will ensure that they are performing towards towards the top end of the range of marks. So, don’t simply comment on the movements in numbers without explaining ‘why’, move away from the ‘textbook’ answers, don’t suggest answers with are not based on the scenario, and make sure you tell the examiner a story!

Written by a member of the Financial Reporting examining team