CCR Chapter 13 PDF

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO ) CHAPTER 13 UNDERSTANDING FINANCIAL STATEMENTS 13-1 UNDERSTANDING FINANCIAL STATEMENTS 13. UNDERSTANDING FINANCIAL STATEMENTS Learning Outcome At the end of the chapter, you will be able to: Key Topics SE FO P R RIN C T O A M B M LE ER...

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO ) CHAPTER 13 UNDERSTANDING FINANCIAL STATEMENTS 13-1 UNDERSTANDING FINANCIAL STATEMENTS 13. UNDERSTANDING FINANCIAL STATEMENTS Learning Outcome At the end of the chapter, you will be able to: Key Topics SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO of accounts and their limitations in financial risk analysis. ) Demonstrate an understanding of the various components of financial statements In this chapter, you will be able to read about: Components of Annual Reports Fundamentals of Statement of Financial Position Fundamentals of the Statement of Comprehensive Income Fundamentals of the Cashflow Statement Limitations of Financial Statements Summary Assessment Criteria During the exam, you will be expected to: Demonstrate an understanding of the various components of an annual report. Outline the fundamentals of the statement of financial position. Outline the fundamentals of the statement of comprehensive income. O T Highlight the fundamentals of the cash flow statement. (N Discuss the non-financial information contained in the financial report. Outline the limitations of financial statements analysis. 13.1 COMPONENTS OF ANNUAL REPORTS A company’s full-year financial statements are typically included as part of its annual report. An annual report is a comprehensive compilation of important accounting and legal information regarding the company’s business results for the financial year just ended. It comprises information deemed important to the public and business stakeholders, such as shareholders and creditors. Generally, annual reports provide financial and non-financial information to the credit officer. This includes information from the directors in office, together with the auditor’s opinion and details of items in the financial statements, supported by CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-2 statutory declarations from identified officers or directors as to the accuracy of the disclosure for the year. It is essential that the credit officer reads the entire annual report thoroughly and not just the financial statements position. SE ) 13.1.1 Financial Information The financial information in the annual report includes the statement FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO of financial position (previously called balance sheet), statement of comprehensive income (previously called profit and loss statement), statement of cashflow, statement of changes in equity, and notes to the accounts. These represent mandatory information which companies must disclose. Financial reporting in Malaysia has converged with the International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board (IASB). With effect from 2013, Malaysian companies are obliged to report their financial results under the adoption of the IFRS in the form of the Malaysian Financial Reporting Standards (MFRS). Non-compliance with these standards obliges the auditor to make a disclosure in the audit opinion. This constitutes a weakness for the company, with analysts judging it a negative action affecting borrowing power. For the purpose of credit risk assessment, the credit officer will conduct a detailed review of the financial information, using the notes to the statements, as necessary. The first step is a review of the external auditor’s opinion of the financial statements along with the notice of the directors who have been O T responsible during the financial year under review. (N 13.1.2 The Statement of Financial Position The statement of financial position is represented by the equation: Assets = Liabilities + Capital Assets are effectively the needs of the business that are financed by the sources of cash in the form of liabilities and capital. The major limitation of the statement of financial position is that the information is historic and static. It reports the financial position of a business at a single, past moment in time, namely, at the end of the reporting period. The numbers in the statement of financial position are recorded on a cumulative basis. In other words, it includes assets that were acquired in the past and continue to be owned by the company. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS As the assets are normally recorded at historical costs, there may be some hidden reserves due to an increase in current fair market valuation. Since the assets have not been sold, the current fair market valuation could be optimistic. Only further investigation can confirm this fact, and if true, the company is in a stronger financial position than that suggested by the statement of financial position. SE ) Essentially, the statement of financial position is used to assess the following: FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Extent of shareholders’ financial commitment in the company, vis-à-vis the company’s other sources of financing such as lenders, trade and other creditors. Snapshot of the company’s short-term solvency. Suitability of the company’s funding structure relative to the nature of business. 13.1.3 The Statement of Comprehensive Income The statement of comprehensive income reflects the management’s dayto-day decisions on the company’s bottom line, as well as the company’s ability to increase the wealth of its shareholders. CASE STUDY: Information Risk – Implications for credit T The statement of comprehensive income is effectively a report card on the performance of the management. The sayings that a company is “in the black” (i.e., profitable) or “in the red” (i.e., loss-making) come from the practice of using red ink to represent debt or losses in statements of financial position. However, a black statement can represent either a distinction or a marginal pass, while a red can mean either a marginal loss or a total failure. Even if a company has performed well, it is important to assess whether the distinction is of good quality or one-off. The assessment of the quality of the earnings will be addressed in the next chapter. O (N 13-3 Example: MAS will be back in the black KUALA LUMPUR: Khazanah Nasional Bhd. is confident that loss-making national airline Malaysian Airline System Bhd. (MAS) will return to the black if it continues to stay focused on improving productivity and yields. Khazanah’s managing director Tan Sri Azman Mokhtar says that given its high passenger volume, MAS has the potential to turn profitable by increasing its yield by at least 10 per cent. “We’ve communicated this to MAS management and board…the issue revolves around productivity and yield actually. “MAS loads are at record high, but at what price? This is the key…If it can improve yield by 10 to 30 per cent, then it will literally be back in the black,” Azman said. (Excerpt from New Straits Times, 21 January 2014). CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-4 Any profit generated by a company, if not paid out as dividend, will add to shareholders’ equity, while losses will reduce shareholders’ equity. The fundamental purpose of incurring an expense in a business is to generate revenue. Hence, the statement of comprehensive income is where expenses are matched against the revenues for which the expenses were incurred. In addition, the revenues and the expenses are accounted for on an accrual ) basis. This means that revenues are recorded as long as they are considered FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO will be recorded even if payment has not been made yet. SE earned, even though they may have not been collected yet. Expenses incurred The statement of comprehensive income has been structured to show two sets of results for users of financial statements: a. The company’s revenue and profit from normal business activities. This section of the results discloses all operating revenue, cost of sales or operations, and operating expenses normally incurred by those business activities. Finance costs and non-related items are disclosed as additional information. The end result of this first part is the net operating profit from core business activities. b. The second part of the statement of comprehensive income provides other details of items not associated with direct business operations, but which have an impact on the profit or loss results of the financial year ended. Under the MFRS rules, the various items will be disclosed here. These items include adjustments in asset valuation and write back of past years’ depreciation provision, as well as foreign currency effects on loans and liabilities. The end result is a final figure to indicate the overall net income for the financial year ended, attributable to the shareholders. T The credit officer would be more concerned about the regular business O activities but should note any unusual effects on non-operational matters (N carried into the comprehensive income statement. 13.1.4 Statement of Cashflow The statement of cashflow essentially reveals the company’s sources and uses of cash during the year. It provides an understanding of the size and sources of cash and how it has been used. The credit officer should understand that profitability is not equal to liquidity or cash. This is largely due to the use of receipts or the accrual system of accounting where income and expenses are recognized ahead of receipts or payments. This results in an early recognition of profit or loss. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS The statement of cashflow enables the examination of the cashflow implications of events in the statement of financial position and the company’s profit and loss activities. For the analysis to be meaningful, it should be reviewed together with the statement of financial position and the comprehensive income statement. SE ) 13.1.5 Notes to Accounts (i.e., Notes to the Financial Statements) The notes to the accounts provide valuable information, particularly FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO concerning the statement of financial position and the statement of comprehensive income. The notes are essential to provide supplementary information and further explanation to some contents of the financial statements. Notes to accounts normally include: a. Significant Accounting Policies The key accounting policies the company has adopted, because its profit and loss, and financial condition can differ under different accounting policies. Among the significant accounting policies reported include: ▶ Basis of accounting: whether the accounts were drawn up using historical, cash, or accrual basis. ▶ Depreciation policy: method and rate of depreciation. ▶ Stock valuation method: the use of first in, first out (FIFO) or weighted average cost formula (MFRS 102). ▶ Income recognition method: for example, percentage of completion or completed basis for long-term contracts, as in the property and construction industries. T These notes will facilitate comparing results between two or more O companies. The credit officer should take note of any differences in policies (N 13-5 adopted by the companies that may have a significant impact on their financial condition. b. Breakdown of Fixed Assets by Categories The breakdown will assist the credit officer in assessing the following: ▶ Whether the borrower has the right combination in the various categories of fixed assets that are consistent with the business nature; ▶ Possibility of the borrower outsourcing some production processes to reduce investment in fixed assets and risk of obsolescence; ▶ Possibility of hidden reserves, particularly if the properties were acquired long ago and not re-valued. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-6 c. Collateral Arrangement for Banking Facilities and Maturity Profile of Term Loans The note provides a general description of the terms of the company’s bank borrowings. This will enable the credit officer to assess the bank’s priority position vis-à-vis other lenders and determine if the bank is at least ranked pari-passu (on equal footing). ) The note may provide constructive notice on whether the company has the SE capacity to encumber its assets and if the company has issued a Negative FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Pledge. A Negative Pledge is an undertaking to the bank by the borrower not to pledge its assets as security for loans granted by other lenders. The note additionally enables the credit officer to form a general opinion on the bargaining position of the company with its lenders. If all the borrowings are unsecured, then it would be difficult for the bank to obtain collateral. Also, the description of the company’s term loans maturity profile, together with past cashflow trends, can provide an indication of its ability to meet future debt service obligations. 13.1.6 Significant Events Subsequent to the Statement of Financial Position This will indicate whether any significant events have arisen after preparation of the statement of financial position and the annual report has been signed off by the directors and external auditors. Such information may have an impact on the future business direction, profitability, and financial health of T the company. O This information is important to credit risk analysis, as the credit officer must (N know the company’s capacity expansion plans and indicative sources of funding, as both factors can affect the company’s gearing. 13.1.7 Capital Commitment Information is provided on the company’s capital commitments entered into during the financial year of reporting but not completed up to the date when the directors and auditors have signed off the annual report. The completion of the capital commitments after the financial year-end might require additional funding. If the amount is significant, the credit officer should investigate further into the importance of the capital commitment to core activity. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13.1.8 Stock Breakdown in Broad Categories The breakdown of the categories of stocks for a manufacturer generally comprise raw materials, work-in-progress and finished goods. This enables the credit officer to check whether the business operates in a consistent manner. Inconsistency in operations may suggest the business has changed its method of procurement and terms of trade, or a warning sign that SE ) something is amiss. The stockholdings should reflect the operating cycle of the business. For FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO instance, for a contract manufacturer, the finished goods level should be low. This is because the company’s production cycle should normally accord with the purchase orders or the buyers’ production schedule. If the level of finished goods is high, it may suggest that some rejected goods have not been written off. This could inflate the profit for the financial year concerned. It may also indicate the possibility of stock obsolescence if it is unusually high. Where stocks provide security, the breakdown allows a basis to evaluate the discount value by each category and assessing the ease of liquidation. 13.1.9 Investments in Subsidiaries and Associate Companies For a company to be considered as an associate or a subsidiary, one consideration is the level of the parent company’s control or significant influence over it. The normal quantitative test of control is above 50% ownership (subsidiary), while significant influence is assumed for ownership of 20-50% (associate company). The information provided for each associate and subsidiary company T includes the name, percentage of ownership, extent of investments, principal O activities, and country of incorporation. This will enable the credit officer to identify the major operating subsidiary and associate companies as well as (N 13-7 assess the parent company’s corporate strategy and synergy. 13.1.10 Related Party Transactions It discloses the company’s transactions with related parties, such as subsidiaries and associate companies. From a credit risk perspective, related party transactions should be investigated by the credit officer to ensure the transactions are at arm’s length and for the benefit of the borrower company. It should not be to the detriment of the lender’s risk position. Related party transactions are usually described in the notes to the accounts in two categories, as follows: CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-8 a. Trade-related transactions, which represent purchases from or sales to related parties, and; b. Advances, which represent amounts owing to or by related parties. SE ) Related parties trade transactions indicate the degree of the company’s dependence on the related parties for its purchases or sales. If there is a high amount of related party trade transactions, it may suggest possible transfer pricing practices especially when there is a tax incentive to do so. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Transfer price is the price at which different companies within a group price their products when they sell or purchase products from one another. As the “transfer price” may not be at the market price level, the credit officer should be concerned the profits accruing to the borrower may be “transferred” to another related company in the Group through transfer pricing mechanism. Advances involving an amount owing by related parties can be treated as a form of capital leakage, while an amount owing to related parties can be considered as a form of indirect financial commitment. 13.1.11 Contingent Liabilities These are not yet liabilities on the statement of financial position date but may crystallize to liabilities at some future date, depending on the occurrence of an event. The details of the contingent liabilities must be disclosed in the notes to the accounts. Examples of contingent liabilities include: (N O T Outstanding major public liability or litigation. Public liability relates to suits involving public damages such as the oil spill by Exxon in Alaska in 1989. If the company were to lose the suit, it could be deemed liable for damages. Litigation relates to commercial suits such as infringing copyrights. Losing such a suit will definitely cause the company to face a court injunction to stop selling the affected product and possibly pay damages. Some companies may not be able to survive if these contingent liabilities become a reality. The credit officer has to assess such risk. Third-party guarantees. These relate to guarantees provided by the company on behalf of its subsidiary or related companies. The failure of the party on whose behalf the guarantee was provided may negatively impact the company providing the guarantee, even though the company is operationally and financially viable on its own. Major outstanding, unrealised financial obligations such as letters of credit, foreign exchange forward contracts and derivative instruments. If these are related to a company’s normal course of business, then the risks are minimal. However, it is important to track the amount to ensure they are commensurate to the level of core business activity and rule out speculative tendencies. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13.1.12 Non-Financial Information In addition to reading the financial statements, there are other important sections of the company’s annual report which provide the user further insights. The non-financial information sheds light on the credibility of the presented accounts. It should not be ignored by the credit officer. However, some of the information is not mandatory under the CA 2016 and may only Malaysia). FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO a. Chairman’s Report SE ) be required if the company is publicly listed on the stock exchange (Bursa This report is only required for companies that are listed on the stock exchange. It normally provides a summary of the company’s performance for the financial year just ended, any milestones achieved for the year, and a brief outline of the company’s future plans. It provides a basis for the credit officer to assess: ▶ major events or activities that took place in the last financial year which can impact the company’s future; ▶ risks or opportunities as perceived by management and how these were addressed; and ▶ future plans, risks, and the company’s prospects In light of this knowledge, the credit officer is able to take appropriate action, for example: ▶ provide more credit lines to finance the company’s expansion plans; ▶ remain status quo and monitor closely; or T ▶ look out for means to reduce credit exposure. O b. Directors’ Report (N 13-9 This is a mandatory report required pursuant to Section 251(2) of the CA 2016. It is effectively an attestation by directors and requires a declaration by the reporting directors that what is reported is true. The report’s content must comply with a prescribed format. This includes: i. Names of the Directors and the Extent of the Directors’ Shareholdings in the Business The names of the directors and the extent of the directors’ shareholdings in the business, including deemed interest, can indicate the directors’ commitment in the business. ii. Acquisitions/Disposals Information on a company’s acquisitions and disposals can indicate if the company has changed its business. In turn, changes to the company’s activities may alter the company’s financial performance and condition. The credit officer should analyse the information to CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-10 determine whether the changes were well-planned with necessary financial and operational support, particularly if the company is venturing into a new line of business. iii. Issuance of Shares or Debentures It is important to know whether the issuance was in the form of cash, along with the intended use of the funds raised. Debentures are debt ) securities issued to investors or lenders in return for financing, such as a SE loan. The debenture can be traded on the stock exchange if listed. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO iv. Provisions for Impaired Debts and Diminution in Value of Assets In analysing this information, the credit officer should consider factors such as under-provision for a negative change in the values of assets, which will result in an overstatement of the current year’s profit. As such, the company’s actual performance may be worse than what is reported, and the financial strength of the company may be overstated. If a debenture over all the company’s assets is taken as security for a loan and the company’s assets are overstated, the lender may end up with security which does not reflect fair market value. v. Appointment of Auditors It is important to note whether there has been any change of external auditor. This could be due to dissatisfaction with the external auditor’s vigilance in the auditing process. A change of the external auditor is sometimes made to bring in “friendly” auditor who is more accommodative to the directors of the borrower company. S 269(3) of the CA 2016 provides for the automatic re appointment of an auditor for a private company. In respect of a public company, the (N O T auditor’s appointment is until conclusion of the company’s next AGM as per S 271 CA 2016. vi. An Attestation An attestation by the company’s directors on its ability to meet the company’s short-term obligations subsequent to the financial year end is required in the annual report. Any reservation made in the attestation can indicate potential problems. vii. Extraordinary Items During or After Financial Year End Where these exist, there is a need to determine the extent of their effect, particularly if they are events subsequent to the financial year end. viii. Other Items Other items in the directors’ report, which are self-explanatory, include: ӽ Summary of results and material movements in reserves or impairment provisions. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS ӽ Arrangement for directors to acquire shares or debentures of the company or other corporate bodies. ӽ Dividend declared. ӽ Other circumstances affecting accounts. ӽ Directors’ contractual benefits. SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO ӽ Share options outstanding. ) ӽ Share options granted or exercised. 13.1.13 Importance of the Directors’ Report Failure to read the directors’ report may result in the credit officer missing out on critical information concerning the borrower that cannot be found elsewhere in the annual report. 13.1.14 Activities Report This is not mandatory unless the company is publicly listed on the stock exchange. It is a report detailing the operations, activities, and achievements of the company by division, department, or geographic location. Hence, it allows the credit officer to be informed of the company’s range of products or activities, enabling the lender to determine the most lucrative or sustaining areas of a company’s core business. 13.1.15 Auditors’ Report Every limited company is required by the CA 2016 to have its annual accounts O T audited. However, under Section 255(3) of the CA 2016, the CCM may exempt certain classes of companies from appointing an auditor. In August 2017, the ROC issued Practice Directive 3/2017 exempting three categories of private (N 13-11 companies, namely dormant companies, zero revenue companies and threshold-qualified companies. The external auditor is an independent party appointed to “verify” the financial statements on behalf of the shareholders. The audit report is addressed to members or shareholders, reflecting the fact that the external auditor should represent shareholders’ interests and not management. However, in some companies where the directors are also the major shareholders, the independent role of the auditor may be perceived as weak or limited. After each audit, the auditor issues a report required by law, which usually contains two paragraphs: a. Scope paragraph: identifies statements examined and states the scope of the examination. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-12 b. Opinion paragraph: expresses the auditor’s opinion of the company’s financial statements, with regard to the fairness of the reporting on the company’s financial position. It is not an opinion on the company’s financial health. Auditor’s Opinions SE ) There are four general types of auditor’s opinions: An unqualified opinion states that the statements present fairly the financial position and results of operations in line with generally accepted accounting principles consistent with those applied in the preceding period or periods. Qualified opinion A qualified opinion indicates that the auditors have some doubt as to whether the statements present fairly the financial position and results of operations in conformity with generally accepted accounting principles consistently. Disclaimer opinion A disclaimer opinion states that because of limitations in the scope of audit, or uncertainties about the future that cannot be resolved or the effect of which cannot be estimated, an opinion cannot be reached. Adverse opinion An adverse opinion states that the statements do not present fairly the financial position or results of operations in conformity with generally accepted accounting principles. This type of opinion is rarely encountered. (N O T FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Unqualified opinion Figure 13.1: The four auditor’s opinions The majority of auditor’s reports express either a qualified or an unqualified opinion. The key phrases distinguishing the former type of opinion are “subject to” and “except for”. The presence of these words suggests immediately that the report is qualified. Before any qualification, the auditor will have alerted the company’s management as to the issues possibly warranting a qualified opinion. All qualifications should be taken seriously, and the credit officer should investigate the reasons for the qualification. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13.1.16 Reasons for Qualifying the Report Some of the most common reasons for an auditor to qualify the report include: a. Compliance with Approved Accounting Standards The Companies Act 2016 (CA 2016) mandates companies to comply with approved accounting standards. Section 244(2) of the CA 2016 requires ) the directors of a company to ensure that the financial statements of SE the company are prepared in accordance with applicable accounting standards which presently is MFRS. Section 244(7) of the CA 2016 prescribes FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO that if a conflict or inconsistency arises between the provisions of an applicable accounting standard and the CA 2016, the provisions of the applicable approved accounting standard shall prevail. Non-compliance is a serious matter, and credit officers should seek clarification from the company as to the reason for non-compliance and assess if it is acceptable under the circumstances. b. Uncertainties Surrounding the Fair Value of Assets This arises when the auditor has doubts concerning the fair value of a particular asset, such as the value of equipment or accounts receivable. In the following sample auditors’ report for Company A Sdn. Bhd., there is a qualification on the value of accounts receivable, as the collectability of an amount of RM533,234 owing by former subsidiary companies was uncertain. If the shareholders’ equity amounts to only RM2 million, then the amount qualified as uncertain is significant. c. Going Concern Ability of the Company is in Doubt This qualification normally appears when the company goes into negative net worth. This means that the shareholders’ equity has been totally eroded O T by accumulated losses and the continuity of the company will require the support of its creditors, including lenders. (N 13-13 13.1.17 Management Explanation The management of the company is given an opportunity to explain and convince the auditor on why the financial statements should not be qualified. If the auditor is not convinced, management will have to rectify the identified issues at hand. The auditor will express an unqualified opinion if management rectifies the issues quickly. If the management fails to rectify the situation to the satisfaction of the auditor after presenting their management explanation, the auditor will express a qualified opinion. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-14 Samples of Qualified Opinions The samples of qualified opinions in an auditor’s report are shown below. EXAMPLE: Qualified Auditor’s Report SE ) Auditors’ Report to the Members of Company A Sdn. Bhd. We have audited the accounts in accordance with the Statements of FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Auditing Guideline and Statements of Auditing Practice and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered appropriate in the circumstances. We are unable to satisfy ourselves as to the collectability of debts totalling RM533,234 (202X: RM536,000) owing by former subsidiary companies for which no provision for impaired debts has been made. Subject to the effects of any adjustment which may arise had the provision for impaired debts mentioned above been subsequently found to be necessary, in our opinion: a. the accounts are properly drawn up in accordance with the provisions of the Companies Act 2016 and Statement Accounting Standard and so to give a true and fair view of: the state of affairs of the company as at 30 June 202Y and of the results of the company for the year ended on that date; and the other matters required by the Companies Act 2016 to be dealt T with in the accounts; (N O b. the accounting and other records and the registers required by that Act to be kept by the company have been properly kept in accordance with the provisions of that Act. Public Accountants 8 December 202Y CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS EXAMPLE: Adverse Auditor’s Report Auditors’ Report to the Members of XYZ Sdn. Bhd. We have audited the financial statements. Our audit was made in accordance with the Statements of Auditing Guideline and Statements of Auditing Practice and, accordingly, included such tests of the accounting ) records and such other auditing procedures as we considered necessary SE in the circumstances. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO We are unable to satisfy ourselves as to the completeness and accuracy of the company’s accounting records, owing to insufficient documentary records and unsatisfactory internal control. Owing to the materiality to the effect of the above reservations, we are unable and do not express the opinion that: a. the accompanying financial statements are properly drawn up in accordance with the provisions of the Companies Act 2016 and Statement of Accounting Standard and so as to give a true and fair view of: the state of affairs of the Company as at 31 March 202X and of the results of the Company for the financial year ended on that date; and other matters required by the Companies Act 2016 to be dealt with in the financial statements. b. the accounting and other records and the registers required by that Act to be kept by the Company have been properly kept in accordance T with the provisions of that Act. O Public Accountants (N 13-15 10 November 202X 13.1.18 Further Notes to the Accounts and Financial Statements Some notes to the accounts are not financial in nature. This provides the credit officer with a feel for the company’s business nature, whose financials are to be analysed. The principal activities described may not fully reflect the true activities of the company. Under Companies Act 2016 (CA 2016), the memorandum and articles of association are now collectively known as the constitution. It is expressly stated in Sections 31 and 38 of the CA 2016 that only a company limited by CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-16 guarantee shall have a constitution; other types of company may or may not have a constitution. It is optional for them. 13.1.19 Detailed Financial Statements When the credit officer receives the annual report from the borrower, the ) report must include the detailed statement of comprehensive income and SE manufacturing accounts. They may not be automatically provided by the borrower as the company is not required by law to include the detailed FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO statements for filing with the CCM. Private exempt companies are not required to have their financial statements audited and filed with the CCM. a. Trading Concern For a trading concern, there is only a detailed statement of comprehensive income that will show all the company’s revenues and expenses for that year. b. Manufacturing Concern For a manufacturing concern, the detailed manufacturing account must be requested in addition to the statement of comprehensive income. The statement of comprehensive income may not provide enough information for a complete analysis. For instance, the depreciation recorded in the statement of comprehensive income is low because it only comprises depreciation charged for office equipment, furniture, and fixtures. The bulk of the depreciation is captured in the manufacturing statement, which represents depreciation charged on the company’s T manufacturing fixed assets, including the factory and machinery. Both (N O statements need to be jointly assessed as they are related. The bottom line in the detailed manufacturing statement represents the cost of goods manufactured, which is an input in the statement of comprehensive income in determining the cost of goods sold. c. Construction or Property Concerns For a construction or property concern, a detailed statement of comprehensive income provides the breakdown of the company’s profits and revenues from its various activities such as construction, property development, rental income, and sale of investment properties. This enables a focused analysis on the various activities undertaken by the company. CERTIFICATE IN CREDIT 13-17 UNDERSTANDING FINANCIAL STATEMENTS 13.2 FUNDAMENTALS OF THE STATEMENT OF FINANCIAL POSITION The statement of financial position is made up of various items of assets belonging to the company and any accompanying debts and liabilities at a particular date. The list of assets and liabilities are drawn from the accounting records, namely the general ledger of the company. The various items in the statement of financial position are classified for better understanding of the users, such as the credit officer SE ) and investors. Figure 13.2 shows the statement of financial position is segmented into assets and FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO liabilities, and each segment is in turn classified in different categories: 13.2.1 Classification of Assets The classification of assets is made by the auditor after considering the nature of business and the characteristics of each asset owned by the company. Generally, assets are classified into three categories. a. Non-Current Assets Non-current assets comprise permanent assets that the business has no intention of selling within the next 12 months. These are assets required to run the company’s main business activities. For an airline business, the fleet of aircraft form part of its non-current assets, just as plantation land is a non-current asset for a plantation company. Other non-current assets include those referred to as fixed assets, such as manufacturing equipment, plant and machinery, office furniture, as well as computer equipment and installation. (N O T Statement of Financial Position Non-current assets Assets Intangible assets Liabilities Current assets Owner’s equity Long-term liabilities Current liabilities Figure 13.2: The structure of a Statement of Financial Position At times, these non-current assets may include strategic holdings of investments in other companies such as subsidiaries and associate companies. While these may be important, they also represent financial resources that are tied up. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-18 b. Intangible Assets The term describes assets that are permanent in nature but not in physical form as with land or equipment. Rather, they are in the form of licenses, copyrights, and brands, as well as expenditure capitalised. This includes capitalised advertising and promotion costs, and oil and gas exploration expenditure pending confirmation of commercial viability. ‘Intangible FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO c. Current Assets SE offs, as considered appropriate. ) assets’ are subject to fair value impairment test annually for specific write- Current assets comprise assets that will be converted to cash within the next 12 months. These are components of the asset conversion cycle such as raw materials, finished stocks, and receivables. 13.2.2 Classification of Liabilities In a similar manner, liabilities are classified by the auditor to indicate their character in terms of urgency of settlement. More urgent liabilities requiring prompt payment are differentiated from those with more lenient terms for settlement. Liabilities can be classified into two sub-categories as follows: a. Current Liabilities Current liabilities comprise obligations that need to be honoured within the next 12 months. Some current liabilities are revolving (e.g., trade creditors, overdraft, and bills payable), while others may not be (e.g., hire-purchase creditors, current portion of term loans, tax payable, and dividend payable). “Revolving” means that whenever an obligation is paid off, the company T will normally be allowed to re-avail the credit. “Non-revolving” means that (N O there will not be any replenishment of cash used to pay off the obligations. Hence, a high level of non-revolving current liabilities will pressure a company’s cashflow in the following financial year. b. Non-Current Liabilities Non-current liabilities comprise obligations that need not be honoured within the next 12 months. However, there is nothing preventing the company from pre-paying a long-term loan if it has the resources to do so. Classification of liabilities is easier as there should not be any inconsistency in the classification. However, some items may appear under current as well as non-current liabilities, such as hire-purchase creditors and term loans. This is due to the accounting requirement that the principal repayment required over the next 12 months be classified as a current liability. The rest of the principal to be paid beyond the next 12 months will be classified as a non-current liability. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13.2.3 Classification of Capital FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Capital can be categorised as follows: SE ) Capital is also known as shareholder’s funds, equity, or net worth when it is added with retained earnings and reserves. It represents the amount of permanent financial commitment of the shareholders in the business, both in terms of paid-up capital and retained profits. It allows the credit officer to gauge whether the financial commitment of the shareholders is sufficient, thereby complying with or compromising the principle of proportionate stake in the taking of credit risk. Share Capital Share capital represents the capital funds put up by the shareholders in the business. It represents a permanent commitment. There are two general classes of shares, namely: a. Ordinary share capital Ordinary shares convey absolute ownership, as the shares come with voting rights. However, ordinary shares do not provide dividend assurance. Ordinary share capital is risk capital of the business. b. Preference share capital Preference shares have restricted ownership rights, as the shares do not come with full voting rights. There is some dividend income assurance but not a guaranteed payment. O T Preferred shareholders have preference in two aspects. Firstly, dividends will have to be declared to them before any dividend can be declared to ordinary shareholders. Secondly, in the event of liquidation, voluntary or involuntary, preferred shareholders will be paid their subscription value before any payment is made to ordinary shareholders. (N 13-19 13.2.4 No Par Value Regime Under Section 74 of the CA 2016, all shares issued before or upon the implementation of this Act, effective 31 January 2017 shall have no par value (NPV). All subscription monies received by a company will be credited to Share Capital Account. Introduction of the NPV regime will not affect the existing rights of a company to issue redeemable preference shares (RPS) under Section 72 of the CA 2016. In the NPV environment, shares are issued at a price to be determined by the directors. Under CA 2016, a newly incorporated company is not required to state its authorized share capital or the nominal value of its shares. Consequently, shares issued at a discount, shares issued at a premium and the share premium account have become redundant. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-20 13.2.5 Reserves SE ) Reserves are funds belonging to the ordinary shareholders and arise due to a number of factors. They are seen as additional value introduced in the company because of a change in the value of the business and its assets or because profit earned has been captured and kept within the company. However, reserves need not be in the form of cash. There are two types of reserves in the statement of financial position: FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO a. Revenue Reserves Revenue reserves arise from the business’s daily operations. They are related to the profit and loss generated by the company each year, and effectively represent the accumulated profits not distributed to shareholders as dividend or bonus shares. The amount can be made available for future distribution. Whenever profits are generated and collected throughout each year, they come into the business as cash. The cash can in turn be used to acquire assets for the business. When the revenue reserves are used for the subsequent declaration of cash dividends, they will decline. Revenue reserves as part of equity are subject to the risk of capital leakage if they are distributed as cash dividends. In a bonus share issue, the amount of revenue reserves will reduce while the share capital correspondingly increase. There is no movement of cash out of the company, and so capital leakage does not occur. It is therefore common for lenders to request that bonus issues be made out of revenue reserves, effectively converting the latter into paid-up shares which are no longer available for payment as cash dividends. (N O T b. Capital Reserves Capital reserves arise from capital transactions such as an asset revaluation exercise and are not profit and loss related. When an asset is re-valued upwards, the asset will be recorded in the statement of financial position at the re-valued amount. Correspondingly, the increase in the value will be accounted for as revaluation reserve. As clearly shown, an increase in revaluation reserves does not cause any cash inflow but is merely a book entry to reflect that the value of the company’s assets has increased. The benefit of such an increase accrues to the shareholders. Capital reserves are not available for distribution as cash dividends, although they can be distributed as bonus shares. This will cause the capital reserves to reduce while the share capital increases. The company’s statement of financial position will be perceived as strengthened, with a higher paid-up capital, without any actual cash being injected. However, the total shareholders’ funds remain the same, as only the composition has changed. There is no concern of capital leakage from distributing this type of reserve. CERTIFICATE IN CREDIT 13-21 UNDERSTANDING FINANCIAL STATEMENTS 13.2.6 Dividend In the CA 2016, the dividend rule is found in Section 131. It has two principles; the dividend is to be paid out of the company’s profits and the dividend should not be paid if the payment will cause the company to be insolvent. SE ) As the directors are the ones who authorise the payment of dividends, they must be satisfied that the company will be solvent after the distribution is FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO made. Section 132(2) of the CA 2016 provides for the liability of the director and manager who wilfully paid or permitted to be paid dividends out of what they knew to be not profit. They are liable to the company to the extent of the amount exceeding the value of any distribution of dividends that could properly have been made. The CA 2016 also prescribes the new liability imposed on the member. Section 133 (1) states that the company may recover the amount of distribution received by a shareholder which exceeds the amount which could properly have been made unless the shareholder has: received the distribution in good faith; and no knowledge that the company did not satisfy the solvency test. 13.3 FUNDAMENTALS OF THE STATEMENT OF COMPREHENSIVE INCOME Revenues and expenses are matched in the statement of comprehensive income to T arrive at the accounting profit for the period. Naturally, the two form the main items (N O in the statement. 13.3.1 Classification of Revenues Revenue items can be broadly categorised as follows: a. Operating Revenue Operating revenue relates to income generated from the core business. However, in the statement of comprehensive income, the definition of operating revenue is broad. It includes income that may not be from its core business. b. Non-Operating Revenue Non-operating revenue refers to income generated from activities that are not part of the core business. It is important to assess whether such income is expected to be recurrent. For example, a company involved in CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-22 the manufacturing business receives some income from the rental of a building. Since this rental income is not from its core business, it will be treated as other income. 13.3.2 Classification of Expenses SE a. Cost of Goods Sold ) Expenses can be categorised in the following manner: FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Cost of goods sold are costs directly incurred for the products sold, such as manufacturing costs, shipping costs, and customs and port charges for imported goods for sale. b. Operating Expenses Operating expenses are expenses incurred in the normal course of business. These expenses can be sub-categorised for more focused analysis into: ▶ general and administrative expenses, including office staff rental of offices, and office maintenance costs; salaries, ▶ selling and distribution expenses such as salesmen’s salaries, commission, and advertising and promotion costs; ▶ finance expenses including interest on loans, bank charges, and fees and impaired debts written off. c. Non-Operating Expenses Non-operating expenses refer to the expenses that the business has incurred but which may not be related to its core activities, for example, legal fees for the acquisition of an investment property, or costs incurred O T due to a major accident or natural disaster. (N 13.4 FUNDAMENTALS OF THE CASHFLOW STATEMENT The cashflow statement provides the credit officer with an explanation of how cash was generated and applied through three critical activities in any business. These activities are operating, investing, and financing. Although comparative statements of financial position will show the amount of the increase or decrease in cash balances, this does not give a full picture of what caused the change. CERTIFICATE IN CREDIT 13-23 UNDERSTANDING FINANCIAL STATEMENTS 13.4.1 Classification of Activities in Cashflow Statement The cashflow statement captures three critical activities that can affect the cashflow of a business in a particular year. Each of these is given prominence in the statement of cashflows and serves to inform the credit officer of some salient points concerning the company’s financial health. ) a. Cashflow from Operating Activities SE The section on cashflow from operating activities examines the cashflow effects from the company’s day-to-day trading activities and its efficiency FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO in managing daily net working capital for the year just ended. The trading activities relate to the profit and loss account items, while the efficiency relates more to the current items in the statement of financial position. b. Cashflow from Investing Activities This is the second section of the cashflow statement. It examines the effects of the company’s strategic decisions (acquisition or disposal) concerning capital expenditure, investment in subsidiary and associate companies, research and development, and other long-term assets on the cashflow of the business in the year just ended. It does not, however, provide any indication of the future effects on the cashflows arising from the company’s strategic decisions. Investing decisions are recorded as assets on the statement of financial position. c. Cashflow from Financing Activities Finally, the cashflow from financing activities examines how a company sources its funds to finance any deficit that results from its operating and investing activities. If surplus funds have been generated, then it will show whether they were used to increase cash holdings or reduce borrowings. T Financing decisions are recorded on the statement of financial position as (N O a liability. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-24 13.4.2 Summary Statement of Cashflow As an illustration the summary statement of cashflow would appear as follows: Example: Statement of Cashflow 400,000 + Depreciation of assets 100,000 FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Net profit after tax SE ) Cashflow from (+/-) operating activities + Provisions for bad debts and stock write down 50,000 + Losses on sale assets 15,000 Profit from sale of assets - 35,000 530,000 Changes in working capital items Decrease in inventories and stocks 350,000 Decrease in trade creditors - 200,000 Increase in accounts receivables - 170,000 Net cashflow from operating activities - 20,000 510,000 Cashflow from (+/-) investing activities - 350,000 Disposal of fixed assets 130,000 Dividend income received 40,000 (N O T Purchase of fixed assets Net cash from (to) - 180,000 Net cashflow before financing 330,000 Cashflow from (+/-) financing activities Issue of additional capital 120,000 Drawdown of loans 110,000 Repayment of loans and interest Payment of dividends Net cashflow from financing activities Net increase/decrease in cash and cash equivalents CERTIFICATE IN CREDIT - 400,000 - 60,000 - 230,000 100,000 13-25 UNDERSTANDING FINANCIAL STATEMENTS In analysing the statement of cashflow, the credit officer should make the following observations: a. The size of the cashflow from business profits (adjusting for provisions and depreciation), as this represents the cash from its selling and production- related activities. b. The change in working capital items, which indicates whether operating SE ) activities are absorbing cash or releasing cash to the business. c. The size of investment activities, particularly the purchase of assets, FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO especially when operating cashflow is not strong, d. The financing of any deficit cashflow including the repayment of loans and dividends to shareholders. This observation is to be tied to the assessment of the company’s ability to make loan repayments during the year, which is calculated through the following debt service ratio: Net cashflow from operating activities Loan instalments + interest payments e. The eventual cash balance or deficit for the next year’s operations, which may have an impact on future liquidity and borrowing requirements. 13.5 LIMITATIONS OF FINANCIAL STATEMENTS Although the financial statements of a company do reflect the nature of the business and reveal considerable information relevant to assessing its creditworthiness, there exist limitations that the lender must appreciate to ensure the accuracy of the risk analysis. Limitations in the statements are: O T 13.5.1 Limitations of the Statement of Financial Position (N Assets are recorded at historical costs and may not reflect current market values. Hence, the statement of financial position may not represent the economic reality surrounding the business at the reporting date. Assets that can be subject to this limitation are fixed assets and marketable investments. As the auditor is supposed to test for any diminution in fixed asset values, any asset that is overvalued would have been reduced to its fair value. However, fair value is highly subjective. The statement of financial position is a static snapshot of the business at a particular point in time. This would suggest that it might be outdated by the time it is analysed, especially as there is usually a lag between the time at which the financial report is prepared and the time when the lender receives copies of the audited report. CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-26 The statement of financial position may be distorted for businesses that experience seasonal swings. For instance, a statement of financial position where the financial year-end coincides with the low seasonal period may reveal unduly low stocks, accounts receivable, accounts payable, and borrowings. The statement of financial position therefore does not reflect the position throughout the financial year. ) Assets that are not expressed in monetary terms cannot be reflected on the SE statement of financial position. These “assets” include human resources, the FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO company’s performance track record, its market reputation, etc. Such assets may be able to contribute to the future success of the company but cannot be quantified in monetary terms. 13.5.2 Limitations of the Statement of Comprehensive Income The income statement reveals the past performance of the business. There is no indication as to whether its future performance will improve or deteriorate. It is the future performance that the lender depends on for debt repayments. As with the statement of financial position, the statement of comprehensive income may also conceal the company’s current state of affairs. For instance, if the business performs well in the first nine months of the year but dismally in the last three, its entire year’s profits may still be commendable. When the audited results are ready four to five months later, the business could in fact have been performing dismally for seven to eight months. Therefore, the lender should not wholly rely on the “latest” financial statements but attempt to obtain some key financial information used internally by the O T company’s management on the results of their most recent operations. (N 13.5.3 Limitations of the Cashflow Statement The statement does not reveal the actual timing of the statement of financial position events or profit and loss activities. Hence, the statement may show that the cashflow for the entire year is satisfactory although the company may have faced some difficulties in cashflow during the financial year. The lender should be aware that the statement is again historical and does not provide an indication of the company’s future cashflow potential. CERTIFICATE IN CREDIT 13-27 UNDERSTANDING FINANCIAL STATEMENTS SUMMARY Financial statements will always be among the most important information that the credit officer must obtain and analyse in depth to assess the borrower’s financial position and financial performance. However, before an in-depth analysis can be performed, the credit officer must have a thorough understanding of all the information contained in SE ) the financial statements. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO To do this, the entire financial statements must be read from end to end. There is no substitute to this approach. Although there are limitations to the financial statements, they still provide important information for the analysis of the financial risks of the borrower. The credit officer must be aware on how the accounting practices adopted by the company can impact the reported results in terms of profits and asset values. It is necessary for the credit officer to take an interest in how special, large or unusual business transactions, such as the purchase of an unusual asset, are being treated in the financial statements. The auditor’s opinion contains an important message as to the fair conditions of the company’s finances via its financial statements. A qualified audit opinion is often regarded as a warning signal on the reported results. PRACTICE QUESTIONS (INDICATIVE ANSWERS CAN BE FOUND IN THE TOPICS LISTED FOR THE RESPECTIVE QUESTIONS) What is the non-financial information that must be published if a company is publicly listed? (13.1.12) O T 1. (N 2. What is the difference between a qualified auditor’s opinion on an annual report and an unqualified opinion? How would you distinguish between the two? (13.1.15) 3. Explain why and how a qualified audit opinion can serve as a warning signal to the bank. (13.1.16) 4. Give examples, with proper explanation, as to why the note on significant events subsequent to the statement of financial position date is important to credit risk assessment. (13.1.6) 5. Discuss the amount of trust the lending bank can place on the audited financial statements of the borrower company. (13.1.15, 13.1.16, 13.5, 13.5.1, 13.5.2 & 13.5.3) 6. “It is pointless to read the directors’ report and auditors’ report as they are usually standard.” Discuss. (13.1.12 (b), 13.1.15, 13.1.16 & 13.1.17) 7. Name three types of contingent liabilities that a company may have and explain the possible implications of each of the contingent liabilities identified. (13.1.11) CERTIFICATE IN CREDIT UNDERSTANDING FINANCIAL STATEMENTS 13-28 8. Explain how detailed financial statements assist in assessing the financial performance of a company. (13.1, 13.1.1 to 13.1 18, 13.1.19, 13.2 to 13.4) 9. Give examples of the need for lenders to reclassify some of the assets in a company’s statement of financial position to enhance the analysis. (13.2, 13.2.1 to 13.2.6) 10. The shareholder’s equity is important to lenders in assessing a company’s financial position. Explain with examples, why the composition of the shareholder’s equity is of ) concern to lenders and how these concerns can be mitigated. (13.2.3 to 13.2.6) SE 11. Explain and illustrate how an increase in net working capital is an application of cash. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO (13.4 & 13.4.1) 12. What are the three critical activities highlighted in a cash flow statement? Briefly describe each activity. (13.4.1) KEY TERMS Liquidity Annual report Negative net worth Bonus share issue Net worth Capital Non-current assets Capital commitment Non-current liabilities Capital leakage Non-financial information Capital reserves Non-operating expenses O T Accrual basis Non-operating revenue Cost of goods sold Operating expenses Current assets Operating revenue Current liabilities Ordinary shares Equity Preference shares Income statement Profitability International financial reporting standards Qualified (N Contingent liabilities CERTIFICATE IN CREDIT 13-29 UNDERSTANDING FINANCIAL STATEMENTS Solvency Revenue reserves Statement of cashflow Share capital Statement of changes in equity Shareholders’ funds Statement of comprehensive income Share premium Unqualified (N O T FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE ) Related party transactions CERTIFICATE IN CREDIT