We continue our series of articles meant to help shareholders in their investment decisions. In this second article, we look more closely at Costs estimated to be incurred in the future, but which relate to the current reporting period.
In the previous article we saw how it was possible for companies to magnify revenue in a given period, simply by applying “judgement”. We also learnt how investors can protect themselves by asking questions like:
- “How is revenue earned in this business?”
- “Is this a reasonable way to define revenue?”
- “Which period does this revenue relate to?”
- “Is this how other competitors define, measure and match revenue to expenditure?”
In this second article, we look more closely at Costs estimated to be incurred in the future, but which relate to the current reporting period. Companies have to apply the matching concept under IFRS in order to match revenue in a given period with the corresponding costs that give rise to that revenue in that given period. This matching is necessary, and when these costs are uncertain, they must be estimated. This means judgement must be applied. And where there is judgement there is room for imagination and creativity! So, shareholders, be aware and ask the right questions!
What to watch out for
Some typical examples of where future costs need to be estimated and reported in the current period are:
- Inventory that is expected to become obsolete in future periods is a loss that should be reported in the current period, i.e., in the period when the decision to purchase the inventory was made. If the loss is shown in a future period, that would mean that the current period overstates profits (and bonuses to management!) while future periods overstate losses (and by then those managers that were responsible for these losses will have gone on a permanent holiday with hefty rewards!).
- Receivables that become bad debts in later years as clients default should also be estimated and shown in the current period, i.e., in the period when the sale was made and the decision was made to extend credit to the customer. Again, if we do not apply the matching concept, i.e., matching costs with the related revenues, then current profits will be overstated and future periods will overstate losses.
- Goods returned from customers in later periods will obviously be shown as “losses” or “costs”. But which period do they relate to? The corresponding period that these “costs” must be matched to is the period in which the sale was effected. Therefore an estimate must be made as to the cost of such future returns, and show this as a cost of the year in which the sales were made.
There is no end to the examples where companies should make provisions for future costs when they know it is likely that such costs will arise. Estimates can either be inflated to overstate future revenue and reserves, or these estimates can be diminished in order to achieve the exact opposite result: it just depends on what suits the management!
We will focus here on a few examples that bring out the importance of the matching concept and show what sort of behaviour shareholders should watch out for. Let us look into some real life cases and see in detail the various elements of the transactions:
Example 1 – Prudence
The management of a company have changed the composition of the board. Consequently, the new management started to “clean” the balance sheet of any asset that was suspected not to generate benefits in the future (by definition the management are using the balance sheet to make certain declarations – or as they are technically known, ‘’assertions’’ – e.g., to communicate that this asset exists and the value attached to it is the least it is expected to generate in the future).
Management also went on to create provisions for all possible risks, e.g., the reduction in the value of the asset due to obsolescence or change in technology, and so on. This approach resulted in heavy losses in the first financial year of the new management, but of course these were losses that were the responsibility of the previous management! The following year it turned out that the company was “over prudent” as far as (a) doubtful debt provision, (b) fixed assets impairment provision and (c) provision for legal cases were concerned. The management then reversed some of these provisions which resulted in overstated profits in the second year of their management and a related big bonus!
Example 2 – Unfinished projects
A construction company with year end 31 December 200X had a number of ongoing construction contracts: the profit for the year was tiny compared to the revenue and prior years’ profits. Management were desperate to show any profit in that current year and instructed their accountants to deliver one! Although the head accountant knew that losses expected on unfinished contracts should be recognised immediately in the income statement, she picked one loss-making contract and recognised profit relating to that current year while ignoring the unfinished part of the contract that related to future years. If she properly provided for the expected future loss of the contract as at 31 December 200X, the company’s profit for the year would turn into loss. It is a basic accounting rule that once a future loss is in sight then that loss must be shown immediately in the current year. However, ‘’judgement’’ may lead one to believe that there are no future losses in sight!
Example 3 – Residual value
Yet another real-life example relates to residual values of assets (i.e., the value estimated at the end of its life, otherwise known as scrap value). Management is supposed to estimate residual values of assets every year and review their estimates with any new information that comes to their knowledge. So if you buy a piece of equipment for 100 million euro to use for four years and agree to sell it back at the end of the four years for 20 million euro, then the cost of this piece of equipment over the four years is 80 million euro. But if judgement leads one to estimate that the piece of equipment will be sold back for 35 million euro then a 15 million overstated profit will be reported over the four years!
One transport company operating with 900 trucks had an agreement with the truck supplier to buy back these trucks after 4 years. Had the company properly recognised the residual values, then on the day when these trucks were sold back to the supplier the company would recognize neither profit nor loss. This was not the case: the company had to recognise significant losses in the year when the trucks were sold back to the supplier because the residual value was overstated in the previous years. By that point, the members of the management board were probably not all there! But they would most probably be enjoying their past bonuses at that point.
Do not assume reported costs and revenue are correct – protect yourself by asking questions!
So, to avoid lost investments, here are the questions that shareholders should ask before making investment decisions:
- Are there items in the financial statements that may have a future impact on the profit or loss?
- Are estimates made for these uncertain events?
- Are the measures of these estimates clearly shown and do they look reasonable?
- Is there sufficient disclosure and explanations of these estimates in the notes of the financial statements?
- Do these estimates compare to what other companies in the same industry and environment do?
IFRS and judgement
As analysed in our previous article, reporting under IFRS requires judgement in deciding how and what numbers are to be reported. At the same time, the objective of IFRS is to implement standards that will prevent “creative” reporting, which hides costs and shows profits that do not exist.
In the next article we will look at the Balance Sheet and how assets are valued, as well as how this valuation may have an impact on the shares of the company.
If you liked this article, please consider following GnosisLearning for more top quality IFRS analysis. We will return in the New Year with more helpful IFRS analysis for shareholders. In the meantime, all best season’s greetings to all our readers!