Understanding the limits (of financial reporting)

As of July 2021, this is how the section in the HSC Business Studies Syllabus reads.

(We’re in HSC Topic Three: Finance, in Processes.)

“Limitations of financial reports — normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements.”

I found this dot point challenging. What is that students really need to grasp here?

I think about it this way. Financial reporting is extremely important. Investors rely on accurate and timely financial reports to gain a complete picture of a business and make an informed decision about whether to invest.

However, there are problems (what the syllabus calls ‘limitations’) with financial reporting. Therefore investors cannot rely on financial reports to automatically be accurate.

(When we talk about ‘financial reporting’ we’re talking about financial statements — balance sheet, income statement, cash flow statement and so on.)

There are a number of ways financial reports can present an inaccurate picture of a business, and these are the limitations of financial reports. Let’s have a quick look at each of these limitations set out in the syllabus.

Normalising earnings

Businesses can avoid normalising earnings, including one-off examples of income in their financial accounts, to boost their revenue levels and overall profit. As an investor, we want a business to normalise earnings — to exclude one-off injections of revenue.

Capitalising expenses

Businesses can also choose to classify spending as an ASSET rather than an EXPENSE. This is not illegal. However, investors should be aware of the consequences of this — namely overstating profit and understating expenses.

Valuing assets

A business can choose how it values its assets. Again, not illegal. But this will affect the valuation of assets on the balance sheet and MAY NOT be accurate in the context of what those assets are worth, right now, on the market (market value).

Timing issues

In addition, a business can bring forward its expenses or delay recording revenue. This will affect the level of expenses and profit for a given financial year. This could artificially inflate or lower profit levels. Investors should be aware this can happen.

Debt repayments

A business may not present all the information that is relevant to its debt repayments in the financial statements. As a result, investors could find it hard to understand the true solvency of the business, the real story when it comes to the business being able to pay off its long-term debts.

Notes to the financial statements

Finally, a business includes many notes to its financial statements. These can be dense and complex and challenging to understand. As a result, investors may not be able to correctly interpret this information and get a true picture of the state of the business, including its health and performance.

The key point: all of these issues are limitations of financial statements. They can stand in the way of investors getting a complete and accurate picture of the business.

I’ve created a summary sheet of these limitations that can also help. Use it to follow along with the video below.