Chapter 3 • Financial statements and their interpretation
Problems with accounting figures
Earlier in the chapter, we considered the nature of accounting information and problems
with using it. In the context of accounting ratios, there are probably two particularly
significant weaknesses. First, there is a tendency for the income statement to overstate
profit, relative to a more true assessment of the amount of wealth created; and second,
there is a tendency for balance sheet figures to understate the amount of wealth that is
tied up in the business. The combination of these raises a particular problem when we
are dealing with ratios that are calculated using one figure from the income statement
and one from the balance sheet. A good example of this is the return on capital
employed ratio. For example, would it be wise to conclude that Jackson plc’s return on
net assets of 19.0 per cent for 2008 represents a better return than bank deposit account
interest of, say 5 per cent, even ignoring the disparity in the level of risk?
Another problem with using balance sheet figures is that they represent the
position at a single, defined, point in time. This point in time, the particular business’s
accounting year end, may not be typical of the business throughout the rest of the
year. This may be true by design: for example, management may choose a particular
year-end date because inventories tend to be low at that time. It is quite common for
businesses to have to carry out a physical count of the inventories at the accounting
year end, and this task will be made easier if inventories levels are low. Using year-
end balance sheet figures may therefore result in ratios that are unrepresentative of
the business’s performance during the year and may, in turn, lead to inappropriate
decisions being made about the future course of the business.
Cadbury Schweppes plc, the confectionery and drinks business, mentions in its
2006 annual report that the balance sheet date represents a low point in the business’s
seasonal borrowing cycle. This is presumably to warn readers that the business’s
borrowings, shown in the year-end balance sheet, are unusually low compared with
the position at other times in the year.
Where a particular ratio relates a balance sheet figure to one from the income
statement, there is a further problem. The balance sheet represents the position at a
particular point in time, but the income statement summarises a series of transactions
over the period. If the balance sheet figure is not typical of the period, this can lead to
distorted ratios. For example, we calculated the return on capital employed for
Jackson plc by relating the operating profit to capital employed at the endof the year.
Yet it is clear that at other times in the year the capital employed was not the same as
the year-end figure (see the 2007 balance sheet, in the appendix to this chapter). In
other words, the funds that were invested to generate the £135 million were probably
less than £709 million for almost all the year.
An obvious solution to this problem is to average the opening and closing capital
employed figures and use this in the calculation of the ratio. This would give a ratio
for 2008 of 19.9 per cent (that is, {135/[(651 +709)/2] ×100%}), compared with the ori-
ginal calculated figure of 19.0 per cent. As we have already seen, it is not necessarily
the case that the balance sheet figures are representative of the rest of the year. Here
simply averaging the start-of-year and end-of-year figures may not do much to
remove the distortion. This will not pose a problem to those who have access to the
underlying figures, because they can deduce a more representative average figure.
Outsiders can do no more than average the figures that are available.
Although International Financial Reporting Standards seek to increase the extent
to which financial statements are prepared on a consistent basis from one business to
another, there are still areas where one business may legitimately deal with the same