37 The reliability, relevance and trustworthiness of financial statements

Why we need financial information

Financial information is used to make decisions. Financial statements are thought of by many (if not most) people, whether they are investors or non-investors, to be the primary source of financial information about a business or company. Therefore, it may be surprising to learn that, despite their perceived importance, financial statements have a number of significant limitations.

Whether you are an investor, customer, employee, creditor or other stakeholder, it is important to be aware of the limitations, when making decisions based on financial statements.

A focus on the past and not the future

Financial statements focus on the past because historic information is reliable whereas the future, by definition, is uncertain.

By reporting the past, financial statements can capture truthfully what ‘has happened’ because evidence of historic transactions should exist.

Historic information can also be independently validated through external audits, giving investors and other stakeholders more confidence in the reported numbers (see Chapter 20 External financial audit).

Financial statements do not reflect the true worth of a business

A business typically records its asset values at historic cost (known by accountants as ‘book value’). Historic cost does not reflect current market values.

While accounting regulations permit a choice of either historic cost or revaluation as a basis for recording assets (see Chapter 17 Revaluation), a balance sheet does not capture hidden value inherent within a business. Inherent goodwill arises from factors such as reputation, location, brand, customer loyalty, employee expertise etc. Accounting regulations do not permit inherent goodwill to be reflected on a balance sheet (see Chapter 10 Goodwill and other intangibles). Yet, for successful businesses, inherent goodwill will comprise a large (if not the largest) element of their value (see Chapter 28 Business valuation).

A balance sheet may also not reveal all liabilities. Certain liabilities are hidden because they are not known about at the time financial statements are produced, for example claims for faulty products that can be made within a guarantee period. These claims will necessarily be omitted from the balance sheet, until they are submitted by the customer.

How accurate are financial statements?

While financial statements are based on historic information and therefore expected to be reliable, they are nevertheless unlikely, if ever, to be entirely accurate.

True and fair

Financial statements are prepared on a ‘true and fair’ basis, which means that the numbers should be free of significant errors and also not be subject to bias. True and fair is not, however, a guarantee that the accounts are free of all errors. At best, they should not contain significant errors.

Management estimates and judgements

Financial statements include numerous estimates and judgements, many of which may ultimately prove to be inaccurate. Examples of estimates, judgements and uncertainties that directly affect numbers reported in the financial statements (income, expenditure, assets and liabilities) include:

Assets

Purchased goodwill

Purchased goodwill (see Chapter 10 Goodwill and other intangibles) is subject to an annual impairment test to validate that the carrying value continues to be justified. Directors use their judgement to assess the future cash flows, which support the balance sheet value of goodwill. Future cash flows are by their very nature subjective and therefore ultimately a matter of judgement.

Stock

The valuation of stock (see Chapter 11 Stock) can involve a high degree of judgement to assess its likelihood of sale. The value of slow moving or obsolete inventory must be reduced to net realisable value, where this is lower than cost.

Liabilities

Provisions

Provisions (see Chapter 14 Provisions and contingencies) are by nature judgemental and based on assumptions. For example, provisions for claims made against a company can only be estimated once compensation is finally agreed between the parties.

Operating leases

Operating leases carry financial commitments, for which a company is legally liable. Yet, until quite recently, accounting standards did not require the liability in relation to operating leases to be included in financial statements.

Under IFRS 16, for accounting periods starting after 1 January 2019, commitments under operating leases must be included in the balance sheets of companies (see Chapter 9 Tangible fixed assets and depreciation).

Under UK GAAP, operating lease commitments are an example of off-balance sheet financing, although they must be disclosed in the supporting notes to the accounts.

Profit and loss

Many accounting policies involve judgement that impact accounting profit:

• ■Revenue recognition (see Chapter 6 Revenue recognition)
• ■Capitalised expenditure (see Chapter 7 Opex and capex)
• ■Rates of depreciation (see Chapter 9 Tangible fixed assets and depreciation)
• ■Assumptions on accruals (see Chapter 13 Prepayments and accruals)
• ■Impairment charges (see Chapter 18 Impairment)

The risk of fraud

A company’s income, expenditure, assets and liabilities are all susceptible to the risk of fraud. Legally directors have the primary responsibility for preventing and detecting fraud. They are expected to create a control environment in which fraud can be prevented or detected.

Investors, however, can never be certain that the financial statements are free from fraud. For example, where directors are complicit in fraud, they will attempt to conceal this from shareholders.

Unlike directors, auditors are not primarily responsible for fraud detection. Auditors are required to exercise due care and professional scepticism when conducting audits and use professional judgement around estimates. It is important to note that auditors will not check every transaction and may not be able to uncover fraud, especially carefully concealed frauds, where management is complicit (see Chapter 20 External financial audit).

A snapshot of the business

A balance sheet shows assets and liabilities at a particular point in time, typically on the same date each year, to enable year on year comparison. A snapshot taken a day (or even a minute) earlier or later may show a very different picture of the business, in part because of the timing of transactions.

For example, a company may manage its cash resources by delaying payment to creditors owed at the balance sheet date. It could use this cash to pay creditors the day after the balance sheet date. A reviewer of balance sheets prepared on these two different dates would likely form a very different view of the liquidity of the business.

Companies are able to choose their balance sheet date. The choice of date can significantly impact the financial position portrayed. For example, tour operators typically choose a balance sheet date towards the end of the summer, whereas gift retailers select the end of December, as this is when seasonal trading patterns result in the most favourable cash balances.

Can the past be used to guide the future?

A company’s future performance is usually more important that its past performance, especially when making investment decisions (see Chapter 28 Business valuation). While investors and other stakeholders can scrutinise historic financial information, they can only reveal what has happened. While this may offer some reassurance about the ability or capability of a business to generate a similar performance in future years, it is certainly no guarantee about future performance. In short, historic information lacks relevance.

Investors and other stakeholders ideally want information relating to the future as this is more relevant to decision making.

In addition, financial statements are typically significantly out of date. Depending on the size of the company, information may not be published until up to 9 months after the financial year end (see Chapter 21 Information in the public domain).

Financial reporting has moved cautiously towards incorporating forward looking disclosures, for example by including going concern and viability disclosures (see Chapter 25 Insolvency and going concern risk). The reliability of these forward-looking disclosures remains a subject of close scrutiny, however, as does the quality of auditors’ independent assessments of these disclosures (see Chapter 20 External financial audit). This is especially the case whenever there are high profile corporate collapses.

The accounts and audit reports of both BHS (2016) and Carillion (2018), for example, gave little or no indication in their going concern or viability disclosures about survival into the future. Yet both businesses failed shortly after filing their financial statements.

While relevant information is highly desirable, there is a trade-off in that any information provided will suffer from a lack of reliability. The inherent uncertainty of forward-looking statements have, therefore, kept financial statements anchored around their reporting of historic information.

Are there any plans to enhance the reliability, relevance or trustworthiness of financial information?

It is argued that the UK already has one of the strongest corporate governance regimes in the world. However, despite the progress made over 30 years towards strengthening UK corporate governance, there continue to be too many high profile, unexpected, corporate failures and the question of who to blame resurfaces perennially.

The downfall of high-profile companies such as Carillion, Patisserie Valerie and Thomas Cook, amongst others, have heightened the need for urgent reform, specifically around the role and responsibility of directors and auditors.

Proposals to strengthen the UK’s framework for major companies

In response to continued business collapses, the Department of Business, Energy and Industrial Strategy (BEIS) set out proposals in 2021 to reform the UK’s framework for major companies, including the way they are audited. The objectives of the proposals (set out in a White Paper consultation) were to:

The government’s proposals, in particular around respect of financial reporting, directors and auditors, include the following:

The government consultation includes a number of proposals to address this, including the setting up of a new, stand-alone audit profession, underpinned by a common purpose and principles – including a clear public interest focus.

The proposals are far ranging and subject to widespread consultation and therefore may evolve. The full consultation can be accessed on the UK government website.¹

1 gov.uk/government/consultations/restoring-trust-in-audit-and-corporate-governance- proposals-on-reforms