Executive summary
Special purpose financial statements that are conventionally provided by small businesses usually offer limited information in both quality and quantity. The main reason behind this is the freedom in reporting that small businesses have. Consequently, lenders have to be careful when using these statements in lending decisions. As a small business, Boat Builders Pty Ltd’s financial statements may not be in a good state as provided to be used in a lending decision. A critical evaluation of whether they represent the true status and performance of this business is necessary before a detailed financial analysis is done. A number of concerns arise from the examination of Boat Builders’ statements. The debtors account on the statement of financial position is undervalued by at least $244 830 while the inventory account is homogenously categorized. Taxes payable of $95 000 have been omitted from the liabilities as well as superannuation payable amounting to $35 922 that appears in the expense account. The leased factory unit is also omitted from the original statements while and the related lease liability, expected to be paid in the current period is also absent from the current liabilities section. After ranking these concerns and asking the proprietor appropriate questions, the above accounts were modified before the financial statements go through a thorough financial analysis.
Boat Builders Pty Ltd Case Study
Special-purpose financial statements
Entities can provide either special-purpose and/or general-purpose financial statements for a number of reasons. Small businesses, however, provide the former mainly due to constraints imposed by inadequate resources and the less stringent and vaguely defined frameworks under which the statements are prepared. The most notable reporting freedom that small businesses enjoy include the freedom to decide on whether to prepare annual statements or not, whether to have the statements audited and the freedom to deviate from the standards imposed by the Australian Accounting Standards Board (Matic, Gorajek, & Stewart, 2012). Conventionally, they prepare special-purpose financial statements that serve specific users, for instance the case of lenders, and therefore the amount of information contained therein is limited (KPMG, 2007). On the other hand, the general-purpose financial statements provide more comprehensive and substantially complete information concerning an entity that can virtually meet the needs of all users of such information. According to KPMG (4), preparation of such statements relies on a profound framework that outlines the requirements of reporting. Medium-sized to large businesses provide this type of statements in compliance with regulatory authority.
As a lender, the nature of accounting information provided by special-purpose financial statements has serious implications for decision-making. The quality of the accounting information that is reported in special-purpose financial information is low (Green, 2003). Consequently, such info may not provide an adequate basis lending decisions from their outset. Higher risks are necessarily associated with accounting information provided by small businesses including Boat Builders Pty Ltd for which this assessment is based. On that account, other information other than Boat Builders Pty Ltd’s financial statements is needed for the proprietor’s comprehensive assessment as a credit worthy client. As a lender, it is imperative that the assessment of the financial statements of small businesses be approached with utmost caution because they might have been prepared to entice a lender, being special-purpose financial statements (Bruner, 2007)
Boat Builders Pty Ltd financial statements
Concerns
A number of concerns have been identified in Boat Builders Ltd’s financial statements that may be attributed to the freedom in reporting explained above. The first concern is over the inventory reported by Boat Builders. Since the Company’s central business involves building boats, it should have a three-part inventory to indicate the level of inventory of raw materials, primarily aluminum, work-in-progress inventory and finally the finished goods inventory (Stice, Stice & Skousen, 2007). Knowledge of the three types of inventory would help in determining the company liquidity level in reality because it may take quite a long duration to complete the process of building a boat. Additionally, the boats in the finished goods inventory may have aged after a long period awaiting sale.
Second is the concern over the debtors account in the statement of financial position. Additional information indicates that DSFE owes Boat Builders $280 000 since May 2003, but the overall figure in this account reported by Boat Builders as at 30th June 2003 was $35 168, an understatement by $244 832. This figure is very large and would significantly undermine the liquidity ratio determination and analysis if omitted. A possibility of other debtors’ accounts being omitted in the Company’s financial statements cannot be overruled. Such an understatement, according to Matic, Gorajek and Stewart (2012), is used by small businesses like Boat Builders that seek to minimize the level of taxes to be submitted to the authority. Consequently, the information provided in such accounts needs careful screening.
Third, the presentation of liabilities does not include taxes that are payable in October 2003 and the information provided regarding superannuation is questionable. Boat Builders expects to pay $95 000 in taxes during in October 2003, despite having a cash balance of only $4 978 on 30 June 2003, and a negative overdraft balance ($4000). Inferably, Boat Builders has omitted this tax liability purposefully from this financial statement as well as the income statement. For the case of superannuation, two discrepancies can be observed. On the one hand, the amount expended in the fiscal year ended 30th June 2003 of $35 922 as reported in the expenditure section of Boat Builders’ income statement is exceptionally high compared to the previous period’s $202. On the other hand, additional information on Boat Builders indicates that the Company is yet to pay superannuation contributions that are due later on in December 2003. The large charge on expense may have been deliberate in order to minimize taxation as is the likely case for omission of Boat Builder’s largest customer’s debt. Inflating this amount from the previous period’s figure would arrive at the same effect.
Fourth is the failure to report leased assets in the assets section of the statement of financial position. Boat Builders entered into a lease agreement in which it procured the existing factory equipment that is expected to end at the end of October 2003. Since the leased asset agreement will come to an end within the current cycle, Boat Builder should present the remaining liability under lease as a current liability, but not a non-current liability as is the case (Stice, Stice & Skousen, 2007).
Finally, the omission of the discount costs on the bill facility is also an issue of concern. The face value of the bill is $220 000, but the reported figure on the statement of financial position is $216 780. Clearly, the bank was allowed a discount on this bill. Effectively therefore, Boat Builders should have expensed the difference in the income statement (Stice, Stice & Skousen, 2007). The concerns noted above undermine the quality and therefore the usefulness of the information provided in the financial statements of Boat Builders Ltd.
Ranking of the concerns and key questions
The concerns identified above vary in significance as regards lending this client. Below is the ranking of these concerns over Boat Builders’ financial statements from the most significance to the least significant with respect to a lending decision.
1. The understatement of the debtors account by $244 830.
This account is of primary significance when determining the liquidity of the business, and the difference identified is very large. For small business lending, liquidity measures are of prime importance and since this misstatement compromises this measure to a large extend, it ought to be the first concern (Vera & Onji, 2010).
2. The presentation of inventory as homogeneous instead of as separate components.
Like debtors, inventory is another crucial ingredient in the determination of liquidity. A boat may take considerable time to build, and considering the fact that Boat Builders operates mainly on tenders, the implication may be that there are no boats in the finished goods inventory, or worse still, the available ones are aged and may not be easily sold. A classification of the inventory may offer more precise information.
3. Omission of taxes payable and superannuation contributions payable from the liabilities accounts. The two are current liabilities and also directly impact on a company’s liquidity. For the case of taxation, the obligation facing Boat Builders in the amount of $95 000 will see considerable cash flow out of the entity and has serious implications for Boat Builders’ liquidity.
4. Omission of the leased asset account (leased factory unit) in the balance sheet and its flawed presentation in the contra account as a non-current liability. The agreement is expected to be called off in the current accounting cycle and therefore any amount outstanding under the lease obligation will require cash outflows. This is yet another reason to worry about the liquidity of Boat Builders as a lender.
5. The least significant concern is omission of the discount costs on the bank bill from the entity’s income statement. Being an expense, this cost reduced the net profit from operations. Although the amount may seem small compared to those under the other concerns, its omission from the income statement compromises the accuracy of important figures both in this statement and the statement of financial position.
Consequently, the following are the questions that the proprietors/accountant of Boat Builders would be asked about the financial statements:
i. Why is the amount reported in the debtors account understated yet DSFE owes Boat Builders $244 832 more than the reported value?
ii. What other accounts may have been omitted from this account considering the fact that even the entity’s largest customer’s account is not accounted for as a debtor in the statements?
iii. What are the proportions of raw materials, work-in-progress and finished goods that make up the inventory reported on the balance sheet and for how long have they been in stock? Justify why the stock of inventory value is the same as last years.
iv. Why were the tax payable and superannuation accounts not included in the liabilities section?
v. How do you justify the omissions of the leased asset account and the bill discount costs from the financial statements?
Modification of the financial statements
In a bid to minimize the risk inherent to low quality information provided in Boat Builders’ financial statements, a modification of these statements is necessary. Based on the answers to the key questions presented above the following modifications are deemed as the most appropriate.
The debtors account balance in the statement of financial position would be updated to at least the level of the amount owed by DSFE ($280 000). Similarly, the level of sales presented in the income statement would also be increased by a similar margin. In this scenario, the major underlying assumption is that Boat Builders may have made an error in recording the correct amounts in both accounts. The two entries are necessary in order to balance the accounts and in event conform to the double entry system (Stice, Stice & Skousen, 2007). In this case, it has also been determined from the response that all other debts have been collected, or otherwise written off as bad debts except for that owed by DSFE and another modification on the inventory. This is why the error has been referenced to DSFE’s debt only. The stock has also been modified to a figure above the previous because Boat Builders had more business in this subsequent period
In the liabilities account, two accounts are opened to take care of the omitted obligations under tax and superannuation contributions that are due in two to three months. The taxes payable account then reflects a balance of $95 000, and a contra account (tax expense) is also debited with this amount because the expense was not recognized in preparation of the accounts for the period ended. Similarly, the superannuation contributions payable is credited with the amount recognized as an expense in the income statement ($35 922).
In the balance sheet, a leased asset account with the carrying amount is opened as well as a lease liability account, with the latter being reflected as a current liability because it is expected to be paid up when the lease expires at the end of October. The bill discount cost is also recognized in the income statement as an expense because it reduced the amount received on the transaction. These figures are given by the proprietors/accountant.
These modifications are presented below:
a) Debtors
Dr $244 832
Sales
Cr $244 832
b) Stock
Dr $15 000
Creditors
Cr $15 000
c) Tax expense
Dr $95 000
Tax payable
Cr $95 000
d) Superannuation expense
Dr $35 922
Superannuation payable
Cr$35 922
e) Leased asset
Dr $100 000
Lease liability
Cr $100 000
Following these modifications, Boat Builder’s accounts will be of better value and can hence be evaluated using financial ratios with a higher level of confidence than before.
Special purpose financial statements provided by small businesses are reported under much freedom and as a result may contain poor quality information that does not meet the information need of lenders. As a consequence, a critical review of these statements and necessary modifications should be done before a detailed analysis involving financial ratios and other performance ratios is carried out.
The case of Boat Builders Pty Ltd best illustrates this crucial stage undertaken by lenders of small businesses.
Reference List
Bruner, F. R. 5th ed. 2007. Case Studies in Finance. Managing for Corporate Value. Australia:
McGraw Hill.
Green, H. C. 2003. Financing the Small Business. Sydney: McMillan Publishers.
KPMG, (2007). Flash Report Australia [pdf] Available at:
http://www.kpmg.com.au/Portals/0/07FR-39.pdf
Matic, M. Gorajek, A. & Stewart, C. (2012) Small Business Funding in Australia. Small
Business Finance Roundtable [pdf]. Available at: http://www.rba.gov.au/publications/workshops/other/small-bus-fin-roundtable-2012/pdf/02-small-bus-funding-aus.pdf
Stice, D.J., Stice, K. E. & Skousen, F. K. (2007). Intermediate Accounting. Sydney: South-
Western.
Vera, D. & Onji, K. 2010. Changes in the Banking System and Small Business Lending. Small
Business Economics, 34(3) pp. 293-308.
